CA - NorthWest Healthcare: Buy High-Sell Low Why The Remaining Distribution Could Go

2023-09-25 17:44:09 ET

Summary

• We assigned a sell rating to NorthWest Healthcare Properties REIT previously due to the high risk and the virtual certainty of a large distribution cut.
• On September 22, the REIT announced it was cutting its distribution by 55%.
• We analyze the press release and update our thesis.

Note: All amounts discussed are in Canadian Dollars

On our last coverage of NorthWest Healthcare REIT ( NWH.UN:CA ) we went back to a Sell rating. The REIT got the highest risk on our proprietary Kenny Loggins Scale, and we did not think trying to catch the falling knife was a good idea.

Ideally, they should be paying only what is required under REIT rules and stopping the distribution to deleverage. If we were to bet, we would wager that they cut it by 50%, within three months. NorthWest gets the maximum rating on our proprietary Kenny Loggins, dividend danger, scale.

You can still lose money by buying a discounted NAV REIT as the NAV falls and the discount widens. That is what we see happening here and would look to only buy after the distribution cut assuming a coherent plan to address the longer-term concerns is put into place.

Source: The Distribution Is Set For A Big Cut

NorthWest signaled the cut coming when the distribution was not announced as usual on the fifteenth of the month. With the markets closed late on Friday, it finally felt it was time to drop the news.

Northwest Healthcare Properties Real Estate Investment Trust today announces steps to strengthen its financial position, including financing and disposition initiatives, and a reduction to its monthly distribution.

Source: NorthWest Healthcare Press Release

There are five parts to this press release, and we go over each and give you our take.

1) Extension of Credit Facility

NorthWest extended its non-revolving credit facility of US $127.5 million by one year, from January 2024 to January 2025. This takes a little bit of the liquidity pressure off as we see interest rate pressures continuing to ramp up. With $4.0 billion of total debt (about US $3.0 billion), we would not get too excited about a one-year extension of 4% of the total.

2) Australian Unity Healthcare Property Trust ("AUHPT") Unit Sales

AUPHT unit sales generated $82 million and a further $110-$120 million are expected in the next two quarters. Modest amounts, but they will reduce some high interest expenses. NorthWest is paying exorbitant rates on its Aussie dollar debt and this is a step in the right direction.

3) Asset Sales

The REIT did generate some asset sales in Q2-2023 after which it announced that it was going to do a buyback. Of course, with the UK portfolio sale called off, asset sales are going to be the primary weapon used for deleveraging. So more were expected and NorthWest announced an additional $150 million that could be expected to be completed shortly.

4) Distribution

In all honestly, the only people who did not see the cut coming have to be those not reading the financial statements. The warnings were there one year back, when we brought this to the forefront . We finally got the cut, and it was every bit as deep as we expected.

Management has undertaken an analysis of the REIT's distribution payments, with a specific focus on expected 2024 operating results and cash flows, including the maturity of the in-place interest rate caps in Q1 2024 (which is expected to decrease the REIT's AFFO per unit by approximately $0.16-$0.20 per annum).

The Board of Trustees (the "Board") has carefully considered the results of management's analysis and advice from the financial advisors regarding the REIT's distribution payments. The Board today announces an immediate reduction of the REIT's monthly distribution to unitholders from $0.06667 per unit to $0.03 per unit, or from $0.80 per unit to $0.36 per unit on an annualized basis.

Source: NorthWest Healthcare Press Release

What was interesting there was the comment about the interest rate caps ending. These swaps, while available for everyone to see in the financial statements, are hard to decipher with certitude. The drop in adjusted funds from operations (AFFO) is quite a bit steeper than what we expected. This is also a bit strange in light of comments in the Q1-2023 conference where management appeared to be suggesting AFFO would increase to 80 cents (over 20 cents a quarter) by the end of 2023.

...AFFO per unit declined to $0.17.

And over the course of 2023, the collective impact of hedging activities, the UK and US joint ventures and non-core asset sales previously announced are expected to increase per unit AFFO by approximately 20% relative to the current quarter run rate.

Source: NorthWest Healthcare Q1-2023 Transcript

Obviously they knew those swaps would be ending in 2024, even back then. So why boast of a full coverage of the distribution when it was going to be shattered in 2024, even in the best case scenario?

5) Update on Strategic Review

It appears that the empire building exercise is coming about in a full circle. After years of remorseless buying of properties without a care to shareholder value, the financial markets are finally forcing them to unload these.

The Committee has engaged Canadian banks, Scotiabank and RBC Capital Markets, and international bank Deutsche Bank Securities, each as co-advisors to provide financial advisory services, and DLA Piper (Canada) LLP as legal counsel to the Committee.

The Committee and its advisors have received a broad range of enquiries from third parties, including expressions of interest and non-binding proposals regarding certain potential asset dispositions. The Committee, following consultation with its financial and legal advisors, has determined to explore, among other strategic initiatives, transactions involving the potential sale of all or part of Northwest's U.S. and/or Brazil property portfolios.

There is no certainty regarding the results of the Committee's strategic review or that any particular transaction will be agreed upon or consummated. The REIT does not intend to comment further on the strategic review until it determines that additional disclosure is appropriate or required.

Source: NorthWest Healthcare Press Release

This likely will be a buy high, sell low process as the cap rates are not what you would get during ZIRP. On the positive side, most of their properties produce better operating income today than when they bought them and that should dampen the blow.

Outlook & Verdict

The outlook is extremely murky here. What we do know is that the distribution has been roughed up into less than half and the payout ratio is likely to be as high as 75% on even this reduced distribution. As draconian as the distribution cut looks, we think it needed to be more extreme. The REIT should have committed to only paying what was required under REIT rules. That would probably mean no more distributions for 2023 based on their high return of capital numbers for 2022. Click on image for larger view.

Now expenses are also way higher, thanks to the higher interest payments. So an elimination would theoretically be possible. Of course, to the extent they deliver big asset sales in 2024, this picture would change. But again, they are unlikely to sell above IFRS values or their cost basis, which means that they may not need to pay a distribution.

Those asset sales need to come in fast and furious as based on their AFFO metrics, interest coverage likely declines below 1.5X in 2024. That is dangerous territory and where things can break and covenants can be tripped. At present with a price of $5.37, we are upgrading this to a "Hold" and removing our Sell rating.

This reflects a more appropriate price for the risks, though we think we are likely to visit $4.50 before a bottom.

Convertible Debentures

We have previously suggested the three convertible debentures as a way of playing NorthWest in a safer manner. They are,

1) The G series (NWH.DB.G:CA).

2) The H Series (NWH.DB.H:CA).

3) The I series ( NWH.DB.I:CA ).

The NWH.DB.G matures in December 2023, and they don't offer exciting return prospects. The REIT has more than enough liquidity to redeem those. NWH.DB.I is actually quite expensive relative to NWH.DB.H. The former has a convertible price of $10.55 while the latter has it at $16.00. Since we don't believe the REIT will trade at double digits outside a reverse split, we would look for a stronger yield to maturity rather than upside with the call option. NWH.DB.H is hence better. At present, that would be the only legitimate way to play the strategic review.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

For further details see: