Summerset Group Holdings (SNZ.AX, SUM.NZ) BUY. Company Report. If You Build It, They Will Come Initiating With a BUY and a AUD$3.05 TP.

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1 Dec 13 Mar 14 Jun 14 Sep 14 Company Report 19 December 2014 Summerset Group Holdings (SNZ.AX, SUM.NZ) If You Build It, They Will Come Initiating With a BUY and a AUD$3.05 TP BUY Risk: High Key Information Price (AUD$ps) 2.70 Target Price (AUD$ps) 3.05 Market Cap (AUD$M) 618 GICS Sector Health Care Equipment & Services 52 week Hi-Lo (AUD$ps) Daily Vol (M, mth avg) 0.0 Weight of S&P 200 Index (%) 0.00 Cash (NZ$m) $18M Debt (NZ$m) Gearing (ND/ND+E) (%) $105M 27% Forecast Total Return (%) 15% Investment Fundamentals - NZ$ YE 31 Dec FY13 FY14F FY15F FY16F Sales ($m) EBITDA ($m) Margin (%) 44% 52% 56% 60% NPAT ($m) EPS (cps) EPS Growth (%) 58.2% 12.5% 17.0% 11.5% DPS (cps) Franking (%) 0% 0% 0% 0% Source: Shaw Stockbroking Ratio Analysis YE 31 Dec FY13 FY14F FY15F FY16F PE (x) PE Rel (x) Yield 1.1% 1.5% 1.9% 2.1% ROE 8.3% 9.1% 8.8% 8.2% P/BV (x) 2.2x 1.9x 1.5x 1.3x PE Rel is compared to the Market (Industrials + Resources) SNZ (AUD) vs S&P/ASX Market Index $3.60 $3.40 $3.20 $3.00 $2.80 $2.60 $2.40 $2.20 SUM Performance 1 Mth 3 Mth 12 Mth Absolute (SNZ) -8.7% -18.5% -24.1% Rel to Market -3.9% -13.7% -25.2% Company Activities Summerset Group Holdings Limited provides integrated retirement villages, rest homes, and hospitals in New Zealand for the elderly. Major Shareholders Milford Asset Management New Zealand Superannuation Fund Paradice Cooper Investors Accident Compensation Corporation Directors and Management Robert Campbell James Ogden Anne Urlwin Norah Barlow Dr Marie Bismark Julian Cook Index (rebalanced) Shareholding 6.7% 6.6% 6.4% 6.1% Chairman CEO Event Shaw initiates coverage on SNZ with a BUY rating and a price target of A$3.05. Key points Exposure to New Zealand s ageing population. SNZ is a play on two structural themes; the ageing NZ population and their increasing preference for retirement village living. The number of New Zealanders over the age of 75 is forecast to more than double by 2034, from 270,000 to 600,000. While changing consumer perceptions and improved village quality are, in line with international trends, driving increased retirement village demand. SNZ s differentiated model is delivering market share growth. SNZ s continuum of care model, which includes retirement units and aged care beds, provides a full spectrum of care to its variety of residents and a sense of security which is a big factor in the elderly s choice of a retirement village. A self-funding model that allows for growth and shareholder returns. In order to accommodate the growth in demand, SNZ is planning to increase its retirement unit footprint by ~50% over the next 4-5 years funded by recycled capital. Capital released from its completed villages is recycled back into new developments, enabling the company to continually grow its asset base without having to raise equity or put its balance sheet under unnecessary stress. Scale and internal strategies to drive margins and improved cash flow. SNZ has a sixteen year track record of getting the basics of its offering, from site acquisition through to resales, right. It is now internalising the design, construction and procurement of its villages which should continue to drive up its margins. Scale, which is partly a function of time, is now the key feature required to fully extract the models cash generation capability. Risks. Retirement villages have previously been associated with debt and cash flow issues as a result of too high gearing and inaccurate calculations of when Deferred Management Fees will be received. We believe SNZ s relatively conservative gearing and disciplined growth ambitions will provide a cushion from these issues, however increasing lifespan remains a key risk facing investors. Industry over supply and a number of secondary risks are discussed below. Recommendation - BUY SNZ is emerging as one of the market leaders in an industry primed for long term growth. The company has significant development plans that are expected to see it increase its market share, achieve economies and provide considerable growth in cash flows whilst retaining conservative gearing levels. Our 12 month DCF derived TP is $3.05, however longer term, as SNZ s operational objectives are achieved, we expect it to trade towards a valuation that makes it more comparable to its larger and longer established peer and best compco Ryman Healthcare (RYM.NZ). Refer to disclaimer on last page Darren Vincent dvincent@shawstock.com.au Henry Hill hhill@shawstock.com.au

