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Omega Healthcare Investors (OHI)

We published an updated look at Omega's ongoing turnaround efforts in August 2018. You can find our latest analysis of the firm's dividend safety here.

Founded in 1992, Omega Healthcare is America’s largest skilled nursing facilities (SNFs) REIT, with approximately 1,000 properties rented to 77 operators across America and the U.K.

Approximately 84% of the company's total rental revenue is derived from SNF facilities, which are Omega Healthcare’s specialty; senior housing accounts for the remaining 16% of rental revenue.

Patients discharged from hospitals are sent to SNFs when they still require care or rehab before they can be sent home. Compared to hospitals, SNFs can provide short-term care on a more affordable basis to save healthcare costs.

Approximately 88% of Omega Healthcare’s total revenue is from rents paid by its tenants, who primarily receive revenues through reimbursement of Medicare, Medicaid, and private pay for their services. 

The remaining 12% of Omega’s revenue comes from loans and mortgages it finances to construct third-party facilities.

Business Analysis

Omega Healthcare is the largest SNF-focused REIT with more than twice as many properties as its next largest competitor. The business has been playing the role of consolidator in this large and fragmented market, compounding its gross investment base by more than 20% annually over the last decade.

Omega boosted its property count by nearly 50% in April 2015 with its $3.9 billion acquisition of Aviv, which helped the company gain operating, growth, and cost of capital efficiencies. Importantly, the deal also increased Omega’s diversification by state and operator; no state or tenant accounts for more than 10% of total rent. 

This diversification helps prevents the company from being overly exposed to unexpected headwinds that could emerge at any given tenant or in any particular state as it relates to issues such as government reimbursements.

While the skilled nursing industry certainly has its share of risks (more on that later), there are also several attractive elements. Most notably, the industry’s long-term supply and demand fundamentals appear attractive.

From a demand standpoint, Omega’s occupancy rate has consistently remained in excess of 80% thanks in part to the non-discretionary nature of its operators’ services. More importantly, despite various changes in Medicare and Medicaid, which have affected rates and shortened lengths of stay, the continued aging of America’s senior population means that overall patient volume and pay per day is expected to increase in the future.
Source: Omega Healthcare Investor Presentation

Furthermore, SNFs seem likely to remain a primary choice for post-acute care because they offer one of the most cost-effective environments for rehab services due to their relatively smaller footprints and lower staff counts. As a result, SNFs have received about 50% market share of patients sent to post-acute care in recent years.
Source: Omega Healthcare Investor Presentation
Looking at industry supply, the number of facilities and beds to meet increasing future demand has been limited in part due to Certificate of Need (CON) restrictions, which are aimed at restraining health care facility costs and have helped support industry occupancy rates.

However, it’s also true that there just hasn’t been a big need yet for more supply with the industry’s occupancy rate hovering around 80% and the number of patients in certified beds flat to down since 2009. Many of the expected demographic benefits have yet to show up in the numbers.
Source: Omega Healthcare Investor Presentation
For now, Omega estimates that SNF occupancy will exceed industry capacity in less than 10 years without efforts to reduce lengths of stay and increase utilization of alternative care sites. As you can see below, the number of SNF residents is expected to increase substantially in the years ahead as the population continues aging.
Source: Omega Healthcare Investor Presentation

Besides the company's fast pace of acquisitive growth and industry's potential to show improved fundamentals over the long-term, income investors have been attracted to Omega Healthcare's business for several other reasons.

First, Omega Healthcare uses triple-net lease agreements, which are generally thought to have less risk because they require the tenant to pay property taxes, insurance, and maintenance expenses. The company has also been careful to stagger its long-term contracts to reduce risk. Fewer than 2% of Omega Healthcare’s leases expire any given year until 2022, and over 95% of its portfolio expirations take place after 2021. 

Management’s approach to growth has also been very disciplined. The company targets properties run by strong operators, meaning an EBITDARM (earnings before interest, taxes, depreciation, amortization, rent, and management fees) coverage ratio greater than one. 

