Aged care, important to everyone, whether it be now as an investor or in the future as a potential recipient, is now likely to be under the Australian government’s Royal Commission spotlight.
The Commonwealth has proposed this top-line inquiry into the Australian aged care sector but has provided no details, as yet, on the focus. Brokers believe the negative coverage in the media and the prospect of a Royal Commission increases the investment risk for aged care stocks. While listed operators are typically more efficient, the attention and scrutiny raises operating and financial risk.
JPMorgan suspects it unlikely listed providers will be revealed as the villains in the piece, albeit they are also unlikely to emerge unscathed. The broker expects the commission to, ultimately, shine a light on the inadequacy of funding, noting one recent report which indicated over 40% of providers are losing money.
In this aspect, an aged care Royal Commission is probably going to be different from the Hayne Royal Commission into Misconduct in Financial Services, in so much as residential aged care providers are not making massive profits.
One potential path of investigation, Morgan Stanley agrees, may be the application of the Aged Care Funding Instrument (ACFI), which is used to determine the level of care required for those eligible for government funding, and this could be open to over-estimating treatment. Those requiring a higher level of care mean the facility receives more funding.
Other areas include the quality of care in aged care facilities, as a result of allegations and concerns voiced through the media. Currently, there is no legislation for specific staff/patient ratios except for publicly-run facilities in Victoria. A 2017 government report estimates only 13.5% of aged care staff were registered nurses in 2016.
Another issue is the overall level of care and whether it is adequate, whether residents are neglected and as a result suffer high levels of depression. Morgan Stanley believes investors should assess the potential outcome from any regulatory changes to the above issues, should they arise.
JPMorgan is confident the sector is at the bottom of the funding cycle and the commission could offer a catalyst for reform. While this may be provide a buying opportunity, the broker warns that the process will be protracted and falling property prices add risk.
Headwinds to margins and cash flows are probably now exacerbated, Macquarie suggests, although it is difficult to forecast the impact. The broker notes a continuing trend away from incoming residents parting with large amounts of personal wealth to prefrencing daily accommodation payments.
Greenfield developments may offset this trend but the broker believes operators with material debt levels are the higher risk investments. There is also a heightened risk of falling occupancy in residential aged care and, similar to experiences in the first half of FY18 which coincided with the impact of severe flu, falling occupancy corresponds to pressure on earnings because of a relatively high fixed cost base for aged care operators.
Stock Specifics
Macquarie estimates a 100 basis points decline in occupancy could lead to FY19 net profit reductions of -9.1% for Estia Health ((EHE)), -14.6% for Japara Healthcare ((JHC)) and -9.5% for Regis Healthcare ((REG)).
In analysing Estia Health, Morgan Stanley envisages benign growth in the company’s funding, forecasting 1% growth from FY18 onwards. Under a scenario where the ACFI was reduced by -10%, the broker’s FY20 earnings (EBIT) estimates would be -10% lower and discounted cash flow -8% lower.
The broker also calculates that the addition of one extra registered nurse per shift per home adds around $12m to annual staffing costs per year (based on an assumption of three RN shifts per day, a $60,000pa salary and 68 homes).
Such a rise in costs equates to around 13% of Estia Health’s FY18 operating earnings (EBITDA). Given the significant uncertainty that a Royal Commission introduces into the investment debate, the broker expects the stock will gravitate towards a new bear case.
At a minimum, Morgan Stanley suggests rising compliance costs should be expected and the stock will remain range-bound until more detail is forthcoming. Macquarie agrees compliance costs are likely to increase and there will pressure on balance sheets from underperforming operations as well as cuts to dividends.
While Estia Health was the broker’s preferred stock among the listed operators it is now likely to struggle. Macquarie downgrades Estia Health to Neutral from Outperform and Japara Healthcare to Underperform from Neutral. An Underperform rating is maintained for Regis Healthcare.
Japara Healthcare is part way through a cost initiative focusing on reducing staff, which was considered necessary to protect earnings and, given increased scrutiny, the broker suspects this strategy is at risk. A negative change in occupancy is also considered a greater risk for Japara versus its peers.
Meanwhile, Macquarie considers the mature portfolio of Regis Healthcare is already facing pressure. Regis Healthcare remains JPMorgan’s preference in the sector with an Overweight rating.
