DHCNL - Diversified Healthcare Trust: Latest Developments Are Cause For Concern

2023-09-28 05:35:11 ET

Summary

• Diversified Healthcare Trust's financial performance has been poor, with costs exceeding revenues by $50 million in the first half of the year.
• The company's violation of credit covenants has eliminated its ability to refinance.
• Diversified Healthcare Trust is facing a potential distressed debt exchange as it struggles to meet its debt obligations.

Diversified Healthcare Trust ( DHC ) has had an eventful September. First, the healthcare REIT announced it has agreed to terminate its proposed merger with Office Properties Income Trust. Then, on Tuesday, the company announced it had hired B. Riley Securities as its financial advisor to help it determine next steps regarding its debt and capital structure. While income investors may be tempted by Diversified Healthcare's 10-14% yields on debt, I believe the company's financial performance combined with the addition of B. Riley are reasons to avoid investing in the company's debt.

Diversified Healthcare saw revenue jump the first half of this year by nearly $70 million compared to the same period a year ago. The jump was led by improvements in service fee revenue in its senior housing segment. Unfortunately, the company's costs rose almost dollar for dollar with the revenue increase and those costs exceeded revenues by $50 million in the first half of the year. This loss does include a $17 million impairment charge, which was non cash, but does not include $95 million in interest expenses. While Diversified Healthcare has increased revenue and improved its interest expense, the company still lost $125 million during the first half of this year.

The company's balance sheet also showed things moving backwards during 2023. In the last six months, the company's cash on hand has been cut in half, while its real estate assets have depreciated by $60 million. While part of the cash reduction went towards reducing the credit facility from $700 million to $450 million, the remainder covered operating losses which led to a $130 million drop in shareholder equity.

From the cash flow side of things, Diversified Healthcare is now generating operating cash flow compared to burning it a year ago. Despite the improvements, free cash flow is negative meaning that the company is burning cash to fund capital expenditures. Of the $320 million reduced on the balance sheet, $250 million came from the paydown of a credit facility and $70 million came from funding capital expenditures. The company is halfway through the turnaround it needs to get to $0 free cash flow.

Several have pointed to improvements in the company's senior housing business as a saving grace, but these improvements could not come at a less relevant time due to the decline in occupancy of the office portfolio. While the office portfolio consists of only 15% of revenue and 32% of book value, the segment represents nearly half of the net operating income (NOI). As the office segment erodes, the SHOP segment must improve that much more, which it has been unable to make up for in 2023.

Now, Diversified Healthcare Trust has its back against the wall with the OPI merger being off the table. The merger was designed to relieve Diversified Healthcare from its violation of credit covenant but failing to generate sufficient consolidated income for debt service. This covenant violation disallows the refinancing or issuing of any debt, essentially cutting the company off from the credit markets. There was likely hope that a combination with OPI would negate these conditions and create more financial flexibility.

Diversified Healthcare does have a credit facility, but it is currently fully drawn, meaning it cannot add any liquidity beyond the $330 million of cash on hand. While the minimum liquidity requirement was decreased, the collateral securing the facility has been written down below the threshold required to stay in compliance with the loan.

Diversified Healthcare faces the maturity of its credit facility in January along with $250 million in bonds due later in the year. The credit facility lender is likely going to want more collateral to provide flexibility and with an additional $500 million coming due in 2025, I believe the company is headed towards a distressed debt exchange.

A distressed debt exchange is where bondholders would accept new bonds in exchange for the old bonds, with the new bonds having a reduced principal or face value. While a distressed debt exchange would help address the $142 million in interest expense from the unsecured notes, I believe it will be used to enhance liquidity. Should Diversified Healthcare Trust want to upsize its credit facility to $1 billion (up $550 million) at the existing 8% interest rate, it would eliminate roughly one third of its unsecured debt, which could be done by a distressed exchange. This move would require existing 2024 and 2025 note holders to take a 30% cut from current prices. Afterwards, the company would have an additional $550 million in liquidity with less debt.

An exchange poses serious questions as to the value of the company's debt which is why I'm staying on the sidelines. While an arbitrage opportunity may be available to investors considering the 2042 maturing debt at 56 cents on the dollar, investors must keep in mind that an exchange will likely create a senior creditor to the unsecured notes. Senior creditors will have the ability to place significant pressure on the company should operating conditions not improve, and unsecured creditors are due for upcoming debt maturities (see Frontier and Diebold as examples). I will wait to see if an exchange happens, and what the terms are prior to investing.

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