Description

Spire Healthcare

Disclaimer: I have a position and am looking at building it around here

Quick Investment Case

I would buy Spire Healthcare at current levels (about 113p as I write this).

Over the last year or so, the shares have fallen from a high of about 370p to the current 113p on the back of:

• Top line pressure in the NHS business as the NHS looks to reduce the cost of work outsourced to the private sector

• Top line pressure in the PMI business as PMI’s continue to be focused on pricing and look to consolidate spend based on good outcomes

• Moderating top line growth in the Self-Pay segment

• Increasing cost base driven by labour, regulatory compliance and drug inflation, together with some self-imposed damage from strategic spend behind marketing

• Disappointing earnings from their largest shareholder, Mediclinic, decreasing the probability of a bid from Mediclinic and even prompting some discussion over a potential sale of their stake

The above factors have driven meaningful earnings pressure. Underlying EBITDA has declined from £160m in 2016 to £152m in 2017 to a guided range of £120m-£125m this year. Adjusted EPS will more than halve this year, from a peak of 19.1p in 2016 to about 8.6p this year, while the IFRS numbers are 16.3p and 6.3p, respectively.

The company is relatively highly levered, with net debt of £460m; if the company were to miss their adjusted EBITDA range of £120m-125m by 10%, they would be in breach of their debt covenants; they have already downgraded guidance once this year, from adjusted EBITDA “slightly below” the 2017 level of £150m, to the current £122.5m at the midpoint of the range.

In spite of the above, I believe that the stock is a buy at current levels. I believe that the company should benefit from the following trends going forward:

• The NHS business should bottom out this year, or at least the rate of decline should moderate. The government is targeting a decline in waiting lists from 4.3m procedures to 3.8m procedures. The only way to achieve this goal will be more use of the private sector, which should benefit Spire:

https://www.theguardian.com/society/2018/aug/30/nhs-urged-to-use-private-healthcare-to-reduce-waiting-lists

• The PMI business should benefit from a move from the insurance companies to consolidate their business among the larger players able to deliver better outcomes, which requires investment. Spire have invested £500m over recent years and are a preferred player, winning several contracts recently. The cost of compliance among the smaller players is now reaching a pain point where they cannot continue. Anecdotally, I am aware of a few them have already reached out to Spire about being acquired as they see the writing on the wall

• The largest private hospital player, BMI, is in severe financial distress following a disastrous sale and leaseback transaction several years ago. Upward only rent reviews and NHS business weakness have meant that the company have been unable to invest in their business. They are losing business (https://www.ft.com/content/e32a174e-3405-11e8-a3ae-fd3fd4564aa6)  and, anecdotally, may be shopping their hospitals to buyers. Spire, operating at just 65% capacity utilisation, will be able to slot that market share into their own business at a high incremental margin

• The company is working to eliminate non-frontline-related costs, which should save a few million pounds in the coming year or two. It will be things like removing some staff from the London HQ, centralising the medical assistant function, which is decentralised and poorly-managed currently

• This combination of better top line momentum and the associated operating leverage, together with some cost savings, should generate meaningful adjusted EBIT growth in FY19.

• Over the medium-term, I expect them to benefit additionally from the following trends:

• Part of the elevated cost the company is experiencing now relates to an investment they are making in quality. Currently, about 70% of their hospitals are rated “Good” or “Outstanding” by the CQC. That is far better than NHS hospitals (<50%), but only about in line with other private operators. Spire are spending heavily at the moment (hiring former public sector employees responsible for the CQC reviews, doing their own inspections, at a higher level of scrutiny vs the CQC reviews, twice per year at the hospitals ranked below “Good”), which is dragging on costs. Over the medium-term, though, this will drive the percentage of hospitals rated “Good” or “Outstanding” to 100%. Quality of care is the key differentiator in the Self-Pay business, so this investment should accelerate top line growth over the medium-term and drive operating leverage. Competitors will not be able to do this – BMI (largest operator) is financially distressed, while it is a similar case for many smaller players. Ramsay (top 5) is an NHS-focused business, while only HCA (top 3) is better-positioned

