2023-08-19 03:40:49 ET
Summary
- Medical Properties Trust has received downgrades from Raymond James and Bank of America due to uncertainty about its future and its largest tenants.
- MPW's dividend yield is in question after management's comments about considering cutting the dividend.
- The commercial real estate industry is facing headwinds, with rising interest rates and inflation making real estate less attractive as an investment.
Investment Thesis
Medical Properties Trust (MPW) is once again under fire after it received a downgrade from both Raymond James and Bank of America , citing uncertainty about the future of MPW and its largest tenants. Since our last article , there has been a divergence between the S&P 500 (SPY) and MPW, with Medical Properties Trust falling -17.79% versus the S&P 500 rising 5.62%, after pointing out our belief that investors should not chase the dividend yield.
Today, we put major question marks on MPW's 15.47% dividend yield after management's comments during the last earnings call, saying that "everything is on the table," when asked if the board has seriously considered cutting the dividend. An analyst asked if they would consider such a cut to leave more cash to "improve the balance sheet faster and pay down debt", to which management gave the following response:
And so going all the way back to, I think, our fourth quarter call back in February, I think, we actually said everything is on the table and that's at the Board level. And then, again, just a few minutes ago, I said the Board is constantly evaluating, considering that. And we've talked already on this call about liquidity opportunities and I'll just repeat it, if everything is on the table. ( Q2 Earnings Call )
This article also delves into how much we think MPW's real equity and leverage is, looking at cash flows. We also share what we think could happen to the stock price if one or more of their tenants got into financial trouble, and why the stellar dividend yield of 15.47% could be headed for the intensive care.
Headwinds Persist
Looking at commercial real estate and the macroeconomic background in general, it is no wonder that commercial real estate in particular is struggling. Not only are we currently facing the highest Fed Funds rates since 2000 and 2007, we are also seeing some interesting developments when we look at real yields , or the amount of return investors get after deducting inflation expectations from Treasury yields.
Between 2010 and 2020, investors actually got negative real returns on 2-year Treasury bonds, which bodes well for other asset classes such as REITs and equities, which have shown positive real returns over long periods of time. Recently, however, real yields have skyrocketed and are currently at levels not seen since the late 1990s or early 2000s, making real estate and other investments less attractive as they're a competing asset class.
Not only that, but it is noteworthy that most investors probably invest in MPW primarily because of the attractive dividend yield it offers. The difference between a risk-free yield of nearly 0% on Treasury bonds between 2010 and 2020, compared to the current offering of 5.50% makes quite a difference. And given the $10.29BN of outstanding debt that MPW currently has, it will also be much more challenging to refinance this already outstanding debt at the same attractive rate.
The company currently pays only a weighted average interest rate of 3.93% on their outstanding debt, but if we look at the current yield at which their outstanding debt is trading, it is closer to 10%. For example, if we look at the most recent data on their 2029 outstanding maturities , we see that they are currently trading at about 74 cents per dollar, with a yield of about 10.46%.
The bonds, rated BB+ by S&P and Ba1 by Moody's, are well above the market average, where, according to Fed data, the average effective yield on BB bonds is currently 7.03%. We believe that while the 17.94% yield on equities is considered too risky, it is plausible that there is some alpha to be earned on their bonds.
Senior Debt Securities should have higher safety and seniority compared to shareholders, as we believe there is a possibility of being wiped out if things go too south. We will go into detail in a moment about what happens if MPW has to raise capital at higher rates or if yields generally rise, or what happens if rents at their major tenants were to get reduced.
Follow The Cash Flow
Before we get into the underlying fundamentals, let's reiterate one of the key factors that we see as a red flag, and that is primarily concentration risks associated with MPW.
We don't even have a problem with concentration risk in general, but we do find it a problem when these concentrated entities can themselves pose a risk when it comes to questionable entities. Like Steward, Circle, Priory and Prospect which make up 43% of all assets.
Especially when operators like Steward have previously come under fire and been sued for allegedly failing to pay for services from multiple vendors. An operator, which makes up 19% of MPW's assets, whose recent financials remain unknown because the last available report dates back to 2020, when the operator was already in questionable financial health.
The fact that Medical Properties trust, for example, has also lent against their own tenants makes it notoriously difficult to analyze the company, in addition to the fact that the company has issued many shares to fund their revenue growth, and thus dilution also needs to be taken into account. In the third quarter, for example, MPW also announced that they had invested another $140 million for a minority interest in a syndicated asset backed credit facility for Steward. But if we look at metrics such as free cash flow per share , we see that it has remained virtually flat on a trailing twelve-month basis since 2015, even though FFO/AFFO has grown quite exponentially.
