At the end of 2015, hospital groups were among the darlings in investment portfolios, having outperformed the market by several multiples over the prior 15 years, as the private medical market grew rapidly over the period. From 2000 to 2015, a R1 million investment in Netcare would have yielded just over R50 million compared to R10 million from a similar investment in the JSE All Share Index (30% per annum compared to 16% for the market, all dividends reinvested).
Fast-forward almost 10 years from 2015 to the end of June 2024 and this R50 million would have become R26 million (-8% per annum), while the R10 million in the market would have grown to R21 million (9% per annum).
WHY THE UNDERPERFORMANCE?
The reasons for the poor performance over the past decade stem primarily from a stagnant medical aid pool as the South African economy failed to expand its formal sector employment levels over the period. In fact, the number of medical scheme members – nine million – has remained virtually unchanged over the past 10 years. The resultant oversupply of hospital beds has given the schemes more pricing power and the ability to negotiate network deals at far below market levels.
In addition, the hospital cost base has been under pressure due to insufficient numbers of new nurses being trained by government facilities, which has led to a severe shortage and thus more negotiating power for workers when wages are set. To compound matters further, the Covid-19 pandemic had a short-term negative impact on hospital demand. These factors have worked in unison to squeeze both hospital margins and returns on capital.
MARKET OUTLOOK
Clearly, this is not a sustainable situation, and it can’t go on indefinitely – either demand for private healthcare needs to pick up or supply must be rationalised. The problem with the latter option is that the capital has already been spent, so it often makes more sense to continue to operate for as long as the hospital can still break even after paying staff. The more likely outcome is that few new hospitals will be built until demand can catch up and existing hospitals see better occupancy rates.
What are the prospects for growth in private hospital demand? This will depend to a large extent on economic growth in South Africa. While the recent formation of the government of national unity was viewed in a positive light by the market, many challenges remain. However, with the threat of the political far left removed for now, as well as increased accountability in the government, the outcome of the elections was certainly net positive.
In terms of economic growth, there is also low-hanging fruit. The Bureau for Economic Research estimates that if only the structural reforms currently in progress (for example, rail and electricity) are completed, gross domestic product growth can lift from ~1% currently to closer to 3.5%. If this growth is sustained, it can make a meaningful difference to employment as well as to medical aid membership.
An additional supportive trend for hospitals is the ageing medical aid population. Although scheme membership is not growing, the existing pool is expected to use more healthcare services over time as they age.
NATIONAL HEALTH INSURANCE
No discussion about private healthcare can be complete without considering National Health Insurance (NHI). Despite objections by numerous parties, NHI was recently signed into law by President Cyril Ramaphosa. The NHI document proposes a system that will eventually see no medical schemes, with a single buyer of healthcare services from either private or public facilities for all citizens. While this doesn’t necessarily have to be detrimental to private hospitals, since it will probably result in higher patient volumes, the pricing power of a single buyer is likely to eventually lead to a net negative outcome.
While we are cognisant of the risks of NHI to our investment case for Netcare, we still believe that not much is likely to change for at least the next decade. NHI faces severe funding constraints, not to mention legal pushback against many of its clauses, including those setting out where medical professionals should work and disallowing private medical schemes entirely for services already covered by NHI. In addition, the initial focus will be on clinics and primary healthcare, which won’t impact private hospitals directly. The most significant short-term impact may be the loss of medical practitioners to emigration because of future uncertainties.
NETCARE’S RESPONSE
How has Netcare responded to the market challenges? After the company’s exit from the UK in 2018, the focus has been on optimising the existing asset base and increasing efficiency. We think Netcare has done well in highly challenging operating conditions. The company recently concluded its digitisation programme, in terms of which health records are now electronic, eliminating some costs and improving customer experience. Unlike its largest listed peer, Life Healthcare, Netcare took a much harder stance on network options, settling for a lower occupancy rate rather than accepting uneconomic tariffs on new network deals. Time will tell which strategy works best.
Despite the poor market conditions, the valuation is appealing in the context of a highly cash-generative business. Earnings essentially equal free cash flow given limited capital spend on new facilities (except for some growth in mental health facilities – unfortunately a growing problem in our society). Based on our estimates, without assuming any meaningful growth in patient visits, the current market cap can be repaid by dividends or buybacks in roughly seven years, with the business trading on a forward free cash flow yield of more than 10%. By another measure, we estimate that the hospital groups have market values worth only 50% of the replacement cost of their entire hospital portfolios.
Therefore, looking forward, we see a favourable risk-reward trade-off from current price levels. While private hospitals may not be the most exciting growth story, in our view, Netcare’s cash underpin, combined with the low valuation, provides ample margin of safety.
