Primary Health Properties — Update 27 February 2017

Primary Health Properties (LSE: PHP)

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Research: Real Estate

Primary Health Properties — Update 27 February 2017

Primary Health Properties

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Written by

Real Estate

Primary Health Properties

Long-term income

Full-year results

Real estate

27 February 2017

Price

106.25p

Market cap

£636m

Net debt (£m) as at 31 December 2016

663.3

Shares in issue

598.2m

Free float

98%

Code

PHP

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(1.2)

(3.6)

1.8

Rel (local)

(2.5)

(10.2)

(15.4)

52-week high/low

440.0p

350.0p

Business description

Primary Health Properties is a long-term investor in primary healthcare property in the UK and, recently, Ireland. Assets are mainly long-let to GPs and the NHS or HSE, organisations backed by the UK and Irish governments, respectively. The tenant profile and long average lease duration provide an exceptionally secure rental income stream.

Next events

AGM

26 April 2017

H117 results

July 2017

Analysts

Julian Roberts

+44 (0)20 3077 5748

Andrew Mitchell

+44 (0)20 3681 2500

Primary Health Properties is a research client of Edison Investment Research Limited

FY16 was Primary Health Properties’ (PHP) 20th year of uninterrupted dividend growth and saw a return to full dividend cover. The capital increase in April 2016 (£145.3m net of costs) enabled management to reduce LTV, lower the cost of debt and continue to expand the portfolio of modern, purpose-built primary care assets on long leases mainly to government-backed tenants. The efficient operating model should deliver further reduction in the EPRA cost ratio in FY17 as the portfolio grows, increasing profitability and underpinning the secure dividend stream. The first quarterly dividend for FY17 of 1.31p has been declared, and we forecast continued, fully covered dividend growth to 5.25p per share in FY17 and 5.36p in FY18.

Year end

Revenue (£m)

PBT*
(£m)

EPS*
(p)

DPS
(p)

Yield
(%)

EPRA NAV/
share (p)

12/15

63.1

21.7

4.9

5.000

4.7

87.7

12/16

67.4

26.7

4.8**

5.125

4.8

91.1

12/17e

72.6

32.2

5.4

5.250

4.9

92.9

12/18e

78.5

33.7

5.6

5.360

5.0

95.3

Note: *PBT and EPS are on an underlying EPRA basis, excluding valuation movements and other exceptional items. **Using weighted average shares for the year. The total cash dividend was fully covered by earnings.

Progress on all fronts

PHP acquired £74.2m of properties in FY16, increasing the rent roll by £4.2m and contributing to EPRA earnings of £26.8m, 23.5% higher than in FY15 (£21.7m). The £145.3m capital increase in April enabled the company to reduce revolving debt and other measures reduced the average cost of debt too, causing finance costs to fall by 3.7%. The EPRA cost ratio was flat year-on-year at 11.5% despite the end of a discount period on administrative costs charges by the adviser. This is the lowest in the sector and will fall in future as marginal costs decrease as the portfolio grows. Following the FY16 results we have slightly adjusted our estimates which point to further fully covered dividend growth.

Structural drivers of growth

Both the UK and Irish healthcare property markets have strong underlying drivers in the medium to long term: populations are growing and ageing and there is broad political will to reform healthcare provision, placing more emphasis on primary care. This requires high-quality premises of the sort PHP invests in. Tenant covenants are strong in both countries: the government either pays directly or reimburses the tenant for 90% of PHP’s UK rents and 75% in Ireland. The company continues to have diverse sources of funding and a healthy pipeline of acquisitions (c £120m).

Valuation: Secure dividends continuing to grow

PHP’s FY17e dividend yield of 4.9% is supported by a portfolio of leases that are largely backed by the UK and Irish governments. The healthcare market is much less sensitive to economic cycles than other commercial real estate subsectors and therefore shows less volatility in occupancy, rents and valuation. The dividend is fully covered by EPRA earnings and we expect the 20-year trend of growth to continue.

