With shares in Estia Health Ltd (ASX: EHE) diving 50% over the past 12 months – and now paying a 7% dividend – investors must be wondering if it's a bargain. After all, a number of well-known (and successful) investors have made their reputations on buying businesses that very few other investors saw value in. Surely Estia could be one of these?
It receives a significant regulated fee, the Aged Care Funding Instrument (ACFI), from the government for its services, plus there's the tailwind of an ageing population. The 3-tonne cherry on top is the Refundable Accommodation Deposit (RAD) Estia receives from guests, which is treated as an interest-free loan to be used for investment.
Unfortunately, I would not feel comfortable investing in Estia today. Japara Healthcare Ltd (ASX: JHC) and Regis Healthcare Ltd (ASX: REG) appear more attractive, while Estia in particular has a number of problems.
Warning signs
- Government audit of ACFI fees, which account for roughly half of Estia's cash flows. The Mid-Year Economic and Fiscal Outlook (MYEFO) specifically stated that aged health providers have been claiming higher fees that cannot be explained by increased frailty of residents
- Shaky balance sheet – if you strip out goodwill on Estia's acquisitions, Estia has negative net tangible assets (i.e., it owes more than could be recovered by selling its assets)
- Cash flows – half of Estia's operating cash flow is a result of incoming RADs being more than RADs paid to outgoing residents. Factor in dividends and Estia's operating cash flow was just $30 million at its most recent report
- High error rates on ACFI documentation with 1/8 believed erroneous – this appears to be on par with industry average, but is an increase from industry average of 1/7 a few years ago
- Growing through acquisition – most of Estia's growth comes from highly-priced acquisitions, it will have trouble funding more of these in the future without debt
- Director and founder Peter Arvanitis quit and sold his 17 million securities on the market the same day. Insiders selling in this manner is not encouraging
I could add a few more to that list, such as potential media coverage hurting customer demand. Not long ago, many Australian pathology providers reported a significant drop in customer demand because of proposed changes to the bulk-billing fee for scans, which never eventuated – but the impact did.
Selling your house to move into a nursing home is a huge leap of faith and even a little adverse media coverage or changes to regulation could be enough to cause potential residents to postpone their decision. Nursing homes require a significant amount of trust from would-be residents, who must believe that the home treats them with respect and dignity – not as cash cows – in their later years.
Additionally, Estia has been rather aggressive with its treatment of RADs, using them heavily to fund acquisitions of businesses trading on high multiples. It relies on the recent industry trend for incoming RADs to be higher than outgoing RADs. This makes sense, because the average resident's tenure is 2.5 years and the fees incurred in this time reduce their RAD significantly. However, regulatory change or media coverage could affect this trend, and with $30 million in the bank Estia just doesn't have enough to cover the average year's RAD refunds. It would have to take on more debt, which already sits at around 45% of its net equity. This is starting to get high, considering the risks facing the business.
But it's cheap?
Indeed, it appears to be, but Estia has low margins and even a small reduction in ACFI fees would meaningfully hurt profits. Combined with the risks above, I would advise steering clear of Estia.
The aged care industry is an attractive one, but has modest margins, relies on government funding, and although it has long term tailwinds it's also fairly low-growth. I would prefer to see this kind of business run more conservatively, focusing on operational excellence while reinvesting excess RADs into attractive new facilities (or even into bonds) rather than buying existing ones. Instead, Estia appears to have been run pretty aggressively and it doesn't look as though it will take much for more trouble to eventuate.
