Historically, our view has been that there is a supply and demand imbalance in the aged care sector, with the lack of supply and rising demand only going to be exaggerated over the next few years as the bulge bracket of the Australian population moves deeper into retirement. The proportion of people aged 65 years or over in the total population projected to increase from 15.3% in 2017 to 21.8 per cent in 2056.*

We therefore share the view that the potential for the aged sector is very good. However, the sector’s reliance on government spending and the associated regulatory risk makes it a difficult sector to pick at the corporate level. In 2016/17 governments spent about $17 billion on aged care, with 69% of this going towards residential aged care.** The vast majority of this funding comes from Federal Government.

Companies like Regis Healthcare, Japara Healthcare and Estia Health are heavily regulated businesses and run off largely government-mandated revenues. When these stocks originally listed, investors preferred to concentrate on the top line market growth rather than the regulatory risk – the funding for residential care has risen from $9.7 billion in 2011/12 to $12.1 billion in 2016/17.*** Investors predicted that the increasing public spending, plus the supply and demand imbalance, would continue to drive valuations in the sector, and therefore put the stocks on significant premiums to the broader market.

However, the regulatory risks have come back to bite them. About 96% of government spending comes from the Federal Government. By some estimates, the cost to the budget of delivering aged care is set to eclipse the entire cost of Medicare by 2031-32. **** It would be silly to think that such a drain on the government coffers would not warrant more attention as to service levels, and therefore corporate costs.

The Federal Government is looking to pull back on spending, claiming it will not be able to afford this level of growth in the future. This has affected the valuations of the corporate players in the sector – even before the royal commission into the aged care sector was announced earlier this month.

"It is difficult to tell what providers may receive the largest dressing down in the commission and what that will mean for confidence levels."

As anyone with experience of the financial services royal commission will bet, there is a good chance that this new commission will look into stories about the mistreatment of clients and poor management. This will affect the reputations of the companies in the sector, when the sector is dependent on clients and their families being able to trust providers to do one of the most personal (and difficult to track) jobs – looking after older Australians. It is difficult to tell what providers may receive the largest dressing down in the commission and what that will mean for confidence levels (hence why all the major players were hit after the commission’s announcement).

Over the longer run – no matter the outcome from the royal commission - we will see the government refusing to increase what it pays the sector to the same extent as it has had in the past. In such an environment it is difficult to see how the sector earns a positive return, particularly when there will be pressure to increase staffing levels and improve facilities.

However, the royal commission may find that funding has to be increased to deal with the increased demand for beds as the baby boomers enter their 80s. If that is the outcome that happens, then it actually will be positive for the industry. But look at what the insiders are doing. In the past 12 to 24 months Regis, Japara and Estia’s acquisitions have been diversifying them away from aged care into retirement villages. This reduces their risk in the midst of aged care funding changes, but they have had to pay top dollar for these retirement village development opportunities as house prices in Sydney and Melbourne peak.

Is there a buying opportunity in the aged care space? Yes, potentially, over the longer term. But the fact is that the underlying fundamentals of the sector will not continue to grow to the same extent as they have, as the government pulls in the reins.

Uday Cheruvu

Portfolio Manager, PM Capital Australian Companies Fund.

Ada Wong

Thanks for your post. Agree profitability is going to be constrained in the near term but I would be interested in your view: Is it likely that more facilities will overtime go broke if costs increase from increased regulation such as staff costs and monitoring? And, would that mean that the government will over time be more likely turn to consumers to pay what they can to address this funding gap especially given the outcome of past government reviews such as the Tune Review? Is it possible that facilities which are more in demand either for quality, value or other reasons such as location may actually be well placed? Also, my understanding was that only Regis had expanded into retirement living recently with Aveo going the other way.

PM Capital

Hi Ada, Yes you are correct, increased regulation will drive drown profitability and put weaker players out of business, adding further add to the demand – supply imbalance. Our original thesis when we invested Japara was that the government would see this reality and either increase funding or deregulate the industry (from a pricing perspective) and charge consumers more. However, the actions by government have gone in the other direction – ie increased regulation and lower funding – so every player in the industry is being hurt. We do not see this changing in the medium term. Regis has investments in retirement villages. Japara has also flagged that they will expand into this area and invest more capital in retirement villages. Estia’s capacity to grow is constrained due to its historic acquisition-led strategy that impinges on its capital generation. So the actions by the listed players suggest they too believe that diversifying out of aged care makes economic sense. As a result, our thesis is that there is more downside to go with these companies before earnings find a sustainable base. This, in addition to the royal commission and the potential curve balls it can throw up, limit our interest in these companies for the time being - Uday.