2023-10-17 00:30:12 ET
Summary
- Medical Properties Trust has seen increased investor interest due to a combination of its defensive business model and struggles on the debt and tenant front.
- The stock currently trades in a deep value territory, making it an interesting value play despite the fact that many investors have already got burned by the structurally declining price.
- There are two aspects that should contribute to the decreased risk premium: successful refinancing and normalization in the lease collection front.
- Based on the recent transactions, liquidity profile, and dividend cut, MPW seems to be in a safe position to successfully refinance and/or retire the forthcoming maturities.
- Yet, the issue with Prospect Medical Holdings is still unclear. If this goes south, it is very likely that MPW will continue to lose its market cap. It boils down to an option-like trade with an optionality for a huge upside at the expense of total (potential) loss of initial investment.
Since early 2022, there has been an increased chatter around Medical Properties Trust ( MPW ) and its prospects to deliver solid returns for REIT investors. It is a combination of many unpleasant factors that have contributed to a more pronounced investor and Seeking Alpha audience interest.
Yet, the overarching driver of why MPW has been so an interesting case is its defensive fundamentals (i.e., business model) on the one hand and on the other the idiosyncratic struggles, which impose significant downward pressure on the MPW's market cap level.
Interestingly, starting from 2022 there has not been a meaningful period in which the Stock assumed an upward momentum or even traded sideways. Instead, it has gone from one decline to another decline providing value investors with a reason to consider opening a position.
Investors, who previously thought that the bottom was already achieved have got burned, experiencing further declines and dividend cuts.
Summary of my previous thesis back in August and why revisit the thesis now
A while ago, I delivered an article on MPW stating that the talks around potential dividend cut overshadow the underlying value. Since then, the dividend cut took place and the market cap continued to plummet.
My thesis points revolved around the underlying resiliency of MPW's operations. For example, almost full occupancy, positive NOI, and successful transactions on the asset monetization front.
I also argued that the leverage, while relatively high from the capital structure perspective, looking at the ICR level, the debt coverage remained very solid. In other words, my firm opinion was that MPW will eventually manage to reduce its leverage and successfully roll over the near-term maturities.
This in combination with depressed multiples rendered the overall investment case interesting.
Yet, at the same time, I pinpointed the potential downside risks stemming from continued uncertainty on the operator front. Unfortunately, this has materialized and sent the stock price 30% below the level when my article was circulated.
However, now that MPW is down 65% since the first struggles began (i.e., tenant default risks), value investors (including me) are left with no choice but to revisit the thesis once again.
I am fully aware that the same logic was prevalent in earlier periods as well, but on a 3-month basis, the price decline is just too steep to ignore.
On top of that since the publication of my article, we have received a couple of positive updates on the Steward and Prospect tenant situation as well as new data points associated with asset divestitures.
At the same time, MPW has approached a deep value territory with even the forward-looking P/FFO trading at 3.2x.
No matter which valuation metric you look at, MPW is cheap both on absolute and relative terms.
Yet, the devil lies in the details, and prudent value investors have to be very careful to avoid making a "long" decision, where the odds are stacked against normalization in the underlying cash flow generation (or fundamentals).
In my opinion, one of the main reasons why the multiples are so depressed across the board is that the market has not yet fully calibrated the long-term path of MPW's cash flows. In other words, there is a significant risk premium attached to MPW because of the inherent uncertainty about its tenants, refinancings, and the effects of the "higher for longer" scenario.
For me, it is clear that MPW will not become the next A-rated REIT that is associated with stability and dividend predictability for long-term investors.
However, I am interested in getting compensated for the elevated risk premium and reallocating once the situation normalizes (i.e., risk premium contracts) and multiples have bounced back to a more reasonable levels.
In my view, for this to happen MPW has to deliver on two aspects:
- Successfully refinancing its near-term debt maturities at reasonable terms.
- Maintaining stability in the leases.
#1 Debt management
One of the main drivers behind the massive decline in MPW's stock price is the uncertainty around MPW's ability to pay off its debt burden, which going into the new era of "higher for longer" scenario was not that optimal, especially if compared to the sector peers.
As of now, MPW has a net debt to adjusted EBITDAre of 6.8x. These days everything that is above 5x could be deemed suboptimal, implying an elevated exposure to financial risk. In MPW's case given the uncertainty around its leases and high cost of debt, being on the aggressive end with the leverage is not great.
Currently, the weighted average cost of financing that is embedded in MPW's books is 3.9% - clearly below the market terms. This is so because of the debt structure, where 84% is based on fixed rate financing. The remaining 14% have already percolated through the system and brought the financial rate up.
The key question now is how long MPW can ride with these rates of financing and when the first major debt rollovers could take place that will inevitably render a negative impact on the incremental cash flow level. This is critical considering the current YTM levels of MPW's outstanding bonds that are revolving around 13 - 15% territory . Namely, we are talking about ~10 - 12% of negative spread that could eventually feed into MPW's current cash flows via the repricing of its indebted balance sheet.
