As you may recall, in January I outlined certain “factors” that have been found to correlate with higher stock returns. I displayed a list of stocks that display one or more of these helpful factors, and I have been going down the list stock-by-stock in this year’s Dividend Growth Stock of the Month articles.
This month, I am skipping a few names on the list, and dropping all the way to the bottom, because I have a personal reason to focus on a particular stock. I will explain the personal reason at the end of this article.
The company that I want to analyze is Ventas (VTR). If you haven’t heard of it, it’s a small health-care REIT (real estate investment trust). It is a Dividend Challenger on David Fish’s Dividend Champions, Contenders, and Challengers, meaning that it has between 5 and 9 years of consecutive annual dividend increases under its belt.
Let’s put it through the meat grinder.
This is a good resume.
Five categories are green: Yield (5.3%), the 2015 increase (9.9%), 5-year DGR (dividend growth rate (8.8%), DGR trend, and dividend safety rating (B).
Ventas froze its dividend a single year during the Great Recession, in 2009.
Absent that, the company has increased its dividend every year since beginning in 1999.
Without the one-year freeze, Ventas would have a streak of 16 years going.
VTR’s dividend growth trend gets a “good” rating, because the 1-year, 3-year, 5-year, and 10-year DGRs not only show a slight uptrend, but also have been at a high rate of percentage increase:
The orange flag is for increasing share counts. This is always a consideration for REITs, because they all issue shares periodically. This is the opposite of buying back shares and retiring them. Why do they do this?
By law, to avoid taxation at the corporate level, REITs must pay out most of their profits as dividends to shareholders. Thus REITs cannot retain most of their earnings to fund growth. Therefore, they must turn to other sources of capital: debt and issuing more shares.
The increasing share count is unavoidable, but it nevertheless is a risk factor. As we saw last year with Kinder Morgan (KMI), if the bottom falls out of the share price, the company cannot raise much money by issuing shares, so it will stop doing so. But then it is left only with the options of taking on more debt or curtailing growth.
Another unattractive feature of issuing new shares is that they dilute the ownership percentage of existing shareholders.
Thus it is incumbent on the company to put the proceeds from share issuance to profitable use. That’s why, in a REIT, we look for conservative fiscal practices and intelligent investment decisions by management. If the money raised from issuing new shares is squandered, it costs the owners real value.
Because of the law requiring REITs to pay out most of their profits as dividends, they tend to have high payout ratios. Check out the following chart.
In the graph, VTR’s profits (represented by its cash flows) are shown by the dark green area topped by the orange line. The gray line running through that area shows the amount paid out as dividends. You can see that the dividends use up most of the profits each year.
In 2015, for example, the ratio was $3.04 / $4.47, or 68%. The ratio stays around 70% most of the time.
By the way, you can also see VTR’s dividend freeze: The gray line is flat from 12/2008 to 12/2009.
What’s the Story on Ventas? How Does It Make Money?
Ventas is a real estate investment trust that invests in health care facilities. Its assets include housing for seniors, specialty care facilities, hospitals, and medical office buildings. It owns facilities in the USA, Canada, and the UK. The following display is from VTR’s most recent investor presentation.
The senior healthcare facilities industry is surprisingly fragmented. Ventas estimates that less than 15% of the $1 trillion market is owned by REITs. That means that there is a large growth potential for a roll-up business strategy.
Ventas grows largely by making acquisitions. Since 2004, it has made nearly $29 billion in strategic investments. Just as you do as an investor, VTR attempts to achieve a diversity of revenue streams. Ventas’ model seeks to achieve a balance across several key measures – geography, asset type, tenant/manager mix, revenue source, and operating model.
The company’s geographic diversity and variety of types of facilities are shown by this map.
Ventas’ senior housing operating properties, which provide an estimated 32% of net operating income, are largely in top metropolitan areas with higher average household incomes. This gives Ventas the opportunity to charge more at their facilities than national averages.
By investing in senior- and healthcare-related facilities, of course, Ventas is riding a global megatrend, namely the aging of the population, that will spur demand. Its natural demographic market is growing very fast, as pointed out in the recent company presentation:
• The senior population is growing 7x faster than other adults
• 10,000 Baby Boomers are turning 65 and becoming eligible for Medicare daily
• Seniors visit doctor’s offices 2.5 times more than other adults
• Seniors spend 5 times more than other adults on healthcare
Ventas operates some facilities, while leasing out others on a triple-net-lease basis (meaning that the tenant assumes all operating costs and responsibilities). The company summarizes its investment attributes as follows:
• Long and successful history of outperformance, stability, growth, and income
• Strong balance sheet
• Growth opportunities from demographic and environmental trends (including health insurance and eligibility for Medicare)
In 2014, Debra Cafaro, CEO of Ventas, was named to the Best Performing CEO’s in the World by Harvard Business Review (ranking #27). Morningstar rates Ventas’ Stewardship as Exemplary, its highest rating, and gives the company a Narrow Moat rating, its 2d-highest rating.
S&P Capital IQ’s below-average quality rating for Ventas puzzles me. They do not explain its derivation for this stock. In general, their quality ratings reflect growth and stability of earnings and dividends, among other factors. As we have seen, Ventas’ dividends have had strong growth at stable high rates. Furthermore, S&P Capital IQ has a 4-star “buy” rating on the stock. Go figure.
