The Guide to Investing in Stocks and Shares

Southern Cross Healthcare: Update

Dan Tebbutt - A Shareworld Contributor

Published - 28th November 2010

3 months ago I wrote about Southern Cross Healthcare (SCHE), then trading at 18.5p per share, concluding that it was "rather good value". I backed my words with deeds, and bought a few shares (admittedly not very many).

Within a week of my article appearing, SCHE rose by more than 50% in one day on takeover news. The shares peaked at 36.5p but then began a steady decline to their current 17p - reversing all their gains and more. (Regrettably I missed the chance for a quick profit and am still holding mine). Just last week they announced that the original bidder, Towerbrook, had pulled out, but that they remained in discussion with other parties.

Last time I wrote about SCHE I stuck to a fairly big picture view, but this time I thought I'd look into some of the specific problems that they are currently facing.

Debt

At 6th August 2010 Southern Cross had £13.6m of debt and £11.8m of rental guarantees outstanding against a £50m revolving credit facility. This was renegotiated in August, as part of which the fixed charge covenant was reduced from 1.33x to 1.23x. I don't know the exact calculation that is used to test this covenant, but I would expect it to be something like:

(adjusted EBITDA + rent + interest charge) / (rent + interest charge)

For 2009 that calculation would give 1.37x - i.e. they were within a whisker of breaching the covenant. Extrapolating from available numbers suggests that for 2010 they will meet the new lower covenant, but only just.

Southern Cross are cash flow positive, and they have £15m of freehold property that they are trying to dispose of, but the risks here are still very much on the downside. They appear to be relying on the goodwill of their bankers to either waive covenants or renegotiate as required - a precarious situation to be in.

Cash flow

For 2010 Southern Cross are predicting adjusted EBITDA of £53m. Unfortunately that is some way off their free cash flow - they need to spend roughly £20m per year on maintaining "fixtures, fittings and equipment" and a couple of million on interest payments, leaving a free cash flow of about £30m.

Given time this free cash flow would be sufficient to pay off their debt and start to rebuild a more robust balance sheet. But it represents only about 3% of their revenue - the slightest squeeze on their margins (as is currently occurring) could leave them cash flow neutral/negative.

Even if they maintain cash flow from operations, they have a significantly negative working capital position - if their suppliers start demanding payment sooner, then they will have to rely on their bank facility to take up the slack.

Rental costs

SCHE pay almost £200m in rent each year - and they are committed to long-term contracts with upward-only rent reviews and in many cases automatic rises (either fixed or in line with RPI). At a time when funding from local authorities is slackening, this inflexible framework leaves SCHE vulnerable.

Even if their landlords are generous and renegotiate these contracts, I suspect that may lead to an unwelcome demand from the tax man. SCHE have been unprofitable for years on the basis of "future minimum rental increases", accruing a massive liability on their balance sheet. If their contracts are torn up then that liability vanishes - generating a paper profit for SCHE of ~£250m and therefore, presumably, a tax charge of £70m - which they won't have the cash to pay.

The future

SCHE's future as an independent company looks very shaky - but that doesn't make the company worthless. Their landlords would much rather negotiate a fresh deal with a solvent SCHE rather than let them go bankrupt and see all their contracts torn up. If SCHE can get an injection of equity then they can pay off the consequent tax charge, invest in their estate, and start making a decent profit.

Even taking into account the costs of turning the company around, I think a private equity company could turn a healthy profit after doing a deal at (say) 50p per share.