We are initiating coverage on KPJ Healthcare with a MARKET PERFORM recommendation and a TP of RM6.37 based on 23.5x its FY14 Fully diluted (FD) EPS, 15% discount to its peers average due to its smaller market capitalisation. We are positive on KPJ’s long-term prospect, asset-light business model and defensive earnings. However, the stock growth trajectory is already reflected in its financials. Based on our forecast, the stock is now trading at 24.8x FY13 and 22.1x FY14 FD EPS numbers, which appear rich, compared to its average net profit growth of 13% p.a. over the next two years.

Aggressive expansion cost not reflected in the bottom line yet. A new hospital takes an average of two to three years to build and a gestation period of three to five years to turn profitable. It is thus a long term investment. The preferred alternative is to acquire an existing hospital because the gestation period is shorter at one to two years, although this would entail paying a premium. Either way, an aggressive expansion drive such as what KPJ is undertaking, will be a drag in the short to medium term on earnings growth.

Asset-light business model via 49%-owned Al-`Aqar. An integral part to KPJ’s business model is its strategy to inject hospital assets into its 49%-owned Al-`Aqar to unlock value and free up its cashflow. To date, five tranches of asset injection exercises involving 18 hospitals and one college building totalling >RM1bn have been completed. The most recent tranche involving three hospitals for RM139m was completed in end 2012.

Expansion program to drive growth. KPJ operates a network of 20 hospitals in the country and two in Indonesia (which is currently loss-making) and recently completed the acquisition of a hospital in Thailand. Earnings contribution over the next two years is expected to come from the building of new hospitals as well as expanding its existing capacity and services. The planned capex in FY13 and FY14 is estimated at between RM200m and RM250m p.a. For FY13, the KPJ Pasir Gudang Specialist hospital (120 beds), which has been fully constructed, is now awaiting the inspection and approval by the Ministry of Health. Once this is done, the hospital is expected to commence operations in 2Q2013. Meanwhile, both its Sabah Medical Centre (250 beds) and KPJ Muar Specialist are expected to start operations by end 4Q2013. Looking into FY14, a new hospital in Bandar Datuk Onn, Johor Bahru (400 beds) and KPJ Pahang Specialist are targeted to be operational by 2014. Over the longer term, KPJ plans to build a new hospital each in Perlis and Miri, Sarawak, as well as one each in Terengganu and Melaka, which it currently does not have a presence in.

ETP play. Six of the seven KPJ’s new hospital developments have been named as new projects under the country’s Economic Transformation Programme (ETP), which has a key focus on medical tourism. When completed, these five projects will collectively add 822 beds to KPJ’s existing capacity of more than 2,500 beds. They are expected to generate a gross national income (GNI) of almost RM1.3b and more than 3,000 new jobs, and also give KPJ the capacity to serve more international patients.

Key acquisitions and expansions over the last 12-15 months appear expensive. In a bid to sustain and maintain its growth pace, KPJ has acquired stakes in several hospitals as well as land to built new hospitals over the past 12-15 months, which appear expensive going by their purchase valuations.

Initiating coverage on KPJ with a MARKET PERFORM recommendation. Based on our forecast, the stock is trading at 24.8x FY13 and 22.1x FY14 FD EPS numbers compared to its average net profit growth of 13% p.a. over the next two years. Since its growth trajectory has already been reflected in its financials, we recommend only a MARKET PERFORM recommendation on the stock with a target price (TP) of RM6.37 based on 23.5x its FY14 Fully diluted (FD) EPS, 15% discount to its peer average due to its smaller market capitalisation. The key upside risk to our earnings forecast includes a faster-than-expected turnaround of its newly opened hospitals.

Source: Kenanga