Health Management Intl - OCBC Investment 2017-03-24: Healthy growth momentum

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HEALTH MANAGEMENT INTL LTD 588.SI

Health Management Intl - Healthy growth momentum

• Healthcare provider with an edge.
• Set for sustainable growth over the long term.
• Initiate with BUY and S$0.80 FV.

Strong management team with a competitive edge 

• Health Management International (HMI) has established a strong track record in management execution and developed an edge for themselves with their unique business model. The group had notably turned around an unprofitable hospital in a short span of time for Mahkota Medical Centre (MMC) in Malacca, and grew Regency Specialist Hospital (RSH) from an empty building in Johor into an established profitable hospital. 
• HMI went on to display consistent growth in estimated core earnings, at an approx. CAGR of 101% over FY11-16. Amid a competitive private healthcare sector, the group’s unique adaptation of the independent clinic model for its hospitals has allowed HMI to attract and retain their doctors.
• In addition, being the first to address a lack of certain treatment methods has also been one of HMI’s strengths, in our view.

Multi-strategy approach to drive further organic growth

• Looking ahead, through a multi-strategy approach grounded on talent management, broadening scope of specialties, expansion of facilities, capacity building, and efficiency initiatives, we see better and sustainable profitability outcomes ahead. 
• RSH will also start works on a new medical block extension that is slated to double its existing capacity when completed in 2020. 
• HMI’s growth story is further supported by a backdrop of favourable secular trends, greater private insurance coverage, and encouraging government initiatives for the local healthcare and medical tourism sector.

Initiating with BUY and S$0.80 fair value estimate 

• The consolidation of its ownership in both hospitals (from 48.9%-owned MMC and 60.8%- owned RSH to 100% each) is a positive move in our view, as it offers clarity to investors on earnings. We believe the group is on a healthy growth momentum, backed by a multi-strategy approach and strong management team. 
• Initiate coverage on HMI with a BUY and DCF-derived fair value estimate of S$0.80

Investment Merits 

i. Solid fundamentals 

Strong track record in management execution 

• Looking back, the group had acquired a 20% interest in Mahkota Medical Centre (MMC) in 1999, a loss-making hospital that was operational since 1994. Through a comprehensive restructuring plan that saw a revamp of operations to marketing campaigns being made, the group shortly achieved a turnaround of MMC in FY01. They went on to gradually raise their interest in Mahkota to 48.9% by 2007, before proposing an acquisition to consolidate its interests in 2017.
• In 2007, the group also acquired a 44% effective stake in Regency Specialist Hospital (RSH), an empty hospital building then. The hospital was commissioned in FY08 while the group gradually raised its effective interest 60.8% by 2009. Management had successfully turned around Regency, with the hospital achieving its first year of profitability in FY14.

An edge in business model for talent attraction and retention 

• HMI, in various ways, has been developing an edge for themselves in Malaysia’s healthcare scene. To start off, HMI adapted the independent clinic model within a hospital setting for its hospitals, which are more common in Singapore, allowing specialist doctors to own and operate their clinics, by either purchasing or leasing. As HMI provides the patient flow, more than half of these specialist doctors, who are independent practitioners, practise full time at HMI. Placing emphasis on structuring a strong partnership with specialist doctors has allowed HMI to attract and retain top specialist doctors for their hospitals.
• Over the next few years, the HMI People Development Roadmap will be implemented, which includes looking at Competitive Performance-Based Remuneration for talent management.
• Drawing on the strengths of a strong management team, coupled with a unique business model in place, the group displayed a strong growth in core earnings since its turnaround in overall performance in FY11.

Commendable margins 

• We acknowledge the multitude of factors that vary across each hospital such as maturity, geography, regulatory landscape. These peers are also larger in scale when compared to HMI. Nonetheless, as an indication, MMC’s EBITDA margins have been over 26% in the past three years, and are notably higher than the average EBITDA margins recorded by most other hospital players over the last six years.
• The dip in MMC’s EBITDA margin in FY15 from FY14 was mainly due to the increase in input GST which could not be recovered, and regulated doctors’ fees were raised following the government’s approval.

