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Australian undervalued defensive stocks in healthcare

Lex Hall  |  29 May 2019Text size  Decrease  Increase  |  
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In part two of our survey of defensive stocks to consider, we look at several healthcare names. Our selection is based on results from the Morningstar share screener.

Our search criteria includes: 3 to 5 star-rated stocks in the following sectors: healthcare, utilities and consumer defensive. These sectors are considered relatively immune to economic cycles. In line with this, we sought medium to low fair value uncertainty – a measure of the predictability of a company’s cashflow. This search yielded two names in the healthcare sector: Australian hospital operator Healius (formerly known as Primary Health Care) and health equipment provider Fisher and Paykel Corporation. They are trading at discounts of up to 10 per cent.

As Morningstar analyst Nicolette Quinn notes, healthcare stocks, such as Fisher & Paykel, “enjoy defensive revenue streams, particularly when they are exposed to multiple geographies and don't have single product dependency.”

That said, biotechnology powerhouse CSL (ASX: CSL) doesn’t figure in our selection as it is trading at close to fair value.

Our list includes other names in healthcare, which are trading at higher discounts but have a higher degree of fair value uncertainty. The uncertainty rating captures a range of likely potential intrinsic values for a company based on the characteristics of the business underlying the stock, including such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors. If the range of potential intrinsic values is narrow, the company earns a low uncertainty rating. If the range is great, the company earns a high uncertainty rating.

Australian defensive stocks in healthcare

Source: Morningstar, as at 29 May 2019

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Following is a summary of the stocks we’ve selected with commentary from Morningstar analysts Daniel Ragonese, Nicolette Quinn, Brian Han and Adrian Atkins.

Healius

Formerly known as Primary Healthcare Healius (ASX: HLS) provides investors with exposure to a portfolio of medical businesses with reliable earning streams. It is currently trading at a 10pc discount to Morningstar’s fair value estimate of $3.50.

We expect the latter to grow solidly over the medium and longer term as the firm fills excess capacity and benefits from rising demand from an aging population. Earnings should be relatively insulated from cuts to public healthcare budgets, as the effective delivery of diagnostic services helps to constrain healthcare costs by enabling early treatment of disease. The aging population and ongoing technology innovation will also help to underpin pathology and radiology test volumes.

Primary Health Care, which was founded 30 years ago by the late Edward Bateman and operates pathology, medical centres, IVF, imaging and day hospitals, changed its name to Healius as part of a rebrand late last year. In January this year, Healius was subject to a non-binding $2.02 billion bid from a unit of its largest shareholder, China’s Jangho Group.

This implies forward fiscal 2019 price/adjusted earnings of 21, enterprise value/EBITDA of 9.0 times, a free cash flow yield of 9.0 per cent, and a dividend yield of 3.0 per cent (fully franked). We use a cost of equity of 9.0 per cent and a weighted average cost of capital of 7.5 per cent. Return on invested capital, or ROIC, is only about 6 per cent, as a result of the significant goodwill Healius paid when it acquired Symbion in 2008. During the next five years, we forecast ROIC to average 6.3 per cent. (Daniel Ragonese)

Fisher and Paykel Corporation

Fisher & Paykel's (ASX: FPH) respiratory and home care products have helped lift the company's full-year profit 10 per cent to a record $NZ209.02 million ($197.74 million).

The dual-listed health equipment provider lifted revenue 9.0 per cent to $NZ1.07 billion for the 12 months to 31 March as sales across its hospital group - which includes products used in respiratory, acute and surgical care - grew 11 per cent to a record $NZ642.3 million. It is currently trading at an 8pc discount to Morningstar’s fair value estimate.

