KPJ Healthcare Reuters: KPJH.KL Bloomberg: KPJ MK Exchange: KLS Ticker: KPJH

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1 Company Global Markets Research GEMS: Asia Malaysia Health Care Health Care 9 April 2007 KPJ Healthcare Reuters: KPJH.KL Bloomberg: KPJ MK Exchange: KLS Ticker: KPJH Healthcare remedy; initiating with a Buy Joe Liew, CFA Research Analyst (60) joe.liew@db.com Undervalued, under-researched small-cap hospital operator KPJ Healthcare (KPJ) is the largest private hospital operator in Malaysia and looks set to register 28%, 16% and 16% p.a. core EPS growth over FYDec07-09, respectively. Rising affluence and an ageing population will push up Malaysian healthcare spending in our view. KPJ is seeking to add one hospital a year to its group domestically. P/E of 11.5x FY07 is below regional peers and the Malaysian market average, while FY07 net dividend yield of 4.4% is forecast to rise to 6.0% in FY09. Our 12-month RM3.80/share TP implies 41% upside from current levels. Favourable industry dynamics Healthcare spending in Malaysia was 3.4% of total GDP in 2006 vs. 8.6% for OECD countries and 15.2% for USA, indicating that there is still more room for growth. KPJ is also aiming at managing more overseas hospitals. Attractive valuation; recent hospital acquisitions at much higher P/Es KPJ s FY07E P/E of 11.5x is below the Malaysian market average of 16x and its regional peers x. In late 2006, Khazanah and Parkway acquired the listed Pantai Holdings at 16x consensus FY07 P/E. In 2005, Khazanah also acquired a stake in Apollo Hospitals, India, for 25.5x one-year forward P/E. KPJ s sale of mature hospitals into a REIT has helped it enhance ROEs from 8.5% in 2005 to 9.8% in 2006 and reduce net gearing from 78% to 56%. Key catalysts for the stock: delivery of strong quarterly earnings and increased foreign attention on small-cap stocks in Malaysia versus large caps due to the valuation gap. TP RM3.80 based on 16x FY07E P/E We peg KPJ at 16x FY07E P/E because of its steady earnings growth and favorable industry dynamics. Our Gordon growth model points to a valuation of RM3.90/share. Key risk is an economic slowdown that would lead to lower healthcare spending. Major shareholder Johor Corp has been reducing its stake. Forecasts and ratios Year End Dec A 2006A 2007E 2008E 2009E Sales (MYRm) , ,272.4 EBITDA (MYRm) Reported NPAT (MYRm) Reported EPS (MYR) DB EPS FD(MYR) DB EPS growth (%) PER (x) EV/EBITDA (x) Yield (net) (%) Source: Deutsche Bank estimates, company data 1 DB EPS is fully diluted and excludes non-recurring items 2 Multiples and yields calculations use average historical prices for past years and spot prices for current and future years, except P/B which uses the year end close Initiation of Coverage Buy Price at 6 Apr 2007 (MYR) 2.70 Price target - 12mth (MYR) week range (MYR) KLCI 1,279 Price/price relative /05 7/05 Rel. to KLCI (L.H. Scale) 10/05 1/06 4/06 7/06 10/06 1/07 KPJ Healthcare (R.H. Scale) Performance (%) 1m 3m 12m Absolute KLCI Stock data Market cap (MYRm) 553 Market cap (USDm) 160 Shares outstanding (m) Major shareholders Johor Corp (52.9%) Free float (%) 47% Key indicators (FY1) ROE (%) 10.4 Net debt/equity (%) 44.6 Book value/share (MYR) 2.36 Price/book (x) 1.1 Net interest cover (x) 4.2 Operating profit margin (%) 8.5 Comparatives Bangkok Dusit Medical Servi (BGH.BK),THB35.75 Hold 2006A 2007E 2008E P/E (x) EV/EBITDA (x) Price/book (x) Bumrungrad Hospital (BH.BK),THB41.00 Buy 2006A 2007E 2008E P/E (x) EV/EBITDA (x) Price/book (x) Bangkok Chain Hospital (KH.BK),THB8.70 Hold 2006A 2007E 2008E P/E (x) EV/EBITDA (x) Price/book (x) All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Independent, third-party research (IR) on certain companies covered by DBSI's research is available to customers of DBSI in the United States at no cost. Customers can access this IR at or call to request that a copy of the IR be sent to them. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1

2 Model updated:05 April 2007 Malaysia Reuters Code KPJH.KL Price as of 06 April MYR 2.70 Price Target MYR 3.80 Web Site KPJ Healthcare is an investment holding company with subsidiaries that operate specialist medical centers, provides pathology and laboratory services, hospital management services, drugs and medical distribution and operates a nursing college joe.liew@db.com DB EPS (MYR) P/E (x) DB EPS growth (%) EPS FD (MYR) P/E FD (x) CFPS (MYR) Free CFPS (MYR) P/CFPS (x) NM DPS (MYR) Dividend yield (%) BV/Share (MYR) Price/BV (x) Weighted average shares (m) Average market cap (MYRm) Enterprise value (MYRm) EV/Sales (x) EV/EBITDA EV/EBIT EV/Op. Capital (x) Sales revenue ,153 1,272 Operating EBITDA Depreciation Amortization Operating EBIT Net interest income (expense) Associates/affiliates Investment and other income/expense Exceptionals/extraordinaries Income tax expense Minorities/preference dividends Net income Cash flow from operations Movement in Net Working Capital Capex Free cash flow Other investing activities Equity raised/(bought back) Dividends paid Net inc/(dec) in borrowings Other financing cash flows Total cash flows from financing Net cash flow Movement in net debt/(cash) Cash and other liquid assets Tangible fixed assets Goodwill Other intangible assets Associates/investments Other assets Total assets ,116 1,199 1,335 1,465 Interest bearing debt Other liabilities Total liabilities Shareholders' equity Minorities Total shareholders' equity Net working capital Net debt/(cash) Capital Absolute Price Return 1m 3m 12m 22.7% 33.7% 63.6% 52-week Range MYR Market Cap MYR 553 m USD 160 m Company Identifiers Bloomberg KPJ MK Cusip SEDOL Sales growth (%) NM EBITDA Margin (%) EBIT Margin (%) Payout ratio (%) ROE (%) Return on capital (%) Operating return on capital (%) Capex/sales (%) Capex/depreciation (x) Net debt/equity (%) Net interest cover (x) Source: Deutsche Bank estimates, company data Page 2