While operating conditions can change quickly as the healthcare landscape continues evolving, Omega Healthcare’s overall portfolio carried a reasonable EBITDARM coverage ratio of 1.71 as of June 30, 2017, which helps ensure that most of its tenants are profitable enough to pay their rent.

Management's conservative use of leverage has helped keep the company's balance sheet and dividend on solid ground as well. The company maintains an investment grade credit rating and has no material debt maturities until 2022 (assuming allowable credit facility extensions). The majority of its debt carries fixed interest rates as well, lessening the cash flow blow if rates were to significantly rise. 

Overall, the SNF industry offers some interesting long-term growth potential as America's population ages and properties continue consolidating. Omega Healthcare has done its best to run its business conservatively as it waits for more significant demographic tailwinds to kick in, rewarding investors with higher dividends each year since 2004 as they wait. However, the industry still faces a number of uncertainties that could cause real problems.  

Key Risks

While Omega Healthcare has the wind at its back when it comes to acquisition-fueled growth and favorable demographic trends, there are nonetheless several important risks to keep in mind.

Most notably, skilled nursing generally has higher reimbursement risk than other areas of healthcare because its operators depend more on reimbursements from the government. As a result, changes in federal policies and increased scrutiny over billing practices of SNF operators have the potential to materially impact the ability of Omega’s tenants to meet their lease obligations.

Only 11.6% of Omega's rent came from private payers during the fourth quarter of 2016, for example. Medicaid and Medicare / Insurance accounted for 52.6% and 35.8% of revenue, respectively.

The company’s percentage of revenue from private payers has been gradually climbing over time, thanks to management’s decision to decrease its reliance on government healthcare funding, but Omega’s prosperity is unfortunately at the mercy of Washington for the foreseeable future.

On the bright side, legislative efforts to repeal/replace the Affordable Care Act and incorporate Medicaid payment reform have largely fallen flat so far, leaving existing SNF funding intact at the federal level for now. The GOP tax bill that passed in December 2017 has made some uneasy as they worry that a potentially increasing deficit will make future cuts to retiree programs all the more likely, but it seems far too early to speculate.

Here’s what Fitch noted about the industry in 2017:

“SNF margins are being pressured by increasing coverage under Medicare Advantage, Department of Justice investigations potentially influencing billing practices, and pilot programs for bundled payments and coordinated care. While the Trump administration appears to be in favor of slowing the growth of bundles and making participation voluntary, we believe the long-term demographic and economic factors will continue to drive the market towards these programs over the long run. We view these as long-term headwinds that stronger operators should be able to manage given they are fairly well-telegraphed.”

While Omega has enjoyed rising Medicare and Medicaid rates over time, lengths of stay are declining under alternative payment models such as bundling and managed care. When combined with the fact that almost all of Omega's operators are private companies, there is very little visibility into the industry's real-time health.

However, it is very clear that the SNF industry has been facing some trying times. For example, over the past few years numerous other healthcare reforms have resulted in declining industry profitability and EBTIDARM coverage.
Source: Omega Healthcare Investor Presentation
Omega's business is not immune. One of the company's four largest tenants, Genesis Healthcare (GEN), saw its stock price crumble nearly 80% since the start of 2015 as it faced charges for submitting false claims to Medicare and Medicaid for unnecessary therapy.

More recently, Omega stumbled into trouble in late 2017 when several of its tenants came under increased financial pressure. The company had to place one of them on a cash basis for accounting purposes (i.e. Omega only recognizes revenue from this tenant as it receives cash) after the operator continued missing its budget and failed to pay its monthly rent obligations.

Management commented that Signature, the company’s third-largest operator, was facing liquidity challenges to pay rent on a timely basis. These two tenants accounted for close to 12% of annualized contractual rent during the quarter and underscore the potential landmines in this space (learn more here).