FY16 dividend fully covered

PHP’s FY16 results were closely in line with our forecasts on an EPRA basis, with EPRA earnings per share of 4.8p and EPRA NAV growing to £545m, or 91.1p per share. Significantly, this was the first full year since the financial crisis in which the dividend was 100% covered from cash earnings, a particularly strong performance given the increase in the number of shares following the £150m equity raise in April at £1 per share. The EPRA cost ratio remained the lowest in the sector at 11.5% (FY15: 11.5%) and we expect it to fall further as gross asset growth incurs incrementally lower advisory fees. As mentioned in our last note, PHP made its first investment in Ireland in 2016, where property yields are higher than in the UK, the costs of debt are slightly lower and lease length and tenant covenant are of a similarly high quality. The proceeds of the share issue were used both to acquire new assets and to pay down some of the company’s revolving credit facilities (some of which have been cancelled to reduce non-utilisation fees), and the premium to NAV at which funds were raised offset the cost of renegotiating the swap contracts. We have modified our FY17 estimates slightly to take the results into account, and added forecasts for FY18. We provide a summary of the results below before discussing the estimate changes in more detail in the following section.

Highlights of the full-year results

PHP acquired £74.2m of fully let assets in 2016, with a rent roll of £4.2m, taking the portfolio to 295 standing let properties and one under development. These were valued at £1.22bn as of 31 December 2016 and had contracted rent of £68.0m and a weighted average unexpired lease term (WAULT) of 13.7 years (FY15: £1.09bn, £63.7m contracted rent and 14.7 years WAULT). The decrease in WAULT was partly due to the purchase of properties with leases under 14 years, which management expects to be able to extend in conjunction with asset management initiatives. The purchase of two more standing let properties was announced in January 2017.

Net rental income increased 6.9% to £66.6m and EPRA earnings grew 23.5% to £26.8m (FY15: £21.7m). EPRA earnings per share were 4.8p, down slightly from 4.9p in FY15, as a result of the 150m new shares issued in April. A revaluation gain on the portfolio of £20.7m was driven largely by yields tightening by 15bp to 5.17% on average. 166 rent reviews in the period gave a modest 0.9% uplift on average, in line with FY15 and generating £0.3m of additional rent.

PHP raised a net £145.3m in April at 100p per share, a 14% premium to NAV of 31 December 2015. This lifted EPRA net assets by 37%, and revaluations added 2.3% to the investment portfolio, meaning that year end EPRA NAV was up 39% from £392m to £545m at 31 December 2016. EPRA NAV per share increased 3.9%, from 87.7p to 91.1p.

The cost of debt was reduced by renegotiating the interest rate on swaps with a nominal value of £88m from 4.79% to 0.87% for a one-off cost of £14.5m (largely offset by the premium to NAV of the equity issue), saving £16.4m from November 2016 to August 2021. Some of the proceeds of the equity issue were also used to pay down credit facilities, reducing interest costs, and a £100m credit facility was cancelled, reducing non-utilisation costs. A facility maturing in August 2017 will be refinanced for up to £100m for up to five years and at a cost 15bp lower than before. The weighted average cost of debt is now 4.65% (FY15: 4.67%) and LTV stood at 53.7% on 31 December 2016 (FY15: 62.7%). Management has also indicated an intention to increase the average maturity of debt.

PHP has paid dividends totalling 5.125p per share in respect of FY16, 2.5% above FY15 and marking 20 years of dividend growth. The dividend was 100% covered by cash (shares issued in April qualified for the third and fourth quarterly dividends). The total shareholder return of 8.2% outperformed the benchmark FTSE All Share REIT Index by 15.2 percentage points and the total property return of 7.9% was 4.3 percentage points above the IPD All Property Index.

Market developments

The demographic trends of growing and ageing populations in the UK and Ireland will continue to increase the burden on national healthcare infrastructure and there is widespread political will to reform healthcare services in both countries. In both cases, this includes moving more care provision into a primary setting.

In Ireland, the Department of Health (DoH) has taken a direct approach and plans to build c 100 primary care centres (PCC), which will house state-provided primary care services as well as GPs. The Health Service Executive (HSE; equivalent to the NHS) will be the tenant of 60-75% of the space in these, with the rest let to GPs, pharmacies and other private tenants. This plan is well underway, as evidenced by PHP’s investment in a PCC in Tipperary, where the HSE pays 75% of the rent and two GP practices and a pharmacy the rest. The GP practices are reportedly taking on five to 10 new patients a week who had previously used other GPs in the area, attracted in part by the convenience of having other services co-located with their GP. This is an encouraging sign both that the care model proposed by the DoH is working and that PHP’s tenants are likely to perform well. The lessons learnt from the process of developing the Tipperary PCC will help to accelerate the investment pipeline in Ireland, which comprises €53m of opportunities.

