I am regularly asked what to buy – but just as important is what to sell. One area I would definitely avoid just now is the support services sector (eg, Serco, Capita and Amec). Valuations are stretched and debt levels high. If a recession does start to bite, then these stocks have a long way to fall.
CareTech (CTH), tipped as a BUY by The Daily Telegraph
Take CareTech. It floated on Aim in October 2005 at 160p and has since gone on an acquisition spree that has tripled sales. The company is now a top provider of specialist residential-care services, mainly for people who have learning or physical disabilities. CareTech also supports a smaller number of clients who suffer from autism or mental health problems.
The majority of CareTech’s services are under long-term contracts, with residents typically joining in their teens and staying for 30 or 40 years, giving the firm strong and steady revenue flows. The UK market in 2004 was put at £2.1bn, of which the ‘for profit’ sector accounted for 47% (£1.0bn), which is almost entirely funded by NHS, local authority and income-support budgets.
Demand for these services is buoyant, with CareTech reporting record results last week. Turnover was up 59% to £53.1m, with adjusted EPS jumping 67% to 13.7p. It also increased the number of available beds at its centres from 739 to 1,029, while keeping occupancy levels stable at 90% or above.
Prospects also seem favourable, with chairman Farouq Sheikh saying that, “smaller operators are struggling to meet an increased regulatory burden, while demographics are driving greater demand, especially among the most disabled users”. House broker Brewin Dolphin is forecasting adjusted EPS of 21.4p for 2008, rising to 25.4p in 2009.
But amid all this bullishness, investors have overlooked three key warning signs. The shares look vulnerable, trading on inflated p/e ratios of 24.3 and 20.4 for the next two years. This is even more evident when the heavy net debt load of £70m stripped out.
If one instead looks at the operating profit to enterprise value ratio (EBIT) – which measures the firm’s return on invested capital – then this comes in at a paltry 4%. This should be at least 8% for this sector. So either the EBIT needs to double or, more worryingly, the share price could drop like a stone.
Next, if Libor spreads (ie, the margin above base rates), which have rocketed since the summer, don’t ease in 2008, then I can see CareTech’s interest cover falling dangerously close to two – which is the minimum level required under its banking covenants. Its lenders may even try to renegotiate tighter cover ratios in light of the softer commercial property market, because CareTech’s homes are secured against this debt.
Lastly, as recently experienced by Nestor Healthcare and Care UK, the allocation of NHS budgets can rapidly alter; so the perceived stability of CareTech’s revenues may not be as robust as the City assumes. With a stretched valuation and significant headwinds ahead, I say sell the stock.
Recommendation: SELL at 577p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments