Are retirement operators pulling the wool over our eyes?

The retirement sector offers numerous investment options, including six NZX listings: Ryman Healthcare (RYM), Summerset (SUM), Oceania Healthcare (OCA), Arvida (ARV), Radius Care (RAD), and Promisia (PHL). So it was a pleasure for NZSA’s Auckland Branch to host Arie Dekker, Head of Institutional Research at Jarden, at its recent branch meeting. Arie covers the Retirement Village sector and has been cautious on the sector for a number of years due to the lack of free cashflow the sector produces. Among the topics covered, perhaps the most under the radar topic to retail shareholders is the sector use of underlying profit.

Underlying Profit

Arguably, the most crucial figure in a company’s financial statement is the Net Profit After Tax (NPAT), which often determines how much investors are willing to pay for a security. However, the retirement sector has introduced an alternative (non-GAAP) earnings estimate called underlying profit.

As can be seen above, when Ryman release their financial results, the headline number is their underlying profit. Since the statutory profit is influenced by changes in the fair value of investment property, it is appropriate to make adjustments to obtain a true representation of the operating business performance. Nevertheless, certain exclusions from this figure raise doubts about the reliability of underlying profit.

Development Margins

Development margins are included in the calculation of underlying profit. This encompasses the profit earned from the sale of new units but excludes costs associated with common facilities, care facility construction, and core infrastructure. Jarden believes that when the full costs of constructing a retirement village are taken into account, the development margin can range from a loss to approximately 10-15% in very good cases as opposed to the ~25% margin quoted in their presentations.

Maintenance Capex

When a resident vacates a property, the village operator must refurbish the villa or apartment before selling it again. They also invest in maintaining the amenities of the village.  This expenditure on maintenance capital expenditure (or depreciation of the village and the units) represents a genuine cost that is not accounted for in the calculation of underlying profit which does not include any depreciation allowance for investment property. To provide some context, Ryman invests nearly $100 million annually on projects and its asset base, much of it associated with maintaining depreciating assets. Notably, the NZX REIT (Real Estate Investment Trusts) sector does include Maintenance Capex in their Cash Earnings Calculation (AFFO). So why does the retirement sector not follow suit?

Shareholders Equity

An analysis of the balance sheets of Ryman and Summerset over the years reveals that the increase in shareholders equity, which represents additional capital added to the balance sheet, is completely dominated by the appreciation in the valuation of investment property. Capital raised also features.  This implies that the operating business (comprising development and resale profits, Deferred Management Fees, and Care) has generated little in the way of profits. As a result, these companies rely on the appreciation of their properties’ value to deliver returns. This calls into question the credibility of the so-called underlying profit that has supported cash dividends.

Dividends

Historically, Ryman and other operators have used underlying profit as the basis for determining dividend payouts to shareholders. Given the issues surrounding underlying profit and its recent capital raise, it is not surprising that Ryman suspended their dividend this year, as they are now focused on debt servicing. Jarden expects other companies in the sector to follow Ryman’s lead and reduce their dividends with recent Arvida and Oceania results suggesting this is coming.

NTA

Net Tangible Assets (NTA) is a commonly used valuation method in the property sector. Typically, properties are independently valued on an annual basis by firms like CBRE. This approach works well for industrial, office, and retail REITs listed on the NZX because there are numerous transactions that provide confidence in asset values. However, in the case of retirement villages, the number of transactions involving entire villages – and particularly large ones – is relatively low, which means that valuations have limited transaction evidence supporting them. Additionally, retirement village operations entail substantial corporate overheads that are not subtracted from the NTA valuation.

Valuation

Ultimately, the most effective way to value a company is by calculating the sum of discounted future free cash flows and adjusting for debt, a method known as a DCF (Discounted Cash Flow). In this regard, it is worth noting that Ryman and others have recently started reporting free cash flow in their presentations. There is more work to do – Ryman, for instance, reported a negative free cash flow of $389 million alongside their $2.3 billion in net debt but this cash flow is dominated development cash flows.  There is more work to do in the sector on separating out and focusing on the “underlying” cash operating earnings that underpin valuation. Clearly, for Ryman to justify its valuation, it will need to consistently achieve positive free cash flow in the coming years. They have set a target to reach overall free cash flow breakeven, including development activity, by 2025.

Summary

While Ryman has taken the brunt of the criticism, the issue of reporting underlying profit extends throughout the entire sector. Underlying profit fails to assist in assessing the valuation of listed retirement operators as it does not reflect the true free cash flows due to the exclusion of significant cash outflows such as maintenance capex and the omission of amenity and care costs in the development margin. In my opinion, the presented underlying earnings are largely meaningless and arguably deceptive.

Chris Steptoe

Disclaimer: While the author owns none of the companies mentioned above, his parents have been living in a Summerset village for nearly a year and they are loving it!