• The trend in the NHS is to focus spending on primary care (GPs), emergency care (A&E) and cancer treatment: https://www.telegraph.co.uk/business/2017/10/01/private-healthcare-market-going-reverse/ Elective procedures such as orthopaedics, which are 50% or so of Spire’s revenues, are at the bottom of the list, and waiting times are ballooning. The company told me anecdotally that waiting times on the NHS for knee and hip replacements have extended out to 12 months in many areas, back to the highs in the mid-90’s before the UK voted in a Labour government that ramped up spending on the NHS. In the future, if one wants to get an elective procedure done in a timely fashion, Self-Pay will become increasingly attractive

I see revenues recovering from £928m this year to £957m in 2019, £995m in 2020 and £1,082m in 2022. I think adjusted EBITDA will recover from £128m this year to £146m in 2019, £157m in 2020 and £181m in 2022. The company guided for revenues of £1.2bn and adjusted EBITDA of £200m by 2022 at their CMD, but I don’t believe they need to make these numbers for the shares to be a buy at current levels. I think they will struggle to get there, but frankly nobody on the sell side believes they will do it, hence it is not something that the investment case rests upon.

In terms of EPS, it would imply that IFRS earnings recover from 8.6p this year to 12.5p in 2019, 15.2p in 2020 and 19.8p in 2022, hence the headline multiples would look attractive and the shares would begin to screen well for generalist value investors in the coming year or so. The EV multiples are a bit less attractive, but the company should generate £290m of cumulative true FCF (don’t look at the company/consensus definition as they reclassify interest costs into CFI – that is about £22m per annum) from 2019-2022 vs current net debt excluding operating leases of £460m.

My fair value estimate is 250p (+106%), which I think the shares can get to by year end 2021, which would be an IRR of just over 20%. The fair value is a blended average of 14x adjusted 2022 EPS of 19.8p, which gets me to 270p, an 8% target EV FCF yield, which gets me to 245p, and a target EV/IC of 0.7x given the assumed 6% ROIC, which gets me to 210p.

I believe that downside will be protected by asset backing, solidified by the fact that the company was the subject of a bid from their largest shareholder last year at a price of 315p. In terms of the asset backing, the company has a tangible book value of £513m; on top of this, the company owns the freehold over about half of their hospitals. The work that I have been able to do would suggest that the market value of the properties is £260m over the cost value stated on the balance sheet, putting the adjusted tangible book value at £773, or 193p/share, suggesting a margin of safety at the current price of 113p/share. The fact that a trade buyer made a bid for the company meaningfully above the adjusted tangible book value to try to take advantage of the discount is further supportive, in my view.

The CEO bought £200k of shares after the recent profit warning, while the Chairman bought £160k and the new CFO bought £75k. They are well offside on their purchases, and obviously the amounts, while not insignificant, are not huge compared to their total comp and net worth, but they do appear to be putting (some of) their money where their mouths are.

Company In Detail

They are one of the largest providers of private acute cure in the UK. They came into being in 2007 when Cinven acquired 25 hospitals from Bupa, which they followed up with the acquisition of Classic Hospitals, a 10-hospital network, in 2008. They currently own 39 hospitals and 13 clinics throughout the UK. The company is managed by Justin Ash, who has been CEO since 2017, following the death of the previous CEO. Before Spire, he was in charge of Oasis Dental Care, a large private dental care provider that was purchased by Bupa for £835m in 2017. Oasis was a rollup story, whereas Spire is more of a turnaround/blocking and tackling-type story. He owns about 345k shares, worth £570k, and bought 125k recently when the shares dumped after he had to step away from the guidance offered at the CMD in April.

The revenue split is about 30% NHS, 70% Private, with 45% of the 70% in Private coming from PMIs and the other 25% (roughly) coming from Self-Pay.

By service, at the group level, the biggest service line is Orthopaedics at nearly 50% of revenues, followed by General Surgery at about 15%, and then a very long tail of business including Oncology, Gynaecology, Urology and Plastic Surgery all at around 5% each. The NHS business over indexes to Orthopaedics (70%) with PMI and Self-Pay at 40% and 30%, respectively. Plastic Surgery is obviously much more meaningful to Self-Pay, at 20% of revenues vs 2% each for PMI and NHS.

