Rudi’s View: Healthcare Under The Scanner

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In this week's Weekly Insights:

-Healthcare Under The Scanner
-February 2024; The Final Verdict
-Rudi Unplugged, In April

By Rudi Filapek-Vandyck, Editor

Healthcare Under The Scanner

Technology companies and discretionary retailers might have crowned themselves as Champions during the local reporting season in February, post-season the focus among analysts goes mostly out to Healthcare and REITs, two market segments that have largely been on the nose ever since the world decided covid is just something you deal with.

The irony that healthcare services are among the most persistent victims of what became an enormous global health scare back in 2020, now in the fourth year post pandemic, shouldn't go unnoticed. Reality does have a way of carving out its own pathway, ignoring forecasts made and solidly beating human imagination.

Double irony: healthcare had been by far the best performing segment on the ASX pre-covid, with local sector leaders CSL ((CSL)), ResMed ((RMD)), Cochlear ((COH)) and Sonic Healthcare ((SHL)) delivering above-average returns for long-term oriented portfolios.

In their slipstream followed a queue of smaller-cap performers, including Ebos Group ((EBO)), Fisher & Paykel Healthcare ((FPH)), Nanosonics ((NAN)), and others.

In 2024, it's much more slim pickings to identify outperformers in the sector, or even 'performers' if we exclude brief, short-term share price moves. Pro Medicus ((PME)) and the aforementioned Cochlear have turned into stand-out exceptions, but their ongoing attraction has now become a public debate revolving around 'valuation' and 'true sustainable growth perspectives' for the years ahead.

In a market that likes to reward companies for reliable, oversized growth with no negative surprises, and both healthcare outperformers are certainly part of that group of companies locally, there will always be that investor dilemma of how much premium is too much?

The more interesting question for most investors relates to the rest of the sector: when can we expect the return of healthcare as a solid, reliable provider of strong growth, with no material negative surprises? Call it the good old days, when ResMed, believe it or not, was one of the best performers on Wall Street with a total return in excess of 1000% over ten years.

There's no denying, the operational context for many healthcare companies has changed. There's also no denying share prices for the past three years are reflecting exactly that.

Bugbears include the advent of competing treatments and medications, such as GLP-1s, the modern day miracle weight loss solution (for now), but equally so budget constraints for governments, for hospitals, and for households, fewer GP visits, and a marked pick-up in general costs.

Margin pressure has become the new focal point for the industry at large. Most analysts, and management teams at the helm of these companies, remain confident today's margins will improve in the years ahead, but maybe not to the levels witnessed pre-covid.

This will have consequences for general valuations, and for investors' enthusiasm to invest in the sector.

History shows, what usually happens when a sector remains under the pump for a longer-than-expected period, there usually follows a number of wash-out events, whereby the weakest, lower-quality and most vulnerable business models implode as the relentless pressure builds.

Recent events at Healius ((HLS)), which have driven the share price to its lowest level in more than 23 years, is such an outcome. Once again, also, investors have been reminded of the dangers of owning cheap-looking sector laggards for no other reason than the 'price'.

So let's assume we have cash to spare, and we are hopeful the current spell over the healthcare sector will not prove permanent. Where should we be looking to invest?

I asked the analysts.

The local market leader, CSL ((CSL)), has for many years carried the halo of 'probably the highest quality growth stock on the ASX' but general appraisal has gone silent as the share price keeps reverting back to the $280 price level in line with disappointing margin recovery to date and more negative market updates.

Spending more than US$1bn on developing and trialling CSL112 and ending up empty-handed is not something witnessed every day either locally or elsewhere.

The acquisition of Swiss company Vifor, costing circa US$11.7bn, has not been a grand success either, at least not in the initial phase of ownership. Vifor is being challenged in some of its key products.

Losing the label of apparent immortality has made the local analyst community noticeably less enthusiastic too. Model portfolios have scaled back their allocations, albeit generally in small gestures. Some analysts, like those at Wilsons, have now turned super-critical of the business, labelling Vifor a 'dud' and questioning CSL's small base for future growth.

The majority, however, focuses on the 80% of CSL that is performing well, with ongoing prospects for robust growth and recovering margins; plasma collection and vaccines.

Some analysts might remind investors when CSL acquired Seqirus (loss-making vaccines operation from Novartis) in 2015, the market was equally non-enthusiastic, at first, which allowed for positive surprise.

An investment in Australia's largest biotech, and the country's number three largest company by market cap, relies on belief management can deliver on the promised margin recovery, while integrating and growing Vifor, and grabbing opportunities elsewhere, including from Vifor's pipeline of products under development.

As is often the case in these matters, the outlook for CSL shares is now closely intertwined with investor sentiment and the general perception is the shares don't genuinely move. In other words: a catalyst is needed, some good news. Under such circumstances, patience is a virtue.

