Stockwatch: an income stock about to generate capital growth?

What should we make of the conundrum that is Primary Health Properties (LSE:PHP)? This mid-cap has just pipped Kohlberg Kravis Roberts (who only last week clinched Spectris (LSE:SXS)) in a takeover contest for peer company Assura (LSE:AGR) – supposedly creating the UK’s eighth-largest real estate company with a portfolio of assets worth over £6 billion.

Owning purpose-built healthcare facilities, which are then let out to GPs and other healthcare personnel, and with a strong public sector emphasis, both shares are sometimes described as a “gilt proxy” in that security of income and capital should be much higher than an industrial equity. Moreover, healthcare facilities should also have attractive risk/reward characteristics relative to other UK commercial property, especially if further tax hikes beckon.

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PHP management emits quite a siren song for this combination with Assura. It calls it “a compelling strategic and financial rationale, earnings-accretive for both shareholders... [with] improved ability to benefit from a rising rents’ outlook after significant increases in construction costs in recent years...an expected strong investment-grade credit rating that will deliver future value and underpin the group’s progressive dividend policy.” In summary, “a powerful platform with greater scale, income and valuation growth potential, also lower cost of capital”.

Yet this £1.3 billion company is the second most-shorted share on the London stock market after addiction drugs group Indivior Ordinary Share (LSE:INDV) with 6.5% of its issued share capital loaned out. The total will probably be higher since short sellers only have to disclose their position once it reaches 0.5%. Furthermore, five of these shorts only just recently raised their trades – four to over 1.0%, including one over 1.6%. Short-trading thoroughly contradicts the impression of fundamentals, so how should we reconcile all this?

Primary Health Properties - financial summary
Year end 31 Dec

Source: company accounts.

A steady evolution of total shareholder return  

PHP’s progress has appeared so slow over a decade and more that I lost interest. Last time I wrote about it was in October 2013 and December 2014, when I was overall positive at equivalent prices of 82p and 89p after adjusting for a four-for-one share split in November 2015.

In 2013, the company was proclaiming its 17th successive year of dividend increases against a prospective yield around 6%. Net tangible assets along with profits were projected to resume growth. Very little capital expenditure seemed required, hence operational cash flow could largely be returned to shareholders. For conservative investors, what was there not to like?

I should add, I have also been aware of PHP since its early years as a listed small-cap from the mid-1990s, then trading around 25p.

On a 30-year view, there has been steady capital appreciation and sometimes the shares have traded at a premium to tangible book value, whereas currently they are at 0.94x. If consensus forecasts are fair – for dividends per share of 7.0p in respect of 2025 and 7.2p for 2026 – then the yield is rising to 7.4% at the current share price of 96.5p. This, together with synergies of the Assura takeover, meant PHP’s board considered it fit to improve their cash-and-shares terms to fend off KKR.

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Obviously, we will need to see how pro-forma numbers pan out for this combination, yet PHP and its advisers should have satisfied themselves of its logic, both to sustain modest dividend growth and improve capital prospects.

A critique would be that PHP hopes this deal will rescue growth credentials that have otherwise worn thin – with the balance sheet already looking somewhat strained.

The 2024 results looked like they needed some pep, with net rental income and adjusted earnings per share (EPS) up a modest 2.9%, and a 3.0% rise in the dividend hoovering up virtually all the earnings. Year-end net gearing was around 97%, the income statement showing net finance costs swiping 45% of £103 million operating profit.

True, the business model looks more reliable for yield than an industrial equity or regular commercial property. But the share price chart’s reversion to levels 10 years ago after a de-rating in the last five, says something needs to happen if total shareholder return is any kind of objective.

Source: TradingView. Past performance is not a guide to future performance.

Enlarged debt profile is key question for financial risk

The decision by PHP’s board and its advisers to trump KKR’s terms, can be seen as justified conceptually because, unlike a private equity owner, a property management group can exact synergies when increasing scale.

PHP is offering a cash-and-shares mix valuing Assura at around 55p per share (according to fluctuations in PHP’s market price) if also factoring in various dividend commitments, versus KKR having 52.1 per share in cash as its best and final offer on 11 June. This compares with Assura’s last reported net asset value of 49.4p, hence a slight premium compared to some of the REIT takeovers manifesting lately. Yet PHP was unlikely to get its offer recommended without doing so; indeed its own shares traded at a small premium when I drew attention to them a decade ago.

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It involves a fresh £1,225 million unsecured loan in respect of the cash element, which compares with £1,338 million net debt for PHP at end 2024; also £1,575 million net debt on Assura’s last reported balance sheet. The offer document references asset disposals. We have yet to see what that is, but say around £4 billion net debt is a reasonable short to medium-term prospect, it would appear over twice combined net assets of £1.8 billion.

PHP proclaims a “compelling strategic and financial rationale...earnings-accretive for both shareholders”, and reported reactions from Assura’s institutional holders are positive. I would still like to see more pro-forma detail of the financial structure of the combined group. Might this have driven short sellers’ motivation lately?

Yet PHP was being actively shorted before this combination with Assura was mooted, despite PHP’s circa 7p per share dividend looking robust. Mind how the shares dipped on 3 July due to going ex-dividend rather than it being some verdict on the deal.

Note also, the Competition & Markets Authority (CMA) has until 18 July to decide whether to investigate the transaction. You could find a parallel between Aviva (LSE:AV.) and Direct Line Insurance Group, which the CMA has just approved. Yes, it may limit competition somewhat, yet benefits may arise for consumers from the synergies arising.

Alleged inflection point in the business cycle

A key reason I write today is PHP having updated yesterday in respect of its first half-year to 30 June, citing “improving rental growth and stabilisation in yields which underpin valuation growth, further evidencing an inflection point in the cycle”.

Yields of 5.25% on the healthcare assets do appear supported by a 10-year health plan for England just published, with the government committed to strengthening the NHS - especially a transition to modern primary care facilities in local communities.

This PHP/Assura combination happening in such a context would appear to capitalise on these twin benefits, yet there is raised debt plus a motivated raft of short sellers. Given that PHP shares seem unlikely to rally in the near term, I tend to think more time is available to assess how the combined balance sheet may look.

I conclude with a “hold” stance for now, but with the prospect of UK consumer shares souring (last week’s warning from Greggs (LSE:GRG) being a portent) and US tariffs constraining industrials, we should be alert for shares offering attractive yield with strong asset-backing and financial risk contained. Can PHP/Assura prove so, as a more convincing “buy”?

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.