Aug. 21 was a fascinating day for shareholders and followers of Medical Properties Trust (NYSE:MPW). This is because, prior to the market opening, the management team at the business announced that they were cutting the firm’s distribution rather considerably. In most cases of a distribution cut that I have seen, the reaction to such a development is fast and brutal. It’s not uncommon for shares of a company that experience a distribution cut drop 10%, 20%, or more. But this is not what transpired. While it’s true that shares of the company were down more than 1% at one point, they actually spent most of the day trading positively. And by the end of the day, they closed up nearly 1.2%. This says a lot about the perception of market participants and it also follows on some other interesting news in recent days. For the most part, investors should view the developments that have transpired this month to be positive. And even though the most recent development translates to investors capturing less income each year, it will result in the company looking healthier in the long run and it should bode well for those who are bullish on the company.
A big cut was justified
This may be a very controversial opinion, but my own personal and professional belief is that, unless you are in retirement or getting close to it, you should never invest in a company for the purpose of capturing distributions. Even though REITs have special distribution rules and special taxation situations, my overall opinion is that capital is usually best left with the company that generates it for the purpose of that company allocating that capital toward future growth. After all, if you like the value that a company creates with its investments enough to put your money into it, wouldn’t you like it if it had more money to work with? There are natural exceptions for this. An example would be if there aren’t any good investment opportunities out there. But that is rarely the case.
It’s coming from this mindset that I must say that I don’t mind the fact that Medical Properties Trust decided to slash its distribution. In the press release issued regarding the topic, management said that they were “updating” their capital allocation strategy with the goal of “expediting” debt reduction. They justified this by accurately pointing out that the company had, over the past 18 months, monetized a significant amount of assets on its books. Including pending transactions, like the $355 million that the company is getting in cash from selling its Connecticut hospitals later this year and the roughly $300 million that the company is slated to receive for the rest of its Australian portfolio, these actions will result in the total value of leased assets that the company has on its books dropping by around $2.5 billion over this window of time.
By its very nature, a REIT generates all or substantially all of its cash flows from its assets. So it would be no surprise that cash flows would change in response to certain developments. I even, in my most recent article regarding Medical Properties Trust, stated that a distribution cut was probably on the horizon. And sure enough, on Aug. 21, management said that they were cutting the distribution to $0.15 per unit. That’s a cut of almost half compared to the $0.29 per share that the company was paying each quarter up to this point. To be frank with you, this cut was larger than I anticipated. In my last aforementioned article where I discussed a possible distribution cut, I contemplated a possibility for the company to slash the distribution enough to keep its yield, at the pricing then, at around 10%. But given the closing price of the stock on the day prior to this announcement, the effect of yield is about 8.7%. That’s still perfectly acceptable, and is in fact quite attractive, for a REIT.
Even though this might be painful in the near term, I believe that, in the long run, it will add more value than if the company had never cut the distribution. I say this because the debt reduction the company should achieve in response has the benefit of resulting in reduced interest expense. Cutting $100 million in debt, for instance, with a distribution of, say, 6%, results in an extra $6 million annually of cash flow for the business and that benefit is on top of the $100 million of enterprise value shifting from debt holders to equity holders. When you run the math, given the current share count outstanding, the REIT should see its annual distributions drop from $694.1 million to $359 million.
This will result in an extra $335.1 million used for debt reduction. If we ignore the near-term debt that the company is paying off, the next debt coming due isn’t required to be paid off until 2025. Over that window of time, the company should be able to allocate around $670.1 million toward debt reduction without selling off any assets. And the debt due that year has fixed interest rates ranging between 2.349% and 5.25%. So that will result in significant interest reductions. For a company with $9.91 billion of net debt today, which excludes allocating proceeds from sales that have already been announced, this kind of reduction is nice to see.
One of the great things about this development is that it shows that management is taking the debt reduction fight seriously. In fact, in the press release regarding the matter, management made clear that this distribution cut will result in an initial AFFO payout ratio of less than 60%. And that is only factoring in anticipated cash rent that is scheduled to be paid on certain of its troubled assets. This means that the firm has plenty of wiggle room should it need the cash for something other than reducing debt.
In addition to this, management also said that they were looking at other transactions aimed at boosting shareholder value. In particular, they said that they’re looking at potential refinancing, sales and joint venture opportunities while simultaneously looking to cut back on discretionary operating expenses and other costs to become leaner as an organization. In recent years, Medical Properties Trust has demonstrated that it can get attractive returns for the assets that it has. If you look at all of the sales made in 2022 and so far in 2023, the company has achieved confirmed value of $5.3 billion compared to the $4.4 billion in original cost basis on these assets that it sold. This bodes well for shareholders when you consider that the book value of equity for the company is about $8.3 billion as of this writing.
A couple of other developments as well
Although the distribution cut announced by management was the most significant news item, there have been a couple of other developments since I last wrote about the firm. On Aug. 17, management announced that they had sold off $105 million of their interest in a new syndicated asset backed credit facility that was made available to Steward Health Care System very recently. The original facility was for $140 million and it was backed by customer receivables, including not only government payers, but also commercial insurers, managed care companies, and other parties.
What’s more, the firm has a first lien on these receivables, meaning that it does not need to contend with other creditors should something go South. The one downside to this announcement is that we don’t know the terms that the company got for this asset sale. Management indicated that the credit facility had an annual interest rate well in excess of 10%. So it’s not unthinkable that they received 100% of power or possibly even more. But a haircut is also not out of the question given the questionable ground that Steward has been painted as being on.
Only one day after this, on Aug. 18, management also responded to a rather unsavory article about the company published by the Wall Street Journal. This topic has already been discussed in rather great detail elsewhere. So my goal is to not rehash all of these specifics. But the general development talked about was the fact that the deal that the company has with Prospect Medical Holdings, a sizable tenant that has undergone restructuring activities, has been put on hold by the California Department of Managed Health Care. This hold was issued on July 20 and yet management at Medical Properties Trust did not disclose it in their quarterly report. The reason for the lack of disclosure, according to the company, is that a hold of this nature should be considered “standard, expected, and non-controversial” as part of the approval process.
Management asserted that this hold only indicates that additional information is required to be given to regulators prior to the restructuring being considered official. This brings into question the $68 million of equity investment that the company has in PHP Holdings, the managed care business of Prospect, that Medical Properties Trust recognized during the most recent quarter as revenue. Management’s justification from this is that, not only is the hold customary and almost certain to result in an approval of the agreement, but that a refusal by regulators to accept it would mean that the $68 million would revert to being a convertible loan with the same economic interests as equity. Should this be true, I can understand why the company didn’t bother to mention it in their quarterly report. And if it’s not true, it would be a blatant violation of fiduciary responsibility that would make for an easy lawsuit against the company in the future. That’s an incredibly small amount of money to risk such a big lawsuit over. So I’m inclined to believe management on this matter.
Based on the data provided, I will say that the market responded to the distribution cut announced by management better than I thought it would be. I was expecting shares to drop at least somewhat for the day. However, it’s clear now that the market priced in a rather substantial distribution reduction. I am, for the most part, pleased by this development. Even though the cut was larger than I anticipated, I see this as a positive sense I do not prioritize distributions and would actually prefer capital be allocated toward things like debt reduction. At the end of the day, all of this does is boost my confidence in the company further and, in the weeks to come, I suspect I will further increase my exposure to the company.