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One of the best indicators of a stock being oversold is when its fundamentals start to get filtered through increasingly bearish lenses. This happens primarily in 2 forms.
- Good news or neutral news being interpreted as bad news
- Bad news being blown well out of proportion
I believe both are happening to Medical Properties Trust (NYSE:MPW) causing it to be deeply undervalued and it has now become my top contrarian pick.
Let me begin with a quick overview because I think context is important for interpreting what is going on. I will then follow with how the market’s interpretation of fundamentals is so much darker than what I believe reality to be. Finally, I will close with the catalyst that I think will pull MPW out of its slump and restore sentiment to a more normal level along with market price. Overall, I think MPW can more than double from this highly depressed level.
Overview and background
The Birmingham Alabama headquartered REIT has been rapidly acquiring high quality healthcare facilities in the U.S., Europe, and Australia.
While they buy a variety of facility types most of them are some sort of hospital and high on the acuity spectrum.
Over the years, MPW has become quite a large company. Today’s $6B market cap is on a highly depressed market price.
It actually has closer to $14B in assets.
Any REIT can acquire a bunch of assets. The factor that sets MPW apart is that they did so in a highly accretive fashion. Each asset purchased was at a substantial spread over cost of capital resulting in ample FFO/share growth.
At the same time, MPW was able to reduce leverage relative to their size. EBITDA coverage of interest expense has improved to a healthy ~4X.
Over MPW’s decades of successful operation, there have been many shakeups ranging from broader economic recessions like the great financial crisis to more healthcare specific challenges. MPW’s assets have been through multiple changes to Medicare/Medicaid reimbursement. They performed both with and without the Affordable Care Act. The most recent challenge has been COVID which shut down beds to highly profitable elective procedures and dramatically increased regulatory and safety spending.
As we go through the following sections I think it is important to keep this background in mind. This is not some speculative business model, but rather a battle-tested large cap that has overcome a myriad of obstacles. Despite this track record, the market is assuming the absolute worst at every turn.
Good news interpreted as bad
Imagine if you ran an investment portfolio and you could exit your worst position for an IRR of about 7%. That is what Medical Properties Trust just did and somehow the market interpreted this as bad news with the stock trading down 5.26% to close the day.
On 10/6/22 MPW announced the sale of 3 hospitals in Connecticut currently leased to Prospect. MPW got its investment back plus collected a few years of rent over their holding period. Round trip it was a moderate IRR which is not bad for some of its weakest assets.
Prospect was MPW’s worst tenant with an EBITDAR coverage of rent of 0.6X and EBITDARM coverage of 1.3X. Note that the difference between EBITDAR and EBITDARM is management fees of the operator. An operator has to pay rent before collecting their management fees so an EBITDARM over 1.0X is generally enough to stay open, but operators are not happy about the situation.
MPW has quite a few properties leased to Prospect, but as discussed in the 2Q22 call, the east coast Prospect properties are significantly weaker than their west coast properties. So that means not only did they reduce concentration in their weakest tenant, but they got rid of the 3 worst assets of the worst tenant.
Getting to do this sort of portfolio pruning by simply selling the assets back at the same price MPW bought them for and keeping the collected rent is a great outcome.
Minor bad news interpreted as dire
With hundreds of properties leased to dozens of tenants in a challenging healthcare environment there are bound to be problems that pop up here and there.
On October 3rd, Pipeline healthcare announced that it had filed for chapter 11 bankruptcy. They are a small tenant of MPW. They are also a small tenant of Global Medical REIT (GMRE).
Here is Pipeline’s self-description:
“Pipeline Health has seven hospitals in three states, each one serving diverse underserved communities for decades. These hospitals include: Weiss Memorial Hospital and West Suburban Medical Center in Chicago; White Rock Medical Center in Dallas; and four hospitals in the Los Angeles area – Memorial Hospital of Gardena, Coast Plaza Hospital, Community Hospital of Huntington Park, and East Los Angeles Doctors Hospital.”
