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Morningstar | Ramsay Remains Undervalued Following FVE Cut to AUD 65. See Updated Analyst Note from 17 Oct 2018

We have cut our fair value estimate for narrow-moat-rated Ramsay Health Care, or RHC, by 14% to AUD 65.00 per share following a reduction in our long-term earnings growth forecasts and the transition of coverage to a new analyst. However, at the current market price of AUD 54.38, we continue to believe the shares are undervalued. We have incorporated the acquisition of Swedish healthcare firm Capio AB, by RHC’s 51%-owned subsidiary Ramsay Générale de Santé, or RGdS, into our forecasts. This has no impact on our fair value which implies RGdS has paid a fair price for the business. However, Ramsay’s eagerness to acquire Capio, and increase its bid price by 20% in the process, reflects revenue growth challenges in other areas of the group to some degree and partly influences our long-term earnings growth downgrade. While we’ve maintained our forecasts for the next five years, we’ve reduced our long-run growth expectations, leading to a lower terminal value than our prior valuation.

Based on our revised earnings forecasts, Ramsay currently trades on a fiscal 2019 P/E ratio of 18, versus 23 at our fair value. We forecast an EPS CAGR of 8% over the next five years, versus 16% over the past five which were boosted by acquisitions and a stronger demand for private healthcare services. Our forecast of 2% EPS growth in fiscal 2019 is within management’s EPS growth guidance of "up to 2%." Over the past decade, RHC has traded on a one-year forward P/E ratio of between 12 and 32 and close peer Healthscope, a stock which we also believe is undervalued, trades on 21 currently. Healthscope’s recent takeover bids from BGH and Brookfield implied a P/E multiple of around 24. We assume a 51% dividend payout ratio, which implies a fiscal 2019 dividend yield of 2.2%, or 3.2% including franking credits at the current share price. We have also maintained Ramsay’s medium fair value uncertainty rating.

The acquisition of Capio makes strategic sense, giving access to new markets while adding modest scale to Ramsay’s existing operations in France. We think Capio allows an expansion of Ramsay’s European business across the healthcare service continuum beyond private hospitals and into primary-care settings, extending the commercial opportunity from acute-care settings through to chronic disease management, which we see as an attractive opportunity, given the ageing population and psychiatry, complementing Ramsay’s 119 hospitals in the region. We also expect integration of Capio’s French assets could be executed with minimal disruption to operations and benefit from current cost-out initiatives now under way. In France, Capio AB operates eight emergency hospitals, 12 local hospitals, and three specialist clinics for rehabilitation

Ramsay has agreed to pay AUD 1.9 billion for Capio on an enterprise value, or EV, basis which we estimate implies a fiscal 2019 EV/EBIT multiple of around 22, well above RHC’s current multiple of 14. However, the acquisition will be predominantly debt funded which will help achieve EPS accretion, something we expect from fiscal 2021, and we assume Capio contributes earnings to RGdS from the second-half of fiscal 2019. The acquisition increases group revenue by around 25% on a fully consolidated basis, with RGdS’s revenue rising to 50% of the group, from 40% previously. Capio will diversify RHC’s regulatory and business risk as it operates in the Nordic countries (Sweden, Denmark, Norway), France, and Germany, comprising 56%, 36%, and 8% of group revenue, respectively, and 46%, 49%, and 6% of group EBITDA. However, the company generates a relatively low EBIT margin, of around 4% versus 11% for RHC, meaning RGdS will comprise 40% of group EBIT post acquisition on a consolidated basis, or 15% on a look-through basis for RHC shareholders.


Aside from the Capio acquisition, Ramsay faces a tough regulatory environment in France, given the negative tariff environment, which we expect to continue for the remainder of fiscal 2019. As such, we still only assume a revenue CAGR of 1% for the division over the next five years, excluding Capio, reflecting underlying volume growth broadly in line with the general population. We remain positive on management’s plan to centralise noncore hospital functions, such as finance, administration, and HR, into a national service centre outside of Paris over the next three years, and we expect this (along with significant reduction in headcount over three years, commencing this half) to generate annual savings of EUR 5 million once fully implemented and expand EBITDA margins in France to expand to 13% from 12% currently. In the U.K., we continue to expect no growth over the next five years, given challenges to NHS admission created through the implementation of demand management strategies and guidelines around elective-care services on the part of the government, with potential disruption of Brexit adding to the government’s budgetary woes.

Our longer-term outlook for Ramsay’s Australian hospital division remains positive, given its dominant market position in the domestic market. Although deterioration in private health insurance participation is a concern, we think Ramsay’s hospitals are well located in catchment areas with high participation levels and good exposure to the growing over-65 demographic segment. These include the large metropolitan hospitals of North Shore Private, St George Private, and Hollywood. A key factor cited by management for softer volumes was lower transfers to the private system from emergency departments in collocated sites, with public hospitals holding onto private patients for revenue purposes. This is part of a larger issue, currently under review by the government, regarding treatment of private patients in public hospitals, which we estimate accounted for about 800,000 private patients in fiscal 2017. As such, we regard this as undermining government support of the private system and see any redirecting of patients back to the private system as positive for Ramsay. We have maintained our mid-single-digit revenue CAGR for the Australian hospital division which is largely predicated on increasing utilisation by the over-65 segment, which we see growing ahead of the general population at around 3% per year over the next five years.

From a balance sheet perspective, Ramsay is in reasonable shape, but we caution that the company is quite vulnerable to a deterioration in earnings given sizable operating lease obligations. Net debt was AUD 3.2 billion as at June 30, 2018 on a fully consolidated basis which implies a reasonable net debt to EBITDA ratio of 2.3, and EBIT to interest coverage of 9. However, metrics look worse on a lease adjusted basis, with net debt/EBITDAR of 3.8 and EBITR/interest plus rent of 2.3. We expect the Capio acquisition to increase fully consolidated net debt by AUD 1.4 billion which we expect to stretch the net debt/EBITDA ratio to 3.2 and reduce the EBIT/interest coverage to 7.6. Although the interest coverage ratio is comfortable, it’s dependent upon low interest rates to a certain degree. If the already weak revenue outlook deteriorates further, the fixed cost nature of the operating leases could cause the relatively high net debt/EBITDA ratio to become an issue, although debt covenants aren’t disclosed, and we don’t assume this in our base-case scenario. Considering much of RHC and RGdS’s debt is not due until 2022, we don’t believe the group faces a material near-term refinancing risk at this stage. The sale and lease back of the AUD 4 billion property portfolio is also a potential source of funds.