One very good reason to avoid Estia Health Ltd shares

An article in Fairfax media last night outlined some of the risks that Estia Health Ltd (ASX: EHE) continues to face, despite new management’s focus on lifting regulatory compliance and improving occupancy.

As many commentators have noted, Estia’s operations over the past few years have been funded significantly from client Refundable Accommodation Deposits (RADs), which are a lump sum paid to Estia. These RADs are treated as an interest-free loan from the retiree to Estia, which it draws down on to provide for the cost of caring for said retiree.

But what would happen if there were no RADs?

With the pace of Estia’s expansion, it has relied heavily on RAD funding alongside debt to pay for its acquisitions. Now the company has elevated debt, and the RAD gravy train could be coming to an end, with Fairfax suggesting that Estia’s residents are increasingly choosing to pay their fees daily, rather than sell their home and give the company control of a lump sum. This means Estia only gets enough to ‘pay the bills’ so to speak, rather than receiving several years’ worth of fees in advance.

Estia’s own Annual General Meeting (AGM) presentation last week aligned with media reports, with RAD deposits so far tracking well below last year’s levels. Occupancy was also down, adding to the company’s challenges.

Management’s decision to cease making acquisitions and focus on reinvesting in its existing facilities in order to improve occupancy could be an implicit acknowledgement of this fact. I was initially surprised to see that management was investing heavily to improve occupancy, since occupancy levels are still quite respectable at 93%.

Yet if more attractive facilities leads to longer resident tenure and higher occupancy (and thus more RAD inflows) the reinvestment will prove to have been a bargain. Coming from this perspective, reinvesting in facilities makes a lot of sense – it could directly contribute to the strength of the company’s balance sheet.

I previously noted in this article that Estia was at risk of alienating potential residents given recent unfavourable media coverage of the company. That’s probably another reason management has really focused on lifting compliance and improving quality recently.

Foolish takeaway

Estia appears to be headed in the right direction. The company has asserted that its balance sheet remains adequate and that it has sufficient headroom in its debt covenants. However, Foolish readers will know that problems never surface when management’s forecasts are accurate – only when they are not. In my opinion, Estia is too risky for the average investor, given the company’s shaky financial situation.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. 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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