Apollo & Fortis: Strong margin triggers

The stocks are fairly priced now, as the recent run-up in prices captures a large part of the gains

The stock price of India’s two largest listed healthcare services providers, Apollo Hospitals and Fortis Healthcare, has gained 4-10 per cent in the past couple of trading sessions on valuations and expectations of margin gains. The immediate trigger has been the valuation attributed to the IPO-bound Narayana Hrudayalaya, a Bengaluru-based company which is in the same segment as the two listed entities. Narayana is asking for a 15 per cent premium to the existing players on a one-year forward enterprise value / operating profit basis. The gap has narrowed after the run-up in prices for the two entities over the past week.

In addition to the gap in relative valuations, for Apollo Healthcare, the trigger would be the end of the company’s current investment cycle. In FY17-18, this should lead to a recovery in margins and return on capital employed, say HSBC analysts. The company added 1,300 beds over the past two years and it is planning to add 895 beds by the end of FY16. Blended margins of 14.1 per cent at the end of the September quarter have been on a downtrend over the past four quarters due to higher operating costs of newly commissioned facilities, higher share of the low-margin pharmacy business (3.7 per cent margin), and higher competition in the Hyderabad region.

Analysts at Bank of America Merrill Lynch expect a 100 basis points (bps) margin expansion to 15.2 per cent by FY18 on the back of 25 per cent annual growth in operating profit over FY15-18. They also expect return on capital employed to expand by 730 bps to 20.1 per cent during this period on the ramp up in new/existing hospitals and improved profitability in pharmacy. Margins in the pharmacy business have grown by 40 bps to 3.7 per cent at the end of September 2015 quarter compared to the year-ago period.

On Fortis, the Street is positive given the company’s focus on improving its profitability both in the hospitals and the diagnostics segments. The improvement is due to the management’s focus away from the low-margin and government business that had resulted in higher occupancy at the cost of lower revenues per bed. The trend of double-digit growth in average revenue per operating bed has been due to the rationalisation in the hospital segment. The surprise for the Street, however, has been the diagnostic segment where margins reached record levels of 28.3 per cent, up 760 basis points year-on-year, in the September 2015 quarter. While seasonal uptick is part of the reason, analysts say the consistent improvement is due to better realisations and mix. Margins are expected to move to about 30 per cent over the next couple of years. It is the spurt in diagnostic profitability which has helped blended margins (before business trust costs) to move up from 9.9 per cent at the end of FY14 to 17.5 per cent now. Including the business trust costs, margins are at seven per cent.

Two-thirds of the analysts tracking the two stocks have a ‘buy’ rating on the companies. Their consensus target price of Rs 205 for Fortis and Rs 1,442 for Apollo Hospitals indicates little upside especially for the Apollo stock. Investors with a longer term perspective might accumulate these stocks on corrections.