I think it is quite a testament to REIT underwriting that 5 of the 7 hospitals operated by Pipeline are owned by REITs and yet it was the 2 non-REIT owned hospitals (the Chicago ones) that were the source of the bankruptcy.
It appears as though the REIT owned hospitals will continue to be operated.
Andrei Soran, CEO of Pipeline said:
“We intend for the restructuring process to allow our hospitals to remain open and operating in their communities, while putting the hospital system in a more secure and sustainable financial position going forward,”
Hospitals staying open and operating requires paying rent. As of the most recent quarter Pipeline was current on rent to both GMRE and MPW and it appears they intend to continue paying at least for now.
I interpret this tenant bankruptcy as clearly being bad news. However, the magnitude is nowhere near what the market’s reaction implies. As recently as October 5th, MPW was a $11.98 stock and on October 7th it is at $10.10. While Pipeline announced on the 3rd, the news had not yet been noticed until the 5th.
The nearly $2 per share drop seems rather absurd to me given the following:
- Pipeline is a very small portion of MPW’s revenues at about 2%
- Pipeline is still paying rent so there might not be any impairment whatsoever
Hospitals are a different sort of asset class. When an office tenant, for example, goes bankrupt, the office building is frequently going to be left vacant.
Hospitals are essential to the well-being of communities and as such are rarely left vacant. When something like this happens the 2 most likely outcomes are:
- The tenant finds a way to stabilize. In this case, the announced sale of the failing Chicago hospitals could potentially stabilize Pipeline
2. A stronger operator comes in to run the asset. The new operator would then take over the lease with MPW, thus preserving the healthcare of the community and the rental income.
The key aspect that I think the market is missing is that MPW owns the hospitals rather than the operations. An operator failing does not mean the real estate is bad. Another key aspect that I think the market is missing is that this is not a new thing.
Healthcare is a challenging industry. It always has been. Healthcare operators correctly prioritize patient outcomes over finances so patients will be treated even if they cannot pay. This leads to challenges in tracking down reimbursement from the government which can be delayed. Making healthcare even more difficult is the extent of regulations. Not only do hospitals have to provide good care, but they need to do everything according to regulations and keep paper trails proving they provided good healthcare. Medicare/Medicaid reimbursements are not always enough to cover these expenses.
Over the long run, the CMS (Centers for Medicare/Medicaid Services) adjusts reimbursement rates upward to ensure the healthcare system remains financially stable. In the short run however, spikes to costs can hurt operator profitability. Healthcare operators have had a particularly difficult time in the last couple years with a combination of labor prices spiking and COVID related PPE expense.
This has broadly lowered the profitability of operators. Those who were highly profitable previously are now moderately profitable and those that were marginally profitable before are now hurting. Some of the weaker operators are going out of business.
Importantly, this challenging environment is not a permanent state. It is in everyone’s best interest to have a functioning healthcare system, so when things get too hard for operators adjustments are made. In early August, the CMS responded with a significant increase to hospital reimbursement rates.
According to KHN Morning Briefings:
“CMS Hikes Inpatient Medicare Reimbursements By 4.3%
The change, which is higher than an earlier proposed raise, is expected to increase hospital payments by $2.6 billion.“
This will go a long way to restoring operator EBITDA. I suspect 2Q22 and 3Q22 will be the trough operator earnings. Thus, it is a matter of getting through the hard period.
Stronger operators are taking over the facilities of the struggling operators. In most cases this happens through a voluntary transition. In other cases, an operator goes bankrupt, and a stronger peer takes over.
Medical Properties Trust generally works with strong counterparties, but in this tough environment some of its operators are struggling a bit. Overall portfolio EBITDARM coverage is 2.6X as of the 2Q22 supplemental and EBITDARMs are reported with a 1 quarter lag so that is 1Q22 for the operators.
Looking at this list I want to make note of a few things:
- 2.6X EBITDARM coverage is far higher than that of the big healthcare REITs Ventas (VTR) and Welltower (WELL)
- MPW has been proactive in dealing with the tenants on the lower end of its coverage spectrum
Those marked in yellow have recent news. We already discussed MPW’s successful exit from the troubled Prospect facilities and the Pipeline issues.
