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Morningstar | Raise Ramsay’s FVE to AUD 70 on Better Margin and Free Cash Flow Outlook

We raise narrow-moat Ramsay Health Care's fair value estimate to AUD 70 from AUD 65 on the back of an improved view of long run margins and lower capital spending required to achieve organic growth rates. Ramsay’s value is derived largely from its Australian business, where an estimated 80% of revenue is earned via private health insurance, or PHI. This enables the firm to achieve high-teen operating margins, in line with global private hospital peers. This business is also the only source of moat, based on payor negotiating power-which allows the firm to achieve above-peer increases from PHI providers-and cost advantage. Conversely, in Ramsay’s other geographies the bulk of revenues are low-margin public tender contracts. Despite a lack of sustainable competitive advantages in these regions, the firm’s acquisition trail continues, which dilutes the contribution of the premium Australia business. We question the benefits of being global in this industry. While scale within a geographical market brings cost and, in Australia, payor negotiation benefits, we think geographic spread adds regulatory and process complexity.

Nonetheless, we expect the bulk of earnings to stem from Australia over the long run. We estimate 90% of attributable profit coming from the region in fiscal 2019, and this contribution reducing to a still-substantial 80% in the longer term even as the recent Nordic-focused Capio acquisition starts to contribute to the bottom line alongside some recovery in the U.K. and France segments. We expect annual organic revenue growth between 4% and 6%, with reported numbers boosted by the acquisition in 2019 to 24.4% and in 2020 to 12.7%. We expect near-term margin dilution, with core EBITDA margins down to 14.4% in fiscal 2019 from 15.2% in fiscal 2018 due to inclusion of the lower margin Capio. Core EPS growth of 5.9% to AUD 2.96 in fiscal 2019 is above the 2% management guidance and factors in the most recent market data in all geographies.

We forecast slowing revenue growth in Australia as we don’t expect an increase in PHI participation rates over the next several years. The number of lives covered for hospital treatment has reduced by 110,000 over the past two years, or 1% of the 11.2 million enrolled, despite population growth of 2.7% over that period. The impact to Ramsay is muted in the near term as the company is specifically exposed to trends in the hospital-going cohort aged 65 years and above. Our base case assumes the number of lives stabilizes at current levels and we factor ongoing declines in lives covered of approximately 0.5% per year into our bear case.

Over the long term, government attempts to boost participation, such as standardising contracts and allowing discounted premiums for patients under the age of 30, should be beneficial for Ramsay, but it is too early to assess whether these strategies are having the desired impact. Furthermore, examination of the major parties’ healthcare policies suggests three main areas which could affect Ramsay depending on the outcome of the imminent federal election.

First, PHI rebates. The PHI rebate is the amount the government contributes towards a person’s PHI by means of a tax rebate. Eligibility is currently dependent on an individual’s income level and can substantially improve PHI affordability for low to mid-income earners. The total value of PHI rebates afforded to households is AUD 6 billion per year. The Coalition policy explicitly guarantees the PHI rebate continuing whereas Labor has not yet formulated a view and is deferring to a Productivity Commission review of the sector before making a call on the rebate policy. However, election of a Labor government poses a substantial risk to the PHI providers and consequently Ramsay. History has shown PHI participation rates respond directly to changes in the rebate. The worst-case scenario for Ramsay would be the implementation of the Greens policy which does away with the PHI rebate altogether as it would make PHI less affordable for households and decrease take-up.

Second, PHI premium growth. Only Labor has a specific policy on PHI premium cost in which they plan to cap premium growth at 2% for their first two years if elected. Although affordability is the primary reason for people not taking out PHI, it’s not clear that limiting premium growth to broader inflation levels will introduce new marginal buyers of PHI at this stage. We don’t think this strategy to boost PHI take-up will have a material effect on participation rates, however any boost to PHI participation will be beneficial for Ramsay and we factor this into our bull case scenario.

Lastly, Medicare rebates. Labor proposes ending the Medicare rebate freeze and resuming indexation within the first 50 days of governing, versus the Coalition who is only proposing resuming indexation on diagnostic imaging, like MRIs, ultrasounds and x-rays. Indexing Medicare rebates means the cost of the test or procedure covered by the government grows each year by an amount similar to inflation, this reduces the gap payment borne by the patient and is good for household finances. The freeze began in 2013 and is currently scheduled to be phased out by 2020 so Labor proposes bringing this forward by 12 months. We don’t think that improving affordability of public health services shifts private patients back into the public system so this policy has little impact on our Ramsay view.

Outside of government regulatory concerns, a stand-out feature of Ramsay is its excellent free cash conversion of earnings which has averaged 85% over the past five years. We expect this rate to continue. This has fueled the debt-funded acquisition strategy while maintaining very moderate gearing levels and a dividend payout ratio of 51%. We expect deal-making capacity within 24 months and likely further acquisitions from Ramsay.

Conclusion of the proposed Healthscope buyout, which is set to be voted on by shareholders on May 22, will provide a further tailwind to Ramsay as private equity typically rations capital thereby limiting Healthscope’s ability to pursue acquisitions and curbs investment in hospital infrastructure.

On a sum-of-the-parts basis our AUD 70 fair value estimate includes AUD 58.50 attributable to the Australian business which implies an EV/EBITDA multiple of 13.8 times fiscal 2020 EBITDA versus the 14.7 times multiple in the Healthscope buyout. Ramsay screens as slightly undervalued at current levels.