What initially sparked my interest was an upbeat trading statement at the end of last month. In that announcement, CareTech's executive chairman, Farouq Sheikh, reported that his company's performance since its financial year-end has been in line with analyst predictions of a double-digit rise in current-year pre-tax profits. It also comes on the back of a 13 per cent rise in pre-tax profits and EPS to £19.7m and 31p, respectively, in the 12 months to end-September 2014. Underpinned by encouraging levels of demand for its services, CareTech has been benefiting from a growing market where outsourcing to the private sector is on the increase, and a stringent regulatory environment has been driving consolidation.
A twin approach to care
The business is split into two main segments: adult services, encompassing learning difficulties and mental health; and children's services, incorporating young person's residential and foster care. By far, CareTech's adult learning difficulties business is its largest profit centre, generating annual cash profits of £22.6m on revenues of £74.2m, or more than 60 per cent of last year's profits before central overheads. Importantly, it's a growth market, too, as there are 1.4m adults in the UK who have a learning difficulty, of which 185,000 are unable to live independently. The adult residential learning and supported learning market is worth £6.6bn a year, and is growing at the rate of 5.5 per cent a year, according to analysts at Laing & Buisson, a leading source of healthcare market intelligence in the UK.
Moreover, unlike elderly care, these adults will require care throughout their life, so the churn rate of places at care homes is far lower. In total, CareTech has capacity for 1,450 places at its adult learning centres, with the average weekly fee paid, primarily by local authorities, just shy of £1,200. Analysts at broking house WH Ireland expect the adult learning part of the business to increase its cash profits by around £1.2m to £23.8m this fiscal year, based on a £3.3m rise in revenues to £77.5m, implying a healthy profit margin of 30.7 per cent.
The second part of CareTech's adult services business is the provision of mental health care where the company works in partnerships with the NHS to ensure a successful transition out of acute care, and helping these adults support themselves in their own homes. It's a larger market than many would think as one in four people in the UK will at some point have a mental health problem, and a telling statistic is that one in 40 of the population is referred to a specialist psychiatric service each year. The mental health care market accounts for around 9 per cent of the care home market and is worth £1.6bn a year. CareTech offers 151 places at its centres and charges a weekly fee of £1,100. Analysts predict this division will be able to grow its cash profits by around 8 per cent to £2.7m this year on revenues of around £7.7m.
Caring for the young - and profitably
CareTech's young person's residential care business is a similar size and caters for children with learning and emotional behavioural disorders, and physical impairments. The market for these services is growing annually at 5.7 per cent and is now worth £1.1bn a year, according to the Department for Education. It's also under-represented by the public sector, which only caters for one-third of the residential homes in this niche market. As a result of the specific care needs, CareTech charges an average weekly fee of £3,700 for each of the 153 places at its residential care homes and generated annual cash profits of £7.4m on revenues of £21.9m in fiscal 2014. Analysts predict the company should be able to lift profits here by around £500,000 this financial year.
The final profit generator for CareTech is foster care, a segment of the social care market that has been hit by government cost-cutting. That's because, although outsourcing is well established in the culture of most local authorities, austerity measures have led a small number of authorities to reflect on the fee premium paid for independent fostering. The higher cost of independent foster care can largely be attributed to the fact that the most complex and most expensive children are generally placed in the care of independent providers. Of the 51,000 children taken into care in England, around half were outsourced to the private sector.
However, by taking these children in-house, it would appear that certain local authorities have adopted an expensive and quite probably unsustainable approach and one that CareTech expects to reverse once a full-benefit analysis is undertaken by the local authority commissioners. CareTech offers fostering for 320 children at an average weekly rate of £788, but reflecting these changes the unit earned cash profits of £3m on revenues of £12m last financial year, down from £4.3m and £14.3m in fiscal 2013. However, analysts expect a recovery in revenues to around £12.6m this year to drive cash profits up by £500,000. CareTech also has a small learning services business, acquired 16 months ago, and which posted a small profit last fiscal year following a restructuring. This unit is expected to turn in cash profits of around £400,000 on revenues of £10m this year.
The bottom line is that CareTech has a stable income stream generated from a high recurring revenue base with decent growth prospects, too. However, despite reporting a 13 per cent rise in pre-tax profits last year, shares in the company are only rated on 7.5 times post-tax earnings. And having lifted the payout to shareholders by 14 per cent to 8p, the shares offer a decent 3.5 per cent dividend yield, too. As I see it, the main reason for the chronic valuation is the balance sheet structure, something the company has just addressed by raising £21m at 210p a share through a placing.
Balance sheet funding
As one would expect from a business that is highly cash generative - operating cash inflow before working capital changes was £30.6m last fiscal year - and owns substantial property assets, CareTech carries high levels of debt.