3 Investment thesis Outlook: Steady growth and favourable industry outlook KPJ Healthcare (KPJ) operates 17 domestic private hospitals, six overseas hospitals and a nursing college. We expect a 20% core EPS CAGR over the next three years for KPJ as healthcare spending per capita in Malaysia increases. This EPS growth will be driven by the addition of two hospitals at the end of 2006 one in 2008 and one in 2009, a 5% p.a. increase in average spend per patient, and a turnaround in the nine hospitals that were acquired by the group in The recent establishment of a REIT will allow the group to expand without straining its balance sheet as management intends to inject more mature hospitals into the REIT. This should help boost ROEs from 9.8% in 2006 to 12.5% in 2009, and fund growth. On the overseas front, management intends to grow by offering management services. The private healthcare industry in Malaysia is set to record steady growth. The overall expenditure on healthcare is expected to rise, driven by an expanding economy and growing awareness on the importance of healthcare and prevention of diseases. Additionally, Malaysia s 3.4% expenditure on healthcare as a percentage of GDP and on a per capita basis still trails that of the OECD countries average of 8.6%, indicating more upside. The lack of public healthcare services and the increasing take-up rates in medical and healthcare insurance will continue to drive higher average healthcare expenditure. Demographic (ageing population) and lifestyle changes amongst Malaysians indicate that future expenditure on healthcare will increase. Further, the high barriers to entry into the hospital business will prevent any further entrants into the industry. Healthcare tourism, which grew over 40% last year albeit from a low base, is another driving force for the industry. Valuation: TP based on 16x FY07F P/E; initiating with a Buy KPJ is the cheapest healthcare stock in the region. It currently trades at FY07F P/E of 11.5x, while other hospital stocks trade at 16-30x FY07F P/E. The high P/E reflects the positive outlook of the Asian healthcare industry. We believe that the sharp discount is unwarranted and the stock deserves a re-rating because investors are now buying into an enlarged group, a healthier balance sheet and a more aggressive expansion plan as compared to five years ago. We are applying a FY07F P/E of 16x, which is at the low end of the 16-30x range at which regional peers trade. This represents a 33% discount to the industry average of 24x for its small market capitalization and low liquidity. The target price of RM3.80/share represents a 41% upside, and a net dividend yield of 4.4% is above the Malaysian market average of 3.3%. Major shareholder Johor Corp has been gradually reducing its stake from 72.4% at the end of 2005 to 52.9% currently, thereby improving the liquidity of the stock. Risks: Slowdown in healthcare spending and lack of qualified medical personnel are key risks One real risk is a decline in purchasing power due to an economic slowdown, which may lead to lower-than-expected patient visits and admissions as well as lower utilization rates of medical facilities. The lack of qualified doctors and nurses to keep up with KPJ s expansion plan is also another key risk. Also, the risk of overpaying is prevalent in its aggressive hospital acquisition plans. Page 3

4 Table of Contents Attractively valued versus peers... 6 Cheapest healthcare stock in the region...6 Pantai acquisition at 16x P/E...6 Khazanah bought into Apollo Hospitals at 25.5x...6 TP of RM3.80/sh based on 16x FY07E P/E; initiating with a Buy...6 Gordon growth model suggests higher fair value...7 Malaysia s largest private hospital... 9 On expansion mode REIT to fuel growth Earnings growth driven by higher spend per patient and hospital acquisition % dividend payout sustainable Management Major shareholder, Johor Corp appears to be selling down Industry outlook Healthcare spending expected to have a steady growth Lagging behind more developed countries Public Healthcare Not enough to go around Medical and health insurance Reducing financial burden and increasing utilization Malaysia s ageing population Changes in lifestyle should boost spending on healthcare Significant barriers to entry Medical tourism Another attractive source of earnings growth Key risks Page 4

