Fitch Lowers Outlook on HCP, Inc. (HCP) to Negative; Q4 Metrics Consistent, but Weak for Rating

February 10, 2016 3:09 PM EST

Fitch Ratings has affirmed HCP, Inc.'s (NYSE: HCP) Issuer Default Rating (IDR) at 'BBB+' and revised the Rating Outlook to Negative from Stable. A full list of rating actions follows at the end of the release.

The Negative Outlook reflects that, while HCP's fourth quarter 2015 (4Q15) metrics remain consistent, albeit weak, for the 'BBB+' rating, it is more likely that fixed charge coverage (FCC) for HCP's largest tenant - HCR ManorCare, Inc. (HCR; 24% of annualized revenues at Dec. 31, 2015) - will remain pressured and that a renegotiation of the master lease is the most logical source of potential relief. HCR's operating performance has deteriorated further, offsetting the relief from the rent reduction that occurred earlier in 2015 and HCR will not achieve the coverage levels that HCP guided to in March 2015. The Negative Outlook also reflects that HCP does not have the same cushion in its metrics to address this issue as it did in years past, however, HCP could increase dispositions.

Fitch will look to resolve the ratings and Negative Outlook by either downgrading the rating or affirming and revising the Outlook to Stable at the earlier of a material HCR announcement or metrics sustaining at elevated levels. Future rating actions will be determined in part by whether the issuer presents a well-articulated and achievable plan to support the credit profile, with the Stable Outlook requiring a pathway back to historical levels.

On February 9, 2016, HCP announced $836 million of combined impairments to the HCR investments and switched the lease accounting from an accrual basis to a cash basis. These actions reflect HCP's expectation that HCR will continue to operate with a thin margin to meet its obligations due to persistent operating headwinds. FCC for the guarantor was weak at 0.97x and 1.07x in 2H15 and 2015, respectively, as compared to the 1.28x-1.30x projections in March 2015 pro forma for the lease amendment and asset sales. Moreover, the reported levels are similar to those that preceded the March 2015 lease amendment.

HCP stated on its 4Q15 earnings call that they are not actively negotiating a lease amendment. However, Fitch expects the situation will be fluid as HCP made a similar claim on its 4Q14 earnings call. Less than 50 days after that call, HCP announced the lease amendment. As the lease is HCR's largest obligation, we believe another rent reduction is one of the few meaningful levers left for HCP and HCR. Moreover, HCR's liquidity profile is complicated by amendments to its revolving credit facility (RCF) and the Department of Justice's (DOJ) current investigation. Earlier in 2015, HCR was able to extend at least $120 million of its $175 million RCF to 2018 from the April 2016 maturity. The extended maturity is a credit positive for HCR offset by the reduced capacity ahead of a potential fine or settlement with the DOJ. In January 2016, one of HCR's peers (Kindred Healthcare Inc.) entered into a $125 million settlement with the DOJ.

While HCP could deny any requests for relief on rent and re-tenant the portfolio if HCR were to default -effectively ending HCR's business, as the master lease covers practically all of its operations - Fitch places limited value on this negotiating position. The cash costs of re-tenanting a portfolio of this size and lost earnings would be significant. Furthermore, Fitch believes there is much more at stake for HCP than for HCR's private equity owners who have little remaining equity in the investment.

HCP has been operating with leverage at the high end of the range appropriate for 'BBB+' with limited cushion to sustain below 6x in the event of another lease amendment or a lease default. Leverage was 5.9x in 4Q15 compared to the 4.9x-5.7x (5.2x average) reported in every quarter from 3Q12 to 1Q15 before the first lease amendment. Fitch does not envision HCP issuing equity at current levels for the sole purpose of reducing leverage and thus the main mechanism to delever back toward historical levels will likely come from continued asset sales and organic growth in recurring operating EBITDA.

A rent reduction of a similar magnitude to the first one that improves EBITDAR coverage to 1.2x-1.25x would increase leverage by two-tenths of a turn, all else equal. Fitch calculates leverage as debt less readily available cash-to-recurring operating EBITDA including recurring cash distributions from JV operations.

FCC remains strong at 3.6x and 3.5x for 4Q15 and 2015, respectively, and as compared to the 2.5x-3x range that Fitch established in its Rating Sensitivities. Fitch defines FCC as recurring operating EBITDA less straight-line rents and recurring maintenance capital expenditures-to-total interest incurred.

Fitch expects the lack of a permanent resolution for HCR will continue to act as an overhang and pressure the prices at which HCP can access the debt and equity markets. Fitch expects HCP's access to capital will be weaker on a relative basis to other 'BBB+' REITs over the rating horizon. HCP's shares were down 17% on the 4Q'15 earnings announcement. Fitch projects that HCP's uses of liquidity exceed its sources by $866 million (0.7x) for the period Jan. 1, 2016-Dec. 31, 2017. However, Fitch does not envision a material liquidity crunch and instead expects HCP could look to refinance its maturing mortgages (assuming an 80% refinance rate) would improve liquidity coverage to 0.9x. Fitch calculates liquidity coverage as sources (readily available cash less undrawn capacity under the $2 billion RCF due 2019 after an extension option and retained cash flow from operations) to uses (debt maturities, remaining development expenditures and recurring maintenance capital expenditures).

The contingent liquidity provided to HCP in the form of its unencumbered assets was negatively affected by the HCR lease amendment in 2015 and covered net unsecured debt by 1.7x-2.2x at Dec. 31, 2015 assuming 8%-10% cap rates. This compares to 2x-2.4x prior to the amendment.

Fitch's key assumptions within the rating case for HCP include:
--HCR's operating fundamentals will remain under pressure;
--A second amendment to the HCR lease could be announced;
--HCP's access to capital will be affected until a permanent resolution is announced;
--HCP's ex-HCR portfolio will exhibit low- to mid-single-digit growth in same-store net operating income through 2017;
--HCP will look to reduce leverage through asset sales.

Fitch expects to resolve the Negative Outlook at the earlier of a material HCR announcement or metrics sustaining at elevated levels without a well-articulated plan to support the credit profile.

The following factors may have a negative impact on the ratings and/or Outlook:

--A sustained and material weakening in coverage for skilled-nursing/post-acute operators in whole and in part;
--Fitch's expectation of leverage sustaining above 6x (leverage was 5.9x for 4Q15);
--Fitch's expectation of FCC sustaining below 2.5x (FCC was 3.6x for 4Q15);
--A liquidity shortfall.

Fitch could affirm the ratings and revise the Outlook to Stable should there be a well-articulated plan to revert back to historical metrics. Although unlikely, the following factors may result in positive momentum in the ratings and/or Outlook:

--Reduced risk from skilled-nursing/post-acute operators as measured by reduced exposure or a sustained and material improvement in coverage in whole and in part;
--Reduced tenant concentration;
--Fitch's expectation of FCC sustaining above 3x for several consecutive quarters;
--Fitch's expectation of leverage sustaining below 4.5x.


Fitch has affirmed the following ratings:

HCP, Inc.
--IDR at 'BBB+';
--Unsecured bank credit facility at 'BBB+';
--Unsecured term loans at 'BBB+';
--Senior unsecured notes at 'BBB+'.

The Rating Outlook is Negative.

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