Leasing Business Diversification

Transcription

1 Equity Research Financials Leasing Business Diversification Positive (maintained) From leasing to hospital operation an overview of leasing companies presence in the healthcare sector Wang Wen SFC CE No. BGL GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Healthcare an attractive sector for financial leasing companies Leasing assets allocated in the healthcare sector have grown rapidly with a CAGR of ~46%, significantly higher than the overall leasing asset growth of 29% during Growth prospects are promising as medical equipment sales continue to increase in China and with ongoing population ageing. Compared to leasing assets allocated to other sectors, leasing assets in the healthcare sector tend to have higher yields and better asset quality, making the business attractive to leasing companies. From financial services to industrial operation On one hand, market competition has intensified as new leasing companies join the scene. This has put pressure on the yield on leasing assets allocated in the healthcare sector. On the other hand, leasing companies with abundant experience in the healthcare industry have accumulated resources related with medical equipment procurement, years of industry consulting experience and a pool of professionals. Meanwhile, since 2010 the government has issued multiple policy documents to support the participation of private capital in hospital operation and hospital reform in China. The number of beds at private hospitals could triple over the next three years according to the 13th five year plan for medical and healthcare system reform, indicating large market space. In addition, we also see a large number of business opportunities arising from public hospital reform, given that government guidelines on the reform of SOE-affiliated hospitals have been issued and those for the reform of military hospitals are likely on the way. operation in China With rising medical expenses and a changing population structure, the number of hospitals in China has continued to increase. For-profit and notfor-profit hospitals accounted for 33% and 67% of all hospitals in China respectively as of end-2015; on a different breakdown, public and private hospitals represented 44% and 56% respectively as of end With regard to the distribution of hospital resources, the current status of private hospitals in China can be summarized as a large quantity, small business scale, less efficient operation and lower income. Public hospitals still have advantages in terms of medical resources and operation scale, and they are responsible for offering the majority of medical services available. The five key business models for private capital to participate in hospital operation are the building of a new hospital, the acquisition of private hospitals, the acquisition and restructuring of public hospitals, participation in not-for-profit hospital management (e.g. the IOT model), and the establishment of a joint venture (e.g. the BOT model). The last two are essentially the operation of hospitals via the PPP model. Private capital with a purely private-sector background has mostly followed the first two models to involve themselves in hospital operation, resulting in a rapid increase in specialized hospitals. In contrast, companies with an SOE background tend to cooperate with public hospitals through the PPP model to generate revenue from management fees and supply chain management business.

2 Financial leasing companies seeing attractive business in healthcare sector Growing leasing business in healthcare sector Market volume Leasing assets allocated to the healthcare sector have grown rapidly, thanks to policy support, increasing financing demand from hospitals and sound asset quality of the healthcare industry. According to data from the MOC, leasing assets allocated to medical equipment increased from Rmb36.5bn in 2014 to Rmb78.32bn in 2016, with a CAGR of ~46%, significantly higher than overall leasing asset growth of 29%. As financial leasing companies regulated by the CBRC are not covered in the data collected by the MOC, the actual amount of leasing assets allocated in the healthcare industry should be even higher. Figure 1: Leasing asset allocation in 2016 (Rmb bn) Energy equipment Transportation equipment Infrastructure and real estate General machinery and equipment Industrial equipment Medical pharmaceutical equipment Construction equipment Communication electronic equipment Mining, metallurgical special equipment Sources: MOC, GF Securities (Hong Kong) Growth prospects Based on industry research, sale-leaseback accounts for a majority of financial leasing business in the healthcare sector, mainly due to the following reasons. 1) Sale-leaseback allows for more flexible use of funds for hospital clients as they have diversified financing needs beyond equipment purchases. 2) Medical equipment leasing usually has durations of 3-5 years, matching the usable lives of equipment, while credit loans from commercial banks tend to have durations of just 1-2 years. 3) The applicable tax rate for sale-leaseback has decreased to 6% after the VAT reform, lower than the tax rate for direct leasing (usually at 17%). In other words, the continued growth of leasing business in the healthcare industry is not only driven by growing medical equipment sales but also reflects strengthening healthcare sector investment. Medical equipment sales increased from Rmb170bn in 2012 to Rmb370bn in 2016, with a CAGR of 21%, of which medical equipment sales to hospitals accounted for ~70%. Due to the fast pace of technological development, medical equipment is being upgraded rapidly, with a typical service life of just 3-5 years, leading to steady demand of equipment replacement. Long-term investment growth in the hospital sector in China is driven by population ageing, which is progressing noticeably at present, with the population mix of those aged above 65 years old rising from 7.9% in 2006 to 10.8% in This percentage is estimated to pick up further to 26% 2

