Q1) Does a dominant market share mean a business has a strong moat and is infallible?
Q2) Does having the courage to expand overseas mean a business has a long runway to grow?
Healthcare Service Provider (HSP), is its country’s number two in its industry going by its revenue of USD1b, and a far distance to the number one spot held by Company M with USD1.8b revenue; their net profit varied even further – USD52m vs USD 230m.
By any quantitative measure, if one had to choose between the two, the logical choice will be to choose Company M over HSP, since M’s business is not only 80% larger but also 4 times more profitable coupled with its net profit margins at 12% versus HSP’s 5%; i.e. M is simply dominant over HSP, and the logical choice is to buy the winning business. Some might even call them the price setters.
In late 2011, M, headed by its new and energetic CEO, decided to venture into the lucrative US Healthcare Service market by buying up a US peer almost the same size as itself. This move, the company proclaimed, will allow them to grow their business many times more than what it already had. The CEO put his name and the company’s on the map, since he is the first in the industry to make such a heroic move. Fund managers quickly took notice and bought its share price up significantly. Analysts started issuing target prices and recommended “Buy” positions. Shareholders were swooned by the CEO’s charisma, obvious capabilities, and high ambitions – surely the perfect concoction for a winning investment?
Interestingly, while its larger peer made a name for themselves by providing healthcare services to the big pharmaceutical giants, lauding lucrative “recurring income” as their clients provided them a steady stream of patients to qualify their drug research, HSP went the boring way of providing healthcare service to the patients in hospitals and clinics getting their health checked.
While M was busy integrating the newly acquired US operations which enabled them to “double their earnings” quickly, HSP was busy providing an enhanced one-stop solution to the hospitals and clinics, going as far as to convince hospitals to outsource their niche department services to them and even renting their clients’ space to do those work, i.e. they are highly integrated with the hospitals and once they “installed their base”, it is very unlikely for the hospitals to send these niche work to other providers. It makes sense for the hospitals which are pressured by the authorities to keep healthcare costs low and service standards high.
In fact, due to this unusually high pressure over the years, many smaller peers have been calling it quits as they simply could not lower their costs any lower while increasing their service quality. So HSP has been quietly buying over these smaller players over the same period, each one at a much smaller scale than their overall operations, such that the integration was digestible while the enlarged scale and scope over similar geography coverage provided them much synergy – increased volume plus automation equals increased productivity.
If we took just a quick glance at both company’s balance sheet and track record, we would in fact have seen the ballooning goodwill in M’s balance sheet, increasing each year from 2011 to 2017 as they kept buying more US peers to boost their operations, to the point that their goodwill and debt were much higher than their cash and operating cashflow. HSP, on the other hand, again quietly took a 2% stake in the number four service provider with a significantly smaller business while buying other much smaller players, its goodwill line item hardly budging at all, while its operating cash flow kept spewing cash into their balance sheet until it is currently more than 60% of their entire net tangible assets (NTA), and 37% of their market capitalisation. They can buy out the number four peer tomorrow if they like to, even at a 100% premium to number four’s share price. Although we think they are in business for the long haul and are very cautious with their capital allocation.
While institutional investors kept buying M’s shares, pushing its share price to a record high, we were in our corner with HSP, perhaps forgotten altogether.
Moving 18 months forward to 2018, M and its charismatic CEO decided they could not continue their game any longer, and decided to call it quits in the US, finally admitting that they were not ready to grow so fast overseas. They had to cut off their enormous goodwill when they sold their US operations in a fire sale, and their revenue decreased significantly while profits shrank to USD70m range (HSP is very close by now). The once highly supportive institutional investors started dumping M’s shares, analysts reverted to issuing “Hold” and “Sell” calls…
What can investors learn from this episode?
Instead of having their business “given” to them, HSP sought after real demand from the grassroots level, and this has proven to be resilient compared to the unpredictable nature of drug research services. And instead of going for the sexy moves that M sought to “create value”, HSP worked on its fundamental Kung Fu, digging deep into its service roots based on real demand from paying customers. In the same 7 years that passed since the fateful late 2011 acquisition, M now find themselves back in square one, and shareholders suddenly realise their domestic revenue and sales have not budged since 2011. Meanwhile, HSP’s revenue increased by about 40% while their earnings grew 60 percent; they became so good at what they do that they have now ventured into new food safety services.
If the mother of all crisis were to occur tomorrow, what will happen to their business? Will humans stop going for health checks or forsake food safety checks? Both seems very unlikely.
Equally important, will the price of this business decrease drastically compared to well-covered and/or highly priced companies? This seems unlikely as long as investors are not overpaying at a ridiculous valuations (like 20x EV/EBIT?) for their shares – that is not our way. If anything, they’ll probably be in a much better position to utilise their huge cash position given their toehold in the number four peer and their consistent track record of buying and integrating smaller peers. Let’s remind ourselves, they have been consolidating their position for decades amidst great pressures and crises anyway.
Now consider that Asia Pacific is facing a greying population with some regions experiencing an accelerated pace, coupled with a rapidly rising middle class – Will high quality healthcare service and food safety services be more sought after ten years from now? Will we be able to afford more for these services as our income grows?