On August 29th, MPW profitably exited its loan to Springstone Health and secured its tenancy with LifePoint with the extension of the master lease until 2041. LifePoint has 2.0X EBITDARM coverage of rent which is not phenomenal, but stable.
There is a long history of MPW successfully transitioning from troubled tenants. In fact, over its 18 year history, MPW has made a net profit on hospitals where tenants have failed.
The above math is done by MPW. I calculate the profit as slightly lower because I would use a different cap rate on the re-leased Adeptus properties.
A while back, Adeptus was a major tenant for MPW and its entire Texas system failed. It was a scary few months, but MPW was able to facilitate the transfer of the Adeptus facilities to new operators and largely maintained its rental revenues.
MPW originally paid $415 million for 59 Adeptus facilities. 37 were transferred to new tenants at largely the same rent. Another 19 were sold and 3 remained vacant. MPW is valuing the sold properties and sale price and the re-rented properties at a 6.5% cap rate.
I think a 7.5% cap rate is more appropriate, so the net Adeptus gain is probably a bit lower.
That is an impressive track record. The net summation of MPW’s “failed” assets is roughly a break even or slightly better.
Thus, I think the market is entirely over-reacting when a few of its tenants are struggling in the challenging healthcare environment.
Quite simply, the real estate is valuable and will permanently be in demand as long as humans need healthcare. It must stay open and to stay open rent must be paid. Tenants will rotate but the real estate remains.
This rock bottom sentiment has sent MPW down to half of its former valuation at a time when earnings (FFO/share) are the highest they have ever been. This creates a highly opportunistic valuation
At today’s price of $10.10, MPW is trading at 5.5X current year FFO and 7.2X current year AFFO. Consensus estimates show MPW continuing to grow FFO going forward, albeit at a somewhat slower pace.
A 5.5X multiple does not imply slow growth. It implies some sort of collapse, so either the market is wrong, or the analysts are wrong.
It is easy to understand why the market has gotten so bearish given the swirling news of healthcare difficulties. It takes quite a bit more digging to understand the durability of the real estate assets. The analysts have done the digging and I think their numbers look about right.
The reason growth is slowing is that acquisitions volumes are dropping. MPW has shifted focus in recent months to further paying down debt. This is healthy for the business in the long term, but does not lead to growth in the same way that property acquisitions have.
Over time, MPW will return to acquisitions and in this high cap rate environment they look as accretive as ever. Despite having a 10.85% dividend yield, MPW has a low FFO payout ratio. The yield is high simply because the stock is cheap. With its low payout ratio, MPW gets to save a large portion of its cashflows which it can then channel into debt reduction in the near term and accretive property acquisitions in the medium and long term.
Risks to thesis
The ability to swap in new operators to take over rents of departing operators is predicated on the overall healthcare system remaining stable. Historically it largely has remained stable. There have been some bumps and even some potholes, but for the most part healthcare facilities have remained in operation.
There are plausible scenarios in which that changes. Adverse legislation or reimbursement rates that are out of touch with reality or any number of big mistakes could derail the hospital system. In such an event it would be much harder to replace tenants and MPW could legitimately lose a large portion of FFO.
I don’t see this as likely, but I am reviewing industry news at least weekly to try to anticipate events that could lead to such systemic problems.
The CMS Catalyst
As previously mentioned, the CMS has increased reimbursement rates by 4.3% for 2023. Healthcare is a high expense and high revenue space, so a 4.3% increase to revenue is a big deal.
This will go a long way to stabilizing operators and will help EBITDARM coverage ratios tick back up. MPW has traditionally had EBITDARM coverage in the 3X-4X range and if it can return to that level it should put the fears to rest.
This would allow MPW to trade back up toward its normal FFO multiple which is in the mid-teens.
Perhaps one could argue that a lower multiple is appropriate for the now higher interest rate environment. So rather than 14X MPW should trade at 11X. Well, that is still a double from today’s price.
This is a good business that has gotten unreasonably cheap on out-of-control fear.
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