3 Rmb bn Sector report in 2050 according to the national population development plan ( ) issued by the State Council. Besides, chronic diseases are becoming increasingly common in China due to changes in the population structure, lifestyle changes and environmental pollution. With 54% of those aged above 60 suffering from chronic diseases, continued population ageing is driving sustained growth in the demand of medical resources. According to the World Bank s data in 2014, the number of hospital beds per thousand people in developed countries is positively correlated with the proportion of the population aged above 65. For example, in Japan, with 26% of the population aged above 65, the number of hospital beds per thousand people has reached Amid ongoing population ageing in China, the number of beds at medical institutions per thousand people also increased from 2.7 in 2006 to 5.4 in 2016, or from 1.9 in 2006 to 4.1 in 2016 specifically for hospital beds. These two figures are expected to grow further to 6 and 4.8 for medical institutions and hospitals respectively in 2020 according to the national medical and healthcare service system planning ( ) issued by the State Council ( 国务院关于全国医 疗卫生服务体系的规划纲要 ( ) ). Figure 2: Continued growth in medical equipment sales Figure 3: Population ageing in China % 25% 21% 21% 20% 30% 25% 20% 15% % 26% 30.0% 25.0% 20.0% % 5% 0% % 7.9% 8.3% 8.9% 9.4% 10.1% 10.8% % 10.0% 5.0% Medical equipment sales E 2030E 2050E 0.0% Medical equipment sales in hospital market YoY Population aged over 65 (100m) As % of total population (RHS) Sources: Wind, GF Securities (Hong Kong) Sources: Wind, State Council, GF Securities (Hong Kong) Figure 4: Population ageing and bed number Figure 5: Beds per 1,000 people continue to increase % 21% 17% 19% % US UK France Germany Japan 30% 25% 20% 15% 10% 5% 0% E No. of beds per 1,000 people No. of hospital beds per 1,000 people % of population aged above 65 No. of beds per 1,000 people Sources: World Bank, GF Securities (Hong Kong) Note: 2014 data. Sources: Wind, GF Securities (Hong Kong) 3

4 Key competitive strengths The core ROE of financial leasing companies mainly hinges upon their interest spread, asset quality and financial leverage. Leasing companies operating with different licenses are subject to different regulatory requirements, with a leverage ceiling of 12.5x for financial leasing companies under the CBRC and 10x for those under the MOC. Compared to leasing assets allocated to other sectors, leasing assets in the healthcare sector tend to offer higher yields and better asset quality, making it attractive for leasing companies. Higher leasing asset yields Many hospital clients, especially not-for-profit public hospitals with abundant cash flows, are not highly sensitive to the interest rates offered by leasing companies. They also value professional expertise, integrated medical service solutions and differentiated value-added services. We have observed higher leasing asset yields from the healthcare sector for leasing companies with years of experience operating in the healthcare industry and extensive medical resources. Universal Medical (2666 HK) has maintained a high leasing yield above 8% since 2012, relying on its extensive connections with world-leading medical institutions and internationally renowned experts. Far East Horizon (3360 HK) has also recorder a higher leasing asset yield from the healthcare sector over the last three years compared to its overall yield on assets allocated to nine industries. Better asset quality The non-performing asset (NPA) ratio of leasing assets allocated in the healthcare sector is much lower than those allocated to other industries. Take Far East Horizon as example, the NPA ratio of its healthcare leasing assets was remained below 0.2% since 2012, much lower than its overall NPA ratio (for assets allocated in nine industries, e.g. education, machinery, transportation, electronics). Universal Medical has also maintained an NPA ratio at a low and safe level below 1% with zero write-offs since 2012 (Due to their different accounting policies for NPA recovery, the NPA ratios for Universal Medical and Far East Horizon are not comparable). Better asset quality in the healthcare sector is mainly attributable to the fact that: 1) Healthcare is a less cyclical industry and most hospitals have stable cash flows. 2) Not-for-profit hospitals usually have a good repayment record. Overdue payments may occur because of leadership replacement, pending arrival of medical insurance funds and delayed payments due to finance or bank settlement issues. These may be recognized as NPAs in leasing companies financial reports, but most of them can be recovered afterwards based on past experience. 3) The market size is large with a total of more than 29,000 hospitals across China. Leasing companies can select hospital clients with good operations and sound solvency. Figure 6: Higher leasing yield of healthcare sector 9.00% Figure 7: Lower NPA ratio of healthcare sector 1.20% 8.00% 1.00% 7.00% 6.00% 5.00% 0.80% 0.60% 0.40% 0.20% 4.00% H % H17 Leasing yield-univeral Medical Leasing yield-feh(healthcare) Leasing yield-feh(overall) NPA ratio-universal Medical NPA Ratio-FEH(Overall) NPA Ratio-FEH(Healthcare) Sources: Wind, GF Securities (Hong Kong) 4

