Diversified Healthcare Trust (NASDAQ:DHC) Q1 2023 Earnings Call Transcript May 9, 2023

Diversified Healthcare Trust beats earnings expectations. Reported EPS is $-0.22, expectations were $-0.23.

Operator: Good morning and welcome to the Diversified Healthcare Trust First Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Melissa McCarthy, Manager of Investor Relations. Please, go ahead.

Melissa McCarthy: Good morning, and welcome to Diversified Healthcare Trust call covering first quarter of 2023 results. Joining me on today’s call are Jennifer Francis, President and Chief Executive Officer; and Rick Siedel, Chief Financial Officer and Treasurer. Today’s call includes a presentation by management, followed by a question-and-answer session. I would like to note that the recording and retransmission of today’s conference call are strictly prohibited without the prior written consent of the company. Today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and other securities laws. These forward-looking statements are based upon DHC’s beliefs and expectations as of today, Tuesday, May 9, 2023.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call other than through filings with the Securities and Exchange Commission, or SEC. In addition, this call may contain non-GAAP numbers, including normalized funds from operations or normalized FFO, EBITDA, net operating income or NOI and cash basis net operating income or cash basis NOI. Reconciliations of net income or loss to these non-GAAP figures are available in our financial results package, which can be found on our website at www.dhcreit.com. Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our filings with the SEC.

Investors are cautioned not to place undue reliance upon any forward-looking statements. On today’s call, we will be discussing the planned merger with Office Properties Income Trust in our prepared remarks. We have not yet filed a preliminary joint proxy and registration statement with the SEC and therefore, will not be taking questions about the merger. And now I’d like to turn the call over to Jennifer.

Jennifer Francis: Thank you, Melissa, and good morning. Thank you for joining us on today’s first quarter 2023 conference call. I’d like to begin the call by highlighting the enhanced earnings release format that we issued last night. We believe this combined presentation of information will be helpful for analysts and investors to efficiently digest information about our company and results. Before I review DHC’s performance for the first quarter of 2023, I’ll discuss our recently announced merger with Office Properties Income Trust, or OPI. DHC is facing a number of short-term challenges. While we’ve been encouraged to see the turnaround in our senior housing operating portfolio begin to materialize, the recovery has not occurred fast enough to address several concerns.

First, due to our debt covenants, we’re restricted from issuing or refinancing debt. Without the financial flexibility afforded by the merger, we do not expect to be in compliance with these debt covenants before $700 million of debt becomes due in 2024. Second, to ensure the successful turnaround of the communities in our shop segment and to realize its long-term value potential, additional investment is needed. Stand-alone DHC has insufficient liquidity to continue to fund this critical capital. And third, due to these capital constraints, we do not believe we would be in a position to increase DHC’s current annual dividend of $0.04 per share until 2025. The merger with OPI addresses all of these challenges and benefits DHC both financially and strategically.

Following the completion of the merger, the combined company will immediately be in compliance with debt covenants and will have a greater scale and diversity with access to multiple capital sources to fund the business and address upcoming debt maturities. The merger is immediately accretive to our leverage as well as normalized FFO and CAD. In addition, the pro rata annual dividend represents a 267% immediate increase for DHC shareholders. Strategically, the merger provides the necessary liquidity to continue with the capital deployment strategy needed to fund the SHOP turnaround underway. Not only does this mutually beneficial combination address the near-term challenges in our business, it also provides more long-term growth opportunity for OPI as it navigates continued headwinds facing its traditional office portfolio.

DHC shareholders will benefit from that upside as well. By creating a stronger, more diversified REIT with a broad portfolio and defensive tenant base, we believe the merger will unlock significant long-term growth potential and value-creation opportunities. We continue to expect the transaction to close in the third quarter of 2023. And while we focus on completing this mutually beneficial combination, we’re continuing to take steps to increase operating efficiencies in the communities in our SHOP segment and improve our bottom line so that we enter the combination from a position of operational strength. With that, I’ll move to DHC’s first quarter results. After market closed yesterday, DHC reported normalized FFO of $0.05 per share for the first quarter.

