Initiating Coverage. Decent growth prospects largely priced in. Healthcare Bloomberg Ticker: KPJ MK Bursa Code: April 2013

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1 Initiating Coverage (Member of Alliance Bank group) PP7766/3/213 (32116) 3 April 213 Analyst Cheah King Yoong, CFA cheahky@alliancefg.com Tan Kee Hoong keehoong@alliancefg.com month upside potential Target price 6.7 Current price (as at 3 Apr mid-day) 6. Capital upside (%) 1.2 Net dividends (%) 2.2 Total return (%) 3.4 Key stock information Syariah-compliant? Yes Market Cap (RM m) 3,92.2 Shares outstanding (m) 65.4 Free float (%) week high / low (RM) 6.3 / mth avg volume (') 1, mth avg turnover (RM m) 8.2 Share price performance 1M 3M 6M Absolute (%) Relative (%) Share price chart Major shareholders % Johor Corporation 37.6 Employees Provident Fund 13.4 Nomura Asset Management 7.8 Waqaf An-Nur 7.2 KPJ Healthcare Decent growth prospects largely priced in Neutral Healthcare Bloomberg Ticker: KPJ MK Bursa Code: 5878 We are initiating our coverage on KPJ Healthcare with a Neutral recommendation and a target price of RM6.7, pegging on a FY13 forward P/E of 24x. Despite our positive outlook for the group supported by favourable industry dynamics and its near term expansion plan, we believe that current valuation has already priced in these positive catalysts. Barring any significant re-rating catalyst, we do not foresee any significant upside to the current share price. A pure play for booming Malaysian healthcare sector KPJ s Malaysian operations remain its key earnings drivers, contributing 97.5% and 91.5% of its FY12 revenue and profit after tax, respectively The group has reported a commendable 5-year CAGR of 6.8% and 6.7% in the number of inpatients and outpatients, respectively, for its Malaysian operations from FY7 to FY12. KPJ dominates the supply of hospital beds in sub-urban states such as Pahang, Kelantan and Sabah and has a strong presence in Johor, Negeri Sembilan, Perak and Selangor. This enables the group to ride on the growing affluence of the Malay population. KPJ had managed to secure the affiliation and service of 977 medical consultants as at 211. Based on our estimates, this represents around 47% of medical consultants who served in the private sector in Malaysia. We understand that the group s healthcare services, particularly those located in the rural area, are targeting the middle income segment of the population. Therefore, largely shielded from competition. Positive outlook due to various positive industry dynamics The group is well positioned to benefit from the favourable demographic changes in Malaysia such as (1) aging population, and (2) strong population growth, particularly the Bumiputera community. KPJ is poised to benefit from the trend of household income growth, particularly the Bumiputera households which reported 8.1% income CAGR, outpacing the overall population household income CAGR of 7.2%. In addition, reduction in government s budgeted healthcare development expenditure for 211 and 212 is expected to stress the public healthcare system going forward, resulting in stronger demand of private healthcare services. We foresee this to be accentuated by proliferation of medical insurance, which will drive patients to KPJ group of hospitals that targets the mid-to-high income population. Good financial prospect We expect the group s core Malaysian operations to continue to report decent growth due to (1) favourable demographic patterns, (2) strong presence in sub-urban states and (3) targeted expansion plan. We expect losses from the group s Indonesian operations to narrow significantly in FY13 supported by earnings contribution from its newly acquired RS Medika Permata Hijau. We forecast the group s adjusted fully-diluted EPS to grow by a 3-year CAGR of 12.% from 21.5 sen in FY12 to 3.2 sen by FY15, underpinned by (1) the addition of 913 beds by 215, (2) lower turnaround time and (3) rising demand for private healthcare. Initiate with a NEUTRAL recommendation We initiate coverage on KPJ with a Neutral recommendation and a target price of RM6.7, based on an expected FY13 P/E of 24x. In spite its rosy earnings prospects, we believe that its current share price has priced in most of its decent growth prospects. Key downside risks to our NEUTRAL recommendation includes, (1) longer than expected gestation period for the new hospitals to be profitable, and (2) potential restructuring of the healthcare system. All required disclosure and analyst certification appear on the last two pages of this report. Additional information is available upon request. Redistribution or reproduction is prohibited without written permission

2 SNAPSHOT OF FINANCIAL AND VALUATION METRICS Figure 1 : Key financial data FYE 31 Dec FY11 FY12 FY13F FY14F FY15F Revenue (RM m) 1,99. 2,112. 2, , ,51.6 EBITDA (RM m) EBIT (RM m) Pretax profit (RM m) Reported net profit (RM m) Core net profit (RM m) EPS (sen) Core EPS (sen) Alliance / Consensus (%) Core EPS growth (%) P/E (x) EV/EBITDA (x) ROE (%) Net gearing (%) Net DPS (sen) Net dividend yield (%) BV/share (RM) P/B (x) Source: Alliance Research, Bloomberg Figure 2 : 12-month forward P/E trend Figure 3 : 12-month forward P/B trend P/E (x) P/E Average P/E +1/-1 SD +2/-2 SD 3 P/BV (x) 4.5 P/BV Average P/BV +1/-1 SD +2 / -2 SD Source: Alliance Research, Bloomberg Source: Alliance Research, Bloomberg 2

3 Figure 4 : Regional peer s comparison Company Call Currency Target price Share price Mkt Cap (USD m) EPS Growth (%) P/E (x) P/BV (x) ROE (%) Net Dividend Yield (%) CY13 CY14 CY13 CY14 CY13 CY14 CY13 CY14 CY13 CY14 IHH Healthcare Sell RM , KPJ Healthcare Neutral RM , Bangkok Dusit NR THB NR , Medical Ramsay Health NR AUD NR , Apollo Hospitals NR INR NR , Bumrungrad Hospital NR THB NR , Raffles Medical NR SGD NR , Fortis NR INR NR Healthcare Bangkok Chain Hospital NR THB NR Average Source: Alliance Research, Bloomberg Share price date: 3 Apr 213 3

