Description

Southern Cross is the largest elderly care home operator in the UK.

The company generates 70% of revenues from local authorities, and 30% from patients who pay out of pocket. As elsewhere in the west, the nursing home industry enjoys attractive growth prospects and steady CF streams. Yet Southern Cross trades at only 3.3 times EBITDA, and 4.5 times earnings - a large discount to European peers Orpea and Korian which are valued at over 10 times EBITDA and 17 times earnings.

This, we believe, is due to a fundamental misunderstanding of the company, its balance sheet, and its CF potential.

Southern Cross lost over 75% of its market value last July after announcing that it had breached debt covenants - which did not make sense as the company had less than 2 times net debt to EBITDA (note that peers operate with 5-6 times net debt to EBITDA). Though covenant terms were not fully released, we have learned that previous management had agreed to maintain a minimum level of cash on the balance sheet, and had transgressed these levels given difficulties in selling the real estate portion of newly acquired nursing homes.

Since then, the company has appointed new (and incomparably more competent) management, has re-paid a portion of debt, has re-negotiated covenants, has sped the sale of remnant real estate, and has embarked on a little advertised restructuring plan focused on savings potential in staffing and foods costs.

Yet the stock continues to trade at a dramatic discount to peers as investors are worried about sudden declines in occupancy rates, potential decreases in reimbursement rates, cost escalation, and the fact that mentioned homes have not yet been sold in totality.

We believe that these concerns, and the ensuing discount, make no sense at all.

Occupancy rates, as disclosed earlier this year, are steady and have never shown dramatic declines in any given period (and we cannot think of any reasons why that would change now). Local counties across the UK will announce price changes in coming months - but we have called over 33% of such councils and have discovered that depending on the locality rates are slated to increase from 2 to 4%. This is publicly available information that no investor, including the company's largest, had bothered to unearth, and which we have not shared until now. Finally, shortly after expressing an interest in the company's real estate assets for sale, we were told by the brokerage firm in charge that they had received a conclusive offer above ask.

We believe that Southern Cross is as attractive, a-cyclical and well positioned a company as it was a year ago. Conversely, its stock trades at a 75% discount to year-ago levels. We recommend accumulating a position with over 100% upside from current levels.

Catalyst

Announcement of Real Estate Disposal (any day)

Announcement of fee increases across UK (April / May)

Possible take-private by Blackstone (historical owner)