Fisher & Paykel enjoys a long growth trajectory as both the hospital and homecare markets for respiratory devices are growing strongly. Application of their high flow nasal therapy is the main driver of growth and is gaining clinical traction in the hospital market where Fisher & Paykel have an established stronghold. The market for this and other new applications has grown at a five-year CAGR of 24.2 per cent and we forecast a forward growth rate of 20 per cent. The use of Fisher & Paykel product in producing clinical evidence and leadership in nasal high flow therapy lead us to consider the market position as entrenched in the medium term. Although most of the margin expansion targeted by management has played out, with operating margin just 0.5 per cent below the targeted 30 per cent, the company has set out a revenue growth aspiration of 12 per cent per year which our five-year forecast of 9.5 per cent falls short of. (Nicolette Quinn)

Australian Pharmaceutical Industries

Narrow-moat API (ASX: API) is the most vertically integrated of Australia's three national full-line pharmaceutical wholesalers. Incremental conversion of the corporate-owned Priceline stores and additional growth of the Priceline Pharmacy franchise network are revitalising API's earning's profile. Growth of API's Priceline Pharmacy franchise business in the competitive health and beauty category is encouraging, given the improved earnings profile over the past two years, which suggests that scale benefits from the now 479-strong combined network (Priceline and Priceline Pharmacy) are beginning to emerge. Nonetheless, ongoing reform of the Pharmaceutical Benefits Scheme and increasing competition continue to hamper revenue growth. API is currently trading at a 27pc discount to Morningstar’s fair value estimate of $1.80 a share.

We consider pharmaceutical wholesaling and distribution to be a relatively mature industry, and forecast modest growth for the next decade, given the Australian government's determination to contain PBS costs. Nonetheless, continued expansion into the highly competitive health and beauty category is generating scale benefits and forging an attractive franchise model for community pharmacies seeking a stronger retail-facing business. We also believe diversification into non-PBS-related manufacturing revenue will support margin improvement, given vertical integration into corporate-owned retail stores and banner group channels.

Accordingly, we have factored in a 2.1 per cent five-year revenue CAGR and 2.3 per cent average operating margins over our explicit forecast period. This compares with a three-year historical revenue CAGR and operating margin of 5.2 per cent and 2.2 per cent, respectively. (Brian Han)

Sigma Healthcare

Sigma Pharmaceuticals (ASX: SIG) is one of Australia's three pharmaceutical wholesalers. It is the largest pharmacy network in Australia, with more than 1,200 branded and independent stores. It also has an expanding presence in the hospital pharmacy services and other healthcare services. Management initiatives have delivered significant efficiency gains at the operational level during the past three years. Nonetheless, ongoing reform of the government Pharmaceutical Benefits Scheme remains a major challenge to profitability.

Our fair value estimate for Sigma Healthcare stands at 68c a share – a 21pc discount – and incorporates the contribution of the Central Healthcare Services and Discount Drug Store acquisitions. Sigma operates in a highly competitive and relatively mature industry. Nonetheless, efficiency gains achieved by management's cost and revenue initiatives have been encouraging. We forecast modest growth for the next decade, given the Australian government's determination to contain Pharmaceutical Benefits Scheme costs and the intensifying competition from generics. We are encouraged by development of non-PBS-related revenue in practice management service fees under the banner group strategies, which also leverage its expanding range of private- and exclusive-label products. (Brian Han)

Blackmores

Blackmores (ASX: BKL) has been the market leader for complementary medicines in Australia since 2003, following the demise of competitor Pan Pharmaceuticals that year. A combination of product innovation, category expansion, and increasing distribution scale has helped the company maintain this position and achieve strong profit growth. Key products include the performance multirange, eco krill oil, executive B stress formula, and pregnancy and breast-feeding gold. A growing acceptance of complementary medicines as a viable alternative to traditional medicines leaves the industry with growth potential in the years ahead. Although we view the primary geographic market of Australia as largely mature, offshore sales in Asia are increasing significantly. Blackmores' strong brand position stems from its heritage-brand status in Australia.

Our fair value estimate is reduced to $105 per share – 13pc discount – after watering down expected profit margin expansion stemming from Asian growth. Our long-term forecasts incorporate low-to-mid-single-digit organic growth in the core Australian business, coupled with double-digit growth in sales to China and the other Asia segment (which includes Singapore, Hong Kong, Taiwan, Korea, Indonesia, Vietnam, Cambodia, and Kazakhstan). This is predicated on current plans to double manufacturing output and takes into consideration the uplift in Blackmores' Asian business. (Adrian Atkins)

is senior editor for Morningstar Australia

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