4 COMPANY BACKGROUND The largest private healthcare provider in Malaysia Largest private healthcare provider in Malaysia 913 beds in the pipeline via 9 new hospitals KPJ Healthcare (KPJ) is the largest private healthcare provider in Malaysia in terms of licensed beds. It operates more than 2,716 beds (licensed beds: 2,77) through a network of 21 hospitals in Malaysia. In addition, KPJ also has a small presence in Indonesia with a total capacity of 143 beds in 2 hospitals. It has 9,78 employees who support the medical services provided by circa 977 medical consultants specialising in various disciplines such as cardiology, oncology, orthopaedic, plastic and reconstructive surgery. For its future expansion, KPJ has in the pipeline 913 beds via the addition of 9 hospitals by 215. Due to the gestation period required for a new hospital to be profitable, management has indicated that they will launch circa two hospitals per annum in order to avoid a significant start-up costs that could hit the group s ROE. Figure 5 : KPJ current hospital network (as at December 212) Name of Hospital State/Country Number of Licensed Beds MSQH Accreditation JCI Accreditation KPJ Johor Specialist Hospital Johor 26 Yes Puteri Specialist Hospital Johor 12 Kluang Utama Specialist Hospital Johor 3 Kedah Medical Centre Kedah 8 Yes KPJ Perdana Specialist Hospital Kelantan 89 Yes Sentosa Medical Centre Kuala Lumpur 212 Tawakal Hospital Kuala Lumpur 158 KPJ Seremban Specialist Hospital Negeri Sembilan 13 Yes Yes Kuantan Specialist Hospital Pahang 81 KPJ Penang Specialist Hospital Penang 236 Yes KPJ Ipoh Specialist Hospital Perak 26 Yes Taiping Medical Centre Perak 48 Sabah Medical Centre Sabah 15 Damai Specialist Hospital Sabah 22 Kuching Specialist Hospital Sarawak 75 Sibu Specialist Medical Centre Sarawak 26 KPJ Damansara Specialist Hospital Selangor 25 Yes KPJ Ampang Puteri Specialist Hospital Selangor 23 Yes Yes KPJ Selangor Specialist Hospital Selangor 173 Yes KPJ Kajang Specialist Hospital Selangor 118 Yes KPJ Klang Specialist Hospital Selangor 94 Malaysia 21 2, RS Medika Permata Hijau Jakarta 83 RS Medika Bumi Serpong Damai Jakarta 6 Indonesia Note: MSQH = Malaysian Society for Quality in Health JCI = Joint Commission International Source: Company Venture into aged care facility through its acquisition of Jeta Gardens KPJ has also forayed into the aged care facility business through the acquisition of the Australia-based Jeta Gardens Waterford Trust in 211, which operates a retirement village in Brisbane, Australia. The retirement village is home to more than 2 residents living in 23 villas, 32 apartments and the 18-bedded aged care facility. There are some 15 staff members at the resort that provide various services to the residents. In December 211, the Australian Federal Government granted approval to Jeta Gardens to add a further 7 beds in its aged care facility and the resort is also developing 1 additional villas. To date, we understand that roughly half of the land bank (total: 64 acres) has been developed. 4

5 In addition, KPJ also operates a private education arm through its KPJ International University College of Nursing and Health Sciences. It has recently acquired the University College status, which allows it to conduct its own bachelor degree programme in 211. Meanwhile, KPJ has a centralised purchasing arm via its subsidiary, Pharmaserve Alliances Sdn Bhd (PASB). It is the second largest purchaser of hospital supplies in Malaysia after the Ministry of Health. Its range of products include pharmaceutical, medical disposables, radiological, rehabilitation, laboratory and other related goods, as well as sutures and catgut, implants and stationeries. Major shareholders and management The controlling shareholder of KPJ is Johor Corporation (JCorp), a state investment corporation. It has a 37.6% stake in KPJ. Its controlling position is further augmented by the 7.2% stake held by Waqaf An-Nur, the endowment fund of Johor Corporation. The other major shareholders of KPJ are institutional funds such as Employees Provident Fund (13.4%) and Nomura Asset Management (7.8%). The board of director is currently led by its chairman, Kamaruzzaman Abu Kassim. He is the President and CEO of Johor Corporation (JCorp). Five of the eleven members of the board of director are independent non-executive directors. Members of the board have an average working experience of 35 years. The executive committee, which is responsible for managing the strategic issues of the group, is led by its managing director, Mr Amiruddin Abdul Satar. As for the hospitals, the day-to-day operations are managed by the Executive Directors or the General Manager of the respective hospitals. Figure 6 : KPJ s board of directors Name Role Background Experience (years) Kamaruzzaman Abu Kassim Chairman Currently the President & CEO of JCorp 24 Amiruddin Abdul Satar Managing Director JCorp appointee; accountant by profession (member of ACCA) 27 Datin Paduka Siti Sa diah Sheikh Bakir Zainah Mustafa Dr Yoong Fook Ng Ahamad Mohamad Dr Kok Chin Leong Non-Independent NED Served as MD since 1993; Re-designated as nonexecutive director on 4 Dec 212 Independent NED Also sits on board of several other KPJ companies; accountant by profession (Fellow of ACCA) Independent NED Chairman of the Medical Advisory Committee; Fellow of the Royal College of Surgeons of Edinburgh Non-Independent NED At present, he is the Chief Executive of Palm Oil Division of JCorp Independent NED Fellow of the Royal College of Physician of United Kingdom Datuk Azzat Kamaludin Independent NED A lawyer by training 42 Rozan Mohd Sa at Non-Independent NED CEO of Hospitality Division of JCorp 29 Datuk Dr Hussein Awang Abd Razak Haron Independent NED Fellow of the Australasian College of Surgeons in 1972 Non-Independent NED Currently the Executive Vice President (Compliance) overseeing JCorp s Group Internal Audit Note: NED - Non-executive director Source: Company, Reuters, Bloomberg Businessweek, Bursa Malaysia 5

