-Rising collection centre costs
-Regulatory uncertainty prevails
-Is the downgrade now factored in?
 

By Eva Brocklehurst

On the heels of its rival, Primary Health Care ((PRY)), Sonic Healthcare ((SHL)) has also downgraded its FY15 estimates. The company now expects the FY15 result to fall 3-4% short of prior guidance, as Australian pathology operations have underperformed.

With capacity to fund further acquisitions now diminished - the company recently acquired Medisupport in Switzerland - Deutsche Bank expects earnings growth will track back to mid single digits in the medium term. The broker observes domestic pressures are largely stemming from the impact of reimbursement funding cuts and rising collection centre costs, which will have a flow-on effect on FY16. The company has guided to FY16 earnings to be up 20% on FY15 but still well below consensus estimates. Guidance excludes the Alberta Health Services contract because of uncertainty surrounding the commencement date. Deutsche Bank now assumes this contract starts July 2016.

The lift in collection centre numbers this year partly explains weaker margins, in Deutsche Bank's view. Industry feedback suggests rents paid to medical practices have continued to climb, reflecting competition between providers. The broker highlights market hopes that new regulations will be implemented to limit rental payments but, at this stage, the health minister's intentions are unknown and, if current regulations are maintained, downward pressure on domestic pathology margins is expected to continue.

Credit Suisse, which downgraded the stock to Underperform just prior to this guidance update, believes the Australian government could decide to change regulations and, as a result, instigate a reduction in collection centre rents. Separately, there is also a review taking place in the Medicare Benefits Schedule with actionable points being delivered to the minister later this year. All up, the broker suspects there is downside risk to growth in pathology outlays over the medium term. In its favour, Sonic Healthcare has exposure to more favourable and/or stable pricing geographies, and further acquisitions in these regions could be well received.

Morgans suggests, with the stock falling 10% over the week since Primary Health Care's announcement, the latest downgrade is factored in. The broker considers the company's forecast of 20% growth in FY16 is fair, albeit mainly driven by acquisitions. This is the second downgrade from Sonic Healthcare for FY15. Last November the company signalled it was plagued by weaker volume growth, higher collection costs and Medicare funding restrictions for vitamin D/B12 and folate testing and brokers maintain this latest downgrade reflects the same issues.

Morgans believes the crux of the problem appears to be management's difficulty in determining the fall-out from changes to Medicare funding because, given the cycling of changes come this November, the impact should not be ongoing. The upcoming review of Medicare item numbers remains a major uncertainty but Morgans suspects this review may have more bark than bite.

Overall, weakness could persist as governments around the world are facing budgetary pressures so reimbursement cuts could exceed the market's expectations. On this basis UBS also trims US earnings estimates for FY15 and FY16. Citi, however, forecasts a gradual improvement in revenue growth for Australian pathology and the US, generally, with its restructured CBLPath unit. The broker no longer includes acquisitions in base forecasts so the potential award of the Alberta contract and further bolt-on acquisitions represent upside risks.

The extent of the second downgrade surprised Morgan Stanley as the company indicated previously that Australia was on track, albeit the broker suspected previous guidance requiring 4-8% growth in the second half was a challenge. Nevertheless, no structural issues seem to be behind the downgrade and pathology volumes are expected to recover. While surprised by the escalation of collection centre costs, Morgan Stanley envisages potential for regulation to reduce this burden. The broker believes the downgrade has been priced in and retains an Overweight rating.

The company has four Buy ratings, three Hold and one Sell (Credit Suisse) on the FNArena database. The consensus target is $22.01, suggesting 2.7% upside to the last share price and compares with $22.52 ahead of the update. Targets range from $20.80 (Deutsche Bank) to $23.90 (UBS).

See also, Sonic Booms In Europe on June 16 2015.
 

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-Among the highest margin earners
-Continued margin deterioration a risk
-Can fund hospital expansion from sale
 

By Eva Brocklehurst

Australian private hospitals are under the spotlight at present as health insurers battle to sustain margins. Insurers are feeling the chill wind of churn, as customers look for better value premiums and downgrade their cover as costs escalate. How does this translate to the hospital sector?

Morgan Stanley has initiated coverage of Healthscope ((HSO)), citing a mix of influences on the private hospital sector. Healthscope is Australia's second largest provider of private hospital beds, with Ramsay Health Care ((RHC)) the largest and twice its size. Hospital industry margins have risen over the past seven years but insurer margins are flat to lower. Insurers are intent on paying lower rates to hospitals as rising lapse rates signal ongoing premium increases will not assuage their margin downtrend.

In this aspect, Healthscope has signalled more openness and a willingness to accommodate insurer concerns, based on industry feedback, but then then the broker observes Helthscope also has more potential for cost reductions in Australia relative to Ramsay. In the main, the margins hospitals enjoy imply rate reductions from insurers can be withstood without materially affecting capital expenditure. Morgan Stanley estimates Healthscope has a relatively underdeveloped hospital portfolio compared with Ramsay Health Care and this means a larger capacity to bring more brownfield beds on line, which in turn implies better medium-term organic growth.

Morgan Stanley's calculations signal around 2.0% growth in hospital beds over the next 10 years would be required to maintain occupancy at or below 85%, at a total cost of $10bn, funded by the hospitals. Healthscope is well placed as it enjoys some of the highest earnings margins among Australian private hospitals. Moreover, management has signalled potential for more upside if it realises the benefits of centralising newly launched procurement and staff management systems.

