Lines On The Face Of Health Sector

This story features RESMED INC, and other companies. For more info SHARE ANALYSIS: RMD

-Diverging outlook for health stocks
-Organic revenue growth vs acquisitions
-Cochlear under pressure
 

By Eva Brocklehurst

Outperformance is showing its age, that's the message CIMB is receiving from the healthcare sector. The stocks that make up this sector have been widely seen as defensive yield plays but cracks are starting to appear in this picture.

What is driving brokers to review the area is the prognosis for global growth. The mixed signals as to whether the strengthening of the growth outlook will continue and the decision by the US Federal Reserve to continue economic stimulus will underpin the sector for the time being, but CIMB contends that there is an increasing shift to stocks that offer better prospects for earnings momentum and capital appreciation. This should limit further gains, or at the least make them harder to win.

CIMB has moved the sector to Underweight but continues to advocate stock selection in lieu of sector allocation because of the diversity of business models. What's the broker's top picks? Top for CIMB is Primary Health Care ((PRY)), ResMed ((RMD)) and Sonic Healthcare ((SHL)).

ResMed has to deal with challenging industry dynamics but CIMB thinks margin stability will enable the company to offset the pressures it faces, hence the broker retains an Outperform rating. Goldman Sachs is on the same song sheet with regard to ResMed and adds the stock to its Buy list, expecting double digit earnings growth in FY14 given a positive shift to higher-value devices, new patient acquisitions and a focus on costs. The broker divides ResMed, along with CSL ((CSL)), Ramsay Health Care ((RHC)) and Cochlear ((COH)), as those with faster organic revenue growth, from Ansell ((ANN)), Primary and Sonic. Over the past five years, this faster organic revenue growth has partly driven the stronger growth in value and returns. What is notable also is that these faster growing companies received relatively little boost from acquisitions.

Goldman adds CSL to the Buy list for these reasons and expects earnings in each of the next three years will be supported by strong organic revenue growth, market demand and further share buy-backs. CIMB is more neutral on CSL, suspecting that, while the operating environment remains favourable and sentiment is positive for Australia's largest biopharmaceutical company, the moderating and evolving product pipeline is likely to pressure earnings over the medium term.

Goldman has downgraded Ramsay to Neutral given a lack of valuation support. Deutsche Bank is also muted on the stock, but has observed the UK Competition Commission's report on the UK private healthcare market, due next year, is unlikely to be material for Ramsay. Ramsay's competitors will probably be forced to sell hospitals, so maybe there's some developing opportunities, but it will be hard for Ramsay to take out a larger competitor. Deutsche Bank does not expect Ramsay to bid for any of the NHS hospital operating contracts currently in tender, given the restrictive terms of the proposed arrangements.

Cochlear has suffered from strong currency headwinds as well as product recalls and market share erosion. CIMB rates the company as Underperform and thinks competitive pressures, slower sales and growing reliance on emerging markets as well as adult patients bodes for increasing volatility. Deutsche Bank has decided that, because the company missed out on the latest Chinese tender, it's time to downgrade the rating to Sell. The tender miss is considered symptomatic of the increased competitive pressures Cochlear faces. While the N6 offers the potential for some differentiation, the broker doubts this will be evident in the near term given the staggered US regulatory process. Goldman also expects slower growth at Cochlear but thinks processor upgrade sales should trend up strongly in FY15, once the fully featured product enters the market.

Of the slower growing companies that Goldman outlines – Primary, Ansell and Sonic — Primary's organic growth is seen as being too modest. This is partly from run-off of Symbion GPs, partly from pathology fee cuts and partly from a change in revenue recognition in the radiology division. The broker notes strong revenue growth has come largely from the Symbion acquisition that was made in 2008. CIMB takes a different tack and thinks Primary's operation will continue to improve, as Australia’s largest private medical centre operator and a major pathology provider benefits from GP productivity gains. Primary remains one of CIMB's top picks.

CIMB thinks Ansell will continue to suffer volatile earnings and the company's softer FY14 outlook is considered an accurate barometer of a turbulent future, rather than simply being conservative. Goldman also observes that Ansell has relied heavily on acquisitions to augment what the broker describes as sluggish organic growth.

Sonic has made a significant number of acquisitions over the years, such that its overall revenue growth was more in line with the organic growth achieved by the faster growing companies, according to Goldman. The broker has decided to downgrade Sonic to Sell. Without acquisitions, Goldman can find few positive catalysts for Sonic in FY14. CIMB goes the other way, listing it as a top pick and comfortable that the pressure surrounding global fee adjustments can be overcome. Relative trading levels also point to further upside for the stock, in CIMB's view, with the shares trading at forward price/earnings of 1.08 times.
 

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