A merger-arbitrage special situation creates an opportunity to own an undervalued specialized German hospital asset, which is also a M&A target

RHK explores strategic alternatives with Fresenius to unlock shareholders’ value

A special situation has been created after RHK (Germany’s third largest hospital chain) in a surprising move announced an asset purchase binding agreement with Fresenius Helios (Germany’s largest hospital chain) on September 13, 2013 for the sale of two-thirds of its business involving a portfolio of 43 hospitals for an all-cash consideration of €3,070m. The portfolio represents 65.7% of combined FY12 sales and 68.2% of combined EBITDA. The consideration represents a multiple of approximately 12.3x FY13 EV/EBITDA and 1.5x FY13 EV/Sales. The management has proposed a special dividend of €1.9bn (equal to €13.80 per share) and equivalent to ~72% of current market cap from the transaction proceeds.

What makes the situation interesting is that 1) the market is giving the Stub (New Rhoen) a dirt cheap implied valuation of 4.2x FY13E EV/EBITDA, and thereby an attractive entry point, 2) the deal being not as simple as the earlier takeover offer by Fresenius in 2012, which was failed, special situation investors would be reluctant to enter the stock again, and finally 3) I expect the Stub (New Rhoen) to be acquired once there is more clarity on the 90% threshold rule. Additionally, I expect the transaction has a good probability of going ahead as it only requires simple majority, thereby providing a solution to the legal backlog.

Background: Earlier in 2012, Fresenius proposed a full takeover of RHK at €22.50 per share. However, the bid was blocked by Asklepios, Germany’s second largest hospital chain, and Braun Melsungen, a medical device company, with the purchase of more than 5% outstanding share capital of RHK each. With a total share of more than 10%, the two companies established a blocking minority as RHK’s charter required 90% voting majority for changes to the charter and important strategic decisions.

New Rhoen (Stub): Attractively valued with hidden asset and strong balance sheet

After the completion of the transaction, only five highly specialised hospitals (Bad Neustadt, Bad Berka, Frankfurt/Oder and Giessen & Marburg) with total revenue of €984m and EBITDA of €97m will form the new Rhoen group. On the basis of revenue, it will become the fourth largest hospital group in Germany. I believe that New Rhoen represents an interesting situation in itself owing to being an 1) acquisition target itself as the German acute care market is undergoing structural changes towards market consolidation and privatization, 2) new RHK debuts with a net cash balance of €155m after meeting the needs of capex and special dividend, thereby enabling the scope of  further cash distribution potential in terms of higher dividends, 3) allows new CEO (appointed in Jan 2013) and CFO to have a focus on a small concentrated portfolio, enabling it to achieve organic revenue growth target of 3.5%-4.5% until 2015 and an EBITDA margin of 14% by 2015.

I believe that RHK is cheaply valued if the current share price of €19.22 is split into a cash deposit of €13.80 (without taking into account the tax consideration) and the remaining €5.42 as the technical split price for New Rhoen. I see an upside of 17.6% on the combined entity and a significant upside of 62.3% on New Rhoen (post divestment) based on the technical split price.  

Why Insiders are important:

Eugen Muench (Founder): The Chairman of the supervisory Board and a member of the founding family of RHK, Eugen Muench is the largest shareholder in the company, with a 12.5% stake along with his wife, and has a significant say in the supervision of the company. Mr. Muench supported the full takeover offer of €22.5 per share by Fresenius in 2012 and even tendered all of his shares. He has been keen to cash in on his family holding and exit the company because it allows him to pursue his vision of exploiting the benefits of a full national hospital operator.

Asklepios: The Asklepios Group is one of the three largest operators of private hospitals in Germany, with a market share of ~20%. Asklepios had opposed the Rhoen-Fresenius tie-up, with a view that it could play the strong Rhoen card to trump rivals when public-sector hospitals were put up for auction. The group owns about 140 hospitals worldwide, including those in Russia, China and California with 44,000 employees. The mastermind behind Asklepios is the founder and sole shareholder Dr. Bernard Broermann, who also owns luxury hotels and has made it to the Forbes list of billionaires (rank 39 in Germany with an estimated $2.1bn net worth as of March 2012). The group snapped up a 5.01% stake (6.9m shares) of RHK, thereby thwarting the takeover bid by Fresenius. I estimate that Asklepios most likely bought this position during the bid process between €21 and €22 per share and hence sits on a loss. 

