Over the past 12 months Apollo Hospitals (APHS) stock price has declined 12% vs. the Sensex return of 27%. Factors such as stent price control, slower volume growth, fall in Kolkata JV profitability and substantial rise in doctor payouts impacted the hospital business margins adversely. Also, the decline in losses in subsidiary Apollo Health & Lifestyle Limited (AHLL) is slower than our expectations. Accordingly, we reduce our earnings estimates for FY18F and FY19F by 31% and 25%, respectively. We expect a recovery from a low base in FY18F. We expect operating and financial leverage to play out as volumes and occupancy rise. APHS has consistently reduced ALOS (average length of stay), leading to enhanced capacity and ARPOB (average revenue per occupied bed). The ramp-up in new hospitals is encouraging, particularly at Navi Mumbai, which is set to achieve break even in early FY19F, in our view. We expect earnings to record 32% CAGR over FY17-20F. We expect growth to remain strong beyond the explicit growth period, as there is significant scope to increase margins in the hospital and pharmacy business, and improvement in AHLL performance. We value APHS at 17x one-year forward EV/Ebitda (unchanged). We apply 17x EV/Ebitda to the proportionate share of Ebitda (based on holding) to arrive at our target price of Rs 1,307, down from Rs 1,505 previously. Our target price implies potential upside of 24%. Maintain Buy.
Catalyst: Increase in occupancy levels leading to higher margins
On EV/Ebitda basis, APHS is currently trading at 23% and 27% discount on FY19F and FY20F estimates, respectively, compared to regional peers. The stock has been trading between 18-22x one-year forward EV/Ebitda over the past three years and is currently trading at the lower end of this trading range.
Improvement in ALOS is a significant positive
Across hospitals, Apollo Hospitals has recorded significant improvement in ALOS (average length of stay). ALOS has decreased by 10-35% across clusters over the past eight years as indicated. ALOS is driven by case mix and better technology. Lower ALOS increases system efficiency and creates capacity. For instance, on standalone basis, the number of operating beds has increased by 2,050 over the past eight years. In our assessment, an additional 2,300 effective beds were added due to reduction in ALOS.
The expanded capacity resulted in lower occupancy rate. The number of occupied beds expanded at just 4.5% CAGR over the past eight years. The slowdown was quite significant in the past two years with almost no rise in occupied beds. As a result, the occupancy rates declined. The occupancy rate has declined from above 73% in FY09 to just 60-65% currently. Reduction in ALOS contributed to improvement in ARPOB as well. As turnaround is faster, more patients can be treated at the similar occupancy levels. Though most of the improvement in ARPOB is driven by case mix and pricing, we estimate that reduction in ALOS helped improve ARPOB by 15% over FY09-17.
Hospital business margins under pressure; however, we expect a revival from FY19F
Over FY13-17, the hospital business Ebitda recorded a muted 5% CAGR, despite consistent increase in ARPOB. The Ebitda margin declined by more than 400bps, from 24% in FY13 to below 20% in FY17, largely driven by a rise in overheads. In this computation, we have netted off doctor retention fees from revenues. Lower occupancy levels, commissioning of new hospitals/operating beds, significant increase in doctor retention fees and reduction in prices of medical devices such as stents led to the reduction in Ebitda margin.
New hospitals are recording improvement in profitability: The losses from the new hospitals ex Navi Mumbai have reduced and the segment has turned profitable at the Ebitda level in FY17. The momentum in improvement in the profitability is sustained in 1HFY18, when the new hospitals ex Navi Mumbai recorded Ebitda of `226m, 88% of the Ebitda recorded in FY17. Even in Navi Mumbai, the Ebitda losses are declining. From `299 m Ebitda loss in 4QFY17, the first full quarter after commissioning, the losses are now at Rs 84 m in 2QFY18F. The management expects the Navi Mumbai hospital to turn Ebitda-positive in 1QFY19F.
The new hospitals’ (operating beds: 1,340) occupancy is currently low at 52%. We expect new hospital Ebitda to rise over the next three years with occupancy reaching 60%. We have factored in initial losses from the new Chennai facility in our estimates in FY20F.