6 OPERATIONS REVIEW Malaysian operations contributes majority of the revenue and profit KPJ has operations in Malaysia, Indonesia and Australia. Nonetheless, the group s operations in Malaysia contribute majority of its FY212 revenue and profit tax at 97.5% and 91.5%, respectively. As such, it can be considered as a direct investment proxy to the booming healthcare industry in Malaysia. Figure 7 : Revenue breakdown by segments for FY212 Figure 8 : PAT breakdown by segments for FY212 Hospitals - Malaysia Support Services Hospitals - Indonesia Aged care facility - Australia 7.1% 1.% 1.5% Hospitals - Malaysia Support Services Hospitals - Indonesia Aged care facility - Australia -5.7% -2.8% 21.6% 69.9% 9.4% Source: Company Source: Company Malaysian operations reporting strong patients growth Growth in patients outpaces the growth in operating beds Stable utilisation rate about 7% The group has reported a 5-year CAGR of 6.8% and 6.7% in the number of inpatients and outpatients for its Malaysian operations from FY7 to FY12. This is commendable as it outpaces the number of operating beds it added, which grew by a CAGR of 5.% from 2,132 in FY7 to 2,716 in FY12. Based on our estimates, KPJ s historical utilisation rate since FY7 is around 7% with the exception of FY1, which recorded utilisation rate of only 64%. The lower utilisation rate in FY1 was mainly dragged by the addition of 23 beds from the opening of KPJ Tawakkal Specialist Hospital (addition of 15 beds) and extension of KPJ Johor Specialist Hospital (addition of 53 beds). The utilisation rate has subsequently normalised to 7% in FY11. Figure 9 : Inpatients in Malaysia operations Figure 1 : Outpatients in Malaysia operations Number of patients 3, 25, 2, 179, ,291 26,97 225,936 24, ,589 Number of patients 3,, 2,5, 2,, 1,733,5 1,956,33 1,978,699 2,231,992 2,388,25 2,42,291 15, 1,5, 1, 1,, 5, 5, FY27 FY28 FY29 FY21 FY211 FY212 FY27 FY28 FY29 FY21 FY211 FY212 Source: Company Source: Company 6

7 Figure 11 : Number of operating beds Figure 12 : Estimated utilization rate of Malaysian operations Number of beds 3, 2,657 2,676 2,716 2,5 2,454 2,132 2,172 2, 1,5 1, 5 FY27 FY28 FY29 FY21 FY211 FY212 Source: Company Capacity utilization 76% 74% 74% 73% 71% 72% 7% 7% 69% 68% 66% 64% 64% 62% 6% 58% FY27 FY28 FY29 FY21 FY211 FY212 *Assuming inpatient days the same as industry average Source: Company, Alliance Research Strong presence in sub-urban states Strong presence in areas outside Klang Valley With the exception of Perlis, Terengganu and Melaka, KPJ is represented in all the states in Malaysia. A check with the database of The Association of Private Hospitals of Malaysia indicates that KPJ dominates the supply of licensed hospital beds in states such as Pahang, Kelantan and Sabah. In addition, KPJ also has a strong presence (i.e. more than 3% of the bed capacity) in Johor, Negeri Sembilan, Perak and Selangor. This enables the group to ride on the growing affluence of the Malaysia population going forward, which will be explained further in the Investment Case section. Figure 13 : KPJ group s distribution of hospitals and beds in Malaysia as at FY212 State Number of hospitals Number of licensed beds % of KPJ s total beds % of capacity in the state Johor % 38.1% Kedah % 19.9% Kelantan % 57.8% Kuala Lumpur % 13.7% Negeri Sembilan % 41.4% Pahang % 61.4% Penang % 1.4% Perak % 37.1% Sabah % 91.% Sarawak % 26.% Selangor % 31.% *% of capacity in the state = KPJ s bed divided by private hospitals beds in the state Source: Company, The Association of Private Hospitals of Malaysia Targeted expansion plan will enable the group to avoid the competitive landscape Meanwhile, the group also plans to open up to 9 hospitals with a total of 913 beds from FY213 to FY215. The expansion is mainly focused on areas outside the Klang Valley. We view this expansion plan favourably. Despite areas outside the Klang Valley having relatively lower income segment, we understand that operating landscape is less competitive outside the Klang Valley. 7

8 Figure 14 : Expansion plan Name of hospital Location Number of beds Sri Manjung Specialist Centre Perak 23 KPJ Sabah Specialist Hospital Sabah 8 KPJ Pasir Gudang Specialist Hospital Johor 6 Maharani Specialist Hospital Johor 12 To be added in KPJ Pahang Specialist Hospital Pahang 12 KPJ Specialist Hospital Bandar Dato' Onn Johor 15 KPJ Miri Sarawak 1 To be added in KPJ Perlis Specialist Hospital Perlis 6 Kota Bayuemas Klang Selangor 2 To be added in Higher mean bed occupancy rates in areas outside Klang Valley Source: Company With less concentration of healthcare operators outside the Klang Valley area, we observe private specialist hospitals in states such as Terengganu, Pahang, Kelantan, Kedah, Negeri Sembilan, Melaka, Johor and Sabah have enjoyed a substantially higher mean bed occupancy rate as compared to the national average. This augurs well for KPJ, which has a significant exposure in these states (i.e. aggregate of 991 beds representing 37% of total beds). Figure 15 : Mean bed occupancy rate of specialist hospitals in Malaysia (as at end-21) Public Private Malaysia Perlis Terengganu Pahang Kelanatan Kedah Negeri Sembilan Melaka Johor Sabah & WP Labuan Perak Pulau Pinang WP Kuala Lumpur Selangor Sarawak Source: National Healthcare Statistics Initiative Large number of medical consultants in the service of the group The most crucial element of hospital operations is the availability of doctors. As KPJ operates a chain of specialist hospitals, majority of its medical officers comprise of medical consultants (i.e. specialist - a doctor who has post-graduate training in an area of expertise). These medical consultants usually have a pool of patients who are loyal to them by virtue of their professional reputation. As such, they directly influence the patients who are under their care in deciding which hospitals to seek admission for medical treatment. Malaysia currently has 4,811 medical consultants or specialists (source: National Specialist Register), with less than 3, medical consultants working in public hospitals (source: Ministry of Health Annual Report), this implies that there are currently only around 2, medical consultants who are employed in the private sector. Coupled with the fact that the training of a medical consultant may involves a period of up to 1 years, these healthcare professionals have higher bargaining power in relation to the hospital operators. 8

