2023-11-25 06:11:07 ET
Summary
- CareTrust has a solid track record of success with strong revenue growth and profitability improvement.
- The company is well-positioned to benefit from the secular demographic trend of the rapidly aging U.S. population and has a balanced approach to geographical diversification.
- My valuation analysis suggests the stock is more than 20% undervalued.
Investment thesis
CareTrust (CTRE) has a solid track record of success with 18% rental revenue CAGR over the last decade and the operating margin doubling as the business scaled up. The company is benefiting from the secular demographic trend of the rapidly aging U.S. population and the ability to capture secular tailwinds is a clear indication of the sound strategy selection and execution. Despite the current challenging environment CTRE continues demonstrating revenue growth and profitability improvement. The management is also investing heavily in the portfolio of properties in 2023, which will likely build long-term value for shareholders. The current environment of high-interest rates does not favor REITs, and the stock now trades at about a 20% discount, according to my valuation analysis. The attractive valuation, together with a solid almost 5% forward dividend yield, makes CTRE a "Buy."
Company information
CareTrust is a self-administered REIT engaged in the ownership, acquisition, financing, development, and leasing of skilled nursing, seniors housing, and other healthcare-related properties. As of the fiscal 2022 year-end, CRTE's real estate portfolio consisted of 216 skilled nursing facilities [SNFs], multi-service campuses, assisted living facilities [ALFs], and independent living facilities comprising 22,831 operational beds across 28 states.
The company's fiscal year ends on December 31. According to the latest 10-K report , SNFs represent more than 70% of the REIT's total rental revenue.
Financials
The fund's financial performance over the long term was strong, with rental revenue compounding at 18% over the past decade. As the business scaled up, the operating margin expanded significantly from 30% to 60%. The free cash flow [FCF] margin has been volatile due to the nature of the business, which involves unstable cash acquisitions and sales of properties. The FCF margin, in general, also expanded significantly over the decade. The improved operating leverage is a solid secular bullish sign for investors, indicating well-rounded portfolio management and operational capabilities.
CTRE has consistently paid dividends to investors, and the current payout ratio is nearly 80%. The past five year's dividend growth rate was solid at a 6.9% CAGR. While the forward dividend yield might look decent at 4.9%, it is slightly lower than the sector median. It is also crucial to underline that for the next couple of years, consensus estimates forecast a slower dividend CAGR of around 2.5%. Despite the expected temporary dividend growth deceleration, I think the dividend is safe, given the wide FCF margin and CTRE's healthy balance sheet with moderate leverage.
Seeking Alpha
The latest earnings release was on November 9, when the company missed the bottom-line consensus estimates but was outnumbered from the top-line perspective. Q3 performance looks promising since revenue demonstrated a solid 11% YoY growth, and the operating margin expanded from 56% to 60%. Strong financial performance, even amid the current uncertain environment, indicates the business model's resilience and the management's flexibility.
Seeking Alpha
During the latest earnings call , CEO Dave Sedgwick underlined that $280 million had been invested in property year-to-date, financed by selling $420 worth of equity. These proceeds were utilized to pay down a $600 million line of credit, significantly improving the balance sheet. While I generally consider delusions a bad sign, the current environment of high interest rates suggests that raising equity finance is not the worst choice. The CEO named the current investment environment favorable and strongly believes that the current portfolio expansion will add value to shareholders over the long term.
Apart from improving financial performance and expanding the pipeline, I like the company's strategic positioning and balanced approach when we talk about geographical diversification. CTRE's geographical diversity with properties in 28 states, including key states like California, Texas, Louisiana, Idaho, and Arizona, ensures a balanced income stream and mitigates the impact of market fluctuations. The team's balanced focus on building sustainable revenue growth and cost discipline positions CareTrust well to build long-term value for shareholders.
The unfolding secular tailwind for CareTrust is the rapid aging of the American population , facilitated by advancements in medicine. As American people live longer, the demand for various types of healthcare, including senior housing and skilled nursing facilities, is on the rise. Such a favorable secular trend creates long-term growth opportunities for companies like CareTrust, given the focus on healthcare real estate investment. CTRE's strong operating leverage and diverse property portfolio make the company well-positioned to benefit from this demographic trend. Therefore, I am not surprised that consensus estimates forecast strong double-digit revenue CAGR for FY2024-2025.
Valuation
CTRE rallied by 22.5% year-to-date, outperforming the broader U.S. stock market. Seeking Alpha Quant assigns the stock a medium "C" valuation grade, which means the stock is approximately fairly valued from the valuation ratios perspective.
I want to proceed with the dividend discount model [DDM] simulation. I use an 11% WACC as a required rate of return. Consensus dividend estimates forecast the FY 2024 payout at $1.15, and I use the last five years' dividend CAGR of 6.87%.
Author's calculations
According to my calculations, the stock's fair price is around $28. This indicates a 21% upside potential from the current stock price levels, which I consider a very attractive valuation.
Risks to consider
CareTrust is highly dependent on the successful operation of its healthcare operator tenants, who lease the company's properties. Any significant adverse event affecting the tenants' business will likely have a direct and significant impact on CTRE's operations and earnings. According to the latest 10-K report, in FY 2022, 35% of the total rental revenue was generated from the largest tenant, Ensign. Such a large portion of revenue depending on a sole tenant means huge concentration risks for CTRE.
The current environment of tight monetary policy in the U.S. is also a notable headwind, and the timing of the Fed's pivot increases the level of uncertainty for the business. Higher borrowing costs limit the company's ability to secure financing for expansion at favorable rates and conditions. Moreover, the uncertain interest rates policy landscape introduces elevated unpredictability that may complicate the formulation and execution of the company's business strategies. Last, strict monetary policy also impacts market sentiment and investor confidence in REITs, which means compressed valuations might stay longer.
Bottom line
To conclude, CTRE is a "Buy". The stock is very attractively valued and offers a decent dividend yield with moderate growth in the upcoming two years. The company's strong execution with solid revenue growth and delivering operating leverage gives me high conviction that dividend growth will accelerate as tough macro-economic conditions start easing. CTRE's business looks well-rounded to me as the management focuses on responsible revenue growth together with strict financial discipline.
For further details see:
CareTrust: High-Quality Business Attractively Valued