MGSM835 Financial Management

4th Term 2016 Due November 23rd

Santiago Palazuelos 43963641

Stewart Flecknoe-Brown 30385385

Pablo Pucci 44101961

Rodrigo Limon Fernandez 44535384

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Table of Contents

1. Executive Summary

2. Company Background and Operating Environment

2.1 Business Description

2.2 Facilities and Services

2.4 Market Share and recent Growth

2.6 Recent outcomes

3. Opportunities for Growth

4 Valuation Model

4.1 Cost of Capital – WACC Analysis

4.2 Cash Projections and growth rates

5 Valuation Results

5.1 Share Price Calculation

5.2 Qualifications to calculation

5.3 Recommendation

References

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1. Executive Summary

The aim of this report is to give a stock purchase recommendation of Regis Healthcare Limited. It is based on projections from the company’s financial reports and takes into account a number of assumptions made regarding future growth rates of the institutions cash flows, economic indicators and success rates of present and future projects.

The process followed to reach the stock prices of our best and worst case scenarios resulted in a higher-than-market price range of $4.85 - $7.36. This prompted us to investigate reasons why a lower number of investors are taking an interest in the stock this year.

After reviewing the company’s business model and capital structures we were able to get a better understanding of how the company works. We investigated the rules and underlying definitions of debt and growth that affect management decisions. Some of the most important factors we identified were the levels and type of debt the company tends to use, the legislation supporting it, and the likely decisions that management will make regarding the capital structure into the long term. Regis Healthcare borrows heavily in the form of Refundable Accommodation Deposits from its guest to fund its growth plan and has no real reason to cease running at above normal debt levels. The current pipeline includes growth projections that are more than one financial year away and will likely lead to further debt expansion.

We found that although the stock price appears undervalued, the likely long term outcomes for the business are suited to a limited set of investors who have patience to span years, to monitor various factors that constitute risk and tolerance of high debt levels.

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2. Company Background and Operating Environment

Business Description

Formerly a private company called Fairway Investment Holdings Pty Limited, Regis Healthcare Limited was listed on the ASX in 2014. The Chairman’s Letter in the Prospectus for IPO describes the company’s history before then:

Regis was formed in the early 1990s and has grown from its original 104 places into one of the largest and most geographically diversified private residential aged care providers in Australia. Today, Regis operates 45 facilities with 4,719 Operational Places primarily located in metropolitan areas across Australia.

Regis has built a platform that over many years has delivered care to many people in need and has experienced consistent growth. It has a history of strong operating performance characterised by significant earnings growth over the past five years. This growth has been underpinned by offering premium services, optimising entitlements to Government funding, a strong development program, and acquisition activity as well as delivering operational efficiencies as a result of procurement strategies and labour management.

Regis targets the premium end of the market through its provision of particular facilities and services. The business model is of a vertically integrated aged care provider. The core measurement of the size of Regis Healthcare in industry terms and in comparison to its competitors is how many ‘places’ it provides. The total count of places is distributed across facilities around Australia. Efficiency of management can be demonstrated in the percentage occupancy of the places across the company, a recent figure of occupancy was 95.2%. Creation of places is achieved by acquisition of existing businesses, improvement of facilities and development of new properties. Services are added to the provision of places as part of the business model.

Revenue comes from a combination of Refundable Accommodation Deposits (RADs) and Daily Accommodation Payments (DAPs). These are subsidised either partly or fully with government funding on the basis of means-testing per individual and the guests, as lenders, are guaranteed by the government against non payment in the event of bankruptcy. Funding covers two types of aged care: Permanent residential aged care and Residential respite care.

Funding for residential aged care facilities is calculated using the Aged Care Funding Instrument (ACFI) . Using the ACFI, a residential aged care facility will assess the care needs of residents requiring permanent care—it is not used for residents requiring respite care. Once the care needs have been assessed, the outcomes are then used in determining the funding to be paid to the aged care provider. 1

1 http://www.aihw.gov.au/aged-care/residential-and-community-2011-12/aged-care-in-australia/

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2

Receipt of Deposits provides for development of new facilities - the proportion of payments via DAPs contributes to acquisition and development of places. The average revenue per occupied place was $272 per day in 2016 including government income of $190.