5 Sector report From financial service to industrial operation Increased competition Increased competition in leasing business The number of leasing companies in China has continued to increase, from 643 as of end-2012 to 8,218 as of end-june 2017, with a CAGR of 76%. During the same period, the value of outstanding leasing contracts increased from Rmb1,550bn in 2012 to Rmb5,600bn as of end-june 2017, with a CAGR of 33%. The growth in the number of industry participants has significantly exceeded the pace of business growth in the industry, indicating intensified market competition as more new entrants join the scene. Amid intensified market competition, the yield on leases allocated in the healthcare sector has also come under pressure, as newcomers offer cheaper prices to expand their market shares. Besides, financial leasing companies under the CBRC s supervision have competitive strengths in terms of a lower borrowing cost and higher leverage ceiling. Take Universal Medical as example, the company has maintained a high leasing yield above 8% since 2012, relying on its extensive connections with world-leading medical institutions and internationally renowned experts. However, its leasing asset yield (see Figure 6) remained relatively stable during 1H17 (slightly higher in 2016 mainly due to the effect of the VAT reform), while its peers leasing asset yields rebounded as market interest rates picked up, reflecting pressure from competition on the company s leasing assets. Given the pressure on leasing assets and continuously rising market interest rates, we believe leasing companies NIS will narrow in the long term. In light of this, leasing companies with years of experience in the healthcare industry have begun to actively explore opportunities both upstream and downstream for the next profit driver. Figure 8: No. of leasing companies in China Figure 9: Outstanding leasing contracts 9,000 60% % 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, % 40% 30% 20% 10% 0% -10% % 12% 10% 8% 6% 4% 2% 0% CBRC regulated Domestic funded Foreign funded QoQ Sources: Wind, GF Securities (Hong Kong) Outstanding leasing contracts (Rmb bn) QoQ Consulting experience and professionals along supply chain Leasing companies with years of experience in the healthcare industry have accumulated resources in the following three significant aspects. Medical equipment purchasing Far East Horizon and Universal Medical, the top two campiness by market share in medical equipment leasing, have in-depth understanding of medical equipment and have accumulated rich experience in negotiating with manufacturers. Far East Horizon established its medical business 5

6 department in It has provided services for over 2,200 hospitals and has engaged in medical equipment leasing for nearly 15 years. Far East Horizon has signed strategic group purchasing contracts with world-leading medical equipment manufacturers, and completed over Rmb50m worth of equipment purchasing in 7M17 at prices 5%-10% lower than individual private hospitals or 50%-60% lower than public hospitals. The major shareholder of Universal Medical, China General Technology Group, is the largest service provider in China for importing advanced equipment and technology, and also the largest importer and exporter of medical and healthcare products. Relying on China General Technology Group s strength in trade and extensive overseas resources, Universal Medical has gained immediate access to advanced medical technology and equipment, and has a strong advantage in importing global medical equipment. So far the company is the exclusive agent for 19 medical device categories in China, covering a total of over 200 medical products. Consulting experience Both Far East Horizon and Universal Medical provide consulting services for hospital clients, which has in turn helped them gain experience in hospital operation and related fields. In addition to consulting on financing, Far East Horizon is cooperating with Changhua Christian in Tainwan to provide management consulting services including hospital review and evaluation management, patient safety and medical quality promotion, performance management, hospital image management, project management, and the organization of visiting and training services. Meanwhile, with extensive connections with world-class hospitals, medical units and well-known experts, Universal Medical has helped hospital clients with clinical department upgrades, the introduction of advanced modern hospital management concepts, and leading clinical diagnostic and treatment technology. By the end of 2016, the company had established strategic partnerships with 68 leading international healthcare institutions and more than 200 experts in various fields. The company also has a specialty in stroke unit upgrade services, which effectively integrates financing, equipment and technical services together. Professionals Apart from their experience in the healthcare industry, these leasing companies have also gathered a group of professionals well versed with hospital operation. For Far East Horizon, half of its hospital investment team comes from the healthcare industry, while the other half has finance expertise. In addition, one-third of its finance professionals have healthcare related educational backgrounds or working experience. The company has also invited experienced experts to join its hospitals. Its medical management team has Chen Xiuzhu, dean of Changhua Christian in Taiwan, and other experienced deans from domestic public hospitals. Some well-known professors have also been invited to join them as chief experts of key disciplines. With professors Pei Guoxian and Zhang Chuncai as chief experts in orthopedics, the company has established a physician team of over 250 doctors to serve 1,400 beds nationwide, covering over 95% of orthopedic techniques. For Universal Medical, it has focused on the healthcare industry and provided comprehensive services for hospital clients since Half of its frontline business staff has healthcare related educational backgrounds or working experience. Besides, the company participates in hospital operation under the PPP model, meaning it mainly relies on Grade III Class A public hospital resources and management capabilities. Business opportunities arising from ongoing healthcare reform in China Market space The number of private hospitals in China has grown rapidly over the past few years and has exceeded the number of public hospitals since However, the amount of investment, number of operational beds and amount of technical personnel for each private hospital remain much lower than the average levels for public hospitals. The government has been encouraging private investment in hospitals. For example, public hospitals had 3.9 beds per thousand people in 2015, 6

