NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the ratings of HCP, Inc. (NYSE: HCP), including the Long-Term Issuer Default Rating (IDR) to 'BBB' from 'BBB+'. Fitch has also placed the ratings on Rating Watch Negative. A full list of rating actions follows at the end of the release.
KEY RATING DRIVERS
The downgrade of HCP's IDR to 'BBB' reflects that its credit metrics (notably leverage and contingent liquidity) will be weaker upon the spin-off of its largest investment (HCR ManorCare, Inc.). The Rating Watch Negative reflects execution risk surrounding the spin-off financing and by extension the distribution to HCP in a weaker capital markets environment. The execution risk also extends to the additional asset sales given their importance in reducing leverage and restoring liquidity through 2018. Fitch could remove the Watch and assign a Stable Outlook should HCP complete the transaction as contemplated. Positive elements of the transaction include headline improvements in remaining portfolio quality measures and decoupling from HCR, which will allow management to restore its focus.
HCR SPIN WILL TAKE LEVERAGE HIGHER
Fitch expects HCP's leverage will increase markedly at the time of the spin due to the loss of HCR's sizable, albeit thinly covered, rent. The final leverage will be determined by the relative size of the cash distribution back to HCP and the incremental asset sales. Fitch expects leverage will maintain in the 6x - 7x range through 2018 as compared to the 4.9x - 5.7x (5.2x average) range reported in every quarter from 3Q'12 to 1Q'15 before the first lease amendment. Fitch does not see a likely pathway for HCP to restore leverage back to historical levels of 5x - 6x if the issuer wants to balance considerations for shareholders and debtholders. Fitch defines leverage as total debt less readily available cash to recurring operating EBITDA including recurring cash distributions from joint ventures.
Similarly, Fitch expects fixed-charge coverage (FCC) will weaken back towards 3x over the next 12 to 24 months from 3.6x and 3.5x for the quarter and year ended Dec. 31, 2015. Fitch defines FCC as recurring operating EBITDA less straight-line rent and recurring maintenance capital expenditures to interest.
NEGATIVE WATCH REFLECTS EXECUTION RISK; CREDIT STABILIZING
The Negative Watch reflects the event-driven nature and the execution risk surrounding the spin-off's financings and HCP's asset sales, which are needed to maintain leverage between 6x-7x and operate with a liquidity surplus. Fitch expects to resolve the Watch upon completion of the transaction as described by HCP. Should the transaction not proceed as contemplated, Fitch would then consider the broader implications on headline metrics and access to capital.
Fitch expects the higher quality remaining portfolio (e.g. predominantly private pay, appropriate rent coverage in net leases) should provide generally stable and growing operating cash flows. Continued risk surrounding some of the United Kingdom investments and senior housing supply should be offset by growth in the medical office building and life sciences portfolios.
TRANSACTION OVERVIEW
On May 9, HCP announced its intention to spin-off its HCR portfolio (23% of HCP's annualized revenues at March 31, 2016) into a new publicly traded company (HCR SpinCo). The HCR portfolio was a $6 billion skilled-nursing investment that struggled with persistently weak rent coverage, had a rent reduction in 2Q'15 and was impaired in 4Q'15. As currently contemplated, HCR SpinCo will pay a cash distribution to HCP which, when combined with asset sales at HCP, should total $2.75 billion. HCP expects to close the transaction in the second half of 2016.
Fitch believes there is execution risk to completing the financing of HCR SpinCo in the current environment and considering weakness earlier in 2016. Should HCR SpinCo be unable to complete the financings or HCP complete asset sales as contemplated, the size and timing of the distribution back to HCP could be reduced, negatively impacting HCP's leverage and liquidity measures.
Fitch recognizes the strategic rationale for the transaction and the higher relative quality portfolio at HCP afterwards. Moreover, the permanent separation of HCP and HCR should reduce the overhang on HCP's capital markets transactions as compared to if HCP chose to pursue another rent reduction instead.
SUFFICIENT LIQUIDITY UPON EXECUTION OF FINANCING AND SALES
Whether HCP operates with a liquidity surplus or deficit will be determined by it successfully executing on the $2.75 billion of HCR SpinCo financings and additional asset sales at HCP. Fitch calculates HCP's liquidity coverage ratio at 0.7x from Jan. 1, 2016 to Dec. 31, 2017 and 1.5x upon completion of the asset sales. Fitch calculates liquidity coverage as sources (unrestricted cash, availability under the $2 billion revolving credit facility due 2019 and retained cash flow from operations) to uses (total debt maturities, estimated development expenditures and recurring maintenance capital expenditures).
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) which would improve liquidity coverage to 1x before the spin-off and asset sales and 1.9x afterwards.
WEAK / OUTLIER CONTINGENT LIQUIDITY
Unsecured bondholders will be supported by less contingent liquidity after the spin-off and asset sales as the HCR portfolio was one of the largest contributors of wholly-owned unencumbered net operating income. Fitch estimates that unencumbered assets (assuming a stressed 8% - 10% cap rates) will cover unsecured debt by 1.4x - 1.8x pro forma. This compares to 1.7x - 2.2x at Dec. 31, 2015 and from 2x - 2.4x before the rent reduction earlier in 2015.
HCP's contingent liquidity will likely sustain below the 2.0x typically carried by investment grade REITs. Unencumbered assets are REITs' primary sources of contingent liquidity to raise proceeds via a sale or pledge against during a time of stress.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for HCP include:
--HCP completes the spin-off and financings as contemplated in the second half of 2016 receiving $2.75 billion of net proceeds;
--HCP does not pursue any material debt or equity issuances through 2018;
--HCP maintains leverage between 6x - 7x through 2018.
RATING SENSITIVITIES
Removal of the Rating Watch Negative and affirmation of the IDR at 'BBB' will be driven by HCP's ability to complete the spin-off, its financings and contemplated asset sales. At that stage, the 'BBB' rating would reflect the following:
--HCP's spin-off of the HCR portfolio and disposition of assets as currently contemplated;
--Fitch's expectation of leverage sustaining between 6x- 7x;
--Fitch's expectation of fixed-charge coverage sustaining between 2x - 3x;
--A liquidity coverage ratio sustaining above 1.0x.
Fitch would expect to downgrade HCP's IDR below 'BBB' absent the company achieving these financings, asset sales, deleveraging and liquidity improvements six months after closing.
FULL LIST OF RATING ACTIONS
Fitch has downgraded the following ratings:
HCP, Inc.
--Long-Term IDR to 'BBB' from 'BBB+';
--Unsecured bank credit facility to 'BBB' from 'BBB+';
--Unsecured term loans to 'BBB' from 'BBB+';
--Senior unsecured notes to 'BBB' from 'BBB+'.
The ratings are on Rating Watch Negative.
Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:
--Historical and projected recurring operating EBITDA is adjusted to add back non-cash stock based compensation and include operating income from discontinued operations.
--Historical recurring operating EBITDA calculated DFL income on a cash basis rather than GAAP;
--Fitch has adjusted the historical and projected net debt by assuming the issuer requires $25 million of cash for working capital purposes which is otherwise unavailable to repay debt.
Additional information is available at www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1004198
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1004198
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https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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