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The third certainty

Created:

20 May 2008

Written by:

Mr Bearbull

I have never liked fridge magnets - why do I have to confront Bart Simpson and Scooby Doo whenever I want a little chilled Sancerre? And I like them even less since my elder daughter popped one on the fridge door bearing the legend: "Be nice to your children, they choose your nursing home". The trouble is, of course, it's a bit too close to the bone. I've got to that stage where I understand just what Bob Dylan meant when he murmured, "It's not dark yet, but it's getting there," on his Time out of Mind album. And, if there had been nursing homes in Benjamin Franklin's days, he would surely have quipped about there being three certainties in this world - adding to death and taxation the obligatory declining years in a nursing home sans teeth, sans eyes, etc.

However, there is one way to make the prospect of that forced stay in the incontinence suite at the Hotel Zimmer a little less horrifying - make some money out of nursing homes. Which is another way of saying, buy shares in a nursing-homes operator. The question is, which one?

Among London's listed companies, there is a choice of two - Care UK or Southern Cross Healthcare. Both groups are similar to the extent that they run care homes, mostly for old people but also for others with various disabilities. That said, each has a chosen different business model, which brings its own risks and potential rewards.

Put simply, Southern Cross is the lower risk operation of the two. It sticks to its knitting, which is running care homes - 728 at the last count, providing just over 37,000 beds. Over 600 of these homes are effectively funded by the public purse. Another 80 or so are funded by old people who are fortunate enough - or foolish enough - to have savings above the limit where state funding kicks in. These folk pay handsomely for the privilege - in 2006-07, £587 per week on average, which generated divisional cash profits before rents of £42m from just £105m of revenues. In contrast, in Southern Cross's much bigger division of state-funded homes, residents paid £477 on average and the chain's equivalent profit margin was 30 per cent, producing cash profits of £178m from £589m of revenue. However, the biggest weekly fee - £912 on average - came from the group's small chain of 45 homes that look after people with learning disabilities. But higher staffing costs meant that this operation made an equivalent margin of only 29 per cent. (Southern Cross is a recent IC buy tip).

If these profit margins sound grand, they are not so impressive when they filter down to the group level after accounting for all costs. In 2006-07, the operating margin on overall revenue of £732m was just 7.6 per cent. But this isn't necessarily a problem, for two reasons. First, thanks to its contracts with local authorities, Southern Cross has assured future revenues. Second, its bosses have chosen a business model that ties up less capital than Care UK. The company's style is to sell homes it acquires to property investors, then take operating leases. Sure, this requires easily available finance to work smoothly, so the credit crunch has caused some anxiety. But management says that Southern Cross's covenant on a landlord's mortgage offers reassurance. Besides, the scope for expansion remains considerable given the greying of the UK's population.

Care UK, meanwhile, has chosen the diversified route. True, its biggest activity is running care homes, and these generated 38 per cent of the group's £249m revenue in 2006-07 and 49 per cent of its £33m of underlying operating profits. In addition, £6.5m of operating profit came from specialist care homes; £5.3m from community care, which means providing the care that keeps old folk in their homes for another year or two; and - most significant - £5.2m from providing healthcare services. That's significant because healthcare provides a very different income stream, and one that could grow fast as, increasingly, the NHS contracts out functions ranging from running GP surgeries to providing specialist clinical services.

The trouble is that working with the NHS is no fun. It neither seems to know what it wants nor how to achieve it, has a poor record of implementing big projects and, after years of spending plenty, is being forced into the tightest of corsets.

Care UK discovered the hazards this brings when a £50m contract to run diagnostic services for the NHS in the West Midlands was cancelled in November just four months after it started. Sure, Care UK should get some compensation. More important, its bosses still believe that the financial imperatives that will drive the NHS mean that the healthcare division will grow fast. They had better be right. They are not quite betting the business on the success of the healthcare division. But following major capital commitment - including a £77m acquisition, by far Care UK's biggest, last year - they are betting both the share price and their jobs on it. (Care UK is also an IC buy tip; latest update here)

Yet shares in Southern Cross - thanks largely to the group's superior return on capital - come out of the Bearbull valuation process better than Care UK's. While I could comfortably justify paying the current 402p for Southern Cross shares, it's tough to show that Care UK's are worth their 443p. Sure, of the two groups, Care UK may provide the more exciting future. But, arguably, providing for old age should be about as exciting as old age itself.

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