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Squaring the unprofitability circle

The care sector is in a financial mess. What’s the current situation and is it likely to improve? Nick Hood shares his thoughts.

Nearly three years ago, comprehensive research was published by the financial health monitoring specialists, Company Watch, warning that the UK care home sector was facing a financial crisis.

It identified that almost 30% of the companies, which said that they operated care homes of one sort or another were financially vulnerable and at risk of failure. 14% of all care home operators were in the commercial equivalent of negative equity, with liabilities higher than their assets. For the sector as a whole, the level of borrowing was spectacular, a total just short of £4bn, equivalent to 81% of its overall value.

Back then, the squeeze on fees from the Government’s austerity public spending costs had yet to bite into profits; instead the principal concern was about interest rates. With such extraordinary levels of borrowing, pundits asked what would happen when rates began to return to more normal historic levels. Surely, the sector would be devastated?

This was also two years on from the Southern Cross debacle, when the industry’s biggest player had collapsed and been rescued with a great deal of pushing and shoving by central and local government, panicked by the fear that this was a systemic threat akin to the banking crisis at the start of the global financial downturn. Somehow, the financial lessons of this debacle went unlearnt. The problems at Southern Cross were put down to financial engineering, with florid sale and lease back deals being blamed for saddling the sprawling empire with unsustainable rent charges. Property costs for the homes were trimmed and rescuers were found.

Fundamental flaws

Unfortunately, little attention was paid to the fundamental flaws in the UK’s residential care home business model. These have since been ruthlessly exposed by the savage reductions in fees paid by local authorities for publicly-funded residents and the inexorable increases in costs such as staffing, arising from a scarcity of nurses and rises, first in the National Minimum Wage and, most recently, the new National Living Wage (NLW). At the same time, a string of scandals, such as Winterbourne View, served to ratchet up capital investment requirements as the Care Quality Commission has quite rightly imposed ever-higher care quality standards.

The irony of the Southern Cross rescue was that it opened up the UK market to private equity players, both from the UK and the US, with their aggressive funding techniques. Instead of excessive rents, some of the bigger players now have eye watering interest costs to meet before they can hope to generate any sort of profit. The recent disclosure by Four Seasons Health Care that its debts exceeded £500m and its annual interest bill was over £50m has lifted the lid on the cesspool of toxic debt, which is swilling around at the heart of the financial plumbing system of the industry. No wonder that two of the world’s leading credit rating agencies are questioning the viability of Four Seasons Health Care, while one of them has also raised similar concerns about another major player, Care UK. Another large operator, Cambian has warned of widening losses for 2015, which have put it at risk of breaching its banking covenants.

Grim realities

Over the past three years, Company Watch has published more data, which, while showing marginal improvement on some financial measures, has only reinforced the grim realities. Earlier this year, Opus Business Services was commissioned by the BBC to carry out research using the Company Watch methodology to update the picture. The research and accompanying commentary was featured in the You and Yours programme on BBC Radio 4 in early May.

The simple truth is that the UK care sector is in a financial and commercial mess, just at the time when demographic trends mean that very significant extra capacity needs to be created to deal with the looming requirements of the legions of ageing Baby Boomers. The Opus research shows that there is still an abnormally high level (28%) of financially vulnerable care home operators, which means that well over 5,500 homes are at risk of going out of business over the next three years. This figure has risen by 17% in the past two years. Technically insolvent ‘zombie’ companies still abound: 761 (13%) of operators have greater liabilities than their assets.

…the financial profile of the industry is parlous. We can only hope that the Government is listening to the growing calls for help

The average level of profit per care home has fallen to £17,600 before tax. These calculations are based on the latest published accounts for the 5,871 companies which operate the UK’s 20,000 care homes. As such, this is a backward looking measure, which does not yet take any account of the impact of the NLW, since its introduction last month. Overall, the sector’s annual profits shown by the research totalled £352m. Estimates of the impact of NLW vary up to some £900m per annum, but even if the real figure was only half of that, it would make the entire industry unprofitable. Staff costs, on average, represent some 60% of the cost base, so the NLW is a very significant, but unavoidable, hit on profitability.

Good news

Almost the only good news is that the level of borrowing relative to business value has fallen since the first research in 2013. The sector still borrows £4bn, but as asset values have risen, this has reduced the level of gearing to 61%. However, this is still worryingly high for an industry which is struggling to make a profit, even if the threat of interest rate rises has receded.

Some parts of the industry are more viable than others. Anecdotally, nursing care earns a higher return for operators, as does specialist care for certain disabilities.

Residential care

Residential care, however, has become a commodity, and one for which its biggest customer (local government) is both unable and unwilling to pay an economic price. Operators both large and small are queuing up to complain that they lose money on state-funded residents. The clamour has even reached the point where some are threatening to turn them away, on the basis that they would lose less money that way. Posturing or otherwise, this is a further systemic risk for the care system. There is little doubt that self-funded residents are subsidising their state-funded compatriots, and to a very substantial level, given the latest estimate by LaingBuisson that 60% of residents are funded by local authorities. How long will they and their relatives put up with this, especially as they are the only way that operators can access more revenue?

Relieve the pressure

Are there other ways in which struggling operators can relieve the pressure? Our experience is that existing funding can sometimes be renegotiated to reduce interest costs and capital repayments, or re-financed more cheaply elsewhere. Equally, it is surprising where operational efficiencies and cost savings can be found. It was interesting that one of the factors cited by Cambian for its increased loss was ‘inefficient cost management’. Some operators are proving that care can be profitable. CareTech may have high debts and a large interest burden of £6.7m, but this and investment costs are well covered by operating cash flow of £27m, according to its latest accounts, and most striking of all, its sales and administration costs are 64% lower than Cambian’s.

Nevertheless, the financial profile of the industry is parlous. We can only hope that the Government is listening to the growing calls for help. If it is not prepared to loosen the purse strings of budget-strapped local authorities, we can only hope that it has a Plan B for the increasing numbers of state-funded residents turned away by operators, and an even more cunning plan for the Armageddon scenario of another Southern Cross-like failure of a major operator. The ability of other operators to absorb such a catastrophe is far more limited than in 2011, and attracting new entrants to the market to plug the gap will be much tougher than it was then.

As for the extra capacity needed for all those Baby Boomers, the only good news is the continued interest of US real estate investors and care specialists in the UK care sector, which they see as offering a higher return than they can earn in their home market. Until the unprofitability circle can be squared, it is difficult to see who else will view this as a market with an acceptable investment risk.

Nick Hood is the Business Risk Adviser for Opus Business Services. Email: Twitter: @NickHood5

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