Healthscope in the waiting room

Compared with Ramsay Health Care, Healthscope is a bargain. But is it cheap?

Compared with Ramsay Health Care, Healthscope is a bargain. But is it cheap?

Ramsay, Australia's largest private hospital operator, currently sports a price-earnings ratio (PER) of 34 and dividend yield of 1.7%. Despite being a very similar business, when Healthscope floats later this month it will have a PER of 25 and a yield twice that of Ramsay's. There's a lot to like about this business but, growing at only 5-8% a year, it's too expensive.

Despite public hospital funding increasing 145% in the decade to 2012, for patients at the bottom of waiting lists, wait times increased by 31%. The Government also recently proposed cutting public hospital funding by $15bn over eight years. This, along with financial incentives like the private health insurance rebate, guarantees increasing demand for private hospitals. Ramsay and Healthscope are set to take most of the spoils.

US private equity giants TPG and Carlyle bought Healthscope for $2.6bn in 2010, then added more beds and operating theatres at a cost of $196m. Healthscope now employs 20,000 people and owns 44 hospitals, which contribute about 75% of the company's $2.3bn in annual revenue.

Increasing demand and utilisation has helped lift revenue by 16% since 2011, whilst costs increased by just 14%. If there's one mob that can control costs, it's private equity. That 2% difference may not sound like much but with hospitals delivering thin margins and admin expenses accounting for over half of all costs, this apparently small improvement helped boost net profit by 39%, from $106m to $147m.

In 2001, Healthscope had just 17 hospitals. After a buying spree, many of its hospitals became regional monopolies. Not only that, the industry itself offers plenty of barriers to entry. The cost of building and accrediting a new hospital is immense and establishing relationships with local GPs takes years. Ramsay and Healthscope's market positions aren't impregnable but we'd expect them to gradually increase their share of the private market from today's 25% and 17% respectively.

To keep pace with demand, and the Government's growing dependence on outsourcing public elective surgeries to the private sector, Healthscope will invest about $274m to expand nine of its hospitals before 2017.

Growing scale also increases negotiating power, which is important in this business. The private health insurance industry is dominated by a handful of players, including listed NIB and soon-to-float Medibank Private. Because the Government needs to approve premium rises, the companies are finding it more difficult to pass on costs to their members. As a result, they're becoming more aggressive negotiators.

With 80% of Healthscope's revenue coming from private health insurers, this is a battle between one oligopoly and another. So far, with Healthscope and Ramsay accounting for such a large portion of the industry, they have the upper hand. The insurers simply can't walk away.

Then there's Healthscope's secret weapon. Michael Sammells, the company's chief financial officer (CFO), is a former CFO of Medibank, Australia's largest private health insurer. Knowledge gained from his time on the other side of the negotiating table is surely invaluable. The formula is, in the end, quite simple. As Healthscope expands, its negotiating power improves, making it a more defensive, profitable business.

In addition to the hospital division, a fifth of Healthscope's earnings are from pathology. Pathology tests typically rely on expensive equipment, so there's a strong incentive to ensure these machines don't lie idle. Dominating local markets helps achieve that objective.

Healthscope is the third largest pathology network in Australia with 7% market share, behind Sonic Healthcare and Primary Health Care. But third place is barely enough to turn a profit.

Sonic and Primary have been taking market share from Healthscope since the deregulation of collection centres. Healthscope wrote off $120m from the value of its pathology assets in 2013 following the sale of its WA operations to Sonic in October 2012. Unlike its hospitals, Healthscope's Australian pathology operations face a losing battle.

But in New Zealand, where Healthscope services 65% of the population and is the sole provider on the South Island, the situation is much better. The company's international pathology division, including NZ, Malaysia and Singapore, has an operating margin of 23% – higher even than the 18% Sonic achieves locally and a far cry from the 6% Healthscope's Australian labs deliver.

The New Zealand business is mature so we can't expect much growth, but it's a far better business than the Australian operations, which look primed to be sold subject to competition concerns.

So what's Healthscope worth? The float closes on 22 July and the company should begin trading on 31 July. The final offer price is expected to be between $1.76 and $2.29 with about 1.2bn shares on offer. Carlyle and TPG plan to retain a combined 20% to 30% stake in Healthscope, which will carry net debt of $866m.

With an enterprise value of around $4.5bn, Healthscope will trade at about 16 times forecast earnings before interest and tax of $285m for 2015. Net profit is expected to be $147m for the year, increasing to $166m in 2015. Yes, there's growth but on a forward PER of 22, you're already paying for it. As for efficiency and cost reductions, most of those have already gone to private equity.

Despite the defensive earnings, favourable industry fundamentals and high quality New Zealand pathology business, Healthscope looks fully priced. With a dividend yield of just 3% and private equity selling, there's not much in the way of a margin of safety. There's a good business here but we'd need a far lower share price to recommend it. AVOID.

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