They should be a long-term beneficiary of an ageing population as the NHS slowly becomes overwhelmed and realises that partnership with the private sector can help to ease some of the burden. Increasing acceptance of private healthcare as a solution to avoid long waiting lists and risks of infection within NHS hospitals should also help the company over the medium-term.

The company had revenues £932m last year and a gross profit of £440m, so a gross margin of 52%. The revenue and patient split historically, together with my estimates, is set out below:

Operating profit was just £43m, for a margin of 5.1%, however there were some (genuine) one off items.

• There were about £29m of costs associated with settlements against Ian Paterson. It is a long story, but he was a rogue surgeon who was convicted of doing some bad things to women supposedly at risk of breast cancer (he exaggerated the risks and overcharged). Spire compensated them to avoid it going to court.   

https://www.telegraph.co.uk/news/2017/09/13/ian-paterson-spire-healthcare-pay-272m-victims-rogue-breast/

• There were about £15m of costs related to the decisions to close one cancer care centre and not to go ahead with a newbuild hospital in London. The cancer care centre should truly be a one off as almost all of their other hospitals are profitable. The aborted hospital in London was just to do with launch costs. About 40% of self-pay volumes currently occur in London, so it is a market they wanted more presence in. They found a site, but costs got out of hand before they broke ground. When the new CEO came in, they did a review. I was told in a meeting that, at the proposed build cost, they would not have gotten to ROIC>WACC until 2029. It is clearly not a goer on that sort of pathway to value creation, so they pulled the trigger.

• There were about £5m of sundry exceptionals that you can either take the company’s word for or not

I believe that the first two items above probably are exceptional, while the rest is debatable, hence the adjusted EBIT would be about £87m-£92m, depending on how you look at it, hence a margin of about 9.3%-9.9%. The company do not report divisional operating profit; however I understand that the profitability per procedure in Self-Pay is somewhere between 3x-4x the levels in the NHS business. This is mainly driven by pricing – a procedure with a price index of 100 in the PMI business would cost 60 in the NHS business and 120 in the Self-Pay business.

Over the last year or so, the company has suffered heavily from a decline in NHS revenues (32% of the business in 2016), which declined 2% last year and should be down another 8% this year. Meanwhile PMI (insurance-based) revenues (46% of the business in 2016) have been slightly down, while the Self-Pay business has been the only part of the business that has been growing. Sequential weakening in that business (growth fell to 8% in H118 vs 10% in 2017 and the long-term target of low-teens) then drove another leg down in the shares in September. The company will report modestly declining IFRS revenues this year, as strong growth in Self-Pay is insufficient to offset declines in other parts of the business.

The combination of weaker revenue trends together with labour cost inflation and higher drug costs forced the company to lower earnings guidance in September. This was embarrassing for the company as the new CEO has only been in the job for about a year. After having a few months to get a feel for the business, he came with some optimistic targets at the CMD in April, guiding for £1.2bn of revenues and £200m of underlying EBITDA by 2022, vs £932m and £150m, respectively, achieved in 2017. The company also guided implicitly for only a modest decline in underlying EBITDA in 2018. The revised outlook is for EBITDA in the range of £120-£125m, which is down meaningfully from 2017 level.

The downgrade was driven by continuing weakness in the NHS part of the business (which the company had thought might improve in H2, but apparently not), and a slight moderation in growth in the Self-Pay business. The operating deleverage, together with labour cost inflation and higher than expected drug costs driven by mix (more oncology).

The downgrade was also the second time that the company had disappointed the market inside of a year. The first warning was related to the NHS business which, while disappointing, the market had accepted was beyond the company’s control. To disappoint again, this time on costs, so soon after issuing long-term guidance, was not something that the market was willing to give the management a pass on. The shares declined about 20% on the day of the warning and are now down about 50% from pre-warning levels.

NHS Business Detail

Digging a little bit deeper into what is happening with the NHS business, one can split this business into two components, e-referral and Local Contracts. Local Contracts represent the NHS transferring waiting lists from NHS hospitals to private ones due to capacity constraints (NHS hospitals generally have to treat people within 18 weeks or pay for the work to be done privately). The e-referral business (formerly Choose & Book) refers to the part of the business where GPs refer patients to a certain hospital for their treatment. The private hospitals negotiate rates with the local NHS trusts according to a national tariff list, and then seek to build relationships with GPs.  As of year-end 2016, e-referral was £238m of revenues, while Local Contracts were £58m.