9 Exclusive agreement and lucrative compensation package will help the group to retain high quality medical consultants 47% of medical consultants in the private sector are affiliated with KPJ Management has guided that most resident consultants (numbering up to 5), had signed an exclusive agreement to be affiliated with KPJ up to the age of 65. Our analysis has also indicated that on average, 9% of the consultation fees billed to the patients are channelled to the medical consultants as their compensation. Both of these factors should help the group in retaining high quality medical consultants. As at 212, KPJ had managed to secure the affiliation and service of 977 medical consultants. Based on our estimates, this represents around 47% of medical consultants who served in domestic private healthcare sector. We believe that this serves as the key factor underscoring the strong patient growth registered since FY7. Niche market to mitigate competitive pressure The private healthcare industry in Malaysia is largely fragmented with the top two healthcare groups, KPJ Healthcare and IHH Healthcare, commanding a market share of circa 4% of the industry capacity (i.e. licensed beds). IHH Healthcare s hospital network is operating under the brand name of Gleneagles and Pantai. The hospitals branded under Gleneagles are positioned to tap the high income market, whereas those branded under Pantai are positioned to tap the middle-to-high income segment of the population. The Pantai hospitals network consists of a total 1,482 beds in 9 hospitals, out of which 4 of them with a total of 697 beds are located in the Klang Valley. KPJ s focus on middle income population in the rural areas enables it to mitigate competitive pressure As such, we believe that KPJ Healthcare s hospitals, which target the middle income segment of the population, are largely shielded from competition. This is particularly true for its hospitals operating in the rural area, in our opinion. In the meantime, the remaining industry players are too small to pose any serious threats to the group. Figure 16 : Notable private hospital operators in Malaysia Source: Companies website 9

10 INVESTMENT CASE Favourable demographic patterns to drive demand for healthcare services Aging population to increase demand for healthcare services According to the World Bank, the percentage of Malaysia s male and female who had survived to age 65 (as measured by the cohorts that age 65 and above) has risen from 7.4% and 8.6% in 1998 to 76.4% and 85.5%, respectively, in 21. Meanwhile, Malaysia s life expectancy has risen from a mere 55 years in 196 to 74 years in 21. As the trend of rising age profile is expected to continue, we believe that this will create large number of aged population, which is expected to increase the demand for private healthcare services. Figure 17 : Percentage of Malaysian who survived to age 65 Figure 18 : Malaysians life expectancy at birth Male Female Source: World Bank Bumiputera population growth to outpace national average Source: World Bank On the other hand, Malaysia s Department of Statistics projects that Malaysia s population will increase to 32.4m by the end-22 and 38.6 by end-24, which underpins rising demand for healthcare services. This implies a population CAGR of 1% to 24, much lower than the 1.8% CAGR from 2 to 212. Meanwhile, the Bumiputera (Malay and other indigenous) population is forecasted to grow by a CAGR of 1.3% to 26m in 24, outpacing the growth of the general population. Given that KPJ has a strong presence in the rural and sub-urban areas, which comprise of large Bumiputera population, we believe that the group is well positioned to benefit from the trend of relatively strong Bumiputera population growth going forward. Figure 19 : Malaysia s general population projection Figure 2 : Malaysia s Bumiputera population projection million F 22F 225F 23F 235F 24F million F 22F 225F 23F 235F 24F Source: Department of Statistics Source: Department of Statistics 1

11 Growing affluence of the general population Growth in average household income of Bumiputera population outpaced national average Healthcare spending is poised to rise due to rising affluence of the population Low healthcare spending in Malaysia indicates room to grow According to the Department of Statistics, average household income of Malaysia has increased since 197 at a CAGR of 7.3% to RM5, per month in 212. During the same period, the average household income of the Bumiputera population has again outpaced the country s averages at a CAGR of 8.1% to RM4,457 per month in 212. Meanwhile, the Chinese and Indian household incomes have risen at a CAGR of 6.8% and 7.% to RM6,355 and RM5,233 per month in 29 respectively. In tandem with the rising affluence of general population, Malaysia s healthcare spending is poised to increase going forward. According to the World Bank, healthcare spending per capita has increased by 187.2% from USD128.1 in 2 to USD367.9 in 21. This represents a CAGR of 11.1%. Meanwhile, GDP per capita merely increased in the same period by 18.4% from USD3, to USD8,317.89, representing a CAGR of only 7.6%. This implies that as society develops and standard of living improves, rising health awareness and demand for better healthcare facilities will give rise to exponential healthcare spending. As such, we expect the increase in healthcare expenditure of the Malaysian population to continue going forward. In addition, we observe that healthcare spending is still relatively low in Malaysia. Although healthcare expenditure as a percentage of GDP had increased from 3.% in 1995 to 4.4% in 21, it is still well below the ratio recorded by developed economies such as US, UK, Japan and EU. Although we note that Malaysia s income level are lower than these countries, healthcare expenditure in Malaysia should moves towards these levels as national income increases. In short, rising affluence among the Malaysians, particularly the Bumiputera segment, should drive the demand for private healthcare services going forward. KPJ, being the pure play in the Malaysian healthcare industry, is poised to benefit from such development. Figure 21 : Malaysia s average household income Figure 22 : Healthcare expenditure as a percentage of GDP 7, 6, 5, 4, 3, 2, 1, Bumiputera Chinese Indians Average USD 12, 1, 8, 6, 4, 2, 2 GDP per capita (lhs) Health expenditure per capita (rhs) F USD *Health expenditure per capita from 211 to 213 is projected figures Source: CEIC, Department of Statistics, New Straits Times Source: CEIC, World Bank 11

