Primary Health Properties — Update 27 February 2017

PHP’s FY16 results were closely in line with our forecasts on an EPRA basis, with EPRA earnings per share of 4.8p and EPRA NAV growing to £545m, or 91.1p per share. Significantly, this was the first full year since the financial crisis in which the dividend was 100% covered from cash earnings, a particularly strong performance given the increase in the number of shares following the £150m equity raise in April at £1 per share. The EPRA cost ratio remained the lowest in the sector at 11.5% (FY15: 11.5%) and we expect it to fall further as gross asset growth incurs incrementally lower advisory fees. As mentioned in our last note, PHP made its first investment in Ireland in 2016, where property yields are higher than in the UK, the costs of debt are slightly lower and lease length and tenant covenant are of a similarly high quality. The proceeds of the share issue were used both to acquire new assets and to pay down some of the company’s revolving credit facilities (some of which have been cancelled to reduce non-utilisation fees), and the premium to NAV at which funds were raised offset the cost of renegotiating the swap contracts. We have modified our FY17 estimates slightly to take the results into account, and added forecasts for FY18. We provide a summary of the results below before discussing the estimate changes in more detail in the following section.

The demographic trends of growing and ageing populations in the UK and Ireland will continue to increase the burden on national healthcare infrastructure and there is widespread political will to reform healthcare services in both countries. In both cases, this includes moving more care provision into a primary setting.

In Ireland, the Department of Health (DoH) has taken a direct approach and plans to build c 100 primary care centres (PCC), which will house state-provided primary care services as well as GPs. The Health Service Executive (HSE; equivalent to the NHS) will be the tenant of 60-75% of the space in these, with the rest let to GPs, pharmacies and other private tenants. This plan is well underway, as evidenced by PHP’s investment in a PCC in Tipperary, where the HSE pays 75% of the rent and two GP practices and a pharmacy the rest. The GP practices are reportedly taking on five to 10 new patients a week who had previously used other GPs in the area, attracted in part by the convenience of having other services co-located with their GP. This is an encouraging sign both that the care model proposed by the DoH is working and that PHP’s tenants are likely to perform well. The lessons learnt from the process of developing the Tipperary PCC will help to accelerate the investment pipeline in Ireland, which comprises €53m of opportunities.

There are also encouraging signs in the UK: The General Practice Forward View (GPFV) published in April set out a five-year plan and targets for GP services including additional funding for GP services of £2.4bn a year. Another initiative to improve primary care infrastructure also started to bear fruit in 2016: The Estates and Technology Transformation Fund (ETTF) was established in 2015 to accelerate the development of primary care infrastructure. Initially this slowed down the rate of approvals for new primary care projects because it meant that many project sponsors applied to the fund for support, adding another layer of bureaucracy to the process. The first funding awards from the ETTF were made in late 2016, supporting 600 projects, over a third of which are new primary care facilities. Management notes the impact of the ETTF on enabling schemes, although provision of government funding does reduce the potential size of the company’s investment in a scheme. PHP has supported 23 applications by tenants for support from the ETTF. Eight have been approved so far, to which PHP has committed £5.3m, which will generate £325k of additional rent (6.2% yield) and will extend leases on the premises by an average of 13 years. A further 10 applications are at different stages of NHS or other approvals processes, for projects in which PHP will invest £4.6m, adding £222k of rent and more importantly an average of 11 years to lease duration at the relevant premises.

Strategic Transformation Plans (STPs) have also been published for English NHS districts. These set out plans for infrastructure improvement and add support to expectations that the primary care estate will be modernised and expanded to meet the rising demands placed on it. PHP has an existing pipeline of £72m of acquisitions in the UK.

An increase in the rate of primary care project approvals has been anticipated since the announcement of healthcare reforms in 2014, and now appears to be beginning. Apart from allowing a higher rate of investment, which PHP is well-placed to take advantage of, the construction of more modern primary care facilities should also lead to rental growth. The policy of NHS pre-approval of rent agreements prior to construction means there is no speculative development in the sector; any new supply of accommodation is matched to demand and should not weigh on rents. On the contrary, new premises have higher build costs and better facilities and command higher rents as a result. District valuers use them for comparison in rent reviews of existing stock, which should lead to higher rents on those premises than would otherwise be the case. Management does not expect there to be a sudden effect on increases in rent on review, but does foresee an improvement on the 0.9% seen in FY15 and FY16.

The FY16 results were in line with our forecasts, and we have not made any major changes to our FY17 estimates. The new FY18 forecasts continue the current trends of rising profits underpinning a growing dividend, which is 105% covered by cash in FY18 on our estimates. The amount invested in H216 was less than we had assumed in our model, although we note that management expects to be able to announce acquisitions in the UK and Ireland in the near term. That delay in investment means we have reduced our forecasts for FY17 slightly, but this has not affected our dividend forecast, nor our expectation that the dividend will continue to be fully covered in FY17 and FY18. Exhibit 1 shows the changes to our estimates and our newly introduced FY18 forecasts.

We have assumed that PHP will invest £95m in 2017 and £110m in 2018 at a yield of 5% in the UK and 7% in Ireland. We do not assume any valuation yield change but do forecast annualised rent growth of 1%, which we consider to be conservative given that 6% of rents have fixed increases of 2.65% on average and 20% of rents are index-linked (averaging 1.6% in FY16).

Our main assumptions relate to rent increases and the yields at which funds can be invested. These tend to be relatively steady, although we note that acceleration in NHS development could help increase rent growth as described above. The timing of investment is less certain, but we believe our assumptions are reasonable and conservative. Should PHP be able to deploy funds faster, earnings and dividend cover would rise faster too. A further tightening of valuation yields would also affect our estimates, raising NAV per share (but not affecting EPRA earnings).

For the purpose of our model, we have assumed that holders of convertible bonds will not choose to convert during the forecast period (to the end of FY18). The five year £82.5m bond was issued in May 2014 and pays a 4.25% coupon. The conversion price is 97.5p (adjusted for the one to four share split in November 2015) and the option to convert is in the money. From 20 May 2017 onwards, the bonds may be redeemed at par at the company’s option as long as their parity value exceeds £130,000. At year-end the bond had a fair value of £95.0m. If the whole bond were converted and PHP chose to settle the conversion rights wholly in shares, it would issue c 80m new shares, or 13% of the existing share capital. The fair value change recorded in the income statement would not affect EPRA earnings, and the saving on debt costs would help offset the increase in dividend costs, meaning that on our forecasts the dividend would remain fully covered in FY17 and FY18.

Our forecast FY17 dividend of 5.25p represents a 4.9% yield on the current share price, and is fully covered by cash earnings, 90% of which are backed by the UK or Irish governments. This compares to a 1.23% yield on 10-year gilts, 4.2% on the FTSE 100 and 3.7% on the FTSE EPRA NAREIT Index. Because healthcare property is less economically sensitive than other commercial sectors, has effectively full occupancy and no speculative development, its returns are expected to be less volatile. This has made the dividends attractive at a time of economic uncertainty and low returns on other investments, which has contributed to the shares’ c 18% premium to NAV, in line with other stocks with similarly secure dividends and long-term income streams.