Primary Health Care: a finger for every pie

I can't help but feel a little sorry for Primary Health Care. It's always been a bit of a misfit, unable to find its niche in the corporate schoolyard. The company has grown from a single Sydney practice to a $1.8bn network of medical centres largely because it was among the first to see potential in 24-hour bulk-billing clinics and their ability to lower the cost of healthcare.

Actually, no - that's just the story most people are familiar with. The company's GP practices are the front line of healthcare - performing 8 million consultations a year - so that's what most of us think of as Primary's bread and butter. However, the Medical Centre division has had declining profitability for several years, while the company's other divisions have been growing. Medical Centres are now a lowly third place so far as each division's profit is concerned. 

Primary's clinics have made GP visits more affordable and more convenient, but bulk-billing is low-margin work and Primary relies on high utilisation of its clinics. It achieves this by offering multiple services such as physiotherapy, dentistry, radiology and IVF, to ensure people are constantly flowing through the doors.

The next Ramsay?

This 'one-stop shop' strategy has led Primary to make a hodgepodge of odd acquisitions, and it increasingly resembles some sort of warped Play-Doh Fun Factory experiment. 

The latest slab is Montserrat Day Hospitals, which operates five day-hospitals and two haematology/oncology clinics in Queensland, Western Australia and New South Wales. 

Montserrat will be combined with Primary's five existing day hospitals to form a new division and, given the price Primary is paying - which we'll get to later - management is clearly banking on significant growth. Whether we see it, though, is open to question. 

On the one hand, Montserrat is developing three new facilities and has an agreement to purchase a private hospital in Western Australia. This should provide a short-term boost to capacity, so Primary's new day hospital division has a better chance at growing earnings than the company's pathology and medical centre operations, which had poor revenue growth and declining profitability this year.

Nonetheless, Primary is no Ramsay Health Care. As we explained in our recent upgrade of Ramsay, overnight hospital admissions have been slowing and day hospital admissions have come to a standstill - industry-wide, standalone day hospitals had flat volume growth in the year to June, with 4% growth for day admissions at largescale private hospitals. Day hospitals are also more likely to cater for minor elective and cosmetic surgeries, compared to the major operations performed in Ramsay's large hospitals, so revenue will have an added swing factor. 

Whatever the performance of Primary's new hospital division in the short term, it will only be a minor contributor to the company's bottom line and will account for less than 10% of earnings before interest and tax (EBIT), compared to Medical Centres (~14% of EBIT) and Imaging (~18%). All of these, however, are a sideshow to Pathology, which accounts for over 60% of EBIT. 

Hidden benefits

We don't expect Montserrat to transform Primary into a high-quality hospital stock, but that's not to say the acquisition won't act as a fertilizer for Primary's services.

The company's biggest money spinners - pathology tests and diagnostic imaging, such as X-rays and MRI scans - rely on two things: doctor referrals and convenience. 

It's illegal for Primary to financially incentivise or coerce its GPs into referring patients to pathology and imaging tests. However, it doesn't have to when patients go to one of its clinics out of convenience. It's a story all of us have probably experienced - you go to the doctor, they refer you to get a test and, as you walk out the door, you notice a pathology collection centre just across the hall. Are you going to bother shopping around, particularly when Medicare probably covers the bill? No way. Co-locating imaging and collection centres in Primary's day hospitals is likely to provide a constant stream of doctor referrals.

The company's pathology business might get a further bonus from lower property expenses. Since 2010, the pathology division's EBIT margin has fallen from 16% to just 10%. By far the biggest reason for this is the company paying higher rents for its network of collection centres, following deregulation of the industry earlier this decade. Primary pays the highest rents for collection centres located in an independent medical practice, so the more centres that can be moved to its day hospitals, the better. 

Virtus copycat?

The Montserrat acquisition might also be bad news for shareholders of assisted reproduction providers Virtus Health and Monash IVF, due to Primary's plans to expand its bulk-billing fertility business. Primary's management said it would 'take advantage of Montserrat facilities as we grow our specialist businesses, like IVF'.

Virtus already uses day hospitals to support its IVF business by providing the facilities for use by its fertility specialists. This is where the eggs and sperm are collected. 

Virtus's day hospitals generate a bit under half their revenue from IVF procedures, and the rest comes from other specialist fields such as ophthalmology, urology and dentistry. IVF, however, is a cyclical industry and treatment volumes tend to experience significant volatility. By renting its operating theatres to other specialties, earnings are stabilised and it reduces the chance that an expensive operating theatre is left idle if IVF demand wanes, so their fixed cost is spread across a higher volume of procedures. Day hospital revenue also mainly comes from private health insurers, rather than Medicare, which reduces the proportion of earnings exposed to Medicare fee changes and Government budgetary constraints. 

With this in mind, Primary's move into day hospitals looks like a sensible move, and the financial and efficiency benefits will help reduce costs for its IVF and other specialist businesses. With its IVF strategy centred on being the lowest-cost operator, that's bad news for Virtus and Monash as it could lead to greater pricing pressure within the industry.

Better, not great

The Monserrat deal is expected to complete in November and Primary will make an upfront payment of $75m, with additional performance-linked payments able to push that figure to $139m through to 2021. Montserrat is expected to have earnings before interest, tax, depreciation and amortisation (EBITDA) of $7m in 2018, so Primary is paying what looks like a pretty rich figure.

The company is raising $250m via a non-renounceable entitlement offer to fund the purchase. You might spot the glaring mismatch between the capital raising and the purchase price - Primary intends to use the rest of the funds to modernise some of its medical centre properties and will put $100m towards a new software platform for its pathology division. 

Unfortunately, none of the money has been earmarked for reducing net debt, which stands at $770m. Interest expenses consume nearly a third of Primary's operating profit so the company's balance sheet is still a concern. 

The benefits of Montserrat and the medical centre upgrades aren't enough to offset the risks from a stretched balance sheet. Top this off with declining profitability in its major divisions and you can see why we're still happy to AVOID.