Private hospitals are a phenomenal business. We all need them at some stage in our lives, and when we, or our loved ones, need them we are price takers. As health and life are unique and essential, we are price inelastic to these services. In fact, because of this imbalance between buyer and seller, the economic concepts of free will, of willing exchange of money for goods and services, of Adam Smith’s “invisible hand”, are compromised. Therefore, the ethics of paid hospitals are the topics of many essays and much political opinion. I personally think that hospitals should be run by a competent accountable government as a monopoly supplier.
However, decades of political legacies and infighting have created realities in South Africa and other emerging market economies that provide large opportunity for private health care providers. From an investor’s point of view, these are great businesses. Not only are demographic changes, such as ageing populations, and public health challenges, such as obesity, increasingly creating demand for these services, but life style procedures, such as elective surgery, are also supporting private hospitals and will do so increasingly. The particularly poor service delivery in South Africa, create significant demand from a growing middle class. Additionally, the weak Rand and relaxed visa regulations for other African countries, support medical tourism trends, which are likely to grow.
For these reasons, hospital groups have had strong growth in the last decade and the protected nature of their cashflows through business cycles has ensured that these businesses have traded at significant premiums. My interest was piqued, when the large pullback in prices, has suddenly moved these companies into reasonable valuation territory. I prefer Life Health Care Group (LHC), as unlike their peers Netcare and Mediclinic, they have resisted the temptation to expand into developed markets. I am convinced that the real value for these businesses remains in the developing world, where governments will remain incapable of providing these services for many decades.
LHC on paper is currently looking very attractively priced. A PE of 16.5, with a forward PE of 14 and, importantly a dividend yield of 5.2%. The stock is lower today than in mid-2012.
However, in mid-November the group announced a game-changing deal, that boggles the mind and completely changes the investment perspective of LHC:
- They are acquiring the Alliance Medical Group in the UK for a consideration of R13.3bn. At the current market cap of R34bn, this immediately transfers approximate 25% of the LHC value into a developed country that has a saturated private market AND a moderately successful public system in the NHS.
- The acquisition target has Total Assets of 276m Pounds, at a purchase price of 800m, this will result in significant goodwill on the LHC books.
- Worse, Alliance Medical Group has Net Assets of 10m Pounds, essentially implying that the business is EXTREMELY geared and LHC are acquiring no net assets. When interest rates rise (and they are already rising in post-Brexit UK), this amount of debt will bite straight into cashflows.
- Alliance Medical Group has net profit after tax of 9m pounds. What? This implies an acquisition PE of 100. How desperate is LHC management to move into the UK?
The deal appears to distract management from its emerging market growth destinations and – more importantly – appears to severely over price the Alliance Medical Group. If management is that desperate to make a deal in a developed country, it also shows that they have negative views of the Southern African market.
In conclusion, this is an excellent example of how one deal can change the investment fundamentals of a company. In my opinion, LHC has gone from a value business in a market with strong fundamentals and focussed management, to an overvalued business that lacks geographical focus or growth prospects.