Companies provide the ultimate test for Darwin’s survival of the fittest theory. To flourish over the long-term, those running businesses have to suppress emotion and adopt a rational approach to their environment and opportunities. Failure turns today’s market leader into tomorrow’s juicy morsel for a better evolved competitor. South Africa’s private hospital groups reflect the reality of a home base where political ideology threatens their pocket of corporate excellence. So the Big Three have expanded internationally, MediClinic most aggressively through a strategy where it now derives 70% of its profit outside of SA. In this in-depth discussion, independent investment analyst Mark Ingham takes us through the relative attractions of the Big Three, all of which offer pretty good value after recent reversals in their share prices. At my urging, he also shares his top selection. – Alec Hogg
This special podcast is brought to you by EasyEquities and as per regular, Independent Investment analyst, Mark Ingham, joins us now from Johannesburg. Mark, you’ve been having a look at a sector and you like to go for those that are offering value, which is coming across the radar increasingly, because of its globalisation, the private hospitals or the healthcare area. What triggered your line of enquiry here?
Alec, I think the sector has been a bit out of favour of late. There’s regulatory risks swirling, there’s the politics, not only here but abroad, there’s also the local Competition Commission Enquiry too. There’s been some dampener around that. The outlook there is uncertain at the moment and what the implications will be for the industry and pricing.
Then of course we’ve seen the industry spread its wings. We had news just this last week out of Life Healthcare that it’s buying into England and the share prices having come off. They were previously pricing in defensiveness but perhaps a bit too much defensiveness, so they have come back to much better value levels. I think particularly Life Healthcare looking reasonable at these levels. Mediclinic too was affected negatively, after its recent results and so just looking at the sector fresh. Netcare has just recently released results too, and generally speaking the fundamentals of these groups are sound, Alec. Nothing has given me cause to think that the underlying economic performance of these groups will change for the worse any time soon.
Factoring all this into the mix, we have a sense of what the risks are. We have a sense of the opportunities and I think that the added realism too, that’s come into the market as to what these businesses can deliver from an earnings point of view. So, with that background in mind, I’ve been taking a fresh look and I think in a market that has been quite stretched in certain areas, always looking for good value for those who are prepared to look beyond the horizon. I think this is one sector… If you understand the risks, but you understand the opportunities too and you have a good sense of where value lies, this is not a bad place to be.
Well, let’s have a look at the ‘big-three’ and starting off with Life Healthcare because that is the one most recently in the news. That acquisition of Alliance Medical Group, tell us a little about it. From the bit of background research that I’ve done and looking into it. They seem to be specialists in scanning and work with the National Health Service in the UK, so it’s very different in many ways to the UK play that Netcare is making.
Very much so, Alec. It’s a business that they’ll be purchasing for an equity value of £593m and then there’s some debt in there, so the enterprise value will be about £800m. It was founded back in 1989. It provides medical imaging, diagnostic services. In the UK that’s just over half of their revenue and then they’ve got Italy, Germany, Ireland, Holland, and Spain. It’s a vertically integrated, end-to-end service, and MRI type stuff, scanning services. They service both the public and the private healthcare providers. They’ve had a long-term relationship with NHS in England. They manufacture and distribute product too.
Life has pretty much indicated that they would like to diversify their healthcare services offering. They also indicated a while back that they would like to look at M&A in English speaking countries, and that would also include Europe too. So, this opportunity came to them, and I think they’ve pounced. The deal was effective this week and all that remains to be done, is for the funding to be wrapped up.
They’ve got British funding in the short-term but, in due course, they’ll get a line of debt together with equity and I think what they set out to do was see just how much equity they would need because the information at the moment, is a bit sketchy. A circular will be out early next year, so I’ve just done some number work as to what equity, debt mix would be necessary for this, and what the earnings impact would be for the company.