12 Figure 23 : Public and private share of healthcare expenditure Figure 24 : Malaysia s total healthcare expenditure 58% 56% 54% 52% 5% 48% 46% 44% 42% 4% Private Public RM million 4, 35, 3, 25, 2, 15, 1, 5, Source: World Bank Source: World Bank, Department of Statistics Figure 25 : Healthcare expenditure as percentage of GDP % Malaysia UK Japan EU South Korea Singapore Source: World Bank Reduction in public healthcare expenditure to constraint capacity Despite rising demand for healthcare services, we expects the capacity of the public healthcare system, which is an indirect competitor of the private healthcare providers, to be restrained going forward. Public healthcare in Malaysia are heavily subsidised by the federal government where patients only need to pay a nominal fee for its services. Decline in public healthcare development expenditure to constraint public healthcare system s capacity In the recent budget 213, the federal government has only budgeted to spend a total of RM19.3bn in public healthcare system. The amount earmarked as development expenditure is only RM1.9bn, representing a y-o-y decline of 1.2%. This is in spite of y-o-y decline of 41.8% and 11.7% in healthcare development expenditure in 211 and 212, respectively. As such, we believe that public healthcare s capacity could be constrained in the immediate future. Coupled with overcrowding problem already reported by public healthcare system, we expect the general population from the lower middle class onwards to increasingly rely on the private healthcare system to meet their needs. 12

13 Figure 26 : Budgeted total healthcare expenditure Figure 27 : Budgeted healthcare development expenditure RM 'm 25, Annual expenditure (lhs) y-o-y growth (rhs) 2% RM 'm 4, Annual expenditure (lhs) 3,78.3 y-o-y growth (rhs) 8% 2, 15, 1, 5, 19, , , , , , , , % 16% 14% 12% 1% 8% 6% 4% 2% 3,5 3, 2,5 2, 1,5 1, 5 1,298. 1, , , ,26.8 1,948. 1,924. 6% 4% 2% % -2% -4% % % Source: Ministry of Finance Source: Ministry of Finance Proliferation of medical insurance Medical insurance serves as a contract between an insurance provider and an individual or his/her sponsor, whereby the insurance provider will undertake to pay for the individual s medical expenses. We observed that the majority of the medical insurance underwritten in Malaysia operates under the cashless system, whereby the policy holder will be admitted to a hospital for the covered treatment without needing to pay any upfront fees. Adoption of medical insurance to grow going forward Since 27, net medical insurance premium reported by the insurance companies in Malaysia has increased at a double-digit rate with the exception of year 29, when net premium only increased by 6.5% y-o-y, partially dampened by the global financial crisis. Meanwhile, gross medical insurance premium as percentage of total insurance premium has increased 12.% to 14.2% in 211. This indicates a growing number of Malaysians adopting medical insurance policies to meet their medical expenditures. We expect this trend to continue, driven by (1) rising affluence among population, and (2) higher demand for better quality but potentially pricey private healthcare service, and, (3) long waiting period in public hospitals. Figure 28 : Total net medical insurance premium Figure 29 : Medical insurance as a percentage of total insurance RM 'm Net medical insurance premium (lhs) y-o-y growth (rhs) % of total insurance premiums 2, 18% 15% 1,8 1,6 1,4 1,2 1, % 14% 12% 1% 8% 6% 4% 2% 14% 13% 12% 11% % 1% Source: Bank Negara Malaysia Source: Bank Negara Malaysia 13

14 There are currently many innovative packages offered whereby the medical insurance is bundled together with life insurance, with the resulting combined annual premium being lower than purchasing them separately. Although the premium for medical insurance has increased over the years, proliferation of investment-linked funds have contributed to lower upfront cost at the expense of higher premium increase in the future as compared to conventional policies. In addition, the growing affluence of the general population should lead to a larger middle class who can afford the premiums for medical insurance. Meanwhile, the long waiting period experienced in the public healthcare system could drive the lower-middle and middle class to purchase medical insurance to afford treatments in the private hospitals. We expect the problem of long waiting period to remain in the foreseeable future due to the decline in the budgeted development expenditure for public healthcare sector as highlighted above. The lower-middle and middle class segment of the population would most likely purchase medical insurance that provides for mid-level of coverage due to financial constraints, which coincides with KPJ s pricing. Rising adoption of medical insurance will result in higher healthcare expenditure Proliferation of medical insurance to impact KPJ positively as its pricing coincides with the coverage provided by most major insurance providers In addition, common sense dictates that an individual will be more willing to spend for healthcare under the reasoning of it is my life that s at stake especially when the burden of payment is shifted to third party. In addition, doctors and healthcare professionals are also more likely to prescribe more complex procedures to patients who are covered by medical insurance. Doctors and healthcare professionals, especially those who are in the private sector, will generally recommend patients to go for a complete set of procedures to cover all aspect of a treatment. In conclusion, the proliferation of medical insurance bodes well for private healthcare providers, especially those targeting mid-to-high income segments of the population such as KPJ. This is because the pricing of the private healthcare providers targeting this segment is largely in-line with the coverage provided by most major medical insurance providers. Our channel check indicates that most medical insurance plans underwritten in Malaysia provides for coverage of between RM1 to RM3 for hospital room charges per night and an annual coverage cap of between RM1, to RM3,. 14