2.2 Market share and recent growth

Regis competes in an industry against other aged health care providers which are 5% Government, 57% Not-For-Profit organisations with the remaining 38% being private. Regis is the 3rd largest exchange-listed Aged Care provider with 8% of the market currently. This is a $15.8B industry in terms of annual revenue, a majority of which comes from Government funding. Population growth forecasts predict that the industry needs to expand by 40% in the coming ten years to meet demand. Government funding is forecast to grow at 6.7% per year.

3

The highly fragmented market provides opportunity for growth via acquisition if Regis can manage its facilities and services to be competitive with the many existing private, not-for-profit and government providers.

2 Regis Healthcare Presentation for the UBS Australasia Conference 2016 3 Regis Healthcare Presentation for the UBS Australasia Conference 2016

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4

Regis Healthcare’s business model provides for expanding its services into acquired facilities, aiming to achieve a net management and resource efficiency improvement. On the other hand there is only so much added efficiency and value that can be created by privatisation of a given facility, factoring the limits on available staff, local supply chains and the highly regulated nature of the industry. To that, purchasing facilities from not for profit organisations may result in some change of goodwill. Church-run facilities have the financial backing of some of the largest organisations in the world (for example the Catholic church) so the argument that integration into an exchange listed company adds backing is debatable. The growth strategy includes property development and has in the past included a merger (2007-08), in a portfolio of facilities. Growth since 2008 includes 1,622 places via acquisition and 1,120 under construction, with 480 places out of action during the development of two large sites. Places currently expected to open until 2020 are as in the table below:

2017 217 places opening

2018 255 places opening

2019/20 932 places opening

September 2016 saw a total of 7,619 places, up from 6,012 in 2015.

2.3 Recent outcomes

Regis’ share price rose shortly after IPO, particularly in February 2013 following its first announcement of acquisitions and annual reports. In a few months it gained around 50% and hit highs three times during 2015. 2016 has seen announcements forecasting no growth for the period, and debt has also increased as a proportion of the value of the company in this period, resulting in a downward trend returning to its IPO price by October 2016.

4 Regis Healthcare Presentation for the UBS Australasia Conference 2016

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Lack of growth forecast and the consequential share price decline in the current financial year is partly due to investment in renovations and property development. The balance of portfolio which is under construction, renovation and ‘out of action’ is significant and will add to the size of the company mostly in 2019-2020. The situation of places out of action is limited to the current development projects and the company’s long term trend should return to growth. It is possible that the market, in devaluing the share price now, is out of alignment with the priorities of longer-term investors. Another possible interpretation is that new risks are perceived in recent changes that impact the true value of the company. It is possible that under the expected progress of the current growth plan, the share price could recover closer to the opening of the development sites. However again, more announcements could come in 2019-2020 (such as new construction projects) that give continuance to the situation that has evolved in 2016. The valuation process that follows leads to an answer for these questions using currently available information.

3 Opportunities for growth

Only 10% of Australia’s aged population currently reside in aged care facilities . This figure could 5

increase as the population ages and there is a smaller proportion of people available to provide the same standard of care to elderly people as they experience now in their homes. Increasing aged care facilities as a proportion of housing is seen by the government as the best way to efficiently deal with demographic projections but incoming residents will expect improvements to the range and quality of services.

The aged care industry has averaged 5.1% growth between 2012 to 2017 and is projected to achieve 4.4% to 2022. Toward a current revenue of $19.8B, government expenditure will increase

5 Ibisworld; The Aged Care Residential Services industry

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to be over $20B in 2022, making government policy a large contributor to growth projections. Revenue for the industry has grown at 5.1% on average, the current year is expected to be 4.8% due to government cuts to the Aged Care Funding Instrument. All of these figures point to a higher uptake of aged care services into the future.

