AI #10: How Indonesia's doctors could pay you an 8% dividend this year

This week's Asia Investor comes to you partly from beautiful island of Penang. And partly from somewhere rather less luxurious.

I spent the weekend overlooking the ocean at the famous Eastern & Oriental Hotel, once popular with Noel Coward and Rudyard Kipling. Five star living doesn't usually come with the Asia Investor budget, but Malaysia is cheap and the off-season discounts are in full-swing; at the price, I couldn't turn down the opportunity to stay in one of Asia's most elegant locations.

With my report half-finished, I jumped on a sleeper train to Bangkok, slightly concerned that although there was only one type of ticket available, it was still labelled "second class". I was right to be worried: while the bed was better than it might have been, the train was badly late and so was the food. Even the plates of elderly chicken that hawkers kept offering us at the stations began to look edible after a while.

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But worse, there was only a single power point in the middle of the coach and monks were staking out a claim on it as they recharged their mobile phones. With not much battery in my old travel laptop, I didn't get a lot of work done until I finally made it to my hotel. But thanks to plenty of strong Thai coffee last night, I've got an interesting addition to the Asia Investor portfolio ready for you.

As I mentioned yesterday, it's an Indonesian healthcare investment. I think it will be a very solid addition to the portfolio. And as we'll see, one that pays a very handsome dividend.

So let's take a quick look at the background to its business, before diving into the details of the stock.

Why you shouldn't fall ill in Indonesia

As in many emerging markets, Indonesia's healthcare system is extremely underdeveloped. The country spends around 2.5% of GDP on healthcare, compared with around 4% in Singapore and Malaysia.

Resources such as hospital beds and doctors are inadequate compared with better systems in both developed countries and many emerging ones, as the charts below show. And hundreds of thousands of patients go abroad to countries such as Singapore and Malaysia for treatment each year.

According to Department of Health figures, Indonesia has 1,406 hospitals: 721 state-owned and 685 private. Many of these will be very small or basic facilities. It estimates that the country needs an extra 420 hospitals.

Insurance coverage remains low, with more than half the population lacking coverage. However, this is expanding, both under government programs and private providers. And rising incomes also increase people's ability to spend out-of-pocket on healthcare, if it's available at the right price.

So on the supply side, we have a shortage of healthcare provision, while on the demand side, the ability to pay for treatment should be rising. This is a situation that has considerable promise for investors.

Of course, Indonesia isn't alone in this. I think that most emerging markets have promising healthcare trends. However, this isn't a difficult story to wrap your head around and investors have caught on. Most healthcare investments are now looking quite expensive. So rather than chase expensive growth stories, I've been looking in a different direction.

This week's recommendation is a bit different to the stocks we've looked at so far, because it is primarily an income play. But I think it has unique characteristics that add some modest but steady long-term growth, plus some potential for capital gains. And because it's operates in such a non-cyclical sector, it should offer a very solid and dependable stream of dividends.

Add the fact that it currently yields 8% a year, and it begins to look pretty compelling

Flagship hospitals in a thriving healthcare market

First Reit is a Singapore-listed real estate investment trust, specialising in healthcare properties. The trust currently holds eight properties, four in Singapore and four in Indonesia. However, the Indonesian assets account for the vast majority of asset base and income, as the chart below shows and as we'll see below, future growth is likely to come here.

Consequently, the Singapore properties are relatively unimportant and I'll only summarise them briefly. They consist of three nursing homes and a cancer centre that's currently under redevelopment for completion in mid-2011. The lessee on two of the nursing homes and the cancer centre is Pacific Healthcare, a Singapore-listed healthcare provider.

Having a stable, long-term tenant is quite important for a reit operating specialised facilities such as healthcare, because there are fewer potential replacement tenants than for another type of property asset such as an office. Leases on all are for 10 years with the lessee having the option to renew for another 10. The first renewal date falls in 2017 and rents will increase by a fixed 2% per year during the course of the lease.

The Indonesia side of the asset base is much more important, since this is where First's sponsor is based. If you're not familiar with how reits operates, the sponsor is a major shareholder with a pipeline of assets to inject into the trust.