2 Financial Summary Consolidated P&L (NZ$m) FY12 FY13 FY14F FY15F FY16F Key Financials FY12 FY13 FY14F FY15F FY16F Operating revenues Diluted average shares Non operating revenues Reported EPS Total revenues Reported EPS (diluted) Total operating expenses Cash EPS (diluted) EPS growth - 58% 13% 17% 12% EBITDA PER (x) 30.5x 19.3x 17.1x 14.6x 13.1x Depreciation of assets DPS (cps) Amortisation goodwill Payout ratio (%) 34.6% 28.5% 33.9% 35.0% 35.0% Amortisation other Dividend yield (net) 1.1% 1.5% 2.0% 2.4% 2.7% EBIT Franking 0% 0% 0% 0% 0% Interest charges Dividend yield (gross) 1.1% 1.5% 2.0% 2.4% 2.7% Interest received Share of net profits of asso Key Operational Financials FY12 FY13 FY14F FY15F FY16F Profit before tax EBITDA margin (%) 39.3% 43.7% 51.9% 56.1% 60.2% Tax EBIT margin (%) 36.9% 40.8% 48.5% 50.8% 52.4% OEI NPAT margin (%) 28.1% 34.0% 39.7% 40.9% 39.5% Normalised NPAT Tax rate (%) 0.0% 0.0% 0.0% 0.0% 10.0% Significant items (after tax EBITDA growth (%) -20.0% 34.6% 27.6% 23.6% 23.9% Reported NPAT EBIT growth (%) -22.4% 33.9% 27.7% 19.8% 19.2% Cash NPAT NPAT growth (%) -5.5% 132.9% -1.7% -2.8% 11.5% Cashflows (NZ$m) FY12 FY13 FY14F FY15F FY16F Cash Flow Ratios FY12 FY13 FY14F FY15F FY16F Operating cashflows FCF (OC - CAPEX) Investing cashflows FCF (growth pcp %) -9.5% 35.1% 11.2% 47.2% 17.7% Financing cashflows Total CAPEX spend Net increase in cash Net borrowings Cash at end of the year Balance Sheet (NZ$m) FY12 FY13 FY14F FY15F FY16F Balance Sheet Ratios FY12 FY13 FY14F FY15F FY16F Cash Period end shares Receivables NAV per share Inventories ROE (%) 12% 8% 9% 9% 8% Plant & equipment P / NAV (P/BV) 1.9x 1.7x 1.5x 1.1x 1.0x Deferred tax assets NTA per share Intangibles ROTE (%) 12% 9% 9% 9% 8% Other assets , ,126.4 P / NTA (x) 1.9x 1.7x 1.5x 1.2x 1.0x Assets , , , Gearing FY12 FY13 FY14F FY15F FY16F Payables Net Debt Provisions Net Debt / Equity 31% 36% 42% 35% 26% Tax liabilities Net Debt / (ND+E) 23% 27% 30% 26% 20% Borrowings Int cover (x) (EBITDA) Other liabilities Int cover (x) (EBIT) Liabilities Net Assets Net Tangible Assets

3 Investment Thesis SNZ is an emerging market leader, in an industry expected to experience long term growth the two dominant players in the NZ retirement village market are Ryman Healthcare (RYM.NZ) and Metlifecare (MET.NZ). SNZ is smaller, but has a model that will enable it to start closing the gap with RYM (the better compco) as it ramps up development and expands its village footprint in order to service New Zealand s rapidly ageing population that is increasingly demanding more and improved retirement and aged care options. The company s continuum of care model makes it attractive to customers, smooths cash flows, differentiates it from most competitors (including MET) and aligns it with RYM s model SNZ sells the right to occupy its units and the potential to access a full spectrum of aged and hospital care, which provides its residents with a sense of security a big factor in their retirement village choices. The hospital offering not only provides SNZ with a selling point for incoming residents, but also a profitable and stable stream of cash to offset lumpier development cash flows. Self-funding development model allows for growth without raising additional equity SNZ s model is to recycle capital from completed developments into new developments, eliminating the need to come to the market to raise equity. As its model is self-funding, SNZ can substantially increase its asset base without new equity or without excessive leverage. RYM provides an excellent example of this model - it raised $25m in 1999, but has managed to invest $1.4bn in its village portfolio and pay $349m of dividends since, without ever having to return to the market for capital. Internal strategies are expected to drive margin and cash flow generation SNZ has internalised the design, construction and procurement for its villages over the past 2-3 years in an effort to increase the margin it makes on its development projects. The company has also optimised the structure of villages with regards to the proportion of Independent Living Units (lower level of care), Assisted Living Units (higher level of care) and the aged care business to further drive improved returns on capital and profitability which are expected to edge up towards the margins RYM is achieving. There are numerous risks associated with aged care service provision. SNZ, as a consequence of its size, is currently more at risk to these factors than RYM, however we believe its 14 year track record and conservative gearing policy suggest this risk is more than accounted for by the significant valuation differential. We discuss many of these risks on the following page. Industry fundamentals, the valuation differential and SNZ s valuation metrics are attractive. Our 12 month price target of $3.05 for SNZ is derived from our DCF based valuation (which accounts for the complexities associated with SNZ s funding model) while our peer based comparisons imply significantly greater long term potential valuation uplift. SNZ (and MET) trade at a steep discount to RYM (SNZ mkt cap $480mn v. RYM $4.1bn) reflecting: 1) SNZ has approximately half the number of units and villages of RYM, 2) SNZ s villages are less mature and therefore currently generate less cash, 3) SNZ has a shorter track record and is still building towards achieving RYM s margins, and 4) the risk that SNZ may not achieve its development goals and cash flow. However, SNZ has significant development plans that are expected to see it increase its market share, achieve economies, improved margins and provide considerable growth in cash flows whilst retaining conservative gearing levels. As these operational objectives are achieved over the next few years we expect it will begin to trade up to a valuation that makes it more comparable to its larger and longer established peer RYM. 3

