Rising Surgical Volumes And Cost Pressures Will Eventually Erode Margin Expansion Potential

Catalysts

About Rede D'Or São Luiz

Rede D'Or São Luiz operates a large private hospital and oncology network in Brazil, integrating hospitals, oncology centers and health insurance through SulAmérica.

What are the underlying business or industry changes driving this perspective?

• Accelerating surgical and oncology volumes may be approaching a cyclical peak. Any slowdown in complex procedures or internal medical tourism would quickly dilute operating leverage and pressure revenue growth and EBITDA expansion.
• Ongoing systems homogenization and post M&A integration, if delayed or more complex than anticipated, could lock in higher overhead and transition costs for longer than planned and weigh on net margins despite current efficiency gains.
• Rapid greenfield and brownfield bed expansion, combined with rising clinical complexity and expensive oncology drugs, risks structurally higher unit costs that outpace pricing power and may compress hospital segment margins and earnings.
• Dependence on SulAmérica’s gradual portfolio clean up, co participation and post payment migration means any reversal in risk selection or more aggressive competition in health plans could erode loss ratio gains and limit consolidated net income growth.
• Sector wide pressure on smaller hospitals and persistent macro challenges may slow further consolidation or force Rede D'Or into lower return acquisitions and JV structures, tying up capital at weaker returns and limiting free cash flow available for shareholders.

Assumptions

This narrative explores a more pessimistic perspective on Rede D'Or São Luiz compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Rede D'Or São Luiz's revenue will grow by 11.2% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 8.2% today to 10.3% in 3 years time.
• The bearish analysts expect earnings to reach R$7.6 billion (and earnings per share of R$3.44) by about December 2028, up from R$4.4 billion today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as R$9.1 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 17.2x on those 2028 earnings, down from 22.0x today. This future PE is greater than the current PE for the BR Healthcare industry at 16.7x.
• The bearish analysts expect the number of shares outstanding to decline by 0.6% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 18.16%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Hospital and oncology demand is growing strongly, with third quarter revenue up 10.6% year-on-year, oncology revenue up 28.1% and surgical volumes rising over 21%. If sustained as a secular trend of aging population and higher medical complexity, this could continue to lift revenue and EBITDA rather than support a share price decline, improving earnings over time.
• Structural efficiency gains from systems homogenization, automation and standardized procurement of materials and medications are still in early stages. Management repeatedly highlights a long runway for productivity improvements, which could structurally lower unit costs and expand net margins and earnings.
• Rede D'Or and SulAmérica are leveraging portfolio clean up, co participation, migration from pre to post payment and fraud control to steadily improve the consolidated loss ratio. This suggests a durable trend toward more profitable underwriting that could support higher consolidated net income and justify a stronger valuation multiple.
• The company has significant operational leverage, with around 60% of hospital costs fixed and substantial ramp up potential in new beds and JV assets. Sustained volume growth at high occupancy could translate into outsized margin expansion and faster earnings growth than currently assumed.
• A solid balance sheet with net debt over EBITDA at 1.54 times and strong cash generation of BRL 6 billion in operational cash flow over nine months provide ample capacity for continued organic expansion, selective M&A or higher dividends. Any of these could enhance shareholder returns and underpin the share price through higher revenue and earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Rede D'Or São Luiz is R$36.7, which represents up to two standard deviations below the consensus price target of R$49.48. This valuation is based on what can be assumed as the expectations of Rede D'Or São Luiz's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of R$60.0, and the most bearish reporting a price target of just R$36.7.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be R$74.5 billion, earnings will come to R$7.6 billion, and it would be trading on a PE ratio of 17.2x, assuming you use a discount rate of 18.2%.
  
• Given the current share price of R$44.27, the analyst price target of R$36.7 is 20.6% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.