Before we go there, this is an interesting story though, isn’t it? You had an oxygen supplier, Afrox, which then got itself involved in hospitals. Then from those hospitals we’ve got Life Healthcare. Now they’re doing a deal that is about 25% of their business, so it’s a very substantial deal, this Alliance Medical Group, which is in a UK medical field. It’s always interesting to see how companies evolve from many, very different beginnings.
Yes, Life, and previously Afrox Healthcare, as you correctly point out, has been on quite a journey. Relisted on the market a few years back and has been looking at expanding. It’s got an operation in India, it’s got one in Poland, and both of those are a work in progress. The contribution of those to businesses don’t really make much, from a bottom line point of view, but this deal, in one swoop would mean that over a fifth of earnings would come from abroad and a mix of Pound and Euro income.
I think the deal is doable, on the assumptions that I’ve made. I think many companies, Netcare would be in the same category, have probably come to the conclusion that the scope for growth in South Africa is a bit constrained. It’s a relatively mature market, as far as they’re concerned the number of insured lives isn’t growing that much. So, all of them have spread their wings, the ‘big-three’ if we can call it that, have spread their wings abroad. I think Life Healthcare now falls into that too, in that with this deal it will result in a fairly meaningful amount of income being generated outside of SA.
Of course, they’ve got to pay for it and that’s where you’ve crunched the numbers. Always ahead of a rights issue of a company, the share price does seem to be under some pressure, knowing that there are going to be a lot of new shares available. Investors tend to step back a little bit. Have we seen something similar happening here, with Life Healthcare, given that this is a substantial transaction for them?
Yes, there is uncertainty because we don’t have the details, so I think analysts have got to make some educated assumptions and determine as to what the right mix would be. It results in a combined business that would have approximately R21bn in revenue and about R5.5bn in EBITDA. On the calculations that I’ve done on the cost of the deal, if we take the £593m and assume that’s close to R11bn. Then taking into account the debt that Life Healthcare has at the moment, the debt that is in Alliance Medical, and then looking at what the funding would be for the total deal. I come to the conclusion that they would probably need to raise an additional R7bn in equity, and that would entail, assuming that the new shares were issued at R30. That would entail the issue of 232m shares. They have 1.058m shares in issue at the moment, so on that assumption it would mean that there would be a 22% increase in the total number of issued shares, in order for them to pay for the deal.
That would be a mix of approximately 65% equity, 35% debt. The other question as well is then you’ve got the extra interest that would come from the debt that would also need to be raised, to fund the balance, which is approximately R3.7bn. Put that all into the mix and look at what the after-tax position and interest position would be, and you end up with pro-forma earnings of approximately R2.3bn, for the combined entity after the deal has been done, on those basic assumptions, equity and debt. That compares with earnings just released of R1.9bn, and what it means is that it would give you pro-forma earnings per share of 180 cents, and what that means is that on those assumptions the debt would be EPS neutral. In other words, it wouldn’t be detracting from earnings per share, on that basis.
I think it’s always a question that investors have in their minds, particularly when you’ve got big M&A is, is the deal potential earnings decreasing and if so, to what degree? I think it’s always a challenge for corporate financiers to get that balance right. I think if we assume that, and we also take into account the covenants that are in place. The existing covenants with the banks, insofar as debt/EBITDA goes, which is approximately 2.7 times. They’re comfortably under that at the moment, but if they did a deal on the basis that I’ve just actually mentioned. They would comfortably be within those covenants with the banks and, as I say, from a shareholder point of view, on a pro-forma basis, it’s EPS neutral.
I think the merits of it, financially, certainly stack up and we’ll have further detail around that early in the year. I would expect the right’s issue to be done and dusted by the first quarter of next year.
So, done and dusted, you anticipate that they will be getting support from shareholders, like Allan Gray and Lazar, who’ve been accumulating the stock recently?
