Authors: Lonwabo Maqubela and Thomas Blamey
The hospital groups’ lost decade
The South African listed hospital sector was a disappointing hunting ground for investors over the last decade. An investment in Netcare (NTC) and Life Healthcare (LHC) from the beginning of 2015 to the end of 2023 resulted in a total shareholder return of -48% and -40%, respectively. The share price of Mediclinic, which delisted in 2023 after a consortium led by Remgro Ltd completed the acquisition of the healthcare group, had not performed very well either over this period. Given the performance of the industry over the years and some of the challenges it is facing, it may not be that surprising that many investors had thrown in the towel. We, however, came into 2024 taking a contrarian view, believing it to be the right time to be exposed to the sector. In this article, we give a brief overview of the industry, highlight some of the headwinds the industry currently faces and review the investment thesis we had for the companies in the sector.
South African healthcare industry overview
The healthcare industry in South Africa is a two-tier system comprising both public and private sectors. South Africa spends just over R500 billion annually on healthcare, which is about 8% of the GDP. This amount is roughly evenly divided between the public and private sectors.
The public healthcare system serves the majority of South Africans (c.51m), particularly those who are economically disadvantaged, and is funded by the government. It provides a wide range of services, from primary care to specialised treatments.
The private healthcare sector caters to a smaller, wealthier segment of the population (c.9m) that can afford private health insurance. Funded through medical aid schemes and out-of-pocket payments, the private sector offers higher quality care due to better funding and the ability to attract top specialists.
The South African private hospital sector is a consolidated industry, dominated by three large hospital groups – NTC, LHC and Mediclinic. Together, they have approximately 75-80% market share of the industry’s c.40 000 beds. NTC and LHC are the two largest private hospital groups in the country, in terms of both revenue and beds. NTC has c.10 900 beds and generates revenue of c.R25.2bn, while LHC has c.9 200 beds and generates revenue of c.R23.7bn.
Approximately 9 million South Africans have private health insurance (known as medical aid), making the private healthcare industry crucial for 15% of the population. The industry’s growth depends on the number of privately insured members, and after growing at a compounded annual growth rate (CAGR) of 2.6% from 2002-2012 (adding 2 million beneficiaries, in absolute terms), growth slowed to 0.4% per year from 2012-2022, adding only 360 000 beneficiaries This slowdown was a result of the weak economic growth the South African economy experienced over this period which led to an increase in the unemployment rate, and less people being able to afford medical aid. [Figure 1]
While this is anaemic growth, it is not all doom and gloom. Healthcare spending tends to follow the 80/20 rule, with 20% of the population accounting for 80% of the spend. Medical scheme beneficiaries are ageing [Figure 2]. According to the Discovery Health Medical Scheme (DHMS), 6 700 clients accounted for more than R3.5bn of healthcare spending for the 2023 financial year! We believe that this dynamic will result in growth of healthcare utilisation.
The economics of the hospital groups have deteriorated
Despite a slowdown in the medically insured population, the number of private hospital beds has grown, and this has resulted in excess capacity. This, combined with the consolidation of medical aid schemes, has increased medical funders’ negotiating power over hospital groups. DHMS has 2.8 million beneficiaries and dominates the open scheme market with a 60% share, while the Government Employee Medical Scheme (GEMS) covers over 2 million beneficiaries and represents nearly a quarter of all medical scheme members. Economic pressures are also causing consumers to opt for more affordable hospital or network plans, enhancing funders’ bargaining power. According to NTC in 2022, 49% of medical scheme beneficiaries opted for network options, up from 30% in 2016.
These changes in the industry dynamics have resulted in a deterioration of the economics of the hospital groups over the past decade, as evidenced by the EBITDA (Earnings before interest, tax, depreciation and amortization) margins, shown below. [Figure 3]
Why actual EBITDA margins are lower than what is depicted
In 2019, IFRS 16 came into effect, requiring long-term leases to be capitalised as assets and liabilities instead of expenses. This change has the effect of enhancing reported EBITDA margins by reallocating lease expenses to interest and depreciation lines. NTC benefits significantly from this accounting change. Without IFRS 16, we estimate NTC’s EBITDA margins would be approximately 2% lower than currently reported.
In addition to challenges over the past decade discussed above, hospital groups were impacted severely by the Coronavirus Disease in 2020, where occupancy levels fell into the mid-high 50’s and have only begun normalising more recently. However, this recovery has not boosted margins back to normal levels as expected, due to rising costs and pressure from funders, which has limited profitability.
The impact and implementation of the National Health Insurance (NHI) Bill
The NHI Bill has been a major industry topic, gaining more attention over the past year. There is still much uncertainty about its impact on private hospital groups. In the lead up to the national elections during 2024, investors became particularly cautious, and negative sentiment increased towards the middle of the year, with the share prices of companies like NTC and Discovery trading around their 52-week lows when the NHI Bill was passed and signed earlier this year. LHC’s share price fared better due to its restructuring and the sale of its UK and European diagnostic imaging business, Alliance Medical Group which somewhat mitigated the effects of NHI concerns.
