-Competitor disruption eases
-Ramp-up of small players
-Stock looking expensive
 

By Eva Brocklehurst

CSL ((CSL)) needs to reinvigorate broker appetites. The blood products company's performance could be easily overshadowed by major developments among its competitors. In particular, small fractionators have gained market share over 2013, in part because of the rise in the euro relative to the US dollar which has boosted the value of sales in Europe, where most of the smaller players are domiciled. Moreover, major competitor Baxter is no longer constrained by production disruptions while Octapharma has overcome the setback from a product withdrawal in 2011.

CSL was one of the beneficiaries of the supply disruption from Baxter in recent years and saw improved market share. Smaller players also rose to the occasion and are now intent on expanding sales into the attractively priced US market. Deutsche Bank is concerned that the smaller providers may focus on gaining a foothold and pay less attention to near-term profitability. The broker, in reviewing the threats and opportunities faced by CSL, notes all fractionators are planning expansions over the next few years. In its favour, CSL remains one of the lowest cost producers but, with the threat of new extended half-life haemophilia therapies imminent, Deutsche Bank finds there are few potential drivers of above-market growth. The broker has decided to downgrade the stock to Hold from Buy.

Immunoglobulin (Ig) growth continues to be strong, at around 9% per annum according to figures from the Plasma Protein Therapeutics Association. From these figures Citi notes the volume distributed during November and December 2013 was the highest monthly volume for the last six years. The other key product, albumin, was slightly weaker because of comparisons with the spike in November and December 2012. Citi believes CSL's market share for Ig could be under pressure this year because of improving supply from Baxter. The competition is heightened by the launch of Baxter's HyQvia in the US this year as well as the potential launch of a 10% liquid IVIG by Octapharma.

The main risks for CSL are associated with the deterioration in market conditions for plasma proteins, according to Citi. The broker derives a target of $62.20 for the stock, a 15% premium to the average price/earnings of the healthcare stocks under cover. A higher earnings profile, low gearing and strong return make this target appropriate but Citi suspects CSL is becoming expensive, given the medium-term growth profile and particularly because of the competitive threats that are looming for both the Ig and haemophilia businesses.

Deutsche Bank has cut CSL Behring's margin for FY14 and beyond by 0.5% to reflect lower Ig prices and a lift in manufacturing costs. Feedback from European fractionators indicates bullishness has faded from a year ago. The broker attributes this to a return to normal output at Baxter this year, after the company was short of Ig product for much of 2013. The market has now moved to a mildly oversupplied state. In terms of albumin, demand is still strong but Deutsche Bank sees little room for CSL to materially lift output.

CIMB observes that Biogen Idec's latest data on children with Haemophilia A shows continued effectiveness for long-acting drug Eloctate, increasing the likelihood of near-term approval and broadening the target population. The broker doesn't think this development will change the market but, as competitive clinical profiles, pricing and convenience are key determinants of market uptake, CSL should sit up and take notice. The product should be closely monitored for the risk to CSL's Helixate, in the broker's opinion. Eloctate's effectiveness and safety is expected to spearhead submission to the EU for approval, while offering the potential to expand the US patient population.

Earlier this year, a phase 2 trial assessing the prevention of congenital cytomegalovirus (CMV) infection found the administration of a hyperimmune Ig (similar to CSL's Cytogam) did not significantly modify CMV infection during pregnancy. Credit Suisse noted that, for CSL, Cytogam is a small contributor to the Behring business and around 1% of revenue as it's predominantly used for CMV infections following organ transplant. That said, the potential for use in preventing CMV transmission in pregnancy is significant. There is a large phase 3 trial underway, sponsored by the US National Institute of Child Health and Human Development, assessing the use of Cytogam. However, Credit Suisse thinks the result from the phase 2 trial has now cast some doubt as to whether this longer-term earnings opportunity will materialise.

There are five Buy ratings, two Hold and one Sell (Citi) on the FNArena database. The consensus price target is $72.95, suggesting 7.5% upside to the last share price. Targets range from $62.20 (Citi) to $80.00 (Macquarie and UBS).
 

