Nov 11, 2020
The world is currently grappling with a resurgence in COVID-19 cases. New daily infections in Europe, the US and many emerging markets are now far exceeding those experienced in the first “wave” in March. There is an argument to be made that the coronavirus is transient in nature, and will pass (whether through treatment, vaccine, better coordination or society adapting to live with it). Corporate operations will return to a pre-COVID operating normalcy and with it, this ‘bounce-back’ and mean-reversion (to either valuation metrics or operating metrics) will lead to a significant recovery in share prices. Whilst we agree that those investment opportunities exist, the hospital stocks are not amongst them.
Netcare, Life Healthcare and Mediclinic all reached peak share prices within 6 months of each other, between November 2014 and April 20151. They have all since underperformed our market – justifiably so, in our opinion.
Figure 1: Share price performances of Netcare, Life Healthcare and Mediclinic* (R/share)
Source: Bloomberg, Ninety One *Mediclinic’s share price change and dotted line in February 2016 reflects the reverse takeout of Al Noor and primary share listing change from the Johannesburg stock exchange to the London stock exchange.
They have faced similar operating difficulties over this time and market sentiment soured further with their unsuccessful, and value destructive, entries into foreign markets over the last ten years. In short:
Their offshore endeavours demonstrated poor allocation of capital, driven by a combination of ill-executed business models, deteriorating operating environments and the most material factor, in our opinion: regulation. Whilst government regulations may be out of management’s control, the high regulatory risk should have been appropriately captured in the upfront price they paid for these assets. Even if the management teams fail to properly assess an asset’s value, the onus still falls on investors and the valuation multiples we are willing to pay for these stocks.
In October 2015, Poland held its national parliamentary elections, in which the right-wing Law and Justice Party won a decisive majority of parliamentary seats. Nine months after the elections, on 1 July 2016, the Polish government introduced a new tariff plan for cardiac procedures that reduced the price private hospital operators would receive for performing these procedures by 17%. A further 11% tariff reduction was introduced in January 2017. At the time, Life Healthcare owned and operated 52 medical facilities in which cardiology accounted for 45% of revenue. In their next financial year results (to September 2017) following the regulatory change, Poland’s normalised EBITDA declined by 63% and the EBITDA margin fell to just 4.0% from 10.2% in the prior financial year.
In Switzerland, on 1 January 2018, the government significantly reduced the tariffs it would pay private hospitals for outpatient treatments. As the tariffs were gradually rolled out to more cantons and more procedures were added to the outpatient category, Mediclinic’s Swiss EBITDA margin declined from 20% in the 2017 financial year ended March, to just 16% in the 2019 financial year – directly due to this regulatory change.
Lastly, the United Arab Emirates introduced a law in July 2016 forcing nationals on the government health plan to co-pay 20% of admission costs should they wish to use private facilities, versus no payment going to a state-run facility. Mediclinic’s inpatient volumes amongst nationals declined by 33% the following financial year and the EBITDA margin nearly halved, from 21.3% to 11.7% (though there were other complications in the business that also contributed to this decline).
Poland, Switzerland and the UAE are unrelated countries, with different healthcare policies, but a unified goal: reducing the cost of healthcare on fiscal budgets. The cost to provide healthcare due to ageing populations, unhealthy lifestyles and a rising burden of disease is an incredibly complicated problem to solve worldwide. In our opinion, it leads to more downside risk than upside to private healthcare operators as governments will exert this pressure onto the private sector. This is further complicated by political cycles that on average last five years. With every new elected government, there are usually new regulations that can require significant operating model adjustment by the operators.
Valuation multiples have been derating for two primary reasons. The first is the regulatory risk and associated forecast risks hospital companies face, as described above. One cannot place a high valuation on an operation where profitability could quite literally halve overnight. We believe regulatory risks are likely to rise in a post-COVID world.
Figure 2: Forward 12-month PE multiples for the hospital stocks (X)
Source: Bloomberg, Ninety One
The second reason for the derating is the progressively lower growth they’ve delivered over the last five years.
Figure 3: Historic year-on-year revenue growth of the South African hospital operations
Source: Company data
Put together, hospital companies have none of the attractive, steady profit attributes that are associated with other low growth but essential services sectors (such as consumer staples or food producers).
