Healthway Medical Corp Ltd - Turnaround probably not in the short term

Healthway Medical Corp is one of the few companies in the healthcare sector listed on the SGX, operating the biggest clinic network in Singapore. Other than operating GP clinics and dental services, they are also involved in specialist & wellness healthcare division which is involved in Paediatrics, Orthopaedics and Aesthetic Medicine.

Figure 1 - Income Statement

FYI, 2005 to 2007 results are PRO FORMA results found from the IPO prospectus and hence might differ from the actual figure that you see from the FY 2008 annual report. In fact, the pro forma result in 2007 is the highest level of profit that the group has ever recorded in its operating history. The trouble in Healthway occured in 2010 when a group of specialists decided to leave en mass which created a vacuum and losses of customers. What happened is the start of a drop in profitability which accumulated till 2011 where a $58m of intangible asset is being written off. In 2010, they should have also been in the red if not for gain from acquisition of Crane Medical and disposal of Healthway Medical Enterprises. 

2012 1H looks like a pretty good set of result that shows some turnaround occurring with Healthway recording a 10% margin for 2 straight quarters. The question is then has it really turned around? In actual fact, it seemed like the company has largely relied on its other income to boost its profitability. Looking back into the annual report 2011, the company has deferred booking $7.1m in income due to prudent reason of which it has booked approximately $1.6m in 2012 Q2 and perhaps another $1.2m in 2012 Q1 under other income. For more details regarding the deferred income, please refer to http://info.sgx.com/webcoranncatth.nsf/VwAttachments/Att_6AF4D9F6C8EC525F482579E10075BE16/$file/HMCMaterialVariances.pdf?openelement
Now, I shall present the pro forma income statement for 2012 Q1 and Q2 after stripping out these deferred income from 2011.

Figure 2 - Pro Forma Income Statement for 2012 1H

What we see is that nothing much has changed for 2012 1H after taking away the deferred income from 2011, and the company is obviously still struggling to maintain its profitability. Since these deferred income is non-recurrent in nature, it seemed like the company is still stuck in the limbo.

Figure 3 - Operating expense ratio

Figure 3 will allow us to understand the loss in profitability of the company since 2010. From figure 3, we can easily see that the main cause of the losses has been staff cost which has risen from around 44% in 2008 and 2009 to approximately 56% of revenue ever since 2010. In 2012 Q1 and Q2, this has also been held true which goes to show that the level of profitability is similar to that in 2010 and 2011. Do take note that actual percentage for 2011 should also be around 55% as the company chose to "derecognised staff cost recharges of $4.5 million to a 3rd party which remained unpaid" (part of the $7.1 million in deferred income).

However, it is not all bleak from the above figure. The cost of medical supplies and other operating expense as a percentage of revenue have held pretty steady which means that the company has been able to pass on increase in medicine cost and rental to its customers. Another positive point to note lies in its staff cost which in fact provide huge potential for operating leverage given that this is largely a fix cost. If Healthway can focus on increasing its revenue per clinic per doctor, it will definitely be able to return to its profitability in 2009. However, it seemed like the company's main focus is still on further expanding their services be it in specialist, aesthetic or in China.

Figure 4 - Balance Sheet

This is definitely not the ideal balance sheet that any company should have and the biggest problem will be in the intangible asset which stands at $119m compared to $198m in total asset and $160m in total equity. I will discuss about the intangible asset later on. The new management has done a pretty good job in reducing the total debt from a high of $68m in 2008 to the current debt level of $17m. Cash has unfortunately dwindled down to a worryingly level of $5m which raise the prospect of some form of financing option in the short term. However, the group has a loan receivables of $15m which are supposed to be returned to them in the current financial year and this will hopefully strengthen their balance sheet.  

Intangible Asset

Let's explore the intangible asset which is worth $179m at its high in 2007. When company A uses $10m to acquire company B with net tangible asset of $5m, the excess $5m over the NTA will be booked under intangible asset. Therefore, we have to trace back the history of HMC to understand how did such a huge amount of intangible asset appears in the first place.

