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Here's where value is emerging in healthcare stocks

Nicki Bourlioufas  |  24 Apr 2017Text size  Decrease  Increase  |  

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With the federal government aiming to wind back healthcare spending, some healthcare stocks have been weighed down and are now trading below their fair values, particularly Ramsay Health Care (ASX: RHC) but also Sonic Healthcare (ASX: SHL), according to experts.

The Medicare Benefits Schedule (MBS) Review Taskforce is considering how the more than 5,700 items on the MBS can be aligned with contemporary clinical evidence and practice, and improve health outcomes for patients.

While there are no targets for savings attached to this review, the federal government wants to curb inefficiencies by ensuring that low-value items cease being funded by Medicare, allowing investment to be directed to more effective services.

The taskforce is expected to provide a report late in 2017 with recommendations to the Minister of Health.

Chris Kallos, healthcare equity analyst with Morningstar, says government funding is a key risk for domestic medical service providers given the MBS review.

Similarly, the Private Health Insurance Consultation (PHIC), a review of private health insurance payments to private hospitals, has raised concerns about their revenues.

Nevertheless, Kallos says Ramsay is likely to weather the storm and progress towards its fair value of $87 from current trading levels around $70.

"Ramsay is undervalued for a whole range of issues, which have been driving negative sentiment towards the stock. The domestic business is being weighed down by government reviews, including the PHIC," says Kallos.

Ramsay is the largest private hospital operator in Australia by facilities and it has been a strongly growing business, through organic growth and acquisitions.

The company operates 221 hospitals across six countries and its revenue is derived from Australia and Asia (53 per cent of total revenue), the UK (10 per cent), and France (37 per cent).

"The Brexit vote has also been weighing on the stock, as well as the upcoming French election," Kallos says.

He says the upcoming French elections could have a favourable impact on Ramsay's earnings if the current socialist government is voted out, paving way for another government that could treat private hospital providers more favourably.

In Australia, "an ageing population means that demand for medical services is growing. Ramsay is well placed to benefit, given the locations and quality of its facilities".

"Ramsay continues to invest capital in hospital projects around Australia. A disciplined and experienced management team will ensure returns from invested capital that exceed internal benchmarks of 15 per cent," says Kallos.

"On the downside, private hospital operators are vulnerable to the health of the private insurance industry. Regulatory change and economic weakness could lead to a contraction in spending and a decline in membership levels, starving the private industry of funds."

Nevertheless, Ramsay's dominant position in the private hospital market underpins its pricing power and ability to transfer cost increases to private health insurance funds, says Kallos.

Ramsay is expanding its strategic focus in the core domestic business, including a move into community pharmacies under a franchise model, with 22 pharmacies now open.

Kallos also expects the global consolidation of procurement activity by Ramsay, and the leveraging of buying power at the local level, to drive considerable savings.

"The company's cost-saving program is on track and could deliver around $150 million over three years, with $40 million in savings expected this fiscal year," he says.

But these strengths were overshadowed by the surprise retirement of CEO Chris Rex, who in February promoted chief operating officer Craig McNally to the company's top job, effective 3 July. Kallos expects McNally, who like Rex has been employed from within the company's ranks, to be positive for Ramsay.

As of 14 April 2017, the consensus forecast among 11 investment analysts covering Ramsay was that it would outperform the market, according to Thomson Reuters data. The 12 analysts offering 12-month price targets for Ramsay had a median target of $77.55, with a high estimate of $91.00 and a low estimate of $64.30.

Like Ramsay, Kallos says Sonic Healthcare has been weighed down by government reviews of health spending, with pathology, one of the company's key markets, in line for a possible funding hit.

Sonic is also the largest operator of medical centres in Australia, and the second-largest player in the Australian radiology market.

Of the 12 analysts offering 12-month price targets for Sonic, the median price target was $22.68, with a high estimate of $25.10 and a low estimate of $19.50 compared to its current trading level at around $21.50.

Kallos, who puts a fair value on the stock of $24, is upbeat about the company's prospects.

"Europe's relatively fragmented and inefficient pathology markets represent opportunities for Sonic's experienced management team to extract material profit growth. With establishment costs sunk, bolt-on acquisitions now add strongly to profitability," he says.

"The economics of diagnostic medicine, which includes pathology and radiology, are attractive, as diagnostics assist in containing the progress of disease, thereby limiting the requirement for more expensive medical intervention. This should underpin public funding of the industry in the long term."

That contrasts with the Australian pathology market, which is substantially consolidated, says Kallos.

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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