4 Key Risks Risks for the business, our forecasts and BUY rating include: Market oversupply New Zealand s ageing population is a well-established phenomenon that a number of companies, are and will continue to, look to profit from. Given there is no real major barrier to entry for the retirement village industry, one of the biggest risks facing SNZ is that an oversupply of retirement units could eventuate. This could prevent it from realising our forecasts. However, 1) we believe this is already factored into its share price, and 2) analysis by various consultancies and the NZ government suggests long term over supply is unlikely at this point, however, this could change quickly if a number of smaller players decide to ramp up operations. Inaccurately calculated Deferred Management Fees (DMF) The second key risk is the potential for inaccurately calculated DMF s. SNZ derives a significant proportion of its cash flow through DMFs, which are payments made by outgoing residents that accrue over the first five years only of residency. DMFs are typically expected seven years post entry, which is the average stay of a Summerset resident. However, every year in excess of five years that a resident stays, denies SNZ the opportunity to derive a DMF payment. Increasing longevity is the key risk and basis for longer stays than expected. Inability to sell off newly developed units SNZ relies on the initial sale of developed units to retire its bank debt and generate future cash flows. If SNZ cannot sell the units that it develops this creates a financial drag both in terms of keeping its gearing higher that it would like and causing a cash flow drag with respect to higher inventory levels and lower revenue. It could also delay subsequent development and realisation of our longer term forecasts and valuation. However, we believe SNZ s share price and the differential at which it trades relative to RYM accounts for this issue. Missing development targets This issue is related to the risk identified above. SNZ is targeting 300 new units per annum from 2015 onwards and we have forecast that the company hits this targeted build rate. We think this is attainable based on existing land banks that the company own, brownfield development opportunities and potential land acquisitions in the future. A key driver of our DCF valuation of SNZ is the number of units that the company has in its portfolio. If these targeted development rates were not met then our valuation would likely decrease significantly. Protracted decline in house prices retirement unit occupancy right agreement (ORA) resale demand and prices are closely linked to the housing market. If house prices are rising and the market is buoyant, then SNZ can expect increasing ORA as potential residents sell their homes faster and for more. If house prices are falling and liquidity is affected, then SNZ will likely have to charge less for its ORAs potentially leading to capital losses and reduced DMFs. A decrease in New Zealand s aged care penetration rate the aged care penetration rate is the percentage of the aged population that live in retirement villages. The current penetration rate in NZ is 10.5%, up from 9.4% in We expect that the penetration rate will continue to increase modestly in line with US and Australian experience, as retirement village quality improves and the negative stigma of nursing homes, previously generated by the low quality residences provided by underfunded not-for-profit operators begins to wash away. 4

5 Retirement Units % Increase in Units Summerset Group Holdings (SNZ) Company Overview SNZ is a developer and operator of retirement villages in New Zealand. It is New Zealand s 3 rd largest operator and 2 nd largest owner of retirement villages, with an estimated 8% market share. Founded in 1998, SNZ listed on the New Zealand exchange in 2011 and on the ASX in As of August 2015, SNZ owned and operated 18 retirement villages made up of 1,991 retirement units (villas, apartments and care apartments) and 483 care beds. Since 1997, the company has increased its retirement unit portfolio from 129, an 18.7% unit CAGR. SNZ intends to build 300 new units (plus ~60 care beds) per annum from 2015 onwards as it prepares for the avalanche of New Zealanders over the age of 75. SNZ s development plans over the coming years should see it close the gap between itself as the third player in the NZ retirement industry and the two biggest players, Ryman Healthcare (RYM.NZ) and Metlifecare (MET.NZ). Chart 1: SNZ Unit Growth Units (LHS) %Change (RHS) 27.0% 24.0% % % 15.0% 12.0% 9.0% 6.0% % 0 0.0% Source: SNZ, Shaw Stockbroking Retirement Units and Aged Care SNZ operates in two segments of the retirement living sector; retirement units and aged care. Both segments can be categorised further: Retirement unit residents purchase the right to occupy a unit for the rest of their lifetime through an occupancy right agreement (ORA). When the unit is vacated, the unit is resold to an incoming resident. The previous resident (or estate) then receives the initial ORA less a deferred management fee and SNZ keeps the capital gain on resale. Retirement units fit into two categories: Independent Living Units (ILU) units designed for residents with no care requirements. ILUs resemble apartments or townhouses and are generally ~100m 2 in size. Assisted Living Units (ALU) are units designed for client with some mobility issues that require a basic level of care (e.g. meals provided). ALUs are typically half the size of ILUs. These have a higher turnover rate and are more profitable units for SNZ. Aged care beds also have different categories, based on the level of care required: Rest Home Beds are for residents that frequently have mobility and memory issues. These beds typically have a registered nurse on duty and full time care is available. Hospital Beds are for residents that require full-time nursing due to illness and disability. Facilities have a registered nurse and carers working full-time. Hospital beds are more profitable than rest home beds due to the extra care charges. 5