Morgan Stanley models for 4.0% volume growth and rate increases of 1.5% per annum. That said, the broker considers continued insurer rate increases are unsustainable and industry challenges will limit margin expansion. Downside risks for the hospital sector include further deterioration in average margins and government intervention on prothestics pricing. The broker understands surgically implanted prostheses are at a significant premium to cost but remain the industry standard and, therefore, are at risk of regulatory intervention. Prosthetics, on the broker's estimates, contribute around 3.8% to Healthscope earnings and any intervention could mean 5.0% earnings downside for its hospitals.

The broker kicks off with an Equal-weight rating for Healthscope on a $2.59 target as the shares are trading near the fair value estimate. In contrast Morgan Stanley has an Underweight rating for Ramsay Health Care and a $61.58 target.

UBS recently upgraded to Buy from Neutral when Healthscope announced the sale of its Australian pathology business to private equity. That business was lacking in sufficient scale to make it workable, UBS maintains. Funds are expected to be used to finance hospital expansion, which this broker also envisages offers potential to turn earnings around. The company sold the local pathology operations for $105m but retained its overseas business and Australian medical centres, apart from six skin clinics which were included in the sale.

There are three Buy ratings, three Hold and one Sell on FNArena's database. The consensus target is $2.84, suggesting 2.6% upside to the last share price.
 

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-Hospital negotiations critical
-High lapse rates continue
-Expenses a key opportunity
 

By Eva Brocklehurst

Recently listed health fund, Medibank Private ((MPL)), has quickly become the subject of debate among brokers regarding its outlook. While most expect prospectus estimates will be achieved there is growing doubt about just how robust FY16 will be.

Citi backs management's ability to deliver on margins with a large part of the expected expansion coming from lower claims costs. Health insurance revenue may miss prospectus growth forecasts of 6.2% (Citi expects 5.6%) but the broker envisages core profit will come in a little ahead of prospectus. Citi is also confident the company will execute on its strategy to address claims fraud and leakage via improved data mining while negotiating more risk-based outcomes with hospitals. The broker initiates coverage with a Buy rating and $2.40 target.

Central to Citi's argument is the ability to negotiate more favourable contracts with hospitals. The company wants to lead the industry by negotiating more sophisticated contracts with private hospitals rather than the predominant cost-plus basis. Historically, Citi notes, hospitals have had the upper hand in negotiations as consolidation in that segment has increased over time. Still, there is support for a belief that the balance of power could shift more in health funds' favour, as affordability become a significant issue. The broker acknowledges the risk that any stoush with a hospital provider could well become public but believes, generally, hospitals support the push for improved outcomes.

Existing agreements with the two major groups, Ramsay Health Care ((RHC)) and Healthscope ((HSO)) are not due for renewal until next year. Nevertheless, negotiations with Calvary Health Care are unresolved and remain a key point of uncertainty for several brokers.

Citi considers the next catalyst will be the results in August, with an inaugural dividend likely. At that point Australian Prudential Regulation Authority statistics will also be released on the industry for the first time - taking over from the Private Health Insurance Administration Council -  which should allow the relative performance of the business to be determined. On this subject, UBS noted claims growth moderated and margins appeared stable in the latest quarterly industry statistics. Still, the broker remains unconvinced that high lapse rates for Medibank Private are yet to dissipate.

Morgan Stanley does not believe the FY15 results will either surprise or inspire. Top line growth is under pressure and the broker doubts whether meaningful margin expansion will occur. The broker cites rising lapse rates and growth in the lower-premium brands as main challenges. The broker targets a gross margin of 13.5% versus guidance of 13.6%.

The key area of opportunity in Morgan Stanley's view is management expenses, although the broker acknowledges spending is needed to reinvigorate the Medibank Private brand while the major IT revamp should also enhance digital sales and service and data analytics. The broker expects the transition to APRA's capital framework will be smooth but the the government's dividend, IT capex and rise in deferred acquisition costs may require a small sub-debt raising to maintain capital within the targeted 12-14% of premiums. 

On the subject of expenses, Citi agrees there is scant evidence Medibank Private is achieving much in the way of economies of scale but, when viewing expenses on a per member basis, the story is a little better, with Medibank Private having among the lower management costs per average policy, albeit still higher than other large players such as Bupa, HCF and nib Holdings ((NHF)).

Morgan Stanley considers top line growth expectations of over 6.5% are too bullish as the effects of an ageing population and cyclical headwinds mean an aggressive margin expansion story is unlikely to materialise. The broker retains an Underweight rating. The outlook also appears challenging to Credit Suisse. While confident FY15 forecasts will be achieved, or exceeded, the broker believes any FY16 guidance will be indicative of mid single digit growth. The broker cites product downgrades across the industry, increasing competition, the fund's above-industry premium rate increase, the absence of further industry profitability improvements and lower cash rates as all headwinds.

Credit Suisse suspects customers are reaching a point at which, following a decade of above-inflation price increases and reductions to the government rebate, they are closely scrutinising the value in policies. The broker considers the stock fully priced and maintains an Underperform rating.

Macquarie has an Outperform rating, the other "Buy" broker covering the stock on the FNArena database. Macquarie highlight the uncertainty with Calvary Health Care negotiations but expects, in the end, terms will be negotiated which are consistent with moderating claims growth and provide suitable quality outcomes. As claims growth moderates, the broker expects Medibank Private will be able to reduce premiums and still grow margins.

The FNArena database shows two Buy ratings, one Hold (Deutsche Bank) and three Sell. The consensus target is $2.21, suggesting 4.7% upside to the last share price. Targets range from $1.85 (Morgan Stanley) to $2.65 (Macquarie).

Disclosure: The author has shares in the company.
 

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