In First's case, the sponsor is Lippo Group, a major Indonesian conglomerate controlled by the Riady family that focuses on property development. Lippo is known for high-end "planned community" developments such as its flagship Lippo Village to the west of Jakarta, which incorporate retail, schools, healthcare and other facilities as well as housing.

First currently holds four Lippo-originated assets in Indonesia: a 188-bed hospital and 197-bed hotel in Lippo Village, a 192-bed hospital in Kebon Jeruk, also in Jakarta, and a 157-bed hospital in Surabaya, Indonesia's second largest city. These assets are leased to Lippo's Siloam Hospital division on a 15-year lease with a 15-year renewal option. The first renewal date is in 2021.

Rents on these are paid in Singapore dollars at a fixed rate eliminating SGD-rupiah exchange rate uncertainty and are determined by two formulas. First, there's a base component that increases each year by the rise in the Singapore consumer price index, with a floor of 0% and a cap of 2%. This base component amounted to around $24.1m at time of listing, and dominates the overall rental revenue at present (for comparison, total rents from Indonesia last year were $26.1m).

Second, the reit also receives a variable component based on growth in the hospital revenues: 0.75% of revenues for an increase between 5% and 15%, 1.25% of revenues for an increase between 15% and 30% and 2% of revenues for an increase over 30%. Overall revenues at Siloam Hospitals are growing at around 20% per year and based on present state of the Indonesian healthcare industry, I think this kind of pace is could be sustained for a long while.

Obviously, much depends on inflation and revenue growth, but overall I would expect First's revenue and distributions growth on the existing portfolio to average around 3% a year for the medium term, with this rising gradually as revenue sharing plays a larger part.

That's not spectacular, but it's a reasonable starting point to help keep ahead of inflation, and allied to an 8% starting yield, it starts to look very attractive. Further growth in payouts will depend on acquisitions at good prices so let's take a look at what's in the pipeline.

The emergence of a medical empire

Lippo intends to expand its healthcare operations substantially to meet the market for better medical facilities in Indonesia. So I met with Siloam management in the Lippo Village facility to get some idea of how it operates, what its plans are and how this will affect First.

Siloam is one of three major major healthcare players in Indonesia, owning seven hospitals at present and ground broken on the construction of two more. Australian group Ramsay Health Care has three and Mitra Keluarga lists nine. As noted above, long-term prospects for the industry seem good and the lack of tough competition suggests that early movers could build up a very strong position.

Apart from those properties already sold to First, Siloam's most significant asset is the new 210-bed Mochtar Riady Cancer Centre in central Jakarta, which is being completed at present. This is only the second cancer centre in Jakarta and the most specialised in the country: it should attract many of the patients who currently travel abroad for cancer treatment.

There is also a 120-bed hospital in the Lippo Cikarang township, east Jakarta, a small hospital in Jambi province that is being redeveloped, and another more recent acquisition at Balikpapan, also under redevelopment. More will be added in the years ahead: In total, Siloam plans to have 15 hospitals by end 2011 and 22 by end 2012, some of which will be new builds and some acquisitions.

Notable projects include a teaching hospital at Lippo Village, which will use the existing Lippo Hospitals facilities for treatment but offer much lower-end accommodation. This is part of Siloam's strategy of branching out from catering to wealthy Indonesians and expats and tap into a wider market. Management say that this follows a successful model of bringing down costs through high volume already used by Indian healthcare providers in a similar environment.

Siloam plans to circle Jakarta with hospitals to capture the widest market there, while also building a presence in other key cities. To deal with the shortage of top doctors in many disciplines, it will build the key facilities into centres of excellence on various disciplines for example the Lippo Village hospital will be neuroscience and cardiology for example and operate a hub and spoke' model, with other hospitals consulting these specialists and referring patients to them for treatment.

