(Published Dec. 21 by Bob Ciura)
A sky-high dividend yield can sometimes be a sign of trouble. There is a difference between a stock that sports a high dividend yield because it is growing its dividend and a stock that has a plunging share price.
Omega Healthcare Investors (OHI, Financial) is the former.
A declining share price elevates a stock’s dividend yield, but a company in questionable financial position is at risk of cutting its payout.
Omega, on the other hand, has a long track record of dividend growth. It has increased its dividend for 17 consecutive quarters.
Omega is a Dividend Achiever; it has raised its dividend for at least 10 consecutive years.
You can see the entire list of all 273 Dividend Achievers here.
The company’s steady dividend growth has lifted its dividend yield to just below 8%. This is an unusually high dividend yield. Omega is one of the highest-yielding Dividend Achievers.
Omega is in strong enough financial position to continue growing its dividend. Keep reading this article to learn about the compelling investment prospects of Omega Healthcare
Business overview
Omega is a real estate investment trust, commonly referred to as REITs. These companies invest in real estate properties. REITs allow investors to profit from diversified real estate investments without buying physical properties.
REITs are a popular choice for income investors. They are required to distribute at least 90% of their income to shareholders to retain favorable tax status.
REITs invest in a variety of property types. In this case, Omega operates in health care properties. It is primarily focused on skilled nursing facilities.
Source: 2016 Investor Presentation, page 6
In all, Omega has an investment portfolio that includes approximately 1,000 properties located in 42 states and the U.K.
The business model is straightforward. Omega uses a combination of internally generated cash flow and externally raised capital to purchase properties. These properties generate cash flow, which the company uses to buy additional properties.
This creates a virtuous cycle of growth. Last quarter, Omega placed $428 million of new investment to help keep this “snowball” effect intact.
Business conditions are very strong right now, thanks to a critical growth catalyst.
Growth prospects
The No. 1 growth catalyst for Omega is the aging population.
The U.S. population is aging rapidly. The baby boomers are the second-largest generational group in the country. There are thousands of people entering retirement every single day.
Source: 2016 Investor Presentation, page 13
This provides Omega with a structural advantage over REITs that specialize in other industry groups.
As a result, Omega’s fundamentals are in great shape.
REITs are a bit trickier to analyze than the average stock. Most companies are valued using earnings per share, but REITs have significant noncash expenses, such as depreciation and amortization. Many REITs generate little to no net income.
This is why it is important to evaluate REITs based on funds from operation, or FFO. This adds back the various noncash items. FFO provides a more accurate depiction of a REIT’s cash flow.
Omega generated $2.44 per share of FFO over the first three quarters. This represented 30% year-over-year growth.
These favorable demographic trends are why Omega expects to increase adjusted FFO by 10% this year. This growth will help secure the company’s massive dividend payout.
Dividend analysis
Investors should tread carefully with stocks offering ~8% dividend yields.
The most important question to ask is whether the dividend payout is sustainable.
High dividend yields are enticing, but those yields can vanish if the underlying fundamentals don’t support the hefty payouts. Dividend cuts result in lower dividend income. They are also usually accompanied by a severe drop in the share price.
Fortunately, Omega appears to have a sustainable dividend payout. It generates more cash flow than it needs to pay the dividend and has a satisfactory coverage ratio.
Omega’s current annualized dividend payout is $2.44 per share. At the same time, management expects adjusted FFO to be between $3.38 and $3.39 per share for 2016.
The dividend represents 72% of 2016 adjusted FFO. This is a sustainable payout ratio.
The major risk for REITs right now is interest rates. The Federal Reserve recently hiked interest rates and could raise rates three times in 2017.
Higher interest rates can be a detriment to REITs because rising interest rates increase the cost of capital.
Omega is conservatively capitalized so it should be able to withstand higher interest rates. With that said, higher rates will likely lead to slower growth.
Source: 2016 Investor Presentation, page 24
Omega has no long-term debt maturities until 2024. It has wisely taken steps to lock in the low interest rates by securing debt financing now.
Valuation and expected total returns
Despite its strong underlying growth rates, Omega has not seen its share price appreciate much over the past year.
The positive from this is that the stock is cheap. This makes Omega a compelling value opportunity in addition to its attractive income potential.
For example, in the past four quarters, Omega earned $3.25 per share of adjusted FFO. Based on its recent share price, the stock trades for a price-to-FFO ratio of 10.
Price-to-FFO can be used as an equivalent to a price-to-earnings (P/E) ratio.
Omega stock is curiously cheap since it has a high-quality business model. One reason for the stock’s cheapness is investor sentiment surrounding REITs has soured in recent months. The decline in sentiment is due to rising interest rates.
This is what makes Omega such an attractive stock. Investors could see the company’s valuation multiple rise in 2017 as interest rate-related fears ease.
Future returns will be supplemented by FFO growth and the dividend. A breakdown of expected returns could be as follows:
- 4% to 6% FFO growth.
- ~8% dividend yield.
Investors can expect double-digit returns in the range of 12% to 14% per year. These returns factor in relatively conservative FFO growth. The dividend will make up a significant portion of total returns.
Final thoughts
Investing in stocks with ~8% dividend yields can be a risky proposition. The last thing investors want to do is buy a high-yielding stock just before it cuts its dividend.
Fortunately, Omega can support its hefty dividend with the cash flow generated by the business. It already generates more FFO than it needs to pay its dividend.
Going forward, its growth prospects should justify continued dividend growth for this Dividend Achiever.
Disclosure: I am not long any of the stocks mentioned in this article.
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