Yes, you know often at times I think clearly management has to be close to their banker, their shareholders, (major shareholders), but what we have seen is that SavvyMoney has been buying into Life Healthcare in the last few months, so I think as the stock prices have come under some pressure. Those that have done their number crunching, will have seen that it offers value on a longer-run basis, so we have seen Lazar picking up stock. They’ve got over 10% at the moment, and up quite sharply in the last few months. Allan Gray also doubling its stakes since late last year to 10%, so those are fairly weighty shareholders. I would expect, on the right terms, roughly in line with the sort of numbers that I’ve just indicated, I think you would get adequate shareholder support.
Moving onto Mediclinic, and that’s an interesting one because when you look back, just a couple of years ago, it was a pretty boring, South African private hospital company. Then it went on an acquisition spree. It’s now number one in the Middle East. It’s expanded out its businesses in Switzerland, where it’s the biggest private acute healthcare or hospitals company, and of course now it’s in the FTSE 100, and owns 29% of a British healthcare company called Spire. So, transformed from a quiet sleepy, little Stellenbosch-based unit, to a very serious player in the global community. Yet, when the results came out the market did not like them, (that was earlier this month), they knocked the share price back quite significantly, which I suppose for a value investor says ‘hey let’s have a look – I know you have, do you like it?’
Yes, and I know Remgro likes it too. They’ve supported the strategy of going abroad and also raising capital to that end. They had a rights issue not long ago, so Remgro has been an anchor shareholder at 44.5%, and they, as you well know, Alec, Remgro have a very long-term view on things. They’re a very steady shareholder. They’re invested in a number of firms that are listed and unlisted and I think this is a company that they saw great opportunity for and have backed the management team. I think Danie and his colleagues have done a great job into expanding into new areas.
The Swiss business is over half of their EBITDA, so it’s a good, strong, hard currency earnings place to be and then followed by South Africa, at about a third of EBITDA and then the Middle East, which I estimate will be about 14% this year. Just going back to your opening remarks, Alec. I think there was perhaps too much deal of expectation as to what Al Noor could deliver in the short-term. It’s only been integrated into the company for a relatively short space of time. I think in that period there’ve been some challenges in the Middle East. Not least economic challenges and the affordability associated with healthcare. In addition, they’ve had to integrate and there are a number of things that they have to do, I think in Mediclinic eyes, if you will, Al Noor, and that doesn’t happen in a short time.
They did flag adequately to the market on a couple of occasions, early September and then late September, as to what the operational situation was in the Middle East. They also indicated that the EITDA margin would be approximately 11% for the reporting period of the half year, and indeed that’s exactly what it was. They’ve been very good at steering the market, as to what’s going on. I think perhaps it may have been a bit perplexing for the share price to be clobbered so hard as it was, post the results. Going from just over £9 on the London market and then coming all the way down into the early 7’s. As I speak to you we’re at 7.35 in Pence. I just had a sense that this is overdone because I think the markets almost being pricing, and the fact that there’d be almost a permanent reduction of 20% or so in the underlying earnings.
So, the pricing was over done on the downside. I’ve no doubt that Al Noor will improve its EBITDA margin as time goes on. I think it will be a while before it gets to the sort of EBITDA margins we’re seeing out of the Swiss business and the SA business but it will get there. In the modelling, I’ve done, I’ve assumed a fairly realistic outlook on what they can actually achieve and, on that basis, we’re still looking at a good potential earnings performance out of this group, going forward.
I think also, there’s the possibility too, that they may look to take out the entirety of Spire. They’ve got just under 30%. Of course, with approximately half of your cash coming out of Swiss Francs and with the Pound being depressed at the moment, there is the opportunity, I guess too, for them to take a closer look at Spire, which is a good business. It’s a well-run business. It contributes nicely to their net income and if they did take it out on the right terms, it would be a very handsome contributor too. SA, I think will continue proportionately to decrease in its share of earnings for the group.
Well, if you’re a FTSE 100 company you’ve got to do bold moves like that and I’ve no doubt, as you say that Danie Meintjies and his team will be triggering that in the future. Just to close off the ‘big three,’ Netcare, also results coming out just a few days ago in fact. Now, they were the pioneer in moving into the UK some years ago. Things have not always worked out according to plan on that one but how are you reading it now?
