Healthcare Services - Unmet Demand Conundrum; Initiating Coverage

Executive Summary

We believe the Indian healthcare industry needs a new business model to address the demand-supply gap. The premium segment, especially in Tier I cities, is maturing and competition is rising. This, along with government focus on affordability, would impact margins and growth for most hospitals. We believe hospitals need to focus on new doctor engagement and capex model to sustain growth premium. We believe that Narayana Hrudayalaya (NARH) is the best placed with its affordable healthcare strategy. We initiate coverage of Healthcare Global (HCG) at Buy; its selective focus and specialization provide strong growth drivers. We are cautious on Apollo Hospitals (APHS) and initiate coverage at Hold, as we believe rising competition will its keep margins and return ratios under pressure.

Capacity shortage but not uniform
The Indian healthcare industry is capacity-constrained with just seven beds per 10,000, vs the global median of 27. However, the supply gap is not uniform with unmet demand outside top cities and, more importantly, at affordable pricing. Private players have found it difficult to address the affordable segment due to cost structure. We expect the industry to grow at 12% CAGR, led by increased supplies and spending capabilities of patients.

Government intervention to continue
Healthcare will be a major policy focus for the government, in our view. We expect pricing caps to encompass most medical devices and implants. Hospitals should be able to offset the impact mainly through fee changes over medium term. The caps on hospital service fees, we believe, are unfeasible but can occur for some time due to political pressure. The key structural change is any move on increasing insurance healthcare access. This would allow access for a larger population, driving increased volumes to hospitals, consequently reducing charges. Hospitals will need to change their operating model and cost structure to be able to address this, though.

Need a new business model
Indian hospitals trade at par with regional peers despite lower return ratios due to better growth potential. However, the target market of most private hospitals is the premium segment (Tier I cities and high income), which is maturing. In addition, the government’s focus on increasing affordability necessitates a change in business model. The key hurdles in targeting the affordable segment are doctor engagement, standardization and capex. Hospitals have started working on this, but it is still early days for most.

NARH looks best placed; retain Buy
Narayana looks the best placed hospital player. Its affordable focus allows it to target the largest growth segment. It is a beneficiary of any government move to increase access and is the least impacted due to pricing caps. The partnership model allows profitably expansion beyond Tier I cities. We expect improving maturity profile to drive 196bps margin improvement and 25% EBITDA CAGR over FY17-20E. Retain Buy. Risks: key man risk; delay in ramp-up of hospitals.

APHS in transition; initiate at Hold
Apollo hospital business is seeing increased competition which is driving margins and RoCEs lower. We expect APHS to restart capex from FY19 led by competition and expect Hospital EBITDA CAGR of 11% despite the 30% capacity addition over the past three years. Strong growth in pharmacy (19% CAGR) and turnaround in AHLL though would drive EBITDA CAGR of 19% over FY17-20. The stock is trading at 17.5x FY19 EV/EBITDA in line with peers despite slower growth and outlook. We initiate with Hold rating and SOTP based TP of Rs1,150 (FY19E EV/EBITDA 19x). Key risk: Mumbai ramp-up; AHLL turnaround

HCG – niche player; initiate at Buy
HCG, in our view, is well positioned to succeed in the oncology space. It model allows for profitable expansion into Tier II cities. We expect it to report 27% EBITDA CAGR over FY17- 20. The stock is trading at 15.7x FY19 EV/EBITDA, a discount to the sector. We expect the discount to narrow as new centres ramp-up driving strong growth. We initiate at Buy and SOTP based PT of Rs325, valuing it at 18.5x FY19E EV/EBITDA. Key risks: price cap and competition.

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