Costs leave nursing homes looking sickly

The Investment Column

This is a crucial time of year for the UK's growing private nursing home sector. Most of the elderly occupants of its homes depend, wholly or partly, on funding from the state or local authorities, whose financial year has just begun. But since the Government started handing responsibility for financing to cash-strapped local authorities in 1993, nursing home operators have faced a squeeze on their main source of financing and confusion over its timing. Occupancy levels have been hit accordingly. Takare, the second-biggest operator in the sector, reported last month that average levels had fallen 2 percentage points in 1995, ending the year at 94 per cent.

The group warned that its own levels would fall again in 1996, a problem that is likely to be common to the industry, as local authority budgets are again squeezed by central government. Laing & Buisson, a specialist consultancy, estimates that cuts in funding put at pounds 120m this year could spell between 10,000 and 12,000 fewer places. If that lands disproportionately on the private sector, as expected, that could spell a reduction of around 5 per cent. Meanwhile, the rate being paid to nursing homes for residents still covered by DSS payments has been increased by a meagre 2.7 per cent this year.

And while sales growth is being constrained, care homes are facing a pincer movement on costs. Nurses' pay for instance, which rose nearly 7 per cent last year at Westminster Health Care, the biggest operator, is rising well ahead of income. The industry is also being forced to start depreciating property and adopt more conservative practices in accounting for start-up costs. These technical considerations, have a serious impact on profits for a sector expanding at 15-20 per cent a year.

A much bigger unknown is what impact national politics will have on the sector. Difficulties faced by the Government in financing tax cuts in this year's Budget could spell tighter limits on local authorities' budgets, while it is not yet clear what Labour's attitude to private nursing homes will be.

With all this negative sentiment, it is easy to see why shares in the private sector have underperformed the rest of the stock market. But as our table shows, many stocks are trading at substantial discounts to net asset value derived from discounted cash flow calculations by Merrill Lynch. Two of the better companies are looking more fully valued. Westminster Health Care has a credible strategy of diversification away from nursing homes to so-called "higher dependency" units for patients who need more nursing care and where funding is more secure. Quality Care Homes is also well run and has a low cost base, but a high proportion of state-financed residents and could be hit by a minimum wage.

Goldsborough and CrestaCare are looking relatively attractive as recovery plays, but these are only for the brave. External factors, combined with industry rationalisation, are likely to mean that the sector will remain under a cloud for a while yet.