The 47% of NFP facilities that are targeted for selective acquisition represent a large pool of potential growth. Even assuming an equal uptake by the three largest competitors, that means Regis could potentially buy 15%, making it 20% of the whole aged care sector in the future, or representing an almost threefold expansion through acquisition. Allow that early purchases are likely to be more suitable to the business plan than later ones, or diminishing performance of acquisitions is likely. Add to that the same number of facilities through development plus the growth of the industry and there are many more years of potential growth ahead. So the size of the market is not seen as a limit on growth. A more important limitation on growth is the effectiveness of Regis Healthcare’s use of its resources to get the best possible outcomes.

4 Valuation Model

This growth forecast is based on the three years reported as a public company and extends over the next four years. We forecast 4 years ahead because we have information published by the company about its plans which extends that far. Beyond that, the aged care industry is reasonably stable and dependent on macro-economic factors. Past four years into the future we applied a perpetuity to forecast growth using only factors which are more reliable on a long term basis. These include the demographics of future customers and expected long term economic growth. We assume that Regis will continue to source loans on the same model as it does now. Both growth strategies (acquisition and development) should be expected to continue and it is reasonable to assume that they will be offset one against the other in the same proportions, around 50/50%.

We have prepared two scenarios based on the variables we see in the business model. The Beta for the industry is 0.51 and for Regis it is 0.67, so Regis is calculated to be riskier than the industry average.

Best case scenario - Occupancy rate improves by 2.3% over the next four years to 97.6% and expansion plans continue uninterrupted. That occupancy figure is held in perpetuity. This would be a very good managerial achievement. Inflation grows from 1.3% in 2016 to 3.8% in 2020. This forecast was obtained from Trading Economics. The price increase per place is 2% per year in the first four years. Adding price increase and inflation gives a final figure for rate of growth in each year of 2017-2020.

Worst Case Scenario - Occupancy rate decreases by 2% over the next four years to 93%. Industry competition heats up affecting acquisition plans negatively. Construction of new facilities is delayed and from 2018 only 70% of the forecast development pipeline is achieved. Regis lists other risks in its Prospectus prior to IPO in 2014. Inflation remains the same as the Best Case Scenario but the price increase trend per year (over inflation) is negative from 2% growth to 0.5% in 2020.

Occupancy

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Disappointing occupancy figures could see a reduction down no further than 92% because that number is as low as occupancy has been in Australia on average and that was during the GFC. Regis Healthcare is a premium provider and is unlikely to fall below the worst national average of recent times. Another reason occupancy is unlikely to fall this low is the natural pressure of demographics; even if the facilities are not up to the standard expected, there will be more potential customers (demand) per capita in coming years. So our worst case occupancy figure was 93% in 2020.

6

Acquisitions

By acquisition, growth in the number of facilities is enabled by the 57% of the sector currently provided by not for profit organisations. The only potential threat to this strategy is competition for purchasing facilities increasing. Either the two major competitors could evaluate the opportunity highly and begin paying more for facilities, or a new entrant playing catch-up could have the same effect in the market. The current forecast for growth by acquisition is confident and based on the market remaining as it is, so the worst case scenario is based on unforeseen events having a negative effect on the cost or performance of the acquisition strategy.

Development

Since the end of the mining boom Australia’s construction services sector has increased its availability to property development. Should this trend continue, the development of the current portfolio will remain a 50% contributor to growth. In 2016-17, the 10-year bond rate is expected to fall to 2.5%, benefiting industry operators involved in upgrading existing facilities or constructing new facilities. However if macroeconomic conditions create new demand for construction services or if the current construction contracts underperform, the development component of the growth strategy for Regis Healthcare could come under threat. The factor generated by the worst case scenario is a slowdown in the opening of newly developed places at the two current development sites.

6 Caring for Older Australians by the Department of Health and Ageing April 2011

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4.1 Cost of Capital - WACC Analysis

The calculation of the Weighted Average Cost Of Capital used the equation:

WACC = rd(1-tc)(D/V) + re(E/V)

where: rd = Average Net Interest Expense / Average Net Debt

The average net interest expense of Regis Healthcare was found to be $-7,266,500 and the average net debt was $-166,916,500.

Therefore rd = 4.35% We note that this is within the interest rate range covered by RADs, a major source of debt funding (3.75% - 5.76% non compounding).

