Estia’s magical ROCE equation

Over the last few posts we looked at companies that can achieve high ROICs inside their moats and companies that cannot.

Here we will visit a third category – companies that can define its own ROIC.

When a company insists that you assess it using its own proprietary measures, and the picture it paints does not reconcile with what you arrive at using traditional corporate finance measures, then there are a couple of possibilities: either (1) you’re an idiot for not understanding and appreciating the specific nuances of the company or industry; or (2) something peculiar is going on and it’s time to dig deeper.

I have assumed possibility #2 in context of the Residential Aged Care sector (although I do not rule out possibility number #1!). Let’s explore this by working through the acquisition mathematics of recent acquisitions in the sector.

Estia acquired Kennedy Group for a price tag of $271m which generated around $17m of EBITDA in both FY2014 and FY2015 (according to its statutory accounts) equating to an acquisition multiple (EV/EBITDA) of 16x.

Inverting the above (and including an estimate for maintenance capex) gets us to a ROCE of c.5.9%. However, Estia touts a headline ROCE of > 17%.

How do we reconcile this? Well it comes down to the fact that Estia has defined its own proprietary ROCE formula as follows:

Understanding Estia’s proprietary ROCE formula is key to understanding what is really driving the flurry of activities in the residential aged care sector today. So let’s work through how Estia achieves its ROCE magic.

Decreasing the Denominator (Capital Employed)

Estia’s FY2016 acquisitions, including Kennedy, has a combined headline price tag of $399m (or Enterprise Value in standard corporate finance parlance).

From Estia’s perspective though this headline price is not what it actually paid because it is subject to two rounds of reductions being:

• Reduction of $86.9m on account of RAD liabilities already on the Balance Sheets of its acquisition assets (i.e. Net price); and
• Reduction of a further $125.4m on account of future expected RAD liabilities to be taken on Estia’s balance sheet using the assets acquired (i.e. One-off RAD uplift).

So from the vendors’ perspective, they’ve received $399m for their businesses, however from Estia’s perspective it has only paid $187m.

How does one then account for the difference of $212m? Has it simply disappeared into the ethers?

The incongruence is due to the accounting of Refundable Accommodation Deposits (“RADs”) -funds lent to Estia by its residents (as a quasi deposit bond upon entry into the facility) and guaranteed by the Federal Government.

For background, I have previously written a lengthy article on RADs and why I think it’s a potential time bomb for the sector.

Effectively Estia’s ROCE equation says this: these RAD liabilities are very real on someone else’s Balance Sheet (in that they are deducted from the purchase price) but once they’re taken onto Estia’s own Balance Sheet, they simply cease to exist.

Increasing the Numerator (EBITDA)

We know from Kennedy Group’s statutory accounts that it made around $17m of EBITDA each of the past 2 years on an already high occupancy level of 94%, operated by the Kennedy family who presumably know what they’re doing given they’ve been in the aged care game for approximately 43 years longer than Estia.

Then how does Estia intend to increase Kennedy’s EBITDA? The slide below from Estia provides some clues:

So Estia is targeting $6m of EBIT improvement from an “ACFI uplift”, to be implemented over a period of 2 months immediately after the change of ownership.

(The workings appear quite simple, Kennedy has 959 places with an occupancy rate of 94% which equates to 329,033 operating days. Multiply the operating days against the $18 differential between Estia’s average ACFI and Kennedy’s ACFI, we get to $5.9m.)

Significantly, this implies that Estia will incur no additional costs in return for $6m of additional government funding.

It appears that the Kennedy family (chaired by none other than Gary Weiss) were kind enough to leave $6m of incremental EBIT (a lazy c.$100m of value based on its acquisition multiple) on the table for 2 months of essentially procedural work on the ACFI.

Unintended Policy Outcomes

Post the introduction in 2014 of the Living Longer Living Better reforms, the regulatory construct is such that equity analysts have actually stated their preference for aged care providers to acquire existing facilities (at eye-popping valuations) rather than develop new facilities due to the apparent higher IRR achieved.

Instead of RAD funding being utilised to build out new supply of residential aged care facilities to ready Australia for the “grey tsunami” (as per government intent), it is being aggressively deployed to fund the roll-up of existing facilities. These acquisitions are made at such a high prices that RAD liabilities are now supported on the Asset side of the Balance Sheet by predominantly Acquisition Goodwill – the value of which is a direct function of the huge valuations currently being paid in the sector.

So the seemingly clever act of the government guaranteeing and making available retiree savings as capital funding for the sector has in this instance failed to actually increase the new supply of aged care places but succeeded in inflating asset pricing which in turn puts pressure on owners of these assets to make ever more aggressive claims for government funding in order to meet capital market expectations.

I suspect there will be few eventual winners out of this, with the exception of perhaps the long-standing family that gets to exit their business at a once-in-45-years valuation.

Here’s my original piece on RADs for those that missed it.

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.