B. Braun Holding: Owned by the family of Chairman Ludwig Georg Braun, the group competes with Fresenius in the hospital equipment market, such as intravenous and tube feeding supplies. It too bought a stake of 5% in RHK last year (expected to be during the tender period) as it was concerned it would lose RHK as a major client should Fresenius take it over.

Alecta pensionsforsakring: The Swedish firm Alecta, the second largest shareholder with a 9.9% stake, also wants to exit and had tendered all of its shares to Fresenius in its takeover bid in 2012. Alecta is an occupational pensions specialist managing approximately SEK560bn for its owners, of whom approximately two million are private customers and 33,000 are corporate clients. The fund, on May 2013, was reported to put to vote, among fellow shareholders at RHK's annual general meeting on June 12, a proposal to scrap the minimum acceptance threshold in the company's bylaws, which would also apply in the case of a takeover of RHK.

Can the New CEO & CFO afford to be part of another failed attempt?  

Former CEO and CFO: After the failed takeover attempt by Fresenius, Wolfgang Pfohler and Erik Hamann had to leave the company. Wolfgang Pfohler, CEO and Chairman of the management board of RHK, resigned on December 31, 2012 and Dr. Erik Hamann, CFO of RHK, resigned on September 30, 2012.

Entry of New CEO and CFO
On January 1, 2013, Mr. Martin Siebert became RHK’s new CEO. He has been a member of the Management Board since October 1, 2012 and the head of the Median hospitals since early 2010. Previously, Mr. Siebert had worked with Asclepius for 16 years. He holds Supervisory Board mandates at Universitaetsklinikum Giessen und Marburg GmbH, Bundesverband Deutscher Privatkliniken and Willy Robert Pitzer Stiftung (Member of the Advisory Board).

On November 1, 2012, Jens-Peter Neumann became the new CFO and a member of the Management Board. Previously, he served as a member of the Supervisory Board at RHK from May 31, 2007 until November 1, 2012. Additionally, he acted as a member of the Audit Committee as well as Investment, Strategy and Finance Committee of the company until November 2012.

German Hospital Industry
The German hospital market is mature and highly regulated. This limits growth potential for private players but, nonetheless, provides stable margins. As a result, growth via acquisitions remains the only viable option for the players. RHK currently has a 3.7% share of the German hospital market and more than 20% share of the private hospital market. Considering all these, I believe that consolidation is the only way to go for a mature industry like this. Budget pressures, demographics, medical progress and regulatory changes are expected to lead to market consolidation, privatization and the integration of healthcare infrastructures.

New Rhoen

I believe that the planned transaction creates an attractive realigned business model for new RHK focused on specialized and high-end medicine high-end medical approach. New Rhoen-Klinikum will include four clinics (five locations) that are all maximum care providers with 5,300 beds as against previous bed size of 17,104. These locations include Bad Neustadt (>1,000 beds/Revenue €180m), Bad Berka (660 beds/€150m), Frankfurt (Oder) (830 beds/€120m), as well as the university hospitals in Giessen and Marburg (UKGM) (2,200 beds/€530m). New RHK is expected to generate revenue of €984m in FY12 with an EBITDA of €97m.

New RHK targets an organic revenue growth of 3.5%-4.5% until 2015 and an EBITDA margin of 14% by 2015. I believe that the transaction allows significant value to be realised for shareholders, while creating a small concentrated portfolio of maximum care providers. Additionally, a cash-rich balance sheet (starting with a net cash of €155m), after meeting the needs of the intended capex programme of €200m and a special dividend of €1.9bn, will enable new RHK to set further cash distribution potential in terms of higher dividends. 

Misconception and Hidden Asset under New Rhoen

Investors may be skeptical of the transaction that the stub (New Rhoen) is left with a portfolio of hospitals that are non-performing, with EBITDA margins being as low as 9.8% for FY12 as against the divested portfolio clocking EBITDA margins of 11.0%. This is also evident from the fact that the stub constitutes 34% of FY12 sales but just 31.8% of total EBITDA.

Is there a Hidden Asset amongst New RHK?

While acknowledging the fact that the stub will be left with a low-margin business, I would like to highlight that margins of New RHK are depressed because of the undergoing restructuring in UKGM, which constitutes 54% of total New RHK sales but EBITDA margin of just 4.7% (as against 9.8% of the New RHK). Adjusting for the margin dilutive Giessen/Marburg hospital (EBITDA margin of  only 4.7% in 2012) implies that the Non-UKGM clinics operate at a robust margin of  15.5%. Hence, a successful restructuring of UKGM will be a key catalyst, which is currently not factored in by the Street and would help the management achieve its objective of EBITDA margins of 14% by FY15 and organic growth rate of 3.5%-4.5%.

