I have made the 3rd purchase for the 10foot portfolio, Eureka Group Holdings Ltd (ASX: EGH). Eureka is a small, regional provider of rentals, for pensioners with minimal assets that can’t afford fancier options like those provided by several other listed companies. I think it is attractively priced and could become much larger over time.
Given the wall of text attached to previous theses, I’ve tried to keep this one to the bare minimum – but I didn’t have much success. Here’s an overview:
- $80 million market capitalisation
- Net debt of $42 million, paying ~5%p.a. interest, secured against $102m in properties
- Underlying P/E of ~15 (excluding profits on property revaluations)
- EV/EBITDA of ~8
- ROIC of around 10% or a little less
- Net tangible assets of 30 cents per share (purchased at $0.335)
- Occupancy was 86% at end of FY16 due to acquisitions, expected to settle around long term average of 90%
- Is buying back shares
- Solid incoming CEO and well aligned board who have been purchasing shares at recent prices
What Eureka does:
- Provides low cost rentals for retirees with no assets that are highly dependent on the aged pension
- Owns 26 villages and manages a further 9, for 35 in total
- Owns 1,388 units and manages a total of 2,069 (includes owned units)
- Buys villages in ‘clusters’ in order to benefit from local economies of scale (see image below)
- Fragmented industry with limited competition in the bottom end of the market (where Eureka operates)
- Hasn’t really made any serious investment into NSW yet (richer state but i suspect there’s an underserved underclass of poorer retirees)
- Rental revenues are entirely underpinned by government pensions, which is both a strength and a weakness
- Expected average residency term of between 1 and 10 years
- Not exposed to Aged Care Funding Instrument (ACFI) at all
How it will beat the market
A number of catalysts that could either a) create value or b) lead to a re-rating:
- Group has 200 possible acquisition opportunities initially researched, in advanced DD on 4 villages and expects to add 8-12 total during CY2017 (+30% to total village #)
- Ability to add ~620 new units on vacant land in existing villages (+45% to total unit #, at lower price than acquiring)
- Unlocking $14m via land sales at Terranora project (bought for $7m, sold half for $14m, will reinvest this $14m into developing the remaining half)
- Estimate that current operating cash flow (OCF) could generate around 2% growth per annum via acquisition or development, no extra funding required
- Eureka appears to be in a temporary sweet spot regarding its growth (allows near term +scale at lower investment cost):
“…importantly, the technological systems and infrastructure now in place will enable a virtual doubling of the company’s current scale before any additional investment will be needed in these resources.” (this was written in FY16 report when they had $12.5m EBITDA, FY17 forecasts are for $15m EBITDA)
- Has ~$6 million in unused tax loss carry-forwards not recognised on balance sheet, equivalent to another ~1-2 years of tax-free earnings (source: 2016 annual report p39)
- Roll-out of Blue Care services to all Eureka residents in the near future will help ensure a quality experience for tenants
- Strong incoming CEO with good experience, recently CEO at Brisbane Southbank (doubled EBITDA and paid off all debt in 4 years)
- Inability to access funding either via cap raisings or debt
- Inability to pay debt (OCF would double overnight if the company. was debt free)
- Changes to regulation around pensions or rental laws (e.g. could cause compliance costs or increased capex/maintenance costs)
- Potential reputational damage if poor services are provided etc (esp. since many villages are in small towns)
- Inability to acquire enough new villages
- Poor acquisitions/trying to grow too quick (mitigated by the fact that mgmt has specifically held back on acquiring in the past, where properties didnt meet requirements)
- Properties aren’t differentiated (in my opinion), low barriers to entry, although Eureka’s cluster strategy could give a small brand + cost advantage
- Tax will punish earnings
Using rental profits, recycled capital from their land bank, and new developments on existing land, Eureka could become significantly larger over the next 10 years. At today’s low price, 1.1x book, the downside is somewhat limited if things go against the business, while the price is not so high that it precludes upside. Key risks revolve around competition, availability of attractive acquisition opportunities, and availability of funding (e.g. debt, or capital raisings). I would like to see the company continue to add more managed properties to its stable, as this could see earnings grow at a lower capital cost.
Buying Eureka is a specific bet that the company can grow enough in the near term to compensate for the 30% tax hurdle which will be imposed on earnings in the next ~2 years.
As a small operator in a fragmented industry, Eureka could potentially become much larger over time, and the size of the market itself (underfunded retirees) is also growing. 77% of retirees over 65 are dependent on the aged pension.
At current rates, the Property Council of Australia and Grant Thornton predict that there will be 8.1 million seniors over the age of 65 by 2050. Assuming a continued tendency for 5.7% of seniors to live in retirement villages, that implies that the demand for villages will approximately triple in the next 33 years (big deal). The number of Australians living in retirement villages is also quite low compared to the rest of the world. A normalisation would see that figure approximately double again, for ~5%p.a. growth in retiree numbers over the next 33 years. So the macroeconomic tailwinds are there, even if it’s a slow burn. They are nice to have but not central to my Eureka thesis.
My thesis rests on Eureka being able to acquire or develop a small but meaningful number of the ~2,300 retirement villages Australia wide. They currently own 26, or an estimated 1.1% of the market. Note that this ‘whole market’ figure also includes the wealthier retirement villages with which Eureka does not compete.
I suspect that the demand for Eureka’s product is understated, with many pensioners not having the means to consider a retirement living community. I wouldn’t say that Eureka is creating a new market or anything radical like that, but I think that the market could be pleasantly surprised at the degree of demand for Eureka’s facilities. I.e., I suspect that it is unlocking latent/under-served demand in poorer pensioners.
Contrary to my own previous thoughts
I took a good look at Eureka a long time ago, was intrigued by many things, and decided not to buy it. I thought that its low ROIC, aggressive acquisitions via debt and capital raisings, an inability to raise prices, and vulnerability to competition would combine to generate sub-par returns.
I returned to my original thesis and had to specifically counter-think my initial prejudices. My most recent thoughts are that, despite the negatives, Eureka could potentially become significantly bigger in the next 5-10 years. If you’re earning 10% ROIC, and the company doubles in size, you’re earning the 10% ROIC on twice as much capital. That said, holding a significant amount of debt (as Eureka does) will meaningfully crimp returns. So the goal is to be there for the roll-up/development phase, if that can be achieved in way that adds value, and not be there at maturity, when growth requires ever greater amounts of capital to increase earnings.
I am specifically betting that Eureka, at today’s prices, can grow enough via acquisition + development to compensate for its low ROIC, minimal competitive advantages, and imposition of tax.
A price target?
I have not put a firm target price on Eureka. Unlike the previous purchases, which were more ‘value’ style investments where measuring the possible upside and downside were crucial, I view Eureka as more of a ‘growth’ investment. I think that somewhere around 3%-5% market share could be achieved by Eureka over the next 10-15 years (based on estimated cash flows, use of debt, and cost of acquisitions/ building units) and think that it could approximately double in size in the next 5 years, however there are many moving parts in those calculations.
With that in mind, I will persist with the company as long as the story makes sense and the likely returns seem attractive – as long as I think Eureka can continue to grow its market share meaningfully without over-extending or taking too much risk.
I bought 1,550 shares in Eureka Group at $0.325 per share, plus $14.95 brokerage, for a total of $518.70 (effective price $0.334 per share).
Disclosure: I hold shares in Eureka Group.