Investment thesis overview
Korian (OTC:KRMDF) share price has been severely hit during the market sell-off. Investors are worried about the impact of Covid-19 on the company short-term profitability as well as a potential negative structural impact on future profitability. Indeed, during the pandemic, Korian incurred additional expenses to purchase medical supplies such as masks, hydroalcoholic gels, tests and hired more staff. On top of that, the company occupancy rate declined as the company was not able to accept new patients to fill the increasing number of empty rooms in nursing homes and had to face lower business activity in clinics (when they were still opened). At the same time, some investors feared that the occupancy rate of nursing homes will become structurally lower because of the bad media coverage and that all these extra-costs will persist over the coming years.
We believe these fears are the result of a poor business understanding. Indeed, while the company faced additional medical expenses and will likely incur them in the foreseeable future, most of those expenses will be covered by governments. Indeed, most European governments reimburse care and medical expenses (see page 42 for more details). Besides, the occupancy rate will quickly normalize as clinics are authorized to reopen, surgeries restart in hospitals and nursing homes are able to welcome new patients. The poor media coverage will not change the demand for nursing homes. In general, patients do not wish to go in a nursing home; they just do not have the choice as their physical/mental conditions require special infrastructures and care that prevent them to stay at home. Moreover, given the strong demand/supply imbalance, it is almost impossible that occupancy rate will become structurally lower.
Despite the recent rally, Korian is still trading at depressed valuations. After valuing the real estate and the operating company separately, we conclude that they are both extremely undervalued. We believe that the property portfolio appraisal valuation is conservative and that appraisal valuations are far below market values as they already reflect a potential yield compression resulting from the quality and lower risk profile of healthcare assets. On the operating side of the business, valuation multiples are below recent transactions, below Orpea (OTCPK:ORPEF), its closest peer, and at the bottom of its historical range, suggesting that business prospects have deteriorated while we believe they have not.
Korian is a French operator of specialized care facilities with established operations in France (#1), Germany (#1), Belgium (#2), Italy (#1) and recent operations in the Netherlands and Spain. The company provides care to more than 470,000 patients/residents across a network of 893 facilities, comprising 82,675 beds and a pipeline of 14,259 beds.
Korian is present in four different business lines: nursing homes, post-acute and rehabilitation clinics, assisted-living facilities and home care. Nursing homes provide dependency care to elderlies that are not able to stay at home due to their high level of dependency and the costs and complexity associated to such dependency. In general, people joining nursing home are around 85 years-old and stay in average 18 months. Post-acute and rehabilitation clinics provide short-term care for patients with temporary dependency issues. Patients tend to enter into clinics after leaving the hospital and spend a couple of days until their full capacities are restored. Assisted-living facilities target younger independent elderlies (65+ years) that desire to live in an individual specialized apartment but want to have access to communal spaces and services such as catering and social activities. Basically, assisted-living facilities are nursing home for elderly with low dependency care needs. Finally, home cares are provided at the patient’s residence and are an alternative solution to hospitalization.
First of all, demographic trends are supportive. Indeed, the ageing population offers steady growth as highlighted by the ≈3% CAGR growth rate of the 80 and older year-old category over the next decades.
Besides, older people are more prone to develop chronic diseases which increase the dependency of patients and the demand for long-term care. Roughly 80% of people aged 65 or older have at least one chronic disease.
Despite an increasing demand, supply of nursing home beds has been limited as European governments have been financially-constrained due to the lackluster growth following the global financial crisis. The Covid-19 crisis will further pressure government budgets, preventing them to add significant new capacities.
In most European countries, governments pay for a significant portion of long-term care facilities total costs. Even though it varies from one country to another, public bodies cover around 30% to 50% of total price as they pay for care and medical expenses while accommodations and services such as catering, social activities are at the charge of residents.
Reimbursement rate covering medical expenses are negotiated on an annual basis with regulatory bodies. Operators present their financial projections (including wage inflation and additional medical expenses) which are used for determining the reimbursement rate (point 9). As a result, even though governments could decide not to cover these extra costs (by modifying regulations), we believe it is highly unlikely because it's in nobody's interest. By refusing to adjust reimbursement rate, the quality of care would deteriorate, especially among smaller players that account for a huge portion of existing beds, and investments in new and existing properties would collapse while they are needed (lack of capacity and huge need of renovations).
