What to Buy: Omega Healthcare Investors Inc (NYSE: OHI)

Why to Buy Now: This month, we decided to continue our flight-to-safety theme by diversifying away from the energy sector, at least until OPEC finally blinks and decides to cut production.

So once again, we decided to tilt toward the lower end of the high-yield spectrum, with a healthcare real estate investment trust (REIT) whose $0.52 quarterly distribution ($2.08 annualized) has a forward yield of 5.5%. This REIT’s distribution is well supported, with a trailing 12-month payout ratio of 73.6%.

Omega specializes in providing financing and capital to the U.S. long-term healthcare industry, with a focus on skilled-nursing facilities (SNF).

And given the demand aging baby boomers will place on the healthcare system, many payors will likely opt for skilled-nursing facilities’ relatively low cost of care over pricier alternatives.

Omega’s core portfolio consists of long-term leases and mortgage agreements. Its leases are “triple net,” which means tenants are required to pay for all property-related expenses, including real estate taxes, insurance and maintenance.

At the end of the third quarter, Omega owned or held mortgages on 562 skilled-nursing facilities, 21 assisted-living facilities and 11 specialty hospitals, with nearly 64,000 licensed beds located in 37 states and managed by 50 third-party healthcare operating companies.

Toward the end of October, Omega announced a merger with Aviv REIT Inc (NYSE: AVIV) in a unit-for-unit transaction that values the latter at $3 billion, a 16% premium to its closing price prior to the announcement. The combined entity will offer investors the premier pure-play skilled-nursing facility REIT.

Management expects to continue making bolt-on acquisitions in what is a highly fragmented industry. Omega’s roll-up strategy coupled with the tailwind from aging boomers should lead to continuing growth over the long term.

And with a price to funds from operations (P/FFO) per unit ratio of 13.6 compared to a North American healthcare REIT industry average of 15.3, Omega offers good value at current prices.

Omega Healthcare Investors is a buy below 39.

Khoa: I’m kind of surprised by this month’s pick. I had thought you were wary of the healthcare sector in the wake of Obamacare.

Ari: Prior to the passage of the Affordable Care Act, healthcare was one of my favorite sectors for long-term growth.

But ever since Obamacare became the law of the land, I’ve been admittedly leery of investing in the space. That’s because when the government has an outsized role in an industry, it can change the rules of the game at any time, and that means long-term growth is less assured.

Despite such trepidation, I still have personal investments in healthcare-oriented stocks, and, of course, we’ve previously recommended a couple of securities with exposure to the sector in the U.S. and Canada.

Beyond that, the healthcare sector has continued its march higher since the ACA was signed into law in early 2010, and is now up 128.1% on a total-return basis versus 93.9% for the S&P 500. Clearly, investors are betting that the larger population of insured will more than offset any regulatory whims on the part of the government.

Even so, this country’s resources are not infinite, and the rising number of insured will impose a substantial burden on tax payers. That means the government and insurers will be paying even greater attention to cost discipline.

Fortunately, when it comes to care, skilled-nursing facilities are far cheaper than alternatives such as inpatient rehabilitation facilities (IRF) and long-term acute-care (LTAC) hospitals.

According to data gathered by the Medicare Payment Advisory Commission, the average per-case rate at a skilled-nursing facility for care in situations ranging from a hip fracture to a stroke is nearly one-third that of an IRF and one-eighth that of an LTAC.

When you’re talking about medical bills that can total in the tens of thousands of dollars, that’s a huge savings!

Still, SNFs could feel the pinch from tighter government spending.

A significant portion of Omega’s operators derive their revenue from Medicare and Medicaid. Both federal and state governments have focused on cutting costs under these programs, while reimbursement rates have also been pared.

Nevertheless, management believes that its operators can absorb moderate reductions in reimbursement rates, while still meeting the terms of their leases.

Khoa: Tell me more about this merger. That’s a huge deal for a company that has a market cap of just $4.8 billion at present.

Ari: Indeed, as the bond-rating agency Fitch notes, Omega tends to fund acquisitions with secondary equity issuances so that the effect on overall leverage is neutral. So we should expect a sizable equity issuance at some point in the near future.

