Ramsay Health Care update following downgrade

Thursday, July 26th, 2018

On 21 June RHC downgraded FY18 core EPS growth guidance ~2% at the midpoint to ~7% after a sudden decline in maternity and rehabilitation admissions in May, delays to the rollout of Ramsay Pharmacy and softer UK volumes due to restrictions on NHS admissions. There will also be a A$125m charge for onerous lease provisions and asset writedowns pertaining to certain UK hospitals.

Consumers have been drifting away from private health insurance and private hospitals due to poor affordability and a poor value proposition when public hospitals provide a quality, less expensive alternative. Private health insurance premiums have compounded faster than wages for at least 14 years and the high out-of-pocket costs of private health care are increasingly unaffordable for many consumers when the costs of essentials have also risen faster than wages. The public system has both the capacity to absorb private patients and the funding incentives to attract them, as this shifts costs from state governments, which fund public hospitals, to the Commonwealth government, which subsidises private healthcare. So far the federal government has demonstrated little meaningful appetite to reverse this trend. The RBA has admitted wages growth will accelerate only very gradually.

Until the downgrade, RHC’s volume growth had slowed in line with the industry but was still steady monthly. This contrasted with peer Healthscope and was attributable to RHC’s greater diversification and its superior ability to attract medical specialists, a function of more attractive surgical facilities in areas with ample demand for procedures. The sudden deterioration in volumes in May is the first time RHC has reported monthly volatility and therefore the first time monthly volatility has affected guidance. It means RHC is not as defensive as before and the slowdown in private hospital admissions is overwhelming the group’s ability to sustain volumes by having superior hospitals, a better offer for surgeons and avoiding regions with overcapacity.

In the UK, notwithstanding the tariff increase which came into effect in April, NHS demand management strategies are reducing volumes despite record high and increasing waiting lists. RHC said “While the funding boost for the NHS announced this week by the UK Prime Minister is a positive step, we do not anticipate immediate benefits for us and expect operating conditions in the UK to remain challenging in the medium term.”

Formerly our thesis was Australian volumes would grow slowly but steadily, the company’s experience until May 2018. The start of strong monthly volatility in Australian admissions partly breaks our former thesis. It will make RHC’s earnings guidance less reliable and less trusted. The earnings multiple the market applies to the stock has declined to price in greater earnings volatility.

Our thesis also said earnings growth in the UK and France had bottomed and is still our view given high NHS waiting lists are likely to fall over the next three years because this is the top priority for the increase in funding and the waiting lists are unsustainable, and because the French President has promised no further cuts to private health funding.

So it was reassuring to see UK NHS hospital activity data for May, where the data of interest for RHC are general and acute elective admissions (day and overnight cases) as part of the e-referral system (previously called Choose and Book). NHS e-referrals are ~80% of RHC UK’s total admissions, with the balance private medical insurance and self-pay. May volumes for RHC rose 6% on pcp with 12-month rolling average growth improving slightly to -1.2% from -1.7% at the end of April. CY18 volume growth was 1.8% over the five months to May.

While we welcome this improvement, it is already factored into the revised earnings guidance of 21 June. 12-month rolling average growth should turn positive in coming months. With a positive tariff environment and assuming e-referral volumes remain stable the outlook for RHC UK’s revenue growth appears to be improving, also assisted for reporting purposes by AUD depreciation relative to GBP.

Brownfields expansion made a historically small contribution to the 1H18 result but was due to rebound in 2H18 and FY19 as several hospitals and facilities matured. This was not mentioned in the 24 June downgrade, a concern because it means the industry slowdown and arrival of monthly volatility is possibly undermining management’s expected returns on the new facilities. The new procurement cost savings joint venture with a US NGO was also not mentioned as an offset.