UKGM (Giessen/Marburg clinics) – Restructuring under process

RHK has a history of buying low profitability hospitals and restructuring them into its medical network. The acquisition of Giessen Marburg (c. 2,200 beds) in 2006 was an important milestone in RHK’s history. Giessen Marburg is the biggest hospital restructuring project in Germany, which makes RHK the first and only private player in the German hospital market to operate a university hospital. This might give RHK better access to innovative medicine, graduates and scientifically leading physicians. I believe that the restructuring was delayed owing to the focus of the management on the Fresenius bid in 2012. 

 Aditionally, we would also like to highlight that 1) the new management will be completely focussed on UKGM with a focussed portfolio in New RHK, 2) RHK’s past successes in restructuring assets will be very useful in this case too, and 3) the management may have given this asset to new RHK so as to structure the deal that gets cleared with regulators rather than leaving New RHK with unfavorable assets, and 4) ultimately, a takeover bid cannot be excluded once legal clarity is provided on the 90% threshold

Key Risks

1.      Current transaction to sell 66% of business by revenue gets blocked: Even though the current transaction requires a simple majority and has been carefully drafted by both the managements of RHK and Fresenius Helios, I believe that if the transaction gets blocked owing to uncertain circumstances, the share price may fall to a level in which no acquisition is factored in.  On September 13, 2013 (one day prior to announcement) the stock closed at €17.45 (10.1% below current levels) and on April 25, 2012 (one day prior to Fresenius first takeover offer) the stock closed at €14.77 (30.1% below current levels).

2.      The AGM which was held earlier in 2013 resolved to delete the 90% threshold rule from RHK’s bylaws: The 90% threshold is required for all AGM decisions that require more than a simple majority vote. During the AGM, one block shareholder (B. Braun) was not able to fulfill the authorization requirements and, therefore, his votes were not considered. As a result, four invalidation proceedings have been subsequently filed against the AGM decision. We believe that a decision on the 90% rule will bring a clarity and, if upheld by the court, it will make it easy for New Rhoen to also get acquired.

3.      New Rhoen will have a more volatile earnings development given a lack of diversification: UKGM will account for 54% of sales but just 27% of the EBITDA. An unsuccessful restructuring of UKGM would challenge 2015 targets, as it is the key source of earnings growth. 


SOTP valuation derives substantial upside
 

I believe that the current share price of €19.22 can be seen in perspective of €13.80 cash deposit (without taking into account the tax consideration) and the remaining €5.42 as the stock value for New Rhoen. Assuming this €5.42 as a technical split price for New Rhoen, I see a significant upside for the stub as the 4.2x FY13 EV/EBITDA multiple represents a fairly large discount to hospitals and even when compared to the current concluded Fresenius deal multiple of 12.3x FY13E EV/EBITDA. With limited information on the stub, my EBITDA estimate and valuation multiple assume a successful restructuring of UKGM and meaningful reduction of overhead costs. The management has guided for a 3.5%-4.5% organic growth and 14% EBITDA margin target for New Rhoen. Based on the sum of the parts valuation approach, I derive a fair value of €22.59 per share excluding any potential tax obligation, which implies an upside of 17.6%.

Probable scenarios from here

1.      New Rhoen (Stub) gets acquired by Fresenius, as I believe that none of the insiders would like to get stuck in the “New Rhoen” and hence would be open for a consolidation proposal. Additionally, the founder, Eugen Muench, also would want to exit completely as the very idea of “New Rhoen” is against his vision of making an integrated broader medical network. As a result, clarity on the 90% threshold limit would pave the way for this acquisition, which, I expect, to take place in 1HFY14.

2.      New Rhoen gets acquired by Asklepios as a term of settlement between Fresenius, Asklepios and Rhoen. In return, Asklepios withdraws the arbitration proceedings.

3.      Braun and Asklepios sell their respective stake to Fresenius, as recently Asklepios announced that it will not fulfill the condition of selling the heart clinic since this was the condition laid by Federal Cartel Office prohibiting Asklepios from further increasing its shareholding in Rhoen Klinikum to 10.1%.

4.      New Rhoen (Stub) continues to operate independently if the court rejects the decision by the AGM to abolish the 90% threshold requirement. Even in this case I expect New Rhoen to be valued in-line with other hospital multiples and the market to recognize true worth of the entity.