In 2014 ASX investors looking to cash in on long term demographic trends were treated to public offerings of three Aged Care Operators – Japara Healthcare (JHC) beginning trading on 17 April; Regis Healthcare (REG) beginning on 7 October; and Estia Health (EHC) on 5 December.  

In contrast to Retirement Living stocks operating for the benefit of seniors who are able to care for themselves to varying degrees, Aged Care offers residential treatment for seniors who cannot care for themselves to varying degrees.

With increasing frequency investors are deluged with article after article heralding the coming flood of baby boomer retirees expected to live longer lives.  The demographics are beyond dispute.  From the Australian Bureau of Statistics (ABS) the following graph suggests the flood has already begun.

The ABS now tells us the proportion of 65-year-olds and older will hit 22 per cent by 2061, with the number of Australians exceeding the age of 85 jumping to 5%.  

In contrast to ASX companies offering a range of retirement living accommodations, aged care operators are subsidised by the federal government.  Aged Care operators reportedly derive around 70% of their revenue from government funding.  With that level of funding it should come as no surprise the sector is heavily regulated, with a yearly licensing process for new aged care “beds.”  

The process is known as the Aged Care Approvals Round (ACAR) and is highly competitive.  Although the ACAR is open to both existing and new providers attempting to enter the market, the criteria for selection appear to give existing providers an edge. According to the government approval body (the National Commission of Audit) “places are allocated to applicants that demonstrate that they can best meet the care needs of older Australians.”  

In effect the ACAR process provides is a “barrier to entry” for newcomers and thus a substantial tailwind for existing operators.  Once bed licenses are awarded the winning providers have access to interest free consumer capital funding via Refundable Accommodation Deposits (RADs) and/or Daily Accommodation Payments (DAPs) directly from residents.  RAD is a lump sum up-front payment that can be broken down into DAPs.  The amounts charged are also subject to government regulation.  Although the RADs are eventually repaid, while the senior remains under the operator’s care the funds from the deposit are available to the operator for capital expenses and acquisitions, at no interest.

In theory, government funding and government limitations on potential competitors should make aged care operators very attractive investments. In their first year of operation the newly listed operators all saw their share price rise, with two of the three rewarding shareholders with substantial price appreciation.  The following table summarizes the price movements of all three since they listed on the ASX.

In practice, what the government gives it can take away and regulatory changes in the past year or more have hit the sector hard.  While most articles on IPO returns use the issue price as the entry point, we feel the first day opening price is a more valid measure, since retail investors are not always able to get in at the issue price.  The first year share price appreciation is based on comparing the closing price one year following the stock’s first trading day, with the opening price representing the first offer at which most retail investors could buy in.

Health care costs across the board are rising, putting pressure on government assistance of all types to the sector.  The prospect of longer lives from more people has the government scrambling for ways to control costs, with many regulatory changes aimed at passing costs back to the end consumer and the health care operator.

A share price movement chart comparing the two providers still trading above their issue price (Regis and Japara) gives us an idea when investors began to run for the exits.

There are pieces to this puzzle that trace back to the 2012 Living Longer, Living Better Reform Package from the government aimed largely at increasing the number of seniors remaining at home for aged care rather than moving to costlier residential treatment centers. The initial five years of the projected ten year implementation of the reforms included a major review in 2016/2017.

In hindsight, some skeptics observing the current concerns surrounding the future of the aged care operators openly speculate the private owners foresaw troubling regulatory changes, spurring the public listing of their companies. You can see from the chart the share price erosion began in early 2016, perhaps in anticipation of the government review.

The Federal Budget announced on 3 May of 2016 included a $1.2 billion dollar cut to the Aged Care Funding Instruments (ACFI) – the scheme the government uses to determine subsidy payments to aged care providers.  In less than a month the analyst downgrades began, beginning with BAML (Bank of America/Merrill Lynch) slapping all three ASX aged care operators with Underperform ratings.

