MedicX Fund — Update 17 February 2016

MedicX Fund has recently issued a quarterly update for the three months ending 31 December 2015, following FY15 results for the year to September 2015 released in December. The FY15 results showed a strong increase in profits on both a reported and an underlying basis, excluding valuation gains, with asset additions supporting revenue growth well in excess of cost increases. A further reduction in the management fee structure took effect from the beginning of FY16. The Fund has continued to add assets despite competition for high-yielding primary care assets driving continued growth in property values. As expected, dividend cover is showing improvement and has been given greater emphasis, with the Fund signalling that dividends will continue to grow, albeit at a reduced rate. The Fund sees good prospects for growth in Ireland, where yield differentials are materially ahead of those that can be earned in the UK. The Fund made its first acquisition in Ireland in June 2015 by way of forward funding for a new primary healthcare facility at an estimated total cost of €10.1m. A second forward funding agreement of c €8.0m was announced in December 2015.

During FY15 the Fund added six properties (total committed investment £27.4m at a cash yield of 5.87%) and in FY16 year to date (commencing 1 October 2015) it has added a further seven properties (total committed investment £23.4m). At the end of FY15 the total committed investment portfolio stood at £559.5m, with the total completed and income-producing portfolio valued at £544.5m. The average unexpired lease term on the properties of 15.8 years at 30 September 2015 provides security over future cash flows, while the average age of 7.2 years and average value of £4.0m provides support that the portfolio as a whole is focused on larger, more modern properties, which should be able to meet the NHS’s changing needs and create longer-term value. The UK market remains competitive, with a restricted supply of properties ahead of the anticipated upturn in new NHS development approvals and investment yields compressing. The Investment Adviser reports that it continues to be selective, targeting best-in-class assets that have the potential to generate returns over the longer term and not just an immediate yield. The entry into the Irish market came after a period of extensive research. Ireland has similar demographic trends to the UK in several respects: the population is expected to continue to grow while living longer and living with medical conditions requiring treatment for longer. To prepare for the future needs of the population (and as part of a post-financial crisis stimulus package), the Irish government has embarked on a major restructuring of the health system. One of the main objectives has been to establish a single-tier system where primary care will become freely and universally available. As part of this process, the Department of Health strategy seeks to deliver a number of new primary care centres (PCCs); nine were delivered in 2015 and 28 are planned for 2016 and the first half of 2017. At the time that the targets were published at the end of 2014, there were around 30 PCCs under construction with a further 50 planned. The planned facilities are relatively large (1,500-5,000sqm) and host care and affiliated providers. At the FY15 year end MedicX Fund reported a €50m pipeline of potential investments and has since announced the €8.0m forward funding of a primary care centre on the outskirts of Dublin.

Unlike the UK, Irish GP rents and rates are not reimbursed by the government. This has inhibited private investment in healthcare facilities. The new strategy put the Health Service Executive (HSE, the Irish equivalent of the NHS) in the position of anchor tenant in the planned new facilities, accounting for 60-75% of the tenanted space on 25-year leases. The HSE will provide a range of services including community and public health nursing teams, home helps, mental health services, social workers, dental care and other services such as speech therapy. The remaining space will be tenanted by GPs and pharmacies or other private tenants.

In the UK, the Fund receives around 90% of its rental income directly or indirectly from the government and nearly all of the rest from co-located pharmacy operations. While the tenant covenant in Ireland will not be as strong as in the UK, the above tenant mix should provide a good-quality income stream. We understand that investment yields, adjusted for funding costs are 150-200bp higher than in the UK currently. We see the main differences as 1) HSE rents are subject to five-year rent reviews, but may in theory go down as well as up (the UK is effectively upwards only); and 2) unlike the UK, with effectively full occupancy, there may be more variability in non-HSE occupancy. We do not feel that foreign exchange movements between sterling and the euro pose a material threat as it should be possible to mitigate much of the risk by matching euro assets with euro borrowings.

The two investments that have been made to date are both forward funding agreements for properties that are expected to be completed in September and December 2016 respectively. In both cases the lead tenant is the HSE. In Westmeath the other tenants are GPs and a pharmacy, whereas the Crumlin primary care centre, where the HSE has taken 60% of the building, has a longer tenant list including two GPs, a dentist, an optician and a pharmacist.

