The past couple of days now have been pretty tough for investors in Omega Healthcare Industries (OHI). Including an after-hours share price decline of 3.7%, shares of the company have dropped 6.1% in two days, shaving $380.6 million worth of market value off of the firm’s share price. This sudden and unexpected decline is worrisome at first glance, but is it reasonable or is the market merely overreacting to developments that aren’t as bad as they appear? In what follows, I will dig into some of these developments and give my thoughts on why investors should not worry too much, but should keep a close eye on the picture moving forward.
Performance was slammed
My goal in this article is not to focus too much on headline news that you can find elsewhere. That said, it is worth mentioning, at least to put matters in context, what all happened during the most recent quarter so we can better understand what investors are worried about today. Shockingly, Omega, a firm known to be a stable cash cow, ended up coming out with some pretty bad figures. Besides the fact that sales came in at $194.06 million, missing by $44.04 million, and that AFFO (adjusted funds from operations) were $0.79, down $0.06 per share compared to estimates, we need to consider actual FFO.
You see, whenever a company announces that a figure is “adjusted”, it often means that management is trying to make the picture look better than it actually is. In truth, if used and disclosed properly, this is fine, but it can also be used to obscure more significant changes to a firm’s financial position. While Omega’s AFFO came out to $163.6 million, its actual FFO was -$46.8 million (compared to $162.6 million the same time last year), for a swing of $210.4 million from one to the other. This is quite a step, and it can be chalked up mostly to the fact that the firm recognized $194.7 million in impairments during the quarter, plus it recognized a provision for uncollectible accounts totaling $11.9 million.
Some trouble is brewing
In the past, I have written articles on Omega and, truth be told, I find the company an interesting long-term prospect (though I am worried about it from a regulatory perspective). That said, not even the most interesting firms are subject to trouble from time to time. Right now, Omega’s facing its own issues that investors need to contend with. In particular, we have the fact that one of the business’s largest customers, Orianna, is responsible for the recent impairments and the writedown in uncollectible accounts.
You see, despite the fact that only 7% of the revenue generated by Omega is in the form of direct financing leases, Orianna appears to account for a large chunk of that. According to management’s most recent estimates, the customer represents 5.2% of Omega’s total rental revenue (all spread across 42 different properties as of the end of the third quarter). This makes it the company’s fifth-largest source of rental revenue and, at the end of the second quarter when Orianna (previously called New Ark Investment, Inc.) held 54 properties, it represented 6.7% of the value of Omega’s investments.
Due to poor performance, though, Orianna has found it difficult to make cash payments in the amounts due and on time to Omega. This instability has led the latter to require Orianna to be considered a cash-basis contributor to its sales, because otherwise accruing revenue that may or may not come through could create larger issues down the road. This change is what led to the sizable impairment, but the fact of the matter is that the problem is a bit deeper than just that.
Back in 2014, Orianna’s occupancy rates averaged 92%. Today, that number has decreased to 89%. While this does not seem to be a material change, especially over such a long period of time, the fact of the matter is that this drop has led to revenue from Orianna’s properties rising only 2%, while its costs have risen by about 6%. That’s quite a swing in a business where margins generally aren’t considered all that appealing.
In response to this change in business, Omega is now trying to replace Orianna as its facility operator, but that’s expected to take around 6 months to achieve. In addition to any financial burden that may come about as a result of this time lag, management believes that in order for a company to generate better results, current annual contractual rents will likely have to fall to between $32 million and $38 million, down from the $46 million that had been agreed upon with Orianna before. To add to the trouble, there’s another customer (one that has not been disclosed) that is not a top-ten firm but which is also being placed on a cash basis due to performance issues.
The market’s overreacting
When you look at these numbers, they all seem kinda small when you consider that Omega is a $6.26 billion firm in terms of market cap. However, the bottom line impact from an FFO perspective is anything but small. You see, previously, management had forecasted FFO to range to between $3.28 and $3.30 per share this year. Now, that number is between $2.12 and $2.13 per share, or a drop of between 35.1% and 35.8%. To put this in context, using November 30th’s closing share price, Omega has gone from a multiple of 9.4 times FFO to 14.6 times FFO. Using the AFFO results is a little better. According to my estimates, instead of trading for 9 times the metric, Omega’s trading for a more pricey 9.5 times.
All of this looks a bit disturbing, especially using the non-adjusted numbers provided by management. However, while I fully suspect that this will have an impact on the company’s financials through the rest of this year and into part of next year, the short-term impact of a major customer’s arrangement resulting in lower sales while those sales will come from another customer (or customers) will likely mean that this is a short-term affect, not a permanent one. Short-term fluctuations shouldn’t mean much in the grand scheme of things if you’re a long-term value investor.
One concern that I have
Right now, Omega is one of the few non-energy firms that I find to be an attractive prospect. That said, there is one piece of data that I am a little worried about: its occupancy rates. As you can see in the image below, the business’s occupancy, not to mention the industry’s occupany, has been on the decline for at least a few years now. Sure, except for this year, Omega has done well to continue generating strong cash flows, but when you consider that two customers now (Orianna being one of them) have been hit by lower occupancy rates while the company as a whole seems to be on a downward path in that regards, it’s a bit disconcerting.
*Taken from Omega
At best, this data may be indicating a temporary soft spot in the SNF (skilled nursing facility) market. At worst, it might represent part of a permanent decline in this space. Personally, from what I’ve seen in this space, with Omega itself projecting that SNFs will run out of spare capacity by or before 2025, I believe there’s a good chance that this shift is just a soft spot, but investors would be wise to evaluate the situation closely to see what might transpire down the road.
Takeaway
Based on the data provided, I must say that if I were an investor in Omega, I would be quite unhappy with this development. That said, the value investor in me would probably take this moment to buy up shares in the entity at the discount they are now trading at. Personally, I would still be wary of the falling occupancy rates affecting the business, but so long as I stayed mindful to watch over that trend and react accordingly, I wouldn’t mind buying into such a high quality firm like Omega. If, though, this occupancy issue does continue to persist, and especially if it worsens, there is a chance that this could represent a harbinger of tougher times to come.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Article source: https://seekingalpha.com/article/4118794-omega-healthcares-health-scare