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Morningstar | Fourth Quarter Mixed for HCP; 2019 Outlook Lower as Company Sets Stage for Long-Term Growth

Another mixed quarter for no-moat HCP leads us to conclude that we won't change our $27 fair value estimate when we incorporate the fourth quarter into our model. Same-store net operating income growth for the total portfolio again beat our estimate with the company's 1.5% result coming in ahead of our 0.9% estimate. On the positive side, the triple-net portfolio came in well ahead of us with 2.5% growth in the fourth quarter and the life science portfolio bounced back earlier than we expected with 3.9% growth. However, the senior housing operating portfolio continues to heavily weigh on performance. While the core senior housing portfolio was down only 2.3%, relatively in line with our expectations, it is the portfolio of properties that are transitioning to new operators or are slated for disposition that hurt HCP's totals as they posted negative 33.2% NOI growth in the fourth quarter. The mixed results led to HCP reporting adjusted funds from operations of $0.43 for the quarter, in line with our estimate.

We expect 2019 to be another difficult year for HCP, and management's guidance seems to confirm that assumption. Life science should continue the fourth quarter's rebound and be even stronger in 2019 with management guiding to 4.0% to 5.0% NOI growth. However, the senior housing operating portfolio will continue to deal with supply issues in addition to the portfolio's own difficulties in transitioning operators, leading to management's outlook of negative 5% growth at the midpoint. The rest of the portfolio will likely grow around 2%, and with 2019 being impacted by the large dispositions that were back-half weighted in 2018, HCP expects adjusted FFO to decline in 2019 to a range of $1.70 to $1.76, below 2018's $1.82 mark and our $1.79 adjusted estimate. However, we think the issues faced by HCP in 2019 are short term in nature and provide them a solid foundation to grow as healthcare sees increasing demand from the aging baby boomer generation.

Management provided additional detail on its 2019 guidance that explains why the actions it has taken or plan to take cause a hit to earnings in 2019 but set it up for what we think is a platform for significant growth in the following years. First, the company is making a major investment in developing new life science properties. We think that this is a great way for the company to create value long-term for investors as we assume that it can deliver the projects at a stabilized yield in the mid-6% to mid-7% range. However, these projects cause dilution in the near term as funding the construction creates immediate costs and HCP doesn't reap the benefits for 2 to 3 years. While we expected some negative impact from spending on development in 2019, HCP increased its pipeline of projects by over $400 million in the fourth quarter. This will create a lot of long-term value for investors, but it does hurt 2019 as HCP expects to commit $600 million to $700 million in funding in 2019. Some of this funding came from HCP's issuance of $430 million in new equity, immediately diluting earnings. Again, we really like the long-term potential from this pipeline of projects and hope it continues to expand but recognize that near-term earnings will take a hit as they commit more money now toward future growth.

Second, HCP plans to do far more acquisitions and dispositions than we had anticipated for 2019. Management is guiding to $900 million in acquisitions and $500 million in dispositions, ahead of our $260 million and $120 million estimates, respectively. While we view acquisitions and dispositions as generally being value-neutral, so increased volume doesn't really create more value, what did catch our eye was the expected cash yields for the acquisitions and dispositions that HCP plans to do. While management's guidance of dispositions being executed at an average 7.0% cash yield is in line with our expectations, it plan to acquire at 5.25% is below our assumed 6.0% average acquisition cap rate. Trading higher cap rate properties for lower cap rate properties is dilutive to cashflows and earnings in the short term. However, if the company also achieves the goal of improving portfolio quality, then that should lead to higher long-term growth and more stable cashflows, which would create value over the long term. We will have to see what management is able to acquire and if it is able to improve portfolio quality before we are able to determine if it is sacrificing earnings in 2019 for sustainable, long-term gains.