Factors behind margin performance 

• There are several common areas to reduce overheads and improve efficiency, such as through supply chain management, technology investment, workflow changes. In particular for RSH, we see steady EBITDA margins upon leveraging on increasing economies of scale.
• Day Surgery Centres to meet demand and enjoy better efficiency To offer a specific example, we understand that both of HMI’s hospitals can run at near full bed capacity during the day. As such, adding Day Surgery Centres (DCS) has been a key strategy to meet the growing demand from their patients to have day surgeries, and importantly, relieves the hospitals’ operating theatres of minor or low risk surgeries. Doctors can focus on the most complex cases while they are ensured of sufficient availability of inpatient beds, resulting in a faster turnaround of patients and efficient use of inpatient beds.

ii. Multi-strategy organic growth ahead 

• Through a multi-strategy approach covering talent management, broadening scope of specialties, expansion of facilities, capacity building, as well as implementing workflow changes, we believe the group can continue to achieve better efficiency and profitability outcomes. 
• We highlight differing strengths and specific drivers for each hospital in the sections that follow.

iii. Mahkota Medical Centre - Enhancing niche areas 

Medical tourism growth augurs well for MMC 

• MMC is the largest private hospital in the Southern region of Malaysia3 and given its location in Malacca, a UNESCO World Heritage City, it is well-positioned to ride on the growth of medical tourism in Malaysia. MMC sees nearly 300k patients a year, of which more than 80k are international patients, representing ~10% of total medical tourists in Malaysia a year4 .
• The Malacca International Airport in particular, will undergo further developments including an extension of the runway to accommodate larger aircrafts, and introduce more direct flights from other cities in China and Indonesia5 , thus potentially offering new sources of patients for MMC.

Enhancing niche areas 

• As one of the most established hospitals in Malaysia, the group continues to expand the breadth and depth of specialties offered at their hospital, while also developing Centres of Excellence (COE). This strategy reduces reliance on other hospitals, induces more referrals from smaller hospitals, and higher case intensity translates to better average bill size per patient.
• Expanding facilities and optimizing the usage of these facilities also helps to meet demand and drive efficiencies. Recognizing the shortage for oncology treatments, MMC is the first and only hospital in Malacca with a Positron Emission Tomography (PET) scanner, such that they no longer have to outsource this service from 2Q17, and neighbouring hospitals can tap on their service too. In addition, local regulations restrict the presence of a PET/CT Scanner. In the past, PET Scanners were generally rare in Malaysia due to the need for Fluorodeoxiglucose (FDG), a radioactive form of glucose that was costly to import 

iv. Regency Specialist Hospital 

Strategically located; riding on broader development growth 

• Compared to MMC in Malacca, RSH is located within the Iskandar Development Region and in the township of Bandar Seri Alam, Central Johor Bahru municipality, thus its addressable patients base comprises of nearby manufacturing, industrial companies as well as a larger residential population of about 3.5m for Johor (vs. 873k for Malacca).

Room to increase foreign patient load

• RSH’s initial years were focused on local patients, and given Johor Bahru’s profile, RSH has a lower proportion of foreign patients out of its total patient base. RSH has started marketing overseas to build its foreign patient load. It is also approved by Singapore’s Ministry of Health for Singapore residents to use Medisave for hospitalization and day surgeries, albeit we understand this is currently a small contributor. 
• Separately, the nearby Pasir Gudang Ferry Terminal has regular schedules to and fro Batam, Indonesia. Senai International Airport (40-50min drive from RSH) was also the fastest growing airport out of eight largest airports in Malaysia in 2015 according to CAPA. The airport currently caters to over seven destinations including Jakarta, Surabaya, Bandung in Indonesia.
• With a new medical extension block to double existing capacity by 2020 and on-going expansion of its suite of specialties, we believe RSH can capitalize on Iskandar’s broader development growth and potentially enjoy an increase in corporate insurance patients as well as foreign patients.
• Besides KPJ Healthcare’s hospitals in Johor Bahru, IHH’s Gleneagles Medini opened in late 2015 and property developer Rowsley announced their partnership with Thomson Medical and TMC Life Sciences Berhad to develop a 11ha Vantage Bay Healthcare City by 2020. Amid competition, we highlight that RSH is the closest tertiary hospital to Pasir Gudang industrial area and the new Petronas oil refinery-petrochemicals complex. It is also the only private hospital in Malaysia to have a 24-hour Emergency & Trauma Centre staffed by Emergency Specialists, given its proximity to both residential and industrial areas.

