Omega Healthcare: A contrarian gem?

Famed contrarian David Dreman holds 1.4 million shares of this high-yielding healthcare REIT.

By TheStockAdvisors Nov 11, 2011 11:18AM
By Marc Lichtenfeld, The Oxford Club Ultimate Income Letter

I’ve wanted to add a real estate investment trust to our Perpetual Income Portfolio for a while now. Boy, am I glad I waited.

After a recent pounding, many REITs now have very attractive yields. Perhaps none more so than Omega Healthcare Investors (OHI), which leases facilities to nursing home operators. The REIT now yields a mouthwatering 9%.

And just as important, the company has grown its dividend an average of 10.7% per year over the past eight years.

Its share price is down in recent months – like most healthcare-related REITs – on fears of Medicare cuts and what that will mean to the tenants who lease space from the REIT.

On October 1, those fears were realized when Medicare reduced payments to nursing homes by 11.1%. Plus, there will be another 2% cut coming if Congress can’t agree on an additional $1.2 trillion in budget reductions.

While that’s bad news for the nursing homes, it’s only bad news for the REITs if the nursing home companies can no longer pay their rent.

It’s important to realize that Omega isn’t in the nursing home business. These types of Medicare actions don’t hit its margins. Omega is the landlord.

The company receives fixed-rent payments with annual increases from nursing home operators with strong credit profiles. If nursing homes want to stay in business, they’ll continue to pay their rent.

Nearly all of Omega’s business comes from the skilled nursing (nursing home) segment, which is precisely the group hit with the Medicare reduction. As a result, there’s more perceived risk in Omega than its peers.

There’s no such thing as a free lunch, particularly on Wall Street. It’s important to understand that if you’re receiving a 9% dividend yield while other healthcare REITs are paying close to 6%, there’s a bit more risk at stake.

If Medicare cuts payments again to nursing homes, Omega shares will likely fall. Although, a 2% Medicare reduction shouldn’t have anywhere near the same impact as the already-enacted 11.1% cuts.

That being said, you’re being compensated for the additional risk. Not only is Omega’s yield greater than its peers, but the growth rate of its dividend is sharply higher, as well.

Over the past five years, Omega has boosted its dividend an average of 10% per year. That’s practically five times the 2.1% growth rate for HCP and 2.2% for Healthcare REIT. And Omega has raised its dividend every year since 2004.

However, when analyzing a REIT, it’s important to look at adjusted funds from operations (AFFO), which is similar to cash flow from operations.

Omega estimates that AFFO will be between $1.80 and $1.86 per share in 2011. It’s on track to pay out $1.58 per share in dividends, which translates into a payout ratio of 85% to 88% – very healthy for a REIT.

One legendary investor, at least, believes Omega Healthcare is an out-of-favor gem. David Dreman, known as the father of contrarian investing, owns 1.4 million shares.

And he added more in the last quarter through his fund, the DWS Dreman Small-Cap Value Fund.

Over the years, Dreman made a fortune for himself and his clients by zigging while Wall Street was zagging.

And if somehow Congress does agree on steps to reduce the deficit, we should see a rally in stocks with exposure to nursing homes.

Additionally, Omega was recently upgraded to “Buy” from “Hold” at Stifel Nicolaus. My contacts on Wall Street tell me the analyst is the most respected healthcare REIT guy on the street.

He believes the low price of the stock already reflects the risk of further Medicare cuts. And he sees no problems with nursing home operators continuing to make their rent payments.

As for Omega, it’s confident enough in its financial situation that not only did it increase the dividend last quarter, it recently announced a $100-million stock buyback program, as well.

With skilled nursing stocks getting whacked, now’s a great time to take advantage of the low prices and buy this stock generating a nearly double-digit dividend yield.

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