Why this mid-cap stock could rally in further in May following its “buy” upgrade by UBS

Shares in Estia Health Ltd (ASX: EHE) have come bouncing back on the back of pleasing results after suffering from a sharp sell-off over the past two months.

There may be further upside for the stock too in May when the federal government releases the budget. That would be fortuitous for shareholders as that month tends to be a weak period for equities. Remember the market saying “Sell in May, go away”?

This is an interesting turnaround of events for the aged care facilities provider, which tumbled close to 20% since mid-December last year before it staged a strong rally last week when management announced a 5.7% increase in earnings before interest, tax, depreciation and amortisation (EBITDA) to $45.4 million, as revenue increased 3.4% to $272.1 million.

The result was enough for UBS to upgrade the stock to “buy” from “neutral” as it called Estia’s result “solid” and noted that its key operating metrics were strong through the first half of FY18.

Occupied bed days were up 1.4%, average occupancy of 94% is 1% above the same time last year and resident revenue and government subsidies were both up 2% each.

What’s more, UBS believes that the federal government will adopt a number of recommendations from the Tune Review, which are positive for funding and viability of the sector. The federal government is likely to make a favourable announcement on this front when it presents the federal budget in three months that includes the uncapping of the basic daily care fee.

It was also positive to see EHE add 240 new beds to its development pipeline (at St Ives &Wollongong) for FY20 & continue its disciplined approach to sourcing bolt-on acquisitions (with management commenting that sector multiples remain inflated),” said UBS.

Estia’s undemanding valuation, improving outlook for both revenue and margins and the potential upside from the federal budget are the three reasons behind the broker’s decision to upgrade its recommendation on the stock and lift its price target to $4 from $3.75 a share.

The company is also tipped to dramatically increase its dividend with UBS forecasting an 18 cents a share full year payment compared to the 8 cents Estia paid in FY17.

The dividend is expected to increase by over 11% in the following year, which puts the stock on a yield of around 8% if franking credits are included.

But one of the key issues that puts me off Estia and the sector is the controversy around the treatment of the elderly in for-profit institutions.

This is a big turn-off for me and is the key reason why I would rather look at stocks like Ramsay Health Care Limited Fully Paid Ord. Shrs (ASX: RHC) and Virtus Health Ltd (ASX: VRT) even though they may not have the same valuation support.

If you are looking for other stocks that are well placed to run ahead of the All Ordinaries (Index:^AORD) (ASX:XAO) index in 2018, the experts at the Motley Fool have just the thing for you.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia has recommended Ramsay Health Care Limited and Virtus Health Limited. 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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