5 Table of Figures Figure 1: Regional healthcare comparisons...6 Figure 2: KPJ historical P/E band chart...7 Figure 3: KPJ historical P/E band range chart...7 Figure 4: Gordon growth model supports a fair value of RM Figure 5: DuPont Analysis...8 Figure 6: List of hospitals owned by KPJ...9 Figure 7: List of hospitals managed by KPJ...9 Figure 8: Gross margins remained stable despite rapid expansion Figure 9: List of hospitals under Al-Aqar KPJ REIT Figure 10: ROE expected to move up Figure 11: Dividends are sustainable Figure 12: Key earnings assumptions Figure 13: FY2007E COGS breakdown Figure 14: Sources of revenue payment Figure 15: Sensitivities to FY07F EPS on average revenue per inpatient Figure 16: Sensitivities to FY07F EPS on average revenue per outpatient Figure 17: Summary of statistics Figure 18: KPJ shareholding structure Figure 19: Johor Corp gradually reducing its stake Figure 20: Healthcare expenditure real terms Figure 21: Healthcare expenditure per capita Figure 22: Healthcare spending by country % of GDP in Figure 23: Per capita healthcare spending by country US$ in Figure 24: Government expenditure on health as % of total expenditure on health Figure 25: Private hospitals have grown must faster Figure 26: Number of public hospital beds is stagnating Figure 27: Premium income from yearly renewable MHI policies Figure 28: Individuals covered by MHI policies by age Figure 29: Premiums by type of MHI covers Figure 30: Malaysian women live longer than Malaysian men Figure 31: Malaysian on average are getting older Figure 32: Lifestyle diseases are leading causes of death in Malaysia in Figure 33: Malaysian private healthcare industry market share Figure 34: Population per doctor comparison Figure 35: Population per doctor in Malaysia flattening Page 5

6 Attractively valued versus peers Cheapest healthcare stock in the region KPJ is the cheapest healthcare stock in the region. It trades at FY07 P/E of 11.5x, while other hospital stocks trade at 16-30x P/E. The high P/Es are a reflection of the positive outlook of the Asian healthcare industry, which will enjoy material demand from an ageing population and rising incomes. The industry is also a beneficiary of the prevalence of diseases such as SARS and avian flu. Figure 1: Regional healthcare comparisons Company BB Code Price Mkt Cap PER (x) EPS growth Divi Yield PB (x) ROE 06-Apr US$m Bumrungrad Hospital BH TB Bangkok Dusit Medical BGH TB , Bangkok Chain Hospital KH TB Raffles Medical* RFMD SP Thomson Medical* THOM SP Parkway Holdings* PWAY SP , Simple Average (ex-kpj) KPJ Healthcare KPJ MK Source: Deutsche Bank Pantai acquisition at 16x P/E Pantai Holdings was acquired by Khazanah and Parkway Holdings in a 51:49 joint venture. The general offer to Pantai Holdings shareholders was made at RM2.65 per share, which valued Pantai on a FY07E PER of 16.3x, based on IBES EPS forecast of 16.3 sen. The high valuation on the Pantai privatization reflects the positive outlook in the Malaysia healthcare industry in our view. The proposed takeover was announced at the end of August 2006 and the deal was completed at the end of November Khazanah bought into Apollo Hospitals at 25.5x Khazanah bought 13.2% stake in Apollo Hospitals in August 2005 for INR 350 per share. The total consideration paid to TWL Holdings was U$44.2m for 5.5m shares. Based on an annualised 9mFYMar06 EPS (ex-ei) of INR 13.7, the implied one-year forward PER multiple Khazanah paid was 25.5x. India-based Apollo Hospitals is Asia's biggest healthcare provider with 41 hospitals under their umbrella and a range of businesses such as hospital management colleges, diagnostic clinics, third-party administration and telemedicine. The high valuation indicates the positive outlook of the Asian healthcare sector. TP of RM3.80/sh based on 16x FY07E P/E; initiating with a Buy Total shareholder return of 45% (41% upside + 4% yield) KPJ s sharp discount is unwarranted and we argue that there are reasons why KPJ now deserves an upward re-rating. We are applying an FY07E P/E of 16x, which is at the low end of the 16-30x range at which its regional peers trade, and represents a 35% discount to the industry average of 24x for its small market capitalization, slightly slower growth and low liquidity. This is also at par with Thomson Medical Centre (THOM SP, S$0.565, NR), which Page 6

7 has an even smaller market capitalization. A 16x FY07E P/E translates into a target price of RM3.80 and a potential 41% upside from its current price, and dividend yield of 4.4% (versus the 3.2% average in other regional healthcare stocks). Anticipated earnings growth will also help drive down net debt, from a net gearing of 56% in FY06 to 23% in FY09, according to our estimates. This means that the company can easily afford to step up dividends or embark on value-enhancing acquisitions. Looking at the historical P/E band charts, we think KPJ should re-rate upwards of its historical bands as it delivers steady earnings stream and steady dividend growth to shareholders. Figure 2: KPJ historical P/E band chart Figure 3: KPJ historical P/E band range chart x SD: 23.0x 3 11x x 7x 15.0 Avg: 13.9x 5x SD: 4.7x Source: Company data, Deutsche Bank Source: Company data, Deutsche Bank Gordon growth model suggests higher fair value Our Gordon growth model based on its current forecasted dividend stream points to a fair value of RM3.90/share, which translates to a FY07 P/E of 16.3x and is slightly higher than our TP. Hence we are comfortable with our 12-month TP. Figure 4: Gordon growth model supports a fair value of RM F Comments a. ROE 10.9% Average ROE for FY b. risk free rate 6.5% DB standards c. beta year historical beta d. equity risk premium 3.5% DB standard e. COE 8.8% COE = (b) + (c)*(d) f. Retention rate 0.5 Assumed 50% payout ratio g. g 5.5% g = retention rate x ROE h. Implied book value 1.7x h = (ROE-g)/(COE-g) i. BV/share RM2.4 j. TP: Gordon growth model RM3.90 Implied FY07F PER of 16.3x Source: Deutsche Bank Page 7