6 The company s core business is retirement units, but it is also developing a presence in the care bed space. There are two crucial benefits of care beds; 1) they provide a stable source of cash flow to offset the lumpiness of development profits and unit resales; and 2) they give SNZ a full service offering, allowing them to provide for residents as their needs change. This full service offering is marketed to potential residents as a point of differentiation. Cash Flow SNZ derives cash flow in a number of ways, including: Sales of ORAs for new retirement units Deferred Management Fees (DMF) Weekly resident fees (units and villas) Aged care service fees ORA resales We discuss each in some more detail below: Sales of ORAs for new retirement units after SNZ develops a new retirement unit, it sells the right to live in the unit to an incoming resident. This is essentially the same as the sale of a house; however ownership of the unit does not transfer to the resident in this case. SNZ makes a profit through the sale as a margin on top of the cost to develop the unit, known as the Development Margin. Typically, an incoming resident will look to sell their house and free up some capital by purchasing a more affordable retirement unit this habit amongst the elderly drives the demand for retirement units. Deferred Management Fees (DMF) when residents move into new ILU s, they agree to pay a deferred management fee at the end of their tenure. The DMF accrues yearly for the first five years of residency at 5% of the initial sale price capping out at a maximum of 25% of the ORA sale price for villas. For ALU s, the DMF is 30% over three years. The DMF is realised when the resident departs and SNZ on-sells the unit. Villages turnover ~10% of units each year, meaning that once a village reaches maturity (8-10 years), it derives an annuity-style income stream from DMFs. Weekly resident fees (units and villas) residents pay a weekly fee to live in SNZ s units. Weekly fees for non-care retirement units typically cover weekly staff and maintenance costs and are not allowed by regulation to be profitable for SNZ. These weekly fees mean that the retirement units fund themselves between resales which generate cash inflow. Aged care service fees SNZ receives funding from the government under a nationwide Age Related Residential Care (ARRC) contract. These fees are subsidies on behalf of occupants of care beds (higher level of required care). Care beds generate positive cash flow for SNZ and are a stable source of income to balance against the lumpy development cash flows. SNZ and other quality providers are able to charge a surcharge in addition to government subsidised bed fees. This surcharge significantly improves the profitability of the care bed business. 6

7 ORA resales when a resident leaves a unit, SNZ resells the resident s ORA to an incoming resident. SNZ then keeps the difference between the two sale prices. Unit prices are closely correlated with house prices and a strong housing market will see increased resale profits all else being equal as incoming residents receive better values for their homes and quicker selling times. The average stay for a resident at one of SNZ s units is 7 years and, like DMFs, once a village reaches maturity the resale cash flow will stabilise assuming a stable housing market. SNZ releases quarterly summaries of new sale and resale volumes but not pricing. Business Model Self-Funding Development SNZ s business model is fundamentally simple: Borrow money to build retirement villages; Sell the units and rent out the care beds to incoming residents and repay the debt; Resell the unit as the resident leaves at a higher price and keep the capital gain and deferred management fee. The model s major positive is that it is essentially self-funding. While capital is required in the development phase, the cost of village construction is covered by the initial sales of retirement units. This releases capital that can then be recycled into new villages. The remaining unsold units represent the only capital tied up in the business. We estimate that the sale of ~75%-80% of units is enough to repay the debt used for development, with the remaining sales, and DMFs years later, representing returns on essentially no invested capital. Crucial to the model is borrowing debt linked to development working capital, and not gearing up to purchase already constructed villages, a strategy that saw a number of players come unstuck during the GFC as companies waited years to receive cash to repay the debt. The self-funding nature of the model means that SNZ does not need to return to the market to raise growth capital, and it can return cash to shareholders while growing. This allows the company to substantially grow its asset base without having to raise equity or put its balance sheet under unnecessary stress. RYM has proved an excellent example of this model, having raised just $25m in 1999 but managed to invest $1.4bn in its village portfolio and paid $349m of dividends since without ever having to return to the market for capital. Once a village hits maturity the cash flow profile is relatively stable as ~10% of units turnover each year. This means that SNZ s past investment will smooth out lumpiness that was evident early in its development, and current investment will lock in future growth. However, a disciplined approach to debt and growth is key to risk minimization given the unknown variables in calculating Deferred Management Fees, which can result in delayed payments. Unit Cash Flow Chart 2 provides an example of the cash flow cycle of a retirement unit, whereby the incoming resident purchases an ORA at an example price of $300,000 and vacates seven years later, during which time we assume house prices appreciated at 3% p.a. SNZ resells the vacated unit and keeps the difference between the two sale prices and the DMF, which totals 25% of the original ORA and accrued during the initial five years of residency. An ALU s DMF is structured slightly differently, accruing over three years to 30% of the ORA price. 7

8 Chart 2: Retirement Unit Cash Flow Life Cycle Source: Shaw Stockbroking Note chart 2 is illustrative of the reinvestment life cycle of a single unit and not of a village or the SNZ corporate entity. Non cash flow generative facilities such as common rooms are funded out of the developer s margin. The DMF is also effectively prepaid with the initial purchase which also includes the developer s margin. Development Forecasts SNZ s development process typically takes 4-5 years but happens in several stages (Chart 3). The company sells units at each of stage of development, which gives it flexibility when assessing its build rate. If the market is strong, SNZ can ramp up its build rate to finish the village sooner, or vice versa. As the company s debt is only linked to working capital, it can pay the debt off as the village is developed. Typically the company builds units at a time, sells them, then recycles the cash into building the next stage. Chart 3: Development Life Cycle Source: SNZ SNZ has proportionally the largest land bank and unit growth over the coming years within all the major operators in New Zealand. The company has a land bank of close to 2,000 units, or 5-7 years worth of development enough to double its current portfolio. We expect SNZ will purchase one parcel of land per year to keep its land bank up. Given the company has such a large land bank, it can afford to be disciplined with its land purchases, waiting for ideal locations and not overpaying in order to replenish falling build rates. We do not believe that land availability is an issue, but in some metropolitan areas like Auckland, prices are increasing. 8