In the third quarter of 2023, we invested approximately $140 million for a minority participation in Steward's syndicated asset-backed credit facility. The four-year facility was underwritten and sized based on Steward's accounts receivable from government and commercial payors. (Q2 Results, SEC Filing )
It was also announced today that the $375 million deal with one of its tenants, Prospect Medical, has not yet been approved by a California state regulator, who reportedly ordered that the transaction be put on hold. This would also give MPW a stake in Prospect itself. That fact aside, we will focus more on the cash flow side of the business in the future and take that into account to measure MPW's leverage and profitability.
For example, this quarter, although management pointed to some AFFO/FFO and other metrics that were reportedly strong, if we look at the cash flow generated from operations, we see that it has plummeted completely. This is also a trend that has occurred over the last few quarters, which we see as a red flag.
If we look at this cash flow from operating activities on a trailing 12-month basis and compare it to the total amount of dividends paid over the same 12 months, we see that the total amount of dividends paid is higher than the total amount of cash flow generated over the past few months. We would not be surprised if this cash flow from operating activities falls even further, given the financial health of some of their largest tenants, which we think could lead to a dividend cut sooner or later.
So to measure true profitability and leverage, we use cash EBITDA instead of NOI, to exclude things like straight-line rent and also exclude the various other activities, such as lending against proprietary tenants. We calculate cash EBITDA by taking cash flow from operations and adding income taxes and interest expense. We believe that cash EBITDA currently reflects the current situation very clearly, as it has fallen from $1253M at its peak to $878.56M currently, due to the severe decline in cash from operations on a TTM basis.
Furthermore, we contrast these metrics with a wide range of yield rates to clearly see what both fluctuations in cash EBITDA and cap rates would mean for the actual gross asset value of their portfolio. In general, cap rates go up when interest rates rise. We believe the current weighted average cost of debt ((WACD)) for MPW is around 8-10%, looking at the trading prices of their outstanding debt. With current short-term interest rates at nearly 5.50% and the 10-year yield at a record 4.25% since 2007, we believe a cap rate of at least 8% is appropriate in this case, also looking at historical cap rates.
If we take this gross asset value and subtract from it MPW's current debt load, which we mentioned $10.29BN earlier, we think we get an idea of what the true value of equity is here. In other words, if investors believe MPW's key tenants like Steward, Circle Health, Priory, Prospect etc. are in order, then Cash EBITDA should be heading north again and everything should be fine.
Right now, however, we have no information on Steward, for example, that would give us assurance that the company is financially sound. In fact, we think the opposite is true, with Steward's latest annual report indicating that they are losing money. We would not be surprised if MPW's long-term cash EBITDA stays at $850M and requires a cap rate of over 8%, leaving little to no margin for equity investors to receive upside potential.
Speaking of margin, when we next look at the LTV ratio using our metric of Cash EBITDA, we believe investors may also be underestimating their financial leverage, as we believe their LTV ratio is in the danger zone, perhaps above the 80% ratio, when using Cash EBITDA.
Translating this further into what this means specifically for the share price, we believe the potential for a further downturn is significant. Either a rise in cap rates, as interest rates have remained higher, or a decline in Cash EBITDA as tenants come under financial pressure, could easily send the share price plummeting even further, in our view.
Digging a little deeper into current interest rates, it is noteworthy that MPW is currently paying less than 4% in interest on its outstanding debt, while their current debt is yielding over 10%. This means that unless interest rates fall, MPW is also likely to find itself in a difficult position from an interest rate environment perspective regardless of whether their tenants have financial problems.
It will be a difficult road to secure further financing at low rates, as they are currently paying only 3.93%, while the risk-free rate/fed funds rate is already close to 5.50%. And it may get worse, with recent inflation fears and the Federal Reserve considering keeping interest rates higher for longer. For what it's worth, we currently believe there are too many moving pieces, as well as too uncertain a macroeconomic backdrop combined with the questionable financial health of their tenants to have any meaningful conviction to invest in the equity.
The Bottom Line
Following MPW's latest earnings report, Bank of America downgraded the stock from Neutral to Underperform, while Raymond James even downgraded it from Strong Buy to Underperform. We think this is justified given the recent deterioration in free cash flow numbers, the questionable position of its largest tenants and the dividend yield that depends on them.
While we believe MPW may even be able to continue to pay the dividend in the short term, we think it would be to the long-term detriment of the company and its share price. In 1.5 years, the stock plummeted from a high of $20.89 to $6.93 right now. In other words, it would take more than 12 years for the $1.16 dividend to return investors their capital when they invested at $20.89. Perhaps sometimes it is not worth chasing a high dividend yield if investors are still losing their principal at the end of the day. Our conclusion closely aligns with Raymond James in this regard:
Improving operator fundamentals have been the lone positive in recent quarters, but have been more than overshadowed by growing questions surrounding management communication, credibility, disclosure transparency, operator health, corporate governance, leverage, and dividend sustainability. Ultimately, we were hopeful those would improve, but continued investment in top operator Steward (>20% of rent/ interest) this month was the final action that drove our opinion change.
For further details see:
Medical Properties Trust: Dividend Yield Headed For Intensive Care