8 Figure 5: DuPont Analysis F 2008F 2009F a. Tax burden (NI/PBT) 68.0% 66.8% 90.8% 78.3% 77.2% 70.4% 71.8% 72.8% 73.8% b. Interest burden (PBT/EBIT) 98.2% 84.0% 62.6% 68.7% 71.9% 85.1% 82.0% 84.3% 86.3% c. EBIT margin (EBIT/Sales) 12.1% 11.9% 10.0% 10.1% 8.9% 8.5% 8.5% 8.0% 8.1% d. Net profit margin = (a)*(b)*(c) 8.1% 6.7% 5.7% 5.5% 5.0% 5.1% 5.0% 4.9% 5.2% e. Asset turnover (Sales/Assets) f. Equity multiplier (Assets/Equity) g. ROE = (d)*(e)*(f) 8.3% 6.4% 8.8% 9.0% 8.5% 9.8% 10.4% 11.5% 12.5% Note: 2006 includes exceptional gains of RM4.7m Source: Deutsche Bank Page 8

9 Malaysia s largest private hospital KPJ Healthcare (KPJ) is the healthcare arm of Johor Corp and is the largest private hospital group in Malaysia. The group collectively operates 17 domestic hospitals, six overseas hospitals and a nursing college. Figure 6: List of hospitals owned by KPJ Location Hospital Interest (%) Method Year injected into KPJ Damansara Specialist 100 Built 2002 Selangor Selangor Medical 60 Acquired 2005 Sentosa Hospital Acquired 2006 Ampang Puteri Specialist 100 Built 2002 Kuala Lumpur Tawakal Hospital 100 Acquired 2002 Sentosa Hospital Acquired 2006 Johor Specialist 100 Built 1981 Johor Bahru Puteri Specialist 100 Acquired 2002 Hospital Penawar 30 Acquired 2002 Perak Ipoh Specialist 98 Acquired 1981 Pahang Kuantan Specialist 75 Acquired 2002 Penang Bukit Mertajam Specialist 71 Acquired 2002 Kelantan Perdana Specialist 61 Built 2002 Kedah Kedah Medical Center 46 Acquired 2002 Sarawak Kuching Specialist 70 Built 2003 Negeri Semilan Seremban Specialist 13 Built 2004 Sabah Damai Specialist 65 Acquired 2005 Source: Company data Figure 7: List of hospitals managed by KPJ Hospital Location Methods Year started Selasih Hospital Padang, Indonesia Managed 1995 RSM Permata Hijau Jakarta, Indonesia Managed 1996 Serping Damai Jakarta, Indonesia Managed 2006 United Hospital Dhaka, Bangladesh Managed 2006 New Jeddah Clinic Hospital Jeddah, Saudi Arabia Managed 2007 Jeddah Clinic Hospital Kandarah Jeddah, Saudi Arabia Managed 2007 Source: Company data Having listed on the Main Board of Bursa Malaysia on 29 November, KPJ established its first hospital on 10 May 1981 and has grown aggressively to provide a range of services, including cardiovascular and cardiothoracic treatment, oncology, chemotherapy and radiotherapy treatment, cosmetic and reconstructive surgery, dental services, ophthalmology services, orthopedic and trauma services. KPJ currently has a workforce of over 5,000, of which approximately 50% are nurses, 10% are doctors and the remaining are support staff. Ten of the 17 hospitals have been certified to MS ISO 9001:2000 standards in Page 9

10 On expansion mode Period: KPJ went into the expansion mode in 2002 by acquiring nine hospitals and five supporting companies (including a nursing college) from Johor Corp s healthcare division. The acquisition was made with RM48m cash, which was financed by a 1:1 rights issue and an issuance of 95.4m new shares at RM1.30 per share. The 2002 acquisition was not taken positively by the market but the investor today benefits from an enlarged healthcare company The acquisition was priced on a hospital net P/E of 11.9x and 2.3x book. The asset injection resulted in KPJ s net gearing to radically increase from a net cash position to 77.6%. At the same time margins dip due to higher financing and depreciation charges. EPS have been downbeat since the acquisition in 2002 due to the drag from the nine newly acquired hospitals and the time taken to make those hospitals profitable. In essence, KPJ tried to swallow a mammoth. However, we forecast that the EPS will recover to preacquisition levels in Additionally, investors in KPJ today would get a group of a much larger scale and a focused healthcare division of the enlarged Johor Corp. At the end of 2006, the company had 15 hospitals under its management and closed a deal to acquire two more hospitals at the end of December to end the year with 17 hospitals in their portfolio. The company now has a focused strategy for expansion Period: 2007 onwards Management aims to increase its number of hospitals by one each year either via acquisition or building on its own. The criteria being the hospital must be in an area with a population of at least 100,000, a ready supply of doctors, and a pay-back period of five to seven years. Currently, KPJ is targeting to increase its presence in Penang Island and Malacca. It takes two years to build a new hospital, and a gestation period of three to five years to make it a profitable venture. For instance, Perdana Specialist, which was completed in 2002, is still making loss in its fifth year, but Seremban Specialist, which started in December 2004, turned profitable in its second year. Reasons: higher affluence and population density. Therefore, the preferred alternative by management is to acquire an existing hospital for which the gestation period is only one to two years. However, this requires paying a premium. KPJ has a proven track record of successful acquisition and turnaround of several hospitals, which includes the Tawakal Hospital, Kuantan Specialist Hospital, Puteri Specialist Hospital and Bukit Mertajam Specialist Hospital. Management has indicated that three out of the 17 hospitals are still making losses. However, they expect one of those will turn profitable this year and the remaining two next year. Whichever way KPJ expands, there will be initial stages of earnings growth drag from new hospitals as we have observed in However, as KPJ expands the drag on earnings, growth will reduce as the base gets larger. We believe that KPJ is on the inflection point of strong sustainable earnings growth as most of its hospitals are already profitable or turning profitable. Margins took a slight dip due to its rapid expansion plan i.e. due to the drag from the losses of newly acquired hospitals. According to management, without any new acquisition, EBITDA margins should hover around 15-16%, EBIT margin around 12%, and PAT margins around 10%. In comparison, our earnings estimates are conservative. Page 10

