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Take care

Created:
6 May 2008
Written by:
Richard Hemming

CareTech's 11 per cent share price spike after it announced the £22.5m acquisition of Beacon, a fellow care home company, has provided a much needed boost to the confidence of both shareholders and managers of healthcare services companies. The real significance of the deal was less about the share price rise - at 450p, CareTech's shares are actually well below their 12-month high of 822p - but rather CareTech's ability to secure a new £120m credit line which will be partially used to fund the acquisition.

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One of the key reasons care home companies' shares have suffered more than most sectors this year has been the concern that a major method of creating earnings growth is no longer viable following the credit crunch. Indeed, the underlying residential care market looks enticing as demand for such services is being fuelled by the UK's ageing population and frustrations with government provision. Yet the share prices of care companies have declined by between 30 and 80 per cent from their 12-month highs compared with a relatively benign 7 per cent fall in the FTSE All-Share Index in the past 12 months.

Companies such as CareTech, Southern Cross Healthcare, Care UK, Claimar and Supporta rely upon acquiring smaller businesses in their fragmented marketplaces. Typically, such businesses can be bought on a lower multiple of earnings than that of the acquirer, which means that the enlarged group's earnings are enhanced. These deals are mainly funded with debt.

"[The CareTech acquisition] indicates that deals can still be done. When CareTech originally looked at Beacon, the price would have been higher. It provides an indication that the high multiples vendors were looking for are coming back to more realistic levels," says Chris Glasper, analyst at Brewin Dolphin.

Because of the worsening credit conditions, prices for care home properties have gone down, which can benefit buyers like CareTech. Mr Glasper estimates that the multiple of 10 times operating earnings achieved by CareTech for care provider Beacon would have been closer to the mid-teens three years ago, which translates into a price of about £35m.

But it is the financing of the deal rather than its price that is the major reason for celebration. Of the £120m available to it, CareTech has drawn down £100m and broker Brewin Dolphin forecasts that its net debt will increase in 2008 from almost £70m to £103m. It is forecasting a gearing ratio (net debt as a percentage of net asset value) for 2008 of a whopping 389 per cent. But the gearing, while lofty against the sector norm of between 50 and 100 per cent, is not as much of a concern as it first appears. This is because CareTech's property portfolio is valued on its books at a historical level. So, were its properties re-valued gearing would be more like 70 per cent.

The leading care provider in the sector, Southern Cross Healthcare, which provides about 8 per cent of the total beds in the UK, has another way round the debt issue. Unlike CareTech and Care UK, Southern Cross has managed to minimise the properties on its balance sheet and consequently the amount of debt it holds through a sale and lease back strategy. That means that Southern Cross buys properties, then sells them on again while retaining a long-term lease on the premises to operate its care business. Its debt is forecast to be £50m in 2009, which translates to a gearing ratio of under 30 per cent.

In order to obtain a return on equity (ROE) closer to Southern Cross’s 33 per cent, Care UK is trying to emulate the sale and lease back model. Care UK has an ROE of 9.5 per cent and its net debt is close to £169m (giving it a gearing ratio of 157 per cent). There is no doubt that investors will be encouraged if the company achieves its planned £60m worth of sales from its £200m plus property portfolio.

But high debt levels and concern about the availability of fresh debt isn’t the only reason the share prices of companies involved in residential and domiciliary care have been falling. Indeed, Southern Cross's share price has fallen steadily by 41 per cent over the past six months. Investors are also concerned about the sustainability of healthcare companies’ profit margins given the fee rate pressures in the industry. Although there are increasing numbers requiring aged-care services, due to the ageing population, the finite pot of public funds is not growing as quickly as it has done in the past five to 10 years. And eligibility criteria is changing for elderly-care service, reducing the amounts available to home and domiciliary care.

On the clinical, or hospital care, side there are funding issues that affect private operators like Nestor Healthcare and Care UK. All these issues serve to highlight that although healthcare companies are direct beneficiaries of the ageing population, investors have to counterbalance this with their financial structures and the highly political environment they are operating in. While CareTech's recent deal is an encouraging sign that banks will still back acquisitive growth in the sector, it nevertheless remains a case of buyer beware from the investor's perspective.

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