News  In an announcement to Bursa Malaysia, KPJ Healthcare (KPJ) via wholly-owned subsidiary, Kumpulan Perubatan (Johor) Sdn Bhd (KPJSB), is exercising its option to buy Menara 238 for a cash consideration of RM206m. KPJ has the first rights of refusal under the existing tenancy agreement with Danaharta Hartanah Sdn Bhd.

 Currently, the occupancy rate is only 15% and largely occupied by KPJ’s corporate office.

 KPJ expects to complete the proposed acquisition by the third quarter of 2014. Note that the proposed acquisition is subject to the removal of a private caveat on the property and must be fulfilled within nine months from the date of the S&P.

Comments  The property transaction at a 6.3% discount to the market value of RM220m based on the latest valuation from CH William Talhar & Wong, an independent valuer appointed by KPJ.

 Based on a rental rate of RM3.50/sq ft, average occupancy rate of 60% and net lettable area of 491,429 sq ft, the yield works out to 6%, which appears decent.

 KPJ is expected to increase its current occupancy rate from 15% to 30% by moving non-revenue generating services that are occupying KPJ hospitals to the building, giving the hospitals opportunity to utilize more spaces to generate higher revenue.

 We are neutral to negative on this latest corporate development by KPJ because : (i) KPJ has to secure tenants from the remaining 70% of the floor space not occupied by KPJ, and (ii) KPJ might not have the necessary expertise in managing and getting tenants for its remaining unoccupied space, which is not their core business. We believe the funds can better utilised in KPJ’s hospital expansion programme over the next few years.

 For illustrative purposes, we believe KPJ’s balance sheet is expected to be stretched following this latest acquisition. Together with the two recent announcements; (i) JV with UTM to build and operate a hospital (RM76.8m KPJ’s effective cost), and (ii) acquisition of a private hospital in Rawang for RM88.1m (including debt), KPJ’s net debt and net gearing is expected to balloon from RM568m to RM939m and 0.54x to 0.9x, respectively.

Outlook  Recall, on 26th July 2013, the Johor Bahru High Court had allowed the claim by Dr Mohd Adnan bin Sulaiman and Azizan Sulaiman (plaintiffs) against KPJ wherein both plaintiffs alleged that KPJ had breached the Joint Venture Agreement dated 30th May 1995 whereby the said High Court had awarded the sum of RM70.6m including costs. According to the quarterly notes accompanying the interim financial report, a notice of appeal against the whole judgement has been filed at the Court of Appeal and case has been fixed for hearing on 12th Dec 2013.

 In the meantime, the above-mentioned judgement sum has not been provided for yet. However, for illustrative purposes, the RM70.6m (damages and costs) would reduce its NTA by 8% or by 11 sen/share from RM1.35 to RM1.24 based on its financial position as at 30 June 2013. Our FY13 net profit forecast would also be reduced by 50%.

 Earnings contribution over the next two years is expected to come from the setting up of new hospitals as well as the expansion of its existing capacity and services. The planned capex in FY13 and FY14 are estimated at between RM200m and RM250m p.a.

Forecast  No changes to our forecasts.

Rating Maintaining our UNDERPERFORM rating with a target price (TP) of RM5.75 based on unchanged 23.5x FY14 Fully diluted (FD) EPS.

Valuation  Based on our forecasts, the stock is trading at 28.9x FY13 and 25.0x FY14 FD EPS as compared to its average net profit growth of 7% p.a. over the next two years.

Risks to Our Call  The key upside risk to our earnings forecast includes a faster-than expected turnaround of its newly opened hospitals.

Source: Kenanga