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-Small positive step
-Second half still challenging
 

By Eva Brocklehurst

Cochlear ((COH)) has received approval from the US Food & Drug Administration for the Nucleus Hybrid L24 implant. While welcoming this development, brokers believe it is only a small positive and unlikely to significantly improve the outlook.

The implant is for adults with severe or profound high-frequency hearing loss in both ears and is the first such device approved by the FDA. The device combines a cochlear implant with the sound amplification of a hearing aid. The implant is expected to offer benefits for hearing loss where a hearing aid has proven inadequate, but this is a specific need which is expected to limit market penetration. Brokers think there are a number of constraints. There is a risk of permanent damage to the residual low-frequency hearing and added cost and risk of subsequent surgery.

CIMB believes the product will offer benefits where traditional aids have proven inadequate and has potential for earlier intervention in the key adult patient segment. The broker observes some modest success for hybrid products that are currently available from Cochlear and Med-El in the European Union over the last two years. CIMB maintains the stock is not trading at levels which reflect the more challenging operating environment. Moreover, guidance given at the first half result for the second half of FY14 still looks optimistic. A Reduce rating is retained.

It's a sizeable market opportunity but the potential for loss of low-frequency hearing may limit the market penetration, in Credit Suisse's opinion. The FDA was concerned about this issue but considered the overall benefits outweighed the risk for those who do not benefit from hearing aids. Hence, Credit Suisse thinks clinicians will be very cautious, given in some cases there's the potential need for repeat surgery.

In BA-Merrill Lynch's view the company is yet to spearhead a technological or efficacy advantage that can be recognised by the industry as enough to regain market share. Nevertheless, the approval of the hybrid is an important step in pursuing a sub-set of patients. The broker does highlight the fact that Cochlear is the only provider of this product system which signals the potential for a new area of sales. The next area of product development is expected to be implants that reduce trauma upon implanting, with the aim of preserving residual hearing.

Merrills contends that, while small, the FDA approval of this hybrid does reduce the downside risk for the stock, and warrants a raising of the price target to $56.30 from $55.35. This target represents the top of the range on the FNArena database. Merrills considers the stock's premium to peers is also warranted given the products are more necessity-based and there are high barriers to entry.

Cochlear has no Buy rating on the database. There are four Hold and three Sell recommendations. The price targets range from $47.29 (CIMB) to $56.30 (Merrills). The consensus target is $51.67, signalling 10% downside to the last share price.
 

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-Questions over quality, sustainability of growth
-Uncertainty regarding further downgrades
-Key to turnaround is in FY15
 

By Eva Brocklehurst

Disappointing was the buzz word around Cochlear's ((COH)) first half. Brokers came away with the impression there's a lot hinging on the promise implied by an improved sales trend in the second quarter. Will this be enough to stave off the bleeding in the company's market share and turn around the growth outlook? Only a few are prepared to assume the worst is over.

BA-Merrill Lynch decided to upgrade the stock to Neutral from Underperform. The broker thinks that despite ongoing concerns about the outlook and the downgrade to FY14 guidance, the run rate is improving. This should herald a meaningful uplift in FY15. Still, Neutral is the cautious call, as Merrills considers the optimism is largely predicated on a declaration by Cochlear that the second quarter was much better. This doesn't answer the broker's questions regarding the contributions to weakness in the first quarter. So, no Buy yet. What is critical to Merrills' thesis is the growth rate in the industry, overall. The improvements in the second quarter, and hence the FY15 tailwinds that are envisaged, are too specific to the company. Merrills wants to know what the shift to lower-value markets means and observes there has been little that the industry has done to reverse or improve on this trend.

It's the third FY14 downgrade in nine months and because of ongoing competitive pressures, lack of transparency and a lofty multiple, the risk is outweighing the reward in Morgan Stanley's view. The broker acknowledges there may be some share price recovery in the short term but competitive pressures over the longer-term underpin an Underweight rating. Furthermore, ongoing patent disputes and risk of associated charges limits the flexibility of the balance sheet. For Deutsche Bank the key issue was higher expenses in the first half, especially in manufacturing. This will need to normalise in the second half to deliver on guidance, according to the broker.