As of Q2, 2023, MPW had ~ $2.4 billion of maturing debt by 2026, or ~21% of the total debt portfolio. It is critically important to pay careful attention to 2023, 2024, and 2025 maturities given the market's consensus estimates on the future Fed Fund's rate, which indicate that by 2026 we could be converging back to ~3% level.
In other words, avoiding debt repricings until we arrive at more friendly interest rate levels is important for all corporates, but especially for those who are finding themselves in an already difficult financial position - like MPW.
At first glance, ~ $2.4 billion seems a lot. Yet, let me explain why MPW could do just fine with the forthcoming debt maturities.
First , it has recently made a couple of lucrative exits from foreign markets that have injected well-needed liquidity into the MPW books. The most recent divestitures were of the Australian facilities that were sold to HMC Capital at a 5.7% cash cap rate for $305 million. As a result of this, MPW now holds ~$950 million of pure liquidity that could be channeled towards successful debt refinancing.
Second , roughly only ~ $1 billion of all debt maturities until 2025 are based on fixed rate financing. What this means is that MPW has the luxury to fully retire these borrowings, thereby avoiding an unfavourable rate of change in the interest rate component. The remaining ~ $1.4 billion is already subject to SOFR, which at the extension of the rollover date would not add that much of incremental financing cost (the risk premium might be higher, but it is peanuts compared to the repricing of below 3.9% yielding debt).
Third , when thinking of forthcoming debt maturities we have to factor in extra tailwinds that are associated with the relatively recent dividend cut. Back in August 21, MPW decreased its quarterly dividend from $0.29 per share to $0.15 per share. This has now brought the AFFO payout to 60% level.
Unfortunately, we cannot get the AFFO or NOI number that is directly associated with the recently sold Australian facilities, but one thing is for sure - these are not material numbers. Based on the 10-k data , we can isolate this exposure via the registered revenues per each state and/or country level. In the end of 2022, the Australian market accounted for roughly 4% of the total revenues and a bit less than that on the total asset level. Now, after the successful disposal, MPW is left with around 1.6% exposure towards the Australian market. Hence, when making any estimates on the prospective AFFO figures, there is absolutely no reason to significantly revise downward the Q2, 2023 AFFO result.
So, assuming a 5% drop in the AFFO due to the recent divestitures and keeping the remaining data constant (as there is also no reason to inflate the financing costs due to the reasons described above), we get ~ $842 million in the annual AFFO. Thanks to the dividend cut, MPW is able to retain around $335 million that could be used for gradually deleveraging the balance sheet.
Assuming that there are no major negative shocks in the MPW's operations and taking into account the existing liquidity, by 2026 MPW is set to generate an additional ~ $750 million of incremental liquidity on top of the currently available ~ $950 million - totalling to ~ $1.7 billion.
Again, this is more than enough to not only successfully refinance, but also to retire a major portion of these borrowings that kick in from 2023 - 2025.
Granted, the risk beyond 2025 remains as in 2026 and 2027, MPW will have to refinance 42% of the currently outstanding debt. From these, $2 billion is currently fixed and thus with the potential to inflict notable damage from higher cost of financing when refinanced.
Now, let's take a rather pessimistic view and assume that MPW will not be able to partially pay off this and that it will have to roll over the entire amount with an additional spread of 10% in the cost of financing (to match the current YMT level).
This would result in an annual AFFO reduction of ~ $200 million. It would wipe out a significant chunk of the currently retained AFFO indeed, but it would still leave MPW with an AFFO coverage of less than 100% (closer to 90%).
Even in such a pessimistic scenario, MPW's dividend is covered.
Finally , while mathematically this works, there are some implicit risk factors that could make it difficult to execute refinancings. For example, some banks and/or institutional investors could decide to not give new loans at the required amount, thus forcing MPW to tap into more expensive financing sources such as private credit. There could be also a risk stemming from more aggressive covenants, which would limit MPW's capital allocation tactics. Plus, if the 2026 and 2027 maturities are fully repriced at yields above 10%, the remaining cash flows would be very small to weather any incremental struggle on the operations or leasing front.
So, my assumption is that MPW will divest some additional facilities to bring down the leverage and make the debt refinancings in 2026-2027 period less painful. Granted, further divestitures will reduce the underlying AFFO, but considering the embedded cash cap rates at most likely around 6 - 8% (based on the recent transactions) and the cost of debt levels at 12 - 15%, it is more than a smart thing to do.
Again, a smaller base of assets will indeed hurt the cash generation, but as we can see with the Australian property case, even a tiny share of a portfolio that is divested renders a significant benefit to MPW's liquidity, where the reduced debt pressure outweighs the foregone AFFO.