Another S$250m expansion in the pipeline

Not all of Siloam's new developments will necessarily be injected into First, but there is likely to be a steady stream of acquisitions in the years ahead, since a sale and leaseback deal on existing properties is Siloam's strategy for raising funds for new developments and expansion. The confirmed pipeline consists of the MRCC and Lippo Cikarang; management is negotiating on this at present and the sale is likely to be closed this quarter or early next year.

Details on the price of these assets aren't finalised, and management won't give guidance beyond confirming that it will be substantial relative to the existing asset base of S$340m and market cap of S$263m. But I've seen estimates that the value of these assets is likely to be somewhere in the region of S$250m.

Aside from Lippo properties in Indonesia, First can also acquire healthcare and medical assets elsewhere (and has done in a small way with the Singaporean assets). Management has looked at other deals, including two hospitals in China, but these haven't gone through.

This reflects the fact that First needs to be comfortable with the quality of the assets and the quality of the tenant, as well as getting the property at a price that is "yield accretive" ie it grows the yield that existing unitholders are receiving. For this reason, the majority of its future acquisitions are likely to be in Indonesia and from the Lippo pipeline, since there's a better alignment of interests to do good deals between reit and sponsor than with third parties.

Acquisitions will be funded through a mixture of equity and debt. Under Singapore's reit rules, a reit without a credit rating which includes First - can have maximum gearing of 35% (those with gearing are allowed to have up to 60%). First's current gearing is 16.5% and redevelopment costs for the Singapore cancer centre will raise this to 20%.

However, management aren't comfortable going as high as 35% and want a cushion, thus 25-30% is likely to be the upper limit. So First will be issuing new units to pay for most of the cost of its planned acquisitions. Investors should be aware of this and prepared to participate in future rights issues, assuming the terms are good enough.

A few risks to keep an eye on

As the sponsor, Lippo is the largest shareholder with a stake of just over 20%. The next largest shareholders are Penta Investment, which is a central European private equity fund, Raiffeisin Zentralbank Osterreich, an Austrian banking co-operative, and CIM Investment Management, a boutique value-based fund manager.

Although it looks as if the public float should be fairly large, in reality most of the shares are probably held by long-term investors and are not available. In practice, the free float is probably closer to around 20%. Average daily turnover in the past year has been 268,976 shares per day. The free float and liquidity should hopefully increase as a result of rights issues for acquisition, but even at these levels most Asia Investor readers should not have any trouble dealing in the shares.

Management-wise, First is managed by a small team of around 10. This includes experienced executives who have previous worked within Lippo's healthcare division and at Parkway, Singapore's largest healthcare company. To clarify, a reit's management is supposed to act in the interests of all shareholders, not just the sponsor. In reality, this depends on how professional the reit management are and how much influence other reit shareholders have. In this case, the signs are good but please see the risks section below.

In addition to the usual risks on Asia Investor recommendations, I'd stress the following specific ones for First:

The trust is heavily exposed to a single master lessee, Lippo's Siloam Hospitals for its Indonesia assets. While I think Lippo's healthcare prospects are good, if it were to hit trouble and struggle to meet its rental obligations, this would have a major impact on First. In addition, if Lippo were to decide not to renew its leases on expiry, First might struggle to find another suitable tenant (although given that these buildings are key to Lippo's healthcare plans, non-renewal seems unlikely).

First is also virtually a pure play on Indonesia and the growth of Indonesian healthcare. Obviously, this is one of the reasons I like it as an investment. But this means it could be vulnerable to economic or political problems there, or other factors that could disrupt the development of the industry such as terrorism or natural disasters. From a market point of view, the shares could be hit if the current positive sentiment on Indonesia reverses.

Lastly, First is obviously closed tied to Lippo and it has to be said that the words "Indonesian family conglomerate" and "honesty" do not always go together. And while Lippo has by no means the worst track record, if you look around you will find a few past controversies involving the Riadys. Personally, I would be disinclined to invest in one of Lippo's Indonesia-listed vehicles such as Lippo Karawaci or retailer Matahari.

However, First has a Singapore listing, a professional management team and directors, a clean structure, a majority of outside shareholders and seems to be important for funding Lippo's healthcare plans. All this argues against it being sold poor quality or overvalued assets. So I would expect everything to remain above board and I'm not greatly worried about this risk.