Look, the earnings contribution from the UK is minimal. Its 5% to 6% of the bottom line and that’s largely because of the capital structure that they have in the UK and they’ve got an opco/propco structure and there’s debt associated with that. So, although from an EBITDA point of view, the UK operation is one quarter. When you get to the bottom line it’s relatively small and I don’t see that changing dramatically any time soon. Although it looms over quite large at the top end of the PNL, with half of the revenue out of Britain and a quarter of EBITDA.
The analysts looking at this from an earnings point of view, would essentially see a South African dominated group, so I think from a cost to capital point of view and from a rating point of view, you would probably rate it in line with the SA risk profile. It’s certainly a well-run operation. They’ve invested strongly in their domestic operations over the last number of years. Comfortably profitable and I think they, like their two major peers are also wrestling with some of the local cost pressures and certainly, I think anybody who has health insurance in South Africa, will be facing quite a hike this year. I think everybody is looking at ways in their business model where they can contain costs but yet still keep a good level of service to the paying customers out there.
I think the other thing on the agenda, for all of these hospital companies too, is the degree to which there can be more public/private cooperation in the future. I think particularly given the fact that public health in South Africa is failing and there’s a lot of expertise and learnings that these companies can provide to Government, to ensure that there’s a far better service delivery. A far better clinical outcome and I know all the teams are cooperating closely in this regard, and I would hope in the next months and years that there can be far more cooperation between private and State.
Netcare, I think offers an attractive yield. I think one should be a bit circumspect on the degree to which these companies can grow. I think there are limitations to the degree to which they can grow revenue and profits in this more, downbeat sort of environment. I think for investors that are looking for a relatively reliable cash flow stream, and a comfortable cash divvy, all of them offer different aspects to them, different geographies, different makeup of the earning streams, but they all offer, I think, relatively good value for money, at a time when some aspects of the market are looking a little stretched.
But if you could only buy one or pick one of the three, which would it be?
I’m on record, Alec, as saying that if I had to buy one it probably would be Mediclinic. That’s not to say that the others aren’t good value for money or that they aren’t as good. I felt for a while that the strategy Mediclinic has been employing is sound. I like the mix of operations that they have, at the moment. Understanding the risk profile associated with that and I think now with the share price having come back to relatively reasonable levels. It’s certainly under-priced. I can justify a share price on the company well north of where we are now. The fair value I have on the company, Mediclinic is £8. The target price is £8.40.
If you looked at an optimum situation with Al Noor operating to a level that they would deem good, then I think you could very well get the stock price back to above is £9. Of the three, at this stage this is probably the one I would be actually tucking away.
I think you also, well the intention is that you like Life Healthcare as well, but maybe wait for that rights issue to come out first. You might be able to buy the shares cheaper.
Yes, that’s right. I think around about R30 or so, maybe slightly under, there is a deal of uncertainty at the moment. We await the circular and, of course people won’t be quite sure as to where the pricing will be. I think that’s going to put a lid on the price in the short-term. But I think once that is nailed down, early in the new year, and we know where we stand. Then I think you will probably see a sort of positive momentum coming into the stock. In the absence of that lack of detail, hence the work I’ve done around ‘what if’ and looking at what the implications potentially could be. So, yes, I think there is a cap in the short-term. We could even see the stock prices trading at about 32 at the moment. We could see it ease back further.
I think if you’ve got your powder dry, you’ve done your homework, you’ve looked at what they’re doing, and you look at the quality of the asset that they’re buying in the UK, then at the right time, even if you’re a little uncertain at the moment, at lower levels it will be a good time to go in and I think you will probably look back in a year or two or three, and see it as a fairly good entry point.
Mark Ingham, is an Independent Investment Analysist, and this special podcast was brought to you by EasyEquities.