11 Figure 8: Gross margins remained stable despite rapid expansion F 2008F 2009F No. of hospitals Gross margin (%) EBITDA margin (%) EBIT margin (%) PBT margin (%) PAT margin (%) Note: 2006 EBITDA margins were lower due in part of the listing of the REIT Source: Deutsche Bank Overseas expansion KPJ is currently managing three hospitals in Indonesia, one in Bangladesh and most recently it announced a contract to manage two hospitals in Saudi Arabia. Generally, KPJ charges a management fee as a percentage of the revenue subject to a minimum amount, and takes some form of profit sharing. Management is eyeing Vietnam and the Middle East as the next foreign destinations to grow its overseas hospital management business. REIT to fuel growth KPJ disposed of six of its more mature hospitals into Al-Aqar KPJ Real Estate Investment Trust (AQAR MK, RM0.95, NR) for RM461.25m, which was satisfied by RM cash and 160m new units of Al-Aqar at RM1.00 per unit. KPJ received RM277.5m cash and units representing 47.06% of Al-Aqar. Figure 9: List of hospitals under Al-Aqar KPJ REIT Hospital Location Year of Completion Land area (sqf) Gross floor area (sqf) Johor Specialist JB, Johor , ,571 Ipoh Specialist Ipoh, Perak , ,032 Ampang Puteri Specialist KL, WP , ,675 Damansara Specialist PJ, Selangor , ,131 Puteri Specialist JB, Johor , ,033 Selangor Medical Shah Alam, Selangor , ,455 Source: Company data Dividend payout of 50% is sustainable in our view. As KPJ continues to acquire or build more hospitals, management intends to inject more mature hospital assets into the REIT. Thus, allowing KPJ to continue expanding its business without straining its balance sheet. The REIT would allow the company to enhance ROE and increase dividend payouts to shareholders. Management has guided for a pay-out ratio of 50%. The net effect from injecting the hospitals into the REITs should be neutral as interest savings, reduction in depreciation and income from its share of the REIT will be offset by the rent paid to the REIT. Page 11

12 Figure 10: ROE expected to move up Figure 11: Dividends are sustainable (%) RM 0.50 Operating CF per share DPS Net payout ratio 60% % 40% % % Q1FY04 Q2FY04 Q3FY04 Q4FY04 Q1FY05 Q2FY05 Q3FY05 Q4FY05 Q1FY06 Q2FY06 Q3FY06 Q4FY F 2008F 2009F Note: Q3FY06 excludes one-off from sale of hospitals Source: Deutsche Bank F 2008F 2009F Source: Company data, Deutsche Bank 10% 0% Earnings growth driven by higher spend per patient and hospital acquisition Expected core earnings growth of 28.5%, 16.3% and 16.2% over FY07-09 is driven by: 1. the addition of two hospitals at the end of 2006, one in 2008 and one in a 5% p.a. increase in average spend per patient at KPJ s hospitals 3. a turnaround of the three loss making hospitals by We have factored the two hospitals that KPJ recently acquired into our earnings model in 2007 (instead of 2006 because the hospitals were acquired at the end of 2006), with an additional 487 beds from recent upgrades and new beds from newly acquired hospitals. We have assumed a 5% increase in average spending per patient in We have imputed a 50% dividend payout into our model (versus 48% in FY06 and 49% in FY05). Page 12

13 Figure 12: Key earnings assumptions Assumptions No of hospitals No of beds 1,371 1,395 1,611 1,633 1,944 2,431 2,711 2,811 Outpatients 416, ,231 1,078,933 1,162,585 1,378,896 1,544,569 1,748,569 1,840,129 Inpatients 43, , , , , , , ,148 Average revenue - outpatient Average revenue - inpatient 2,705 2,704 2,888 3,025 3,168 3,319 3,477 3,644 COGS/Revenue 73.1% 71.8% 71.0% 71.5% 70.7% 70.3% 69.7% 69.6% Tax rate 33.4% 13.0% 22.1% 32.1% 28.8% 28.0% 27.0% 26.0% Income Statement Revenue , ,272.4 EBITDA EBIT PBT PAT Margins EBITDA margin (%) 17.0% 15.8% 15.5% 14.2% 12.8% 11.5% 10.8% 10.9% EBIT margin (%) 11.9% 10.0% 10.1% 8.9% 8.5% 8.5% 8.0% 8.1% PBT margin (%) 10.0% 6.3% 7.0% 6.4% 7.2% 7.0% 6.8% 7.0% PAT margin (%) 6.7% 5.7% 5.5% 5.0% 5.1% 5.0% 4.9% 5.2% Per share data EPS (RM) DPS (RM) BPS (RM) ROE Source: Deutsche Bank Figure 13: FY2007E COGS breakdown Figure 14: Sources of revenue payment Depreciation, 4.3% Rental expense, 0.8% Staff costs, 25.4% Material costs, 28.6% Out of pocket, 30% Personal insurance, 40 Medical consultants fee, 40.9% Source: Deutsche Bank Source: Deutsche Bank Company insurance, 30% Page 13

