Why the Estia Health Ltd share price crashed today

Aged care provider Estia Health Ltd (ASX: EHE) suffered a weak start in today’s trading on the ASX. Investors saw the billion-dollar company’s shares sink by more than 8% in early trading.

Before today, Estia shares had delivered strong returns — rising in value by around 30% over the last 12 months. What does today’s news suggest about Estia’s prospects in 2016?

Why did this happen to Estia Health shares? 

This morning, Estia announced that net profit after tax (NPAT) grew by 16% to $23 million in the six months ending 31 December 2015. Revenue grew much more strongly — up 43% at $196 million.

When investors see a big difference between growth rates of sales and earnings, they tend to inspect profit margin trends and what’s driving them. In Estia’s case, its strategy of acquiring relatively low-margin businesses has pushed down its ratio of earnings before interest and tax (EBIT) to sales by several percentage points.

It seems Estia may have underestimated the costs of integrating recently-purchased aged care businesses Padman, Cookcare and Kennedy. That would help explain why Estia has fallen short by more than $3 million of this period’s EBIT target that it set out in its prospectus when it joined the ASX in December 2014.

On the bright side, Estia reasserted its prior guidance for NPAT growth of more than 25% in the year ending 30 June 2016. It will also pay an interim dividend of 12.8 cents per share, up 16% on the dividend from one year earlier.

What’s next for Estia Health Ltd? 

Estia understands investors will mark it based on its ability to boost profit margins as it works toward its target of adding more than 1,100 net new beds by 2020. The group is funding its expansion with debt, which raises the stakes for investors.

When you also consider that Estia is highly exposed to potential regulatory change, you can see why investors might hesitate to value this stock at a premium price.

Foolish takeaway 

Aged care might seem like a low-risk industry, but before you invest, you should think about the differing growth strategies of firms like Regis Healthcare Ltd (ASX: REG) and Japara Healthcare Ltd  (ASX: JHC). You should also consider how each firm plans to fund its growth, and if debt is a factor, how comfortable you are with the risks that rise with heavier borrowing.

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Motley Fool contributor Tim Dohrmann has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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