In fact, we can confirm this by looking at the recognized gains from the recent transactions, which indicate that the property book values reflected in the balance sheet are considerably below the fair value levels at which the properties could be sold.
All in all, I am not worried about MPW's financial risk.
#2 Lease management
The second component that is necessary to reduce the elevated risk premium in the Company is the stability on the top-line front. Currently, there is a lot of uncertainty around MPW's ability to collect all of the stipulated leases.
Optically, the lease structure is very robust and I would argue that it is one of the greatest in the industry. No meaningful lease maturities kick in over the next 10-year period. This, theoretically, provides MPW with the necessary cash flow visibility to plan for either accretive M&A or organic growth projects. It also helps with the debt management aspect, where the lease cash flows could be aligned with the debt service payments.
Moreover, the average financial health of MPW's tenants looks solid.
The EBITDARM rent coverage above 2.4x could be commonly deemed satisfactory. In fact, it has not been much higher even in the pre-pandemic period.
So, on average, MPW's tenant and lease profile is solid.
Yet, the devil lies in the details, and more specifically in two tenants:
- Steward Health Care , which accounts for ~ 25% of the total revenues. In other words, a major tenant for MPW. In the past, MPW was forced to step into a partnership (via 50% stake) with one institutional investor to provide financing for Steward. Obviously, not a great sign. This was one of the key catalysts behind the massive decline in MPW's stock price. With that being, recently there have emerged some positive signs in this context. First of all, the TTM EBITDARM rent coverage of Steward has gone up to 2.8x. Then MPW announced positive news that Steward had managed to successfully refinance its credit facility. At the same time, MPW has communicated that it has sold part of its equity stake to external parties getting back the invested proceeds fully on a pro rata basis.
- Prospect Medical Holdings, which accounts for ~ 20% of the total revenues. In August 2019, the tenant started to face financial difficulties and MPW together with other partners was forced to provide fresh equity and debt proceeds. Since then, there have been additional recapitalization plans through which MPW has lost some of the injected value and unbilled rents. In May 2023, the Prospect Medical Holdings finally obtained a well-needed financing from external lenders in the amount of $375 million. The underlying mechanics of the deal would benefit both MPW and Prospect, where MPW could get an additional stake in Prospect, continued rent, and debt service payments. However, on July 20, a California state regulator put the deal on hold to review the stipulated terms and conditions and whether there has been a fair representation of this in the reports. According to the MPW's management , it is highly unlikely that the regulators won't approve the transaction once they get the required information.
In a nutshell, MPW carries an elevated risk exposure towards two tenants, which together constitute around 45% of the total lease payments. While Steward's case seems to be de-risked at this moment, the situation around Prospect remains uncertain.
Unfortunately, we lack details to make any judgment as to what would happen in case the deal does not go through. Based on the publicly available information, the odds are in favour of the deal actually taking place, which then, in turn, would definitely stabilize the lease collection process.
Yet, at the same time, we do not have sufficient details about Prospect's financial position post-transaction which makes the cash flow forecasting extremely difficult (considering the 20% share of the total leases).
Bottom line
Currently, MPW trades at extremely depressed valuation levels, where it yields ~ 12% despite the recent dividend cut and the AFFO payout ratio of 60%. It is clearly evident that the market is attaching a huge risk premium to the Company.
In my opinion, there are two major reasons for that.
First is the debt problem, where MPW's debt trades at 13 - 15% YTM level, which in the context of a 3.9% cost of financing that is embedded in the books and significant near-term maturities could imply surging interest expense component. This risk, however, is greatly mitigated by MPW considering the recent asset divestitures at very attractive cash cap rates, close to $1 billion liquidity, dividend cut, and future AFFO generation.
Second is the struggles on the lease collection front. While I would assume that the situation with Steward is somewhat fine, the case with Prospect Medical Holdings is far from acceptable. Namely, we do not have any data or information that would warrant a justified decision-making around the future lease payments stemming from Prospect (which accounts for ~20% of the total leases). Looking at the publicly available information, there is a bias towards a more positive outcome, but even in such a case, we would still lack details about Prospect's financial health.
If the Prospect's situation normalizes, investors would be able to capture a significant value as the tenant risk decreases and as the market finally recognizes that MPW's debt problem is totally manageable.
If MPW experiences further struggles with the lease payments, the tenant problem would transform into a true debt (refinancing) problem and, ultimately, send the stock price even lower.
In my humble opinion, until we do not receive additional details pertaining to Prospect's deal, there is not sufficient ground to make either a short or long call. Yet, if I had to make a bet, I would open a tiny long position in MPW and treat it as a call option (i.e., writing off the paid premium in case the lease situation goes south, and capturing a huge payoff if the situation stabilizes).
For further details see:
Medical Properties Trust: Capturing Value Or Catching A Falling Knife?