15 FINANCIAL HIGHLIGHTS FY12 core profit grow by 7.3% 4QFY12 s results within expectation Aged care facility turn profitable for the first time in 4QFY12 Recent acquisition of Rumah Sakit Medika Permata Hijau to reduce the losses from Indonesian operations substantially KPJ s FY12 core net profit of RM133.8m, excluding its share of FV gain in investment properties recognised by its associate, Al-Aqar Healthcare REIT, came within the consensus estimates. The group s aged care facility in Australia has turned profitable for the first time in 4QFY12. If this proves to be sustainable, the acquisition of Jeta Gardens will start to be earningsaccretive going forward. Meanwhile, revenue generated from the group s Indonesian operations has increased by 92% from RM11.5m in FY211 to RM22.1m in FY212. As a result, its losses from the Indonesian operations have narrowed marginally by 2.3% y-o-y. With the recent acquisition of an 8% stake in Rumah Sakit Medika Permata Hijau (RSM), we expect the group s losses from its Indonesian operations to decline significantly, supported by earnings contributions from the newly acquired subsidiary. We wish to highlight that RSM has consistently reported profits for the past 15 years (RM8.8m PAT for FY211). Figure 3 : Results commentaries % y-o-y change % q-o-q change FY12 FY11 % y-o-y change 4QFY12 4QFY11 Comments Key financial highlights Revenue (RM m) ,112. 1, Grow by 1.6% y-o-y on the back capacity expansion Operating profit (RM m) Pretax profit (RM m) Net profit (RM m) Net profit decreased y-o-y in the absence of FV gain in investment properties by its associate, Al-Aqar Healthcare REIT (KPJ s share for FY211 is RM19m) Core net profit (RM m) Q core net profit stable despite start-up costs on launching of a new hospital Per share data EPS (sen) Core EPS (sen) Core EPS decrease mainly due to conversion of company warrants Net DPS (sen) BV/share (RM) Margins Pretax (%) Net profit (%) Segmental revenue Hospitals - Malaysia (RM m) ,91. 1, Indonesia (RM m) Revenue from Indonesia almost double Aged care facility (RM m) >1 Support services (RM m) Segmental profit Hospitals - Malaysia (RM m) Indonesia (RM m) Indonesian losses narrowed marginally Aged care facility (RM m) <1 Turned to black in 4Q Support services (RM m) , Source: Company, Alliance Research 15

16 Double-digit earnings CAGR going forward KPJ had reported a 5-year earnings CAGR of 13.4% from RM74.2m in FY7 to RM139.1m in FY12. This was driven by its strong revenue CAGR of 13.8% during the same period. Majority of the group s revenue is derived from hospital charges, consultation fees and sale of pharmaceutical, medical and surgical products. These three items collectively account for 98.8% of the group s total revenue in FY11. (FY12 revenue was not broken down in its latest quarterly financial statements) Sale of pharmaceutical, medical and surgical products experienced strong growth with a CAGR of 17.5% from FY7 to FY11, driven by (1) increasing outpatient mix (outpatient divided by total patient) from 9.6% in FY7 to 9.8% in FY11, and, (2) growing popularity of minimally-invasive surgical procedures, which results in lower average inpatient days. Private hospitals in Malaysia had reported a drop in average inpatient days which fell from 3.17 days in 29 to 2.85 days in 211. Meanwhile, the growth in hospital charges was supported by addition in operating beds from 2,132 beds to 2,716 beds. We believe that the lower turnaround time per patient also contributes to more efficient utilisation of the hospitals facilities such as surgical theatres, leading to higher revenue generated per bed day usage. We expect these trends to continue going forward. Recent progress in the field of medical technology has allowed for less invasive procedures being applied in the treatment of various illnesses. Coupled with growing popularity of day surgery, this has resulted in faster turnaround time for the treatment of patients. This is evident in the average inpatient days reported by the private hospitals in Malaysia, which fell from 3.17 days in 29 to 2.85 days in 211. As a result, we believe that KPJ will be able to show revenue and earnings growth in excess of the bed capacity growth. Our earnings model implies that revenue derived from hospital charges provides the greatest impact to the bottomline, given the low incremental cost involved. Meanwhile, we estimate revenue derived from sale of pharmaceutical, medical and surgical products to have a gross margin of circa 2%, followed by consultation fees gross margin of circa 1%. As such, the ability of revenue derived from hospital charges and sale of pharmaceutical, medical and surgical products to outpace the consultation fees since FY7 is reassuring. Forecast 3-year earnings CAGR of 12.2% We forecast the group s adjusted fully-diluted EPS to grow by a 3-year CAGR of 12.2% from 21.5 sen in FY12 to 3.4 sen by FY15, underpinned by (1) its beds expansion of 913 beds through 215, (2) lower turnaround time, and, (3) stronger demand for private healthcare services. Figure 31 : Revenue breakdown by products FY27 FY28 FY29 FY21 FY211 CAGR Hospital charges % Consultation fees % Sale of pharmaceutical, medical and surgical products % Clinics rental % Others % Total revenue 1,18. 1, , , ,99. *Revenue breakdown not available for FY212 Source: Company 16