There are also encouraging signs in the UK: The General Practice Forward View (GPFV) published in April set out a five-year plan and targets for GP services including additional funding for GP services of £2.4bn a year. Another initiative to improve primary care infrastructure also started to bear fruit in 2016: The Estates and Technology Transformation Fund (ETTF) was established in 2015 to accelerate the development of primary care infrastructure. Initially this slowed down the rate of approvals for new primary care projects because it meant that many project sponsors applied to the fund for support, adding another layer of bureaucracy to the process. The first funding awards from the ETTF were made in late 2016, supporting 600 projects, over a third of which are new primary care facilities. Management notes the impact of the ETTF on enabling schemes, although provision of government funding does reduce the potential size of the company’s investment in a scheme. PHP has supported 23 applications by tenants for support from the ETTF. Eight have been approved so far, to which PHP has committed £5.3m, which will generate £325k of additional rent (6.2% yield) and will extend leases on the premises by an average of 13 years. A further 10 applications are at different stages of NHS or other approvals processes, for projects in which PHP will invest £4.6m, adding £222k of rent and more importantly an average of 11 years to lease duration at the relevant premises.

Strategic Transformation Plans (STPs) have also been published for English NHS districts. These set out plans for infrastructure improvement and add support to expectations that the primary care estate will be modernised and expanded to meet the rising demands placed on it. PHP has an existing pipeline of £72m of acquisitions in the UK.

An increase in the rate of primary care project approvals has been anticipated since the announcement of healthcare reforms in 2014, and now appears to be beginning. Apart from allowing a higher rate of investment, which PHP is well-placed to take advantage of, the construction of more modern primary care facilities should also lead to rental growth. The policy of NHS pre-approval of rent agreements prior to construction means there is no speculative development in the sector; any new supply of accommodation is matched to demand and should not weigh on rents. On the contrary, new premises have higher build costs and better facilities and command higher rents as a result. District valuers use them for comparison in rent reviews of existing stock, which should lead to higher rents on those premises than would otherwise be the case. Management does not expect there to be a sudden effect on increases in rent on review, but does foresee an improvement on the 0.9% seen in FY15 and FY16.

Changes to estimates

The FY16 results were in line with our forecasts, and we have not made any major changes to our FY17 estimates. The new FY18 forecasts continue the current trends of rising profits underpinning a growing dividend, which is 105% covered by cash in FY18 on our estimates. The amount invested in H216 was less than we had assumed in our model, although we note that management expects to be able to announce acquisitions in the UK and Ireland in the near term. That delay in investment means we have reduced our forecasts for FY17 slightly, but this has not affected our dividend forecast, nor our expectation that the dividend will continue to be fully covered in FY17 and FY18. Exhibit 1 shows the changes to our estimates and our newly introduced FY18 forecasts.

Exhibit 1: Changes to estimates

Revenue (£m)

EPRA EPS (p)

DPS (p)

Dividend cover

EPRA NAV/share (p)

Old

New

% diff

Old

New

% diff

Old

New

% diff

Old

New

% diff

Old

New

% diff

12/16

67.2

67.4

0.4%

4.8

4.8

-0.5%

5.125

5.125

0.0%

101%

100%

-1.0%

91.6

91.1

-0.5%

12/17e

72.9

72.6

-0.5%

5.4

5.4

-0.5%

5.250

5.250

0.0%

103%

102%

-0.7%

94.8

92.9

-2.0%

12/18e

78.5

5.6

5.360

105%

95.3

Source: Primary Health Properties data, Edison Investment Research

We have assumed that PHP will invest £95m in 2017 and £110m in 2018 at a yield of 5% in the UK and 7% in Ireland. We do not assume any valuation yield change but do forecast annualised rent growth of 1%, which we consider to be conservative given that 6% of rents have fixed increases of 2.65% on average and 20% of rents are index-linked (averaging 1.6% in FY16).

Sensitivities

Our main assumptions relate to rent increases and the yields at which funds can be invested. These tend to be relatively steady, although we note that acceleration in NHS development could help increase rent growth as described above. The timing of investment is less certain, but we believe our assumptions are reasonable and conservative. Should PHP be able to deploy funds faster, earnings and dividend cover would rise faster too. A further tightening of valuation yields would also affect our estimates, raising NAV per share (but not affecting EPRA earnings).