Even though no profits are realized on the medical part of the business, nursing homes are free to set freely the price for the room and the different services, which allow them to be profitable.
The sector offers also tremendous consolidation opportunities as the market is highly fragmented. On average, public and non-profit organizations account for ≈70% of the market.
These operators tend to be smaller than private players and struggle with increasing regulation requirements. Indeed, regulators are continuously increasing quality standards to which operators comply with, which negatively impact their profitability. In the last decade, private operators have gained market share over public and non-profit institutions as they have been able to invest while governments were not. Besides, many public and non-profit facilities need renovation while they do not have financial resources, which suggest that many of them could be acquired by private players as they have the financial resources but struggle to get new licenses. Finally, residents who want better facilities and services naturally turn to private operators as they benefit from more recent and higher quality facilities. As a result, private operators should outgrow the ≈3% market growth by 1 or 2 points.
In addition to benefit from predictable growth, the long-term care industry is protected by significant barriers to entry. First of all, regulation acts as a significant barrier to entry as it prevents new entrants to freely enter the market. Indeed, most countries require licenses to operate a facility and those are difficult to obtain. In general, they are granted to operators justifying a solid track-record, which favor incumbents.
Moreover, quality standards are very high and growing, thus it becomes increasingly more expensive for companies to comply with them. Smaller players struggle to comply with regulatory requirements, which again benefit large existing players.
Finally, all these positive attributes as well as the institutionalization of real estate have attracted new capital into the industry and supported the valuation of healthcare properties. Korian and Orpea, the two largest industry players, have been the main beneficiaries as they own a portion of the real estate they operate.
Why does this mispricing exist?
First of all, Korian is a French mid-cap company which is relatively unknown with a specific business model. Then, we believe its valuation is pressured by a combination of fears surrounding short-term issues and structural changes. Following the Covid-19 pandemic, several facilities, located among the regions the most impacted by the virus, had to face a wave of deaths among their residents. These patients are old and quite often in bad shape as most of them suffer from chronic diseases and/or mental illnesses. As a result, occupancy rate fell as the number of Covid-19 victims increased and operators were not allowed to welcome new patients in their facilities. The fall in occupancy was exacerbated by the clinic business which faces a collapse of surgical operations in most hospitals and the closure of clinics decided in some countries such as Germany.
Nursing homes have a high proportion of fixed costs (staff costs, rental expenses and D&A account for approximately 80% of the cost base). The negative operating leverage coming from the decline in the occupancy rate, estimated at ≈5 percentage points, is going to impact negatively the group profitability. On top of that, some investors are worried that extra-costs coming from the purchase of additional medical supplies such as masks, hydroalcoholic gels, tests as well as hiring more staff would impact company profitability as they are not well aware of how the business model works or just afraid that governments won't pay their shares (change in regulations, not reimbursing costs that were not budgeted during negotiations...). Finally, some investors fear potential lawsuits (and related fines) because of all deaths that occurred in their facilities.
In addition to be worried by the short-term evolution of the organic growth and profitability, some investors seem also worried by the long-term company prospects. First of all, they believe that restoring the occupancy rate to its pre-Covid level would take time and some of them even believe that the press coverage, blaming nursing homes for their inability to keep their residents safe, will reduce the willingness of people to join a nursing home. Moreover, they believe that wages, which have always been a hot topic for the industry as they are the company’s largest expenses and have been increasing due to labor shortage, will increase significantly going forward. Even though medical staffing costs are reimbursed by most states, the complexity behind these reimbursements can lead to temporary margin declines if the company is poorly managed. For instance, Korian faced issues in Germany in 2015/2016. Following several acquisitions, the company failed to properly integrate them at the group level. As a result, its IT infrastructures were not consolidated which led the company to hire more expensive temporary workers to run its operations. Of course, these extra costs had to be borne by the company. In short, some investors believe that korian’s profitability will be structurally lower than it used to be.
We clearly do not share those views and are more optimistic about the future company prospects. Even though quarterly results would be impacted by these additional costs and lower occupancy ratio, the situation will quickly normalize. Some clinics were opened and treated patients recovering from Covid, offsetting the negative impact on the traditional business. Besides, clinics are now authorized to reopen in Germany and surgeries restart as most surgeries can only be postponed. The demand has been so strong in the last few years that many nursing homes had to implement waiting list. Our long-term view is even more positive because we believe governments’ budgets will be even more under pressure, reducing the probability to see a lot of new capacity, which is positive for occupancy rate. Overall, we are pretty confident that occupancy rate will be back to ≈97% pre-crisis level in a matter of months.