Today’s valuation metrics reflect their operational realities better than ever before. That said, we do expect their valuation multiples to recover from current levels, just like the rest of the equity market will as the economy recovers. However, the hospitals’ share price recovery won’t be as great because the multiples they recover to will (and should) be lower than their historic average. There is no valuation mean reversion to come for these operators – unless they can reinvent themselves away from just being acute healthcare providers.
Figure 4: Netcare’s forward PE multiple relative to history (X)
Figure 5: Life Healthcare’s forward PE multiple relative to history (X)
The hospital operators have received consistently negative earnings revisions over the last few years that go beyond the regulatory headwinds or their acquisitive missteps. They face significant structural challenges.
The share prices have tracked underlying operating margins closely, with occasional deviations as news flow on regulation or corporate action have arisen. But by and large, the share prices best reflect their operating realities. So, what’s critical to the investment case is determining where operating margins will recover back to post the recent weak COVID-driven results.
We need to reflect on the reasons for the margin compression before the coronavirus even hit to answer that question. We will review South Africa, where all the companies’ operations overlap and which is to varying degrees still an important driver of earnings.
Figure 6: Historic EBITDA margins for the SA operations*
Source: Company data, Ninety One estimates. *We also include Mediclinic’s Switzerland operating margin, as it contributes over 50% of group profits and is the dominant driver behind share price performance. | The “last update” period refers to the latest data points the companies disclosed: Netcare’s 11-month margin to end August, Life Healthcare’s margin from March to July 2020 and Mediclinic’s 6-month margin to end September. | All margins are on an IAS17 accounting basis, barring Mediclinic’s “last updated” margin of 8%, which is on an IFRS16 basis.
From 2009 to 2015, the hospital groups benefitted from job growth, more people getting private medical cover, resulting in increased medical demand that created the opportunity to build more hospitals to service said demand.
However, SA’s macroeconomic realities began to encroach. The lack of job creation saw privately insured lives growth stall, which led to slowing volume growth (measured as patient days). The new facilities that were built now faced a smaller-than-anticipated market to serve. Occupancy rates began to drop as the new beds were not matched by new patients. Unfortunately, hospitals have a relatively inflexible, high fixed-cost base, and so margins began to compress.
Figure 7: Historic year-on-year volume growth (measured as paid patient days)
Source: Company data
Figure 8: SA hospital occupancy rates
Source: Company data
Insurers faced their own operating pressures. Funders restructured tariff plans with the hospital companies. Contracts were adjusted to a fixed payment method where insurers would pay for procedures at an agreed upfront fee. Generally, any costs that ran over this were borne by the hospital groups. Doctor behaviour also came under scrutiny and the funders stopped what they considered unnecessary admissions.
More affordable network schemes were launched, with plans that limited choice of where a member’s care could take place. These schemes came with even tighter tariff pricing to the hospital operators: increased volumes directed to certain facilities, but at lower tariffs. Faced with the abovementioned low occupancy rates, volumes were critical for hospitals to maintain operating margins. Pricing for these tenders became increasingly competitive between the operators.
Meanwhile, operating expenditure continued to rise. Nurses’ wages account for over 60% of the cost base and are CPI-linked. Overhead costs at hospital facilities are largely fixed. The groups have managed to adapt where possible. More stringent nursing shift coordination, centralising procurement to negotiate lower the cost of the PPE and consumables from suppliers, installing renewable energy and even switching underutilised beds to higher in-demand medical disciplines have all helped. It has been a commendable efficiency programme launched by all three operators. Regardless, the operating margin decline has continued.
Over the coming nine months the operators will experience a strong recovery in volumes; by our estimates the highest growth in six years. Most of the elective procedures that were delayed due to COVID-19 will return. The burden of disease has not disappeared. This catch-up will run with the ordinary volumes one would expect. However, the full benefit of this near doubling of activity won’t be fully realised in operating profit. The cost of operating in a COVID environment are higher. Screening all entrants to facilities, more frequent cleaning and higher PPE inventory have intensified. Maximum bed capacity is also lower. Some beds will need to be ringfenced for coronavirus patients and associated social distancing needs mean fewer beds for a given area. It is not easy to reduce nursing staff or shifts in this environment.
Beyond the next nine-month bounce, the long-term trends will resume, and likely at an accelerated rate.
The weak economic environment will result in more consumers migrating to the more affordable network plans – the very plans associated with the toughest tariff pricing the hospital groups receive, as described earlier. Average revenue per paid patient day will fall.
The best case scenario for the hospital groups is that privately covered lives will remain the same. Under this scenario, hospital companies will see an increase in volumes of around 0.5% to 1.5%, which is the natural volume growth that comes with an ageing population.