9 SNZ is on track to build 250 units in FY14 (136 were built in 1H14) and plans to build 300 units per annum from We have forecast that SNZ hits its target development rates, building 300 units per year from FY15 to FY19 before winding down to 150 per year until FY24. The 300 units expected to be built in FY15 will represent ~14% unit growth and at that build rate, SNZ should have grown its finished portfolio ~65% by FY18. This will generate a substantial increase in cash flow per year. We estimate SNZ s free cash flow in FY18 to be in the order of $50m-$52m. Continuum of Care Offering a Point of Difference SNZ believes it has a point of difference through its continuum of care model, through which it can cater to the changing needs of residents as they age and require higher levels of care. The continuum of care model involves expanding its aged care capabilities as it continues to develop and grow its village footprint. The offering works as a branding tool to attract older (and potentially more lucrative) residents. As older incoming residents have shorter tenure, SNZ is able to realise the cash on an ORA resale and DMF sooner. SNZ s average entry age is years old and its aged care beds average 97% occupancy. Chart 4: Life Expectancy at Birth to Source: Statistics NZ SNZ has won awards for its aged care business for the past three years, validating the quality of its offering. SNZ s model provides it with a selling point to potential residents, as they are offered a longer term solution than at pure retirement village owners. Key to the offering has been the introduction of the serviced apartment style unit, which is smaller than a typical villa but still allows for a certain level of independence for residents. These serviced apartments have a lower selling point ($220,000-$250,000 vs. $350,000-$400,000 for a villa) but a significantly higher turnover rate (3 years vs. 7 years), which means they have a faster cash generation cycle. The DMF for a serviced apartment is also a higher percentage of the initial sale price (30% vs. 25%) and accrues fully by the end of the second year of residency. This move toward the serviced apartment style of care has been an initiative by retirement companies like SNZ and RYM to try and privatise the aged care segment of the market, which has traditionally relied solely on government subsidies. Within a typical village, retirement units and apartments outnumber care beds 5:1. Nursing homes have historically proven to be poor businesses generating low returns due to an inability to generate revenues above government subsidies. However, SNZ and RYM have shown a disciplined approach will generate positive cash flow from this service. SNZ management believes the key is a higher quality, differentiated offering that the aged and 9

10 their families are prepared to pay for. As SNZ improves the quality and the average age of its portfolio reduces, we believe the profitability of the care business will improve materially. Currently, we estimate SNZ make $16,000 EBITDA per bed. We estimate new hospital beds make ~$21,000 and new rest home beds make ~$15,000, with older beds making $2,000- $3,000 less per bed. Supply Chain Optimisation to Drive Margins The development margin is the profit that SNZ makes after selling all the units within a village, retiring the debt used to fund the development and constructing the care business and common facilities. For example: if a village costs $100m to build, typically $85m will be spent on building the retirement units. These units will be sold for $102m-$108m this constitutes the development margin. From the remaining $17m-$23m the care bed business and facilities, which may cost ~$15m-$17m, are funded. This means that the care beds businesses are essentially funded from ORA sale profit and thus have no cost of capital. The leftover cash, ~$2m-$6m, goes to SNZ. A key focus of the company is maximising the development margins on new villages. Development margins have averaged 12%-14% over the past 2.5 years, up from 6% in The company is targeting a 17% margin. RYM, for reference, has achieved development margins of between 20% and 25% for years. We believe SNZ s target margin is attainable. To achieve the target margin, SNZ has internalised its development, planning and construction over the past three years, a strategy that has already yielded positive results, with a rise in margin in 1H14 to 13.6% from 12.4% in 1H12 and 11.9% in 1H11. We understand that 2H14 will be the last period of development that involves villages that had outsourced planning, design and construction. We expect SNZ can hit its 17% target margin by 2H15 and can likely get to around 20% (~5% on the cost of the total village) within three years as the company s internal strategies mature through experience although we have not forecast this. SNZ has experimented in a couple of recent developments with the direct sourcing of labour, which should also help margins, although it is unlikely to roll this concept out across all its developments to maintain some labour supply flexibility. SNZ has also recently hired a Head of Procurement to optimise its supply chain. This is a newly created position that the company believes could materially improve margins. Chart 4: Development Margins Source: SNZ, Shaw Stockbroking 10

