Like other large nursing-home operators, this company has benefited from rising demand from an ageing population, a cut in the number of homes (many of the older ones have disappeared due to stricter regulation), the ability to raise fees ahead of inflation, and a pool of cheap immigrant labour. But a downturn in commercial property prices or NHS spending could spell trouble.
Southern Cross Healthcare (SCH), rated a BUY by KBC Peel Hunt
Southern Cross Healthcare is the largest provider of retirement homes in the UK, with about a 6% share of the £11.8bn market. It runs care homes for the elderly (95% of sales) and for young people with learning and physical disabilities (5% of sales). Around three-quarters of the residents need around-the-clock attention. Occupancy levels are about 90%, with local authorities accounting for more than 70% (or £520m a year) of turnover.
The company has been able to make acquisitions without additional fund-raisings due to its sale-and-leaseback structure. This enables the firm to buy a care home and then sell the underlying property to landlords, which gives Southern Cross the operating business but with minimal impact on cash flow. On the surface, this all sounds great. However, the strategy also raises concerns: it is essentially another form of off-balance-sheet finance that creates a very high level of operational gearing. It works perfectly while commercial property prices are rising, but creates difficulties in a downturn. Indeed, the majority of Southern Cross’s costs are fixed, with staff, running and rental expenses in aggregate accounting for a whopping 90% of turnover. Clearly, if there is any softening in sales, profitability will suffer.
Another worry is the extent to which revenues are dependent on local authority funding – Southern Cross carries a fair dose of political risk. For example, a sudden change in the political climate could have an adverse effect on local authorities’ ability to pay. A typical resident at a Southern Cross home costs the Government around £24,000 per year. As NHS budgets are being reined in, council bosses could become penny-pinching sooner rather than later.
Finally, note that this has been a great success story for private equity. Blackstone bought Southern Cross for £167m in September 2004 and listed the stock on the London Stock Exchange in July 2006 at 225p per share, before finally off-loading its remaining 21.8% stake in March 2007 at 412p. As a result, it is estimated that Blackstone banked £800m to £1bn of profit.
This type of disposals – by very astute professionals – should always raise alarm bells for the retail investor. If Blackstone believes now is a good time to exit, then it takes a brave man to bet against them. Moreover, the valuation supports this, as the shares are certainly not cheap – trading on a 2007 p/e ratio of 28. Personally, I would value the stock on a multiple of 20 times at best, implying a fair value of around 380p per share – or 30% less than today.
Recommendation: TAKE PROFITS at 540p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments