Prognosis Negative for RKA’s Purchase of Ailing German Hospital HSK

Prognosis Negative for RKA’s Purchase of Ailing German Hospital HSK

On 10 February, German private hospital operator Rhoen Klinik AG (RKA, Baa2 stable) said it received approval from the city of Wiesbaden, Germany, to acquire a 49% stake in public hospital Dr. Horst-Schmidt-Kliniken Gmbh (HSK, unrated). This transaction, if completed, is credit negative for RKA as it is yet another example of its long-term strategy of acquiring loss-making operators.

We expect the transaction, which now awaits a possible referendum vote in Wiesbaden (there will first be a vote to decide whether to hold a referendum), to cost €250-€300 million, or 0.7x-0.9x of RKA’s reported 2011 EBITDA, including upfront costs and capital expenditure (capex) commitments. RKA will get full operational and economic control, with the city of Wiesbaden having veto rights on strategic issues. It marks RKA’s first large deal since raising €440 million of equity capital in 2009 for acquisitions.

The terms have not been disclosed, but depending on the split of the transaction value between an upfront payment, assumption of liabilities and capex commitments, we expect the acquisition will reduce RKA’s strong liquidity buffer of €370 million and increase its debt. In addition, the transaction would put its operating margins and cash flow generation under pressure during the next 18-24 months, reflecting HSK’s loss-making operations and the time needed to restructure, thereby leading to a moderate contraction of RKA’s credit and operational metrics. The company expects a 0.6 percentage point decline in its forecast 2012 EBITDA margin to 12.2% (its EBITDA margin has averaged 12.3% during the past five years) and that net income will fall around 10%, or €16 million, for 2012.

Given HSK’s losses, upfront cash compensation is likely to be moderate and a substantial portion of the overall transaction value will be related to the assumption of liabilities and to capex commitments that are spread over several years for investments in new facilities and refurbishing and modernizing equipment. RKA’s capex consistently averages 2.5x-3.0x depreciation, reflecting this acquisition strategy. We expect the negative impact will be spread over time, allowing RKA to maintain a net debt/EBITDA ratio of less than 2.5x, versus 1.8x for the 12 months to 30 September 2011, and a retained cash flow/net debt of above 30%, versus 40% currently. Those figures are within the appropriate range for a Baa2 rating, but if RKA makes additional acquisitions of a similar size over next 12 to 18 months, it would consume that rating headroom.

Given its long track record of restructuring loss-making operations and HSK’s proximity to several of RKA’s other hospitals in the region, the transaction is fully in line with RKA’s strategy and does not present particularly high integration risks.