When the tide goes out

Earlier this year we published an article on leverage hidden within the Australian listed residential aged care sector (read this first if you need a primer on the sector).

Crucially, we set out how a key source of funding for the sector, Refundable Accommodation Deposits (“RADs”), were simply not accounted for as a liability by a large portion of the market (which is not inconsistent with the views held by the providers themselves). Underpinning this thinking was the assumption that RAD balances can only ever increase and never decrease – hence it should be considered as essentially a nil-cost, covenant-free evergreen funding source.

And this worked really well while residential aged care providers were benefiting from net RAD inflows, allowing them to tout some highly impressive ROCE numbers despite making acquisitions at eye-popping multiples.

Conversely though, in a scenario where providers are subject to net RAD outflows, a completely different story unfolds.

The mathematics of RAD outflow

To simplify, a residential aged care provider’s capital structure is essentially as follows:

Capital employed = RAD + Debt + Equity

In the event that RAD capital reduces, additional funding is obviously required to replace the shortfall in capital (in the form of either debt or equity) so that the equation above balances.

The incongruence lies in the fact that the market ascribes an Enterprise Valuation for listed residential aged care providers based on Debt and Equity only (i.e. RADs are not taken into account):

Enterprise Value = Value of Debt + Value of Equity

So what happens when you experience net RAD outflow and have to introduce additional funding to replace the short-fall?

Theoretically, Enterprise Value shouldn’t change (given it’s the same business just with a different capital structure) and neither should the Value of Debt (try telling CBA or Westpac to take a haircut!). Therefore, for there to be new capital on the RHS, the only way for the equation to balance is to compress the value of Equity by an equivalent amount.

So due to the simple quirk that RADs were not regarded as a liability when things were good, when RAD capital decreases and need to be replaced with debt or equity, it has the direct impact of reducing the value of your equity.

The other way to look at this is, if net RAD inflows were considered part of “operating cashflow” on the way in (as per the cashflow statements of 2 of the 3 listed providers), then net RAD outflows should obviously be considered as negative operating cashflow on the way out.

Estia’s $137m capital raising in context

Moving onto Estia’s $137m capital raising this week, we received a very important new piece of information as part of its capital raising disclosure:

Essentially, only 45% of new non-concessional residents are now electing to fund their stay via RAD. This compares with 70% of Estia’s existing non-concessional residents currently funding their stay via RAD.

Holding everything else constant, this implies a new “steady state” RAD balance of c.$551m (assuming current RAD pricing and occupancy rate), compared to Estia’s existing RAD balance of c.$681m.

In other words, using data provided by Estia itself, we can extrapolate that c.$130m of capital is set to exit Estia’s balance sheet upon the next turnover of Estia residents (c. 2.5 years) on current trends.

(Estia asserts that it can partially mitigate this through “the positive EBITDA impact from increased DAPs which add approximately $21,400 annual EBITDA per resident” but take note that this will be need to be largely offset by the additional cost of capital from having to replace the $371k in RAD funding per resident – there is no free lunch here).

I caveat the above by recognising that there are obviously many parameters with varying levels of sensitivity at play (e.g. occupancy rates, residents having a 6 month window to pay their RAD, refurbishments etc) so it’s difficult to make definitive short-term RAD flow projections (even for Estia itself I’m sure) but this was exactly why RAD liabilities had to be respected as part of your capital structure in the first place.

Easy capital inflow today can just as easily become easy capital outflow tomorrow and “only when the tide goes out do you discover who’s been swimming naked.”

Note: The above article constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. 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. Disclosure – I hold a short position in EHE at the time of publishing this article.