v. Clearer structure with consolidation of ownership in hospitals 

• On 11 Nov-16, HMI announced its plans to consolidate its ownership in Mahkota Medical Centre and Regency Specialist Hospital by increasing ownership in 48.9%-owned MMC and 60.8% RSH to 100% each via the acquisition of existing shares in certain shareholders. The aggregate consideration for the acquisition is MYR556.5m (S$183.2m), agreed on an arm’s length basis between the company and sellers.
• The purchase will be financed through a combination of cash (~S$69.3m) and new HMI shares issued to the non-controlling shareholders of MMC and RSH (~S$113.9m). The cash component will be funded by a senior secured five year term loan of up to S$62.0m, a renounceable rights issue of new HMI shares and internal cash resources. The S$0.57 issue price represents a discount of 5.8% to the closing price of HMI shares as at 10 Nov-16. We view this transaction positively, as this offers clarity to investors given that 100% of earnings would be attributable to shareholders, compared to previously when PATMI may have seemed lumpy on a quarterly basis. Furthermore, the acquisition is considered 30.4% accretive to shareholders.
• Based on the company’s assumptions (namely taking up of additional debt facility of S$62m at 5.25% interest rate and post-transaction weighted average number of shares of 821.6m), the fully-diluted EPS for FY16 would be 30.4% higher than the current fully-diluted EPS for FY16 of MYR3.38sen, albeit this excludes one-off transaction costs expected to be incurred.
• In view of its expansion plans, we note that the consolidation also enables greater operational flexibility as well as improves the group’s access to funding options.

Key risks 

Malaysia medical tourism sector’s dependence on Indonesia 

• Currently, Indonesia contributes 70% of total medical tourism revenue for Malaysia, while China and India have been increasing. Thus any decline in patient volume from Indonesia may still be impactful. 
• As for HMI, we note that MMC is more reliant on international patients (about 25%of total patients) vs. RSH, while we understand that their patients from Indonesia are diversified across the country. 
• About 1/3 of total revenue comes from foreign patients. There have also been efforts by relevant authorities such as Malaysia Healthcare Travel Council (MHTC) to attract medical tourists from other countries.

Talent supply and competition 

• As is the case for most countries, a key challenge is the shortage of professional talent and doctors. Strict regulations for hiring of foreign doctors tend to pose difficulties for hospital operators to hire. In Malaysia, we understand that the concern is not on the supply of general medical personnel, with about 5000 new medical personnel graduates each year7 .
• Rather, as hospitals strive to differentiate through their specialization mix, there is competition over hiring of a limited pool of sub-specialty doctors.
• Nevertheless, HMI has been able to attract and retain their doctors, by way of their unique business model in Malaysia and incentives offered to them.

Adverse changes in regulations 

• While healthcare reform initiatives seem generally supportive towards the local healthcare sector, we are cognizant of any adverse changes in the regulatory landscape. 
• The changes could possibly span from a stricter framework for medical professionals, approvals and licensing of medical equipment, or changes in the domestic insurance market.

