The healthcare sector had always been considered to be a defensive play along with infrastructure and utilities. An individual’s health seldom seemed to be discretionary, but over the past few years, post-global financial crisis, there has been a shift in thinking with some people deferring health care due to financial constraints.
Presidential elections in the United States, increasing budgetary constraints on governments around the world and the European debt crisis are among factors expected to weigh on Australian health stocks.
While a doubling in the proportion of Australians older than 65 is set to underpin earnings for healthcare companies in the longer term, investors and analysts are more concerned about today’s global economic and regulatory uncertainty. A collective global belt-tightening by governments under pressure is expected to weigh on the healthcare sector, with Australia among countries looking to cut spending in this area, in part by means testing the 30 per cent private health insurance rebate. This is due to come into effect on July 1.
The government also recently installed price cuts to drugs on the pharmaceutical benefits scheme to gain $1.9 billion in savings.
The healthcare sector has slightly underperformed over the past 12 months but there has been a bit of a renaissance in the stocks after the February reporting season.
The ASX S&P 200 Index is down 11.8 per cent over the past 12 months, while the ASX Healthcare 200 Index declined about 3 per cent over the same period, boosted by a strong performance in February.
Stripping that month out, the ASX Healthcare 200 Index was down 13.6?per cent. “The sector is recession-proof in terms of demand still being there with baby boomers turning 65 years old, but the government is looking at the extra volume and wanting to sharpen its pencil,” says UBS health-care analyst Andrew Goodsall.
“I think we are a sovereign risk here. On the domestic front we have had policy changes which have impacted confidence. Names like Sonic, Primary and Ramsay have been impacted because of policy changes in each of their areas. “Sigma and API have also taken on risk due to PBS cuts and Pfizer is going direct in response to PBS cuts to generic drugs.”
Goodsall says the nation’s demographics are still compelling, with the ageing population supporting the sector. “Past the age of 65, people become a large consumer of health services.” He has a “neutral” rating on blood plasma group CSL after strong stock price performance and a “buy” on medical device maker ResMed, both of which have a high exposure to the US market.
“We like CSL and ResMed as they are both global companies,” he says. “Those two stocks have more a portfolio effect because they are in many countries. Currency remains a continuing issue, however, for both those companies.” While no healthcare company is immune to funding pressure in this economic environment, some have materially higher exposure than others. Macquarie Securities analyst Craig Collie believes the most protected stocks are bionic ear device maker Cochlear and CSL, which both operate in small sub-sectors and offer life-changing/saving therapies. Collie says both Cochlear, which trades on a price/earnings of 21.7 times, and CSL, which trades on a P/E of 19.5 times, are lowest risk for funding cuts. “As CSL and Cochlear deliver highly critical therapy – clotting agents for haemophilia and hearing devices for deaf children – it is politically difficult to cut their funding,” he says. “Additionally, both sub-sectors have relatively low spend, meaning they are low priority for funders looking to identify meaningful savings.”
However, Goodsall has a “sell” rating on Cochlear after its recall of its Nucleus 5 hearing device last year. The stock lost 40 per cent of its value last September but has since clawed back some losses to trade about $61 per share.
Goodsall says Cochlear has more than 80 per cent market share of the hearing device market but it is now looking like it will recoil to around 65 per cent. “Cochlear will still dominate market share but things have levelled out somewhat and the safety record has been marred,” he says. “There still about seven or eight failures per day globally. That said clinics say the company handled the recall well. But its main competition, Advanced Bionics, is back in the market and expected to take back market share.” Collie says sleep-disorder company ResMed and Ramsay Healthcare are the most exposed to imminent funding pressures. His top picks in the sector remain CSL, Cochlear, Ansell and Sonic and he has an “outperform” rating on all four stocks. He has an “underperform” on drug wholesaler Sigma Pharmaceuticals, Primary Health Care and regenerative medicine company Mesoblast. Mesoblast chief executive Silviu Itescu recently told the Credit Suisse Asia Investment Conference in Hong Kong that his group had a distinct advantage over the drug companies because its stem-cell technology had been favourably received by the powerful US Food and Drug Administration. Itescu reassures investors that Mesoblast has sufficient funds to get it through to the commercialisation of Revascor (its stem-cell treatment for congestive heart failure) by 2015 and develop its other treatments. It is burning cash at a rate of $60?million a year and has $240?million in the bank. Mesoblast does not pay dividends. Mesoblast’s largest shareholder is global pharmaceutical company Teva, with 19.6 per cent. It holds exclusive worldwide commercialisation rights to cardiovascular and neurological indications developed by