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Morningstar | Slight Disappointment in Welltower's Short-Term Results, but Long-Term Thesis Intact

Even though Welltower raised funds from operations guidance for the year, we view the company's second-quarter results as a slight disappointment. The company reported normalized FFO of $1 for the quarter, a penny below our estimate. Welltower reported net operating income higher than we estimated, but this was driven by the closing of previously announced dispositions being delayed past the second quarter. Same-store NOI growth was 1.4% for the total portfolio, in line with our estimate for the company for the second quarter. However, same-store NOI growth for the senior housing operating portfolio was only 0.1%, well below our 1.2% estimate. The underperformance from this segment comes from a 1.1% occupancy drop compared with our estimate of down 0.75% and margins falling 70 basis points, though rate growth continues to be solid. While the company sees less supply in its markets than the national average, senior housing inventory grew 3.3% in Welltower's markets with only 2.4% absorption, leading to the occupancy drop. However, the company has seen construction starts continue to decelerate, which gives credence to our story that we are at peak supply now but supply will fall off over the next few years as demand ramps up from the aging baby boomers. We expected 2018 to be a tough year for senior housing, so while flat growth is a slight disappointment for Welltower's high-quality portfolio we recognize that the long-term story remains intact. The company did raise the midpoint of 2018 FFO guidance to $4.025 from $3.99 on the news that it closed the QCP acquisition on July 26, over a quarter earlier than we had anticipated. Overall, we see nothing that has changed our outlook for Welltower, leading us to reaffirm our $74 fair value estimate and no-moat rating.

The company discussed two management contract restructurings on its senior housing portfolio that will have negative short-term impacts but could lead to positive long-term results. The first is a deal it announced in June to transfer 60 of the 145 assets managed by troubled operator Brookdale to new operators, reducing Welltower's NOI exposure to Brookdale to 2.9% from 7.6%. Welltower will transfer 37 to a new management group, Pegasus Senior Living, formed by senior housing turnaround specialists, 12 to independent living specialist company Cogir, and 11 properties to six other existing Welltower partners with those assets fitting the regional portfolio and operational experience of those operators. Given that these assets are only 82% occupied, we believe that there is room for improvement in more capable hands. The company is losing an estimated $5 million a year in revenue from the transition, but that immediately improves the portfolio's EBITDAR coverage ratio and Welltower will collect $126 million in cash from a $58 million termination fee from Brookdale and a $68 million investment from Cogir. While the cash flow dilution is a negative, we view the reduction of the exposure to Brookdale, the improvement of the coverage ratio, the potential for occupancy and NOI gains under new management and the cash payment as wins for the company.

The other significant restructuring that occurred subsequent to quarter-end was a deal to restructure the 27 Brandywine assets from a triple-net structure to the operating structure. Brandywine is one of Welltower's top operating partners, having outperformed the CAGR NOI growth of the rest of Welltower's senior housing portfolio by 190 basis points since the inception of the relationship. Brandywine's portfolio is at the top of Welltower's high quality portfolio given that the 27 assets average $7,500 revenue per occupied room per month and generates approximately $29,000 in NOI per room on an annual basis. Switching to an operating structure allows Welltower to benefit in the upside of this exceptional operator running top-of-the-line assets. However, we recognize that Welltower will suffer significant short-term dilution to achieve these results and have questions about how the company got into this situation. The company expects a $0.02 negative FFO impact from the switch to the second half results, so annualized that is $0.04 dilution in switching from triple-net to operating. While the switch allows the company to recognize more of the portfolio's upside, it will take many years for these assets to make up that amount of dilution. While the switch will improve the company's EBITDAR coverage ratio as these assets must have been under 1.0 times, we question how many more assets the company may have to right size over the next year or two before the senior housing market turns around. We believe the company's claims that there is nothing operationally wrong with the assets and that the issues were created simply by the initial lease terms being set in a more optimistic period that demanded results even the best assets couldn't possibly produce. Still, the company set many leases in this period and with the restructurings they have had to do for Genesis and then Brookdale and now Brandywine we question if more could be coming down the pipeline.