2023-08-09 13:28:27 ET
Summary
- Medical Properties Trust shares plunged 14.1% after announcing Q2 financial results.
- Despite the decline in revenue and net profit, MPT's FFO and adjusted FFO showed improvement compared to the previous year.
- MPT's debt reduction efforts and potential asset sales provide opportunities for the company to improve its financial health.
- A distribution cut is probable, but not certain.
If you are a shareholder of Medical Properties Trust ( MPW ), your mindset about investing would have been the determinant of how you felt about the company's share price performance on August 8. Shares of the company plunged, closing down 14.1%, after management announced financial results covering the second quarter of the company's 2023 fiscal year. If you are worried about portfolio fluctuations and/or you have a shorter investment horizon, that made for a bad day. If you are a bargain buyer like myself, you might feel neutral or even positive about what happened. Personally, I have a sizable chunk of my own capital invested in the REIT. And by selling off one of my other positions and funneling some new cash in, I managed to increase my stake in the company by roughly 36%. To some, this may seem crazy. But when you look at the data as a whole, the business still looks significantly undervalued and seems to offer some nice upside from here.
A difficult day despite progress made
Before the market opened on August 8, the management team at Medical Properties Trust announced financial results covering the second quarter of the company's 2023 fiscal year. When looking at only the headline news, the picture might be a bit scary. Take revenue for instance. Overall sales reported by the company totaled $337.4 million. That represents a decline of 15.7% compared to the $400.2 million reported one year earlier. Interestingly, three of the four revenue categories for the company actually improved during this time. Most notably, rent billed reported an increase from $241.2 million to $247.5 million. The real pain came from a massive shift in straight line rent, with the metric falling from $58.5 million to negative $39.3 million. This was the result of a $95 million write-off associated with the early termination of leases involving the company's largest tenant, Steward, as part of a transition of those properties to CommonSpirit.
On the bottom line, the picture is also interesting. The company went from generating a net profit of $189.6 million in the second quarter of 2022 to generating a loss of $42 million the same time this year. In addition to suffering from the aforementioned write-off, the company had some other issues, such as $286 million of accelerated depreciation involving the same properties as in the paragraph above. But for those who watched the company closely, none of this should have been surprising. Management indicated previously that these would be part of the transactions that the company was engaging in.
There are, of course, some other profitability metrics that we should be keeping an eye on. During the quarter, for instance, the company reported FFO, or funds from operations, totaling $339.6 million. That's up soundly from the $274.9 million reported one year earlier. Normalized FFO came in at $285.3 million compared to the $274.7 million reported one year earlier. While both of these are metrics that are commonly followed in the REIT space, I do not believe that either of them are terribly significant when it comes to gauging the value of Medical Properties Trust. This is because a good portion of these metrics is comprised of non-cash straight line rent revenue from operating and finance leases that the company has. In theory, this is value that should accrue to shareholders. But until we see the cash come in, it would be wise not to factor the results into our assessment.
A more meaningful measure would be adjusted FFO. That's because this strips out the aforementioned straight line rent revenue. But even in this case, the company did well, posting a reading of $242.9 million compared to the $212.3 million reported one year earlier. Another metric worth paying attention to is EBITDA . On an adjusted basis, it came in at $345.6 million for the quarter. This one is actually down from the $380.7 million reported in the second quarter of 2022. Even though this is disappointing, the company has gone through a lot of structural changes over the past year, including now some significant asset sales. On an annualized basis, this still leaves us with about $1.38 billion in EBITDA.
Digging deeper
Now that we have touched on the headline news items, we should dig a bit deeper to better understand the health of the company as it stands today. One of the major complaints that investors have about the REIT is that it does have a significant amount of debt on its books. The good news is that this picture seems to be improving nicely. Net debt as of the end of the most recent quarter was $9.91 billion. This is down from the $10.14 billion that the company had in the first quarter.
If this drop doesn't seem significant, it's because it isn't. Previously, management was focused on bringing net debt down even further. But that process has not been as quick as the company thought it would be. For instance, when management announced toward the end of May that they had completed the sale of seven of their hospitals in Australia in exchange for AUD$730 million and settled the prorated portion of an interest rate swap associated with that for a gain of AUD$20 million, they stated that they believed that the remaining AUD$470 million worth of sales and subsequent debt repayment would be completed in the second quarter. That has now been pushed to sometime before the year is out. According to management, if it does take place in the final quarter of the year, it should be early in that time.