JP Morgan also felt the time was ripe for an upgrade - to Neutral from Underweight. The result may have disappointed and validated the belief that competition has increased significantly but the broker is prepared to accept a bottom of the cycle in earnings may have passed. Momentum appears to be improving and FY15 shaping up for growth. The broker noted delays at the FDA in approving the features of the N6 have not helped but management now expects approval in the first half of FY15 and that should drive growth. The broker observes from its survey last month of audiologists in the US that the N6 received a good reception despite the delays and this supports the notion it remains viable in the US.

Citi found the first half sales very disappointing. Excluding Chinese tenders the cochlear implant unit sales were flat. The broker fears Cochlear is clearly losing market share, predominantly in the US and the pre-launch of N6 seems to have contributed to this. The full features of the N6 will not be available until FY15, and patients appear to be holding off for the new product. The broker does not expect N6 upgrade sales to contribute significantly until FY15.

On the positive side, Citi thinks the company can deliver on expectations in FY15 if the upgrades are successful and market share loss can be stabilised. In terms of the latter, a new implant may be required to achieve this stability and the broker does not rule this out as a possibility. Citi's fundamental query is around whether the earnings shortfall seen in the first half can be recovered by a return to sales growth. Achieving such sales growth may be problematic. Hence, the broker thinks investors should be seeking a bigger discount in the price, given the uncertainties.

Time is needed for the new CI units to gain traction, while the uncertainty is increased amidst a growing reliance on emerging markets and the uptake of units in adults, in CIMB's opinion. Sure, new products, the 30% sequential increase in second quarter sales and an impending upgrade cycle in implants all look to be supportive, but the broker is unsure whether this will be the last downgrade to FY14 guidance. Credit Suisse has a host of worries too, citing many issues that need to be resolved before there's some clear air on the stock and a re-rating can occur. These issues include a stabilising of market share, formal approval of the N6 processor, resolution of patent infringement and lawsuits, as well as improvement in converting earnings to cash flow. Then there's also the foreign exchange factor and the question of why this, plus fewer unit sales, had such an impact on gross margins.

Cochlear stated that the dividend will be frozen at 127c per half until earnings recover to support a 70% pay-out ratio, which UBS estimates will not occur until FY18. The broker sees the company inching towards more realistic guidance but this hinges on the N6 launch reinvigorating growth. From UBS' calculations the numbers that are required stack up to a big challenge. The other item of note for the broker was the reduction in first half margins, affected by the costs of launch, high cost of goods sold in terms of a loss of manufacturing scale, as well as other input costs. UBS maintains that Cochlear's risk profile has changed, so valuation should de-rate towards peer multiples. Moreover, the expected FY15 recovery is predicated on cyclical gains from the rolling of FX hedges and an N6 upgrade cycle, not underlying unit sales. It all adds up to a Sell rating for UBS, one of the five on the FNArena database. There are three Hold ratings and no Buy.

Is there are more positive outlook? Macquarie thinks investors could become a little more positive, as the company believes the growing pains with new product launches are now behind it and strong momentum from the second quarter sales can also address the margin issues and deliver a substantial increase in second half earnings. Still, Macquarie struggles with the multiples for the stock, as unit sales have been flat for the past three years. Cochlear may be looking cheaper on a relative basis but the broker suspects the stock will stay around current levels in the near future. The broker maintains a Neutral rating.

On the FNArena database the consensus target is $51.56, suggesting 7.1% downside to the last share price. This target has fallen from $54.08 ahead of the results. Targets range from $47.29 (CIMB) to $55.02 (JP Morgan). The dividend yield on both FY14 and FY15 forecasts is 4.6%.
 