For the purpose of our model, we have assumed that holders of convertible bonds will not choose to convert during the forecast period (to the end of FY18). The five year £82.5m bond was issued in May 2014 and pays a 4.25% coupon. The conversion price is 97.5p (adjusted for the one to four share split in November 2015) and the option to convert is in the money. From 20 May 2017 onwards, the bonds may be redeemed at par at the company’s option as long as their parity value exceeds £130,000. At year-end the bond had a fair value of £95.0m. If the whole bond were converted and PHP chose to settle the conversion rights wholly in shares, it would issue c 80m new shares, or 13% of the existing share capital. The fair value change recorded in the income statement would not affect EPRA earnings, and the saving on debt costs would help offset the increase in dividend costs, meaning that on our forecasts the dividend would remain fully covered in FY17 and FY18.

Valuation: Secure and attractive dividends

Our forecast FY17 dividend of 5.25p represents a 4.9% yield on the current share price, and is fully covered by cash earnings, 90% of which are backed by the UK or Irish governments. This compares to a 1.23% yield on 10-year gilts, 4.2% on the FTSE 100 and 3.7% on the FTSE EPRA NAREIT Index. Because healthcare property is less economically sensitive than other commercial sectors, has effectively full occupancy and no speculative development, its returns are expected to be less volatile. This has made the dividends attractive at a time of economic uncertainty and low returns on other investments, which has contributed to the shares’ c 18% premium to NAV, in line with other stocks with similarly secure dividends and long-term income streams.

Exhibit 2: Financial summary

£000s

2013

2014

2015

2016

2017e

2018e

Year end 31 December

IFRS

IFRS

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Revenue

41,982

59,985

63,115

67,439

72,564

78,485

Cost of Sales

(398)

(723)

(852)

(868)

(953)

(1,031)

Gross Profit

41,584

59,262

62,263

66,571

71,611

77,454

Administrative expenses

(6,080)

(6,782)

(6,807)

(7,332)

(7,652)

(7,996)

EBITDA

35,504

52,480

55,456

59,239

63,959

69,457

Other income and expenses

638

0

0

0

0

0

Non-recurring items

(2,702)

(2,426)

0

0

0

0

Net valuation gain on property portfolio

2,313

29,204

39,767

20,686

9,872

12,331

Operating profit before financing costs

35,753

79,258

95,223

79,925

73,831

81,788

Net Interest

(26,016)

(34,275)

(33,727)

(32,490)

(31,795)

(35,788)

Non-recurring finance income/expense

0

0

0

0

0

0

Early loan repayment fees

(950)

(1,187)

0

(24)

0

0

Fair value gain/(loss) on interest rate derivatives and convertible bond, and swap amortisation

11,432

(6,916)

(5,464)

(3,710)

0

0

Profit Before Tax

20,219

36,880

56,032

43,701

42,036

46,001

Tax

1

0

0

0

0

0

Profit After Tax (FRS 3)

20,220

36,880

56,032

43,701

42,036

46,001

Adjusted for the following:

Net gain/(loss) on revaluation

(2,313)

(29,204)

(39,767)

(20,686)

(9,872)

(12,331)

Fair value gain/(loss) on derivatives & convertible bond

(11,432)

6,916

5,464

3,710

0

0

Profit on termination of finance lease

(638)

0

0

0

0

0

Early loan repayment fees

950

1,187

0

24

0

0

Issue costs of convertible bond

0

2,426

0

0

0

0

EPRA basic earnings

6,787

18,205

21,729

26,749

32,164

33,670

Period end number of shares (m)

441.9

445.1

446.3

598.2

599.6

601.1

Average Number of Shares Outstanding (m)

356.5

444.2

445.5

560.0

598.8

600.5

Fully diluted average number of shares outstanding (m)

356.5

496.6

530.2

644.6

683.5

685.1

EPS - fully diluted (p)

5.7

7.9

11.2

7.3

6.4

7.0

EPRA EPS (p)

1.9

4.1

4.9

4.8

5.4

5.6

Dividend per share (p)

