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Morningstar | Healthscope Remains Undervalued With Northern Beaches Hospital Boost Imminent

We maintain our fair value estimate for narrow-moat-rated Healthscope at AUD 2.40 per share following the transfer of coverage to a new analyst. Healthscope has had a busy 2019, with both takeover bids, from BGH at AUD 2.36 and Brookfield at AUD 2.50, being rejected and triggering a strategic review of the company. The sale of the Asian pathology assets for AUD 279 million and closure of underperforming hospitals should help to improve the firm's financial performance. We also expect the Northern Beaches Hospital, or NBH, to open this year and eventually boost revenue by around AUD 300 million, or around 12% of group revenue.

At the current market price of AUD 1.80 per share, we still believe Healthscope is undervalued. We expect that market concerns around short-term weakness in private health insurance, or PHI, participation rates are unjustifiably weighing on the stock. The current share price implies a fiscal 2019 price/earnings ratio of 19 versus 25 at our fair value estimate, which incorporates an 11% EPS CAGR forecast over the next five years. Our share price and fair-value-implied P/E ratios for peer company Ramsay Health Care are 18 and 23, respectively, implying slightly lower earnings-growth rates, with the difference likely due to the NBH. Management expects fiscal 2019 EBITDA growth of at least 10% (versus our 11% forecast) for the Australian hospital business, which comprises 86% of group EBITDA. The share price also implies a dividend yield of 3.9%, which we expect to be unfranked.

We still expect strong revenue growth for the Australian hospitals division, which comprises around 90% of group revenue, and forecast a 7% CAGR over the next five years. Our outlook is supported by the NBH, representing 450 beds and 20 operating theatres, as well as the ongoing brownfield expansion program. We also expect a slight improvement in EBITDA margins to 16.9% by fiscal 2023 from 16.1% in fiscal 2018, driven by the combination of revenue growth and operating leverage. We assume the sale and leaseback of hospitals to raise a net AUD 750 million, implying a sale price of AUD 1.5 billion, versus the AUD 1.0 billion book value, which was last revalued in 2010, and that Healthscope retains around 50% of the unlisted REIT. We also assume a net rental increase of AUD 45 million, as Healthscope will retain an interest in around 50% of the REIT, with funds raised used to reduce debt and interest costs.

Healthscope’s balance sheet is stretched currently and will remain so until the completion of the NBH and associated payment from the New South Wales state government of around AUD 400 million. As at June 30, 2018, net debt/EBITDA had increased to a relatively high 4.5, up from 3.9 in the prior year; however, excluding NBH-related debt, the ratio was 3.0, which is still relatively high but is manageable considering the defensive nature of the business and our expectation of strong earnings growth. Credit metrics are much more comfortable on an interest coverage ratio basis, with fiscal 2018 EBITDA/net interest expense of 7.8. We expect credit metrics to improve following the completion of the NBH, with the NSW government payment reducing debt and the hospital ramp-up boosting earnings.