Ask anyone about lucrative sectors to invest in, and it’s very unlikely that hospitals will feature prominently. In fact, they will probably not be mentioned at all — unless you’re speaking to Remgro executives. After participating in a deal to take Mediclinic private, they believe strongly in that opportunity; and if recent updates in the sector are anything to go by, then the Remgro crew might be onto something.
Setting the scene with a 10-year share price view is most unfortunate for Netcare and Life Healthcare, as both stocks peaked roughly a decade ago. That was a frothy time on the JSE, with institutional investors putting pressure on management teams to diversify globally and get their money as far away from Jacob Zuma’s ANC as possible. The hospital groups were only too happy to oblige. When acquisitions are justified by push factors rather than pull factors, you’re going to have a bad time. Sure enough, both companies have lost roughly two-thirds of their value since then.
The aftermath of such poorly considered dealmaking is as predictable as it is painful. Companies go from presentations full of global images and references to “diversification” and “rand hedges” through to decks that talk about a “return to the core” and a need to “improve focus” in their operations — in other words, an acknowledgment that things went very badly in faraway lands.
Many sectors have been through this. The health-care sector (especially hospitals) just suffered more than most, as hospitals have been underperforming assets for some time in terms of return on capital. This makes them even worse when management overpaid for offshore acquisitions. Defensive though they may be, you can’t have a situation where hospitals are giving lower return on capital than government bond yields. They might be low-beta stocks (in theory at least), and hence don’t need to give the same returns as cyclical stocks, but they certainly need to be ahead of government bonds.
If these hospital groups were medicine, they would be that hideous, lumpy syrup that I occasionally had to take when I was really sick as a kid. But these days, there’s a much sweeter taste in the mouth of investors. The flavoured syrup has been prescribed and it works, with Life Healthcare up 29% in the past 12 months and Netcare up 25%.
While it’s true that underlying dealmaking is a driving force in the Life Healthcare share price at the moment (it sold Berlin-based Life Molecular Imaging — and gave investors an ugly reminder of what an “agterskot” payment to the previous owners of the business looks like), it’s also true that the underlying story in both businesses is improving.
If we find ourselves in a world where there is rapid growth in demand for hospitals, then your portfolio will probably be the least of your worries
Strong top-line revenue growth is unlikely to be the order of the day for these companies. If we find ourselves in a world where there is rapid growth in demand for hospitals, then your portfolio will probably be the least of your worries. Rather, the bull case is based on these groups finding the right verticals to play in and investing accordingly. As an indictment of our modern world, mental health services are growing much faster than maternity cases. Megatrends such as declining birth rates mean that hospital groups need to evolve accordingly. If they get the trends right, then the usual inflationary increases in revenue are joined by a most welcome bedfellow: growth in paid patient days.
This is essentially how hospital groups measure growth in volumes. Much like in airline economics, the incremental cost of filling another bed in the hospital is low as there are vast fixed costs relative to variable costs. This means that the incremental margin is high, so overall margins are boosted by even a modest improvement in paid patient days. Conversely, any disappointment in paid patient days can easily lead to revenue growth being below the increase in expenses, which leads to a deteriorating operating margin.
For example, in the six months to March, Netcare had a 1.1% increase in paid patient days, a 5.3% increase in revenue and a 10.7% jump in operating profit. Operating leverage is on full display here, as such a modest increase in volumes has led to a double-digit improvement in operating profit. Also for the six months to March, Life Healthcare achieved paid patient days growth of 2% and revenue growth of 8.1%, though operating profit on a normalised basis was only 7.5% higher. Margins haven’t gone the right way for Life Healthcare, but the dividend was 10.5% higher at least.
The market is starting to pay attention here. One wonders just what Remgro can achieve with Mediclinic.
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