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Should bargain hunters look at aged care shares like Estia Health Ltd for opportunities?

Those looking for a classic example of a “dead-cat” bounce will be intrigued by the share prices of our listed aged care providers as the sector comes under renewed pressure today.

Stocks like Japara Healthcare Ltd (ASX: JHC), Estia Health Ltd (ASX: EHE) and Regis Healthcare Ltd (ASX: REG) resumed their fall after staging a tentative recovery yesterday following Monday’s brutal sell-off on news that the federal government is setting up a Royal Commission to investigate the sector.

It’s way too early for bargain hunters to jump into the sector as I have little doubt there is more downside risk for these stocks, and a sector-wide downgrade by Macquarie Group Ltd (ASX: MQG) only reinforces my bearish outlook.

Don’t get seduced by arguments of valuation or yield. These are irrelevant because no one can yet properly quantify the impact on the industry from the Royal Commission, which starts in the new year.

This is one reason why Macquarie is urging investors to sell both Japara and Regis, while it downgraded Estia to “neutral” from “outperform”.

“The aged care Royal Commission and negative media coverage is likely to increase investment risk on aged care stocks,” said the broker.

“Listed operators are typically more efficient operators. However, increased attention and scrutiny raises operational and financial risk, in our view.”

That’s putting it lightly in my opinion. The sector will have to endure months of negative publicity as the public awaits the terms of the Royal Commission to be defined. Thereafter, shareholders will have to sit through the Royal Commission process to discover where the skeletons are hidden.

You only need to look at the Banking Royal Commission to see how agonising the whole process can be with our major financial institutions like Commonwealth Bank of Australia (ASX: CBA) and AMP Limited (ASX: AMP) suffering big share price de-ratings.

It seems one sector is charging dead people fees for services while another maybe helping its residents get to the point of no return sooner. Talk about synergies!

Coming back to Macquarie’s latest research note, the broker highlights two danger areas for the aged care sector.

The first is from volume as occupancy rates at these facilities are likely to fall given the intense media spotlight into bad practices in the industry. This isn’t dissimilar to what happened in the first half of this year following a severe flu epidemic.

Falling occupancy is a big problem for any aged care facility due to the relatively large fixed-costs involved in running such businesses.

Margins are also likely to be squeezed from higher compliance, marketing, public relations and legal expenses in FY19, added Macquarie.

The broker estimates that a 100 basis point (1 percentage point) decline in occupancy will cut Japara’s FY19 net profit by a whopping 14.6%, while Estia and Regis will suffer 9% plus drops in their bottom lines each.

If profits are under pressure, you can bet dividends will be too. That’s why I don’t think any valuation argument will be enough to win me over.

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Returns as of 6th October 2020

Motley Fool contributor Brendon Lau owns shares of Macquarie Group Limited. 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 Scott Phillips.

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