11 Industry Overview There are an estimated 450 retirement villages and 27,000 units in New Zealand. The industry in New Zealand is dominated by six players that make up roughly 50% of the available beds. The remaining 50% of the industry is highly fragmented. Competitive Landscape The major players in NZ outside of Summerset are: Ryman Healthcare (RYM.NZX): 4,207 units, 15.5% mkt share. RYM is the largest player in the New Zealand market and, like SNZ, operates a continuum of care model. RYM has been developing approx. 400 units pa but is looking to step up its development plan, targeting 850 units per year from 2017 onwards. RYM has positioned itself as a slightly more upmarket offering than SNZ. MetLifeCare (MET.NZX): 3,900 Beds, 14.4% mkt share. MET is primarily focussed on retirement units with a limited offering of care beds. MET has a planned build rate of 200 units per annum from 2015 onwards and will likely need to acquire more villages/land to fill out its pipeline. MET has positioned itself as a slightly more downmarket offering than SNZ. Oceania: 1,216 beds, 5% mkt share (JLL 2013 est.). Oceania is a private company that was built through a number of acquisitions, and has an aged care centric focus. In July 2015 it was rumoured that Oceania was looking to list on the NZX at a value of ~$300m. Bupa Care Services: 1,067 units, 4% mkt share (JLL 2013 est.). Like Oceania, Bupa is a private company that focuses predominantly on aged care beds. Bupa doesn t make available information with regards to its future development plans or its land bank, however it is known to have a large land bank in Auckland and is looking to focus its activities in this region. Arvida: 812 units, 3% market share. Arvida is due to list on the NZX in late December. The company is a roll-up of a number of existing village operators with a focus on aged care. The company does not have a comparable development pipeline to SNZ or RYM, instead focusing on the brownfield development of its existing villages. Table 1: Key Peer Comps Villlages Units Care Beds Aged care % Land Bankand Bank % Growth Plan Mkt Cap ($m) Ryman 27 4,207 2, % 4, % 850pa from 17 4,055 Metlifecare 23 3, % 1, % 200pa from Summerset 18 1, % 2, % 300pa from Bupa 26 1,216 3, % N/A N/A N/A N/A Oceania 26 1,067 2, % N/A N/A N/A N/A Arvida % % 121 in 15/ Source: SNZ, Shaw Stockbroking There is a number of other smaller operators which combined, account for 46% market share. Smaller operators have typically found it more difficult to secure the necessary funding to develop villages, as banks have been reluctant to lend to operators that don t have a portfolio of a certain size that allows for risk mitigation. We believe that some of the smaller players may come under pressure to fund existing developments due to lack of scale. Larger operators including SNZ also enjoy better economies of scale give it considerable advantages over the smaller players, in terms of spreading fixed costs over a greater number of villages, better access to funding and flexibility with regards to pricing and village structure. We believe that SNZ, as an emerging larger player with a quality, full care spectrum offering, is well positioned in an industry that is increasingly split between large, well-funded players and smaller players that have a weaker financial position. Any shakeout at the smaller end of town would obviously have a positive effect on demand for SNZ s units. 11

12 Chart 5: Retirement Unit Market Share 16% Ryman 46% 14% Metlifecare Summerset Oceania Bupa Arvida 3% 4% 5% 8% Selwyn Foundation Villages of NZ Other 2% 2% Source: SNZ, Shaw Stockbroking The aged care segment of the market is more fragmented. Bupa is dominant player with 11% of the market followed by Oceania and Ryman at ~7%-8% each. This fragmentation is understandable given the more constant cash flow profile particularly in the initial years which makes it easier for a smaller player to operate an aged care business than a retirement village. Further, aged care businesses do not have the same balance sheet requirements as retirement villages. While we expect SNZ s retirement unit market share to increase as it rolls out its development plan, we do not expect its share in the aged care market to increase at a similar rate. This is because SNZ uses its aged care business as a selling point for potential village residents which is the core business. While the aged care businesses provide a nice income stream, the company s primary source of cash is its unit business. Chart 5: Aged Care Market Share 11% Bupa 8% Oceania Ryman 7% Presbyterian Support Radius 60% 4% 5% Arvida Metlifecare Summerset 1% 3% 1% Other Source: CBRE, Shaw Stockbroking, NZ Ministry of Health Penetration Rates A crucial figure in the retirement village industry is the penetration rate - or the percentage of people within the population that live in retirement units. The penetration rate in New Zealand in 2013 for over 65s was 4.5% and for over 75s, 10.5%. These figures varied substantially between the North and South Islands. The North Island (86% of SNZ units) has a penetration rate of 11.7% for over 75s, while the South Island penetration rates are 7.3% 12

13 reflecting the warmer climate. Penetration rates also differ significantly between regions, in Auckland for example, penetration rates have been growing at ~1% p.a. for the past decade, from an estimated 5.8% in 98 to 12.8% in In other regions growth has not been as strong. The strongest penetration rate growth has been in the over 75s which has been increasing steadily for the past decade. In 1998 it is estimated to have been ~ 5%. It is believed that penetration rates have increased due to; a) an increased number of quality retirement villages being built; and b) a decrease in the level of independence among elderly New Zealanders, a phenomenon highlighted in the study, Changes in the Aged Care Residents Characteristics and Dependency in Auckland, which was carried out three times by the University of Auckland between 1988 and Internationally, penetration rates are difficult to compare as often comparisons are not exactly like-for-like. However, it is worth noting that NZ s 65+ penetration rate of 4.5% is lower than Australia at 5% and significantly lower than the US at 10%-12%. Other international rates are difficult to assess accurately. The most likely driver of an increase in penetration rates in improved village and facility quality. Not-for-profit operators that dominated the retirement village industry 25+ years ago often constructed villages that provided the bare minimum in terms of facilities, which in turn negatively influenced consumer attitudes with regards to retirement homes. As private operators like SNZ, RYM, MET and others continue to developer higher quality offerings this should lead to greater acceptance of retirement village living by older New Zealanders. Table 2 demonstrates the significant change in potential demand that is caused by small shifts in the penetration rate as the New Zealand population ages. Table 2: Penetration Rate Demand Sensitivity Year 75+ Penetration rate Population 10% 11% 12% 13% ,000 30,200 33,220 36,240 39, ,600 35,760 39,336 42,912 46, ,000 44,800 49,280 53,760 58, ,000 53,700 59,070 64,440 69, ,600 63,960 70,356 76,752 83,148 Change ,760 33,776 37,154 40,531 43,909 Source: Statistics New Zealand, JLL, Shaw Stockbroking A further increase in the penetration rate will add an extra layer of demand to expected population growth, driving up ORA prices (and in turn DMFs and capital gains on resales) and allowing operators to charge higher rates for care bed services. Regulation and Additional Surcharges The key legislation for SNZ is the Retirement Villages Act of 2003, which outlines a code of practice for operators and residents. It stipulates that all operators must register their villages with the Registrar of Retirement Villages and appoint a statutory supervisor for each village who is responsible for protecting the financial interest of residents. The other relevant legislation for SNZ is the Health and Disability Services Act of Which relates to government residential care subsidises for people aged 65 and over, who meet both a needs and financial means assessment. The needs test is performed by District Health Boards (DHBs) and assesses an individual s eligibility for residential care. To enter DHB-funded residential care, an individual must be assessed as: 1. Having high, or very high needs which are indefinite (ie, the person s condition cannot be reversed) ; and 2. Being unable to be safely supported within the community. (Ministry of Health n.d.) 13

