Description

Introduction
Generale de Sante (Bloomberg: GDS FP), the leading private hospital group in France, offers investors compelling value along with a favorable “micro” and “macro” backdrop.
Given the complexity of regulatory issues in France, it’s quite easy to overlook the coming changes in the “macro” landscape that will drive GDS’s earnings over the next few years. From a “micro” perspective, GDS has just completed a program aimed at divesting non-hospital assets and streamlining operations. It is now in a position to expand margins substantially. GDS currently trades at a discount to its peer group, and a 50% discount to its intrinsic value. It currently has a dividend yield of 2.0%, and at a FCF Yield of 10%.

“Micro” Thesis on Generale de Sante :
Generale de Sante has 112 healthcare facilities, 11% share of the €9.0 billion French private hospital care market, and a small presence in Italy and Portugal. The company was created in 1987, and went public in 2001. It has lost approximately half its value since then. Much of this underperformance has been due labor cost issues and declining profitability. Similar to most healthcare providers, labor is the biggest component of the cost structure coming in at just under 50% of sales. In the 3rd quarter of 2003, GDS announced a strategic plan to restore its profitability. The plan consists of divesting non-hospital care assets, reducing acquisition activity, and refocusing on the integration and profitability of its existing hospital care business. In accordance with this plan, GDS sold its nursing homes and international activities outside of Europe in 2003, and has recently completed its divestment plan by selling its hospital-services (catering, cleaning) businesses to Elior.


New Strategic Shareholder : Dr. Ligretsi
In July 2003, a new shareholder, Dr. Antonio Ligretsi, joined the company after acquiring a 33% stake at €12.30 per share. GDS rejected a competing offer, by Capio AB (CAP SS), a leading European hospital operator based in Sweden, of €12.50 per share for this stake and the rest of the company. Dr. Ligretsi’s purchase of the stake effectively culminated the exit plan of various venture capitalists whose stake in GDS was held via an entity known as Santé Luxembourg. Dr. Ligretsi’s experience as a cardiologist and successful Italian hospital entrepreneur background should add significant value to GDS’s management team as Chairman of the Board. It is important to note that Dr. Ligretsi built, managed and then sold an Italian hospital chain for greater than €100m and invested a significant amount of the proceeds into GDS.

Evidence of Progress
Since Dr. Ligretsi has joined the company, the following have been implemented: (1) a new CFO and COO have been appointed, (2) a plan to cut costs by 30% at the headquarters was announced, and (3) a strategic margin expansion plan has begun. This plan, known as “Tremplin” (or in English “Trampoline”), aims to save Euro10m per annum from 2005 onwards. In March this year, the company enhanced its corporate governance by creating supervisory board headed by its largest shareholder, Dr. Ligretsi. The initial progress can be seen in GDS’ first half results: margins expanded, revenue was up 16% y/y and EBITDA was up 23% y/y. On the conference call, management affirmed its plan to achieve an EBIT margin of 8% by 2006 (at 12/2003 EBIT MGN was 5%), growing at 100bps on average per year. Additionally, management made favorable comments about the labor situation, stating that it should increase at a rate less than their price increases, which are determined by the government. 2004 will be the first time since GDS’ IPO that its price increases will exceed the rate of growth in personnel expenses. Recall that over the past few years the 35 hour work week was introduced and there was a nursing shortage thereby placing pressure on GDS’s labor costs. If management’s comments hold true the labor market conditions should be extremely beneficial to margins and shareholders.

“Macro” Thesis on the Private French Hospital Market:
Firstly, it is important to note that the healthcare services sector is quite different in France than it is in the United States. Most notably, healthcare is almost entirely funded by French Social Security, and reimbursement is currently based on healthcare provider costs versus standardized rates as in the United States. Such a cost based system creates tremendous inefficiencies. Similar to the United States, there are both private and public healthcare providers. In the current French system the public healthcare providers, however, are not encouraged to be efficient. The inefficiencies embedded in the current French system can be quickly realized in the fact that public healthcare providers are paid on average 30% more for the same procedure than a more efficient private provider. Over the past few years, this inefficiency has been highlighted as being a large contributor to the nation’s deficit and has been targeted for major reform by the French government.