7 while private hospitals had just 0.52 beds. According to the medical and healthcare system reform plan for the 13th Five Year Plan period, the number of beds per thousand people is targeted to increase to 4.8 by 2020, of which 1.5 beds will be attributable to private hospitals. In other words, the number of beds at private hospitals could triple over the next three years. Policy support Relevant policy changes have significantly influenced the scale and business model of privatesector capital being involved in hospital operation, which started when the State Council first allowed individuals to practice medicine in 1980 ( 关于允许个体开业行医问题的请示报告 ) and when the Ministry of Health first allowed private-sector capital to provide healthcare services in However, up until 2010, despite the constantly growing number of private medical institutions, the vast majority of private hospitals were for-profit hospitals subject to policy restrictions. The State Council issued Several Opinions on Encouraging and Guiding the Healthy Development of Private Investment in 2010 to allow not-for-profit hospitals to be registered by private-sector investors. Several other important documents have been issued since to support private capital participating in hospital operation and hospital reform in China, which are briefly summarized below in Figure 10. 7

8 Figure 10: Supportive policies since 2010 Date Document Highlights Several Opinions of the State Council on Encouraging and Guiding the Healthy Development of Private Investment Decision of the Central Committee of the Communist Party of China on Some Major Issues about Deepening Reforms Support private capital participation in public hospital restructuring. Support private medical institutions to undertake public health services, basic medical services and designated medical insurance services. Implement tax policies for non-profit medical institutions. Encourage private capital to construct medical institutions and give priority to non-profit medical institutions. Private-sector funds can participate in the restructuring of public hospitals. Allowing physicians to work at multiple medical institutions and private medical institutions to be included in medical insurance Several policies and measures on accelerating the development of privatesector healthcare institutions Implement government subsidies on private non-profit medical institutions. Encourage local governments to cooperate with multi-layered capital markets and provide financing assistance for private hospitals. Accelerate and regulate the practice of physicians working at muti-locations. Tax exemptions (business tax exemption for healthcare institutions; exemption from property tax, urban land use tax for qualified non-profit healthcare institutions; exemption from property tax, urban land use tax within three years for qualified for-profit healthcare institutions; exemption from corporate income tax for eligible revenue from healthcare services of non-profit healthcare orgnizations). Incorporate private healthcare institutions into medical insurance th Five Year Plan for Deepening Medical and Healthcare System Reform During 13th FYP, a hierarchical medical system ( 分级诊疗 ), modern hospital management, universal medical insurance, medicine supply guarantee and comprehensive supervision need to achieve new breakthroughs. Hierarchical medical system: A hierarchical medical system would be gradually improved and pilots carried out in more than 85% of cities by By 2020, a hierarchical medical model will have gradually been formed and a hierachical medical system in accordance with national conditions will have been established. Guide public hospitals to participate in the hierachical medical system. Further improve and implement medical insurance payment and medical service pricing policies, promote the construction of hospital alliances, explore referral machanisms by allowing physicians to work at multi-locations, strengthen drug supply at local healthcare institutions. Drug reform: Starting from 2017, the revenue contribution of drug sales at public hospitals in pilot cities should be redcued to about 30% (excluding TCM decoction pieces). The growth of public hospital costs should be controlled below 10% Guiding Opinions of the General Office of the State Council on Promoting the Construction and Development of Alliances Set up medical groups in cities and hospital alliances in counties. Form specialist alliances across regions and develop telemedicine networks in remote and poor areas Opinons on supporting private capital to provide diversified healthcare services Encourage the development of general medical services, accelerate the development of specialized services and comprehensively develop Chinese medicine services. Orderly develop cutting-edge medical services, encourage strong private medical institutions to focus on the forefront of medcine and promote the development of multi-sector integrated services. Explore the development of distinctive healthcare service clusters to meet higher-end health consumption demand and relax control over market entry Guiding Opinions on Deepening Reform of SOE-Affiliated Medical Institutions Encourage administration transfer to local governments. Support SOEs or state-owned capital investment & operation companies focused on healthcare sector to innovate and upgrade medical services to develop elderly healthcare, healthcare tourism and other industries. Give priority to the restructuring of non-profit medical institutions and screen for optimal investors with transparency. Encourage SOE-affiliated medical institutions to participate in government procurement of medical and healthcare services. Implement supportive policies regarding taxation, land use, investment and financing. Sources: GF Securities (Hong Kong) 8