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-Unclear re extent of price disruption
-Margin strength a key positive
-New product should spark sales growth

By Eva Brocklehurst

Sleep disorder specialist ResMed ((RMD)) suffered from weak revenue growth in the second quarter as the US competitive bidding processes continue to disrupt the customer base. Brokers vary over the degree to which they're prepared to look through this disruption, which has persisted for some time.

The second quarter weakness follows a soft outcome in the first quarter and CIMB questions whether the worst is now behind the company. The broker remains confident in the long term but just doesn't like the short to medium-term trajectory for the stock. With the US system in flux amid competition risks, CIMB has decided to reduce the rating to Hold from Add pending greater visibility on the dynamics. A lack of clarity surrounds whether US competitive bidding is a mere distraction, as management contends, or whether it reflects a more sustained change in the pricing/volume of the business, as distributors review their business models. CIMB still thinks the company is well placed, with multiple levers to offset such pressures, but expects the stock will be volatile. The broker adds a proviso that, should any considerable weakness develop, the rating would be reviewed as the multiples do not appear overly extended.

Citi is more confident growth will return, particularly as home sleep testing is increasing the rate of new diagnoses. The broker observes ResMed is losing market share in masks and new product launches over the next six months need to address this loss, although it will take time to gain traction. Gross margin remains a key factor in ResMed's favour, according to Citi. Moreover, while foreign exchange contributed, margins were underpinned by manufacturing gains and a favourable product mix. The broker assumes ResMed will invest this gain back into lower US customer pricing in the second half to stem the market share decline.

Another broker that is prepared to dismiss the current softness is JP Morgan, convinced that once US pricing has been re-based the company will regain its strong position in the healthcare sector. The broker considers an FY15 price/earnings forecast of 15 times, adjusted for cash, represents a good point of entry for a stock that will benefit from reinvestment in R&D and the increasing awareness of sleep apnea via home sleep testing. The broker also expects some easing of the disruption as distributors and medical centres in the US come to terms with the subcontracting arrangement and re-supply documentation.

UBS, while expecting competitive bidding will overhang the stock for some time, thinks the new platform that's due by the end of FY14 will herald a new growth phase in FY15. UBS rates the launch of the new flow generator platform in the fourth quarter as extremely likely. History suggests sales growth of 16-43% follows a new product launch. The broker notes consensus forecasts for just 8.5% sales growth in FY15 do not factor in a launch response. The broker has based forecasts on modest launch success, with growth of 15%. Credit Suisse also considers it important that ResMed launches an array of new products, priced effectively to ensure a stemming of market share losses. The broker considers the impending launch of a new respiratory care platform and a falling Australian dollar will be beneficial, but remains concerned about how quickly the US market pressure will abate. Until Credit Suisse is convinced about the growth trajectory a Neutral rating is retained.

The company has little choice but to cut prices to shore up the market position and the risk that such a strategy leads to a price war cannot be ignored, in Deutsche Bank's view. What stands the company in good stead is its gross margins are at a 10-year high and it continues to refresh the product base. The broker is confident the drag from competitive bidding will disappear. The Hold rating is retained because of limited upside to the broker's price target. Deutsche Bank expects pricing to be more aggressive this year, limiting further market share losses, and expects US sales could contract slightly in the second half.

Until top line earnings growth returns, Macquarie considers a re-rating unlikely. This could be some way off and the broker finds it hard to foresee when the disruptions will peter out. What concerns Macquarie is that management said ResMed will re-evaluate price premiums given the state of the current market. This suggests to the broker the company has been surprised by the extent of competitor price reductions and that prices will get worse in the third quarter. Macquarie suspects that price headwinds could continue until mid FY15. Still, the broker is confident that, in the longer term, revenue headwinds will ease and ResMed will retain a strong position in its market.

There are four that retain Buy ratings on the FNArena database. The other four have Hold ratings. The consensus price target of $5.95 suggests 18% upside to the last share price. Price targets range from $5.40 to $6.74.
 