Since 2016, the Local Contracts business has fallen off a cliff, down about 46% to about £27m estimated for FY18. This has been driven by waiting lists getting longer (i.e. the NHS taking longer to deal with people and, importantly, not referring them on to private hospitals once they exceed the “red line” waiting time) and the charts below demonstrate (please forgive my fun and games with the scales in the second chart to try to bring home my point). The NHS has also understandably made it a policy to prioritise essential things, meaning that if you find a lump on your breast or your balls, they’ll deal with it ASAP. If your back hurts or you need a hip replacement but you can live with the pain (the GP will ask you questions about the pain and rank your responses on a scale of 1-10 – unless you tell them you are in agony and are sleeping 2 hours per night due to the pain, you get a 4), then you’re out of luck and maybe it will get dealt with in 12 months, possibly never.

Source: https://www.england.nhs.uk/statistics/statistical-work-areas/rtt-waiting-times/rtt-data-2017-18/

This first manifested in the Local Contracts business, where they experienced volume pressure and also had a couple of contracts with local authorities cancelled. The decline they have suffered in the Local Contracts business is huge, but by year end, it will be at a level (£27m) where it could continue to decline at 10% per annum and it would be manageable.

The e-referral part of the NHS business had until recently held up better, with revenues up from £200m in 2015 to £234m in 2016 to £248m in 2017 – the momentum worsened in H118, with the company reporting a 5.6% decline. The driver behind that is a change in how the GP referral process is managed. It was formerly the case that if a GP felt a patient needed secondary care, they would be able to manage that referral process. What happens now is that the referrals are managed by a centralised review group of GP’s, i.e. it is taken away from the front line people. What that has meant in practice is a higher burden of proof for referral onward, especially with non-essential things like orthopaedics.

In terms of why I am not more concerned about this – I cannot get away from the fact that, to reduce waiting lists by 500,000, the private sector will need to be utilised. I know from personal experience in the UK that the NHS is stretched to breaking point. I will not belabour the issue with anecdotes, but it is all laid out pretty well here by the King’s Fund:

https://www.kingsfund.org.uk/publications/how-nhs-performing-june-2018

“Our most recent quarterly survey of NHS finance leads shows services remain under substantial pressure. There are 4.2 million patients waiting for consultant-led hospital care, and there is little optimism that the current A&E performance milestones set by the government can be achieved… the NHS is now being asked to focus on the number of people waiting for planned hospital treatment rather than on how long patients wait (as long as it is less than a year). This could have serious implications for both hospitals and patients. The 92nd percentile (the time by which 92 per cent of patients are seen) has already crept up to 22 weeks by March 2018 – its highest level since March 2009 and far above the 18-week target. But even the task of containing the size of the waiting list at its March 2018 level will prove challenging. Although GP referrals for hospital treatment (which add people on to the waiting list) are growing at a slower rate than before, they are still growing. Meanwhile the rate at which patients can be taken off the waiting list (by treating them in hospital) is stalling as constrained capacity in hospitals continues to take a toll. Hospital bed occupancy has reached its highest level in eight years, and emergency admissions to hospital in May 2018 were a staggering 5.6 per cent higher than in the year before. There is simply not enough capacity in hospitals to cope with rising demands for both emergency and planned care. The potential net result of all this might be a waiting list in March 2019 that is not only larger than intended but is filled with patients who have been waiting longer than in the past with more complex (and more costly to treat) conditions.”

The NHS is great (in my view), but it has been overwhelmed by demographics and population growth. The improvements the government seeks are only achievable with help from the private sector. While the left-leaning politicians and commentators moan about the private sector profiting from people’s pain, it is worth noting that the NHS deals with over a million patients every 36 hours, while in 2016, GPs made a grand total of 892k referrals to independent providers – a relatively small sum. I would also point out that, among the private hospitals, Ramsay Healthcare generated a mediocre ROIC of 8.3% last year, while Spire do not cover their cost of capital, and BMI is facing financial distress, It is a great soundbite for politicians to virtue signal about protecting the NHS and its patients from vultures in the private sector, but unfortunately it has limited grounding in economic reality.