Earn 8.4% next year on prime property

With reits, the key number is the distribution per unit (DPU) ie the dividend which is based on the revenue it receives from property rental less property costs, administrative overheads and manager and trustee overheads. Earnings per share are often less meaningful, since they frequently included paper gains or losses on revaluing the property portfolio, which obvious does not represent cash available for distribution to unitholders.

Recent numbers and my estimates for First are shown in the table below. Because details of any deal are uncertain, the estimates do not factor in the likely acquisition of the MRCC and Lippo Cikarang, although I'll make an adjustment for this later on in the valuation.

The main valuation metrics for a reit are price/book value and distribution yield. Other than in a takeover situation, I would tend to regard price/book as not especially useful. For reference, First's price/book ratio is currently 0.98.

The distribution yield for the trailing twelve months is currently 8%. My estimates for 2011 suggest a yield of around 8.4% next year.

That's fairly attractive in this low-rate environment and I suspect that many investors are going to be assessing this investment on its yield alone. But it also holds out the potential for a respectable capital gain.

Valuations on Singaporean reits have risen markedly since the global crisis as one of the smallest reits, First Reit was trading at around a 20% yield at the height of the crisis. We're not going to get a yield squeeze as big as that again, but I think there's still room for some further rerating. First should benefit from investors' hunt for income, a higher profile and larger size following the likely acquisition and rights issue, and continuing investor enthusiasm for the Indonesia story.

Singapore's other healthcare reit, Parkway Reit, trades on a yield of around 5%. It's larger, better known and owns major properties in Singapore, so a premium to First is not surprising. But it seems likely that First will close the gap somewhat I think it could trade on a yield as low as 7% or so in a year.

Finally, there's also the likelihood of the yield getting quite a decent boost from the probable MRCC and Lippo Cikarang acquisition at a favourable valuation. Obviously, all this depends on factors like the price of the assets, the yield they offer, how much debt and equity are involved in the purchase and so on. But assuming a S$250m purchase price and a 9% net yield on the properties, I reckon that with the acquisition factored in and a rerating to around a 7% yield, First could be worth up to S$1.20 in a year's time.

With Asia Investor recommendations, I usually set a minimum hurdle of a potential 15% annualised capital gain. Based on this, I'm setting an initial buy limit for First of $1.04.

I should stress one final thing with regard to an investment like this. As mentioned, First will have to raise capital for acquisitions, which looks likely to be through a rights issue. Rights issues will almost invariably be carried out at a large discount to the prevailing price.

As and when any rights issues are carried out, I will recommend what course of action to take in Asia Investor. But as a general principle, you should be prepared to subscribe for these rights when the time arrives in order to avoid your investment being diluted.

Recommendation

Buy: First Real Estate Investment Trust

Ticker: FIRT (Bloomberg), FRET (Reuters), AW9U (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$26 3m

Bid/mid/offer prices: $0.95/S$0.95 0/S$0.955

Buy limit: S$1.04

52-week low/high: S$0.7/S$0.97

First Reit is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

Yearly performance (since listed): 2006 +7.04%; 2007 +1.32%; 2008 -47.4%;

2009 +101.23%; 2010 +14.46% (to date)

Sources used in preparing this report:

Meeting with Victor Tan, CFO, First Reit, 15/10/10

Meeting with Ho Sun Yee, Director and Giri Subramaniam, Director of Strategic Planning, Siloam Hospitals Group, 13/10/10

First Reit annual reports 2007-2009

First Reit Q3 2010 results

First Reit Q3 2010 results presentation

First Reit IPO prospectus December 2006

First Reit press release 20/09/10

First Reit website

CIMB research report on First Reit dated 18/01/10

CIMB research report on First Reit dated 25/10/10

CLSA research report on Lippo Karawaci dated 20/10/10

OSK DMG research report on First Reit dated 24/05/10

Siloam Hospitals press release 12/05/2007

World Health Organisation Statistics 2010

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

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