9 operation in China Public hospitals vs. private hospitals classification in China With increasing medical expenses and a changing population structure, the number of hospitals in China increased from 18,703 in 2005 to 29,140 in 2016, with a CAGR of ~4%. There are many classification methods of hospitals: for-profit and not-for-profit hospitals as an important one according to administrative classification management, each representing 33% and 67% respectively as of end-2015; public hospitals and private hospitals by registration type, with the former including state-owned hospitals, military hospitals (under reform) and hospitals affiliated to SOEs (under reform), and the latter including individuals, associated, joint-stock and foreign jointventure hospitals ( 私营 联营 股份合作和外商合资医院 ), each representing 56% and 44% respectively as of end There is also a classification by hospital rating: Grade III, Grade II, Grade I and ungraded hospitals each representing 8%, 27%, 32% and 33% respectively in 2016, among which Grade III Class A hospitals are the best in terms of service quality and medical resources in China. Based on a hospital s specialty composition, there are general hospitals, specialized hospitals, TCM hospitals and other hospitals (integrative medicine hospitals and national hospitals). General hospitals accounted for the largest share of 63% in 2015 while the proportion of specialized hospitals (22%) has also increased rapidly with the development of private hospitals. TCM hospitals and others accounted for 12% and 3% respectively. Figure 11: No. of hospitals continues to increase Figure 12: classifications 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 No. of private hospitals YoY No. of public hospitals 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% Not-forprofit 33% Private 56% For-profit 67% Public 44% Ungraded 33% Grade Ⅰ 32% Grade Ⅱ 27% Grade Ⅲ 8% Others 3% of TCM 12% Specialized 22% General 63% Sources: Wind, GF Securities (Hong Kong) Sources: Wind, China Health Statistics Yearbook, GF Securities (Hong Kong) Note: For-profit and not-for-profit hospitals mix updated to 2015; mix of general hospitals, specialized hospitals, TCM hospitals and others updated to 2015; other data updated to For-profit medical institutions refer to those whose profits from medical services are partly returned to investors, while not-for-profit medical institutions refer to those established to serve public interests whose revenue is used to cover the cost of medical services and improve their service capacity rather than being distributed to shareholders or stakeholders. As all public hospitals are not-for-profit hospitals, we can further divide Chinese hospitals into three categories: public hospitals, non-profit private hospitals and for-profit private hospitals. A comparison is given below: 9

10 Figure 13: comparison Funding Tax policies Drug mark-ups Employee management Accounting method Subsidies Reimbursement Price Management Dividend policy Sources: GF Securities (Hong Kong) Public not-for-profit hospitals Private not-for-hospitals For-profit hospitals Government, military (under reform), SOEs (under reform) Enterprises, individuals Enterprises, individuals Income tax, value-added tax of Income tax exempted, value-added tax Income tax exempted, value-added tax medical servicies exempted for 3 exempted for medical services exempted for medical services years All drug mark-ups have been prohibited Voluntary abolishment Voluntary abolishment Government employment ( 事业编制, under reform) Corporate employment Corporate employment accounting accounting Corporate accounting Free land use rights( 无偿划拨用地 ), government subsidies accounted for 9% of total revenue (2015) Most are qualified for basic medical insurance reimbursement ( 医保定点医疗机构 ) Controled by the government No dividends; net profit can only be reinvested in equipment purchasing, technology introduction and new medical services Distribution of medical resources Limited subsidies Most are qualified for basic medical insurance reimbursement Voluntary participation (but subject to government guildlines required by basic medical insurance reimbursement) No dividends; net profit can only be reinvested in equipment purchasing, technology introduction and new medical services Hardly any subsidies Many are not qualified for basic medical insurance reimbursement Voluntary participation (but subject to government guildlines required by basic medical insurance reimbursement) Dividend payouts allowed 1) The number of private hospitals in China increased rapidly from just 3,220 in 2005 (17% of total) to 16,432 in 2016 to account for 56% of all hospitals, representing a CAGR of 16%. 2) That said, public hospitals still have advantages in terms of medical resources and operation scale. While the number of private hospitals in 2016 was 1.29 times that of public hospitals, the number of beds offered by private hospitals represented just 28% of those offered by public hospitals. In addition, the number of technical personnel (including physicians, nurses, pharmacists and technicians) at private hospital was equivalent to just 21% of that at public hospitals. On average, each public hospital has 351 beds and 353 technical staff, compared with 75 and 56 for private hospitals. 3) As a result of their extensive medical resources and patients preferences, public hospitals are responsible for the bulk of medical services, while total patient and inpatient numbers at private hospitals are equal to just 15% and 19% of the numbers at public hospitals. The bed utilization rate for private hospitals is just 63%, significantly lower than the 91% for public hospitals. 4) Private hospitals have much lower income than public hospitals, with their total income equal to just 10% of that for public hospitals in 2015 (total private hospital number was 1.1 times that of public hospitals at the time). On a per-hospital basis, the average income for a private hospital was just Rmb19m, equal to 9% of the income for a public hospital (Rmb205m). 5) Fiscal subsidies: Private hospitals can get much less financial support from the government (equivalent to 1% received by public hospitals in 2015) In conclusion, the current status of private hospitals in China can be summarized as a large quantity, small business scale, less efficient operation and lower income. The distinction between private and public hospitals can also be seen from their respective hospital ratings: public hospitals are mostly Grade III and Grade II hospitals accounting for 93% and 82% of hospitals in 10

