Gamble of the week: undervalued defensive stock

Southern Cross Healthcare is the UK's largest retirement-home provider with an approximate 8% share of an £11.8bn market, managing 37,820 beds across 742 sites. These premises care for both the elderly (95% of sales) and young people with learning and physical disabilities (5%), with three-quarters of the residents requiring round the clock attention as they have been deemed by social services to be unable to live on their own.

So why has such a defensive stock fallen 75% since November 2007? During the era of cheap money, Southern Cross expanded too rapidly, saddling itself with onerous debt. When the credit crunch struck, not only did funding dry up, but its property values also dropped like a stone leaving the firm in breach of its banking covenants.

Since then, a new chief executive with turnaround experience has been appointed, and he has already got to grips with the company's problems. In October 2008, Southern Cross completed a major refinancing after a series of asset disposals, leaving proforma net debt of about £48m. This is well within conditions imposed by its lenders.

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Southern Cross Healthcare (LSE: SCHE)

The focus now is to tackle inconsistent service across the group's large portfolio of homes. A new inspection system has been implemented, with the target of having 80% of all homes rated excellent or good by 2011, compared to 71% today.

Assuming this is achieved without any significant capital expenditure, I'd predict 2009 revenues and Ebitda of £945m and £73m respectively, rising to £1.05bn and £82m by 2011. On this basis, using a 12% discount rate and a six times Ebitda multiple, I value the shares at around £2 each, offering 47% upside on today's price.

As usual there are, of course, risks. Southern Cross could be affected by high operational gearing, further falls in commercial property values, and cut-backs on care spending from cash-strapped councils and the NHS, which account for 77% of turnover. (A typical resident at one of Southern Cross's homes costs the government around £27,000 a year.)

However, taking all these factors into account, Southern Cross should nevertheless be a long-term beneficiary of demand from an ageing population, access to cheaper foreign labour, and a contraction in the number of houses available as rival sites close owing to stricter regulation.

Recommendation: speculative BUY at 136p (market capitalisation £256m)