The company tax rate is 30%, so 1-tc = 0.7

re was calculated using the CAPM model: E(ri) = rf + E(rm - rf) * Beta: The 10 year Australian government bond yield was applied as the risk free rate, rf = 2.72% The market risk premium was derived from the last 4 years of the ASX All Ordinaries index. The figure is not considerably inconsistent with the last 30 years of data. E(rm-rf) = 6.72% - 2.72% = 4% Beta for REG according to Morningstar is 0.67 and we note that is above the industry Beta of 0.51, indicating that REG is said to be higher risk than the industry average. This would be due to their currently high debt level (the total value of the company, is 86.5% supported by debt): At the end of FY 2016, the total value of REG was given by: V = D + E V = 1,164,931,000 (comprising 86.5%) + 181,981,000 (comprising 13.5%) = $1,346,912,000

re = 2.72% + 4% * 0.67 = 5.4%

WACC = 4.35%(1-0.3)(1,164,931,000/1,346,912,000) + 5.4%(181,981,000/1,346,912,000)

Therefore the Weighted Average Cost of Capital (WACC) is 3.37%.

4.2 Cash Flow Projections

Following the method given in Financial Statement Modeling (iLearn, uncited), the Profit and Loss and Balance Sheets for the last three years provided data to project the next four years ahead (2017 to 2020). The company has provided expectations in two recent announcements (11th Oct, 17th Nov 2016) going ahead four years so that was a reasonable timeframe to project cash flows while integrating recently provided data. Beyond 2020 a perpetuity was applied to future growth and the reasoning will follow the table. The table was constructed twice; for the best and worst case scenarios.

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Best Case Scenario:

FREE CASH FLOW CALCULATION 2017 2018 2019 2020 PERPETUITY

PROFIT AFTER TAX 82,985,424 92,507,206 105,651,780 124,555,002 123,682,176

ADD BACK DEPRECIATION 27,370,276 29,170,685 31,381,903 34,312,176 37,662,138

SUBTRACT INCREASE IN CURRENT ASSETS (1,837,461) (1,130,427) (1,556,829) (2,215,387) (166,091)

ADD BACK INCREASE IN CURRENT LIABILITIES 90,604,855 100,961,520 139,044,614 197,862,217 14,834,042

SUBTRACT INCREASE IN FIXED ASSETS AT COST (62,253,235) (70,162,180) (92,467,270) (123,046,708) (123,334,364)

SUBTRACT INCREASE IN INTANGIBLES (19,759,550) (20,747,528) (21,784,904) (22,874,149) (24,017,857)

ADD BACK AFTER TAX INTEREST ON DEBT 1,299,900 1,299,900 1,299,900 1,299,900 1,299,900

SUBTRACT AFTER TAX INTEREST ON CASH AND MKT SEC (961,434) (1,847,287) (2,910,607) (4,470,630) (4,488,749)

FREE CASH FLOW - BCS 117,448,774

130,051,888

158,658,588

205,422,422

25,471,195

In the Best Case Scenario, the perpetuity cash flow assumes a 2% rate of growth. This is achievable by the business but does not exceed the size of the economy in the long run. The industry at its current size provides for the number of places to grow by up to ten times before the market is saturated, if REG expands in equal parts by development and purchases into the 47% (provided in company announcements op cit) that is currently Not for Profit, and maintains a constant market share proportion with its competitors. Therefore a 2% growth rate does not exceed the available places possible for the foreseeable future. Revenue per occupied bed per day in 2016 was $272 and rises to $328 in 2020. Free cash flow continues to grow at 2% in the perpetuity beyond 2020.

