Our Chicken Pox Theory on the HC REITs

Richard Anderson
Richard Anderson Managing Director, Americas Research
April 4, 2016



Upon contracting Chicken Pox, one can expect not to suffer the disease again. As a means to explain our view on the health care REITs, and specifically on past/ current/future legal action related to Medicare billing practices of post-acute/ SNF operators, we invoke a parallel analogy with the Chicken Pox "one-and- done" nature: KND (tenant of VTR) has had Chicken Pox, HCRMC (tenant of HCP) has it now, and GEN (tenant of HCN, SBRA, LTC, OHI) hasn't had it yet. Raising our PT on VTR to $71 from $66 and reiterate our Buy rating.

Key Points

Under the Microscope: The $125mm settlement by KND (related to activities before its acquisition of Rehab Care) and the ongoing process underway at HCR ManorCare (HCRMC) have raised the level of anxiety that additional wrongdoings will be unearthed. The re-emergence of CMS's RAC audits, which we do not view as the formality, may have the benefit of a roadmap to find other infractions. As such, with virtually all of its SNF exposure with KND, VTR seems the most cleansed of the situation on a go- forward basis (assuming KND doesn't replicate bad behaviors). Privately- held HCRMC remains in process, and while its landlord HCP may be closing in on a resolution of its own, the timeline and impact stemming from the DOJ intervention remain in a black box. Of the larger operators, this leaves GEN that still hasn't gotten Chicken Pox.

The GEN Risk: As we show in Exhibit 1, the 2014 and 2015 GEN 10- Ks mentioned a preliminary investigation by the DOJ, which commenced on February 4, 2015. What we know is the possible infractions occurred at Skilled Healthcare Group before it combined with GEN, and that GEN was aware of the situation prior to the merger and determined it benign enough to move forward. GEN had $62mm of cash/equivalents as of 4Q15, and the company has established a $30mm liability (i.e, not a cash reserve) to prepare for the possibility of a future negative event. REIT exposure to GEN as a percentage of the total: SBRA (34%), HCN (14%), LTC (5%) and OHI (4%).

Longer Term: While the potential for future settlements could be a slap-on- the-wrist and one-time in a best-case scenario, elevated scrutiny could cause operators to apply a less aggressive approach to the business. As such, rent coverage metrics could trickle down over the longer-term, which we think lends support to our focus on strong rent coverage for those REITs trafficking in the post-acute space. We like VTR, LTC and SBRA, as discussed below.

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