Financial Highlights and Forecasts 

Revenue grew at 19% CAGR over FY09-FY16 

• Since RSH’s 1st full year of contribution in FY09, the group’s revenue has been growing at a CAGR of 19% over FY09-FY16, proving its resilience especially in weaker times. The group’s focus on enhancing its centres of excellences and expanding its specialty offerings has also helped to translate to increasing average revenue per inpatient over the last three years. 
• On the back of multiple strategies outlined previously, and specific drivers for each hospital, we believe the group’s revenue is likely to continue on its steady organic growth trajectory.
• With respect to regulations in Malaysia, we note that doctors’ fees in Malaysia are regulated under the 13th Schedule of Private Healthcare Facilities and Services Regulations 2006, with its first revision only in 2014 to raise doctors’ fees by 14.4%. While this may seem like deterrence for doctors to practise in Malaysia, we keep in mind that senior doctors take on more complex procedures and high volume of cases.
• To clarify, doctors in HMI hospitals can only provide consultations in their clinics and dispense basic outpatient drugs, while day procedures have to be conducted in the hospital, thus forming HMI’s outpatient revenue. 
• The group’s inpatient revenue comes from the provision of services such as rental of operating theatres and other medical facilities, diagnostics, bed charge, administrative fees, as well as sale or lease of medical suites to doctors. Hospital charges are not regulated.

Steady core earnings growth over FY11-16 

• After RSH officially opened in FY09, the group inevitably incurred gestation costs for this hospital while ramping up operations. Notably, the group’s earnings turned around in 2011 and recorded a 46% CAGR over FY11-FY16.
• Over the years, the group also recognized certain allowances for impairments and FX charges. The dip in FY16 earnings from FY15 was mainly due to one-off recognition of deferred tax assets of MYR9.0m in FY15 and subsequent utilization of MYR5.5m by RSH in FY16, cost increases from non-recoverable input GST (6% GST implemented in Apr-15) as well as share-based expenses. In FY15 and FY16, share-based compensation expenses were ~MYR3m and ~MYR4m respectively. There was about MYR1.2m more expensed in 1QFY17.
• Excluding some of these one-off items, we estimate the group’s core earnings to look relatively steadier over FY11-16.
• Looking ahead, for the acquisition, the group is taking up a five year term loan of up to S$62m with interest rate pegged to the prevailing 3-month Singapore Swap Offer Rate and a margin of 4.25% initially, which would be stepped up over time. Given that the rights issue was fully subscribed, we have assumed a ~S$50m loan taken up. 
• In addition, keeping in mind the extension block at RSH, capex here is initially guided to be ~MYR160m over 2.5 years, and it is likely to be funded by a combination of internal resources and debt. Beyond FY17F, we expect higher pre-operating expenses and finance costs.

Leverage 

• We note that HMI has had a healthy balance sheet and generated strong free cash flow over FY12-16. Post-acquisition, the group estimates its proforma net debt/FY16 EBITDA to increase to 1.6x, in consideration of the additional debt facility it will take up. 
• Looking ahead, the RSH extension will also require a certain level of debt funding. Nonetheless, this temporary increase in leverage will be managed down by the group, on the back of strong operating cash flows achieved (MYR81m in FY16).
• All considered, on the back of an experienced management team, on-going cost control and improving operational efficiencies, the group is able to generate good free cash flow on its profitable operations, manage its debt levels, and continue to sustain a quality showing in earnings growth, in our view.

Valuation and recommendation 

Initiate with BUY rating and S$0.80 fair value estimate 

• We initiate coverage on HMI with a BUY rating and DCF-derived fair value estimate of S$0.80.

DCF assumptions 

• We assume a risk-free rate of ~4%, based on Malaysia’s 10Y government bond yield, and market premium of ~8%, as well as a beta of 0.6 to arrive at a ~8% cost of equity. 
• We also assume a cost of debt of 5.0%. With an estimated debt to capital ratio of 15%, our WACC is ~7.6%. Our terminal growth rate is 3.0%. We have also taken into account the enlarged number of shares outstanding upon completion of the consolidation.

FX translation effect 

• Based on OCBC Treasury Research’s latest FX forecasts, we have used SGDMYR = 3.1885 (Dec-17 forecast). We note that our fair value is dependent on SGDMYR, while at this juncture there are no expectations of a sharp depreciation. 
• Our house view anticipates MYR to depreciate ~1% from Mar-Dec this year against the SGD.

Jodie Foo OCBC Investment | http://www.ocbcresearch.com/ 2017-03-24

OCBC Investment SGX Stock Analyst Report BUY Initiate BUY 0.810 Same 0.80