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The healthcare property renaissance

Has the healthcare property market moved on from the 2011 Southern Cross disaster?
May 1, 2015

Anyone thinking of investing in healthcare property companies can't but hark back to the Southern Cross disaster of 2011. Watching the group's share price tumble 98 per cent in three years, and its market capitalisation shrink from more than £1bn to just £12m is bound to put some people off investing in the sector. It paid the ultimate price for rapid expansion financed by the sale of leases of its homes. But the sale-and-leaseback model implemented by Blackstone - the American private equity company that sold Southern Cross in 2006 - was unsustainable after the 2008 financial crisis. Harsh public spending cuts meant fewer referrals, and Southern Cross found itself unable to make rent on its 750 care homes. By July 2011 Southern Cross was desperate, going as far as to withhold rent payments to keep itself afloat. But it was in vain. All its care homes were eventually taken over by their landlords.

There's no doubt the industry has learnt some harsh lessons. But there are still companies pursuing the same sale-and-leaseback strategy followed by Southern Cross. At the time of its IPO last July, private hospital operator Spire Healthcare's (SPI) parent company European private equity firm Cinven sold 12 properties owned by Spire, replacing them with lease liabilities. That might sound eerily familiar, but chief executive Rob Roger insists it's not the whole story. At the time of Spire's annual results in March, Mr Roger said keeping the company's operational gearing under control was a top priority and any new properties added to the estate are bought freehold. Spire also builds hospitals from the ground up; there are two such sites planned for Manchester and Nottingham. Admittedly, the company still has a hefty net debt pile - about £424m which equates to 44 per cent of net assets. But Mr Roger said after debt repayments and the maiden dividend, there's still £100m in free cash for capital expenditure this year.

 

Spire wasn't the only newcomer in the sector last year. Last April behavioural health specialist Cambian (CMBN) pipped them to the post to mark the first care home float in London since the collapse of Southern Cross. Previously owned by buyout group GI Partners, market watchers said a successful float could spark the sector's "rehabilitation", giving the green light for other private equity-owned healthcare companies to follow suit. Spire wasn't far behind. But, crucially, Cambian's 249 properties are freehold and rental costs represent just 0.5 per cent of revenues. When it courted investors ahead of the IPO, the company said it intended to keep it that way.

On the downside, Cambian's predominant customer is the British government, which only has to raise the minimum wage to inflate Cambian's running costs. This time last year, it was reported that Cambian had already been forced to discount fees paid by the public sector to hold onto its market share. Unlike its flashy rival the Priory (also said to be considering a public offering), Cambian can't rely on the rich and famous to drive its occupancy rates.

But those with reservations about investing in newly listed care home companies could consider Aim-traded competitor Caretech (CTH). The group offers services and residential care for adults and children with learning disabilities, as well as official fostering services for children. Chairman Farouk Sheikh has said he's not too concerned about competition from Cambian - the bigger group has been around since 2004 so it hardly represents a new threat. Instead, Caretech has focused on improving its own business, putting the company through its own formal restructuring in 2013. Mr Sheikh isn't too concerned about the upcoming general election, either. He believes mental health has become "a central issue" for the three main parties, and the slow return to growth bodes well for public spending in the short term. Those tempted by Cambian would do well to notice the discount Caretch offers in comparison. Its shares trade on just eight times forward earnings while Cambian trades on a far punchier 17 times forward earnings.

Investors aren't limited to the UK, either. Healthcare reforms in Dubai and the UAE have spurred the growth of two private hospital operators in the region - Al Noor (ANH) and NMC Health (NMC). The latter's share price has tripled since its IPO in 2012 (the offer price was 210p). The mandatory rollout of healthcare insurance in Dubai is expected to take another two years, so NMC's expansion shows no sign of slowing. Be prepared to pay, however. Shares in the hospital operator are trading on a toppy forward PE ratio of 22.

BOX OUT FROM JONAS:

Primary Health Properties (PHP) owns 269 high-quality medical centres across the UK, with a value of over £1bn. The beauty of the business model is that over 90 per cent of the rental income is paid by the NHS. Political uncertainties may exist ahead of the general election, but when it comes to investing in primary healthcare facilities, the major political parties are all singing from the same song sheet. GP-based healthcare is seen as a logical and necessary means of improving patient treatment and, crucially, as a way of relieving pressure on overworked and understaffed hospital A&E departments. Nearly half of all PHP's leases have over 15 years to run, thus generating significant earnings visibility. There are over 32,000 surgeries in the UK, so PHP's ability to increase its market share is significant. Tellingly, nearly three-quarters of all GPs reckon that their premises are not suitable for the desired range of services, while nearly half maintain that their current premises could not be enhanced to meet these needs. PHP has a strong pipeline of acquisition opportunities, and while the shares trade at a 21 per cent premium to forecast net asset value, this is justified by the quality of the revenue stream. The shares also offer a compelling attraction for income seekers, with a dividend yield of over 5 per cent. JC

IC VIEW:

The arrival of several new hospital and care home providers to the London market suggests the sector is enjoying a 'post-Southern Cross' renaissance. But valuing these companies is fundamentally different to traditional healthcare stocks. Investors should pay closer attention to the balance sheet, seeking buying opportunities via share price-to-book value ratios. Because of the property rights of many of these companies, their value is often better determined by their net assets, rather than a traditional price-to-earnings ratio.

Favourites

Many companies in the sector exhibit toppy valuations. This is unsurprising given the amount of money lost in the past. But our long-standing buy tip Caretech continues to offer long-term value with a forward PE ratio of just eight, while Primary Healthcare Properties is an attractive income play. Investors will have to pay more for growth stories in the sector but NMC offers investors exposure to the growing private healthcare market in the Middle East.

Outsiders

It's hard to judge many companies in the sector given their short life as publicly listed companies, thus far. That said Cambian and Spire Healthcare bear the closest resemblance to Southern Cross and investors would be justified to be wary. There's a more disciplined attitude from both groups, but asking investors to pay 17 and 15 times forward earnings, respectively, hardly signals attractive entry points for new investors. Neither stock trades at a discount to net asset value, either, which does little to bolster the investment case. Shares in Al Noor - NMC's closest sector peer - took a dive when the group missed margin targets in March. That's left the stock trading on a forward PE ratio of 16 - a discount to the longer-term average rating - but the recent offload by private equity backer Ithmar Capital means we're steering clear for now.

Company Price (p)Year-to-date performance (%)Forward PE ratioPrice/NAVIC view 
Al Noor895-9.65166.62Hold, 890p, 23 Apr 2015
Cambian25023.46161.85Hold, 221p, 5 March 2015
Caretech2436.5981.16Buy, 228p, 11 Dec 2014
NMC Health67747.17214.14Hold 520p, 25 Feb 2015
Spire Healthcare321-15.6151.34Hold, 372p, 25 March 2015

Source: Bloomberg