Recent news about private hospital operator Life Healthcare’s international investments has created negative sentiment about the company’s ability to allocate capital wisely. Ruan Stander explains why we believe this creates the potential for long-term investors like us to earn attractive returns.
Life Healthcare has fallen out of favour with the market, but is this negativity over-exaggerated?
The company has spent the last eight years diversifying away from its South African hospitals by acquiring hospital groups in India, Poland and the UK, so far with mixed results. Under a bad scenario, where the Indian business is worth only half of the current share price, the latest acquisition in the UK is worth 50% of the price paid, and Polish hospitals are worthless, the company would lose around 10% of its current value. However, using the cash flow plus growth analysis below, the company still generates a return of 16% per annum (p.a.). Under a good scenario we believe Life Healthcare will deliver a return of 18% p.a., with substantial upside from the removal of negative sentiment.
How are these numbers calculated?
A long-term investor needs to carefully consider three things when evaluating an opportunity:
1. What rate of growth can a business achieve organically?
2. How much cash is generated after spending capital to achieve organic growth?
3. Does the management team manage excess cash wisely?
By way of example, let’s say a company with a share price of R100:
1. Grows at 9% p.a.
2. While generating R3 of free cash flow for shareholders and
3. Distributes all the free cash flow to shareholders in dividends.
Under a good scenario we believe life healthcare will deliver a return of 18% p.a., with substantial upside from the removal of negative sentiment
The outcome for shareholders is a total return of 12% p.a. that is calculated as a 3% dividend yield plus a 9% capital gain, assuming that the valuation multiple stays the same. This is roughly in line with the dividend yield, earnings growth and total return generated by the South African stock market (ignoring the change in valuation multiple) over the past 20 years.
Now let’s consider the prospects for Life Healthcare using this framework.
Growth: Estimated at 10% p.a. going forward in South Africa
Healthcare costs grow faster than the economy in most societies these days for various reasons: ageing populations require more healthcare, innovation increases the variety of treatments available and, importantly, healthcare is a non-negotiable expense since you only get to live once. On the other hand, increasing costs attract the attention of regulators (and politicians), so hospitals need to do their best to control costs and price increases over time for the greater good of society.
Graph 1 illustrates that Life Healthcare’s South African hospitals have done well to keep costs low while growing at a healthy rate. Over the past five years, volumes have grown faster than real GDP at 3.6% p.a., with revenue growth of 9.5% p.a. (implying a price increase in line with inflation) and profit growth of 13.5% p.a. (implying that unit costs increased less than inflation). Some of the cost drivers include scalable central costs, better utilisation of fixed assets by improving occupancies, and working constructively with doctors and medical schemes to reduce the cost of treating patients without compromising the quality of care.
If one assumes 6% price inflation, 3% volume growth (lower than 3.6% before) and 1% from operating more efficiently, the South African business could grow profits at 10% p.a. going forward.
Cash generation: 6.6% yield on South African operations alone
Double-entry book keeping was an important financial innovation but unfortunately some of its benefits come at a cost. One of the costs of an internally consistent accounting system is that accounting earnings almost never accurately reflect the cash a company generates for shareholders. The average company converts only half of accounting earnings to free cash flow and many companies are able to exist for decades on accounting earnings, while never generating a cent of cash flow for shareholders.
In contrast, Life Healthcare has converted around 90% of its South African earnings to free cash flow over the past five years, while growing at a healthy rate. Ninety percent of its latest reported South African earnings is roughly 6.6% of the current share price, which compares favourably with the 3% dividend yield on the South African stock market. Given that 1) healthcare is likely to exist 100 years from now, 2) substantial barriers to entry in private healthcare make it hard for new entrants to take a slice of the pie and 3) the company’s low-cost operations make them strong compared to their competitors, one could argue that these cash flows will be sustainable for a longer period than the average company.
Capital allocation
Life Healthcare has spent significant capital to invest in healthcare services in India, Poland and the recently announced acquisition of Alliance Medical Group in the UK. It is perhaps premature to judge the management’s capital allocation track record, but indications are mixed so far:
- Max India is not making an earnings contribution after financing costs, but the Indian stock market rates the long-term prospects of the investment highly favourable. Revenue is growing fast and earnings before interest, tax, depreciation and amortisation (EBITDA) margins are improving for mature hospitals. If it were to be sold at market prices, Life Healthcare would make an attractive return on its investment of around 20% p.a.
- Scanmed in Poland is struggling after draconian tariff cuts were enforced by the recently elected right-wing Law and Justice Party, undoing the progress achieved in improving the efficiency of hospitals acquired. Given Scanmed’s low cost of doing business, it is well placed to take market share from competitors who are going out of business, which would improve its profits if or when prices become more reasonable.
- The UK acquisition seems fully priced at 20 times estimated free cash flow but, according to the CEO, it operates at a much lower cost than its competitors in diagnostics, a sector which is growing faster than the UK healthcare sector as a whole, and government hospitals are under increasing pressure to outsource to the private sector.
Scenario analysis
A punitive calculation could assume that Life Healthcare overpaid by 100% for the UK acquisition, the Indian business is worth only half the current market price and Polish assets are worthless. In this scenario, disillusioned shareholders need to inject an extra 10% in equity to maintain current free cash flow. This reduces the cash flow yield from 6.6% to 6% but still results in a total return of 16%. One could argue that this scenario holds further downside risk from future poor capital allocation decisions. This would cause shareholders to hold existing board members and management accountable and most likely retreat to focus on distributing South African cash flow to shareholders, limiting the downside of further value destruction.
If the Indian business is sold at market prices, Poland is sold at cost and the UK acquisition is neutral to free cash flow per share over time, the South African business would generate an 8% cash flow yield on the remaining share price (assuming sales proceeds are paid out as a special dividend). If it grows at 10% the total return would be 18% p.a. This scenario could well deliver a higher rate of return from a higher market rating as sentiment should revert from negative to positive.
We currently hold 13.7% of Life Healthcare, which amounted to 1.4% of the Allan Gray Equity Fund on 31 December 2016.