It's all about the banks

Dear Hot Copperites,

I don't have a position in EHE but have been doing some significant research on their current position. I reckon I'm extremely well qualified to comment but as always, don't take one person's post as gospel.

Some initial facts.....

1. A Refundable Accommodation Bond is classified as "current" because the lender (the resident) might drop dead tomorrow and the loan (RAD) is repayable in 28 days.

2. Unless Australia witnesses a bubonic plague or Spanish flu, thousands of residents won't pass away overnight - but they will over the next two years given the "high care" nature of aged care. Under the Living Longer, Living Better changes, more and more elderly residents get low care via home care services and only go to aged care for high care services. Hence the short average life.

3. Residents have the choice of paying a DAP (Daily Accommodation Payment), a RAD or a combination. Where a resident or their family opt for a DAP, the cost of the DAP reflects the daily interest rate that can be charged (as per Govt. rules) of 5.76%.

4. Residents will normally consider a RAD because they can't earn 5.76% on their investments, especially as many have term deposits or conservative assets earning no more than 2.5%. Some may have a share portfolio with significant capital gain and don't want to trigger CGT, or some may want to wait before selling the family home, but the reality is that not all will opt for DAP's.

Now let's look at the EHE balance sheet.

If the RADs were 20% replaced by DAPs over time (extremely drastic in a low interest rate environment), EHE would need the banks to provide them with an additional circa $120 million of funding. Based on the current interest rate charged by the banks, EHE would make more profit if this happened. They would be charged circa 4% by the banks and earn circa 5.76% on their DAP interest.

A bank will not want to provide additional funding if they believe EHE can't service the debt, especially given the high level of intangibles in the balance sheet (i.e. caused by paying more than book value for assets). And why wouldn't EHE be able to service the debt ?

1. Lower occupancy levels
2. Lower income per resident
3. Additional expansion/refurbishment/land purchases which has no cashflow but needs debt servicing

Lower occupancy levels is a lower risk as bed licences are heavily regulated and EHE has product in the market at various price points. Given life expectancy won't jump suddenly in the next 12-18 months, I think this is a low risk.

Lower income per resident is the big risk - EHE and all the providers will no doubt be working with the Government on what this looks like and what impact this has on free cash flow. This issue has two components - income and costs. EHE will be pulling out all stops to ensure their level of care is not reduced but the cost of providing it is minimised. They will also be working with Government on ensuring their income is not reduced such that care is impacted (assuming Scott Morrison has some kindness for our aged citizens).

Additional expansion and refurbs has been dealt with by EHE - they've slowed this right down because they aren't, or won't be, getting the net income to support the additional debt required to fund these works (or acquisitions). They'll be reluctant to sell assets (given the stamp duty they've paid and the strategic nature of these sites), but its another "worst case scenario" alternative.

I suspect that anyone loitering near EHE's Camberwell offices would see a long line of bankers coming and going from EHE's offices. As a betting man, I'd be almost certain that the banks will be willing to increase the current facilities, provided they get some more fees and reprice the margin (used and unused). As part of the negotiations, they are probably putting in new covenants around gearing levels and debt coverage, annual capex and dividend payout levels from free cash flow. No doubt they'll be looking at overall leverage, but given occupancy levels trigger cashflow issues, they might have targets on this which trigger the need to sell assets or raise capital.

As the new Government changes come through, its highly likely that EHE will have to take writedowns on the assets. Quite simply, the income generation from the assets purchased will fall so they aren't worth as much as when EHE purchased them. EHE will no doubt be working with the bankers on this, and the reality is their net asset position will fall. So there will also most likely be a minimum net asset threshold in the new banking agreement.

However, shareholders shouldn't be worried if the writedowns occur but this doesn't trigger anything else - the share price reflects this already. The most important factor is they remain above their minimum net asset level. Then it comes down to free cash flow (otherwise stated as number of beds multiplied by occupancy rates multiplied by net bed income).

With 188 million shares on issue, and at a share price of $2.65, the market is saying EHE is only worth $500 million. This is circa $100 million below its current 2016 net equity level. Given operating places (bed licences) have a tangible value, and EHE has almost 6000 of them in a highly regulated market, the current market valuation is probably not far from the mark. I'm not a bed licence expert but whatever the fall in government revenue (in % terms per bed or resident), this can be effectively applied to writedown the value of each bed (apologies to users of the CapM model who will argue EHE needs a higher beta and margin to reflect the changes in the industry, thereby bed licences fall by more than the income changes).

EHE is still likely to throw out some decent cashflow and their latest EBITDA forecast doesn't look overly optimistic based on YTD run rate and 2016 reported numbers. Obviously 2018 might be a different story given the government changes, but RADs and DAPs aren't going to fall. It's the government subsidies that will.

So assuming the banks don't get too concerned, shareholders might find that a less ambitious EHE which is beholdent to the banks becomes very focused on balance sheet restoration (nil acquisitions and slower development) and cash generation. Yes the dividend will be lower but on the basis that the dividend gets cut to 20 cents per annum, and EHE becomes a yield play, a $2.65 entry price looks cheap for a highly regulated industry with strong demand given the demographics.

In reality, given shareholders or potential shareholders won't know the outcome of the banks requirements until the trading halt is announced, be very careful and don't put at risk more than you can afford to lose ! However, if EHE comes to market and says Westpac and CBA have increased their facility size by $100m to facilitate increased resident preference for DAPs, and with no capital raise required (notwithstanding some additional covenants), you won't be buying EHE below $3.