FNArena's consensus target sits at $313.40, suggesting double-digit upside if sentiment, on balance, remains supportive in the year ahead. CSL remains a cornerstone inclusion in the FNArena/Vested Equities All-Weather Model Portfolio.

Macquarie

The healthcare team at Macquarie still has CSL as its most preferred healthcare exposure, followed by ResMed ((RMD)) and Monash IVF Group ((MVF)).

The resurrection of ResMed shares has been nothing short of spectacular once the shorters' GLP-1 scaremongering was replaced with a better understanding of the risks and potential consequences further down the road for medical equipment manufacturers such as ResMed. But there's also still the ongoing struggles at key competitor Philips, which will return to the US market at some point.

Most importantly, ResMed management got the message post August results season last year, and they made certain there would be upward movement in the company's margins this time around. It worked!

The message emanating from the ResMed experience is that investors want to see tangible evidence of margin recovery three years after the covid pandemic subsided. And if enough evidence is shown, the share price gets rewarded.

ResMed remains among the favourite stocks in the sector for many analysts teams researching the sector locally.

Monash IVF enjoys a positive rating from all four brokers monitored daily by FNArena. The consensus target sits at $1.56, circa 7.8% above today's share price (on Monday).

Morgan Stanley

The healthcare team at Morgan Stanley has also nominated CSL and ResMed as the two local sector favourites.

Morgan Stanley's preference lays with the large caps in the sector, with Monash IVF the sole small cap that carries an Overweight rating, the highest possible in this broker's ratings universe.

Equally worth noting: Ebos Group is also rated Overweight.

Morgan Stanley prefers to avoid Healius and Integral Diagnostics ((IDX)) on margins and elevated labour costs.

The analysts remain skeptical about the short-term outlook for Sonic Healthcare ((SHL)), having endured a series of disappointing market updates, but are prepared to retain an Overweight rating for the shares (on a longer term horizon).

Macquarie analysts are not so kind. They have Sonic Healthcare as their second least preferred sector pick, only preceded by Cochlear (on a too elevated valuation).

UBS

Conversely, healthcare analysts at UBS include Sonic Healthcare in their Top Three sector favourites, alongside Telix Pharmaceuticals ((TLX)) and CSL.

Sonic Healthcare is not a CSL, not in the slightest, but both share a common theme: the underlying core business is performing. At some point, we can but presume, most of the negatives will be left behind in the past and the market's attention will be drawn to the positive core.

UBS has only one genuine dislike; Cochlear. This time it's not the share price. The broker sees a potential threat from a product still in development by Moderna. If the upcoming phase III trial is positive, UBS can see a similar market response as was the case with GLP-1s for both ResMed and CSL last year.

Citi

The highly regarded team of sector analysts at Citi has more dislikes than favourites, also because share prices for Cochlear and Pro Medicus are simply considered too elevated to not warrant a Sell rating.

Other Sells carry too many unanswered questions; Ebos Group, Nanosonics, and Healius.

Citi's two favourites are Australian Clinical Labs ((ACL)) and ResMed.

Wilsons

Healthcare analysts at Wilsons still like ResMed and Cochlear, but here the analysts are prepared to move into the smaller cap space in order to find additional opportunities.

Such opportunities, Wilsons believes, include Telix Pharmaceuticals, Clarity Pharmaceuticals ((CU6)), Neuren Pharmaceuticals ((NEU)), Mayne Pharma ((MYX)), Immutep ((IMM)), Percheron Therapeutics ((PER)), Nanosonics, Avita Medical ((AVH)), PolyNovo ((PNV)), and Mach7 Technologies ((M7T)).

Evans and Partners

The order of larger cap preferences at Evans and Partners is ResMed on top, followed by Cochlear, CSL, Sonic Healthcare, Fisher & Paykel Healthcare, Ramsay Health Care ((RHC)), Ansell ((ANN)), and Healius last. Among smaller caps, the favourite is Integral Diagnostics.

Private hospitals operator Ramsay Health Care ((RHC)) delivered a positive surprise in February, but post share price reset general skepticism dominates. It has been a long while since this company came out with genuinely good news, outside of asset sales to reduce the debt burden or a financial performance that wasn't as bad as feared.

Ansell is only half-healthcare, at best, and that division is still suffering from post-covid hangovers. Similar to Healius, it is no surprise management is restructuring operations.

Sigma Healthcare's ((SIG)) future is now closely linked to the (effectively) reverse take-over by major client and shareholder, Chemist Warehouse. This company is scheduled to report financials on March 21.

According to analysts' forecasts post the February results season, healthcare is one of the strongest growing segments for the years ahead, led by Pro Medicus, CSL, ResMed, and Cochlear. The sector was equally mostly disappointing in February, including through Pro Medicus and CSL.

