NMC Health: Should you consider catching this falling knife?

by Edmond Jackson from interactive investor |

The slump in these volatile and high-risk shares looks increasingly like market psychosis rather than underlying trouble.

Down to 780p in early trading today, shares in Middle East hospitals operator NMC Health (LSE:NMC) have plunged over 65% since the Muddy Waters hedge fund published an assault on its asset values last December. In 2018, they were worth around £40. 

By the time you read this, the shares could be 600p, 1000p, who knows where NMC, the jack-rabbit stock, might twitch next with electrifying volatility. This, for a healthcare group in a wealthy part of the world, the kind of situation you would think should have resilience, dependable financials and hence a decent rating.

Source: TradingView Past performance is not a guide to future performance

Key development in founder taking back control

The financial commentariat has a rush of adages, about how you should avoid stocks targeted by short-sellers, especially those operated overseas but listed in London and showing complex accounts. A bout of negative sentiment has festered into collective neurosis and now psychosis.

Meanwhile, Bavaguthu Shetty, NMC’s Indian-born founder who still owns 15% of the equity, appears reliably reported as limbering up to take back control (having stepped down as CEO in 2017), which counters the sense of a business based on financial quicksand, liable to fold at anytime.

He ought to know whether NMC’s foundations are reliant or dodgy, and my sense, having followed situations quite like this, is that a founder CEO would keep his head down if trouble is in the offing. A founder seeking to take back control doesn’t guarantee the business does not have any issues, but is it really odds-on that a 77 year-old (here) wants to open a can of worms?  

It would appear his advisers have placed on at least one respected media platform, the story about how he is conducting an operational review ahead of formal talks to explore options with shareholders and regulators. 

So, despite high debts that mean a market cap of around £2 billion more than doubles to a £4 billion enterprise value, a hefty $1.6 billion (£1.2 billion) balance sheet intangibles, and after my last review of the shares suggesting “Avoid” at 1,370p on 20 December, my interest is now piqued by the sell-off. Could the stock be oversold?

Bank margin calls on director debt is the catalyst

The latest de-rating from around 1,400p in early January was caused by a 1,200p placing worth £375 million - 15% of NMC’s issued equity – as a result of Deutsche Bank and Credit Suisse calling in loans on two Emirati investors/directors of NMC - Saeed al-Qebaisi and his relative Khalifa al-Muhairi.

Another 1% was sold at 1,250p on 23 January and it appears the founder’s objective is to find fresh investors to replace these unstable shareholdings. It would appear the bank’s motivation was based on a straightforward reading of NMC’s fallen market value, by way of these men’s net worth hence financial risk, rather than examples where banks pull facilities on a company because it is judged inherently weak.

The story around B Shetty is his looking to buy out existing Emirati investors under creditor pressure and bring in new investors. Eliminating such an overhang would indeed be a positive development. 

Source: TradingView Past performance is not a guide to future performance

Elsewhere in “market technical” news, as opposed to company fundamentals, fund manager Capital Group raised its exposure from 11.5% over 12% in late January and disclosed that short selling (i.e. over 5% of the issued share capital) has reduced below 2.3% from 6.0% last August. The only two (disclosed) hedge funds involved bought back stock to trim their shorts on 31 January and 4 February respectively. At least there is no writing on the wall by way of market professionals’ action, to suggest NMC’s risk/reward profile is worsening. If anything, the implication is upside.

NMC Health - financial summary            
year ended 31 Dec 2013 2014 2015 2016 2017 2018
             
Turnover ($ millions) 551 645 881 1,221 1,603 2,057
Operating margin (%) 15.1 13.7 12.6 15.1 17.1 18.7
Reported earnings/share ($) 0.37 0.41 0.44 0.71 0.90 1.19
Normalised earnings/share ($) 0.37 0.41 0.46 0.75 0.96 1.21
Earnings per share growth (%) 7.4 12.3 10.5 64.1 28.0 25.8
Price/earnings multiple (x)           10.5
Operating cash flow/share ($) 0.46 0.46 0.45 0.94 1.35 1.85
Capex/share ($) 0.42 0.60 0.43 0.32 0.32 0.79
Free cash flow/share ($) 0.04 -0.14 0.02 0.62 1.03 1.06
Dividends/share ($) 0.04 0.05 0.06 0.11 0.18 0.18
Yield (%)           1.44
Covered by earnings (x) 8.34 7.63 7.12 6.67 6.95 6.56
Net asset value/share ($) 2.08 2.42 2.63 4.44 5.33 6.26
             
Source: historic Company REFS and company accounts            

NMC continues to rebuff any sense of wrongdoing

Last Tuesday, NMC announced that, in response to Monday’s further drop from around 1,300p to near 1,000p, “it knows of no specific reason” and full-year 2019 results are due in line with management’s expectations.

If market guidance reflects those expectations, consensus is for a 27% rise in net profit to $312 million net profit for normalised earnings per share (EPS) up 24% to 150 cents and the dividend to 28 cents.

The market rating for NMC shares implies a current sterling-based price/earnings (PE) ratio of around 7.7x, although the yield is barely supportive at around 2.5%. The stock clearly says investors are now dubious of NMC’s earnings presentation, hardly backed by yield (although with a professed operating margin over 18% and a 21% return on equity, investment should be rewarded).

A dilemma for all analysts is our being substantially reliant on company accounts to derive targets; all we can do is caution where aspects give unease, but ultimately if the accounts are flimsy then so are forecasts. 

Guidance is similarly for around 26% earnings growth in 2020 and dividend growth of 20%, which does superficially feel rather too good to be true for a multi-billion company, whether dollars or sterling. Investor thinking would typically be divided, reasoning either that the stock now (over) discounts even a financial clean sweep, or much sense of a rose-tinted view means it should be given a wide berth. Hence, the stock’s jack-rabbit behaviour, I concede chart-wise remains in downward trend. 

Outcome of an “independent” review seems predictable

From my own experience, having done an episode of sponsored research well over a decade ago, I would say only the toughest terrier of an analyst stands a chance of getting criticism of management signed off for publication, and being paid for this.

Forecasts, in particular, are amended by finance directors. Period. The trouble for client companies is that this leaves a sense of scepticism in the market, anywhere there’s a commercial link to published “judgment”. So, excuse my cynicism, but I expect the paid-for investigation underway by Louis Freeh, a former US federal judge and FBI director, into the Muddy Waters critique, to broadly exonerate management.

I concede prejudice and I draw your attention to NMC’s “independent” review committee declaring on 17 January that it had hired Freeh Group on a basis to provide “a completely independent, unbiased, comprehensive and transparent report that will address all of these allegations”.

Pragmatically, I also believe that if this report comes across well – as it should - it should also improve stock sentiment. Frankly, at present, it could rise simply by easing market psychosis to measured neurosis.

Speculative but potentially interesting to average into

A chartist would most definitely say the line of least resistance here is downward; you should sit well back and avoid knife catching. Respect to that, pragmatically, but from a fundamentals’ perspective I can see potential catalysts now, where the founder’s action and the Freeh report, are interpreted net-positively in due course.  

I continue with concerns about the accounts, where Freeh needs to clear the air. NMC is effectively a binary call between a debt-ridden accounting black hole and a roaring “buy”.  It’s impossible to assert conviction but, on this week’s developments, I suggest that at around 780p the stock now deserves setting in the frame to Buy
 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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