While Korian has to incur additional costs, these costs should not impact the profitability going forward as they will be covered by governments which finance care and medical expenses for patients in long-term care facilities. The following document clearly shows that gloves, masks and few other medical supplies as well as wages related to medical staff are taken into account into the reimbursement rate.
The decision of the French government to pay a € 1500 one-time bonus to nurses working in the private sector as well as government's speeches suggesting a reform of the healthcare sector, including salaries increase for medical staff working at the hospital and in nursing homes, and similar discussions in some others countries such as Germany give us confidence that European governments will cover future wage increases. Besides, keep also in mind, that most operators are public and non-profit organizations which have lower margins, therefore governments could not cut reimbursement rate without facing the risk to severely hurt weakest operators and the conditions in which residents are taken care of.
Lawsuits could happen but we believe that all those deaths were inevitable given the fragility of the population living in long-term care facilities. Korian has implemented special procedures in February, few weeks before any actions from the government. Besides, Korian is used to deal with traditional flu, thus the group has already existing procedures to deal with infectious diseases. Even if Korian is subject to lawsuits, we do not believe that the company could be considered guilty, especially given the unprecedented nature of the crisis.
How much could the business be worth?
As Korian owns 22% of the real estate that the company operates, we believe that an OpCo/PropCo model is the most appropriate valuation method. Indeed, this method values separately the operating company (OpCo) and the property assets portfolio (PropCo). Basically, the method considers that Korian sells its entire real estate portfolio and operates its business by renting all facilities.
Historically, Korian and Orpea used to trade at an average OpCo EV/EBITDA of 10x and 18x, respectively. Current valuation suggests that Korian is trading below its historical average, reflecting fears that we previously explained. However, despite not being spared by the pandemic, Orpea valuations do not seem to reflect potential concerns.
As we have explained, we firmly believe that the company prospects are not impacted by the current pandemic and that long-term trends are favorable for the company. As such, we believe that Korian has no reasons to trade below 10x OpCo EBITDA. Besides, according to the real estate specialist Knight Frank, recent market transactions for smaller private operators have been executed in the 12x/15x range, significantly above Korian’s current multiple. Given Korian is far more diversified and profitable than smaller players; we see no reasons why the company should not trade at the top of that range. Such valuation would still imply a ≈15% discount to Orpea’s historical average of 18x, which seems fair.
Based on a conservative 10x OpCo EV/EBITDA multiple and on the appraisal value provided by Cushman & Wakefield, an independent appraiser, our base case already suggests 32% upside (target price of € 45).
However, despite offering 32% upside, we still believe that Korian is worth much more. Indeed, we think the OpCo should trade at least at 12x, in line with the bottom range of recent transactions. Using a peer valuation approach based on Orpea, its closest peer, would yield even higher result.
On top of that, we believe that the healthcare real estate category is undervalued. First of all, we believe that from a fundamental perspective, healthcare properties valuations are still too cheap and do not reflect their strong fundamentals. Indeed, a study carried out by Savills show that office, high street retails, industrials and shopping centers have lower yields than healthcare properties (3.95% average yield VS 5.33% for healthcare properties). However, the healthcare real estate sector benefits from strong fundamentals and attractive features: long-term leases, strong tenants, very high occupancy rate, and fragmented market with a lot of consolidation opportunities… Besides, healthcare properties have been more resilient during the pandemic than others categories such as offices and retail assets; therefore we believe than yield compression will keep happening going forward.