The most likely scenario, though, is that the covered population will decline due to job losses, which is magnified for the hospital groups. In the event of one principal member dropping medical cover, you also lose their dependants. The average ratio of principal: dependant members in South Africa is 1:1.2. In other words, hospitals lose at least one other potential patient for every principal member lost.
Our view is that tariff pricing pressure will remain, average revenue per patient day will decline on what will likely be lower volumes. Future operating margins at acute facilities are unlikely to exceed the margins delivered in 2019 for a sustainable period. Thus, operating profit growth will remain in the low to mid-single digit range. We see little scope for earnings to turn positive beyond 2021. To reverse this trend, the operators will need to diversify away from acute care into other areas of the healthcare continuum – sooner rather than later.
Life Healthcare acquired a UK-based diagnostic imaging company, Alliance Medical Group (AMG), in 2016 and is currently looking to buy radiology practices in SA.
Netcare acquired a specialist South African mental health operator, Akeso, in 2018. Mental healthcare needs are rapidly growing in South Africa and it will be the main driver for bed growth going forward. Life Healthcare is also expanding its existing mental health footprint. Mental health care generates materially higher operating margins than acute care.
All operators are either building or reconfiguring their existing sites to day-care facilities, which are lower cost to run. Where possible, we expect some under-performing hospitals to be sold or closed.
Fertility clinics, recovery facilities, old age care and telemedicine are some of the many new areas the operators are investigating. We watch these developments closely. Depending on the nature and size of an acquisition it can change the operational prospects for them. But in the near term, given the balance sheet conservatism they’ve implemented in the wake of COVID, game-changing acquisitions have likely been delayed. For now, whilst acute care still contributes 90%, 67% and 69% to NTC, LHC and MEI operating revenue, respectively, growth and valuation multiples have little upside.
Our philosophy of investing in companies receiving positive earnings revisions that trade at a reasonable valuation has steered us to be underweight the sector over the last five years. It is clear that acute hospital operators are not the high growth, dependable earnings generators they once were. The perception that these stocks are attractive because they provide a critical necessity service that will structurally always be in demand has been shattered.
The steady earnings revisions for the hospital companies ended in 2015. Figure 9 and 10 indicate the earnings forecasts for Netcare and Life Healthcare for their financial years, starting from 2013.
Figure 9: Netcare share price (RHS) and earnings forecasts per financial year (LHS)
Source: Bloomberg, Ninety One
Figure 10: Life Healthcare share price (RHS) and earnings forecasts per financial year (LHS)
Source: Bloomberg, Ninety One
It is easy to remain bearish on these names and write them off, but it is exactly in these circumstances (where expectations become overly bearish or bullish) that our investment philosophy identifies new investment opportunities. The earnings base is low and the forecast risk is higher than it was five years ago, thus any change in earnings expectations to the positive can be a share price catalyst. We continue to monitor the hospital names closely and have a relative preference to Life Healthcare and Netcare over Mediclinic.
Netcare has the best scope to deliver upside with their self-help investment case, should they manage to exit underperforming hospitals, successfully implement the digitalisation initiative they launched last year and continue to focus on shareholder returns as it has the potential to be a highly cash generative operation.
Life Healthcare’s entry into diagnostic imaging has been a strategically positive move, although poorly executed (operating margins have declined from 26% to 20% since its acquisition in 2016). Any sign that they have addressed their operational woes could lead to sustainable, positive earnings revisions2. We also believe it is the hospital best positioned to navigate the structural problems the South African market faces.
Currently, we see more attractive investment opportunities in other SA Inc names where earnings have far higher upside potential and valuations have the scope to rerate higher than the hospital stocks. Amongst the financials, Capitec and Sanlam remain key positions, and in the retail sector we have taken positions in The Foschini Group and Pick ’n Pay.
1 The April 2015 peak refers to Mediclinic prior to its reverse takeover of Al Noor hospitals and primary listing change to London
2 The diagnostics business has also developed a radioisotope to detect a plaque on the brain that is believed to lead to the onset of Alzheimer’s Disease. At time of print, a US pharmaceutical company, Biogen, is currently attempting to get approval for a drug to treat this plaque. Approval would lead to demand for Life healthcare’s radioisotope. Biogen’s drug is a highly contested product amongst the neurology community. It is a fascinating development that will spark debate in the coming weeks.