14 These two legislative acts have created what SNZ believes to be a complex and costly regulatory environment, which is a deterrent to new entrants in the sector. Companies that have economics of scale such as SNZ, RYM and MET are able to handle this compliance burden more easily, providing them with a competitive advantage. While the majority of aged care revenue is subsidised by the government, companies that can provide a quality offering and premium facilities (like SNZ) can charge residents an additional surcharge on top of the government mandated rates. These surcharges have no cost attached to them and can make aged care traditionally an uneconomic business highly profitable so long as residents are willing to pay and occupancy levels are high. A major initiative in recent years to increase the profitability of the aged care businesses attached to villages has been the introduction of ensuites for care beds. Residents pay extra for an ensuite, which we estimate can generate up to $4,000 EBITDA each per year in extra fees. Changing Nature of Facilities A large percentage (~51%) of villages in New Zealand were built prior to the 1990 s. The majority of these villages, built and operated by not-for-profit organisations, no longer adhere to the demands of potential residents and may pose a problem in terms of future supply. There is a trend towards more spacious accommodation and villages with a greater range of common facilities. This will benefit SNZ as it has an increasing proportion of newer, and better laid out, units and facilities. This higher quality, newer offering is likely to keep SNZ a preferred choice for potential residents and entice residents that had not considered retirement living previously. Chart 6: Estimated Age of New Zealand Retirement Facilities Source: JLL, Grant Thornton House Prices Unit demand and pricing is closely linked to house prices, which have appreciated at ~4% on a long term average basis in New Zealand. If house prices are rising and the market is buoyant, then SNZ can expect increasing ORAs as potential residents sell their homes faster and for more. If the housing market is weak, then potential residents will find it difficult to sell their homes and for values they believe are reasonable. If this is the case, SNZ will have two problems; 1) they will be unable to find buyers of their units, and have to hold them unoccupied; and 2) SNZ will need to cut the prices on their units in order to match lower house prices of potential residents. 14

15 The key drivers of house price are typically inflation, interest rates and income. The Reserve Bank of New Zealand (RBNZ) has set an inflation target of 1%-3% and CPI is currently running at the bottom of this range, suggesting interest rates are likely to stay at current levels of 3.5%. The RBNZ lifted interest rate 1% during 2014 (the last time in July) as dairy prices and increased construction activity fuelled strong economic growth and raised fears of inflation moving to the top end of the target range. Despite the recent rise, interest rates have been at historically low levels since 2010 and have helped push house prices higher after stalling between 2008 and 2010 (see Chart 7). The median household income has also shown strong growth in recent years, rising 8.5% in the three years to November 2013 to $68,600 and outpacing inflation by 1.5%. All three drivers of house prices are currently showing strong momentum, suggesting that SNZ should see strong sale and resale demand in the short term. Longer term house prices may stabilise for a period given the Reserve Bank of New Zealand is trying to cool the New Zealand housing market. However the long term average appreciation has historically been 4%. Chart 7: New Zealand House Prices Source: Statistics New Zealand, Thomson Reuters 15

16 New Zealand s Ageing Population New Zealand s ageing population is well documented. Between 2001 and 2013, the number of people aged 75 years or over grew at a compound annual rate of 2.1% vs. total population growth of 1.1%, while increasing as a proportion of the total population from 5.5% to 6.2%. Table 3: NZ Population Counts Census Years Nominal Chg % Chg Nominal Chg % Chg Total 3,737,280 4,027,947 4,242, , % 214, % , , ,032 45, % 11, % , , ,898 25, % 30, % Source: Statistics New Zealand, Shaw Stockbroking Retirement villages are designed for the oldest subset of the population, with 80% of residents over the age of 75. The number of New Zealanders over the age of 75 is forecast to rise from 260,898 in 2013 to ~600,000 in 2034, while increasing as a proportion of the total population from ~6% to 11% (Chart 8). This translates to growth in people aged over 75 of 16,000 p.a. until Even assuming no major shift in the penetration rate, this population growth roughly translates into the need for 2,000 retirement units p.a., or villages. Chart 8: Statistics New Zealand Population Forecasts Source: Statistics New Zealand Given all of New Zealand s major players are ramping up their development schedules, there have been concerns about over supply. Multiple studies(jll NZRVD and Grant Thornton) conducted in recent years have found little evidence for a potential oversupply across New Zealand in the medium term. This is because a significant amount of supply was taken out of the market in the GFC as companies geared up and were left with underperforming assets as housing markets dived. Long term supply/demand balances are difficult to predict, but the wave of over 75 population growth from 2020 onwards suggest that an extraordinary amount of supply would need to come to market between now and then to offset the demand. The area with the most likely short term undersupply is Auckland, which has been a focus area for the majors due to its older population and higher penetration rate. Any short-term oversupply is actually likely to favour a larger player like SNZ, as smaller, higher cost players are likely to fall first shifting the supply demand balance back toward SNZ. 16