Indeed, net borrowings were £166m at the end of September 2014, or the equivalent of 152 per cent of shareholders' funds of £109m. However, net of the proceeds from the recent fundraise, some of which will be used for bolt-on acquisitions over the next 12 months, and part of which will be used for property-related projects, net debt has now fallen to £145m. Furthermore, CareTech owns freehold properties which have been valued by chartered surveyors at £275m, or £47m above the value in the company’s latest accounts. In other words, pro-forma net asset value is actually closer to £177m, after marking properties to market value and factoring in the share placing, which means that balance sheet gearing is nearer to 82 per cent, a far more comfortable figure than the reported IFRS figure implies.
In addition, net debt of £145m equates to a modest loan-to-value ratio of 53 per cent on the freehold properties at their market value, and both cash profits and the aforementioned operating cash flow covered the interest expense four times over. The interest charge on the £171m debt facility is priced at 3.5 percentage points above London Interbank Offered Rate (Libor), so is competitive and the facility with a consortium of banks, including Lloyds Banking Group, Santander, Allied Irish and Royal Bank of Scotland, runs to January 2017.
So in light of the share placing, and one that was backed by the board of directors - finance director Michael Hill and certain senior executives subscribed for a total of £153,000 of shares, and executive chairman Farouq Sheikh and chief executive Haroon Sheikh subscribed for £1m of shares - I feel that the added headroom on that debt facility, and the lower balance sheet gearing, has materially improved the investment risk associated with holding the shares. Clearly, other investors are thinking the same way as the shares have risen since the placing was announced a fortnight ago.
Positive chart set-up
Interestingly, when shares in CareTech rallied off their low of 190p at the end of last month, it not only represented a successful retest of the intraday low from mid-October 2014, but there was positive divergence on the chart, too. On the weekly chart, the relative strength indicator (RSI) was much higher on the retest, indicating a bottom has been formed, a view that is backed by a bullish long tail on the weekly candlestick chart after the successful retest.
Other technical indicators are also highly supportive as the moving average convergence divergence (MACD) momentum oscillator is positive and above its signal line, the 14-day RSI still only has a reading of 60 so is not yet too overbought, and there has been a positive crossover between the 20-day and the 50-day exponential moving averages, both of which are close at hand at the 222p price level. This technical set-up suggests that a move above February's price high of 236p, a price point that halted the rally last autumn too, is firmly on the cards and, if breached, would open the door to what could be a swift rally to last summer's highs around 268p.
Beyond that, I have a fair value target price of 300p, valuing CareTech's equity at £186m and giving the company an enterprise value (market value plus net debt) of £331m, or the equivalent of 10 times forecast cash profits for the financial year ending September 2015. I find this investment ratio the most appropriate way of valuing CareTech, given its debt structure and the cash-generative nature of its business.
It's worth noting that analysts predict pre-tax profits will rise 14 per cent to £22.5m in the 12 months to end-September 2015, based on a £6.4m increase in revenues to £130m, but the 19 per cent increase in the issued share capital after this month's placing means that EPS will be flat at 31p. That said, the shares are still only rated on 7.5 times earnings, and on a hefty 20 per cent discount to book value when marking properties to market value, a valuation that is clearly at odds with the profit generation and much improved risk profile of the business.
Trading on a bid-offer spread of 226p-230p, and offering potentially 30 per cent share price upside to my 300p target price, I would follow the lead of CareTech's board of directors. Strong buy.
MORE FROM SIMON THOMPSON...
Please note that since the start of March I have written articles on a total of 26 companies, all of which are available on my IC homepage... and are detailed in chronological below with the relevant web links for ease of reference.
■ Non-Standard Finance: Buy at 103p ('A non-standard investment', 2 March 2015)
■ WH Ireland: Buy at 92p, target 140p ('A non-standard investment', 2 March 2015)
■ Software Radio Technology: Buy at 31.25p, target range 40p to 43p ('On the radar', 3 March 2015)
■ Vislink: Buy at 48.5p, target 60p ('Tapping into e-commerce profits', 4 March 2015)
■ Sanderson: Buy at 68p, target 80p to 85p ('Tapping into e-commerce profits', 4 March 2015)
■ Town Centre Securities: Run profits at 292p ('To bank profits or not?', 5 March 2015)
■ Sutton Harbour: Buy at 36.5p ('To bank profits or not?', 5 March 2015)
■ Housebuilders: Run profits on Persimmon, Bellway, Barratt Developments, Taylor Wimpey, Berkeley Group. Bank profits on Crest Nicholson, Bovis Homes, Galliford Try and Redrow. Buy Inland at 64p) ('Housebuilders: trading gains', 9 March 2015)
■ Walker Crips: Buy at 47p; Henry Boot: Buy at 232p; H&T: Buy at 179.5p; Nationwide Accident Repair Services: Buy at 85p; Communisis: Buy at 56p; Global Energy Development: Speculative buy at 44p ('Six-shooter of small-cap buys', 10 March 2015)
■ Stadium: Run profits at 123p; Pure Wafer: Hold at 42p ('Electrifying shares', 11 March 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