More patient investors might want to hold off on investing in the REIT, or at least hold off on buying a full position, until that issuance is announced. In my observation, the market tends to reflexively sell off companies following such announcements, even if the issuance itself is in furtherance of long-term growth.

In fact, Omega’s units had actually hit an all-time closing high of $39.46 just prior to the deal’s announcement, and have since declined by about 5%, probably due to expectations that an issuance is forthcoming.

Anyway, the combined entity will have a total market capitalization of around $7.2 billion, making it the fourth-largest publicly traded healthcare REIT in North America.

And its portfolio will jump to 789 skilled-nursing facilities, more than double the number of its nearest competitor Ventas Inc (NYSE: VTR). Equally important, Omega will be the only pure-play SNF REIT among its peers.

The overall portfolio will hold 874 facilities across 41 states, with significant concentrations in Ohio (11% of annualized in-place contractual rent), Florida (10%) and Texas (9%).

In addition to geographic diversity, the merger will also reduce Omega’s dependence on its top 10 operators, with its concentration based on annualized rent dropping to 52% from 69%.

Although Omega will now be the dominant player in the SNF category, there’s still ample room to grow even larger through consolidation. The company estimates the total SNF market is around $100 billion, with 15,900 facilities of which 87% are privately owned.

Thanks to greater scale and an improved cost of capital, it should be able to continue to make judicious acquisitions following the merger.

Management says the deal, which is expected to close during the first quarter, will be immediately accretive to cash flows. Accordingly, it forecasts growth of 9.5% year over year for 2015 funds available for distribution, with a range of $2.81 to $2.87 per diluted unit.

Khoa: Looks like there’s been some nice distribution growth over the years.

Ari: Yeah, Omega’s grown its distribution by 8.6% over the trailing year and by nearly 11% annually over the trailing five-year period.

However, the REIT has cut its distribution in the past, though that was all the way back in 2000, when weak results from its operators forced it to lower its payout to stay current on its debt obligations.

Fortunately, Omega doesn’t have any major debt coming due until 2019. Similarly, Aviv’s next major debt maturity doesn’t occur until 2018.

Khoa: How does analyst sentiment look?

Ari: Analyst sentiment is decidedly neutral, at two “buys,” three “holds,” and two “sells.” Only two analysts offer 12-month target prices of recent vintage, though both were updated prior to the deal’s announcement, so they’re not all that instructive.

Analysts forecast funds from operations per unit, the relevant measure of a REIT’s profits, will grow 6% year over year in 2015, with three analysts boosting their estimates over the past four weeks.

Again, not every analyst seems to have published updated numbers since the merger was announced, so we’ll have a better sense of analyst sentiment when more post revised estimates.

Khoa: What about tax considerations?

Ari: U.S. REITs avoid taxation at the corporate level because they’re required to pass along at least 90% of their taxable income to unitholders. That’s the reason why they offer such high yields.

To keep REITs at tax parity with corporations, therefore, the majority of a REIT’s distribution is typically taxed as ordinary income instead of the more favorable rate for dividends.

In addition to ordinary income, a REIT distribution can also consist of capital gains from the sale of property, and return of capital from real estate depreciation.

The component of a distribution that’s derived from capital gains will typically be taxed at the long-term capital gains rate, while return of capital will reduce an investor’s cost basis and be recaptured at the long-term capital gains rate upon sale of the security.

At the beginning of each calendar year, a REIT will inform its unitholders what the composition of the prior year’s distribution was for tax purposes. In 2013, for instance, 82.6% of Omega’s cumulative distribution was considered taxable as ordinary income, while the balance was treated as return of capital.

As such, it’s best to hold U.S. REITs in tax-advantaged accounts such as IRAs.

Buy Omega Healthcare below 39. 

Portfolio Update

Given the energy sector’s dominance of the high-yield space and, therefore, our Portfolio, we feel it’s worth briefly discussing the latest expectations for crude oil prices before proceeding to individual company updates.

The slide in oil has been painful, and the speed with which it has occurred has been alarming, especially since so many dividend payers operate in the energy sector. However, it’s important to remember that this kind of extreme volatility is characteristic of the energy markets.

There are two factors currently affecting trader sentiment: uncertainty about the trajectory of global economic growth, particularly as it pertains to China and the U.S., and the projected glut of supply.

Cuts to production would almost certainly stop the slide in oil prices. That could first happen among higher-cost producers that operate in unconventional oil plays such as shale formations and Canada’s oil sands, since oil has already fallen below the price where production is economic for some in these areas.

Of course, these entities use derivatives to hedge their exposure to oil prices, so that could buy them some time. And they may also continue production at current levels for a time, just to maintain market share.

The latter point is what’s currently driving expectations about oil prices in the global economy. Saudi Arabia has sent confusing signals to the market about the possibility of production cuts and whether there’s a price war going on between members of OPEC and other producers. We’ll get greater clarity on this when OPEC convenes on Nov. 27.

For now, some believe OPEC is using the bear market in oil as an opportunity to reduce competition from producers who operate in higher-cost unconventional plays, which it sees as a long-term threat. In this way, OPEC members hope to not only maintain market share amid a downturn, but to possibly expand it when higher-cost players are forced to idle production.

OPEC holds about 80% of the world’s oil reserves and is responsible for about one-third of global production.

At this point, $70 per barrel seems to be the line in the sand for OPEC. “At $70 a barrel, there will be panic in OPEC. We have become used to living with $100 a barrel,” one OPEC official told The Wall Street Journal.

That’s because these countries depend on oil revenue to fund their governments, including the social services that help keep some regimes in power or at least stave off unrest. Many have predicated current and future spending on oil being near or above $100 per barrel.

The price of Brent bounced off its recent closing low of $77.49 and currently trades just above $80 per barrel, so we’re not quite there yet. And, of course, there could be other factors that compel OPEC to act, including the fact that some member countries, whose regimes are dependent upon oil trading at $100 per barrel, such as Nigeria, Venezuela and Ecuador, are already hitting the panic button with both fists.

Now, let’s get into the latest company updates.

Artis REIT (TSX: AX-U, OTC: ARESF) reported that third-quarter adjusted funds from operations (AFFO) rose 9.4%, to CAD122.6 million, or CAD0.92 per unit. This equated to a payout ratio of 88% of its CAD0.81 quarterly distribution.

Property net operating income rose 5.4%, to CAD78.6 million, compared to CAD74.6 million in the third quarter of 2013.

Its occupancy rate was a solid 95.6% including commitments, unchanged from the prior quarter.

During the quarter, Artis acquired one retail property in Winnipeg for approximately CAD12.4 million, bringing its total book value to CAD5.4 billion.

The company raised CAD75.9 million in an additional offering of Series A senior unsecured debentures.

Artis is a buy below USD16.

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF) reported average production rose 1%, to 74,720 barrels of oil equivalent per day (boe/d) during the third quarter.

Production revenues rose 5%, to CAD259.7 million, compared to CAD246.4 million a year ago. Funds from operations (FFO) rose 7%, to CAD129 million, or CAD0.60 per unit.

Management attributed improvements to its exploration and development (E&D), which delivered record production exiting the quarter at 80,000 boe/d.

During the quarter, the company closed on the remaining 49% interest in its Wilrich play at Ansell for CAD141.1 million, adding 1,600 boe/d in production. The acquisition also provides the company with another 115 potential drilling locations in the Deep Basin.

Bonavista invested CAD178.9 million into E&D projects, drilling 45 (37.3 net) wells.

Management affirmed its 2014 production guidance in a range from 76,000 boe/d to 78,000 boe/d. This represents a 13% production increase compared to last year, despite the disposition of about 4,300 boe/d of non-core assets.

To improve the efficiency of its E&D program, the company will continue its non-core divestments and reduce total spending.

Its Board of Directors announced a preliminary 2015 capital budget of between CAD425 million and CAD475 million, which is expected to result in drilling between 100 and 110 net wells. This spending is expected to generate annual production of between 82,000 boe/d and 85,000 boe/d, which at its mid-point is a 9% increase compared to 2014 daily production.