17 Figure 32 : Revenue vs fully diluted EPS Figure 33 : Hospital beds vs total patients 3,5 3, 2,5 2, 1,5 1, Revenue (lhs) Adjusted fully diluted EPS (rhs) , 3,5 3, 2,5 2, 1,5 1, 5 Operating beds in Malaysia (rhs) Number of patients (lhs) Millions ,132 2,172 2,454 2,657 2,676 2,716 3,53 3,463 3,723-27A 28A 29A 21A 211A 212A 213F 214F 215F 27A 28A 29A 21A 211A 212A 213F 214F 215F Source: Company, Alliance Research Source: Company Net gearing to rise going forward Expansion in FY12 led to higher net gearing of 35% KPJ s net gearing ratio declined from 57.8% in FY7 to a low 26.3% in FY11. However, net gearing ratio increased to 35% in FY12 due to the group s expansion activities during the financial year. We expect KPJ s expansion plan to require significant capital going forward. The group plans to launch up to 3 hospitals in FY13, namely Sabah Specialist Hospital, Pasir Gudang Specialist Hospital and Maharani Specialist Hospital. In addition to upfront capex requirements, we expect the group s operating cash flow to be dampened by slow take up in the initial opening phase. The management expects these 3 hospitals to have an average gestation period of between 3 to 5 years. Asset injection into Al-Aqar Healthcare REIT will enable the group to mitigate gearing pressure However, we believe the group will be able to mitigate its rising gearing level by injecting the hospital buildings into its 49% associate, Al-Aqar Healthcare REIT. The assets are typically injected to the REIT for a mixed of cash and shares. In any events, KPJ can also dispose the shares it received in the open market in order to raise cash. We view this asset light model favourably due to (1) the ability of the group to maintain control of the hospital assets while unlocking capital for further expansion, and, (2) favourable tax treatments granted to a REIT. With the exception of Sabah Medical Centre, Kuching Specialist Hospital and Sibu Specialist Medical Centre, KPJ has injected all of the hospitals in its network into the REIT. In addition, the group has also injected Jeta Gardens Aged Care & Retirement Village as well as its nursing college into the REIT. Although there is no guidance from the management, we expect the hospitals to be injected into the REIT within a year from the date of operation in order to reduce the group s gearing ratio. Going forward, we project for the net gearing ratio to increase to 53.8% in FY215. However, this should not be a problem for KPJ in light of our forecast for the total debt/ebitda ratio to rise above 2x through FY215. In addition, we also forecast the group s EBITDA margin to be on an uptrend as the gestation period passes. 17

18 Figure 34 : Leverage and liquidity ratio Figure 35 : Operating cash flow vs EBITDA margin 7% 6% 5% 4% 3% 2% 1% % Net gearing (lhs) Total debt/ebitda (rhs) % 45.1% 35.6% 26.3% 21.4% 35.% 37.8% 47.9% 53.8% Rm'm Cash flow from operating activities EBITDA margin (lhs) 13.2% 12.9% 12.2% 12.3% 12.3% 12.2% 12.4% 12.% 11.6% % 13% 12% 11% 1% 27A 28A 29A 21A 211A 212A 213F 214F 215F 27A 28A 29A 21A 211A 212A 213F 214F 215F Source: Company, Alliance Research Source: Company, Alliance Research Dividend payout to remain stable Dividend pay-out ratio of 5% since FY9 Forecast net DPS to hit 15.9 sen in FY15 Although KPJ does not have a formal dividend policy, the group has been paying out 5% of its earnings as dividends since FY9. We forecast net dividend per share to increase at a CAGR of 11.5% from 11.5 sen in FY12 to 15.9 sen in FY15, which translates into a dividend yield of 2.7%. Our forecast assumes a payout ratio of 5% going forward. Using this assumption, KPJ s cash pile from FY13 to FY15 will hover between RM18m and RM26m. This is calculated after taking into account all the announced capex and assuming new hospital buildings are injected into Al-Aqar Healthcare REIT upon completion. As such, it does look like KPJ has the capacity to pay more dividends. We have performed a scenario analysis whereby dividend payout ratio increases linearly from 5% to 7% in the next 3 financial periods. Under this scenario, the cash pile will remain healthy at above RM119m by end-fy15 whereas DPS will double from 11.5 sen in FY12 to 22.2 sen in FY15, translating into a dividend yield of 3.7%. Figure 36 : Dividends sen Net DPS (lhs) Payout ratio (rhs) 52.4% 6% 52.6% 49.4% 5.% 5.% 5.% % % 28.5% 7.5 3% % 2.4% 12.6% 1% % 27A 28A 29A 21A 211A 212A 213F 214F 215F Source: Company, Alliance Research 18

19 VALUATION AND RECOMMENDATION Healthcare sector valuation driven by forward near-term earnings growth Healthcare sector s valuation driven by near-term earnings growth Our analysis indicates that healthcare sector s valuation is driven by the market s expectation of its near-term growth prospect. Regression analysis has shown a strong correlation between the P/E ratio of the healthcare companies and their near-term earnings growth. As such, we would expect any negative earnings surprise to lead to the de-rating in the valuation of healthcare stocks. Figure 37 : Regression of sector s TTM P/E against forward 12m growth Figure 38 : Regression of sector s TTM P/E against 2-year CAGR Healthcare PE vs 1Y EPS growth y = x R² =.677 Healthcare PE vs 2Y CAGR y = x R² = % -2.% -1.%.% 1.% 2.% 3.% 4.% 5.% Earnings growth are based on consensus numbers Source: Bloomberg, Alliance Research. -4.% -3.% -2.% -1.%.% 1.% 2.% 3.% 4.% 5.% Source: Bloomberg, Alliance Research Figure 39 : Regional peer s comparison Company Call Currency Target price Share price Mkt Cap (USD m) EPS Growth (%) P/E (x) P/BV (x) ROE (%) Net Dividend Yield (%) CY13 CY14 CY13 CY14 CY13 CY14 CY13 CY14 CY13 CY14 IHH Healthcare Sell RM , KPJ Healthcare Neutral RM , Bangkok Dusit NR THB NR , Medical Ramsay Health NR AUD NR , Apollo Hospitals NR INR NR , Bumrungrad Hospital NR THB NR , Raffles Medical NR SGD NR , Fortis NR INR NR Healthcare Bangkok Chain Hospital NR THB NR Average Source: Alliance Research, Bloomberg Share price date: 3 Apr