In February the Federal Opposition announced a populist policy to cap growth in private health insurance premiums at 2% pa for two years. If strictly implemented, this could prevent RHC extracting price gains from insurers and therefore weigh on revenue and profitability while costs continue to rise regardless. ROE would fall. The election is due within a year and at the time of writing the Opposition was more likely to win the election, according to betting markets, than the government. Consensus earnings and RHC’s share price will factor in this risk.

Meanwhile the metric for guidance, core EPS, has lost some credibility after the downgrade due to the perception RHC is expensing high rental and operating costs as non-cash charges below the line, and is therefore straying into aggressive accounting and reducing its earnings quality. This follows two successive lower-quality earnings results (2H17, 1H18), the first where cashflow deteriorated significantly and the second where RHC barely met the lower end of its guidance range due to lower interest and tax expense.

Having signalled an intention to make further offshore acquisitions, RHC last week made an unsolicited takeover offer for pan-European healthcare company, Capio AB, through its 50.9%-owned subsidiary, Ramsay Generale de Sante (RGdS). The offer is 48.5 Swedish crowns per share, which values Capio’s equity at €661m. Funding will be via debt and equity. RGdS has an underwritten incremental debt facility and will undertake a rights issue for a planned amount of €510m. RHC will subscribe for its pro-rata share of the RGdS equity raising, which will be debt-funded. RHC’s net debt/EBITDA would increase from 1.8x to ~2.0x.

We have seen estimates of ~8.8x EV/EBITDA and ~20x PER for the transaction, so it is not cheap. Despite this the management of Capio AB has rejected RGsD’s offer as “not adequately reflecting the fundamental value of Capio”.

Capio offers a broad range of medical, surgical and psychiatric services through its hospitals, specialist clinics and primary care units. The business operates in three regions: Nordic (57% of group net sales 2017), France (35%) and Germany (8%). In 2017, Capio saw organic sales growth of 2.3% and total sales growth of 8.9%. Capio generated 2017 EBITDA growth of 5% at a margin of ~8%.

RHC likes Capio’s technology capabilities and integrated care model. Capio’s ‘Modern Medicine’ strategy of integrating with primary care networks has sustained procedure volumes and delivered steady improvement in hospital growth and profitability. Capio’s Nordic business has compounded EBITA at ~19% pa over the last four years. RGdS was an obvious suitor for Capio’s French assets, which would increase Ramsay’s earnings in that country by approximately 50%. The addition of Capio’s Nordic business would be positive given the clear growth and scope for further consolidation in those markets. Both RGdS and Capio have struggled in France so the combination of those businesses could be beneficial in terms of market share, integration and new cost-out initiatives.

RHC expects synergies but given the full offer price the acquisition would not add to ‘core’ EPS for at least two years and first-year accretion would be 3-5%. An offer sufficient to secure the Capio board’s approval could push EPS accretion out to the third year unless revenue/cost synergies can be increased. So this is not a catalyst for a rerating of RHC shares, which closed today where the share price was before the announcement. There are no earnings implications for the time being given Capio rejected the offer.

 

Valuation

Post the downgrade, share price fall and cuts to consensus earnings, RHC now trades on ~19 times FY19 consensus EPS. This is high for a stock with mid-single and slowing digit EPS growth with elevated uncertainty about future growth. The market will question the multiple if there is another disappointment. We have rebased our valuation to reflect the slowdown in earnings growth and the increase in earnings and value risk in the form of monthly operating volatility. RR is higher at 10.1%, up from 9.8%, to reflect the arrival of monthly volatility and the increased difficulty of forecasting profitability. Adopted NROE is unchanged at 33%, which was already deliberately below consensus for conservatism.

A central question now is the core EPS growth guidance for FY19. Will it be ~7%, the new guidance for FY18, or ~6%? FY19 intrinsic value lies between $55.98 and $58.60 depending on whether RI is 6% or 7%.

This leaves RHC sufficiently undervalued to hold though a less compelling investment than when RI was 11%. We will hold RHC until we find a better use for the funds – which is how we think about every stock in the portfolio.

 

Clime Group owns shares in RHC.

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