The year-over-year and sequential improvement in normalized FFO from negative $0.09 per share and $0.03 per share, respectively, was driven by several positive trends in our SHOP segment during the first quarter. The first positive trend is the continuing occupancy recovery. Our SHOP occupancy increased 390 basis points year-over-year to 76.9% and SHOP NOI increased by $17.1 million in the same period. We exceeded the NIC benchmark for occupancy growth by 30 basis points during what is generally considered a seasonably weak quarter. New supply continues to be muted from pandemic-related slowdowns, and construction starts have been held in check by high construction costs and the limited availability of financing, which should continue to support our SHOP recovery as should our operators’ continued focus on marketing and sales training.

The second positive trend is NOI margin growth. Our SHOP segment’s margins increased by 610 basis points over Q1 ‘22 and 330 basis points sequentially as operating efficiencies drove more incremental revenue to the bottom line. The third positive trend is the decrease in contract labor expenses. There has been a clear reduction in agency costs – agency labor costs as our operators have been effective in decreasing the use of agency labor by about 50% from last quarter to the lowest level since Q2 ‘21. In fact, in some markets, our operators are reporting the cost gap between agency and in-house staffing is narrowing so that agency use, when needed, is less cost prohibitive than it’s been in the past few years. Turning to our Office Portfolio segment.

Before I discuss this segment’s results, I want to acknowledge the recent publication of The RMR Group’s Annual Sustainability Report, which provides a comprehensive overview of our managers’ commitment to long-term ESG goals. We’re deeply committed to enhancing DHC’s corporate sustainability practices and continue to advance our sustainability initiatives. You can find links to the report and the tear sheet specific to DHC’s highlights on our website at dhcreit.com. On to the results. Rental income for our same property Office Portfolio segment increased 3.1% and cash basis NOI increased 7.7% compared to the first quarter of last year. For leasing activity in our Office Portfolio, we executed 72,000 square feet of new and renewal leases in the quarter with average roll-up in rents of 17.9% and a weighted average lease term of 8.9 years.

We ended the quarter at 90.1% occupancy in our same property Office Portfolio segment, and had a leasing pipeline of just under 1 million square feet at quarter end, roughly in line with our pipeline in the fourth quarter. We have close to 530,000 square feet of transactions, or 53% of our pipeline, where leases have been signed subsequent to quarter end or are in letter of intent stage with leases being negotiated. I’d like to provide a quick update on our wellness centers, which accounted for first – 6.7% of our first quarter NOI. As a reminder, in January, we terminated the leases for 3 wellness centers located in Tampa, Atlanta and the suburban Washington, D.C. area. Since then, we’ve signed leases for all three locations, 2 for 20 years with an existing tenant like Life Time athletics, for the clubs in Atlanta and Tampa and 1 15-year lease with a strong regional wellness club operator in the suburban D.C. property.

We’re encouraged that this portfolio is quickly stabilized, a testament to The RMR Group’s strong tenant relationship management and our well-located properties. Now I’d also like to address information that was included in our financial results package and Form 10-Q filed yesterday. As I’ve stated a few times, the SHOP recovery is underway, but it is not happening fast enough. Current conditions raise substantial doubt about our company’s ability to continue as a going concern as a stand-alone company. Rick will go into more detail on our cash and balance sheet position shortly. But based on our current cash balance and projected cash needs for the next 12 months, we need to take action to fund our operating capital requirements and meet our debt obligations.

This is another reason why the merger with OPI will benefit DHC. I’ll now turn the call over to Rick, who will provide more details on our financial results. Rick?

