One for the thrill seekers – Healthscope subordinated notes

Co-founder of the Switzer Report
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You have to be a little wary when the proceeds from a new issue are being used to repay “senior” borrowers. This is the case for a new $150 million issue from Healthscope, which has a headline grabbing interest rate of 10.25% fixed for five years. This is one for the thrill seekers.

Healthscope is a leading private healthcare services provider, with revenue of $2.1 billion and EBITDA of $303 million in the 2012 FY. The group was delisted and taken private in 2010 when it was acquired with funds managed by two private equity players, The Carlyle Group and TPG.

Healthscope runs 44 private hospitals and is the second largest operator in Australia with 75% of their revenue coming from private hospitals. Hospitals include Prince of Wales Private and Norwest Private in Sydney, and Melbourne Private and Knox Private in Melbourne. Australian pathology and a portfolio of medical centres and skin clinics account for a further 17% of revenue, with the remaining 8% of revenue being derived from international pathology in Singapore, Malaysia, Vietnam and New Zealand.

Healthscope already has an ASX listed issue, the $200m Healthscope Notes I (ASX Code HLNG), which is due to mature in June 2016.

This issue – Healthscope Notes II

Healthscope Notes II will pay interest quarterly at a fixed rate of between 10.25% and 10.75% for the five-year term, with the final price being set in the institutional book build later this week. Other key details are:

Debt levels

A quick study of Healthscope’s proforma balance sheet at 31 December reveals the indebtedness of the group. As the numbers below show, total debt is more than two times shareholders’ equity and tangible assets of only $1.5 billion are supporting net debt of $1.6 billion. And of course, subordinated note holders come behind almost $1.3 billion of senior debt.

Most of the group’s operating cash flow goes into paying the interest on the debt – around $180 million per annum. Healthscope defines the ratio that measures the capacity to pay its interest bill as its ‘debt service cover ratio’ (pretty similar to ‘interest cover ratio’), and says that at 31 December, this was 1.41 times. This doesn’t provide a lot of room!

Pricing

With the five-year bank bill swap rate at 3.40%, this issue is priced at almost 700 basis points over the benchmark. The Healthscope Notes 1 issue (ASX Code HLGN), which matures in three years in June 2016, closed on Wednesday at $105.30. This implies a yield to maturity of 10.15%.

Is a margin of almost 7.0% enough? Unfortunately, you really can’t read too much into the secondary market pricing of the other Healthscope issue, as it is pretty thinly traded. That said, it is enough in the ballpark to make you think.

Our view

Thrill seeker territory. The positives – the fundamentals of the healthcare sector are favourable, with expenditure growing each year at rates well in excess of normal GDP growth. As a group, Healthscope has demonstrated a record of growth through the cycle, and has an articulated growth strategy for the hospitals division. If Healthscope can grow the revenue, it should be able to service the interest. And a margin of 7% is pretty attractive.

The negatives – this is a high-risk investment. Because they are highly geared, if there is a downturn in their business, or a change in government regulation affecting private hospitals, or a material decline in membership of private health funds, or some other exogenous event, they may be challenged to generate the cash flow to service the interest. If they can’t generate the cash flow to meet their interest expense, it is more than likely they will be placed in administration – and subordinated note holders, who are at the bottom of the pile, won’t be left with much.

Maybe worth considering within a portfolio with diversified credit exposures, or as a small punt. But don’t bet the house on it.

With one-year term deposits at just over 4%, such a dividend play may be not such a bad idea.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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