Ramsay & Healthscope: Results 2016

‘We have commenced a strategic plan to extend our services beyond the hospital walls,' said Ramsay Health Care's chief executive Christopher Rex.

It sounds a little like Ramsay is planning an invasion, and in some ways it is. The company intends to open a network of community pharmacies across Australia, with an initial focus on those areas that surround its existing hospitals.

Normally, when it comes to managements branching boldly into new industries, we think one thing: Don't walk away. Run.

In this case, though, the new venture could actually make some sense. Stand-alone retail stores are something new, but Ramsay already operates 200 pharmacy dispensaries in its hospitals so managment has a good understanding of the industry. Ramsay's size also means it can negotiate better terms with suppliers.

However, we'll be watching the venture with our eyes wide open. Industry profit margins are already in the low single digits and the prices of prescription medicines are under pressure as the Government tries to find savings in the Pharmaceutical Benefits Scheme (PBS). Growth in funding has declined materially over the past five years, with many drugs receiving price cuts.

It's also a hotly competitive industry, and the Government is toying with the idea of making it even more so by overturning a set of archaic restrictions that protect pharmacists from competition (see Sigma & API: The pharmacy wars).

Industry regulation could change materially in the future and, even if it doesn't, the Government seems hell-bent on lowering prescription prices, which would anchor revenue growth at pharmacies and squeeze margins further. Details of Ramsay's plan are still scarce, so it's too early to pass judgement but it isn't without its risks. We'll be watching closely.

Full-year result

Nonetheless, Ramsay has reported another impressive result with revenue increasing 18% to $8.7bn for the year, mainly due to strong admission growth in Australia, acquisitions and the lower Aussie dollar.

Ramsay's Australian business had a particularly strong year with revenue up 9% to $4.4bn (50% of the total) thanks to recent expansion projects and healthy (or should that be unhealthy?) growth in admissions as an ageing population boosts bed occupancy rates.

Smaller competitor Healthscope increased revenue 6% to $2.2bn but increased Aussie hospital revenue only 5% due to ongoing capacity constraints. In other words, Ramsay is increasing market share at its smaller competitor's expense. Still, we expect Healthscope to claw back some of that loss over the next few years.

Ramsay invested roughly $300m in hospital expansions during the year, with 500 additional beds and 26 operating theatres being added to the group. Healthscope, on the other hand, invested a good $440m despite being half Ramsay's size.

Healthscope may be late to the expansion party but it has a larger pipeline of development opportunities. Management noted ‘Our major hospital development, Northern Beaches Hospital, is progressing extremely well and remains on schedule to open in late 2018'.

The company expects to add 980 new beds and 50 theatres to its 4,400 bed network between now and 2018 – a 22% increase in capacity over the next two years (see Will the aging population rejuvenate Healthscope?).

Return on capital

We usually avoid businesses that require lots of cash to grow – so called ‘capital intensive' businesses – but there's a difference between, say, Qantas, and hospital operators.

In Qantas's case, the company rarely produces any free cash flow as it must continually invest in new planes and infrastructure – but the industry is so competitive that margins are dismal and the return earned on all that capital even more so.

Ramsay and Healthscope are in a different position. Negotiating power is a function of competition and Ramsay's 69 hospitals and Healthscope's 45 hospitals are a collection of regional monopolies. In many cases, patients have only one private hospital within driving distance and that gives Ramsay and Healthscope extra muscle when negotiating prices with private health insurers.

The result? Ramsay and Healthscope earned a return on invested capital of 13% and 9% respectively in the year to June. That's nothing stellar compared to a capital-light business, such as REA Group, but with interest rates where they are, a stable, economically immune 9–13% return is extremely valuable.

To top it off, there's plenty of growth ahead, so the companies can keep reinvesting at these rates. Total public hospital funding Australia-wide will be cut by more than $50bn over the next decade, so the Government will need to outsource more and more services to private operators.

Operating earnings

Many of Healthscope and Ramsay's costs are fixed, so, as revenue grows, a larger portion falls to the bottom line. Healthscope's earnings before earnings before interest, tax, depreciation and amortisation (EBITDA) increased 7% to $408m, while net profit rose an impressive 25% to $195m thanks in part to lower interest expense. Ramsay's underlying EBITDA increased 18% to $1.7bn, while underlying net profit rose 17% to $481m.

Ramsay's management said a rising rate of chronic disease and an ageing population would continue to drive growth for the company and that it expects underlying net profit to increase 10–12% in 2017.

Over the long term we expect volume growth of around 3–4% and revenue to grow a little faster than capacity due to negotiated price increases with private health insurers, which have averaged about 1.5% over the past few years.

Net profit should grow slightly faster still due to the company's relatively fixed cost base, and we expect long-term earnings growth of 6–8% for both Healthscope and Ramsay. Healthscope, though, should be able to grow earnings above 10% a year in the medium term as its expansion projects reach completion.  

Both companies have plenty going for them – lots of growth potential, dominant positions, and stable income streams to name just a few. Though we're a long way from buying, they also trade at reasonable valuations, with Ramsay having an enterprise value 14 times underlying EBITDA and Healthscope trading at around 16 times. We're increasing the price guides for both companies and continue to recommend you HOLD.