17 Valuation Our 12 month price target of AUD$3.05 for SNZ is derived from our NZ$3.23 DCF based valuation converted back into AUD. The peer based comparisons we have provided below imply significantly greater long term potential valuation uplift than our DCF. However, there are a number of reasons (discussed below) why we believe SNZ is unlikely to trade up to similar multiples over the prospective twelve months and therefore the peer based comparisons have not been used to determine our 12 month target price. DCF Our DCF based valuation for SNZ is NZ$3.10. Unfortunately, the cash flow statements of aged care companies do not provide an accurate reflection of operating performance. Receipts for Resident Loans (including the prepaid DMF, a construction margin, gain on resales and an interest free loan component) are contained within the operating activities masking what would usually be understood to be the net cash flows from operating activities. We restate SNZ s net cash flows from operating activities to provide a free cash flow figure that we believe represents the cash generated by the company s non-financing operation and available for it to use. While this restatement introduces an added degree of uncertainty into our DCF analysis, it is we believe the best basis on which to assess SNZ s net cash flows from operating activities in order to derive a DCF valuation. We will discuss the approach to restating net cash flows from operating activities with our clients. Otherwise the underlying drivers and parameters factored into our DCF valuations include: Our WACC of 9.4% is based on a beta of 1.4, a 4% risk free rate and a 6% equity risk premium. We assume an optimal debt/equity ratio of ~45%/55%. For our terminal value we assume a long term growth rate of 2.5%. We assume SNZ reaches its targeted development margin of 17% by 1H16. Given the positive difference that current strategies to boost margins have already made, this could prove conservative. Small tweaks in the development margin in FY15 and FY16 are unlikely to have a material impact on valuation but will demonstrate improving operational efficiency. We note that RYM s development margins have averaged 22%+, so we believe the risk is to the upside for development margins in the future. We have assumed 3% growth in house prices, which is below the long run average of 4%. Our forecasts for house price growth drive two key inputs into our DCF, ORA new sales and resales. We have assumed a 4%-5% growth rate for profitability in the care business. As SNZ continues to make progress on village optimisation, this rate could look conservative. We have assumed long term unit turnover of ~10%, consistent with industry averages, but note that there is upside to this figure as serviced apartments, which typically have a 3-5 year turnover rate, become a greater proportion of total units. 17

18 Table 4: DCF Inputs & Outputs DCF Parameters DCF valuation NZ$m NZ$ per share Rf 4.5% NPV - years 1 to $1.83 Rm - Rf 6.0% NPV - terminal $1.99 Beta 1.4 Enterprise value $3.82 CAPM (Ke) 12.90% Net Debt $0.59 Equity 56.35% Equity valuation $3.23 Debt 43.65% Kd 7.0% Tax rate 30.0% WACC 9.4% LT growth 2.5% Source: Shaw Stockbroking Asset Based Valuation and Per Unit Comparison Peer multiple comparisons are difficult for retirement village developers due to the lumpiness of earnings and the different types of earnings recognised as underlying and reported. Instead, we have compared SNZ s value to peers with respect to its current and potential future units. At the current EV of $616m, the market is attributing $0.31m value for each existing retirement unit. This figure does not take into account the value of the aged care business or future units which is partly responsible for the valuation differentials with RYM ($1.03m) and MET ($0.24m). ASX-listed aged care peers Japara Healthcare (JHC.ASX), Regis Healthcare (REG.ASX) and Estia Health (EHE.ASX) trade at two year EBITDA multiples of ~10x-12x. If we take the bottom end of this range and apply it to our estimates of per-bed EBITDA, we can derive an approximation of the value of aged care businesses. Table 5: Aged Care Business Value Current Beds 2 Yr Forecast EBITDA per bed EBITDA ($m) Multiple Value Summerset , Metlife , Ryman 2,517 2,917 16, Source: SNZ, RYM, MET, Shaw Stockbroking If we were to include two years of expected development, the value per unit drops substantially. It drops again if we remove the value of the aged care business (Table 6). Table 6: Market Values Per Unit EV/ Current Units EV/ 2 yr forecast Summerset Ryman Metflife Source: SNZ, RYM, MET, Shaw Stockbroking EV/ 2yr exaged care The long term development pipeline for all three players is large; RYM s is the largest in nominal terms, but SNZ s is larger in relative terms. RYM s substantial care business, track record and dominant market position delivers it a premium. However, given SNZ has the strongest relative growth outlook amongst the majors and internal strategies helping drive improved operational performance, we believe that the per unit discount it trades at relative to RYM is excessive. For our valuation, we have applied a $0.3m value per unit to the forecast number of units in two years time ( inline with current selling price of the portfolio which we estimate to be 18