JUST RED, NOT DEAD

Red is usually not a good color in the investing world. When a company is losing money, an accountant would say “….such and such inc. is in the red.”   Not good. Equally bad was the angry red stain I found on my brokerage statement this month, indicating that my investment in HCP INC, has not paid off. Amid the greatest bull market in recorded history, the financial statistics next to HCP indicate that the stock price has gone nowhere but down. Thus, the red numbers flashing on my computer screen. But I have never been a standard investor.  I like to look for bargains, which have been hard to find as stock prices have soared to stratospheric highs, month after month, year after year. HCP was flashing just enough red to catch my attention…..just because the stock price was in the red, does that mean that the company itself was in the red? Is HCP, a venerable provider of senior housing and a member of the S&P 500, in some kind of trouble?  What could they have possibly done for their share price to be punished while everyone else makes money hand over fist on Wall Street? After reaching a peak of $45 per share in 2013, the share price has sunk to about $25. Is this a bargain? Or it a A “value trap,”  a stock that looks like a bargain, but later collapses due to some unforeseen threat lurking on the balance sheet?  With a juicy 5.5% dividend yield, I decided that HCP was certainly worth taking a look at.

Warren Buffett, who I often look to for inspiration, is often quoted as saying that if you are going to buy .01% of a company, you should act as if you were buying 100% of the company. So the very first thing we have to ask ourselves is, current stock price aside, “How healthy is the fundamental business of HCP?”   If we didn’t have to worry about the whims and moods of Mr. Market, would we want to buy this company?

A quick look at the 2nd quarter financial report leaves us with a resounding “Yes.”  If you believe in the “Grey Tsunami,” or the massive business opportunity presented by the ageing of the the Baby Boom Generation, then HCP is the ultimate Grey Tsunami surfboard.  The company has simply built the premier portfolio of properties that cater to every stage of need presented by the ageing human body. According to the report published for Q2, 2018, only 22% of income comes from senior living facilities. A whopping 23% of income comes from ownership of medical office buildings, while an additional 23% of income is derived from life science properties. In other words, not only does HCP give Grandma a place to live, HCP also provides a place for the doctor to see Grandma, and even a laboratory for Grandma’s next medicine to be discovered.  With 10,000 grandma’s per day graduating into the Medicare program, and many of those folks destined to live well into their 80’s, HCP, Inc, aims to be part of Grandma’s life for decades to come.

So Far, So Good………

The demographics and diversification behind HCP’s cash flow certainly sound good, but there must be something wrong, right? Otherwise the share price wouldn’t be wallowing while everyone else  in the S&P 500 is partying. Afterall, that juicy 5.5% dividend yield means nothing if they will need to cut the payout next year. Let’s take a look.

Once again, we will skip the analyst hype, and management discussion, and just look at what the cold hard numbers tell us from the company’s Q2 annual report to shareholders. And in this aspect, HCP does provide a lot of numbers.  HCP is a REIT, which is a special kind of corporation organized in a way to maximize yield paid out to shareholders. So we will be focusing on two critical areas, Funds from Operations (FFO) and leverage (debt). Since REITS do not retain cash earnings the way that other large corporations do, management must borrow funds to invest in the company’s real estate portfolio, so FFO and leverage are the key items that we must scour for signs of trouble.

For the second quarter of 2018, each share of ownership produced $.47 of cash. For the first half of 2018, that cumulative number is $.95. Management paid out $.37 and $.74 respectively. This means that, on a pure cash flow basis, without taking into account any fuzzy concepts such as “depreciation,”  the company’s portfolio could easily pay out enough tangible cash to cover that sexy dividend. No trouble here!

So far so good. But what about debt? Maybe the share price has been sluggish because Mr. Market finds that management has been imprudent, and borrowed too much?

Not really. The financial institutions that have loaned HCP money set certain guidelines as far as how much additional debt HCP can take on. These are called covenants, or ratios. And we find that management has remained well within these boundaries. For example, the lenders would allow HCP to borrow money up to 60% of the total equity of the company, but HCP has only borrowed 46%. In fact, shareholders of HCP inc control $13.4 billion in assets, but only have $8 billion in liabilities. Although HCP’s share price is “In the Red”  the company itself is very much in “In the Black,” meaning profitable, solvent, and not in any danger of cutting the dividend.

Fallen Star?

So, here we have a diversified portfolio of real estate investments, with only modest debts to service, and great cash flow prospects for many years to come. Why on earth would the share price be down?

There are a few reasons, none of which should worry the long term investor. Many of the reasons why HCP has been punished have nothing to do with HCP at all!

Many analysts fear what will happen to REITs in general in a rising interest rate environment. As you are probably aware from the pathetic yield on your savings accounts or CD’s, we have been in an ultra low interest rate environment for many years. This has been good for REIT’s, as they must borrow money to fund real estate transactions. Now that rates are rising, the entire sector has been written off by analysts worried that real estate profits will be crimped by those rising interest rates. Afterall if a REIT must pay more interest to borrow money, it can only raise rents so much to offset the higher interest costs. Is this a real fear with HCP?

What should be a molehill has been turned into a mountain. Another quick look at the Q2 investment statement will show that HCP has wisely locked in low interest rate loans for many years to come. So yes, they will face higher rates at some point, but the effect should be slow and gradual. You may remember that HCP has been prudent both in the amounts they have borrowed, and in how much they actually pay out. This means that the 5.5% dividend will very likely flow undisturbed for years to come.

Another fear that has pummeled the whole REIT industry is a fear of competition for yield hungry investors. Due to our ultra low interest rate environment for the last decade, the REIT sector was one of the few places conservative investors could find decent, reliable cash flow. Now many of these investors will go back to investing in bonds, as they had for decades before the Great Recession. While it is true that now REITS will have more competition for those folks looking for regular income, only equity ownership can offer participation in the underlying growth of a business. In other words, ownership in HCP is much more than a source of steady cash flow. HCP shareholders stand to directly benefit from the explosion in elderly population that is flooding America.  No one can tell where interest rates will be in ten years, but according to the Social Security Administration, the millions upon millions of women turning 65 today can expect to live, on average, to age 86.7. That means a lot of demand for the properties that HCP owns for decades to come.

Lastly, many analysts have criticized the senior housing industry for overbuilding. As Warren Buffet would say, many senior housing owners have no “Moat”……yes, the senior population is exploding, but after all senior housing isn’t that tough to build.  This is why HCP’s ongoing push towards diversification is all the more impressive. Perhaps your cousin the general contractor and your college buddy the real estate developer could team up to build senior housing. But see if they can get the contract to develop laboratory space for Amgen in San Francisco, of if they can find a place on the campus of Johns Hopkins to build new space for cancer patients to be seen.  HCP shareholders own a lot of prime property in spots that are hard to access and impossible to duplicate, which means limited competition to surf that Grey Tsunami.

So let’s reconsider the color red. Often it’s bad news when we see that color in our stock portfolio. But sometimes it just means one of our stocks has fallen out of fashion, or been neglected by the talking heads that run Wall Street.  For my portfolio, I know that this stock in the red will eventually pay me some green!