The Investment Adviser has indicated that Irish assets will not exceed 15% of the total portfolio. This seems like a realistic ambition given that the market is much smaller than the UK. Having conducted a cost benefit study, the Fund has concluded that the most efficient structure to hold the Irish assets is as a non-resident landlord, until they total roughly £50m in value. This may change in future if the cost of a different structure is outweighed by the tax saving; other options are under review.

For the core and much larger UK market, we believe the medium- to long-term growth outlook remains strong in a market driven by an ageing population with growing healthcare needs, an underinvested primary healthcare estate and a general acceptance of the need for more integrated primary care services in the community.

The NHS Five-Year Forward View has adopted the main recommendations of Simon Stevens’ review and this has been endorsed by government. An additional £10bn pa in funding for the NHS has been committed and £6bn of this has been brought forward to 2017-18. In addition to increased funding, the NHS will need to deliver significant operational efficiencies, estimated at £22bn pa and, as part of the plan for achieving this, the NHS plans significant changes to the way it operates. Additional and more integrated services are to be delivered by the primary care sector, in the community, with extended opening hours to improve access. The anticipated changes in healthcare delivery require modern, purpose-built, flexible premises (of the type in which MedicX invests), in contrast to a significant proportion of the existing estate, which is comprised of ageing, converted, residential properties.

Clinical commissioning groups (CCGs) are putting in place their strategies for their primary care estates, aimed at ensuring that the healthcare infrastructure is fit for purpose and able to support changing healthcare needs. As these are completed in the coming months, it is anticipated that the pace of commissioning of required new developments will finally start to increase.

Currently, 50% of primary care premises are more than 30 years old and many of these are converted residential premises (source: Savills/EC Harris). In a recent survey by the BMA, 70% of GPs stated that their premises are too small to be able to deliver enhanced and additional services, 52% stated that their premises had seen no investment or refurbishment in the past 10 years and the majority said that their premises are too small to be able to deliver training and education.

Even allowing for ongoing consolidation of smaller GP practices into larger groups, the implied future demand for investment in modern, purpose-built premises is very significant. However, if the NHS commitment is restricted to rent reimbursement, this would be a much more manageable
5-6% of the capital investment required.

Demand for attractive primary healthcare properties has remained strong, which is continuing to compress yields. While revaluations have helped increase NAV, yield compression continues to make it more expensive to acquire assets and new income streams in the UK. Much of the competition comes from institutional investors seeking larger assets and portfolios, which some market participants indicate are being bought at yields below 5%. For that reason, MedicX is focusing on single assets and forward funding developments.

Funding conditions have continued to be favourable and the Fund has a policy of using long-term, fixed debt to fund acquisitions. A new £50m loan note was agreed in H115 with a term of 13 years and five months at a fixed rate of 3.838%, and an existing £50m loan note was extended by nine years and three months to 2028, locking in a healthy spread between income and funding costs.

In FY15, EPRA NAV total return (the increase in NAV plus dividends) was 17.2%, although total shareholder return (dividends plus share price movement) was -0.4%, affected by share price weakness towards the end of the period. The share price weakness has reversed, with a total shareholder return of 12.2% since 30 September 2015. The primary care sector enjoys high income visibility and security, with effectively full occupancy, long leases and the UK government as the effective tenant of 90% of properties (in Ireland government income will be 60-75%). Income forms a higher proportion of returns than for the commercial sector in general and both income and capital returns are less volatile in primary healthcare than other sectors. The Fund’s costs are relatively certain because it uses an external manger and does not have the risks associated with being an operator or developer of property. The rising dividend, supported by the security of income, even though not fully covered by EPRA earnings, forms a substantial part of the total return and there is a scrip dividend alternative for shareholders who do not wish to take their returns in cash.

The dividend yield is a key attraction of the stock and we expect MXF’s dividend for FY16 to be 5.95p per share, a prospective yield of c 7.0%.

