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Morningstar | Healthscope Takes Knife to Hospital Portfolio and Unveils Unlisted Property Trust Strategy

Narrow moat Healthscope’s full-year results contained myriad nonrecurring items, reflecting a year of restructuring and remedial action across the hospital portfolio. Despite a stronger second half, the company’s net profit after tax of AUD 151.2 million on group revenue of roughly AUD 2.3 billion, down 10.3% and up 3.7% year on year, respectively, trailed our forecast for AUD 181 million and AUD 2.,4 billion after adjusting for the recent divestment of Asian pathology assets. The main factor was the weaker-than-expected margin performance in the hospital division, which posted a fiscal EBITDA margin of 16.4%, compared with our forecast of 17.8%, given the impact of case mix variability and wage indexation.

Healthscope also announced it will establish a new unlisted property trust to hold the majority of freehold hospital property assets on a sale and leaseback basis, and that it would seek to sell a 49% stake to a third-party investor for around AUD 1 billion. After incorporating fiscal 2019 guidance of at least 10% growth in hospital operating EBITDA and adjusting for the sale and leaseback of property assets, our fair value estimate of AUD 2.40 is unchanged. As such, we consider shares slightly undervalued at current levels.

The Australian hospitals division remains the key value driver for Healthscope, now representing 90% of group revenue and 86% of group EBITDA, up with from 88% of group revenue and 82% of group EBITDA after the divestment of Asian pathology. Following a strategic review of its 45 hospitals in first-half 2018, Healthscope has closed the underperforming Geelong Private Hospital and Cotham Private Hospitals and booked an impairment charge in recognition of an onerous lease at Frankston Private Hospital. As such, we think the group is now in better shape to improve efficiencies, given the smaller network, and we’re more confident in management achieving AUD 10 million in annualised cost savings from resulting operating efficiencies. We forecast EBITDA margins for the hospital division expanding slightly to 16.8% in fiscal 2019 and widening further to 17.8% over the next five years, with a five-year CAGR of 10%.

We also remain comfortable with our projection for revenue in the hospital division to grow at a five-year compound rate of 8%. Our outlook is supported by the Northern Beaches Hospital, representing 450 beds and 20 operating theatres, which is due to commence operations in first-half 2019, and its contribution of an anticipated AUD 300 million in revenue over a two-year period, as well as the ongoing brownfield expansion program.

We are not surprised by the company’s decision to monetize a major portion of its freehold hospital facilities, given the thwarted takeover attempts earlier this year and streamlining of operations in recent years. We assume the AUD 1 billion, coupled with the AUD 279 generated from the sale of its Asian pathology assets, will be used to lower debt in fiscal 2019. Our modelling incorporates guidance of rental payments under the sale and leaseback arrangement of AUD 90 million commencing in fiscal 2020 and growing at around 3% per year. While we view the transaction as roughly value-neutral, we think Healthscope’s financial risk profile will improve and forecast net debt/EBITDA declining from 6.41 times in fiscal 2018 to 1.42 times in fiscal 2019. As such, we remain comfortable with the company’s ability to fund dividends at a payout ratio of around 70%.