14 Earnings sensitivity analysis We estimate that for every 1% change in average revenue per inpatient, there will be a 7.9% change in EPS forecast for FY07F. Figure 15: Sensitivities to FY07F EPS on average revenue per inpatient (RM) % chg EPS %chg EPS TP (16x) 3,485 5% % ,451 4% % ,418 3% % ,385 2% % ,352 1% % ,319 0% % ,285-1% % ,252-2% % ,219-3% % ,186-4% % ,153-5% % 2.33 Source: Deutsche Bank Similarly, we forecast that for every 1% change in average revenue per outpatient, there will be a 6.3% change in EPS forecast for FY07F. Figure 16: Sensitivities to FY07F EPS on average revenue per outpatient (RM) % chg EPS %chg EPS TP (16x) 289 5% % % % % % % % % % % % % % % % % % % % % % 2.63 Source: Deutsche Bank 50% dividend payout sustainable KPJ s strong operational cash generation and current net gearing of 0.56x (as at end Dec-06), indicate that the company is in a strong position to sustain a 50% dividend pay-out ratio for the next three years as guided by management (FY06: 48% and FY05: 49%). Total borrowings at the end of 2006 were RM375.6m. Operating cash flow of RM88-RM94m between FY07F-FY09F will drive net gearing downwards from 0.56x in FY06 to 0.23x in FY09F. Operating cash flow in FY06 was RM3.3m primarily because of a negative working capital change (-RM64.6m working capital change in 2006 versus +RM9.9m in FY05) and a spike up in tax paid to RM27.2m in 2006 versus RM9.5m in FY05. The tax spike up was due to a one-off charge related to the REIT while the working capital drain was caused by a temporary RM55m deposit pledged to a bank in place of land title taken out for the REIT. Operating cash flow should normalize in Our cash-flow forecast assumes a capex of RM105m-RM115m between FY07F and FY09F. Page 14

15 Figure 17: Summary of statistics F 2008F 2009F Net debt/(cash) (RMm) Net debt per share (RM) Net gearing 73.1% 78.4% 78.1% 56.0% 44.6% 32.8% 23.3% Operating cashflow (RMm) OCF per share (RM) Net interest cover (x) DPS (RM) Source: Deutsche Bank Management Tan Sri Dato Muhammad Ali Hashim, Chairman Tan Sri has been the chairman of KPJ since listing in He is also the Group CEO of Johor Corp since January Tan Sri currently is Chairman of Kulim, Sindora Bhd and Johor Land, which are Johor Corp s subsidiaries listed on the Mina Board of Bursa Malaysia. Datin Paduka Siti Sa diah Sheikh Bakir, Managing Director Datin Paduka has been the managing director of KPJ since its listing. She began her career in the healthcare division of Johor Corp in 1978 and was the Group CEO of the holding company of KPJ from 1989 to Nov At the operational level, each hospital has a general manager and each one of them directly reports to the CEO. Further, each resident consultant, if necessary, answers to the Medical Advisory Committee of eleven members. The committee is responsible for clinical governance, which entails improving quality of patient care and implementation of best practices. Major shareholder, Johor Corp appears to be selling down Liquidity is improving Johor Corp currently owns 52.9% of KPJ, which represents the former s healthcare division. After the asset injection in 2002, Johor Corp ended up with 82.5% share of KPJ but has been gradually reducing its stake. In 2006, Johor Corp reduced its stake by 18%. Page 15

16 Figure 18: KPJ shareholding structure as at 31 Dec 2006 Figure 19: Johor Corp gradually reducing its stake Others, 44.9% 82.5% 74.6% 74.0% 72.4% 65.2% 65.2% 65.2% 54.4% Management, 0.7% Johor Corp, 54.4% Source: Company data Source: Company data Johor Corp is the Johor state economic development corporation. It operates on a commercial basis, and its aggressiveness has landed it in financial trouble. In 2002, it had sought the help of the Corporate Debt Structuring Committee to restructure RM4bn debt. Its core businesses include plantations, healthcare, and property development. Page 16

17 Industry outlook Healthcare spending expected to have a steady growth Malaysian healthcare expenditure was 3.4% of GDP in 2006 During , healthcare spending in Malaysia in real terms showed a CAGR of 12%. The federal government spent RM9.5bn in healthcare last year and has allocated RM9.9bn for healthcare in We expect healthcare spending to increase further, driven by an expanding economy, support from the government s health insurance and health promotion schemes, and the growing awareness amongst Malaysian on the importance of healthcare and prevention of diseases. Figure 20: Healthcare expenditure real terms RMm 10,000 Total healthcare exp Health exp as % GDP 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, % 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% % Source: Ministry of Health Figure 21: Healthcare expenditure per capita RM Source: Ministry of Health Health exp per capita GDP per capita E. RM 25,000 Page 17 20,000 15,000 10,000 5,000 -

