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Primary Healthcare learns from history

Posted By Roger Montgomery On In Markets,Shares | No Comments

One investment theme that appeals to us is healthcare: as Australia’s large generation of baby boomers ages, demand for health care services in Australia seems poised for steady growth. Also, the baby boomer generation has accumulated wealth through generally favourable economic conditions, and has benefited from strong growth in residential property prices. This is a generation that can afford to keep itself well maintained into old age.

The opportunity

Primary Healthcare (PRY) is one of the companies positioned to assist with that maintenance. PRY’s main businesses include the operation of medical centres, pathology services, and diagnostic imaging. It also has a smaller medical technology division, which provides IT and software to the healthcare industry.For the first half of FY13, PRY delivered strong growth across a range of financial metrics, driven by improving performance from all four operating divisions. This consistent improvement is an encouraging sign for the future prospects of the business. However, an investment case needs to be founded on absolute value, not just improvement. It is here that the analysis gets a little more challenging.

The history

The challenges in analysing PRY largely flow from its ill-timed acquisition of Symbion Health in early 2008. With the GFC just getting into its stride, PRY acquired Symbion in March 2008 for $3.5 billion, implying a multiple of more than 20 times EBITDA. It funded this acquisition with equity and a large slice of debt that left its balance sheet stretched, and in need of divestment of some non-core assets. [1]As the GFC got into full swing, debt became poison, divesting assets at attractive prices became difficult, and a nervous consumer market meant that PRY got squeezed from all angles. The end result was wholesale destruction of shareholder value, and long-term pain for PRY shareholders.

Fast forward to today, and PRY has been working its way through the problems created by the Symbion acquisition. However, deep scars remain:  the share price is still well below its pre-Symbion level, the balance sheet is dominated by acquisition goodwill (which depresses its reported return on equity), and debt – while reduced – is still a big part of the capital structure.  A simple analysis of these numbers indicates a business with poor economics, a weak capital position and a dismal track record.

Part of the challenge in analysing PRY, then, is working out what the past performance tells us about the future. If you believe that PRY may repeat the folly of the Symbion acquisition when opportunity arises, then this would be a good place to halt the analysis and look elsewhere.

The pros

However, you could also take the view that PRY has learnt the hard way, and after several years in rehab, now has a healthy aversion to transformational, debt-funded corporate transactions. If so, you could consider the business on an incremental basis. In other words, if we draw a line under Symbion and just consider the economics of organic growth subsequent to that transaction, what do we find?

We think that the story here is more promising. Symbion’s main business is large-scale medical centres, into which it has been investing significant amounts of capital in recent years. The economics of these centres are good, with healthy profit margins, and revenues that build over time as a centre matures. PRY has increased the number of these centres from 45 in 2009 to 57 in 2012, and the newer centres should fuel revenue growth for a number of years to come.

In pathology, PRY is squarely placed to benefit from demographic change. Older patients have a far higher intensity of usage of pathology services than younger patients, and so an ageing population is a strong tailwind. Similarly, diagnostic imaging and health technology should benefit from favourable market trends.

The cons

On the negative side, there is the debt.  We dislike debt, and PRY’s gearing remains high. However, it is well within bank covenants, and the cash flows supporting the debt are relatively stable. Provided the underlying cause has been addressed (acute acquisition), we can accept it. Also, if the performance of the business continues to improve, the debt will tend to magnify growth at the bottom line, turning “steady” growth into something more lively.

In many respects, PRY parallels the experience of Wesfarmers – which destroyed significant shareholder value on the overpriced Coles acquisition, but has subsequently created value through improving the performance of Coles; now a strong retailer with an enviable market position.

Several years post the Symbion acquisition, PRY is showing some clear signs of returning to good health, and has given guidance for EPS growth of 20-25% for FY13.  We think that the market is still wary of the company, perhaps unduly so. For the time being, we are willing to give PRY the benefit of the doubt, and hold it in both The Montgomery, and The Montgomery [Private] Funds.

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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