Before we dig into the numbers, I need to explain the financial term FFO. That stands for funds from operations. This definition is from Investopedia.
Funds from operations (FFO) refer to the figure used by REITS to define the cash flow from their operations. It is calculated by adding depreciation and amortization expenses to earnings…. The FFO-per-share ratio should be used in lieu of EPS when evaluating REITs and other similar investment trusts.
REITs don’t use GAAP earnings (generally accepted accounting principles) to determine profit. They must report GAAP results, but their business models necessarily require large capital expenditures. Therefore, it is accepted in the industry to use FFO as a better measure of profitability.
According to NAREIT, an industry trade association:
Funds from Operations (FFO)…is used by REITs to define the cash flow from their operations. [It] is calculated by adding depreciation and amortization expenses [back into] earnings….FFO corrects drawbacks associated with historical cost accounting for real estate assets which assumes that the value of real estate assets will decrease predictably over time. Real estate values actually rise or fall with market conditions, a consideration that…FFO includes.
At first glance, this is not a stellar financial resume, but I think it is better than it looks.
For example, the declining FFO trend is partly explained by a spinoff of skilled nursing facilities that VTR made last year. Most analysts see the spinoff as a good move, because it allows Ventas to be more focused on its three major lines of business: senior housing; medical offices; and loans.
The high debt/equity ratio is typical for REITs. As explained earlier, because of the requirement to pay out most of their profits as dividends to shareholders, they must turn to the debt markets to help fund growth.
Ventas’ revenue stream from its long-term triple net lease properties is relatively predictable. VTR’s tenants and managers derive about 80% of revenues from private pay sources, less than 20% from government insurance programs.
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value, shown by the orange line on this graph.
In this case, FASTGraphs uses a default valuation Price/FFO ratio of 15, the same ratio that we normally use with conventional companies.
Ventas’ actual price is slightly under the valuation line, just 4% below it. Thus this first step suggests that VTR is fairly valued.
Step 2: FASTGraphs Normalized. The second valuation step is to compare VTR’s price to its long-term average P/FFO ratio. This lets us adjust for the fact that some stocks always seem to have a high valuation, while others always have a low valuation.
The blue line on the graph tells us that VTR’s normal average P/FFO ratio over the past 10 years has been 15.7, which is just slightly higher than the default ratio of 15 used in the first step.
Ventas’ actual price is 8% below fair value by this method. That is more favorable, but it is still in the range that I would call fairly valued.
Step 3: Morningstar Star Rating. Morningstar uses a comprehensive net present value (NPV) technique for valuation. Many investors consider this to be a superior method to using P/E ratios as we just did with FASTGraphs.
In its NPV approach, Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
On Morningstar’s 5-star system, Ventas gets 4 stars. That means that they believe the company is undervalued. They assign a fair value of $83 to the shares. Ventas’ actual price is 23% below that, which indicates favorable undervaluation.
Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be above the average than below it.
As you can see in the 2d-last line, VTR’s current yield (4.7% measured on a trailing basis) is about 12% higher than its 5-year average. Using this method, I believe that VTR is about 15% undervalued.
Using the 4 approaches just described, our valuation summary for Ventas looks like this:
So the conclusion is that Ventas is about 15% undervalued at the present time. That suggests that this is an opportune time to purchase the stock.
There are a couple of factors that do not fall into the earlier categories.
VTR’s beta of 0.3 (measured over the past 5 years) indicates a stock price that has been quite stable with respect to the market as a whole. That makes it pretty easy to hold onto most of the time even when the market is experiencing high volatility.
The analysts’ recommendations are from S&P Capital IQ. Their most recent report on VTR shows the opinions of 17 analysts. Their average recommendation is 3.2 on a 5-point scale, which is slightly higher than “Hold.”
Here are Ventas’ positives:
• In the middle of megatrend for healthcare, with demographics working in its favor.
• Its business model, with multiple prongs, allows it to consider a range of opportunities across property types and leasing models.
• Excellent yield of 5.3%.
• Very good dividend growth record, in the 9% per year range over the past 5 years.
• Nice diversity of businesses give it multiple revenue streams. Business model is worthy of a narrow moat rating.
• Conservative, careful management, with high ratings for business stewardship.
• Very low beta.
• Available at an undervalued price.
And here are its negatives:
• Slow growth overall, suggesting that dividend growth rate will need to come down.
• Company must issue new shares to grow, which holds it somewhat hostage to market price fluctuations.
• Just average financials, although the recent major spinoff distorts the company’s growth rate.
I mentioned at the beginning that I had a personal reason for evaluating Ventas this month.
The reason is that I decided to trim my position in Realty Income (O), another REIT, from my Dividend Growth Portfolio. Therefore I was looking for a replacement. Ventas fills the bill nicely based on this evaluation. So earlier this month, I added more Ventas shares to a small existing position. (Here is my article on that original purchase in 2014.)
I will write an article about trimming O and buying VTR later this month to explain both why I did it and what I expect will be the effect on my portfolio.
– Dave Van Knapp
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