HCP, Inc.'s Worst Business Segment in 2016

By Markets Fool.com

HCP's relationship with HCR ManorCare caused the stock to plunge earlier in 2016. Image source: Getty Images.

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There's a lot to like about HCP's (NYSE: HCP) business model. The vast majority of its assets are high-quality, stable healthcare properties that produce consistent and reliable income. And the company has not only paid but also increased its dividend without fail for 31 consecutive years.

However, not everything has been going great at HCP -- here's one area of the business that has seen better days.

HCR ManorCare's relationship with HCP

HCP has a close relationship with skilled-nursing and post-acute care facilities operator HCR ManorCare. In 2011, HCP purchased the majority of HCR ManorCare's portfolio (338 properties) for $6.1 billion in a sale/leaseback transaction, and HCP has a 9.4% equity ownership in the company as well. In all, HCR ManorCare makes up nearly one-fourth of HCP's revenue. So, it's fair to say that HCP's continued profitability and ability to grow its dividend is highly dependent on the success of HCR ManorCare.

Unfortunately, HCR ManorCare hasn't been doing too well lately. The problems with HCR ManorCare started in 2015 when the company was accused of false Medicare reimbursement claims by the Justice Department. To the surprise of investors, HCR ManorCare's fixed-charge coverage plunged to 0.97 in the second half of 2015 (meaning that it wasn't earning enough to cover its ongoing expenses), and caused HCP to take a $35.9 million impairment charge in the fourth quarter. This understandably spooked investors, and HCP's share price plunged following the announcement in mid-February.

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HCP data by YCharts

Since that time, HCR ManorCare has shown that fears were a bit overblown. The company's fixed-charge coverage is now back in the black, and while I wouldn't call the financial results strong, it's certainly not a dire situation.

Making the best out of a bad situation

Along with its first-quarter earnings report, HCP announced that it had decided to split off its HCR ManorCare and other skilled nursing assets into a newly created REIT, which we've since learned will be called QCP, Inc. The company expects this to be completed by the end of the year and has already filed the regulatory paperwork to get the process started.

The idea behind the spinoff is simple. The remaining HCP portfolio will be primarily made up of stable, private-pay assets that generate consistent income and earn more than enough money to cover their ongoing expenses. This improvement in the overall asset quality by eliminating the worst assets will theoretically make HCP more favorable in the eyes of ratings agencies and will lead to more financial flexibility. It will also produce the peace of mind investors love that their perpetually growing dividends are safe.

Source: HCP Investor Presentation

For the newly created QCP, it will allow that REIT's management team to focus exclusively on maximizing the potential of the HCR ManorCare and other skilled nursing assets. The company says that the new management team will have an arsenal of tools at its disposal, including some profit-maximizing techniques that are unavailable or impractical while the assets are still under the umbrella of HCP.

The takeaway

All companies have problems from time to time. In business, unexpected things happen -- market dynamics change, new competitors take market share, and new regulations impact business' profits. Great companies figure out smart solutions to their problems.

HCP's decision to spin off its HCR ManorCare and other skilled nursing assets is a smart solution to the problem of maximizing value from a troubled group of properties. While there is still a lot we don't know about the future state of HCP and QCP, like each REITs post-spinoff dividend policy, I'm confident in saying that this should be an extremely positive change for long-term value creation.

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Matthew Frankel owns shares of HCP. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.