The sell down by private equity firms Quadrant and Mercury Capital out of listed aged care landlord and operator Estia Health raises several questions for investors in the $1.2 billion stock.
In February this year, just over a year after the company listed at $5.75, and just before Estia’s first half result which caused the stock to drop, Mercury Capital sold 7.7 million shares at $6.65 for about $51.2 million.
Not a bad trade, but the next private equity sell down didn’t wait for Estia – a market darling in the area of listed aged care – to improve.
On May 6, Quadrant private equity sold 16 million shares at $5.56, below the issue price, and the following trading day sold out completely with another 14.84 million shares offloaded also at $5.56.
The adage “follow the money” is particularly poignant here.
Estia still has some very large shareholders including Perpetual, the United States giant TIAA, Fidelity and Norges Bank. But their presence on Estia’s register provides even more of a reason to explore the company’s numbers and its potential as a growth stock.
Estia estimates its operating places as of June this year will be 5921. It is forecasting it will have 10,000 places by 2020.
Estia says it can get to 10,000 places because it is smarter at acquiring businesses in what is an extremely competitive environment and better at buying and developing green and brownfield sites.
Greenfield and brownfield developments will only make up a maximum of just over 1000 places between now and 2020. The remaining 3000 will come through acquisitions.
Funding the growth
Estia may have some deals planned and it may have a good track record of developing, but how likely is their success in such an increasingly competitive environment?
More importantly how does it fund that growth?
Estia has borrowed from the banks and the leverage Estia uses is a lot more aggressive than some of the other operators.
Another way Estia can fund its rapid expansion is through the use of Refundable Accommodation Deposits. This is basically using the deposits that customers give Estia on arrival into their new aged care facility. Estia uses these deposits as interest free financing, which the federal government allowed such operators to use only recently.
Estia has already used up a lot of these RADs for its acquisitions and developments and while its a smart use of capital, such an operator has to be careful as to how the value and volume of these may adjust over time.
The proportion of RAD-paying residents at Estia increased to 59.6 per cent in the first half of 2016 up from 46.8 per cent in first half of 2015.
But are Estia’s RAD inflows largely one-off and unsustainable?
RAD growth itself is becoming a less common preference among customers. At listed aged care peers Regis and Japara, the preference for RADs is reversing.
At Japara Healthcare the number of pure RAD-paying residents fell from 79.2 per cent in the first half of 2015 to 62.2 per cent in the first half of 2016. While at Regis Healthcare the number of pure RAD-paying residents fell from 65 per cent in the first half of 2015 to 51 per cent in the first half of 2016.
At a Morgan Stanley conference in Sydney last week the chief executive of the unlisted Hammond Care, Stephen Judd, noted that inflows of RADs will slow comparatively quickly by 2018. He also said the rivers of gold in the aging population might be overstated when it comes to aged care.
The group of people aged over 70 will increase by about 22 per cent from 2016 to 2021, however, the average age of an aged care resident is about 85 and the over 85 year old age group will only increase about 10 per cent over the same period. Only 23 per cent of aged care residents are under the age of 80.
Part of the decrease is also made up by an increase in what is called combinations – this includes customers taking a part RAD and part Daily Accommodation Payments (DAP).
A typical RAD at Estia is now worth $368,943 and that has grown in value. But a combination, which includes a smaller RAD as well as a DAP, has an overall value of $324,987.
As these combinations increase and pure RADs decrease, overall RAD financing available decreases. Of course, there is also the risk that people die – in which case the RAD has to be paid back usually within 14 days and at this point the average duration of a RAD before it is needed to be paid back is about 2.5 years. This makes RADs only a short term financing tool.
So overall, funding the growth ambition of 10,000 places may become a little more difficult for Estia.
If the banks do decide to lend them more money and Estia leverages even further that creates more risk.
It is also worth looking at Estia’s operating cashflow.
Unusually Estia includes its net RADs as operating cash flow not financing cashflow. Net RAD inflow is simply the monetary difference between a new RAD and RADs that have to be paid out because the customer dies or exits.
Is that appropriate given RADs, net or not, are a liability?
The reason it may not be entirely appropriate is that net RADs could well end up negative. The value of a RAD – which is a combination of many factors including house prices – could start to decline.
So when someone dies and Estia need to pay back a $368,000 RAD that could be more than what a new customer comes in on and pays Estia.
All things being equal negative net RADs would then reduce Estia’s operating cashflow.
Other retirement operators such as Japara include net RADs as financing cashflow not operating cashflow. It is seen as better standard practice.
If you are really bullish on the value of RADs then maybe it doesn’t really matter how you classify net RADs. But if you take net RADs out of the operating cashflow and included them as financing cashflow you are left with a much smaller free cashflow to equity (FCFE) and FCFE is a fundamental way to value a company.
Based on Estia’s most recent financial results if you took net RADs away from operating cash flow you would be left with operating cashflow of $20 million as of full year fiscal 2015, which for a $1.2 billion company is quite small. A vast majority of the remaining $20 million is coming from government grants. These grants are called Aged Care Funding Instruments (ACFI).
Estia says they are experts in getting the ACFI payments because they are better at classifying customers under the government qualifications. Estia management, who declined to respond to questions from the Australian Financial Review, says it has the best systems and processes for accurately classifying the customers.
It is basically saying the retirement villages it has acquired weren’t doing their job properly because if they had, some of the customers would have been more suitably classified under the government system.
The federal government has a healthy suspicion of aged care operators’ classification, and last year started to crackdown on this by reducing the growth of grants. The federal government has a responsibility to tax payers to make sure its is not spending more on people who are healthier than others, but classified as not being healthier.
One of the leading analysts on Estia, UBS’s Shavarsh Bedrossian, said this month that he expected the government to be “prudent” on grants.
“The fiscal 2017 reforms do penalise those pursuing higher care levels of ACFI, to fund the absolute growth in average volume and frailty.
“We have lowered our net profit after tax estimates across the listed aged care operators by about 3 per cent in fiscal 2017 and 4-6 per cent in fiscal 2018.”
He expects the worse case is priced in for key stocks following this year’s federal budget and expects that the government will “find it more difficult to find meaningful future savings mechanisms amongst those services”.
Estia’s next financial accounts may indeed show some strong earnings numbers, but the industry is starting to become aware of the challenges facing such owners and operators of aged care and questions are being raised privately about just how ambitious Estia’s growth targets are.
The private equity has already made its call on Estia. Now its time to hear from the institutional investors.
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