Mesoblast. Mesoblast is divisive. Four analysts have a “buy”, two have a “hold” rating while three others have a “sell”. Collie is bearish on Mesoblast. “Risks are stacked against Mesoblast,” he says. “It’s possible the technology could work but we don’t think the risks are properly reflected in its stock price. The key question is why is Mesoblast worth 10 to 15 times its competitors in this highly crowded sector? The answer to this question eludes us, as well as many experts in the field we’ve spoken to. “As an investor it is very important to see clinical data get published. There are huge information asymmetries in biopharma and press releases tend to focus on the most positive findings of a study. Published scientific papers on the other hand include all study information and the data is reviewed by independent experts. Mesoblast has not published any clinical studies in the scientific literature. This is quite unusual and difficult to explain in our view.” Another biotech which has gained investor attention in recent months is Pharmaxis, which focuses on treatments for respiratory diseases. The share price has rallied more than 40 per cent in the past four weeks driven by the imminent launch of its key product, Bronchiltol, in key European markets and via the successful listing on the pharmaceutical benefits scheme in Australia. RBS Morgans expects Bronchiltol to be launched in Germany and the United Kingdom this month. Analyst Scott Power has downgraded his rating to a “hold” from a “buy” given the strong run. The company does not pay any dividends but appears poised to make further gains. Ben Griffiths of Eley Griffiths Group says the small companies segment of the market has spawned some terrific healthcare businesses over the past decade. Primary Health, Sonic, Ramsay and ResMed have each matured into significant businesses within the ASX100. Griffiths says investor interest in recent years has been trained on emerging healthcare businesses such as StarPharma, Acrux and Phosphagenics. “Each have impressive management teams and devices/applications that may just commandeer a good share of their hotly contested respective markets,” he says. “Investors are baying for the next Cochlear or ResMed and, subject to the prevailing market, seem eager to roll the dice and commit new equity once companies can highlight trial successes, third party validation and a path to commercialisation within line of sight.” One senior fund manager and long- time healthcare investor who wished to remain anonymous likens the healthcare sector to the media sector 10 years ago. “Saying healthcare is a growth sector needs to be reconsidered,” he says. “There is change and so there are always going to be winners and losers.” He suggests investors look for businesses that are providing a lot of value for the price they are charging and are difficult to replicate. “Two examples are Cochlear – which has decades of technology behind it,” he says. “Another example of good value for money and hard to replicate are private hospitals. “Why aren’t they being built across the country? It’s expensive. They don’t make enough money to incentivise the building of new hospitals. Ramsay Health Care fits in this bucket.” Ramsay has been popular with investors recently but with the federal government succeeding in its bid to means test the private health insurance rebate, it has clouded long-term forecasts for the hospital operator. Ramsay, which is trading at a high premium to market, could suffer when the means test is implemented on July 1. The fear is that introducing a means test for the 30 per cent rebate for private health insurance could prompt couples earning more than $150,000 to cancel or at least review their cover. Collie says Ramsay operates in an industry with a large overall spend that does not have a political “taboo” in cutting funding, so it remains at risk. He says Sonic is also under funding pressure with low political sensitivity in cutting pathology funding. Citigroup analyst Alex Smith has recently downgraded his call on Sonic to a “neutral” from a “buy” following a rally in the share price over the past six months when it appreciated by 11 per cent. “Sonic is trading on a 12-month forward P/E of about 14 times, which we think adequately reflects the organic growth prospects of the existing business, as well as some value for synergies associated with future acquisitions,” Smith says. The US is likely to drag on group earnings given potential fee cuts to Medicare and Medicaid funding, he says. Sonic is the world’s third-largest pathology services provider behind Labcorp and Quest Diagnostics, and the only truly global player with significant operations in the US, the United Kingdom, Germany, Switzerland, Australia and New Zealand. Smith’s top pick in healthcare services is Primary, which he says has the lowest 12-month forward P/E by some margin at about 11 times compared with about 14 times for Sonic and 16 times for Ramsay, and has similar average earnings per share growth over the next three years at about 12 per cent compared with Sonic and Ramsay at 11 per cent. Smith also flags that Primary offers the prospect of a growing and fully franked dividend payout ratio, and has no significant foreign exchange exposure. Primary looked to ease investor concerns around doctor retention rates last week during a briefing, showing the average retention rate over the past four years is 94.2 per cent. “We expect Primary to re-rate over the next 12 months as earnings growth rates and free cash flow improve,” Smith says.