As the article above notes, if the government is resolute in its refusal to utilise the private sector, it could even be a medium-term positive for Spire. If the waiting lists are filled with people who have been waiting for 9 months plus, there will be an increasing incentive for them to look at going private, which Spire can provide, and which generates a better margin for them. They could theoretically lose three NHS patients, gain one Self-Pay and come out ahead.

As the graphic above depicts, I have the NHS revenues -8.1% this year, then down another 3.9% next year and then basically flat. Who knows how this plays out if we end up with a Labour government in the UK, but I think that they would be foolish to cut the private sector out of the equation on such a politically-sensitive issue.

PMI Business

Regarding the PMI business, revenues have been flat for the past couple of years. The driver of that has been a push by the insurers to improve the profitability of their UK operations. Pricing has held up okay (modestly up) on the basis of slightly increased complexity of procedures, on average, while “like for like” pricing has probably been weaker. Volume growth has been negative due to stagnant demand, which is in turn caused by price increases and reluctance by the insurance companies to pay up for procedures.

The guidance by the company is for limited growth. While I do not think they can grow that business line very fast, things going on in the sector should benefit them. It is not a secret that BMI, with 20% of the UK market, is under financial distress.

https://www.thetimes.co.uk/article/netcare-puts-private-hospital-chain-bmi-on-the-block-0bqvlrctn

https://www.nursingtimes.net/news/workforce/uks-largest-private-hospital-firm-planning-to-shrink-workforce/7022556.article

The company has been faced with an eyewatering rent bill (20% of revenues) subject to upwards-only rent reviews, at the same time as they have faced the same NHS headwinds that Spire have had to deal with. The company have not been able to invest at all, and are losing business as a result. Spire announced at their half-yearly results that they have had some contract wins in PMI (probably from BMI), and I have been able to quantify that the run rate will be a few million on the divisional top line of £430m expected in 2018.

In addition, the assets that BMI owns are up for sale. There is limited information available as it is obviously commercially-sensitive information, but I have met with the company recently and they seem quite excited about the prospects. Aside from the BMI assets, as already mentioned, many of the smaller players see the writing on the wall from the pressured NHS environment, increasing costs of compliance, and a push from the insurance companies to consolidate their revenues into the larger players. A few have approached them about the prospect of being bought, however I do not believe that Spire need to put their hands in their pockets. Theatre utilisation at Spire was under 60% in H1, so I believe that they can just take on quite a bit of business organically. Utilisation will never be anywhere close to 100%, but Ramsay, who are 100% NHS and schedule their surgeries very tightly, get to somewhere around 80%, I believe. Spire will not get there due to the mix that they have, but somewhere between current levels and that aspirational target might be achievable. Gross margins are about 47% at the group level, so the drop through to EBIT should be good. I think that the divisional revenues can grow around 4% in 2019 and then at low single digits over the medium-term.

Self-Pay

In terms of what has been happening in the Self-Pay business, historically it has been a strong grower, very high single digit to 10%-type levels. That has been driven by demographics, increased waiting lists on the NHS, and very strong growth in plastic surgery treatments. I will try not to rehash observations made above, but Spire are quite strong on orthopaedics, with around a 10% share in the UK in hips and knees. As the population ages in the UK, obviously more of these types of procedures are required. As the NHS budget is increasingly stretched and elective procedures are rationed strictly and require longer waiting times, it obviously creates an incentive for one to go private, especially for the older generation who are more likely to have savings to put towards this type of procedure.

Revenue growth levelled off slightly in H118 to +8.3%, but far below the 14% CAGR out to 2022 that they guided for at their CMD. I would reiterate my observation above that they do not need to make their long-term guidance for the shares to be attractive at current levels. In terms of why the growth tailed off, it was a bit unclear – they talked about the fact that they introduced some new automated telephony systems to direct queries in a more efficient way, which did not really work, while at the same time they began to roll out a new marketing strategy which generated enquiries, however the infrastructure was not there to deal with the increased leads.