20 Initiate with a Neutral recommendation Optimistic on the group s prospect, but share price has priced the strong earnings outlook Initiate with a NEUTRAL recommendation Although we are optimistic of KPJ s growth prospect going forward, we believe that its current share price has priced in majority of the group s strong earnings outlook. We observe that the group s share price has experienced strong re-rating since September 211 with the listing of IHH Healthcare causing the investment community to refocus on regional healthcare stocks. We are initiating our coverage for KPJ with a NEUTRAL recommendation. We are valuing KPJ at RM6.7 which implies an upside of 1.2%, based on target CY13 P/E of 24x on the group s core EPS of 25.3 sen. This represents a discount of around 25% compared to its regional peers, which we believe is justified due to (1) its smaller size, and (2) limited regional exposure. We wish to highlight that our valuation represents more than +1 standard deviation above mean of its recent 5 years trading history. INVESTMENT RISKS Key downside risks to our investment recommendation include: Longer than expected gestation period for the new hospitals to turn profitable may result in lacklustre earnings growth. If this happens, there will be a negative impact on earnings. Restructuring of Malaysian s healthcare system, which will adversely impact the private healthcare industry. One possible event within the investment horizon include the 1Care for 1Malaysia plan which might result in an immediate negative impact to the private healthcare providers. The details about the plan are discussed further in Appendix 1. 2

21 APPENDIX 1 1CARE for 1Malaysia Plan The plan was first presented on 2 February 21 by the Deputy Director General of Health, Dato Dr Maimunah bt A Hamid. It called for revamp of our national health system by centralising all medical decisions under the Ministry of Health. Under this plan, primary healthcare providers (PHCP) acting as independent contractors serve as a gatekeeper in referring patients to hospitals. The entire population will be registered to specific PHCP according to location of home/work/schooling. Meanwhile, the function of drugs dispensing will be transferred to independent pharmacies. Under the proposed system, public hospitals will remained fully funded by the government whereas private hospitals will receive case-based funding based on the number of patients referred to them by the appointed PHCP. The proposed plan also called for cross-subsidisation of medical expenses by the rich to the poor. Under the system, a social health insurance (SHI) will be set-up whereby contribution will be mandatory. Some news portals speculated that the contribution could be as high as 1% of personal income. If this is proven to be true, the middle class portion of disposable income intended for private medical insurance will be diverted to the SHI with little left remaining for OOP private medical insurance. Under these circumstances, the patients from the lower to middle class will likely be admitted to the designated hospitals chosen by the PHCP rather than the hospitals of their choice as they could not afford to do so. This may be negative for private healthcare providers which currently have a large following. Figure 4 : Proposed service delivery and patient flow Source: Ministry of Health 21

22 APPENDIX 2 Figure 41 : Private hospitals in Malaysia Name of Hospital State Number of Licensed Beds Century Medical Centre Johor 26 Hospital Penawar Johor 5 Kelinik Rakyat & Hospital Bersalin Johor 18 Kempas Medical Centre Johor 3 Klinik C.S. Koh dan Rumah Bersalin Johor 8 KPJ Johor Specialist Hospital Johor 26 Medical Specialist Centre Johor 7 Pantai Hospital Batu Pahat Johor 68 Pelangi Medical Centre Johor 18 Pusat Pakar Kluang Utama Johor 3 Pusat Pakar Perbidanan & Sakitpuan Raja Johor 11 Puteri Specialist Hospital Johor 12 Regency Specialist Hospital Johor 218 T.K.Tan O&G Specialist Clinic Johor 12 Tey Maternity Specialist & Gynae Centre Johor 19 Kedah Medical Centre Kedah 8 Metro Specialist Hospital Kedah 119 Pantai Hospital Sungai Petani Kedah 8 Putra Medical Centre Kedah 124 Kota Bharu Medical Centre Kelantan 48 Perdana Specialist Hospital Kelantan 89 Pusat Rawatan Islam An-Nisa Kelantan 17 Mahkota Medical Centre Melaka 365 Pantai Hospital Ayer Keroh Melaka 25 Putra Specialist Hospital Melaka 225 Columbia Asia Hospital, Seremban Negeri Sembilan 79 KPJ Seremban Specialist Hospital Negeri Sembilan 13 Mawar Renal Medical Centre Negeri Sembilan 78 N.S. Chinese Maternity Hospital Negeri Sembilan 27 NCI Cancer Hospital Negeri Sembilan Kuantan Medical Centre Pahang 51 Kuantan Specialist Hospital Pahang 81 Apollo Medical Centre Perak 24 Hospital Fatimah Perak 223 Kinta Medical Centre Perak 48 KPJ Ipoh Specialist Hospital Perak 26 Maxwell Maternity & Surgical Centre Perak 13 Pantai Hospital Ipoh Perak 121 Perak Community Specialist Hospital Perak 84 Pusat Pakar Rajindar Singh Perak 1 Taiping Medical Centre Perak 48 Bagan Specialist Centre Penang 15 Bukit Mertajam Specialist Hospital Penang 9 Gleneagles Medical Centre Penang 227 Hope Children Hospital Penang 29 Island Hospital Penang 24 KPJ Penang Specialist Hospital Penang 236 Lam Wah Ee Hospital Penang 422 LohGuanLye Specialists Centre Penang 265 Mount Miriam Cancer Hospital Penang 4 Pantai Hospital Penang Penang 18 Peace Medical Centre Penang 24 Penang Adventist Hospital Penang 216 Tanjung Medical Centre Penang 123 Tropicana Medical Centre (Penang) Penang 24 Damai Specialist Centre Sabah 22 Rafflesia Medical Centre Sabah 17 Sabah Medical Centre Sabah 15 Columbia Asia Hospital, Bintulu Sarawak 2 Columbia Asia Hospital, Miri Sarawak 35 Kuching Specialist Hospital Sarawak 75 Miri City Medical Centre Sarawak 3 Normah Medical Specialist Centre Sarawak 13 Sibu Specialist Medical Centre Sarawak 26 Timberland Medical Centre Sarawak 72 An-Nur Specialist Hospital Selangor 32 Arunamari Specialist Medical Center Selangor 67 22