11 the two grades. In contrast, private hospitals are mostly Grade I and ungraded hospitals, accounting for 63% and 81% of hospitals in the two grades. In fact, the rating of hospitals already considers the function, facilities, technical strength and other qualifications as the criteria for assessment. s with higher ratings are deemed more trustworthy among patients, given that bed utilization rates for Grade III, Grade II and Grade I hospitals were 99%, 87% and 62% respectively in Figure 14: ratings Figure 15: Performance of private vs. public hospitals Ungraded Grade Ⅰ Grade Ⅱ Grade Ⅲ Private hospitals Public hospitals (2016 figures) Public Private Private as % hospitals hospitals of public No. of hospitals % Beds (m) % Medical technicians (m) % Patients (100m) % Inpatients (m) % Daily visits per doctor % Daily inpatients per doctor % Bed utilization rate 91% 63% 69% Average length of stay (days) % Revenue (Rmb bn, 2015) % Revenue per hospital (Rmb m, 2015) % Financial subsidies (Rmb bn, 2015) % Sources: Wind, GF Securities (Hong Kong) Acquisition vs. PPP There are mainly five business models for private capital to participate in hospital operation: the building of a new hospital, the acquisition of private hospitals, the acquisition and restructuring of public hospitals, not-for-profit hospital management (e.g. the IOT model), and a joint venture (e.g. the BOT model). The last two are the operation of hospitals via the PPP model. 1) Building a new hospital Building new hospitals requires a long process of application, approval and construction with relatively high upfront investment and a long payback period. As private hospitals are less attractive for medical professionals as well as patients, there is considerable operational risk. However, investors have absolute control over the hospitals under this model. Guangdong Kanghua is the first and the largest Grade III Class A private hospital in China which was established by Dongguan Kanghua Group with an investment of Rmb2.6bn. The bed utilization rate at Kanghua was 83.2% in 2016, significantly lower than the average for of Grade III Class A hospitals (99%). 2) Acquisition of private hospitals Through the acquisition of private hospitals, the original medical personnel and medical equipment can be retained; therefore it is possible to improve operational efficiency within a short period of time through equipment upgrade, medical unit upgrades and management enhancement. However, there might be issues carried over from the acquired hospital such as existing debt or legal disputes. Furthermore, it also requires the original medical team to accept the new operating model to ensure better operating results. A number of hospitals acquired by Far East Horizon are regional top three private hospitals. 3) Acquisition and restructuring of public hospitals The acquisition and restructuring of public hospitals require a complex application and approval process and strong support from the local government, all of which involves considerable uncertainty. In addition, the restructured hospital has to undertake the debt of the original hospital, replace retired and redundant staff, handle the employee status transition from government- to corporate-employed ( 事业编制转公司聘用 ), deal with asset assessment as well as moral hazards and accept pressure from the public. That said, 11

12 mature public hospitals solid medical resources and reputations should reduce operational difficulties after restructuring. The larger a hospital, the more difficult restructuring can be. As a result, county hospitals with operational issues are the most desirable targets for private capital investment. For instance, CR Phoenix successfully participated in the restructuring of Jiangong and became the latter s controlling shareholder. At present, there are more than 3,000 SOE-affiliated hospitals under reform, providing a large amount of opportunities for public hospital acquisition and restructuring which is supported by government policies. 4) Not-for-profit hospital management (PPP) Not-for-profit hospital management through the PPP model typically meets with fewer difficulties from the government and the public as the ownership of the hospital still lies in the public sector, meaning the not-for-profit nature remains unchanged. The public hospital's medical personnel and reputation can be retained, which guarantees the smooth running of the hospital. However, investors control over business operation and management is weakened. In addition, not-for-profit hospitals cannot pay dividends, which means investors can only share returns from management fees and supply chain businesses. CR Phoenix has several hospitals which have adopted the IOT model (investment, operation, transfer). At the end of the operation period, the operator needs to return the hospital operation right to the public sector. 5) A joint venture (PPP) Many Grade III Class A public hospitals need to expand under the current operating environment, but have limited financial support from local governments. Therefore, the PPP model is brought into the picture under which joint ventures are formed to construct new hospitals using private capital. The co-establishment of the International Land Port by Universal Medical and the First Affiliated of Xi an Jiaotong University servers as an example. Private capital can obtain the operation right and generate management fees through this model and can also participate in the supply chain management for both the old and new hospitals. Both the public ownership and not-for-profit nature of the old and new hospitals remain unchanged, but Grade III Class A public hospitals typically have dominance in management while private-sector investors have relatively weak control over hospital operation. 12

