Fortis is improving, but expensive valuations

Operating profitability is looking up, but stock is at a significant premium to its peers

Fortis Healthcare has increased its stake in its diagnostics subsidiary, SRL, by three per cent (Rs 105 crore) to 57 per cent. The transaction values SRL at Rs 3,394 crore, lower than the earlier estimates (more than Rs 4,000 crore). The stock is down 2.2 per cent after the announcement, as compared to half-a-percentage-point rise in the BSE Sensex. JPMorgan had earlier this month arrived at a valuation of Rs 4,864 crore for SRL, on the basis of one-year forward enterprise value (EV)/Ebitda (earnings before interest, taxes, depreciation, and amortisation) multiple of 20. (EV/Ebitda ratio is used to determine the value of a company. The ratio takes debt into account.)

SRL's competitor Dr Lal PathLabs, which has filed for an Initial Public Offering, is looking at a valuation of Rs 5,000 crore to Rs 6,000 crore. This is 50 per cent more than SRL's valuation. The difference in valuation is largely due to Dr Lal's superior profitability. Dr Lal's Ebitda margin in FY15 was 24 per cent. SRL's was 400 basis points lower at 20.4 per cent. This gap has narrowed in recent quarters. SRL's Ebitda margin has improved from 20.9 per cent in the quarter ended June 2014, to 23 per cent in the quarter ended June 2015.

(Ebitda margin is a measurement of a company's operating profitability. It is equal to Ebitda divided by total revenue. Because Ebitda excludes depreciation and amortisation, Ebitda margin can provide a cleaner view of a company's core profitability.)

Ebitda margin for Fortis' hospital business improved from 1.37 per cent in the quarter ended June 2014, to 2.32 per cent in the quarter ended June 2015. About 14 per cent of Fortis' revenues go towards the business trust, which owns the hospital assets and, in turn, leases them out to Fortis. Before expenses, Fortis' hospital business Ebitda margin is 14.7 per cent, in line with its larger rival, Apollo Hospitals.

Fortis' business is turning around, with Ebitda margins improving after bottoming out in the quarter ended March 2014. But Fortis' stock valuations are expensive, as the stock trades at 39 times FY17 earnings estimates. Even on an EV/Ebitda basis, it trades at 23 times its FY17 estimates, compared to Apollo's 17 times. Analysts at Barclays Research say that despite Fortis being behind peers such as Apollo on returns as well as Ebitda margin, it is trading at a significant valuation premium of 40 per cent to Apollo Hospitals. Thus, while the research firm is positive on the return and Ebitda margin improvement for Fortis, the risk-reward, according to them, is unfavourable for Fortis at such expensive valuations.