Is Ramsay Health Care a property play?

Private hospitals were the best performing real estate assets in 2017, according to a recent report by commercial agent CBRE. Asset managers and pension funds desperate for reliable growth have been clamouring to buy hospital property. Over the past decade, hospital real estate investments returned 16% on average. Prices rose 25% in 2017 alone. Rental yields have fallen from around 9.4% in 2009 to 6.4% today.

The first rule of fishing is to fish where the fish are. And when it comes to private hospitals, the big fish is Ramsay Health Care. Not only is it the largest private hospital operator in Australia, with more than a quarter of available beds, but it's the fifth largest hospital group in the world. 

The opportunity is this: despite prices for hospital real estate - that is, the actual land and buildings - rising dramatically since 2016, the share price of Australia's biggest owner of hospital real estate has fallen 30%.

In August, the second biggest fish in the pond, Healthscope, revealed plans to spin off its 29 freehold properties (generating 65% of operating profits) into an unlisted property trust and then lease them back. The company said assets with a book value of $1.0bn would be put into the trust and that it would generate around $80m-90m in rental income, paid by Healthscope. 

This sale-and-leaseback set-up has a few benefits: it frees up capital that can then be used to fund further expansion projects, pay off debt, or be returned to shareholders; it allows Healthscope to maintain control of the properties, as the company would keep a 51% share of the trust; and, as management put it, it lets Healthscope take advantage of 'attractive valuations ... well in excess of Healthscope's trading multiple'.

We doubt the property trust idea will pan out, though. In the past six months, the company has received two takeover offers, including a bid from an AustralianSuper-led consortium of asset managers for $2.36 per share, which was renewed yesterday. We suspect shareholders will opt to sell the company entirely, rather than mess around with an unlisted property trust. 

Healthscope times two

Ramsay also owns the freehold on most of its 72 Australian hospitals and could do a similar sale-and-leaseback spin-off. We'll focus on its Australian property and leave the overseas assets for another day (the UK hospitals are partially leased, and the French assets are mixed in with many smaller clinics).

Ramsay has $3.6bn of land and buildings on its books. Management doesn't detail what proportion of this is in Australia, but we know that around 50% of total assets are Australian. And we know that most of Ramsay's goodwill was accrued overseas, where expansion has mainly been by acquisition, rather than construction. It seems likely that around two-thirds of Ramsay's land and property assets are here in Australia, giving the local property portfolio a book value of around $2.2bn, compared to $1.3bn for Healthscope. 

It gets better, though. Accounting rules mean that both Ramsay and Healthscope's hospitals are recorded at their cost to build, not their current value. While the bulk of Ramsay's portfolio has been acquired or built in the past decade, roughly a third was added more than 10 years ago and the book value of these properties substantially understates their true value.

Very nice, how much

Healthscope and Ramsay have similar, well diversified portfolios of high-quality hospitals in prime locations. Both portfolios have similar levels of profitability: Ramsay's hospitals generate around $5.0bn a year in revenue and $913m in earnings before interest, tax, depreciation and amortisation (EBITDA) - a margin of 18% - while Healthscope's stable generates $2.1bn in revenue and $344m in EBITDA, for a margin of 16%. 

Hospital by hospital, there are differences in location and profitability, but for the sake of this exercise all we need to know is that both companies' portfolios are similar, on average, in everything but size. 

So let's grab our calculators. Healthscope's management believes the company will pay $80m-90m in rent to the property trust if the spin-off goes ahead. Ramsay's portfolio is just over twice the size, so it's reasonable to assume it could command around twice the rent - call it $175m-200m. 

Using the average capitalisation rate of 6.4% for recent hospital sales, as in the CBRE report mentioned earlier, Ramsay's local hospital properties could be worth $2.7bn-3.1bn - though it's easy to imagine that investors would be willing to accept a lower yield, given Ramsay's above-average assets. We wouldn't be surprised if the capitalisation rate was at the lower end of the usual 5-7% for hospital properties. At 5.5%, it would push the value of Ramsay's local real estate to $3.2bn-3.7bn.  

Not so fast

Given the frothy market for healthcare property, Ramsay may be tempted to sell its real estate - if only to wipe clean the company's net debt of $3.2bn. Nevertheless, Ramsay's management hasn't expressed any desire to spin-off the underlying properties. Indeed, we hope Ramsay holds onto them. 

Ramsay has several competitive advantages, such as economies of scale, high barriers to entry, expertise, and top medical staff. But perhaps its biggest competitive advantage is its land and buildings. From acquiring a large enough plot of land, to the significant development costs, regulatory oversight and licensing hurdles, building a new hospital can take many years and hundreds of millions of dollars. Many of its hospitals are local monopolies. Hospitals don't have the same level of irreplaceability as infrastructure like Sydney Airport, but they're modern day fortresses in a world where competitive moats are narrow. 

If Ramsay were to sell its hospitals and lease them back, it would become a healthcare version of toll-road operator Transurban - amazing assets, but limited lifespan. Let's say Ramsay sold its property and signed onto a 30-year lease. At the end of that lease, the landlord would have significant negotiating power to increase rents and 'capture' much of the company's profits. You hate moving house? How many boxes would you need to move a hospital? Although Ramsay's profitability comes from operating hospitals, its competitive advantages are intertwined with the real estate.  

Some of these risks can be offset, such as by structuring a deal like Healthscope's proposal, where Ramsay would keep a majority stake. But once other owners start to get involved, there will still be a conflict between what's good for the property trust and what's good for the hospital operator. Ramsay doesn't need that kind of headache. Plus, its balance sheet is in better shape than Healthscope's, so it doesn't need the capital either. 

Preoccupying opportunity

Nonetheless, it's good to know that there's a group of tangible, high-performing assets on the balance sheet that could be sold for substantially more than their book value. Ramsay's Australian real estate holdings account for around a third of the company's $11bn market cap, providing a nice floor to our valuation. And we haven't included its portfolio of French and English hospitals, which account for another billion or more in real estate value. 

Ramsay isn't without risk and, like everyone else, we're concerned that the declining rate of participation in private health insurance - which has fallen from 47% of the Australian population in 2014 to 45% today - could lead to a more sluggish growth outlook for the company. Nonetheless, insurance affordability issues and slowing growth aren't a secret and are probably 'priced in'. 

Mr Market's current preoccupation with declining participation misses the big picture: over the past 15 years, the number of private hospitals has risen from 509 to 630, while the number of public hospitals has declined from 726 to 700. More than ever, the Government is relying on private providers, either to lure patients away from the public system or to outsource services. With the Medicare budget stretched and public hospital wait times on the rise, we expect this trend to continue despite the current blip in participation. As the economist Herbert Stein put it: 'If something cannot go on forever, it will stop'.

Ramsay's stock currently trades on a free cash flow yield of 4.8% and a price-earnings ratio of 19. That's no giveaway but it's a good price for an excellent business. With economies of scale, a dominant market share, and a world-class property portfolio, we're sticking with BUY.