There’s almost always a point below which you can say a stock is undervalued. JB Hi-Fi, for example, should be worth at least the cash in its tills minus any debt. It could probably sell all the DVDs on its shelves and any other inventory as well, though a discount may be needed to do so.
Earnings and cash flow can provide further comfort: there’s always a price for a reliable stream of cash. We can put all these things together and arrive at a point where we can say: ‘This stock has to be worth at least this much’.
Pinpointing a sell price is far harder because putting a cap on a stock’s value means putting limits on an unknowable future. Who can say whether a company will develop a new blockbuster technology, or how long it might maintain its exceptional rate of growth; stretching out a high growth rate for an extra ten years can easily double a stock’s value.
Sell price is based on unknowable future
Ramsay is a high-quality stock
Deserves more leeway to outperform
Which brings us to Ramsay Health Care, one of the more controversial companies we cover. Australia’s largest private hospital operator is one of its highest quality companies. Yet we have recommended you sell the stock for more than three years – and we’ve been dead wrong about it.
The case that Ramsay is worth less than our current Sell price remains easy to make. Just as easy, in fact, as the case that it is worth much more. So far the bull case has won hands down: after listing at $2.20 in 1997, the stock is now a ‘30-bagger’, having risen to more than $68 for a total return of 24% a year including dividends.
So should long-term holders really contemplate selling? Let’s examine both the bull and the bear case to find out.
The Bull case
Ramsay’s revenue growth of 18% a year over the past five years has three main drivers: an aging population, competitive advantages and sensible acquisitions. Each of these may persist for a long while yet.
According to the 2015 Intergenerational Report, the number of Australians over 65 is expected to double over the next 40 years. By then, 5% of the population will be over 85 compared to just 2% today. That’s an increase of almost 1.5 million people. No other stock will benefit from an aging population as much as Ramsay.
Demand for healthcare is also increasing. People aged 65 and over account for 14% of Australia's population but a third of healthcare spending. Rising future demand for hospital care is a sure bet and private operators are well placed to take advantage.
The Government is also trying to offload people from the strained public health system, and is cutting public hospital funding by more than $50bn over the next 10 years. The need to outsource more services to private operators will increase. Ramsay, which owns one in four private hospital beds, should take the lion’s share.
Economies of scale
Ramsay’s size also delivers greater negotiating power with private health insurers, like NIB and Medibank, and suppliers of medical consumables, which account for around a quarter of operating costs. That power is evident in the earnings before interest, tax, depreciation and amortisation (EBITDA) margin for Ramsay’s Australian business, which has risen from 13% in 2008 to 17% more recently.
Then there are the growing economies of scale from more efficient use of expensive equipment and operating theatres. Together, these factors should keep Ramsay’s margins increasing as revenue grows.
The company has also successfully expanded overseas and is now the largest hospital operator in France, with 125 facilities, as well as owning hospitals in the UK and Malaysia. The strategy is to build strong regional presences to enhance pricing power and operational efficiencies. Overseas operations now make up almost half of total revenue, reducing the company’s exposure to any unfavourable regulatory changes in a single country.
Then there’s China. Ramsay recently pulled out of its first joint venture in the country but management remains keen on building a presence, an objective that should be helped by the recently penned China-Australia free trade agreement.
What’s more, the Chinese Government wants to expand the private sector significantly over the next few years by speeding up approvals and offering subsidies. As one of the largest and most respected networks in the world, Ramsay will be hard to overlook as an operating partner. Nor should it have trouble making acquisitions in the country.
Having made the bull case, let’s now take the bear for a walk. Private hospitals are heavily regulated. Competitors are usually non-profit governments or trusts, especially in France, where they account for more than 60% of the market. That’s a tougher environment than a more privatised sector.
Secondly, building hospitals requires good sites, lots of up-front capital and long lead times. Healthscope’s new Northern Beaches hospital, for example, will cost around $1.2 million per bed. Dividends play second fiddle in this environment, which is why Ramsay has a 2015 free cash flow yield of just 2.3%, potentially rising to around 3% based on 2016 forecasts.
The flipside is that regulation and capital requirements act as a barrier to entry. Ramsay targets a return on invested capital of 15% – a hurdle it consistently meets – but there’s no guarantee future results will look like the past.
Thirdly, insurers are already more aggressive in their price negotiations with private hospitals. Longer negotiating times and stricter terms are now more common. ‘No questions asked’ price increases are probably a thing of the past. If cost increases can no longer be passed on to insurers, a margin squeeze is a real possibility.
Fourth, rising costs are making private health insurance less affordable. Over the past decade the proportion of policies with exclusions like obstetrics has increased from 8% to 36%. To avoid high out-of-pocket expenses, more and more patients may favour public hospitals.
What else? Well, ongoing Government healthcare funding reviews could lead to lower utilisation rates at Ramsay’s Australian hospitals, which would act as an anchor on revenue growth in the short term (see Ramsay’s interim result).
Then there’s a stretched balance sheet featuring a net debt-to-equity ratio of 150%. This is a high-quality business with stable revenues, so it can handle a decent amount of leverage. Low interest rates also mean that operating earnings are a comfortable 6.7 times the interest bill. However, with $3.2bn of net debt, every 1% increase in rates would cause a 5% fall in net profit. Debt supercharges the upside but it adds risk.
Whilst net profit has risen 57% over the past three years the share price has more than doubled, delivering a price-earnings ratio of around 29 times expected earnings for 2016 and a prospective dividend yield of 1.6%. Could Ramsay meet the growth expectations embedded in those figures? Given its formidable competitive advantages, economies of scale and an aging population, it might.
That’s what we’ve learnt from the past few years, a time where we have consistently underestimated Ramsay’s potential. It’s all good and well demanding a big margin of safety when buying a stock, but for one of Ramsay’s quality and potential for growth, you’re likely to get out too early if you demand that same margin of safety when selling.
High-quality companies tend to give pleasant surprises rather than disappoint, and it’s worth allowing them more leeway as we delve into that unknowable future. Just as you might bag a profit in a low-quality stock at the first opportunity, with high-quality businesses, it’s worth trying to cling on.
On that basis, we’re making a step change to our price guide on Ramsay, increasing our recommended Sell price from $55 to $80. We’re still a long way from where we’d buy the stock (which itself rises from $35 to $40), but if you limit your portfolio weighting to no more than 5%, this is a well-managed, high-quality and growing company worth holding for the long term. We’re upgrading Ramsay to HOLD.