By Paul Rickard

With the health care sector cheapening by the day, several leading value investors are looking at Australia’s private hospital operators, Ramsay Health Care (RHC) and Healthscope (HSO), as possible investment plays. With the tailwinds supporting the health industry still blowing, Roger Montgomery for one has come out quite strongly for Healthscope. But is Ramsay a better option?

I will have a go at weighing them up. But first, an update on the performance of the health care sector.

It has been smashed over the last couple of months as investors have moved into resources, financials and cyclicals. Since peaking on 25 July, the healthcare index has lost 15.4% (to 7 December) compared to the broader market’s net gain of 1.0%. This follows five years of outstanding performance, as the chart below details. It shows the S&P/ASX 200 and the healthcare index using a common base. Over the last five years, the healthcare sector has returned 183%, approximately three times the broader market’s 63%.

 

Source: Data from S&P Dow Jones

The recent fall in Australia has followed the lead from the USA, where healthcare stocks are also on the nose. While the US S&P 500 has returned 10.5% so far this year, the health care sector in the US is down by 3.8%.

But steep falls translate to opportunities for value investors, and the private hospital operators, with their low level of uncontrollable risks, are very much at the top of the agenda.

So, is Ramsay or Healthscope a better opportunity?

Ramsay Health Care

Ramsay is Australia’s largest operator of private hospitals, and ranked in the top five globally. Ramsay Health Care reported core net profit of $481.4 million for the year ended 30 June 2016, a 16.8% increase on the previous corresponding period. Core earnings per share (EPS) grew by 17.7%. 

On a group revenue base of $8.7bn, Australian private hospitals accounts for just over 50%. Ramsay is also the largest private hospital operator in France, through the Ramsay Générale de Santé group. Revenue from France contributes about 35% of the total, while the UK business pulls in 10%.

Ramsay’s strengths include a fantastic track record of delivery and performance (it has met or exceeded every forecast it has issued), a stable and experienced Board and management team, a very focused strategy, an exportable business model and a very disciplined investment process. It has a pipeline of greenfields and brownfields projects, where it adds beds, operating theatres and new hospitals. In Australia, it's also making an expansion into the pharmacy business. It currently operates over 200 hospital pharmacy dispensaries across its global hospital portfolio, and is in the process of establishing community pharmacies in strategic locations, concentrating initially on locations in close proximity to its hospitals in Australia.

Concerns from analysts and investors mainly relate to Ramsay’s overseas acquisitions, particularly the business in France. This centres on the challenging political environment, which is not supportive of the private health sector.

Ramsay peaked on the ASX on 1 September at $84.08 shortly after announcing its full-year results. It closed on Wednesday at $68.04, down 19.1% from its high. 

Ramsay Health Care (RHC) 

Source: Yahoo!7 Finance

Ramsay reaffirmed its profit guidance for FY17 at its AGM on 9 November. It is targeting Core NPAT (Net Profit After Tax) and Core EPS (Earnings Per Share) growth for the Group of 10-12% for FY17.

Healthscope

Healthscope is Australia’s second largest operator of private hospitals. In FY16, the Australian hospital business delivered revenue of $1.95bn (cw Ramsay’s $4.4bn), up 5.1% on FY15. Operating EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) of $355m was up by 8.3%, and represented 82% of Healthscope’s earnings.

The other 18% comes from pathology services outside Australia. New Zealand generates 12% of group EBITDA and has been growing strongly, while 6% comes from Malaysia and Singapore.

At a group level, operating EBITDA rose by 7.1% in FY16 on revenue growth of 6.2%. Ramsay, on the other hand, grew core operating profit by 16.8%.

Healthscope is viewed by some analysts as having a stronger pipeline of greenfields and brownfields projects. Recent brownfield sites at Gold Coast Private, National Capital Private in the ACT, and Knox Private (VIC) have seen admissions growing at a faster rate than the broader market. In 2017, it is set to complete projects at Darwin Private (NT), Holmesglen Private (VIC), Norwest Private (NSW) and Northpark Private (VIC). In 2018, the new public/private 450 bed Northern Beaches Hospital in Sydney is set to open.

The company’s balance sheet is strong, with gearing (net debt/net debt + equity) at 30 June sitting at 35.5%. On the same measure, Ramsay’s was 60.8%.

Ahead of its AGM on 21 October, Healthscope issued a profit warning. It said that “the Company has experienced slower than expected revenue growth in Hospitals in the first quarter. Despite this recent softening in hospital activity during the period, Healthscope remains confident that the industry fundamentals have not changed and the long term demand outlook for the Hospitals division remains strong”. It went on to say, however that “if the trend for the first quarter was to continue, it is likely that Operating EBITDA growth for our Hospitals division would be flat year on year. “

Healthscope floated on the ASX in July 2014 at $2.10 per share, and peaked on 29 September at $3.17. It got smashed after its profit warning, and last night closed at $2.28, down 28.1% from its high.  

Healthscope Limited (HSO)

Source: Yahoo!7 Finance

The Brokers

The brokers are marginally positive on both stocks, but slightly more disposed to Healthscope. On a multiple basis, Ramsay is trading at a considerable premium to Healthscope, being priced on a multiple of 26.4 times forecast FY17 earnings compared to Healthscope’s 20.7 times. This premium narrows in FY18, with Ramsay at 23.4 times and Healthscope at 19.3 times.

On valuation grounds, the brokers have a consensus target price for Ramsay of $79.75, 17.2% above Wednesday’s close. Healthscope’s target price of $2.63 is 15.3% above the close of $2.28. 

Broker Recommendations and Target Prices

Source: FNArena

Broker Earnings Forecasts

Source: FNArena (as at 7 Dec 16) 

One other factor to consider - the short sellers are active in Healthscope. The latest ASIC figures show that 153.6m Healthscope shares are sold short, or 8.85% of its issued capital. This is a reasonably high figure, placing Healthscope in the “top 15” of short sold stocks. By comparison, short sales in Ramsay are 4.3m shares or 2.11% of its issued capital. 

My View

There is no doubt that Healthscope is priced more attractively than Ramsay, and is arguably, better value. However, it can take time for the market to re-rate a stock, and I prefer to back “form” over “potential”. With Ramsay guiding to earnings growth of 10 to 12%, and Healthscope flat, I can’t see this rerating happening quickly. Ramsay remains my pick.

Disclosure: The author and his SMSF own shares in Ramsay Health Care.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.