From meeting with them after the profit warning, it is clear to me that they are very focused on improving the growth rate. In the short and medium-term, it will be a case of investing in systems, while they also have a plan to change the current system whereby a potential patient gets in to see a specialist via liaising with the specialist’s secretary in a decentralised way. What the company have found is that the interaction between the medical secretaries and potential patients is inconsistent at best. The secretaries will generally only work a couple of days a week, as the consultant will only spend that long on private practice, which can mean slow responses, lack of co-ordination and so on. I know from personal experience that when you are unwell, priority number one is generating a list of the best consultants on the issue you are having, then a close second is getting in to see someone ASAP. If they take a couple of days to get back to you when you are unwell and panicking about it, that is sub-optimal. Spire have found that the lead conversion when using decentralised medical secretaries is poor, so they are going to look to centralise that. The key thing for me is that the demand appears to be there, and the company has capacity, it is just a matter of doing a better job on lead conversion, which is possibly more of a “blocking and tackling” thing, and is something that they are very focused on, as they know that 8% growth isn’t good enough.

The main long-term driver of revenues, aside from demographics, will be the investments that they are making in quality. The first chart below shows that quick access to treatment is what initially drives people to go private rather than wait for NHS treatment, however once they have made the decision, quality of service (great outcomes, hygiene, seeing a consultant from start to finish) is what matters the most. The second graphic shows that the company are investing heavily (at the expense of current margin) in the quality of their product, which should drive outperformance:

Numbers

I set out my revenue estimates for the coming years again below:

I think that revenue will bottom this year at £928m before growing in the 3%-4% range out to 2022. NHS growth will probably continue to be weak, but as mentioned above, the rate of decline should ease meaningfully as the Local Contracts part becomes less meaningful (10% of divisional revenues, 3% of group revenues by y/e 2018) and the commitment to reduce waiting lists becomes a rising tide that floats all boats. I think that PMI growth will accelerate into the 3%-4% range as the company benefit from the annualization of contract wins that have already happened, together with further opportunities to take market share.

I should note that the revenue growth in these two divisions is not all organic. The company opened two new hospitals in 2017 (Spire Manchester in January, Spire Nottingham in April) which take a number of years to ramp up. Both of these hospitals are relatively large and state of the art, so their ramp up should add meaningfully to revenue growth. I would also note that they are currently only around breakeven vs. group adjusted EBIT margins in the high single digit range, so the ramp up should add meaningfully to profitability. In addition to Manchester and Nottingham, a third hospital, Spire St Anthony’s, received a poor CQC score in 2016 – they were focused on expanding to a larger site and lost focus on operational excellence, ultimately resulting in contract losses with the NHS. Management at the hospital were replaced and the hospital regained a “Good” rating in 2017, however there was negative revenue growth at that site, together with operating losses in 2017. We know that revenues before the CQC issues were just over £30m, so returning that hospital to growth at a group level margin would probably add modestly to group revenue, while the group EBIT contribution from a normalisation would probably be about £2m-£3m, so that is another tailwind to be aware of.

Finally, I have Self-Pay revenue growth re-accelerating to slightly above 10% - better than the 9%-10% they have managed historically, but below the 14% guided for. The reasons for the improvement are as laid out above – investment in getting the percentage of hospitals rated “Good” or “Outstanding” up to 100%, together with better conversion of enquiries into revenues.

In terms of how that revenue growth translates into profits, I have adjusted EBIT rising from £65m in 2018 to £114m in 2022, which would be equivalent to £129m of adjusted EBITDA in 2018 rising to £181m in 2022. I provide adjusted numbers purely because that is what the company focuses on in their presentations, what mid-term guidance is based upon, and the basis upon which consensus earnings are compiled upon. For my valuation work, I use IFRS numbers.

I would point out that my £181m adjusted EBITDA target for 2022 compares to company guidance of £200m, so I am well below guidance, but about in line or perhaps modestly above consensus estimates.

