Quarterly Publication - July 2017
Mediclinic - July 2017
Global demand for healthcare is rising. Ageing populations, technological innovation and growing incidences of lifestyle disease are among the contributing factors. People require more healthcare, at great expense to governments and individuals. As a result, funders are increasing their efforts to rein in these costs.
Demand for healthcare is difficult to constrain. Better preventative care is helpful. Medical advances mean procedures become less invasive, reducing the required lengths of hospital stay – although often increasing technology costs. Limited ability to control demand means most energy is spent on tackling the cost to supply services. Wholesale structural changes to market practice and efficiency are usually the result of regulatory interventions, while pricing is constantly interrogated. As affordability becomes even more of an issue, the continued pressure on healthcare providers will only grow stronger.
Despite these challenges, well-run hospital businesses should continue to thrive. Private hospitals deliver critical services efficiently in environments where traditional providers (often the government) are very constrained, with limited ability to fund the growing demand. If rational funders want to optimise value-for-money healthcare, the private sector has a role to play if it can deliver efficient services.
Investors in SA have access to three high-quality listed hospital groups: Life Healthcare, Netcare and Mediclinic International. All provide good clinical care domestically. However, it is the size and quality of their international businesses that really set them apart. Mediclinic International generates the bulk of its earnings offshore through market-leading businesses in Switzerland and the United Arab Emirates (UAE). While the outlook for its SA operations is dimmed by a government inquiry, a sluggish economy and challenged affordability, Mediclinic’s international footprint offers an opportunity for growth and protection against adverse risk in a single market.
However, over the last year, Mediclinic has been hit by an almost perfect regulatory storm. In addition to SA’s long-running market inquiry, operations in its largest Swiss hospital faced a potential punitive tax on private patients and Abu Dhabi regulators introduced a 20% co-payment fee on all nationals using private hospitals. The Swiss tax has been averted and Abu Dhabi reversed its regulation, so there is some respite over the short term. Still, we expect regulation will continue to impact hospital businesses from time to time as governments strive to maximise value for their healthcare spending.
Any pressure exerted on pricing must tread a fine line between incentivising investments in desired additional capacity without encouraging excessive investment. Underutilised assets make for an expensive healthcare system. Growing demand means additional capacity must be created in most markets we consider and prices therefore need to be sufficiently high to encourage investment. Our analysis of regional returns shows that Mediclinic does not earn excessive returns on newly deployed capital. In SA, adjusting its assets to replacement asset costs delivers returns in the low double digits. It is the long duration of the asset life (hospital buildings and land), rather than high upfront earnings generation ability, that delivers the returns over time. This low upfront return provides protection from excessive pricing cuts later on, with geographical diversification providing further defence.
Steady earnings and valuations, underpinned by tangible portfolios of land and buildings, mean hospital purchases can be highly geared, reducing the amount of equity needed to fund these transactions. This improves the underlying return that is achievable. These factors deliver returns to patient, long-term investors who are prepared to invest and wait for returns delivered over the asset lifetime. Mediclinic has continued to invest on this basis.
Despite threats posed by regulation, hospital groups trade on high multiples, reflecting the market’s recognition of their structural growth prospects and ability to deliver steady, defendable earnings over time. Mediclinic trades on a oneyear forward price earnings of 21 times. High short-term valuation multiples will unwind as earnings grow.
In the case of Mediclinic earnings, the base is low. In a reverse takeover, Mediclinic acquired the FTSE-listed Al Noor Hospitals Group last year. It has been a rocky start. Al Noor had suffered significant doctor losses as Mediclinic began to transition the group to comply with its global clinical policies. In addition, occupancies were substantially undermined when Abu Dhabi regulators introduced co-payments for state patients using private hospital facilities. First-year reported earnings for the combined regional group collapsed.
We believe that the private sector can be an efficient supplier of high-quality, critical services to the state – a position that was confirmed by Abu Dhabi’s decision to reverse the co-payment regulations in April 2017. Growth in the regional structural demand remains intact and the existing hospital base has spare capacity to be filled. Attracting more doctors is essential to lure patients back, now that regulatory obstacles have been removed. The recruitment of doctors into the UAE is a slow process as work permits, relocation and the build-up of patient bases take time – but the programme is well under way and we would expect earnings to recover strongly in coming years.
The Swiss business has its own challenges. The market has an effective regulator, which tackles areas where overinvestment and excessive profits are detected. From time to time, changes in tariffs on basic insured patients should be expected and the business will face this in the next year. While this will have a short-term impact, over time costs and investment will be adjusted to mitigate the tariff cuts. In addition, the business is investing in integration, building a strong central platform to offer efficient services to its hospitals. Over time, these investments should serve the dual purpose of making existing operations more competitive and creating a lean infrastructure. The platform investment allows for future acquisitions to be simply ‘bolted on’. Mediclinic announced a small hospital acquisition in June, and more are expected.
SA faces a challenging time and the private hospital companies cannot escape this. A lack of growth in private sector employment means membership of medical aid schemes is sluggish. Growth in demand comes from the existing memberships, which is putting pressure on affordability. Attempts to control spiralling healthcare costs by large schemes like Discovery add to the pressure on hospital volumes. Despite this, Mediclinic is reasonably well positioned. Global learnings have been implemented and Mediclinic has focused on clinical quality and patient experience. In addition, a well-located footprint across SA’s secondary towns makes it an important part of any medical scheme network. This will prove significant in a market where we expect competitive forces to accelerate. With this in mind, we expect SA earnings to be relatively resilient.
Hospital companies are attractive businesses with long-duration assets and the ability to deliver steady and defensive earnings over time. While the market recognises this earnings quality with high multiples, the Mediclinic multiple is likely to unwind over the coming years as its Middle Eastern business recovers and its other platforms deliver sustainable earnings.