The sell-off picked up steam in September on the news of more changes in government regulations, the latest surrounding what had been a “cash-cow” for the sector – Accommodation Deposits.  In yet another round of efforts affecting the sector’s funding model, the government is changing the amounts the operators can charge residents.  

Added to the uncertainty and the confusion is the government’s increasing effort to push subsidies for Home Care Packages, a potential competitive threat to the residential aged care operators.

The latest analyst ratings from Reuters reflect the considerable uncertainty about the future of the sector.  For each of the three operators, opinions are mixed but the majority of analysts are recommending Hold, Underperform, and Sell.  Here is the table.

Some analysts see government subsidies for Home Care Packages paid directly to consumers as a major threat to the residential aged care operators. In addition, the Productivity Commission, whose 2011 Caring for Older Australians report ushered in this round of regulatory changes, recommended eliminating regulatory limits on bed licenses.  Should that occur, the aged care operators would lose their current barrier to entry advantage and the supply of aged care beds would undoubtedly increase.

The bleak picture certainly warrants concern, but one could make a reasonable case for a contrarian point of view here.  

No one questions the demand side of the senior retirement and aged care market.  Seniors by increasing numbers will eventually need care they can no longer provide for themselves, regardless of whether they are living at home or in retirement community villages.  The Home Care alternative should help government spending on health care costs, but how realistic is that option for seniors on a long term basis?  

At some point the level of care required could escalate to require skilled nursing care, around the clock. Consider dementia as an example.  Deloitte Access Economics has reportedly estimated the number of Australians suffering from dementia will quadruple by 2050.  Will adult children be comfortable leaving parents in the care of a single live-in nurse?  Will the demand for costlier in home medical care cut into the cost benefit of Home Care Packages?  Dementia is not the only medical condition requiring around the clock skilled care.  Strokes, cancer treatments, post-operative recoveries, and numerous other serious conditions will drive up the cost of in-home care, where the one-to-one ratio becomes far less cost effective than the residential treatment model.

While the government continues to look for ways to manage health care costs, its commitment to the nation’s senior citizens means the government needs the for-profit aged care operators to succeed.  

Investing in aged care operators amidst the current uncertainties over regulatory changes is not for the short-term trader, nor for the faint-of-heart long term investor.  But for those who believe experienced management at these three companies will devise strategies to accommodate declining government subsidies, all three are worth a look, although waiting for the release of the upcoming federal budget would be prudent.  Industry groups are already heralding the need for “stability and certainty” in the funding schemes to ensure expansion of existing facilities to meet demand.  

Of the three, Japara Healthcare has an advantage in that the company offers both retirement living accommodations and aged care treatment at five of its 40 locations.  This should be a major attraction for couples looking to grow old together.  Should one require the need for skilled nursing care, the switch from retirement living to aged care is only steps away, enabling visits from the other partner.

Debt is a concern for all of these companies as the aged care sector is fragmented and acquisition opportunities are expensive.  Estia Health saw its share price drop further in mid-December following the announcement of a capital raise to address the company’s total debt burden of $253 million, as of the most recent quarter.  While Estia will emerge with a stronger balance sheet, potential investors should be aware of the fact the company founder resigned and sold his entire stake in Estia following the company’s dismal earnings release last August.  The company also saw both its CFO (Chief Financial Officer) and CEO (Chief Executive Officer) leave.

On 24 February Regis Healthcare surprised the naysayers with its Half Year Results release.  Despite the regulatory changes, the company posted a 20% increase in revenues and a 9% rise in net profit after tax (NPAT).

The reforms are.

“Nursing homes will undergo a transformation as wealthier baby boomers, and their children, look to maintain expectations – with private room ensuite facilities, secure gardens, personally tailored services and highly skilled care staff.” Mr Parekh said.

“Australia’s emerging dementia epidemic will also play a huge role in the opportunities on offer. Deloitte Access Economics estimates that the number of Australians living with dementia will quadruple by 2050.

“As a result, specialist dementia care is already growing rapidly, and not only will more Australians require care, they will increasingly have the money to pay for better quality care.”

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