Bonavista remains a hold.

BreitBurn Energy Partners LP (NSDQ: BBEP) announced third-quarter production rose 8%, to 3.4 million barrels of oil equivalent (MMboe). Average daily production came in at 36,500 barrels of oil equivalent (boe/d), down from 37,100 boe/d in the preceding quarter.

Despite lower commodity prices, adjusted EBITDA increased 8%, to $118.7 million, primarily due to higher sales volumes and lower commodity derivatives payments.

The company raised its monthly cash distribution by 3%, to $0.1733 per unit, or $2.01 on an annualized basis.

Despite higher oil, natural gas liquids (NGL) and natural gas sales volumes, total revenues slid to $216.1 million, compared to $219.1 million in the second quarter, as energy prices continued to fall.

Distributable cash flow (DCF) was $53.3 million, or about $0.39 per unit for the quarter. This provided distribution coverage of 0.78x.

BreitBurn is still moving forward with its planned acquisition of QR Energy (NYSE: QRE), which is expected to close at the end of the year. QR Energy reported third-quarter production growth of 3%, to 20,859 boe/d. The LP generated $36.6 million in DCF for a 1.1x distribution coverage ratio.

Breitburn is a buy below 21, while QR Energy is a hold, pending the acquisition.

Crestwood Midstream Partners LP (NYSE: CMLP) reported that third-quarter distributable cash flow (DCF) rose 38%, to $88.7 million, resulting in a distribution coverage ratio of 1.05x.

Adjusted EBITDA (earnings before interest, taxation, depreciation and amortization) jumped 36% due to strong performance in its gathering and processing and natural gas liquids (NGL) and crude services segments.

Gathering and processing segment EBITDA rose 16%, to $50.3 million, in the third quarter 2014, compared to $43.2 million a year ago. The increase was due to record natural gas gathering volumes, which averaged 1,261 million cubic feet per day (MMcf/d), up 22% over the corresponding quarter in 2013, and compression volumes which rose 111%, to a record 590 MMcf/d.

NGL and crude services segment EBITDA was $36.7 million, compared to $15.1 million in the third quarter of 2013. Crude oil volumes rose 175%, to 227,000 barrels of oil equivalent per day (boe/d) for the quarter.

Crestwood’s storage and transportation segment EBITDA came in at $35.7 million, compared to $33.4 million a year ago. This was driven by a 7% boost in transportation and storage volumes, which averaged about 1,785 MMcf/d during the quarter.

Crestwood is a buy below 25.

Legacy Reserves LP (NSDQ: LGCY) reported production rose 60%, to a record 32,109 barrels of oil equivalent per day (boe/d) for the third quarter, driven by the company’s acquisitions.

Legacy has closed on roughly $544 million in acquisitions year to date, which should provide some lift in upcoming quarters.

For the third quarter, Legacy posted EBITDA (earnings before interest, taxation, depreciation and amortization) of $77.7 million, up from $76.2 million a year ago.

The LP generated distributable cash flow (DCF) of $36.2 million, down from $44 million last year. Distribution coverage came in at 0.86x due to the impact of an 11.5 million unit equity offering in October. Excluding the new units, the company achieved a coverage ratio of 1.03x.

The $300 million offering gives the company an available borrowing base of roughly $885 million.

Legacy is a buy below 28.

LRR Energy LP (NYSE: LRE) reported third-quarter 2014 distributable cash flow (DCF) of $11.6 million, resulting in a distribution coverage ratio of 1.13x. The distribution coverage ratio showed significant improvement from the second quarter, when the company posted a 0.87x ratio.

Hindered by flaring at its Red Lake field and delayed drilling activity at its Putnam field, daily production fell 4.5%, to 6,304 barrels of oil equivalent per day (boe/d), compared to 6,609 boe/d last year.

Management boosted its quarterly distribution by 1.5%, to $0.4975 per unit, or $1.99 on an annualized basis.

