11 October 2023
Kovai Medical Center & Hospital
Sector: Healthcare
CMP: ₹2,590 per share
Market Cap.: ₹2,832 crores
Kovai Medical Center & Hospital (KMCH) is a Coimbatore-based multi-specialty hospital which, as per the company statement – “since starting operations with 200 beds in 1990, has grown into a 2,250 bed multi-locational, multi-disciplinary super specialty hospital, the best and most trusted one in Southern India.”
KMCH currently trades at ₹2,590 per share – with a market capitalization of ₹2,832 crores. So far, in 2023, the stock is up 54 percent. The latest earnings-per-share is ₹113.04 and latest book value is ₹657.10. At the current market price, the stock trades at a price-earnings ratio of 22.90 and price-to-book value of 3.94.
In the latest – June 2023 quarter – revenue, operating profit, and net profit grew 16.3 percent, 18.4 percent, and 31.1 percent, respectively. The company has reported good results for the past four consecutive quarters.
The foremost requirement in a quality stock is a strong competition position – and our rule-of-thumb method to assess a stock’s competitive position is its gross profit margins: a high (preferably greater than 50 percent) and stable gross profit margin signifies a strong competitive position. For FY23, KMCH has a gross profit margin of 55.2 percent with a standard deviation of 1.8 percent, signifying a favourable competitive position.
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Any single cost component – if it garners – a huge share (say 50 percent or above) of the total revenue – should be considered a risk factor – as volatility in the respective cost will significantly sway the firm’s profitability. Fortunately, KMCH is devoid of any such risk factor. KMCH’s three largest cost components are: the cost of medicines and hospital consumables (27.8 percent of revenue), employee benefits expenses (17.6 percent), and consultant (doctor) charges (15.2 percent). These costs also seem reasonably stable with standard deviations of 0.9 percent, 0.4 percent, and 1.5 percent, respectively.
Capital Cycle: In the four years – FY18 to FY21 – the company made large capital expenditure (capex) – during which its net operating assets (NOA) increased from ₹358.64 crores in FY17 to ₹996.48 crores in FY21 – at CAGR of 29.1 percent. This capex was partly financed through debt – consequent to which, the company’s net financial obligations rose from ₹124.74 crores to ₹486.50 crores during the period – at a CAGR of 40.53 percent.
However, the net operating income made a much smaller growth during the four years – CAGR of 5.48 percent – and as a result, the firm’s profitability suffered during the period. Also, KMCH’s stock significantly underperformed during this period – gaining only 11.72 percent in total, or just 2.8 percent annually.
The capex cycle or capital cycle seems over by FY21, as growth in net operating assets in FY22 and FY23 was only 0.8 percent and 1.7 percent, respectively – a 2-year CAGR of 1.25 percent. However, during the 2 years, net operating income grew at a higher CAGR of 19.71 percent. This superior profitability performance could be seen in the stock’s price too: it gained 29.78 percent annually (2 years) – outpacing the operating income growth.
The firm utilized the increased profitability and lower capital needs by paying off, partially, the debts incurred during the capital cycle. The net financial obligations declined from ₹486.50 crores in FY21 to ₹302.70 crores in FY23.
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The case of KMCH highlights two important points: 1) the adverse impact a firm’s capital cycle shall have on its profitability and stock price; and 2) the vital role of a firm’s profitability on its stock’s return.
KMCH has exhibited high growth in net worth and high return on equity, at least, for the past seven years. The 5-yr median net-worth growth stood at 20.1 percent and the 5-yr median return-on-equity stood at 18.6 percent – as of FY2022-23: both are superior values.
KMCH is a capital-intensive business. For FY23, the capitalisation ratio was 1.42 – the median for the past decade is 1.93. Because of its high capital needs which couldn’t be met entirely through internal accruals, the firm frequently uses debt to meet its capital needs. However, its cost of debt is significantly low – in FY23, it was 4.4 percent. The 5-year median is 2.8 percent. This could be due to the asset-backed, long-term nature of the debts; additionally offset by the high ‘cash & bank balance’ it carries on its balance sheet. The use of leverage and its low cost plays a vital role in gearing up KMCH’s return on equity.
Only earnings and earnings growth that emanate from the firm’s operating activity are sustainable. This could be assessed from the ratio: return on net operating assets (RNOA) – the ratio of core operating income to net operating assets: a sustainable threshold is an RNOA greater than the required return. Competently, KMCH has an RNOA of 13.2 percent against its required return of 11.1 percent.
Additionally, KMCH’s RNOA of 13.2 percent is much superior to its net leverage cost of 4.4 percent. Therefore, the use of leverage (leverage ratio of 0.42), along with its low cost has geared up KMCH’s return on equity to 19.1 percent – a superior value.
The stock pays dividends consistently, however, with a (5-year median) dividend payout ratio of 4.7 percent, the payout is low, which might be due to the capital-intensive nature of its business.
Based on the above considerations, ‘HOLD’ is the obvious strategy vis-à-vis KMCH. However, to determine whether it is appropriate to ‘BUY’ the stock now, we need to consider three things: 1) the distance of the current market price from its 200-day moving average; 2) the distance of current operating profit from its (5-yr) median operating profit; and finally, the most vital, 3) the stock’s valuation.
The current market price of KMCH – at ₹2,590 per share – is 15 percent higher than its 200-day moving average of ₹2,250. A 5 percent distance – ₹2,365 – is what we usually aim for – but 15 percent is not that (worryingly) further – even though, it would be prudent to wait for the price to slither to the 5 percent range.
The current operating profit of KMCH is 36.5 percent higher than its 5-year median value; anything within the 50 percent range is fine with us – KMCH is comfortably within the range.
Valuation is the trickiest aspect of equity analysis. The present value of a stock is the sum of the cash flows expected in the future – but the future is uncertain. Additionally, we estimate the value based on a few assumptions – however, all assumptions are flawed.
A value estimated based on an uncertain future with flawed assumptions… how right it could be? But that’s all we could do… acting within our limitations… but being aware of our limitations… and the humility that comes along… would help us, to an extent, to be less erroneous.
KMCH has a 5-year median return on equity of 20.1 percent and a 5-year median dividend payout ratio of 4.7 percent. The assumption we have made in our valuation is that KMCH will maintain these values –return on equity and dividend payout ratio– for the next decade. Based on that, our estimated fair value for KMCH is ₹3,118 per share – a 20 percent premium over its current market price. At the estimated fair value, the stock will have a price-earnings multiple of 27.58 and a price-to-book value of 4.75 – which seems reasonable, and comparatively attractive.
Apollo Hospitals trades at a price-earnings ratio of 110 and price-to-book value of 11.85; Narayana Hrudayalaya trades at a price-earnings ratio of 31.85 and price-to-book value of 10.08; and Aster DM Health trades at a price-earnings ratio of 44.54 and price-to-book value of 3.97.
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