My estimates imply that adjusted EBIT margins improve from 7.7% in 2018 to 10.5% by 2022. That compares to adjusted margins of 11.6% in 2016 and 10.5% in 2017, so some improvement, but not back to the highs. In terms of what drives that margin improvement, it is the following factors:

• Spire Manchester and Spire Nottingham complete their ramp up phase and achieve group profitability levels

• Spire St Anthony’s recovers fully from the revenue hit related to losing CQC “Good” rating

• As the group gets closer to the 100% “Good” to “Outstanding” target, quality assurance costs drop out. Currently the company are doing twice yearly, rigorous internal inspections of the 30% of the estate not at target levels. That will drop to once per year, which will be a tailwind

• Contract wins from struggling peers drop into the revenue base at relatively high incremental margins

• Change in mix benefits the bottom line. I forecast Self-Pay revenue mix going from 22% of revenues in 2018 to 28% in 2022, while NHS mix goes from 29% to 24% over the same period – profitability in Self-Pay is quite a bit better than NHS, so that should benefit them

• The cost cutting exercise that the company is currently embarking on generates some modest net benefits

In terms of a rough bridge between the £65m of adjusted EBIT that I estimate this year and the £114m I am estimating in 2022, I would guess that the three hospitals I mentioned above are probably about £100m-£150m of revenue and are making very little money right now. Once they hit their full stride, that is about £10m-£15m of incremental EBIT. I think that the cost cutting they are doing now and the elimination of the onerous internal tesing schedule once they get to their CQC targets will probably add about £5m or so to EBIT. Growth from £928m of revenue to £1,082m of revenue would add £10m or so to EBIT without operating leverage. Those three items combined gives you a £25m-£30m uplift, with the remaining

I set out my estimates for profitability, both on an IFRS and an adjusted basis below:

In terms of cash flow, I think that the better profitability, combined with the reduced capex (they had been investing as much as £150m per annum, which will reduce to £80m this year and £60m next year vs. “steady state” requirement of about £55m) will drive strong free cash flow. I think that they will do £22m of equity FCF this year, but that improves meaningfully to £60m in 2019 and £85m by 2022. Cumulative equity FCF from 2019 to 2022 should be £290m vs a market cap of £460m.

One thing to watch out for above is that the company do not classify interest payments as an operating cash flow, whereas for me it is, hence my estimates might not be comparable to company commentary or to consensus.

In terms of how they use the FCF, as you can see above, I have them using it to reduce debt, which should hopefully be something of a value transfer from bond holders to equity holders over time. The company have said to me that they think that the debt burden is too high at the moment, so I think what I have assumed is reasonable. It is possible, however, that some cash is used for acquisitions. There is some distress in the sector right now, and the “new” CEO has a track record for non-organic growth at his previous company, so deals might be a possibility.

Valuation

My approach to valuation is to try to think about how the business will look over the medium-term and to value it on an appropriate multiple, assuming my forecasts are about right.

On a target P/E ratio of 14x 2022 IFRS EPS of 19.4p, the shares would be worth 270p. The broad European health care facilities peer group, including Attendo, Capio, Fresenius Medical Care, Korian, Orpea and Rhoen-Klinikum trade on a median P/E of 20x

On a target EV FCF yield of 8%, the shares would be worth 245p, based on 2022 EV FCF of £97m.

By 2022, I estimate that the company’s ROIC will have improved from a dismal 3.0% this year to a still poor 5.9%. The issue is the mountain of capex they have historically done, which in hindsight was unproductive. Still, a 6% ROIC would justify a target EV/IC of 0.7x, assuming no growth, 0.6x assuming 2% growth. At 0.6x EV/IC, the equity would be worth 175p/share in 2022, while at 0% growth, it would be worth 210p.

I settle on a fair value of 250p, which is about midway between the range of values. It would translate to just over 100% upside, or an IRR of just over 20%.

I see downside as quite limited here. The company has tangible book value of £513m, while the separately-published accounts of their controlled entities owning their leasehold assets suggest that the market value of their properties, assuming a blended average cap rate of 5.7%, is about £260m more than the value stated on the balance sheet. At a market cap of £510m as I write this, the company thus trades at a discount of about 35% to adjusted NAV, which I view as supportive. I would also note that the company’s largest shareholder, Mediclinic (29.9% shareholder) made an opportunistic bid for the company at 315p last year. The headwinds in the NHS business, together with cost inflation, have clearly made the business slightly less valuable since then, but not 60% less valuable, in my view.