Founded by Dr Wong Weng Hong in 1990, HMG expanded its network of clinic to 15 by 1997 and 31 in 2002 before it went on to acquire 4 clinics under "Singapore Family Clinic and Surgery". A management buyout was carried out in 2006 by the founder together with Fan Kow Hin, Dr Jong Hee Sen and a few other investors. By the end of 2006, the group only has a total of 38 clinics, which paled far in comparison to the 80+ they had by the time they were listed in 2008. In the mere span of 1 year, the group went on a massive acquisition spree paying $72.32 million for "Silver Cross" and "Peace" group of family clinic, "Aaron" and "Universal" groups of dental clinics, "Paediatric Centre", "BCNG Laser and Medical Aesthetics". They also went into agreement to acquire IOC, IOCH, SBCC Clinic and SBCC S&T for $107.9m. Therefore, by spending $180m the group managed to expand from a sole family medicine clinic chain into specialist and wellness healthcare services before they got themselves listed on the exchange. Given that they do not have that much cash at that point in time, the acquisition was done through offering of share which lead to its specialist leaving en mass in 2010.

Figure 5 - Intangible Asset

Figure 5 shows us the breakdown of intangible asset as well as the impairment loss carried out in 2011. We can see that the bulk of the write down are for Paediatrics and Orthopaedics which falls under the specialist segment. Family medicine is probably their strongest division as no write-down has been carried out so far. It seemed like it has been a huge mistake for the firm to acquire IOCC, Paediatrics Centre and SBCC in 2007.  

The greater concern currently will then be is the write-down in 2011 the last of impairment loss? Unfortunately, what I see is that another $60m in intangible asset needs to be written down. The calculation of impairment is based on DCF calculation using a discount rate of 8.5% and projecting a terminal value based on the EBIT "from the 6th year at annual growth rate of 1% to 3% to perpetuity." This is definitely acceptable to me. The devil is in the detail where the cash flow growth is projected for the first 5 years. For Family Medicine, Dentistry and Wellness and aesthetics, expected annual revenue growth is approximately 4% from 2012 to 2016.

However, for the Paediatrics and Orthopaedics division, the anticipated annual revenue growth is 9% from 2012 to 2016! Remember that these 2 divisions were the ones that have to be written off in 2011, then why does it have so much higher projected revenue growth than the family medicine? Specialist and Wellness segment produced a loss of $3.7m on revenue of $25.6m before the impairment loss. What's more, the anticipated annual revenue growth in FY 2010 for  Paediatrics and Orthopaedics was at 4% and after 1 year of poor performance, they are now expected to deliver double the revenue growth in FY 2011. I believe that the increase in anticipated annual revenue growth from 4% to 9% is done so as to reduce the amount of impairment loss being recognised in 2011 for both Paediatrics and Orthopaedics division. In any case, I believe that it is pretty reasonable to expect a complete write-off of total intangible asset of $59.5 m for these 2 particular divisions. Garbage In, Garbage Out, but not unexpected from a firm that seemed to love performing financial engineering since they are listed.

Figure 6 - Profitability Ratio

Many might have pointed out that its ROA even in its most profitable year is unimpressive at 7.7% based on the Pro Forma statement. However, if we were to strip out the intangible asset, it seemed like we have a highly profitable business at least before what happened in 2010. As for free cash flow, it seemed like has the ability to generate good cashflow in the long run should profitability stay or improve. Total capex for 5 years are only at $8.5 million of which majority occurred in 2010 where multiple specialist clinics are opened especially the ones at Tripleone Somerset. 

From a valuation point of view, despite the fact that price has tumbled since IPO, the company does not look attractive. With a PSR of 2.0, even if the company manages to return to a 10% profit margin, it will be a PER of 20 which is just slightly lower than the well-run Raffles Medical Group which has a much better track record and balance sheet.

To conclude, an actual turnaround has not really occurred despite the return to profitability in 2012 1H. Discounting the deferred income from 2011, profitability probably remains the same as the past 2 years. For as long as the intangible asset stays in the balance sheet, I believe it will be a time bomb that will not be welcomed by investor. While it is reasonable to say that some gestation period is needed for new clinics to turn in profits, it seemed like there remains numerous loss-making clinics around.

Without doubt, things have definitely changed for the better with the new CEO, Mr Lam Pin Woon in Jan 2011 as we see debt being pared down and a much lower staff turnover rate. Discounting the intangible asset, it is likely that they do have a crown jewel in family medicine clinic and management of clinic and asset. However, it seemed like the company has yet to internalise the importance of focus in operation as they embark on their expansion plan in China and specialist division in Singapore at a point where their balance sheet is weak and certain operations are bleeding. Whether the strategy will work out remains to be seen though it is likely that any turnaround will be visible only in the middle to long term, especially when their clientèle base for specialist and wellness builds up.