Diagnostic re-rating gives boost to Fortis

Reducing loss-making hospitals and falling interest costs will help the firm post sustained profits at the net level

The Fortis Healthcare stock rose 12 per cent on reports that the company was in talks for an investment in diagnostics subsidiary SRL. While Fortis clarified it was talking to investors to facilitate the exit of existing private equity investors in SRL, there were other triggers as well.

Fortis Healthcare had increased its stake in SRL by 3.1 per cent to 57 per cent in September 2015 for Rs 105 crore. The transaction valued SRL at Rs 3,394 crore, much lower than what the Street was estimating.

JPMorgan analysts had estimated SRL's valuation at Rs 4,864 crore, valuing the company at 20 times its enterprise value to operating profit. Given that its size of operations is of the same scale as that of Dr Lal PathLabs, a re-rating was already on the cards with new entrant on the bourses boasting of Rs 7,000 crore market capitalisation.

The difference between the two organisations was the margin gap. Dr Lal’s FY15 margins at 24 per cent were 400 basis points more than SRL’s. This has, however, reduced now with the December 2015 quarter margin for SRL pegged at 22 per cent.

The company had reported a 28 per cent margin in the September 2015 quarter, too.

The other trigger is that while the management has indicated a bit of volatility due to seasonality, SRL has set a goal to expand margins to 30 per cent levels over the medium term. SRL continues to rationalise its portfolio with a focus on balanced growth. It opened 24 new laboratories and 45 collection centres in east and south India, while shutting down two laboratories and 38 collection centres in the December 2015 quarter.

On the revenue growth front, SRL expects growth to be at 20 per cent levels in FY17. SRL accounts for 17.5 per cent of Fortis revenues and 24.5 per cent of the overall operating profit as there is a 800-basis point margin gap between SRL and the larger hospitals business.

Margin expansion of the hospitals business (current margins at 14.3 per cent before business trust costs, in line with peer Apollo Hospitals) coupled with improvement in SRL could lead to a re-rating of the stock, which currently at 15 times its FY18 enterprise value to earnings before interest, taxes, depreciation and amortisation estimates is trading at a 20 per cent discount to market leader Apollo Hospitals.

Of the 13 analysts tracking the stock, 10 have a ‘buy’ rating, with a target price of Rs 214, which from the current levels offers a return of 22 per cent.