Debt Refinancing Eliminates Risk of Default; But Diversified Healthcare Trust Will Need to Raise Equity Eventually

Diversified Healthcare Trust (DHC) reported 2020 second quarter normalized funds from operations (FFO) (according to my definition) of $52.8 million or $0.22 per share, down 33% from $81.1 million or $0.33 per share in the prior year quarter.  The decline was driven mostly by the 2019 restructuring of its lease agreements with its affiliate, Five Star Senior Living (FVE), and also by the impact of pandemic-related restrictions on its business.

The pandemic-related decline in profitability is a concern because of DHC’s high debt levels.  However, the Trust took significant steps during the quarter to bolster its liquidity and eliminate near-term debt maturities.  Although it will likely post GAAP losses for the next six quarters, it has sufficient financial flexibility to weather this downturn.  Meanwhile, DHC plans to continue to execute on its asset sale program, but at a slower pace, in order to reduce debt or fund future acquisitions.  It is also renovating a few medical office and life science properties, which should help to replace the net operating income (NOI) lost on sold properties.

As the effects of the pandemic recede, probably most visibly in the second half of 2021, DHC should see an improvement in its profitability, especially in its senior housing operating portfolio (SHOP); but it is still unclear whether and when profitability in this segment will return to pre-COVID levels.

The Trust completed $50.6 million of asset sales in the second quarter and $5.2 million in July, bringing total sales to $334 million under its current program.  As of August 6, it had $232 million of properties under agreement.  Although DHC intends to complete the $900 million program, it expects the pace of future asset sales to slow because of the pandemic.

Despite the risks facing the Trust, its stock at $3.84 looks cheap.  It is trading at just 5.3 times my projected 2020 normalized FFO of $0.72 and 7.0 times projected 2021 normalized FFO of $0.54 per share.  That is well below the peer group averages of 14.0 and 13.5, respectively.  With the cash generated from asset sales and an anticipated bottoming of its financial performance during 2021, I believe that the company will be positioned to issue equity to repay as much as half of the newly issued but high cost 9.75% Senior Notes when they become callable in June 2022.  Even so, the interest savings from repaying the 9.75% Senior Notes more than offsets the additional dilution, according to my analysis. Consequently, my price target on the stock is $7.30.

August 27, 2020 (from a research report originally published on August 25, 2020).

Stephen P. Percoco
Lark Research
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