4.750

4.875

5.000

5.125

5.250

5.360

Dividend cover

41%

84%

98%

100%

102%

105%

BALANCE SHEET

Fixed Assets

942,020

1,026,232

1,100,621

1,220,155

1,321,277

1,442,358

Investment properties

941,548

1,026,207

1,100,612

1,220,155

1,321,277

1,442,358

Net investment in finance leases

0

0

0

0

0

0

Derivative interest rate swaps

472

25

9

0

0

0

Current Assets

14,052

17,740

7,034

8,442

7,282

5,880

Trade & other receivables

4,764

5,668

4,153

3,343

3,537

3,839

Net investment in finance leases

0

0

0

0

0

0

Cash & equivalents

9,288

12,072

2,881

5,099

3,746

2,041

Current Liabilities

(39,635)

(33,065)

(34,864)

(32,260)

(33,048)

(34,278)

Term loans

(3,843)

(711)

(862)

(803)

(803)

(803)

Trade & other payables

(16,269)

(14,244)

(16,099)

(13,600)

(14,388)

(15,618)

Derivative interest rate swaps

(7,566)

(5,802)

(4,734)

(3,795)

(3,795)

(3,795)

Deferred rental income

(11,934)

(12,308)

(13,169)

(14,062)

(14,062)

(14,062)

Other

(23)

0

0

0

0

0

Long Term Liabilities

(614,052)

(701,777)

(727,431)

(697,141)

(784,141)

(887,141)

Term loans

(460,185)

(437,022)

(460,550)

(429,433)

(516,433)

(619,433)

Bonds

(132,408)

(229,543)

(236,328)

(238,197)

(238,197)

(238,197)

Derivative interest rate swaps

(21,459)

(35,212)

(30,553)

(29,511)

(29,511)

(29,511)

Net Assets

302,385

309,130

345,360

499,196

511,370

526,818

Derivative interest rate swaps

28,553

40,989

35,278

33,306

33,306

33,306

Change in fair value of convertible bond

0

4,462

10,931

12,456

12,456

12,456

EPRA net assets

330,938

354,581

391,569

544,958

557,132

572,580

IFRS NAVper share (p)

68.4

69.5

77.4

83.5

85.3

87.6

EPRA NAVper share (p)

74.9

79.7

87.7

91.1

92.9

95.3

CASH FLOW

Operating Cash Flow

36,682

49,020

57,145

56,838

64,553

70,385

Net Interest & other financing charges

(30,430)

(49,633)

(32,337)

(31,374)

(31,795)

(35,788)

Tax

0

(23)

0

(51)

0

0

Acquisitions/disposals

(54,731)

(54,396)

(29,477)

(97,359)

(91,250)

(108,750)

Net proceeds from issue of shares

65,232

17

(139)

145,232

0

0

Equity dividends paid (net of scrip)

(16,130)

(20,688)

(21,083)

(24,734)

(29,862)

(30,553)

Other (including debt assumed on acquisition)

(211,273)

7,647

(13,764)

(17,027)

0

0

Net Cash Flow

(210,650)

(68,056)

(39,655)

31,525

(88,353)

(104,705)

Opening net (debt)/cash

(376,498)

(587,148)

(655,204)

(694,859)

(663,334)

(751,687)

Closing net (debt)/cash

(587,148)

(655,204)

(694,859)

(663,334)

(751,687)

(856,392)

Source: Primary Health Properties data, Edison Investment Research

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10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205, 95 Pitt Street

Sydney, NSW 2000

Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205, 95 Pitt Street

Sydney, NSW 2000

Australia

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Copyright 2017 Edison Investment Research Limited. All rights reserved. This report has been commissioned by Primary Health Properties and prepared and issued by Edison for publication globally. All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report. Opinions contained in this report represent those of the research department of Edison at the time of publication. The securities described in the Investment Research may not be eligible for sale in all jurisdictions or to certain categories of investors. This research is issued in Australia by Edison Aus and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. The Investment Research is distributed in the United States by Edison US to major US institutional investors only. Edison US is registered as an investment adviser with the Securities and Exchange Commission. Edison US relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. As such, Edison does not offer or provide personalised advice. We publish information about companies in which we believe our readers may be interested and this information reflects our sincere opinions. The information that we provide or that is derived from our website is not intended to be, and should not be construed in any manner whatsoever as, personalised advice. Also, our website and the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. This document is provided for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205, 95 Pitt Street

Sydney, NSW 2000

Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205, 95 Pitt Street

Sydney, NSW 2000

Australia

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