Omega Healthcare: Time To Stop Adding This Passive Income Generator (Downgrade)

Thesis

I have been bullish about Omega Healthcare Investors, Inc. (NYSE:OHI) and published my first bull thesis on it back in early 2022 (see the chart below). My key argument was that the large price correction at that time was a result of market overaction to temporary issues created by the pandemic. And I argued that it was a good investment, especially for income-oriented investors, for the following three main reasons:

1. I am optimistic about its ongoing restructuring efforts to protect the value of its assets and the long-term cash flow generation capability.
2. It was attractively valued at that time.
3. A high, yet well-covered, dividend near 8.5% at that time added further support for the investment here.

Indeed, the stock has delivered a total return of more than 27% since then, far outperforming the S&P 500’s 3.8% loss, as you can see above. However, at this point, I see that all the 3 return drivers above have run their course. As such, I am writing this follow-up article to downgrade my ratings to HOLD. I see the progress from the restructuring efforts fully reflected in its current price already. And in the remainder of the article, you will see that its dividend and valuation multiples no longer offer the very asymmetric return/risk profile compared to early 2022.

Dividend is not that attractive anymore

Passive income investors may be attracted to OHI’s generous payouts, for good reasons. As seen in the chart below, the stock currently provides a Dividend Yield (on an FWD basis of 8.08%, quite high on an absolute scale.

However, when properly contextualized, it is not as high as it seems on the surface. First, its current dividend yield is no longer attractive compared to its historical average. As seen in the chart below (top panel), its 4-year average dividend yield is 8.02%, essentially on par with its current FWD yield of 8.08%. In contrast, the 8.5% yield when I first published my bull was far higher than the average.

Second, bear in mind that risk-free interest rates have also changed a lot since then. The bottom panel shows the 10-year treasury rates (US10Y) as an example. A yield of 8.5% from OHI when 10-year treasury rates were only ~1.5% offered a yield spread of about 7%, back in early 2022, a really thick cushion of safety. Now, with 10-year treasury rates hovering around 4.7%, the cushion is much thinner.

P/CFO ratio offers little margin of safety

The chart below shows OHI's valuation in terms of its price-to-cash from operation ratios (P/CFO ratio). As seen, OHI's P/CFO ratio (on a TTM basis) now sits at 13.51x. Back in early 2022, its Price-to-CFO ratio was around only 10x or lower, offering a deep value play in my view. It was not only far below its own historical average of 11.3x but also far below the average multiple for the healthcare REIT (real estate investment trust) industry at that time (~12.5x based on my estimate).

Fast forward to now, OHI's P/CFO of 13.5x is both far above its own historical track record and above the sector average by a sizable gap. As such, I see its valuation offers little margin of safety at this point.

Business fundamentals outlook

Although the outlook for its business fundamentals is quite stable in my view (and hence the HOLD thesis). For readers new to the stock, it is a healthcare REIT. My assessment of its outlook is based on the consideration of the secular trend and also a few differentiating factors in OHI’s business models.

OHI specializes in skilled nursing facilities (“SNFs”), assisted living facilities (“ALFs”), and post-acute care facilities. The population of the United States is aging, which is driving secular growth in the demand for SNFs and ALFs in my view. Such a secular trend should support the healthcare REIT sector in general.

In addition to this secular support, I also see OHI well positioned in the sector thanks to a few differentiators in its business models. First, OHI has a more concentrated tenant base than most other healthcare REITs. This concentration could be a risk, as it makes OHI more vulnerable to the performance of a small number of tenants. However, I view it as a benefit. It allows OHI to build stronger relationships with its tenants and monitor them more closely. I view its management team as quite experienced and effective on this front (with its track record of dividend growth as a good reflection).

Second, OHI is also only one of the few major healthcare REITs that provides the full spectrum of services ranging from SNFs, and ALFs, to post-care facilities. Such a spectrum of services provides diversification to its income streams and is a positive in my view.

Other Risks and Final Thoughts

Besides the above considerations, there are a few more risks worth mentioning. In the near term, the stock has a sizable increase in its short interest. As seen in the chart below, the short interest on OHI’s shares was about 18.7M in the month of August. But it has increased by more than 10% in the month of September (per the report on Sept 15) to about 20.6M shares.

Of course, an increase in short interest does not necessarily mean that its stock price is going to decline. Short sellers can be wrong. However, the recent increase in OHI's short interest is a sign of concern in my mind given its elevated valuation multiple aforementioned and also the macroeconomic uncertainties.

In the long term, I see the demographic changes in the U.S. as a secular tailwind. However, note that government regulations, especially those regarding reimbursement rates, are a major uncertainty to its business model in the long term. Both SNFs and ALFs are heavily regulated by the government. They are both reimbursed by Medicare and Medicaid. As such, changes in government regulations could have a significant impact on OHI's business.

All told, I am still seeing a stable business in Omega Healthcare Investors, Inc., but I do not see any immediate catalysts to drive market-beating returns under current conditions. All the catalysts that supported my bull thesis in early 2022 have run their course in my view.

To recap, these catalysts included the restructuring efforts, the attractive valuation, and the attractive dividend yield at that time. Now, the results from the restructuring efforts have already been priced in as I see it. Its valuation multiple implies a sizable premium instead of a discount. And the ~8% yield is no longer attractive when benchmarked against its historical average or the risk-free interest rates.