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Tug-Of-Fools: Raffles Medical Group – The Bear Argument

I am Chong Ser Jing. Here is my bear case for Raffles Medical Group (SGX: R01).

Before I start, I would like to point out that I am a shareholder of healthcare provider RMG. But, that does not mean I am not cognizant of the risks involved with the company that could derail this investment. And, that is what I want to share – the important risks I see on the horizon that the company has to face.

To get us started, here is an interesting observation going back to 1 March 1999, which is the earliest date I could gather for the company’s valuation metrics from my data sources. Shares of RMG were worth some $0.55 apiece back then and were valued at 61 times trailing earnings. Now, guess where shares of the healthcare operator were priced at some seven years later on 1 February 2006? There are no prizes here, but its shares were worth $0.55 apiece, but this time with a trailing price-to-earnings (P/E) ratio of just 20.

This brings me to the very first point of my bear case: valuations.

Growth won’t mean a thing if you overpay for it

In investing, one of the best ways to lose money would be to overpay for growth. RMG was a great winner over 16 years, but there were long-stretches of time – some seven years, as I have showed above – where it lost out heavily to inflation and the Straits Times Index (SGX: ^STI) (which gained 71 percent in that seven-year period). That is because shares of the company were priced at a sky-high earnings multiple on 1 March 1999 and subsequent growth in profits could not show up in terms of shareholder returns.

Today, at a price of around $3.25, it is selling for 21 times its reported trailing earnings. That is really quite reasonable, you might say. But, the healthcare provider’s profits were padded by a one-time gain of $20.4 million it had earned after selling a property it no longer had use for. If that gain were stripped away, RMG’s “core” earnings were quite a fair bit lower at $64.9 million. At that level of profit, shares of the company become valued at 28 times earnings instead.

That is more than twice the earnings multiple of 13 that the market average carries, as represented by the STI. While it might be fair to point out that RMG might deserve that premium valuation based on its quality earnings (as alluded to by its superb cash flows) and a rock-solid balance sheet that is flushed with cash, there is also a case to be made against its rich valuation.

Super investors Peter Lynch and Shelby Davis were well known for wanting to invest in companies that were growing at a rate higher than their earnings multiple implied. That way, they could profit from two powerful forces: 1) the growth in earnings and; 2) the expansion of the earnings multiple. With RMG, it seems unlikely we will see an expansion of the earnings multiple given its high valuation at the moment, so investors have to depend on earnings growth.

Over the past three years, earnings growth at RMG has slowed somewhat, as seen in the table below. Given slowing profit growth, there is always the chance that the market could decide to award a lower multiple of earnings to the company’s shares in the future, resulting in profit growth being unable to show up in shareholder returns, as it was from March 1999 to February 2006.

Year Earnings per share % Change from a year ago
2004 S$0.022 17%
2005 S$0.027 24%
2006 S$0.035 28%
2007 S$0.074 110%
2008 S$0.061 -17%
2009 S$0.073 20%
2010 S$0.087 18%
2011 S$0.095 10%
2012 S$0.105 11%
2013 S$0.124* 17%
*Earnings per share for 2013 was adjusted for one-off items

Source: S&P Capital IQ; Author’s calculations

Even if healthcare is considered an industry with strong defensive characteristics providing an indispensable service, there is still a need for good business leadership. Just consider how RMG’s profit margins look like in relation to some of its foreign- and locally-listed peers (though I understand it might not exactly be an apples-to-apples comparison), such as Singapore Medical Group (SGX: 5OT)Pacific Healthcare Holdings (SGX: P47), and KPJ Healthcare.

Net Profit Margin
Year Raffles Medical Singapore Medical Pacific Healthcare KPJ Healthcare
2007 21% 33% 8% 7%
2008 16% 17% -14% 7%
2009 17% 5% -12% 8%
2010 19% 7% -16% 7%
2011 18% -4% -32% 8%
2012 18% -5% -16% 7%
2013 25% -28% -17% 4%

Source: S&P Capital IQ

The net profit margin table gives some strong clues that management can bring a huge difference to the economic performance of a healthcare company. And, this brings me to the second point of my bear case: succession planning.

Who’s The Next Leader?

Dr. Loo Choon Yong was RMG’s co-founder back in 1976. And since then, he has been an important driving force behind the company’s growth. He is still very heavily involved with the company given his current role as the executive chairman. But, Loo’s in his mid-sixties and even though he clearly has a passion for the healthcare profession, succession planning should come to the forefront of an assessment of risks with the company.

In a sound-bite given on December 2010, Loo mentioned that “Raffles [Medical Group]… is building its management succession that could lead the firm to grow for another 35 years.”

While this does give comfort to the fact that Loo’s thinking hard about a new generation of leaders for the company and is trying to accomplish that in an “organic” way by bringing in younger professionals and then building a great culture within the company with them, there is also some concern that there is no mention of the word “succession” or its variants in both the company’s 2012 and 2011 annual reports.

Who are the likely candidates to take over the helm when Loo steps down eventually? How good are they? These are questions that investors ought to think through. I have no good answers myself, but perhaps, that is telling in its own way.

So, to sum up, I see two key risks on the horizon with RMG: 1) rich valuations and; 2) no clear insight into the company’s succession planning.

You can read the bull argument here.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares of Raffles Medical Group.