18 Lagging behind more developed countries Malaysia lags behind OECD countries in terms of spending on healthcare, which is at about 3.4% of GDP. The Southeast Asian countries spending on healthcare in 2003 amounted to less than 2% of GDP. The US has the highest healthcare spending at around 15.2% of GDP vs. the average for OECD countries as a whole at 8.6% of GDP. Healthcare spending in the US was 15.2% of GDP and 8.6% for OECD countries On a per capita basis, average spending on healthcare was US$163 for Malaysian vs. US$366 for Saudi Arabia, US$964 for Singapore, US$2,300 for OECD countries and US$5,711 for the USA. Due to the growing awareness amongst the Malaysians on the importance of healthcare and prevention of diseases, average spending on healthcare will continue to increase. Figure 22: Healthcare spending by country % of GDP in 2003 % Pakistan Iraq Indonesia Philippines Thailand UAE Bangladesh Kuwait Malaysia Saudi Arabia Singapore India Vietnam China Korea Russian Egypt Chile Mexico Afghanistan Iran Poland Luxembourg Ireland Finland Turkey Japan UK New Zealand Italy South Africa Belgium Sweden Australia Bosnia Portugal Netherlands Canada France Cambodia Germany Switzerland USA Source: World Health Organization Figure 23: Per capita healthcare spending by country US$ in 2003 US$ Afghanistan Pakistan Bangladesh Iraq India Indonesia Philippines Cambodia Egypt China Thailand Iran Malaysia Russia Bosnia Turkey Chile South Africa Poland Saudi Arabia Mexico Kuwait UAE Korea Singapore Portugal New Zealand Italy Finland UK Australia Japan Canada Belgium Ireland France Netherlands Sweden Germany Luxembourg USA Source: World Health Organization Page 18

19 Public Healthcare Not enough to go around The public healthcare system in Malaysia is accessible for everyone and is heavily subsidized by the government, and is thus heavily used by the majority of the Malaysian population. However, lack of hospitals and qualified doctors have led to long queues at public hospitals. Figure 24: Government expenditure on health as % of total expenditure on health Long queues at government hospitals have led Malaysians to seek private healthcare services Cambodia Germany France India Pakistan Bangladesh Indonesia Singapore China South Africa Afghanistan Egypt Philippines USA Mexico Iran Chile Korea Bosnia Iraq Malaysia Russia Thailand Netherlands Belgium Australia Portugal Poland Canada Turkey UAE Italy Saudi Arabia Finland Kuwait New Zealand Ireland Japan Sweden UK Luxembourg Source: World Health Organization The number of public hospitals has grown at a 1.2% CAGR p.a. over the past 25 years, while number of hospital beds has grown at only 0.9% p.a. during that same period. The Malaysian population at that same time grew at 2.6% p.a. During that same period, the number of private hospitals grew at an annual rate of 6.1% and the number of beds in private hospitals grew at an annual rate of 9.4%. Figure 25: Private hospitals have grown must faster Figure 26: Number of public hospital beds is stagnating 250 No of public hospitals No of private hospitals 40,000 No public hospital beds No private hospital beds ,000 30, ,000 20, , ,000 5, Source: Ministry of Health Source: Ministry of Health Furthermore, doctors in the public sector are paid 1/3 rd -1/4 th of what the doctors get in the private sector. We foresee that this trend will continue to boost demand for private healthcare in Malaysia. Page 19

20 Medical and health insurance Reducing financial burden and increasing utilization The rising cost of healthcare has seen an increase in the take-up rate of medical and healthcare insurance (MHI) policies. This trend has helped to ease the financial burden of patients seeking treatment at private hospitals. Simultaneously, the utilization of medical facilities at private hospitals has been increasing. Payments via insurance currently make up for 60% of the payments received by hospitals, as opposed to 60% from individuals who paid out of their pockets 10 years ago. Higher take-up in medical and health insurance among Malaysians will increase the usage of medical facilities at private hospitals Figure 27: Premium income from yearly renewable MHI policies RMm Source: Bank Negara Sales of MHI policies surged in the mid-1990s after the government introduced personal income tax relief for the purchase of such policies in 1996 and the relaxation of the policy in 1997 to allow life insurers to sell stand-alone MHI policies. Since 2000, annual premium income generated from yearly renewable MHI policies has increased by 28% p.a. to RM1.5bn in Total premium income including long-term MHI policies amounted to RM2.4bn or 10.2% of the insurance industry s total premium income. Figure 28: Individuals covered by MHI policies by age Figure 29: Premiums by type of MHI covers years, 13% years, 3% >65 years, 1% <25 years, 26% Hospital income, 6% Long-term care, 2% Others, 1% years, 30% Critical illness, 28% Hospital and surgical, 63% years, 28% Source: Bank Negara Source: Bank Negara Page 20

21 An estimated 15% of the population was MHI protected, with 84% of the individuals covered were below 45 years. Those above 55 years accounted for less than 4% of the individuals covered. The distribution pattern of individuals covered by MHI is also not unexpected given the relatively new growth of the domestic MHI sector and more expensive cost of coverage at later entry ages. Over time, however, a larger proportion of insured individuals in the higher age groups is expected due to the higher share of ageing population. Malaysia s ageing population Old age diseases would require more sophisticated and long-term treatment Life expectancy in Malaysia has improved from 63.6 years in 1970 to 74.0 years in Over the medium term, we expect the average life expectancy for a Malaysian to increase further owing to advances in medical technology and increasing awareness of pre-emptive care. However, as the average age of the country s population increases this is also likely to lead to more people being diagnosed with age-related disorders such as Alzheimer s, high blood pressure and heart diseases that require more sophisticated and long-term treatment. Figure 30: Malaysian women live longer than Malaysian men 80 Male Female Source: Ministry of Health Figure 31: Malaysian on average are getting older 0-14 (%) (%) 65 & above (%) 70.0% 62.0% 62.2% 62.5% 62.8% 63.1% 63.1% 63.4% 60.0% 50.0% 40.0% 34.1% 33.8% 33.5% 33.1% 32.8% 32.6% 32.3% 30.0% 20.0% 10.0% 0.0% 4.0% 4.0% 4.0% 4.1% 4.2% 4.3% 4.3% Source: Ministry of Health Page 21

