We came back from a meeting with KPJ feeling optimistic over its 2H18 earnings growth. Cost optimisation initiatives undertaken over the past several quarters are bearing fruits. This coupled with expected ramped-up organic growth from new hospitals crossing gestation threshold are expected to drive growth in 2H18. TP is RM1.35 based on 28x FY19E EPS (historical average 5-year forward PER). Reiterate Outperform.

Solid 1H18 results explained. Management explained that 1H18 core PATAMI rose 5% due to due to better cost optimisation (1H18 EBITDA margin rose 2ppt to 15% from 13% in 1H17), higher complex surgical cases from KPJ Rawang, KPJ Pasir Gudang and KPJ Bandar Maharani and higher volumes in outpatient (+1%) and inpatient (+1.6%). Specifically over the past few years, the group has undertaken cost optimisation measures including better inventory and billing systems, and cost management in administration expenses. Elsewhere, in another strategy to enhance efficiency, the group is planning to phase out or convert four-bedded rooms to twin-bedded ones for better rates. We expect a strong showing in 2H18, underpinned by ramp up of existing hospitals following the slower 2Q18 due to festivals, continuing benefits from cost optimisation initiatives, profitability from hospitals, which were previously at gestation phase (KPJ Klang, Pasir Gudang, Rawang and Muar) and slower new greenfield development.

Earnings growth from brownfield and greenfield. Earnings growth is expected to come from narrower losses and profitability for hospitals built 2-3 years ago including KPJ Klang, Rawang, Maharani, Pasir Gudang and Pahang. KPJ Perlis (greenfield, 90 beds) has commenced operations in 2Q18. Beyond 2018, we expect brownfield development, including KPJ Ampang (149 new beds), KPJ Johor (40 new beds) and KPJ Seremban (90 new beds) to drive earnings beyond 2018 of which gestation period are much shorter than greenfield develoment. Elsewhere, greenfield expansions include Kuching, Sri Manjung and KPJ Johor Bandar Dato Onn, which are expected to start operating by 2Q19. The group is confident that start-up costs from new openings will be absorbed by: (i) incremental ramp-ups from earlier openings, and (ii) steady contributions from matured hospitals.

SST positive for hospital operators. New SST regime to be net positive for hospital operators like KPJ with exemptions to: (i) doctor’s consultation fees, (ii) most or all medications likely to be exempted, and (iii) equipment. Any savings is expected to pass-through in FY19.

Expect divestment of Jeta Gardens by end-2018. We understand that KPJ is in the midst of drafting an agreement to be signed with interested parties to sell its 57% stake in its aged-care business in Jeta Gardens of which the deal is targeted to be completed by end-2018. Given that this non-core segment has been loss-making over the years, the divestment is expected to be positive. Since the investment has been written down in year 2016, any gains arising from the divestment is only expected to be reflected in the balance sheet.

Reiterate OUTPERFORM. TP is RM1.35 based on 28x FY19E EPS (historical average 5-year forward PER). The stock is currently trading at 15% and 40% discount compared to its historical average of 28x and regional peers of 35x, respectively. The 40% discount to regional peers is wider compared to the historical average of 30%.

Key risk to our call. Key risk to our call is slower-than-expected turnaround in the group’s new hospitals.

Source: Kenanga Research - 14 Sept 2018