Worst Case Scenario: FREE CASH FLOW CALCULATION 2017 2018 2019 2020 PERPETUITY

PROFIT AFTER TAX

81,655,054 87,648,414 95,415,388 106,089,886 105,266,395

ADD BACK DEPRECIATION 27,370,276 29,001,175 30,785,610 33,079,905 35,670,650

SUBTRACT INCREASE IN CURRENT ASSETS (1,699,953) (753,577) (973,795) (1,327,345) (146,237)

ADD BACK INCREASE IN CURRENT LIABILITIES 78,323,697 67,303,979 86,972,306 118,548,793 13,060,798

SUBTRACT INCREASE IN FIXED ASSETS AT COST (62,253,235) (57,695,223) (73,545,367) (95,194,078) (95,348,562)

SUBTRACT INCREASE IN INTANGIBLES (19,759,550) (20,747,528) (21,784,904) (22,874,149) (24,017,857)

ADD BACK AFTER TAX INTEREST ON DEBT 1,299,900 1,299,900 1,299,900 1,299,900 1,299,900

SUBTRACT AFTER TAX INTEREST ON CASH AND MKT SEC (834,860) (1,372,735) (1,863,816) (2,524,207) (2,234,022)

FREE CASH FLOW - BCS 104,101,329

104,684,406

116,305,322

137,098,706

33,551,066

In the Worst Case Scenario, revenue per occupied bed per day in 2016 was $272 and rises to only $319 in 2020. The company is unable to capture as much new market growth while wages and salaries for nurses and other staff increase. The cost of debt increases because risk is higher, so

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interest expenses are higher. As a result of these changes to plans, free cash flow continues to grow at only 0.5% in the perpetuity beyond 2020.

5.1 Share price Calculation

Using an NPV calculation for each scenario arrives at a total value for the company today. The best case and worst case NPVs divided by the number of shares currently on the register gives a highest and lowest possible share price. These are effectively a price range for shares in REG.

Share Price = NPV / 300,345,797

The first four free cash flows were discounted by the WACC previously calculated. The perpetuity was discounted with the same rate as previously discussed and assumes a 2% growth rate.

Best Case NPV = $2,210,294,442.11

Best Case Scenario Share Price = $2,210,294,442.110 / 300,345,797 = $7.36

Worst case NPV = $1,455,279,625.01

Worst Case Scenario Share Price = $1,455,279,625.019 / 300,345,797 = $4.85

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Qualifications to the share price calculation

The current price of REG is $4.02. This would normally make REG a strong Buy recommendation in the scenario range that has been calculated. However there are some risk considerations to be aware of which may explain part of the market’s reaction. REG’s price has in the recent past been up to $5.00, within the calculated price range of $4.83 to $7.30. The price has fallen during 2016 and that coincides with a number of figures. Falls in the share price suggest that the market perceives other limitations on the desirability of the company as an investment than shown by the initial financial valuation model does above. REG has high levels of debt on the Balance Sheet. 73% of REG’s debt in 2016 is listed as ‘other current liabilities’ but it is largely in the form of Refundable Accommodation Deposits. These RAD’s are guaranteed by the government to the issuer (the guest) against possible bankruptcy of the holder, creating a lender with no fear of loss of the principal. A base interest rate of 3.75% and a maximum permissible rate of 5.76% is only payable during the period of accommodation in the form of credit toward services provided. When the customer leaves, the holder of its RAD (REG) is only required to pay real interest for the time between their departure and the time of repayment. Because it is spent, the interest paid on RAD’s is non-compounding. In cases where bonds are sourced from mortgage drawdowns or reverse mortgages, the return on the loan arrangement for the guest lender can become a net negative rate. So the cost of development and acquisition is partly funded by the depletion of the wealth of guests, having removed the deposits from other productive areas of the economy such as stocks and housing. Property, Plant and Equipment consistently tracks just under the amount held in RADs on the Balance Sheet. The government allows Aged Care providers to borrow money as RADs from their guests and use it to fund development and acquisition of new facilities. It appears that legislation designs an incentive to make the desired use of the funds held under deposit to construct new facilities. If this is carried out efficiently, it should allow new revenue and assets to come on the books at a low cost of finance, a good intention for the macroeconomic goal of increasing investment in aged care facilities. In the event of the bankruptcy of a company like REG, the government is liable for all the current RADs which the company can’t pay back. It could be argued that this is cheaper and further into the future than if the government were to directly fund construction of the same aged health care facilities now. Nonetheless, the risk of construction and acquisition is being spread while the motivation to borrow and build to the full availability of debt is part of the plan for the operators of REG. For REG, the majority of new places to be created under their current property development program will be in 2019/2020, with over 450 places currently unusable due to construction and renovation on the same site. The consequence is that revenue growth expected from an additional 932 places is not expected to be realised for well past the current period. So for now, investors with a shorter term than the next few financial years are less interested in REG. This situation is not outside of the company’s stated objectives so it does not bring the quality of management into question - yet. It still remains to be seen whether they can turn high debt into value by creating new places to schedule and keeping service standards high. The growth plan depends on management’s success in three main areas; property and business acquisitions, property development, and maintaining a high standard of cost effective service in a growing

