While broadly agreeing fundamental changes to the industry were required, the two Royal Commissioners undertaking the review into aged care, Briggs and Pagone, were clearly at odds on no fewer than 30% of recommendations they made.
Briggs and Pagone were clearly singing from different hymn sheets on issues relating to governance. While Pagone recommended the creation of a body that is fully independent from the government, Briggs believes reforming existing institutions would deliver reform more quickly and effectively than moving to an independent model.
At this stage, Ord Minnett suspects it’s difficult to judge whether either approach is better or worse for the three major ASX-listed providers.
Both commissioners are in agreeance on refundable accommodation deposits (RAD) being phased out to be replaced with an alternative resident-funded accommodation payment.
Recommendation 142 suggests the phasing out of RADs for new residents by July 2025, and the establishment of an aged care accommodation capital facility. Given the materiality of RADs to funding structures, further details are required before the market can draw meaningful conclusions.
Assuming 142 proceeds, Jarden notes resident RAD payers would then be required to pay a daily accommodation payment. The net effect is providers would likely see a material boost to accommodation income and in Jarden’s view, would provide more comfort to investors on property returns.
The government is expected to provide a comprehensive response to the Royal Commission’s 148 recommendations – covering funding, quality and sustainability reforms – in the May budget. As a result, all eyes are now on the government’s May budget response for clues as to both the near- and medium-term financial implications for listed providers in the sector.
However, given the level of disagreement between Briggs and Pagone, the government has been gifted sufficient ‘wriggle room’ with which to cherry pick the measures it wishes to adopt.
If the recent commentary distancing it from an aged care tax levy is any proxy, the government looks likely to disclose its positioning progressively on these key issues between April and May.
Recommendation 144 is for the introduction of a levy of 1% of taxable personal income, suggested to commence 1 July, 2023.
The government response: A catalyst for listed operators
While the government’s future commitment to aged care hinges a lot on its response to the Royal Commission’s Final Report, there’s a strong expectation the $13.4bn it spends on the sector (representing around 70% of total sector revenue) will continue to grow.
Overall, Macquarie considers the government response to the Final Report a key catalyst for listed operators.
As a case in point, funding recommendations from the final report included the matching of aged care subsidy indexation to wage inflation/CPI (Recommendation 110), to negate the negative operating jaws (expense growth rate exceeds income growth rate) for providing care.
While indexation measures clearly aim to align revenue growth more closely with cost growth, Macquarie notes, employee cost growth has outpaced government funding in recent years.
Recommendation 112 is to increase the Basic Daily Care Fee (BDF) by $10 per resident per day, which is to be funded by the Federal Government. Assuming recommendation 112 is accepted and implemented on 1 July, 2021, Jarden estimates implied incremental funding to Estia Health ((EHE)) of $21.6m, Japara Healthcare ((JHC)) of $14.5m, and Regis Healthcare ((REG)) of $23.6m under this scenario.
But given the uncertainty of the recommendations being implemented by the federal government, Jarden makes no earnings per share (EPS) adjustments to forecasts. Given the two funding recommendations aim to offset rising industry costs and create a sustainable environment for providers, the broker believes there’s a high probability the recommendations will be accepted.
Adding to Industry costs is likely to increase with minimum qualifications and time standards. As a case in point, recommendations 78 and 86 suggest mandatory minimum qualification for personal care workers and minimum staff time standard for residential care, respectively.
Jarden notes, although costs are likely to be a result of minimum standards, given the recommendation to index subsidies in line with wage growth, they should be matched with funding.
Meanwhile, while recommendation 68, which calls for the universal adoption of digital technology, may be another driver of additional costs, Jarden suspects the impact on listed providers would be minimal, given they’re already been investing in digital operating models.
Jarden has Buy ratings on Estia Health (target price $3.20) and Japara Healthcare (target price $1.33) and an Overweight rating on Regis Healthcare (target price $2.83).