No doubt, the latter has tempered the market's enthusiasm in the immediate aftermath. Now the big question is: can the former outperformers start performing again, or do investors have to be patient for much longer?

Almost forgot to mention: ResMed too has remained a cornerstone inclusion for the All-Weather Model Portfolio. Plus healthcare services should be among key beneficiaries of AI in the decade ahead.

February 2024; The Final Verdict

In the end, corporate releases generally proved better-than-feared, though share prices were equally supported by positive sentiment.

Hold a big carrot in front of financial markets, in this year's context: the prospect for interest rate cuts, and underlying sentiment finds it a lot easier to look beyond short-term stumbles and hiccups.

But does any of this make the February results season a "good" one, or even a "positive" one?

On CommSec's data-crunching, expenses in aggregate are growing at 6% annually while revenues only increased by 3%. This is why winners and losers throughout the month were largely defined by the management team's ability to rein in costs.

And as most management teams, three years post global pandemic, lockdowns and supply chain bottlenecks, have formed a tighter grip on operational dynamics, the bias turned towards more positive surprises. Subdued economic forecasts and low expectations beforehand also assisted companies with meeting or beating expectations.

In a season mostly defined by cost control, one would expect many metrics to show deterioration, and February truly played to that script. Back to CommSec's data: in February 81% of companies reported a profit, continuing the down-sloping trend since August 2022 and below the long-term average of 87%.

CommSec also reports this is the lowest outcome in seven consecutive reporting seasons. Aggregate profits have fallen by -35%. Less than half of all companies (49.6%) managed to grow profits versus a long-term average of 58%, but February signaled a marked improvement on the two seasons of last year.

This, naturally, weighs on available cash with total levels dropping by -25% over the year. Dividends retreated, but only by a net -2%. Of those paying out a dividend, 52% increased it, against 29% reducing their dividend and 19% holding it steady.

The ASX200 members have declared $33.9bn to be paid out in coming months, compared with $34.8bn a year earlier. More companies are still increasing their dividends, but the percentage is sliding steadily.

The market consensus forecast is for aggregate EPS to fall by -5.5% for the year to June 30th, with a positive follow-up to the tune of 4% in FY25.

A lot will hinge on economic momentum between now and then. Or maybe not. Analysts at Macquarie believe investors can be optimistic because more companies are able to keep costs under control and this should result in upgraded forecasts before the August season.

Already, on the broker's data gathering, more companies issued improved guidance in February than those who felt the need to temper expectations, with the largest contingent maintaining full year guidance. 82% of companies provided some kind of guidance, report the analysts, albeit not always quantified in numbers.

"Overall", concludes Macquarie, "the lack of major negative surprises in reporting season is probably enough to support Australian equities, so long as the cycle continues to improve and investors can look forward to Fed rate cuts and Stage 3 tax cuts in 2024."

Market analysts at Wilsons believe costs and the ability to control costs will continue defining corporate winners and losers over the coming 6-12 months.

Wilsons: "Despite cost deflation/disinflation being evident for freight and some raw materials, other key costs of doing business (CODB) line items have remained relatively sticky including wages, rent and other overheads (e.g. energy, IT expenses). A number of these CODB headwinds will remain prominent in 2H24 and FY25."

The final verdict of the FNArena Corporate Results Monitor is that 32.8% of corporate results proved better-than-expected while another 39.3% proved in line, leaving the remaining 27.9% to disappoint either through earnings, margins, forward guidance or a combination of multiple factors.

Seeing one third of result releases surprising positively is good for the soul and investor sentiment generally, for sure, but in the context of all reporting seasons we've covered since August 2013, and given expectations were low beforehand, it's not a tremendously fantastic outcome.

History shows February usually delivers more surprises than disappointments, and the number of 'beats' can run as high as 47%. February's percentage sits among the lowest from the past eleven years. The percentage of 'misses' (27.9%) is the fourth highest over that period.

CommSec's forecast is for "the Aussie sharemarket to drift through to mid-year as rate cut validation is amassed. The S&P/ASX 200 index is expected to be trading in 7,750-8,050 point range near the close of 2024."

Rudi Unplugged, In April

March is a busy month for Your Editor with presentations to CPA and the Australian Shareholders Association respectively on the 20th and 21st.

Rudi Unplugged, which intends to be an interactive communication/presentation for FNArena subscribers and enthusiasts, will thus take place in April.

I'll keep everyone in the loop; no need to hurry to send in questions and points of interests just yet (Though you can, of course).

Questions received to date relate to dividends, including APA Group ((APA)), investment opportunities, and All-Weather Performers.

Question and suggestions: editor@fnarena.com

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(This story was written on Monday, 11th March, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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