Progress towards full dividend cover continues: FY15 saw cover increase to 63.3% from 53.6% in FY14. We estimate further modest progress in FY16 (to 64.7%) and 68.6% in FY17.

Underlying EPRA earnings in FY15 gave a return of 5.5% on average NAV, ahead of the 5.3% earned in FY14. In 2016 we expect a similar level. This measure excludes valuation movements from earnings, but revaluation does increase the asset base to which they are compared.

EPRA NAV per share, which is adjusted to exclude the impact of deferred tax not expected to crystallise, was 71.2p per share at the end of Q116 (31 December 2015), up from 70.8p at the year end and 65.4p at the end of FY14. At a price of 84.75p, this puts the shares on a P/NAV of 1.19x.

Our forecasts do not assume any further valuation yield compression beyond the 5.4% (FY15 5.46%) reported for Q116, however, this is entirely possible. The Investment Adviser estimated in December that if valuation yields were to decline by 50bps the year-end EPRA NAV would have increased by 15p per share, or 21%, to 85.8p. We would anticipate a similar result to apply to the current portfolio.

The Investment Adviser undertakes a periodic DCF valuation of the portfolio (see the Investment Adviser’s report in the Annual Report for full details of the methodology). The discounted cash flows assume a long term average 2.5% per year increase in individual property rents at their respective review dates. Residual values continue to be based on capital growth at 1% a year from the current valuation until the expiry of leases (when the properties are notionally sold), and assuming the current level of borrowing facilities. The DCF uses a discount rate of 7% for completed occupied properties and 8% for those under construction. The Q116 weighted average was 7.05%.

At the end of Q116 (31 December 2015), the DCF valuation was £352.9m or 95.3p per share.

The long-term rent growth assumption in the DCF is above the current average level of increases being achieved, although these are expected to increase as new development activity picks up. However, with the FY15 results it was stated that for the year-end DCF value per share of 94.9p to equate to the share price (84.5p at 4 December 2015), the calculation would have to assume a 0.6% pa increase in rents, or a weighted average discount rate of 8.2%.

The strong 2015 results reported in December were in line with our forecasts, the only exception being higher reported net valuation gains than we had allowed for. Our practice is to anticipate only the revaluation gains that are likely to arise from rental growth, with no assumption for changes in valuation yields. The continued H2 compression in yields lifted full year 2015 net gains to £25.6m compared with our forecast £20.5m. We have included the £2.5m net gain reported for the first quarter of the current year in our revised estimates, but beyond Q1 and through 2017 the forecast gains are based on assumed average rent growth of 1% in 2016 and 1.5% in 2017.

For FY16 we reduced our expectation for rental income/revenue, but this is offset by financing and cost savings. We have reduced our forecast for new commitments from £80m to £60m with a higher proportion of development properties that will only contribute to rental income when completed. The revenue deferred during FY16 by this mix effect should be made up in FY17 as the development properties complete, and for 2017 we have allowed for £75m of new acquisitions and commitments. As discussed above, the Fund entered the current year with a strong acquisition pipeline and has announced £23.4m of acquisition in FY16 year to date. Our estimates imply that the pace of acquisitions will slow during FY16 and we will monitor the developments to see if this is in fact the case. We are conscious that it will take time for the supply of UK opportunities to increase and our 2016 forecast is already based on an assumed £30m of Irish investment. Including an assumed £20m of Irish investment in 2017 would take the Irish portfolio to around 8% of the forecast total, still well below the indicated higher limit of 15%. We have assumed c 200bp of additional yield spread after financing on Irish investments versus those in the UK.

Our forecasts show dividend cover continuing to increase, to 64.7% in FY16 (previously 64.4%) and 68.6% in FY17.

Our balance sheet projections assume that portfolio growth is funded by additional debt, taking forecast net debt to £342.4m by the end of FY16 at an assumed similar average cost to the existing debt. This would take the ratio of net debt to portfolio value to 55.3% in FY16, well below management’s preference for an upper limit of 65%. Our forecasts do not include additional sales of treasury stock, although these are likely. We estimate that there are around 17m treasury shares remaining in excess of likely scrip dividend requirements through to the end of 2017. At the current share price, these could raise an additional c £15m in cash for investment.