Based on the results from the first nine months of the year, LRR Energy revised its full-year 2014 production guidance to a range of 6,400 boe/d to 6,450 boe/d from the previous range of 6,450 boe/d to 6,550 boe/d.

Due to lower expected development activity in its Putnam and Corral Canyon assets, management also announced it will reduce its capital development program in the second half of 2014 by $2.5 million, to $35 million.

LRR is a buy below 18.

Natural Resource Partners LP (NYSE: NRP) reported distributable cash flow (DCF) of $57.8 million, or $0.51 per unit for the quarter.

During the quarter, management was also able to cut $15.7 million in debt, bringing the total amount of reduced debt for the first nine months of the year to $69.2 million.

Oil revenues fell 46%, to $9.6 million, but were offset by higher-than-expected coal revenues, which rose 18%, to $65.2 million, compared to the prior year’s quarter.

The company affirmed its revenue guidance for 2014 in the range of $370 million to $390 million. DCF is expected in the range of $205 million to $230 million, which would provide a 1.29x to 1.45x coverage ratio.

Wyatt Hogan, President said “All of our commodities performed in line with our expectations for the quarter, and we remain on track to meet our guidance for the year.”

Natural Resource Partners remains a hold.

Navios Maritime Partners (NYSE: NMM) announced it received two 8,204 TEU (20-foot equivalent unit) container vessels, the Korean-built YM Utmost and YM Unity during the period ended Sept. 30. Both container ships will be chartered at a rate of $34,266 per day.

To finance part of the purchase of these two vessels, Navios announced it entered into a new credit facility of up to $56 million.

Third-quarter EBITDA (earnings before interest, taxation, depreciation and amortization) rose by $1.8 million, to $37.5 million for the quarter, compared to $35.6 million a year earlier. The EBITDA growth was driven by an additional $8.7 million in revenue from the company’s expanded fleet and increased voyage days.

Navios has contracted 99.2% of its available days for the remainder of 2014 and 61.3% for 2015.

Navios is a buy below 19.

It appears that the majority of WesternOne’s (TSX: WEQ) decline since its trailing-year high in late August was prompted by the decline in crude oil, which culminated in a sharp selloff in early October.

Crude oil is now officially in a bear market, and if prices persist at these levels beyond the near term, then it will eventually cause higher-cost energy producers in Canada’s oil sands and the U.S. shale plays to curtail production.

We originally recommended WesternOne as an attempt to diversify the Big Yield Hunting Portfolio away from explicit energy sector plays, since so many of the securities in the high-yield space are involved in the production or transportation of energy products.

But while WesternOne is indeed involved in diverse industries in the areas of construction and infrastructure, the buyout firm derives the vast majority of its revenue from Britco, a manufacturer of modular buildings, whose primary customers operate in the energy sector.

WesternOne is only at the beginning of what we believe could be a long-term growth story, but that also means that it’s still a tiny company. And it has a substantial retail investor base that while clearly attracted to its high yield is also easily spooked.

We were hoping that the firm’s third-quarter results would go a long way toward pacifying fearful investors, but it fell short of analyst estimates for revenue by 6.4%, the first miss in six quarters, while also failing to meet expectations on earnings per share.

However, the main culprit for this disappointing performance does not appear to have been the energy sector’s recent woes. Rather, adjusted EBITDA (earnings before interest, taxation, depreciation and amortization) from its Britco unit declined due to increased labor costs for onsite construction at a Manitoba Hydro project as well as higher material costs.

Although 2014 is stacking up to be an underwhelming year for this firm, analysts expect next year to be markedly better, when they project full-year adjusted earnings per share to jump to positive CAD0.28 from this year’s forecast of negative CAD0.06.

The four analysts who track the firm all still rate it a buy, with a consensus 12-month target price of CAD6.38. Though that’s lower than our entry price of CAD7.31, it is significantly higher than current levels.

So even if you’re not inclined to be a long-term holder of the stock after what we’ve experienced recently, you should be able to get out at a better price than where it’s trading presently at some point in the year ahead.

WesternOne is a buy below USD7.85.