In addition, as cash flow improves due to the reduction in capex in 2019 vs 2018 (£20m delta) and via some operating leverage from a sales recovery (£20m delta as well), I see “true” FCF improving to about £60m next year. I believe that should be supportive given equity value of £450. The company has quite a lot of debt, but the £60m equity FCF translates to about £78m of EV FCF on an EV (not lease-adjusted) of £970m, which I view as supportive.

Risks

Lack of presence in the London market. About 40% of Self-Pay revenues come from the London market. The company own some hospitals around/outside Greater London, but they are “out in the sticks” rather than in Central London (Harpendon, Slough, Guildford. Crawley, etc). The company looked at opening in Central London, but costs were prohibitive (they would not have beaten their cost of capital until 2029), so they are betting that the structural growth and the quality of their offering will mean that the slightly sub-optimal location does not matter.

Brexit has an impact on labour costs. They are reliant on skilled labour for services such as nursing. They are already having issues with labour cost inflation and filling roles. A favourable pay deal recently agreed for NHS staff also creates a harder cost infrastructure. They are reliant on non-British staff, so any kind of limit on free movement between the EU and the UK will hurt them.

Labour government is elected, massively increases public spending on NHS, puts a target on the back of private hospitals, creating further organic revenue pressure in NHS business. I have covered this above. It does not take a genius to see that Corbyn is a large seller of private enterprise and a large buyer of nationalisation. I would note that France, which is to the left of the UK (but possibly to the right of what Corbyn really believes) has a relatively large private healthcare sector, while cutting out the private sector entirely would be a disaster for NHS waiting lists and would likely accelerate Self-Pay revenue growth over the medium-term.

CEO goes on an acquisition spree. It is possible that deals get done, but from my conversations with them, they are quite focused on getting the debt levels down, and, given the distress in the sector, they possibly can do deals that will be quite value creative.

Growth in Self-Pay does not reacclerate in the way that I hope

Further earnings cut causes covenant breach

Very Brief Industry Background

UK Healthcare spending was £192bn in 2016; public spending was by far the largest part of that at £144bn, with the NHS the largest single provider, with a budget of about £116bn. By comparison, the private acute care broad subsector that Spire participates in is only about £7bn in size.

I won’t belabour the issue as there’s a lot of information out there on the topic in the public domain, and it is a well-understood trend among investors, but the UK has a problem with healthcare dependency, and it is most likely going to get worse. Spending on healthcare as a percentage of GDP has been rising in the UK, but is still relatively low by international standards, trailing most of the G7 countries:

The IFS estimates that a combination of population growth, an ageing population, and a rise in the prevalence of chronic conditions will drive demand growth of about 3% per annum in healthcare demand in the UK, meaning the in the absence of a major increase in funding for the public part of the healthcare system, a large opportunity will open up over time for private providers:  

In terms of how the UK private hospital market that Spire participates in functions, of the £7bn mentioned above, about £500m is actually NHS private patient revenue, while another £1.6bn was specialist fees outside of hospital networks, while private hospitals had about £4.4bn of revenue. These figures are all as of 2012 – a bit out of date, but they are published by Laing & Buisson, a private consultancy, and I do not have access to the more up to date numbers. The split of the market was about 55% PMI’s, 27% NHS, 17% Self-Pay at the same time – it has probably skewed slightly more towards Self-Pay now.

The PMI market is consolidated, with Bupa, AXA, Aviva and Pruhealth representing about 90% of the market.

On the hospital side, BMI have about 20% (for now), Spire have just under 20%, HCA has about 15%, and Nuffield Health and Ramsay Health have about 10% each. The rest of the market is a “tail” of much smaller chains – over time I think they will, for the most part, either have to be consolidated by the bigger guys or go bust. That is due to the regulatory costs of doing business going up, and the PMI’s focusing their business on the larger networks that meet certain quality of care and safety standards set by the PMI’s. The consolidation process is already starting to happen (I believe Spire have been sounded out already by a few of the smaller players who see the writing on the wall).

Catalyst

Earnings recovery