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-Meaningful FX benefit
-Attractive valuations
-Still need to consider individual stocks
 

By Eva Brocklehurst

Brokers rate the probability of both surprises and disappointments in the Australian health care sector as low during the upcoming reporting season. Those receiving a tail wind from the fall in the Australian dollar in the first half look set to continue to enjoy that benefit. It's this currency variable that has potential to make the greatest difference to the earnings outcomes, in Citi's view, and most of the major stocks in the sector have meaningful offshore exposure.

While there are likely to be few catalysts for a re-rating, brokers note the sector is attractively valued. UBS believes the sector is priced at its most attractive levels in four years. With the exception of Ramsay Health Care ((RHC)), all major stocks are trading well below 10-year averages. The subdued valuations are driven by concerns over changes to government expenditure, both abroad and locally, and until these are resolved any re-rating is considered unlikely. In this respect, UBS believes the Australian federal budget on May 13 should be closely watched.

Credit Suisse also expects the first half of FY14 to have been benign. The risks that may emerge for the full year include potential upside to guidance from Ramsay and Sonic Healthcare ((SHL)), because of the more favourable currency rates, lower interest expenses as well as potential upside in UK margins. UBS thinks Sonic, specifically, has upside earnings risk based on solid growth in domestic services, but this is also reliant on there being no material cut to fees in the second half.

In this respect, Credit Suisse expects Sonic to report ahead of expectations for the first half, largely because of a delay in Australian fee cuts, but be unlikely to upgrade guidance. The company's goals are sound, in the broker's view, but volumes in the US may be soft this year if the roll-out of the health care reforms continues to suffer from implementation difficulties. Citi expects any surprise with Sonic will come from the US business and relate to whether cost cutting initiatives have been enough to offset the tough conditions there.

The greatest risk for a downgrade to the full year is with Cochlear ((COH)), in the opinion of both UBS and Credit Suisse, as the company's guidance signals a heavy weighting to the second half. UBS notes market feedback suggests the release of the N6 processor has only slowed the decline in market share, at best. Credit Suisse expects expects US operating conditions will make it difficult for ResMed ((RMD)) over the rest of the financial year. 

Citi takes a different tack, seeing some upside risk to consensus forecasts for ResMed and Cochlear, with the positive impact of a lower AUD perhaps understated. ResMed is Citi's only Buy-rated stock. The broker suspects the market is not only under-estimating the positive impact of the lower AUD but over-estimating the impact of Round 2 competitive bidding in the US. The broker's least preferred stock is Ramsay. Citi considers there's no room for disappointment in a PE multiple of 27 times and where consensus forecasts are suggesting 22% earnings growth.

Despite the large increases in Australian health insurance premiums, Credit Suisse is more optimistic about the demand for Australian private hospital services. The broker expects Ramsay will deliver a robust result. A key risk in the longer term is the sustainability of price increase from insurers to hospitals, but the broker notes Ramsay has 70% of its insurance pricing contracted over the next three years, so near-term share price risks appear to be on the upside.

UBS sees scope for a guidance upgrade from CSL ((CSL)) on the back of product launches while Citi thinks such scope is limited, acknowledging that commentary on the medium-term competitive threats will be important in assessing any upside.

While investors may be asking whether the sector has become overvalued, having recently outperformed the ASX200, most brokers believe the sector is relatively inexpensive. Credit Suisse cautions that scrutiny must be applied to individual stocks as the models and geography do vary. CSL has the most valuation support for an Outperform rating in the broker's view, Cochlear appears the key undervalued stock relative to the ASX 200, while Primary Health Care ((PRY)) and Ramsay seem to be the most overvalued. Citi thinks there is potential for upside surprise at Primary, given the strength of demand in end markets but believes expectations for the dividend may be overly optimistic. 

 With Ansell ((ANN)) Citi thinks the area of sales growth, or lack thereof, will contain any surprises. End markets appear subdued but declining latex prices should add an important ingredient to the mix. Credit Suisse expects that macro-focused investors will hold Ansell as a reasonably-priced exposure to recovery in industrial economies, as this should drive glove use.
 

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