However, the broker notes, there’s a key risk to the companies’ investment thesis if final report recommendations and outcomes do not meet expectations for returns to meet costs of capital for investment in the residential aged care sector.
Jarden’s 12 month projected returns for Estia Heathcare Japara Healthcare, and Regis Healthcare are 53.8%, 72.5%, and 43.8% respectively (see price targets above).
Minimum staff time
Recommendation 86 also proposes minimum staff time for residents, through the engagement of registered/enrolled nurses and personal care workers for at least 200 minutes per day for the average resident, with at least 40 minutes of that time from a registered nurse (RN).
While the current industry benchmarks indicate around 200 minutes of direct care per resident per day, the composition of current staffing may differ to minimum standards under recommendations in the final report.
In assessing the potential financial impacts of additional funding, Macquarie assumes care management is included within RN staffing, allied health is excluded from the overall calculation, and an average hourly wage of around $35/hour for RNs – and circa $25/hour for other nurses/care staff. On this basis, Macquarie calculates potential total incremental costs of around $7 per resident per day.
Based on these assumptions, Macquarie estimates additional costs associated with minimum staffing requirements would offset a large proportion (around 70%) of the $10 increase in the basic daily fee per resident. This estimation assumes care management is included within RN staffing, and allied health is excluded from overall requirements.
Based on the broker’s estimates, a $1 increase in the basic daily fee per resident (holding all else equal) increases earnings (EBITDA) by 2%, 4%, and 3% for Estia, Japara and Regis respectively.
In relation to indexation, Macquarie sees positive valuation implications for all listed operators. The broker expects a 2.5% annual increase in the aged care funding instrument (ACFI) from FY22 (versus its base case at 2.0% and holding all else equal).
Macquarie is expecting to see a discounted cash flow (DCF) valuation uplifts of 22%, 50%, and 26% for Estia (price target $2.25), Japara (price target $0.80), and Regis (price target $2.10) respectively, reflecting a lower earnings (EBITDA) margin and higher gearing levels.
Within the sector, Macquarie’s preference remains with Estia Health, which reflects improving occupancy trends, lower relative gearing and valuation appeal.
Circuit breaker for sector funding
Meanwhile, the government in its initial response to Briggs and Pagone’s final report has already announced additional funding of $452m to address immediate needs, with $189m to flow to residential providers.
Instead of coinciding support efforts with its review of the final report later in the year, the government’s immediate one-off payments are intended to go some way to restabilising the sector and ensuring services are maintained.
The funding on offer equates to around $760 per resident in metropolitan areas and $1,145 for those in rural, regional and remote areas. These funds are expected to be received before the end of FY21, and based on similar funding received in the December half, Ord Minnett expects to see a revenue boost for each provider to the tune of around 1%.
In light of additional government funding, the latest occupancy trends, government revenue indexation of 2.5% from FY22 onwards, and the FY22 $10 increase to the BDF, UBS now forecasts Japara to deliver a FY21 net loss of -$13m, before lifting to a small profit of $1m in FY22.
In the short-term, UBS expects Japara to benefit from second half FY21 temporary funding (UBS estimates $3m); FY22 increase to BDF, up 19% to around $62 per resident per day; and FY22 increase in indexation from 1-2% to 2-3%. But over the longer-term, the broker’s investment case hinges on activity-based funding levels versus staffing/quality measures, and the continuity of RAD funding.
Overall, listed aged care stocks look relatively well positioned to leverage an improving (baby-boomer led) demand profile over the next decade. However, UBS wants to see a more definitive reform agenda before becoming overly confident about the outlook for either Japara or its two peers.
Based on UBS’ DCF-derived valuation ($0.75 per share), the broker sees Japara’s current share price as fairly reflecting the trade-off between a significant, long-run demand opportunity, a more challenging near-term operating environment, coupled with the regulatory uncertainty of the federal government response to Royal Commission findings within the May Budget.