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Sector update: Hospitals - Expansion done and consolidation on; re-rating ahead?

Listed Indian hospital services companies within our universe have shifted gears into a likely prolonged consolidation phase, post intensive capital expenditure, which entailed significant capacity additions. Management commentaries point to limited or no incremental capex, with no new hospital units being set up over next two years. Managements would instead focus on sweating out mature hospital units and turning around relatively new hospitals, driving accelerated earnings growth over FY19-21E. Given the sharp reduction in future capex outlays, we estimate most listed hospital units would generate positive free cashflows (FCF), sharply improving return ratios over the next 2-3 years. Managements stated their intent to sustain focus on profitability/return ratios, which we believe will help address key investor concerns in the healthcare services space. On the regulatory side, while concerns on incremental action around price control stay, this time around, hospital networks are better prepared to mitigate any negative impact on them, than they were when price control on stents was announced. We see limited impact from implementation of Ayushman Bharat on listed hospital networks. Prices of stocks within our coverage have corrected by ~14% in last 3 years due to companies’ weak operating performances and heightened regulatory risk. However, valuations are now reasonable at ~13x FY21E EBITDA, given strong near-term growth visibility and long-term growth outlook. Apollo Hospitals (Target price – Rs1629) and Narayana Hrudayalaya (Target price – Rs270) are our top picks.

Indian healthcare services – A heady expansion phase ends: Buoyed by secular growth narrative for private sector healthcare services, hospital networks in India embarked on an aggressive expansion phase FY14 onwards. As a result, companies ventured into new geographies, especially in Tier 2/3 towns, through a combination of buyouts, greenfield capacity additions and asset-light expansion strategies. For instance, Apollo added 14 new hospitals over last 5 years. However, most hospital operators found it difficult to successfully scale up these Tier 2/3 units due to challenges in hiring adequate medical talent and generating adequate footfalls of paying patients, causing the break-even period of these units to stretch. This adversely impacted consolidated profitability and return ratios of hospital networks (most hospital networks have now reoriented their strategies to limit future investments into Metro/Tier 1 towns). Additionally, regulatory shocks from price caps on stents/implants and growing negotiating clout of health insurers, which impacted growth/ profitability of mature hospitals added to the chaos of private sector hospital service providers in FY17-18. Hospital networks have now slammed brakes on future expansions and refocused on improving profitability of existing networks. Results are evident from the marked improvement seen in profitability of Apollo and NH in FY19.

Consolidation is the mantra going forward: Our discussions with various hospital management teams indicate clear focus on sweating existing assets, optimizing costs across the network and enhancing profitability. With abatement of macro issues like GST implementation, revenue and profitability growth of mature hospitals have begun to recover, with networks focussing on measures like case mix optimization, in addition to enforcing cost discipline. Further, there is wide variation in unit-level profitability across networks, with well-established mature hospitals operating at 25%+ operating margins, and the <5-year old hospitals struggling at <10% EBITDA margin. Although we believe new hospitals are unlikely to match profitability of top tier hospitals, managements see scope for significant improvement from current levels, albeit gradually. This improvement would provide opportunity to newer hospitals to meaningfully enhance EBITDA contribution in the coming years.

Sector M&A activity will accelerate the consolidation process: Challenges in the listed hospital universe reflect profitability pressures across the entire industry. Heightened M&A activity over last few years, with some large hospital networks changing hands reflect this trend (Buyout of Max Healthcare by Radiant/KKR and of Fortis by IHH are few examples). In our view, these large-ticket buyouts will likely prompt buyers to focus on optimising existing networks before embarking on ambitious expansion plans. This, in turn, will likely limit capacity expansions across the sector and help rationalise costs associated with hiring/retaining doctors. Notably, hospitals’ race to expand over the years has induced significant inflation in medical talent costs (a relatively scarce commodity), which, in turn, has exerted significant downward pressure on profitability across hospital networks. We believe this cost discipline will create a stronger growth platform for hospital network operators over the medium-long term.