22 Changes in lifestyle should boost spending on healthcare Lifestyle diseases are difficult to treat and are increasingly getting more expensive Malaysian lifestyle is becoming more urbanized with fast food and unhealthy hawker food being eaten frequently as families increasingly get less time to prepare and eat meals at home. As a result, the problem of obesity has become a serious concern. Annual occurrence of hazy weathers in Malaysia is also an additional source for health-related problems. According to the WHO, about half of all adult Malaysian men smoke and about one in every nine Malaysian females smoke. Therefore, it is not surprising that lifestyle related diseases such as diabetes, cardiovascular diseases, respiratory diseases and cancer, are the leading causes of death in Malaysia. Figure 32: Lifestyle diseases are leading causes of death in Malaysia in 2003 Traffic accidents, 2.9% Digestive diseases, 4.2% Others, 16.4% Infectious and parasitic diseases, 11.7% Respiratory infections, 6.0% Respiratory diseases, 8.1% Cancer, 16.7% Diabetes, 3.9% Cardiovascular diseases, 29.9% Source: World Health Organization Cancer, high blood pressure, heart-related diseases and diabetes require more complicated treatment and is a major reason why spending on healthcare has increased over the years. Additionally, more people are frequenting hospitals to take preventive healthcare measures. Moreover, lifestyle-related diseases tend to be more chronic and therefore require frequent visits to the hospitals for professional help. We expect these trends to continue, leading to higher levels of spending on healthcare in Malaysia in the years ahead. Significant barriers to entry Dominance of two large players KPJ has 16% of the nation s private healthcare beds The Malaysian healthcare industry is dominated by two large players, namely KPJ Healthcare and Pantai Medical. KPJ operates 17 domestic hospitals, whilst Pantai operates eight hospitals. Large players tend to have higher bargaining power with insurance companies, and suppliers of pharmaceutical products. Additionally, tie-ups with corporate clients with branch/office networks around the country can be easily formed and on better terms. Page 22

23 Figure 33: Malaysian private healthcare industry market share KPJ Group 16% Pantai Group 12% Others 52% Sunway Medical Centre 2% Gleneagles Grou 4% Subang Jaya Medical Centre 4% Mahkota Hospital 4% Assunta Hospital 4% Ampang Puteri 2% Note: Market share is based on the number of licensed beds Source: Company data, Deutsche Bank Lack of medical personnel Although the outlook for the healthcare sector is positive, we do not expect to see new players entering the market owing to the limited number of medical doctors in Malaysia. At present, the country has approximately 19,000 medical doctors. The ratio of population per doctor in Malaysia is roughly 1,387 vs. 714 for Singapore, 390 for USA, and 506 for Japan. Figure 34: Population per doctor comparison Figure 35: Population per doctor in Malaysia flattening 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500-1,000 Indonesia Cambodia Afghanistan Bangladesh Thailand Iran Egypt Philippines India Iraq Malaysia Pakistan South Africa China Chile Bosnia Turkey Saudi Arabia Singapore Kuwait Korea Japan Mexico UAE Canada UK New Zealand Poland Australia USA Luxembourg Ireland Netherlands Finland Sweden France Germany Portugal Italy Russia Belgium Source: WHO Source: Ministry of Health Healthcare tourism contributes to only 2-3% of KPJ s overall revenue Medical tourism Another attractive source of earnings growth The health tourism industry in Malaysia is still at an early stage of development compared to those in neighboring countries such as Singapore and Thailand. To help facilitate the entry of tourism for healthcare purposes, the Immigration Department has agreed to open a fast lane for these tourists at any entry point in the country, upon notification by the hospital concerned. The government has said that health tourism generated revenue of about RM200m a year and the growth in turnover last year was about 40 per cent. About 300,000 tourists visited the country last year to seek medical treatment or for health reasons. Page 23

24 Key risks Risks to our rating and target price include: Our ROE forecast of 10.4%-12.5% in is premised on 5% increase in average revenue per patient and the turnaround of the three loss making hospitals. Risk of lower than anticipated revenue per patient and longer than anticipated turnaround of the hospitals may lead to lower earnings. We currently anticipate one hospital to turnaround in 2007 and two more in Decline in purchasing power due to an economic slowdown, which may lead to lowerthan-expected patient visits and admissions. We estimate that for every 1% fall in average revenue per inpatient will led to a 7.9% fall in EPS and a 1% fall in average revenue per outpatient will led to a 6.9% fall in EPS. Underutilization of new medical equipment and technology. Investment in high-tech medical equipment to cater to the demand of higher income groups may not be in alignment with current mass-market demands. We have assumed a RM40-50m annual maintenance capex, which include the upgrading of medical facilities and extension to new medical facilities. Lack of qualified doctors and nurses to keep up with KPJ s expansion. Limited number of medical professionals may also lead to margin pressure due to higher wage demand. Staff costs and medical consultant s fee make up approximately 41% of the total cost structure. Risk of overpaying in KPJ s aggressive hospital expansion plans, which could lead to longer-than-expected gestation periods resulting in: a drag on the bottom line. Higher operating costs. Patented drug manufacturers would continue to increase prices and pressure the margins. Rising interest rate. KPJ is still geared at 0.6x and any increase in interest rate would add to its interest expense. Currently, approximately 20% of KPJ s loans are on a fixed-term basis. Possible legal risk from malpractice suites. KPJ is not involved in any law suit currently. Page 24