13 Figure 16: Comparison of different models of private capital participating in hospital operation New hospital Acquisition of private hospital Acquisition and restructring of public hospital Not-for-profit hospital management (PPP) Joint venture (PPP) Obstables Relatively long application and approval process Depends on the will of aquired hospital; relatively easy Long negotiation period, strong support from local government, difficult Need to maintain a good relationship with local government Need to maintain good relationships with local government and partnering hospital Upfront investment Medical and personnel resources Developmental period Relatively high Relatively high Medium Medium Relatively high Private hospitals are less attractive to doctors Relatively long construction period; time required for building reputation Original stuff, less attractive to doctors Reputation depends on original hospital; private hospitals have weaker reputation Original stuff, possible objections from employees Relatively short Original stuff Relatively short Support from partnering hospital Requires time for construction Investors' control Difficulty of operation Investors have absolute control Relatively easy, but private hospitals are less attractive to patients Investors have absolute control Relatively easy, but private hospitals are less attractive to patients Investors have absolute control Need to deal with issues of acquired hospital (e.g. placement of retired and redundant staff) Investors have certain control Need to deal with issues of acquired hospital (e.g. placement of retired and redundant staff) Relatively weak control Easy Example Kanghua Healthcare Far East Horizon Far East Horizon/ CR Phoenix Income source Profit sharing Profit sharing Profit sharing CR Phoenix Revenue from operation and supply chain Universal Medical Revenue from operation and supply chain Sources: Wind, GF Securities (Hong Kong) operation: listed companies choices Which model to follow when participating in hospital operation depends on a company s shareholder background, specialties and overall strategy. We have looked at several representative HK-listed companies with different hospital asset allocations, presenting a comparison below. Basic information about their hospitals 1) Guangdong Kanghua Healthcare (3689 HK) The first and largest Grade III Class A private hospital in China: Kanghua. Depends on major shareholder s solid government relationships in Dongguan. Stable and mature business model but with limited expansion potential. 2) Harmonicare Medical (1509 HK) Large-scale operator of private for-profit hospitals specialized in maternity. Invested by private capital but with insurance company participation. Compared with general hospitals, it is easier for specialized hospitals to establish new branches and replicate their business models. 3) Far East Horizon (3360.hk) All hospitals are private for-profit hospitals. Has expanded rapidly through hospital acquisition. While other large-scale hospital operators in China typically focus on densely populated first- to third-tier cities, most of Far East Horizon s acquired hospitals are located in county-level cities. Given that most of the company s hospitals are general hospitals, per-hospital investment is relatively small. 13

14 4) CR Phoenix (1515 HK) Relies on its major shareholder s background: central SOE with healthcare as core business. Rapid expansion through M&A (Phoenix Medical and CR Healthcare merged in 2016). Mainly involved in public hospital management and supply chain business, with general management services (Jiagong consolidation), management fees and revenue from supply chain business as main sources of income. 5) Universal Medical (2666 HK) operation business just started but shows strong expansion momentum. Similar major shareholder background to CR Phoenix s. Participating in hospital operation through PPP with cooperation with strong Grade III Class A public hospitals and actively looking for opportunities in the reform of SOE-affiliated hospitals. Figure 17: Guangdong Kanghua Healthcare Major shareholders Dongguan Kanghua Investment Group (59.06%): company owned by individual(s) No. of hospitals under management 2 hospitals Nature of hospitals under management private for-profit general hospitals Ratings of hospitals under management 1 Grade III Class A hospital: Kanghua 1 ungraded hospital: Renkang (may apply for Grade II hospital rating by end-2017) Geographical distribution All located in Dongguan, Guangdong province How has company become involved in hospital operation? All invested by shareholders and self-built Figure 18: Harmonicare Medical Major shareholders Homecare International Investment Limited (28.78%): company owned by individual(s) Taikang Group (16.07%): insurance company No. of hospitals under management 12 hospitals as of end-1h17 Nature of hospitals under management Private for-profit specialized hospitals Specialized in maternity Ratings of hospitals under management 4 Grade II hospitals and others ungraded Geographical distribution Tier 1-3 cities with large popultaion Top 5 hospitals located in Beijing, Fuzhou, Chongqing, Shenzhen and Guangzhou How has company become involved in hospital operation? 2 hospitals through acquisition The others invested by the company and self-built Sources: Company data, GF Securities (Hong Kong) 14

15 Figure 19: Far East Horizon Major shareholders Sinochem (23.29%): central SOE butdoes not focus onhealthcare as core business No. of hospitals under management 26 as of end-1h17 Nature of hospitals under management Private for-profit hospitals; general hospitals for majority Ratings of hospitals under management 3 Grade Ⅲ hospitals 13 Grade Ⅱhospitals 10 Grade Ⅰand ungraded hospitals Geographical distribution Four major areas + most in county-level cities How has company become involved in hospital operation? 1 through public hospital acqsuition and restructuring; 25 through priviate hospital acquisition Figure 20: CR Phoenix Major shareholders China Recource Group (36%): central SOE with healtthcare as core business No. of hospitals under management 108 hospitals as of end-1h17 (under investment, management and contractual arrangement) Nature of hospitals under management 3 private for-profit hospitals 105 not-for-profit hospiptals Ratings of hospitals under management 7 Grade Ⅲ hospitals 14 Grade Ⅱhospitals 29 Grade Ⅰ hospitals 58 community clinics Geographical distribution First- and second-tier cities + prefecture-level cities Beijing, Shenzhen, Wuhan, Kunming, Baoding, Xuzhou, Huaibei etc. How has company become involved in hospital operation? 1 through public hospital acqsuition and restructuring (Jiangong ); 57 through IOT of PPP model 48 hospitals with sponsorship rights Sources: Company data, GF Securities (Hong Kong) Figure 21: Universal Medical Major shareholders China General Technology (37.73%): central SOE with healtthcare as core business No. of hospitals under management 1 under construction as of end 1H17 Nature of hospitals under management Public hospital Ratings of hospitals under management Grade Ⅲ Class A hospital Geographical distribution Xi'an, and a similar project in negotiation located in Handan How has company become involved in hospital operation? Through PPP model Sources: Company data, GF Securities (Hong Kong) Operational data of key hospitals The revenue of a hospital is affected by a number of factors including its technology, hospital rating, location and whether it is a public or private hospital. Below are some of the key facts we have observed about the operational data of the key hospitals listed above: In terms of spending per visit (calculated as revenue / [inpatient visits + outpatient visits]), the First Affiliated, which is cooperating with Universal Medical and which has strong medical resources in western China, ranks at the top with a spending of Rmb1,570/visit; Harmonicare Medical which specializes in maternity also performs well with Rmb1,360/visit. Following these two are Kanghua Healthcare with Rmb815/visit, CR Phoenix with Rmb 807/visit and Far East Horizon with Rmb 428/visit. In terms of average revenue per thousand beds (calculated as revenue*1,000/beds in operation), the First Affiliated also comes first with Rmb1,570/thousand beds, followed 15

