The Guide to Investing in Stocks and Shares

Southern Cross Healthcare

Dan Tebbutt - A Shareworld Contributor

Published - 23th August 2010

Southern Cross Healthcare (SCHE) is the UK’s largest provider of care home services for the elderly. In the last 2-3 years their share price has fallen by more than 95%, reducing the company’s market cap from £1.1bn to its current £35m (at 18.5p per share). They have fallen almost 90% in the last few months. So, are they heading for zero, or is there some value there?

The numbers

Southern Cross has only earned a profit in one year of the last 5 (2007). In 2009 they lost £22m after tax. Their book value (as of their 2010 interims) is £71m, but after stripping out goodwill it is -£148m. In 2009 they paid no dividend.

Doesn’t sound too good, does it? No wonder their shares are almost worthless.

But dig a little deeper, and things start to look a little more interesting.

IAS 17

A certain accounting standard (IAS 17) has a large effect on SCHE's reported profit. SCHE have signed long-term leases on the properties they run, with minimal rental increases each year. Not so unreasonable - after all, you would expect rent to increase over time due to inflation. But IAS 17 requires them to average out the charges over the entire term of the lease - so their accounting charge in the first year of the period will be exactly the same as in the last year, regardless of the cash charge.

At the moment SCHE are at the early stage of most of their leases, and therefore the accounting charge for their rent is far greater than the cash charge. On the plus side, HMRC seem to believe in this method of accounting, and therefore SCHE's tax charge is substantially lower than it would otherwise be.

We should be able to adjust SCHE's numbers to strip out the effect of IAS 17 as follows:

• Their balance sheet contains a large accumulated charge relating to this. We can ignore this, except for its tax effect - eventually this charge will unwind, being reported as profit in the process, and become liable for tax.
• We can write back the charge onto their earnings, provided we reverse the beneficial tax effect at the same time.

The adjusted numbers

Following the scheme above gives SCHE a net tangible book value of £17m. Their earnings in 2009 would have been £14m after tax. Strip out exceptionals and it would have been about £32m.

In their 2009 annual report they even anticipated paying a dividend in 2010, covered about 3x by adjusted earnings. Given their adjusted earnings in 2009 were roughly equal to their current market cap, that could be rather significant!

Prospects

Southern Cross are contending with a number of thorny problems:

• Cost-conscious local authorities are pressing for minimal increases in the rates they pay for residential care. Recently agreed contracts allowed for only 1%.
• At the same time, local authorities are reducing admissions, leading to lower occupancy rates.
• SCHE face fixed annual rental increases, regardless of the rates they are receiving and their occupancy rate.

In their most recent announcement, SCHE said that they expected 2010 EBITDA to be just £53m. That’s £20m lower than in 2009, and once you've factored in a tax-effect that suggest in adjusted EPS being about 8.5p. Fulfilling their promise on dividends suggests that they might declare a dividend of approximately 2.5p, putting them on a yield of about 13%.

Conclusion

I started writing this thinking that SCHE were a basket case that I wouldn’t touch with a barge pole. Now I’m not so sure - they look like rather good value to me. A yield of 6-7% seems more appropriate than 13%, so there is the short-term prospect of the shares doubling. Looking further ahead, if they can just get back to the sorts of numbers they were achieving in 2007-2009 then their shares could double again. On the other hand, if their occupancy rate continues to fall, they could be toast.