The French healthcare reimbursement system will soon change to imitate that of the United States’ diagnosis-related group (DRG) prospective payment system, known in France as “T2A”, which reimburses based on standardized rates. The implementation of this system will create “one price” for each procedure (DRG) and will be massively accretive for GDS, and any efficient providers. For example, assume that for a given surgical procedure it has historically cost public providers €1050 and private providers €770. The government may set the reimbursement rate for this procedure at €900. Unlike the US’ implementation of its DRG system in the 1980s, France is taking a more conservative approach with a gradual phase in period. This will preserve the financials of the less efficient public operators as well as provide extra comfort for the efficient private operators. Nevertheless, this will force the public providers to be more efficient, and should improve pricing at GDS over the medium term. The changes are expected to begin implementation in December 2004.

Interest in French Hospitals:
Historically owning or operating a French hospital has been a bad business. The proposed “macro” changes to French healthcare policy is generating significant investor interest in French hospital stocks. There are currently two major public hospital companies, Universal Health Services (UHS) and Capio AB, which are acquiring French hospitals. Recently, both UHS and Capio have exhibited signs that they are looking to be even more involved in the French hospital market. Recall Capio’s intention to acquire GDS and also the increased rate at which UHS is adding French hospitals to its portfolio consisting primarily of hospitals based in the United States. Here are some extracts from a recent conversation with Steve Filton, CFO of UHS:

“The French hospital market is attractive…we will continue to expand in France. In 2001 we had 8 French hospitals, today we have 14.”

“We think that we can buy hospitals at 6x EBITDA….and private buyers are willing to pay 8-9x EBITDA for a ‘platform’ of hospitals.”

This interest from private buyers will increase in France as the positive pricing elements emerge from the “T2A” (DRG) healthcare policy.

Valuation:
_______________EV / EBITDAR 2005______P/E 2005_____EV/SALES___DvdYld
Generale De Sante_____5.5x______________10.0x__________0.7x_____2.0%
Capio AB______________7.6x______________18.9x__________0.9x_____n/a
Rhoen Klinikum________5.0x______________11.2x__________0.9x_____1.70%
UHS___________________6.6x______________14.2x__________0.8x_____0.75%
HCA___________________6.9x______________13.7x__________1.1x_____1.30%

Average ______________6.3x______________13.6x__________0.9x_____1.44%

In spite of these encouraging “micro” and “macro” developments, GDS still trades at a discount to its peer group. GDS currently trades at an attractive enterprise value multiple of about 5.5x expected 2005 EBITDAR and has a dividend yield of over 2%. I believe this is largely because investors are stuck in the old paradigm of “France being one of the worst markets for hospital operators”. As the T2A system is rolled out over the next year it seems likely that investors will recognize the potential margin upside for efficient operators and re-rate GDS. A valuation of 6.5x – 7.0x 2005 EBITDA would not be unreasonable, and would produce a share price of € 17.50 – €20.7. Furthermore, I am comforted by a “margin of safety” knowing that in July 2003 two astute hospital investors: Dr. Ligretsi and Capio AB were willing to pay €12.30 and €12.50 per share, respectively. Given that there has been significant progress at GDS since Dr. Ligretsi has joined the company, I believe that his entry price (€12.30) represents a valuation floor.

Catalyst

Catalysts:
- Further clarity about the reform to French healthcare policy
- Announcements of 2005 pricing
- Results for 2004 and a guidance update
- Savings from the Tremplin plan in 2005 and 2006
- Finance Minister, Nicolas Sarkozy, chatter about elimination of the 35hr work week in France