AFTER the Brexit vote, Asian hospital valuations have rerated from a forward price-earnings ratio of 38 times on May 24 to 40 times, as investors seek safety and defensive growth in the healthcare sector. Indeed, the MSCI AC Asia Pacific ex Japan Health Care Index has gained an impressive 12% in the past year, beating a 2% return by the MSCI Asia Pacific ex Japan Index (see chart).

The positive sentiment in Asian hospital operators, as suggested by the rerating and strong share price performance, could soon spill over to the local bourse and give a leg-up to the locally listed healthcare providers. Shares of KPJ Healthcare Bhd, which have lagged its larger peer IHH Healthcare Bhd and currently trades at a steep discount to regional players (see table), could rerate on better cost management.

To be sure, KPJ’s revenue growth has certainly slowed amid weak consumer sentiment. Last year, inpatient volume growth was flattish while outpatient traffic declined 2%. While demand for private healthcare is somewhat inelastic, the company remains cautious on the outlook for 2016 in terms of patient arrivals, particularly for patients who fund their healthcare costs out-of-pocket.

Thus, when KPJ’s shares would be rerated could hinge on how well the hospital operator manages its bottom line during the gestation period of its greenfield projects, especially when the top-line growth is expected to be sluggish. Although revenue growth slowed to 8% last year, net profit declined 5% year on year to RM135.3 million, largely dragged down by non-cash employee stock option scheme (ESOS) expenses totalling RM46 million.

Nevertheless, things appeared to have improved in the first quarter of this year, at least at the operational level. Revenue grew 5% y-o-y to RM744 million, reversing a contraction of 3% in the previous quarter, though this was nowhere near the double-digit rates seen in prior years. Net profit growth was flattish at 1% to RM34 million, mainly due to a RM6 million increase in finance costs and ESOS expenses amounting to RM6 million.

Stripping out the ESOS expenses, which accounted for about 10% of its operating profit, net profit would have expanded 19% to RM40 million. Launched in February last year as part of its initiative to tackle rising staff costs and retain talent, the ESOS comprises five equal tranches and will expire in 2020. For 2016 or the second year of the scheme, KPJ estimates that the expenses will be progressively lower at about RM30 million, based on the current stock valuation.

Positively, earnings before interest, taxes, depreciation and amortisation (Ebitda) grew a healthy 11% y-o-y to RM94 million. Utilisation rate also improved 1.6 percentage points to 72% in 1Q2016 as the 4% growth in inpatient volume outpaced the 2% growth in bed capacity. As a result, operating margin for 1Q2016 increased from 12% a year ago to 13%, albeit still lower than IHH’s 24% and TMC Life Sciences Bhd’s 20%.

Moving forward, JP Morgan expects KPJ’s Ebitda margin to remain at 12% to 13% for 2016 and 2017 due to an ongoing expansion that will give it six new hospitals in the next three years. The research house, however, anticipates margins to gradually improve to mid-teen levels in the longer term, as more new hospitals exit their gestation periods of three to five years.

At the moment, only one out of its 25 hospitals is not profitable at the Ebitda level, according to company sources. At the pre-tax profit level, there are four hospitals that are still undergoing gestation and showing a loss. The utilisation rates for these loss-making newer hospitals range from 49% to 78%, based on the existing capacity.

Balance sheet-wise, net gearing ratio increased slightly to 77% as at March 31 from 75% as at end-2015 as KPJ geared up to fund its aggressive expansion plan and maximise return on equity. Despite the high leverage, the rising gearing is not a major concern as the company has a comfortable interest coverage ratio of 4.6 times. It could also easily inject mature hospital assets into its 45%-owned real estate investment trust, Al-’Aqar Healthcare REIT, and pare down its borrowings.

With six out of its existing 25 hospitals still not in the REIT, KPJ is looking to monetise brownfield assets — new facilities built at mature hospitals — by injecting them into the REIT over the next two years. The management has guided that the monetisation value is in the range of up to RM200 million, which could lower its gearing to 64% based on back-of-the-envelope calculations.

Looking ahead, KPJ believes that its long-term prospects in private healthcare is very bullish, thanks to the ageing population and growing middle class. Even though its overseas operations are not making meaningful contributions to its bottom line, the company says they are strategic assets for the long term.

Once KPJ completes its domestic expansion by 2020, the management sees Indonesia as the next market to grow its business, given that there is already visibility of the KPJ brand among Indonesians. Note that Indonesians are its largest foreign patient segment and it has two hospitals in Jakarta.

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