Rick Siedel: Thanks Jennifer and good morning everyone. For the first quarter, we reported normalized FFO of $12.5 million or $0.05 per share. Normalized FFO improved $34.4 million from the first quarter of 2022, and adjusted EBITDA increased $23.8 million or 61% to $62.7 million. Our consolidated cash basis NOI increased $16.8 million or 42% from the first quarter last year to approximately $57 million. This increase was attributable to significant improvements in our SHOP segment, resulting in an increase of $17.1 million of cash basis NOI. We had previously said that many of our communities were getting to occupancy levels where we expected to see margin expansion as they bring in additional residents and are better able to leverage fixed costs, and we are beginning to see that.

Occupancy in our SHOP segment increased 390 basis points since the first quarter of last year and 60 basis points from the fourth quarter of 2022. Our operators were also able to increase average monthly rates, 8.2% from the first quarter of 2022 and over 6% from the fourth quarter. These increases in occupancy and rates translated to a 13.9% year-over-year increase in SHOP revenues while property operating expenses increased just 6.9% and margin improved 610 basis points. For the first quarter, 128 of our communities produced positive NOI of $31.3 million, an improvement from last quarter when we had 111 communities with positive NOI. These communities had on average occupancy of 83.3% during the first quarter at an average margin of 17%. Further, 74 of these 128 positive NOI communities had occupancies below 90% and margins of just 14%, which we believe illustrates that there is still considerable room for financial improvement in these communities that are on the path towards stabilization.

The remaining 102 communities produced negative NOI of $13.5 million, with average occupancy of 66.1% for the first quarter which is an improvement from the fourth quarter when we had 119 communities that generated $18.7 million of negative NOI. 67 communities were under 75% occupied. These communities will continue to focus on occupancy, rate and expense control as part of their business plans. Interest expense was $47.8 million for the first quarter, representing a 16.4% reduction from a year ago. Attributable to the $500 million prepayment of 9.75% senior notes in June of 2022, and the repayments of our credit facility totaling $250 million during the quarter. As a reminder, in February, we amended our credit facility and reduced the size of the facility in exchange for continued covenant relief.

The weighted average interest rate on our credit facility was 7.6% during the first quarter compared to 2.9% a year ago. As of March 31, DHC had approximately $382.7 million of cash and restricted cash. We are encouraged that our SHOP segment is beginning to improve, but the recovery has not been fast enough. As Jennifer noted, as of today, we have $700 million of debt maturing in the next 12 months, and our debt incurrence covenants prevent us from refinancing or issuing new debt. In April, we announced the plan to merge with OPI, but we cannot provide assurance that the merger will close. If the merger does not close, we will be forced to defer capital investments in our portfolio, which will substantially delay the turnaround of our SHOP segment, and we will look to raise additional capital, but we are limited in the financings we may seek as we cannot incur any debt.

Due to capital market conditions, as of today, we do not believe it is probable that we will raise sufficient capital to alleviate the substantial doubt about our ability to continue as a going concern. However, the merger with OPI will result in a combined company that will immediately be in compliance with all financial covenants and be able to refinance debt. The merger will be immediately accretive to DHC FFO and provide shareholders with an annualized dividend of $1 per share of the combined company. We are actively working towards closing the merger and remain committed to executing our business plan to create long-term value. We are confident that the merger with OPI will provide the necessary liquidity and financial flexibility to address all near-term debt maturities and better position us for long-term growth.

That concludes our prepared remarks. Operator, please open up the line for questions.

Q&A Session

Operator: Thank you. [Operator Instructions] The first question comes from Bryan Maher from B. Riley. Please, Bryan, go ahead.

Operator: [Operator Instructions] At this point, we are concluding our question-and-answer session. And I would like to turn the conference back over to Jennifer Francis, President and Chief Executive Officer, for some closing remarks. Go ahead.

Jennifer Francis: Thank you. Thank you, operator. Thank you all for joining our call today. That concludes our call. We look forward to seeing many of you at the B. Riley conference in May and at NAREIT in June.

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.