16 by Harmonicare Medical with Rmb627/thousand beds, Kanghua Healthcare with Rmb423/thousand beds, CR Phoenix with Rmb360/thousand beds, and Far East Horizon with Rmb165/thousand beds. The location of a hospital has a significant impact on its revenue, based on the performance of hospitals operated by Harmonicare Medical. Figure 22: Guangdong Kanghua Healthcare Kanghua Renkang Overall (1H17) Registered beds 2, ,460 Operational beds Outpatient visits 544, , ,752 Average spending per visit (outpatients) Inpatients 21,703 6,505 28,208 Average spending per visit (inpatients) 14,761 8,904 13,410 Average length of stay Overall bed utilization 84.00% Sources: Company data, GF Securities (Hong Kong) Figure 23: Harmonicare Medical (top 5 and overall) Beijing HarMoniCare Sources: Company data, GF Securities (Hong Kong) Fuzhou Modern Woman Figure 24: CR Phoenix Chongqing Modern Woman Shenzhen HarMoniCare Guangzhou Woman Beds (649 in operation) Revenue (Rmb m) Gross profit (Rmb m) Outpatient visits 37,630 44,812 33,364 14,481 36, ,205 Inpatient visits 1,264 1,495 1, ,584 11,000 Average spending per visit (Rmb) 2, ,287 2, ,360 Overall s in Beijing s outside Beijing Beds in operation 3,895 6,102 Revenue (Rmb m) Outpatient visits 2,327,797 1,338,082 Average spending per visit (outpatients) Inpatients 37,583 85,197 Average spending per visit (inpatients) 17,208 11,290 Average length of stay Overall bed utilization 87.80% 85.00% Sources: Company data, GF Securities (Hong Kong) Figure 25: Far East Horizon (acquired hospitals) Overall Beds Beds in operation 5600 revenue (Rmb m) 925 Gross profit (Rmb m) 281 Net profit (Rmb m) 58 Annual outpatient visits 2,000,000+ Annual inpatient visits 160,000+ Annual surgeries 40,000+ Sources: Company data, GF Securities (Hong Kong) Figure 26: Universal Medical Xi'an First Affliated Beds 2531 Revenue (Rmb m) 4000 Outpatient visits 2,430,000 Inpatients 118,000 Annual surgeries 6500 Average length of stay

17 Comparison of key financial data for hospital operators Large-scale hospital operators (thanks to the economies of scale created the large number of hospitals operated) have shown a strong ability to improve hospital gross profit margins through group purchasing: Harmonicare Medical has a 45% gross profit margin and CR Phoenix a 37% gross profit margin. Far East Horizon has also indicated that the gross profit margin of its hospitals could improve to 40%-45% within one year of acquisition. However, due to the need to make continued investment during expansion and business model experiments, large-scale hospital operators also have low net profit margins at present. The Rmb2m net profit for CR Phoenix as shown in the table below was non-recurring net profit in 1H17. Figure 27: Key financial data comparison Mkt cap Revenue Gross Gross Net Net (Rmb m) (HK$ 100m) (hospital) profit margin profit margin 3689 HK Guangdong Kanghua % 72 11% 1509 HK Harmonicare Medical % 11 3% 1515 HK CR Phoenix % 2 0% 3360 HK Far East Horizon % 58 6% 2666 HK First Affiliated (Universal Medical) na na 42 12% Sources: Company data, GF Securities (Hong Kong) Notes: Market cap date updated to Oct 12, Financial data are as of end-1h17 except in the case of the First Affiliated (2016). The revenue, gross profit and net profit for Guangdong Kanghua and Harmonicare Medical are all generated from hospital operation. The revenue, gross profit and net profit for CR Phoenix represent data for the entire company. The financial data for Far East Horizon are for all hospitals acquired by the company without pro-rata calculations for financial book consolidation. 17

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