“Residential care properties remain all operational (and hence cash flow generating), be it with respect of very strict protective measures (lockdown, visitor ban, increased hygiene, quarantining, etc.). In several countries, (local) authorities have approved aid programs to cover extra costs that could result from anti Covid-19 measures for the operators. The impact of Covid19, in terms of “excess mortality” is being monitored constantly (though most probably will only be measurable over a longer period of time), but Aedifica has till date no indications that any “excess mortality” would have reached levels that would endanger the rent payment capacity of operators in general”
(Source: Aedifica Covid-19 press release)
Our analysis is supported by current REITs valuations. Aedifica (OTC:AEDFF), Cofinimmo (OTC:CFMOF) and Care Property Invest are European REITs specializing in healthcare properties. They invest in assets such as nursing homes, assisted-living facilities, clinics... in order to rent them to operators, including Korian and Orpea, which are among their largest tenants. These REITs are trading at a huge 56% average premium to their NAV (appraisal values). This valuation implies a 3.4% yield for healthcare assets; therefore investors already value healthcare property assets like lower-yield asset categories such as prime offices and high street retails.
Putting aside the potential yield compression, we still believe that current appraisal value for Korian’s asset portfolio is too conservative, undervaluing its portfolio. As a reminder, Korian owns 22% of all real estate that the group operates (meaning that the remaining 78% are rented). Basically, Korians's properties are basically rented to one of the strongest operators of the industry (namely Korian itself) and enjoy a 100% occupancy ratio (all assets are operated by the company). Therefore, REIT's asset valuations are good proxies for valuing Korian's property portfolio. As a result, we believe that the valuation of Korian's property portfolio should be at least similar to the appraisal value of REITs' properties (meaning similar yields).
Using BNP average yield for healthcare properties per country and Korian’s bed breakdown, we have derived a yield of 5.1%, significantly lower than the current 5.6% yield. Moreover, according this analysis, it seems that most fully-owned properties are located in France, which offers the lowest prime yield. As a result, the yield of Korian's properties should be lower than yields used in appraisal values of REITs' properties (likely between 4.9% and 5.1%)
With all this information, we have based our bull case on a 12x OpCo EV/EBITDA multiple and a 5.10% yield for the property portfolio (implying a value ≈10% higher than the appraisal value). Such scenario offers 69% upside (based on a € 34.3 share price) and we believe it is still not too aggressive as PropCo valuation is only 10% higher than current appraisal value (VS a 56% average premium for listed REITs) and the OpCO is valued with an EV/EBITDA multiple significantly lower than Orpea current or historical multiples and in the lower range of recent transactions.
Assuming the company spins off its real estate portfolio, we could even justify a $ 75.1 target price, a 120% upside, by considering that the property portfolio would trades at a 50% premium to its appraisal value, in line with current market value. The increasing visibility on the OpCo could justify a 13.5x EV /OpCo EBITDA multiple, in line with the average of recent transactions and still a 25% discount to historical Orpea valuation of 18x.
Even though we see more than limited downside from here, we still want to assess the risk. The following table shows the OpCo and propCo valuation. In order to derive the target price under a given scenario, suffice to sum the equity value of the OpCo and PropCo, and then divide by the number of share outstanding of 82.7M.
Korian operates in the very attractive long-term care industry. The industry benefits from structural growth drivers such as an ageing population, an increasing prevalence of chronic diseases and the institutionalization of real estate. The ageing population, combined with the market share gain over weakest competitors, should allow Korian to grow mid-single digit revenue growth, which could be strengthened by bolt-on acquisitions. However, Korian seems to be materially undervalued as valuations do not reflect the strength of the business model, the industry prospects as well as the value of its real estate portfolio. We believe that the risk reward is skewed to the upside and the upside potential is very appealing as highlighted by the 69% bull case upside.
Reputation: Reputation and operational track record play an important role to obtain operating licenses. Reputational damage could impact its ability to gain new licenses and/or could affect its ability to retain existing authorizations. Besides, it could lead to a higher level of scrutiny from regulators which could slow down its growth ambitions.
M&A: Korian is a very acquisitive company. The company could overpay for an asset or fail to properly integrate a company.
Reimbursement risk: Reimbursement rate could fail to cover the increase in medical expenses (including medical staff wages) incurred by Korian. Besides, reimbursement rate is negotiated on an annual basis; therefore profitability could be impacted for a few quarters because of the lag.
Rent inflation: Profitability could be impacted if rent inflation outpaces accommodation fees paid by residents. However, Korian can set up freely the price for accommodation every time that a new resident rent a room. Price increase for existing residents is decided by the regulator.
Interest rate: Korian uses a significant amount of debt. A change in interest rate could impact the net income. However, the company has implemented hedging strategies. Almost 90% of its debt is considered fixed-rate or hedged.
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