The biggest question is whether or not these struggling operators are canaries in a coal mine (i.a. an advanced warning of widespread danger in the SNF industry). Management argues that the challenges faced by these operators are specific to them rather than indicative of the broader industry's health. Omega is hopeful that installing new operators at these properties will improve performance, but only time will tell.

Many healthcare REITs were less patient and decided to exit the SNF space in recent years given the industry’s challenges and reimbursement uncertainties. Some of the biggest names include Ventas (VTR), HCP (HCP), and Sabra Healthcare (SBRA), which are all seeking greater portfolio quality and cash flow predictability.

By now, the murky risks of the SNF industry should be clear, and it may not come as a surprise to learn that Omega was forced to cut its dividend in 2000. But why did the company have to cut its dividend, and could that same risk reemerge in the future?

The answer comes from Omega’s 2001 annual report. The Balanced Budget Act of 1997 introduced a new payment system for the reimbursement of Medicare patients in SNFs.

A major shift took place in which a cost-based reimbursement system that was historically used was essentially abandoned in favor of a reimbursement system that capped payments per service at a fixed amount. This was done by the government to save money and attempt to balance the federal budget by 2002.

While some of these payments changes were reversed by subsequent legislation in 1999-2000, the result was a major reduction in payments made to nursing home operators.

Many of Omega’s tenants were forced to declare Chapter 11 bankruptcy and could no longer make their rent payments. They had generally been levering up to fund acquisitive growth in the years leading up to the legislation and were not prepared for the substantial reimbursement reductions.

By all means, the reforms made to the Medicare reimbursement system in the late 1990s were nothing short of transformational.

While federal policy is still characterized by a healthy dose of uncertainty today, new legislation will likely be relatively more incremental, phased in over a long period of time, and will not result in bankruptcies like those that occurred over 15 years ago.

Simply put, another transformational shift seems unlikely, and Omega's management has commented that today's proposals, which are more about fixing policies to prepare the healthcare system for the demographic wave that's coming, are uncomparable to the challenges the industry faced in the late 1990s. Getting more efficient with patient lengths of stay and making sure people have access to care are larger priorities than the dollar amounts paid.

However, the situation is worth monitoring as we all know how unpredictable governmental policies can be, and it's never desirable for an investment thesis to bank on neutral or favorable legislative outcomes.

Even if Medicare and Medicaid policy doesn’t end up shifting severely, the main growth catalyst for the SNF industry (an aging population) is still about a decade away, meaning that the next few years could remain trying for many of Omega’s customers.

A final risk to consider is one that is shared by virtually all REITs to some degree - rising interest rates. Real estate is a capital intensive business that depends heavily on capital markets to finance projects, especially since REITs are required to pay out at least 90% of their taxable income as a dividend, leaving little retained capital for reinvestment

Rising interest rates increase the cost of debt and make higher-yielding, slower-growing dividend stocks relatively less attractive investments, which can put downward pressure on their shares. While Omega's balance sheet and debt maturity schedule look solid, and the majority of its debt has fixed interest rates, a rising cost of capital can be especially problematic for firms with declining profitability. 

Closing Thoughts on Omega Healthcare

Omega Healthcare appears to be a well-managed firm operating in a very difficult industry that faces a handful of risks outside of management's control. The company seems to have a reasonable cushion to absorb some unfavorable developments with its operators for now, but income investors interested in the stock need to keep a very close eye on these developments.  

Monitoring occupancy and rent coverage metrics closely over the coming quarters will help determine how isolated the recent cases of Omega's troubled tenants really are (i.e. are recent issues isolated to a few underperforming operators, or is the tide starting to go out on all SNF players?).

There is certainly risk that Omega Healthcare turns into a value trap, so maintaining appropriate position sizes and healthy portfolio diversification are very important to acknowledge the wide range of outcomes that Omega faces. It's hard to imagine the uncertainty that's facing the industry lifting anytime soon. 

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