Raffles Medical Group - CIMB Research 2017-06-19: Not Yet At The Bottom

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RAFFLES MEDICAL GROUP LTD BSL.SI

Raffles Medical Group - Not Yet At The Bottom

• Even after a c.5% share price retreat since its uninspiring 1Q17 results, RFMD is still trading at 25.8x CY18 EV/EBITDA, above peers’ 19x and its 10-yr mean of 20x.
• As valuations are still lofty, we do not think we are at the bottom yet.
• We see risks coming from: 
  1. cost pressures from Singapore hospital extension, 
  2. additional costs from China in 1H18, and 
  3. lacklustre domestic operations.
• Accordingly, we cut our FY18-19F EPS by 9-16% to factor in Chongqing hospital.
• This lowers our SOP-based Target Price to S$1.25. Maintain Reduce.

How low can it go? 

• We take a deeper look at our current earnings forecasts and think we could still be overly positive on the cost side. We remain comfortable with our FY17-19F revenue growth assumptions of 8-12% p.a. even as 1Q17’s revenue dipped 2%, as expansion projects should boost topline growth. 
• However, our implied core EBITDA margins of 19.3%/19.6%/19.6% for FY17/18/19F (FY16: 19.7%) could prove to be too optimistic. 1Q17 already came in below at 18.3%. Accordingly, we trim our margin assumptions.

Cost pressure should intensify over the next 12 months 

• Margins are now at a low but could go even lower, in our view. FY16’s slide in core EBITDA margin to 19.7% (FY13: 23%) was only due to gestation costs from small expansion projects (Shaw, ISOS, Holland V). 
• With large projects coming onstream over the next 12 months (Singapore hospital extension opening in 4Q17, Chongqing hospital in mid-18), we strongly believe margin pressure will further intensify over FY17-18F.

Our scenario analysis implies a potential c.50% drop in EBITDA 

• We think consensus is struggling to estimate the cost impact from the group’s Singapore hospital extension and the upcoming 700-bed Chongqing hospital, partly because this is the first time RFMD is expanding/building a new hospital since its flagship Raffles hospital and there is little to benchmark against. 
• However, if we use IHH’s newly opened 500-bed Gleneagles HK hospital to get a sense of the magnitude of costs to expect for RFMD, our FY18F EBITDA could fall by a staggering c.50%.

Do not expect Holland V to provide a boost 

• Recall that we were puzzled we did not see any positive yoy impact from Holland V in the group’s 1Q17 numbers since Holland V opened in Jun 16, with revenue declining 1.7% yoy and core net profit growth flat at +0.1%. 
• Management explained that 1Q17 did not include a full quarter of rental contribution as some tenants had still not moved in. Nonetheless, we do not expect Holland V to move the needle for the group.

We could be underestimating the cost of new hospital expansions 

• Expect more margin woes over the next 12 months Margins are now at a low but could go even lower, in our view. 
• 1Q17’s core EBITDA margin of 18.3% is already 1.4% pts lower than FY16’s 19.7% and we should be wary. We reason this is because the margin pressure in recent years has only been due to gestation costs from small expansion projects (Shaw, ISOS, Holland V) and partly due to weak medical tourism. Hence, we argue that margin pressure will only further intensify due to: 
  1. start-up costs for its Singapore hospital extension opening in 4Q17 (this is a sizeable extension that is due to expand its existing hospital’s GFA by 70-75%), and 
  2. start-up costs for its 700-bed hospital in Chongqing due to open in mid-18 (this is also sizeable and is bigger than Raffles’ 380-bed Singapore hospital).

Potential magnitude of costs to expect from Chongqing hospital 

• To get a sense of the magnitude of pre-operating losses, we draw parallels from IHH’s Gleneagles HK which recently opened in 1Q17. Gleneagles HK incurred c.S$50m of pre-operating EBITDA losses over a one-year period preceding its opening in 1Q17. This is a significant number relative to RFMD’s current profitability, and could erode as much as 54% of RFMD’s FY16 EBITDA. Hence, we still see plenty of headwinds ahead.
• Factors mitigating such a steep fall in RFMD’s current earnings will have to come from improved earnings from its core operations in Singapore or a better-than-expected ramp-up in its Singapore hospital extension (due to open in 4Q17). However, RFMD’s recent results still suggest weak demand and slowing medical tourism. Topline is slowing and 1Q17 revenue declined 1.7% yoy, even as Holland V would have provided some topline boost. We, therefore, argue such a scenario as unlikely.
• We also point out that an important consideration is how comparable Gleneagles HK’s pre-operating costs are to RFMD’s Chongqing hospital. Our concerns for RFMD are 
  1. bed capacity: RFMD’s Chongqing hospital is larger with a 700 bed capacity vs. Gleneagles HK’s 500 beds, and 
  2. RFMD’s group practice business model of employing its doctors/nurses vs. Gleneagles HK where the majority of its doctors are independent practitioners (hence lower staff costs). 
• Mitigating these concerns are 
  1. Gleneagles HK opened all 500 beds upon opening whereas we understand Chongqing will open in phases with 200-300 beds in the first phase, and 
  2. lower mean wages in China vs. Hong Kong.

Valuation and recommendation 

Lowering our EPS estimates 

• We lower our FY18-19F earnings as we now factor in Chongqing hospital, which we previously did not include in our earnings forecasts. 
• Specifically, we input additional pre-operating costs, albeit conservatively at c.S$9m-16m p.a. over FY18-19F relative to what IHH incurred for Gleneagles HK (c.S$50m in its first pre-operating year). This lowers our FY18-19F operating margin assumptions by 1.5-2.6% pts and our FY18-19F EPS by 9-16%.

Revise target price to S$1.25; Maintain Reduce 

• We value RFMD on an SOP basis. Our TP of S$1.25 is made up of: 
  1. Singapore operations: S$1.19, based on 19.2x CY18F EV/EBITDA (its -1 s.d. level), which we think is fair given the current weak climate and uncertainty surrounding gestation costs.
  2. Shanghai operations: S$0.03, based on DCF. WACC of 7.1%, comprising 4.0% risk free rate, 9.0% equity risk premium, 5.5% cost of debt, and 1.0% terminal growth rate.
  3. Chongqing operations: S$0.03, based on DCF. WACC of 7.1%, comprising 4.0% risk free rate, 9.0% equity risk premium, 5.5% cost of debt, and 1.0% terminal growth rate.
• At current levels, RFMD is trading at a lofty CY17/18F EV/EBITDA of 24.8x/25.8x. This is near its 10-year historical +1 s.d. level and above both its 5- and 10-year historical means of 23.2x and 20.3x, respectively. 
• Given the headwinds and uncertainty surrounding start-up costs, we think valuations look stretched at current levels. Based on our current FY16-19F EPS estimates, we are forecasting a 1% EPS CAGR, which arguably means the stock should not even be trading at its 10-yr historical mean of 20x when it delivered a 13% EPS CAGR.
• Relative to peers, RFMD is also trading at a premium despite its flat earnings growth which we think is unwarranted. Regional peers are trading at a cheaper 22.3/19.0 CY17/18F EV/EBITDA.

Jonathan SEOW CIMB Research | http://research.itradecimb.com/ 2017-06-19

CIMB Research SGX Stock Analyst Report REDUCE Maintain REDUCE 1.25 Down 1.370