For many investors, the notion of investing capital in the healthcare sector, particularly in hospitals, is counterintuitive. After all, a glance at the 10-year share price performance of South African giants Netcare and Life Healthcare paints a rather grim picture. Both stocks peaked roughly a decade ago, a period characterised by institutional investor pressure for global diversification and a desire to move funds away from perceived political instability.
This drive for international expansion, often motivated by "push factors" rather than genuine strategic "pull factors," ultimately led to significant value destruction. Both companies have seen their share prices plummet by approximately two-thirds since then, a stark reminder of the perils of poorly considered dealmaking. The familiar narrative of "global diversification" quickly gave way to a "return to the core" as management teams acknowledged the missteps of their offshore ventures.
The healthcare sector, especially hospitals, has borne the brunt of this pain. Hospitals have historically been underperforming assets in terms of return on capital, a situation that is exacerbated when management overpays for international acquisitions. While often considered defensive stocks, their returns have, at times, fallen below even those of government bonds – an unsustainable position for any investment.
A Sweet Turnaround: Signs of Recovery
However, the tide appears to be turning. What was once a bitter pill for investors to swallow is now tasting considerably sweeter. Life Healthcare shares have surged by 29% in the past 12 months, with Netcare following closely behind, up 25% over the same period.
While underlying dealmaking, such as Life Healthcare's sale of Berlin-based Life Molecular Imaging, has undoubtedly influenced recent share price movements, a more fundamental improvement in both businesses is also at play.
The Power of "Paid Patient Days" and Operating Leverage
It's crucial to understand that robust top-line revenue growth isn't necessarily the primary driver of success for hospital groups. The true bull case rests on their ability to identify and invest in the right verticals. In a fascinating and sobering reflection of our modern world, mental health services, for example, are experiencing significantly faster growth than traditional maternity cases. As megatrends like declining birth rates reshape demand, hospital groups must adapt their service offerings.
This strategic evolution, coupled with revenue growth driven by inflation, leads to a critical metric: an increase in paid patient days. Much like in airline economics, the incremental cost of filling an additional hospital bed is remarkably low due to the vast fixed costs relative to variable costs. This phenomenon, known as operating leverage, means that even a modest improvement in patient volumes can lead to a substantial boost in overall margins. Conversely, any disappointment in paid patient days can easily result in revenue growth lagging behind expenses, leading to deteriorating operating margins.
Recent results demonstrate this perfectly. For the six months to March, Netcare reported a modest 1.1% increase in paid patient days, yet this translated into a robust 5.3% increase in revenue and an impressive 10.7% jump in operating profit. Life Healthcare, over the same period, saw a 2% growth in paid patient days and an 8.1% increase in revenue, with normalised operating profit up 7.5%. While Life Healthcare’s margins haven't followed suit, a 10.5% higher dividend offers some comfort to investors.
Remgro's Vision for Mediclinic
The market is beginning to take notice of this shift. As investor sentiment improves and the underlying fundamentals strengthen, one can only ponder the potential for Remgro with its investment in Mediclinic. Their belief in the lucrative nature of hospital investments, once an outlier opinion, may well prove to be a stroke of genius.