June 2011

Company Watch analyses the care homes operator Southern Cross as it appears on the brink of collapse

 

Southern Cross announced in May 2011 that it could no longer meet its rental obligations of around £230m per annum. The company is currently in talks with its landlords and bankers as it attempts to avoid administration. To understand what went wrong at the UK's largest care homes provider, it is necessary to go back to the heady days of 2007 when the company, which is now valued at £14m, had a market cap of £1.2 billion.

Southern Cross was founded in 1996 and expanded rapidly using a sale and leaseback business model, floating in London in summer 2006. By the end of 2007 it had reached a market capitalisation of £1.2bn. While market confidence was at its height, the Company Watch H-Score had identified significant underlying vulnerabilities in the company's financial structure and placed Southern Cross deep in its Warning Area (H-Score 17 in October 2006, falling to 14 in September 2007).

What the H-Score model had picked up was a dangerously weak balance sheet: asset values inflated by high levels of goodwill (reflecting the company's continuous acquisition trail) had been funded to a significant extent by short-term liabilities, much of which was debt. Furthermore, in 2007, the year of maximum market valuation, profits were barely at breakeven.

Future growth of the company was dependent on continued high demand from its primary customers - the local authorities; it was also dependent upon a buoyant property market to allow the sale and leaseback model to function effectively. In 2008, however, the business model began to unravel when Southern Cross was confronted with the double blows of local authority cut backs and a decline in property prices. With a poorly structured balance sheet there was little to fall back on.

As market confidence began to wane Southern Cross was forced to sell off assets at a loss to enable it to meet its lease commitments. Although the company was able to negotiate a deal with its bankers, the new round of local authority cut backs in 2010/11 has once again exposed the company's lack of balance sheet strength.