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organisation. This is all necessary while managing to comply to a high level of regulation, stretching the skill base of the management of REG. How effectively the company captures new market share is a big factor in the success parameters for management. On the other hand the dip in revenue to debt from 2015 and going into 2017 (59% - 41% - 47%) does not signal to the market that immediate financial efficiency is a priority of management. It still seems fair to imagine that in 2020 a large number of new places will come onto the books generating new revenue. These will bring with them more RAD payments incoming, increasing the debt level proportionately and most likely motivating more acquisitions and construction projects. So the high debt level is self-perpetuating and a long term holder is exposed to ongoing debt-financed growth. An investor who is comfortable with high debt, even if it is extended in perpetuity, still needs more understanding of the capital structure of the business than can be made clear simply from the terms of the Financial statements. The plan to implement elderly people’s wealth instead of a more conventional source of finance is compounded by the government’s involvement in guaranteeing the main pool of debt to the lender. Regis is likely motivated to continue operating a highly leveraged and exposed growth plan. The investment risk is of a private aged care providers preventing their own bankruptcy due to mismanagement of assets, underachievement of revenue, over-leveraging or the combination of the three in a situation where multiple sources of risk are ongoing.

Recommendation

The recommendation to buy, based on price to forecast earnings becomes a qualified statement. Debt investors in REG are mostly protected by government but equity investors are not. The calculation coming from this business’s financial reports and a more careful look at the definitions of the capital structure necessitates a ‘buy’ recommendation to be accompanied with ‘-and hold long term, and watch how expansion plans are managed, and whether debt levels ever show signs of coming down, and keep an eye on any changes in government policy. Do this while holding, for years.’ There are a great many reservations in a full analysis to carry the Undervalued/Buy recommendation that results from the company’s published figures. The proportion of the stock market that becomes a likely buyer of this stock is reduced, lowering demand and consequently the share price to where it is today.

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References

ConditionsWebsite (no date) Home - Regis investors. Available at: http://investors.regis.com.au (Accessed: 23 November 2016). Health, A.I. of and 2016, W. (2016) Aged care in Australia (AIHW). Available at: http://www.aihw.gov.au/aged-care/residential-and-community-2011-12/aged-care-in-australia/ (Accessed: 23 November 2016). Health, A.I. of and 2016, W. (2016) Aged care in Australia (AIHW). Available at: http://www.aihw.gov.au/aged-care/residential-and-community-2011-12/aged-care-in-australia/ (Accessed: 23 November 2016). Ryan, A. (2015) How accommodation payments work. Available at: http://www.laterlifeadvice.com.au/insights-blog/2014/7/31/how-accommodation-payments-work (Accessed: 23 November 2016). L, B. (2016) Australian rates & bonds. Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia (Accessed: 23 November 2016). TRADING (2016) Australia inflation rate forecast 2016-2020. Available at: http://www.tradingeconomics.com/australia/inflation-cpi/forecast (Accessed: 23 November 2016). Morningstar, I., reserved, A. rights and Policy, P. (no date) DatAnalysis Login page. Available at: http://datanalysis.morningstar.com.au/af/company/pricesensmeasures?ASXCode=REG&xtm-licensee=datpremium (Accessed: 23 November 2016). (No Date) Available at: http://www.treasury.gov.au/PublicationsAndMedia/Publications/2016/PEFO-2016/HTML/Economic-outlook (Accessed: 23 November 2016).

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