How cheap is too cheap?

Thursday, June 21st, 2018

Ramsay Health Care shares were battered to 52-week lows recently by capitulation selling in response to a negative broker report. It’s been a tough two years for shareholders in the former market darling, whose shares have trended lower from a peak over $84 in September 2016 to below $60 today. The resignation of the former popular and highly regarded CEO was followed by two lower-quality earnings results, vocal short-selling and calls by analysts for the premium earnings multiple to de-rate. The stock is now well out of favour.

Given Ramsay’s earlier record of growth and investment quality, value investors will be asking if this is an opportunity. We think it is, but only on a three-year view and there could be more downside yet. Weighing growth, capital management and risk Ramsay is currently worth around $60 – not much more than current prices. Near-term, the stock could drift lower if the market decides the 19 times multiple on forward consensus earnings is too high for a stock with single-digit growth.

Ramsay is often described as a go-to play on population ageing given surgery and hospital-delivered interventions for the baby boomers are set to grow as this cohort ages. The central problem for shareholders today however is the Australian growth curve from ageing is two years away and meanwhile Ramsay is caught in a marked cyclical and structural slowdown in private hospital admissions. Meanwhile the French and UK operations, which together contribute some 20 per cent of operating earnings, are ex-growth. The interim result reported in February missed market expectations on revenue and only just met guidance due to lower tax and interest expense than expected.

Investors still acknowledge Ramsay for its operational quality and clinical excellence, which are crucial to attracting doctors and patients. For this reason, its scale and the superior locations of the group’s Australian hospitals, Ramsay attracts a more profitable casemix than peers and has taken market share over time.

It can probably continue to do so but even Ramsay can’t fight the slowdown in private hospital industry volume growth from seven per cent per annum 10 years ago to 2.8 per cent this year. Australians are turning their backs on private health insurance and private healthcare, due mainly to declining affordability. Over the last five years private health insurance premiums compounded at 5.8 per cent per annum, faster than average wage growth of around two per cent. Awareness of the high out-of-pocket costs of surgery and accommodation in private hospitals has grown.

Hospital private health insurance coverage is down to 45.5 per cent from a recent peak of 47.4 per cent in the March quarter of 2015. Exclusions within policies are more popular, causing some insureds not to be covered for all surgeries. The resulting increase in high-end surgeries in the public sector is one main reason for the deterioration in casemix for private hospitals. We do not expect the federal government’s October 2017 reforms to private health insurance (gold, silver, bronze and basic policies from April 2019) will materially reduce the trends away from membership and towards more exclusionary policies. There is also no broad acceleration in wages underway to restore the affordability of membership.

Consumers who kept their private health policies are increasingly using them for admission to public hospitals, which cover more costs than private hospitals including policy excesses. Public hospitals have incentives to pursue private business because it shifts costs from the states/territories back to the Commonwealth, which so far has not introduced policies to limit the shift of private patients into public hospitals.

Healthcare services stocks always carry elevated political/legislative risk given intensive regulation. While we do not expect the federal opposition, if elected, would remove or further dilute the private health insurance rebate, its policy to cap growth in premiums at two per cent per annum for two years would almost certainly damage private hospital profitability by reducing contracted payments from insurers while costs keep rising regardless. The sharemarket is already starting to price in this risk given the opposition is competitive in the polls. The policy probably wouldn’t increase private health insurance membership given funds would respond with more exclusions, higher excesses and greater co-payments.

Meanwhile, Ramsay’s acquisitions in the UK and France remain unproven. Tariff cuts and disappointing volume growth have forced the company to bolster earnings by cutting costs.

Having considered this gloomy bear case, investors now need to ask if it is fully priced in by the fall in the share price. As long as the government is returned at the next election, we consider Ramsay is worth $60 per share and would be oversold at $54, where the forward earnings multiple would be too low at 17 times.

It is also important to stand aside from the gloom and ask if the consensus earnings downgrades have now ended. Large-cap stocks like Ramsay are intensively researched and react quickly to changing perceptions of earnings fundamentals. While the stock is not about to return to its glory days of double-digit earnings growth, and profitability will fall due to less operating leverage from slower growth in Australia, we do think tariffs in France and the UK have bottomed. There was a 0.75 per cent average tariff increase in the UK in April and French President Macron has said he will not seek further cost savings from the healthcare sector over the next four years. The UK National Health Service’s demand management strategies, which inflate surgery waiting lists, are also unsustainable. All this means probably no further downgrades to earnings forecasts for Ramsay’s European operations and adds to the case the share price is within a few dollars of bottoming. We would see further weakness from downgrades to forecasts for Ramsay’s Australian business as an opportunity.

 

Clime Group owns shares in RHC.

Originally published in The Australian, Tuesday 19th June 2018.

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One Response to “How cheap is too cheap?”

  1. michael says:

    Capital growth is one thing but like any investment there needs to be a return on capital. I love this stock but with a return of 2.2% in a rising interest rate world I cannot see it is value at $60.
    Given that the current government is on the nose and running an unashamed class war I suspect even the right wing media may not push it back into office, so what will a Shorten government do to this sector? Sounds like risk on risk so not sure why Clime analysts think $60 might be the bottom. All will be revealed in time.

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