Even though the company has undergone some other interesting transactions, many of these have not brought in cash as of yet. At the end of the first quarter, for instance, Medical Properties Trust only had $50 million worth of exposure in the form of investments in unconsolidated operating entities that involved Prospect. That number has now ballooned to $654.5 million. That increase, however, was largely the result of the $586 million convertible loan that the company has, translating to a roughly 49% ownership interest of the managed care business under Prospect. This should accrue interest at a rate of 8% per annum, translating to $46.9 million in value to the company each year. But unless management can sell these loans off or otherwise extract value from them, it cannot use a lump sum to reduce debt materially.
The good news is that, so long as nothing comes flying out of left field, the business should be able to collect the cash from the various transactions that it has entered into. The aforementioned convertible loan likely will not be monetized until 2024, during which time the company will receive, in theory, a lump sum of cash that it can use for further debt reduction. But there are other transactions that should pay off sooner. In July of this year, as one example, the REIT sold off three general acute hospitals for $100 million. The aforementioned properties in Australia should ultimately be sold off as well. Another $355 million should be brought in as a result of a pending sale for three hospitals in Connecticut to Yale. And the company also mentioned a repayment of a $60 million mortgage loan that it received late in the second quarter. But that is already factored into current net debt figures. Management has also identified another $200 million worth of potential cash proceeds associated with smaller transactions that the firm might complete by the end of this year.
All combined, and excluding any of the assets that might be monetized next year, the company should have the potential to reduce debt by roughly $969.2 million based on my own estimates. That would reduce net debt to roughly $8.94 billion. When using the annualized EBITDA figure from the first quarter to account for all known transactions at the time and reducing net debt further to account for another adjustment that management makes for the purpose of calculating leverage, we are left with a pro forma net leverage ratio of about 6.60. The good news is that, after paying off debt that the company has green lighted to be paid off with asset sale proceeds, it will not have any significant maturities until 2025. That definitely gives the business some breathing room.
This might end up being offset to some degree by a rather interesting investment that the company made. Subsequent to the end of the second quarter, tenant Steward managed to refinance its asset-backed credit facility five months ahead of schedule. As part of that deal, Medical Properties Trust was invited by the third-party investors to make a contribution of up to 25% of the fully syndicated facility, subject to an upper limit of $140 million. Management did not say in their investor presentation how much of this had been or would be ultimately deployed. But in the investor call, when asked about this, they stated that investors should assume that the facility was drawn entirely, including up to the $140 million limit that Medical Properties Trust committed itself to. If this sounds like a bad decision, it's important to know that the transaction is backed by first lien patient receivables. This makes it incredibly safe in the grand scheme of things.
I must also touch on another topic, which is guidance for the year. Previously, management had forecasted FFO per share guidance of between $1.29 and $1.40. This has now been increased to between $1.56 and $1.60. Normalized FFO per share should be a bit higher at $1.53 and $1.57. This represents a narrowing in guidance compared to the $1.50 to $1.61 management previously forecasted.
This brings me to my final point, which is the question of the distribution. Even though I am incredibly bullish on Medical Properties Trust, I acknowledged in a previous article that distribution coverage is fairly tight. It is within the range of some other major REITs in the market, REITs that also have high amounts of leverage. But it is a real possibility that the distribution could eventually be cut. In fact, as you can see in the interesting exchange posted in the image below, management did not rule this out when pressed on the matter since implied cash flows in the second half of this year might be a bit tight. Personally, I wouldn't mind a distribution cut if it means further debt reduction.
At current pricing, the stock already yields 13.4%. Reducing this down such that, at current prices, the company would have a yield of 10%, would allow the business to allocate around $175 million in extra cash payments toward debt reduction each year. Even though I like seeing the distributions come into my account from time to time, I never make an investment based on a distribution. In fact, in multiple investments that I have, I have lamented the fact that management does not cut the distribution in order to grow the company faster or to reduce debt. This does not mean that I am forecasting a cut. I would say that it is likely to occur in the next three months. But the degree of conviction I have in that call is not strong.
Takeaway
To an extent, I understand why some investors and market participants might have waxed bearish when it comes to Medical Properties Trust. Having said that, most of the data provided by the company for the second quarter was positive. That is why I felt confident enough to increase my stake even further. Is it possible that we could eventually see some sort of distribution cut? Certainly. That risk remains elevated, but at least management is making some good moves aimed at decreasing it. For now, I would say that while the REIT is most certainly not riskless, it is appealing enough that those who like distributions and/or attractive appreciation prospects should be drawn to it. And at the end of the day, I would argue that the risk to reward payoff here is still very much in the favor of the bulls. Until shares do go up, I intend to collect what distribution the company does pay and to continue building up my position in it.
For further details see:
Medical Properties Trust: Buying With Both Hands Despite A Possible Distribution Cut