While we agree that South African public healthcare needs significant improvement, we disagree with the government’s implementation plan for the NHI Bill, which we find nonviable in its current form. We believe the process has been poorly managed with little consultation with the private sector. DHMS estimates an additional R200 billion per annum is needed to fund the NHI. Many private healthcare participants believe full implementation is at least 10 years away and expect legal challenges. Bodies such as Solidarity, and the Board of Healthcare Funders and the SA Private Practitioners Forum have legally challenged the bill. To date, the Government is sending mixed messages and has asked for Business Unity South Africa (BUSA) to come up with proposals (for a law that it already promulgated).
An additional constraint for the NHI is South Africa’s shortage of skilled medical professionals. These skills take time to develop and are highly sought after globally. The current NHI Act makes the industry less attractive for new potential joiners. For the NHI to succeed, it needs the support of medical professionals, the very people who feel alienated and prejudiced by the current process. Recently, government has shown a willingness to collaborate with the private sector on issues like the electricity crisis, and freight rail and port operations. We believe similar cooperation will be needed between government and the healthcare industry to benefit all parties.
While the NHI poses a potential risk to private hospital groups, it is not the imminent threat that was seemingly reflected in share prices in the first half of 2024.
Investment case for listed hospital groups
Despite the deteriorating economics; the NHI regulatory risk; and other challenges facing the industry during the course of the past two years, we held the view that the expectations implied in the share prices were too negative, and the shares of both NTC and LHC looked attractive from an investment perspective. When investors focus on near-term headwinds and share prices reflect this pessimism, some of the most attractive investment opportunities can arise. In assessing these investment opportunities, we often look for catalysts or self-help measures that can unlock value for shareholders. In this case, we considered the fact that the two hospital groups were addressing challenges differently.
Netcare: NTC is focussing on operating its assets more efficiently, with previous technology investments beginning to pay off as depicted below. While hospitals have been slow to adopt digital technologies, digitisation can lead to operational efficiencies and better staff utilisation, thereby reducing labour costs. NTC claims a 2 to 4-year lead in digital strategy over competitors, which should lower care costs, improve efficiencies, and enhance the patient experience. There are signs that this strategy is starting to bear fruit.
Life Healthcare: LHC has pursued a strategy of gaining market share to improve margins by securing more preferred network deals. Despite achieving faster revenue growth than NTC recently, this approach has not yet offset the upfront discounts associated with being a preferred network which have led to reduced profitability. We believe that the level of discounts offered by the industry is unsustainable, as evidenced by NTC’s challenges in meeting its cost of capital. Additionally, LHC acknowledges cost issues and has been implementing corrective measures. The efficiency of LHC’s operations should improve, however, it does not seem likely to go back to historical levels.
In addition to this, LHC does still have an international asset that could potentially unlock value for shareholders, in the form of their Life Molecular Imaging (LMI) business. LMI develops and sells products that are used in the diagnosis and treatment of diseases with the main product, NeuraCeq®, supporting the diagnosis of Alzheimer’s Disease. LMI have recently sublicensed a product known as RM2 – which is used to diagnose and treat Metastatic Castration-Resistant Prostate Cancer – for around $36m (c.R650m) and LHC management have used those proceeds to pay a special dividend to shareholders.
Better days ahead for hospital groups
Tough times often inspire operational efficiency in businesses, and we think there is scope to do so at both NTC and (to a lesser extent) LHC. There was some irrational behaviour in the industry, where smaller independent hospitals have added beds to what is already a mature market, and we believe this behaviour is unsustainable. Having disposed of their international operations, the management teams of both NTC and LHC are focussing on their core SA operations. Investors are set to enjoy more disciplined capital allocation, with both companies now focussing on returning capital to shareholders.
Hospitals, as defensive businesses, are less susceptible to fluctuations in discretionary income compared to other industries. With a high fixed cost base, they have historically benefited from operating leverage during periods of rising occupancy, yielding strong earnings growth. These businesses typically generate robust returns on capital and cash flow. If the South African economy shows signs of sustainable growth, in addition to the above-mentioned efficiency programs, the hospital groups will likely benefit from their operational leverage. Recent months have shown how swiftly sentiment can change, with share prices for LHC and NTC rising 61.5% and 29.8% since the beginning of May. [Figure 7]
Given our investment theses outlined above and our view that the underlying fundamentals for the hospital sector are improving and will ultimately impact shareholder returns, we came into 2024 with active positions in both NTC and LHC our client portfolios [Figure 8]. This position was rewarded into as the year progressed.