[Sold as of Q1 2024 for a total gain of +175%. This thesis was written up retrospectively on the date below and refers to prices from Nov. 2, 2022 to Feb. 27, 2023.]
Date: Jul. 24, 2023
DHC is a REIT that owns medical office properties and a number of senior living communities. After a series of management missteps, the company was forced to cut the dividend in 2019, sending the stock into a freefall from $19 to $7. Then the pandemic followed, forcing the temporary closure of some of their senior communities, leading to more sizable losses, and effectively an elimination of the dividend. For almost 7 months this year, the stock traded under $1 and the outlook was grim.
With the company's short-term future under question, the REIT's manager, RMR Group, proposed to merge DHC into another one of its companies, Office Properties Income Trust (OPI) in order to refinance the DHC debt under more favorable terms. This merger proposal in April was negatively received by some DHC shareholders as it appears to strongly undervalue the conversion from DHC to OPI shares (0.147 OPI shares for each DHC share).
A proxy fight was initiated by two investment firms (Flat Footed LLC and D. E. Shaw) who intend to vote against the merger as they see very large upside in allowing DHC to continue operating on its own. They cite favorable senior population trends and propose a variety of possible asset sales to cover the significant upcoming debt maturities. Both of these companies have filed detailed reports on the matter and judge the fair value of the stock around $9.
I started following DHC in October of 2022, before the merger announcement. At $1 per share ($239M market cap), the equity seemed to carry significant upside given the vast asset base ($4.8B net property value, or $20 per share). It was hard to see how the company could default on the debt given the large number of desirable properties it owns, a number of which have started to recover. I started a small stake, bought more when it went down to $0.79 and some more at $1.06. My average price on DHC is $1.12. Since the merger announcement, the stock has done backflips, fluctuating between $1 and $3 per share.
In my view there is a sizable likelihood that the merger does not go through based on the deviation between DHC's current price and its after-merger price when seen from the point of view of OPI's share price. Assuming the upcoming debt is taken care of, the undervaluation will likely correct in the years to come.
If the company fails to refinance the debt and liquidation takes place, things would not look good for equity holders, and permanent loss of capital might occur. I believe this outcome is unlikely, but since it is possible, DHC was a small investment that nevertheless could produce significant upside.