Is it time to buy aged care stocks?

There are two opposing views on aged-cared stocks. The bulls say the fallout from the Royal Commission into Aged Care Quality and Safety is already priced into stocks. Share prices have fallen too far, creating opportunity for contrarians who see value.

In contrast, the bears say aged-care stocks have further to fall. Optimists are underestimating the Royal Commission’s likely impact on the sector, just as they did with the Financial Services Royal Commission and its effect on bank share prices.

I favour the bears on aged care, although I’m not as pessimistic as some. After tumbling from their 52-week highs, value is returning to Estia Health (EHE), Japara Healthcare (JHC), Regis Healthcare (REG) and Aveo Group (AOG). But the margin of safety is not yet sufficient to account for risks.
 

Chart 1: Aveo Group (AOG:ASX)

Source: nabtrade

Better to stand aside and watch and wait for improved value. There is no obvious catalyst to re-rate the sector in the next six months (the Commission’s final report is due April 2020) and the risks are firmly on the downside. I suspect the fallout from the Royal Commission will be stronger and last longer than the market expects.

Still, it pays to consider the bull case. The best argument for aged-care stocks – an ageing population – is firmly intact. Almost 5% of the population, or nearly 2 million Australians, will be aged 85 or over by 2054-55, shows the Federal Government’s latest Intergenerational Report. In 1974-75, this age group was just 1% of the population, or around 80,000 people.

This remarkable growth in people aged 85 or over explains the construction boom in aged-care facilities to house the elderly. The number of people in this age category is expected to double by 2036 and double again by 2046. Few industries have such strong underlying growth trends.

Australia’s $20-billion aged-care residential services industry will grow at 4.4% annually from 2019 to 2024, predicts business forecaster IBISWorld. That’s faster than the economy and still a decent growth rate, given the likely effect of the Royal Commission.

The industry remains highly fragmented with 1,846 operators. IBISWorld estimates the market share of the largest operators is each around 2-3%. That means potential to consolidate smaller players and open extra facilities to create bigger brands and economies of scale.

Providing extra services is another long-term tailwind for aged-care operators. Residents are tending to enter aged-care facilities later in life than previous generations. Older patients have more needs and higher demands for extra services. Changing preference is another factor: witness the growth in “five-star” aged-care facilities for upmarket clientele.

The other bull argument is valuations. Aveo now trades on a forecast price earnings (PE) multiple of 10, consensus estimates show. Estia is on 13 times, Regis on 15 and Japara on 16.

A target price of $3.52 for Regis, based on the consensus of six brokers, suggests it is materially undervalued at $2.52. Aveo’s $1.92 share price compares to an average broker target of $3.05.
 

Chart 2: Estia Health (EHE:ASX)

Source: nabtrade

Estia’s $2.11 price is well below the consensus $3.11 target. Even Japara at $1.22 is trading below the $1.44 consensus price target. If one believes the average view of broking firms that cover aged-care stocks, the sector is a screaming buy after recent heavy price falls.
 

Chart 3: Japara Healthcare (JHC:ASX)

Source: nabtrade
 

Bear case

I’m not convinced by the consensus broker view. The Royal Commission will cast a huge shadow over the sector for years. A two-part investigation by ABC Four Corners on the treatment of elderly Australians in aged-care facilities gave a sobering glimpse of the problems.

When Prime Minister, Scott Morrison, urges the community to brace for bad news in aged care, you know there are horrific case studies ahead. My hunch is the abuse of the elderly in some aged-care facilities, uncovered through the Royal Commission, will be worse than the market anticipated.

Whatever the outcome, the sector faces a barrage of daily bad news in the next six months. We don’t know how this will affect aged-care demand, but I’d be surprised if the revelations do not encourage some people to delay moving into commercial aged-care facilities, choose home support for longer, or favour not-for-profit providers, who account for about half the sector.

Then there’s the regulatory response. Extra compliance could constrain industry profitability and pressure profit margins. Operators could find it harder to lift prices and there could be greater scrutiny of service providers. Aged-care workers could have improved bargaining power amid the fallout (they deserve it) and push for an overdue pay rise, pressuring costs.

If this coincides with falling occupancy rates, aged-care operators will have declining margins, lower earnings and lower intrinsic company valuations. That’s a threat for aged-care providers, who have high fixed-cost bases and less scope to cut variable costs or lift prices, to maintain margins.

Another unknown is the financial cost of the Royal Commission on aged-care operators. Multiple class actions from shareholders and affected residents are a given, as has been the case with the financial services Royal Commission. Unlike the big-four banks, a class-action settlement is not a blip on the earnings of aged-care operators, which are mostly small- or mid-cap companies.

Legal costs alone could dent the earnings of operators. Perhaps a bigger cost is the management distraction: unlike the banks, aged-care operators do not have armies of lawyers and public-relations and marketing experts who can address the Royal Commission fallout. They don’t have a long history of dealing with intense public scrutiny and acrimony, at least at the level expected during the Royal Commission, and government investigations and findings.

Don’t be surprised to see greater management or board change at some aged-care operators after the Royal Commission, another distraction as new leadership settles in.

In relative terms, the aged-care Royal Commission could have more impact on operators than its financial services counterpart, given the banks have been dealing with extra regulation for years. That’s not to downplay the financial services Royal Commission or terrible banking scandals. Rather, it’s obvious that a $116 billion bank (CBA) has greater scope to handle a Royal Commission – and its fallout – than a $568 million aged-care operator (Estia).

Quantifying these and other costs of the Royal Commission on commercial aged-care operators is difficult. The bulls might argue that the market, in wiping billions off the combined value of aged-care operators, has already done that. I only see downside risk to earnings forecasts and the likelihood of lower valuation multiples.

The inescapable conclusion of the Royal Commission is that the Federal Government will put the brakes on industry profitability through extra regulation and compliance. And greater public pressure on operators generally to lift service standards, which could weigh on profitability and reduce the speed at which commercial operators expand through new facilities or acquisitions.

Some aged-care operators have welcomed the Royal Commission and see it as an opportunity to make the sector more accountable and sustainable. That could be true in the next 3-5 years, but there’s lots of short-term pain ahead, after a terrible 12 months for the sector.

Every stock, of course, has its price and Aveo, on a forecast PE of about 10, looks the pick of aged-care stocks. Aveo is a few years away from shaking off the publicity after a separate Four Corners expose on its contract practices.

Value in is emerging but even the best contrarians have been burned by buying too early. That looks to be the case with aged-care stocks right now, given the uncertainty. Don’t anchor your view to past share prices and think aged-care stocks now look cheap. This will be a changed industry with a changed growth profile, pending the Royal Commission outcome.
 

Chart 4: Regis Healthcare (REG:ASX)

Source: nabtrade