Coronavirus puts healthcare stocks in the spotlight

Healthcare stocks are in high demand during current market volatility and this is reflected in their high valuations.

Of the 14 healthcare companies in Morningstar Australia's research stable, only two currently hold five-stars. Neither of these hold economic moats–or sustainable competitive advantages–in the eyes of Morningstar analysts.

"Because of the defensive nature of the sector, it's not trading at the deep discounts that we see in other sectors," says Nicolette Quinn, Morningstar equity analyst.

"People are still going after the quality names, and in the healthcare space there aren't a horde of local opportunities."

Australian Pharmaceutical Industries (ASX: API)

The owner of Priceline retail pharmacies and a growing chain of health and beauty Clear Skincare clinics, API is currently trading at a 59 per cent discount to Morningstar's fair value estimate.

While at first glance it may look like a bargain, Quinn recently cut the fair value estimate by 6 per cent after API's interim 2020 results. This reflects Morningstar's 18 per cent cut to its earnings outlook for the company over fiscal 2020 and 2021.

"Although Priceline managed to hold market share with like-for-like sales declining 1.3 per cent in the half, we forecast a revenue decline of 6 per cent in fiscal 2020 with foot traffic expected to be heavily impacted by social distancing," Quinn says.

Avita Medical (ASX: AVH)

The other five-star name in the local sector, Avita is a dual-listed US- and Australian-domiciled manufacturer of spray-on skin.

Avita's third quarter update conveyed mixed results. While the company had a healthy fiscal third quarter, including a 67 per cent jump in third quarter revenue to $8.065 million, management flagged road bumps in the rollout of Recell.

Quinn has rated Avita's fair value uncertainty as "very high risk" due to the unpredictability around the pace and success of its roll-out of flagship product, Recell. The company doesn't currently hold an economic moat because its patent protection of RECELL doesn't extend beyond Morningstar's 10-year evaluation period.

Quinn also believes the enzyme that is central to the product–of which Avita owns the intellectual property–the company doesn't make the Recell product itself. This leaves it open to being replicated by a competitor once the patent expires after 2024.

The fact that the no-moat stocks within the sector are trading at the sharpest discounts to Morningstar's fair value indicates investors are hungrier for the quality names. And they're prepared to pay up for them, says Quinn.

"What is scarce for investors? Companies that are resilient and high quality, and by that, I mean they have consistent cash-flow," she says.

"People will go after defensive quality at a time when there is so much uncertainty."

Cochlear (ASX: COH)

Hearing implant company Cochlear is the only local healthcare name that holds a Morningstar wide moat. This is earned largely thanks to Cochlear having few competitors within its highly-specialised field, and the secure demand for its products within developed markets.

"The company’s approximately 60 per cent market share in cochlear implants has remained materially stable for the last decade, and because it has an established network of surgeons who are unlikely to switch brands, we foresee this market position continuing," says Quinn.

She notes that while the company reports its earnings in Australian dollars, most of its sales are in US dollars and euros. This has boosted Cochlear's earnings growth over the past few years.

But Quinn highlights this as a risk if the weaker Australian dollar turns around: "This trend may change and have a knock-on impact on dividends."

Cochlear recently raised $880 million of equity from shareholders, as its loss of a long-running US court battle imposed a bill of more than US$390 million–further compounding the company's covid-19 woes.

"Consequently, we expect the second-half fiscal 2020 dividend to be suspended and believe the 70 per cent dividend payout policy is at risk," Quinn says.

Quinn says Cochlear is also vulnerable to the drop-off in elective surgeries that has occurred in the wake of the coronavirus epidemic. A recent study published in the British Journal of Surgery suggested the six-weeks of restricted elective surgery had created a backlog of around 400,000 patients.

Fisher & Paykel (ASX: FPH)

Dual-listed respiratory device-maker Fisher and Paykel Healthcare has been a beneficiary of the coronavirus pandemic because it has driven demand for hospital hardware.

Quinn recently boosted her fair value estimate for the company to NZ$19 from NZ$17.90 on the back of hospitals' increased use of consumables during the pandemic.

"While we see this boost as a short-term in nature, the larger installed hardware base should support a moderate increase in long-term demand for associated consumables," she says.

In line with this, Morningstar's five-year compound annual growth rated for sales is tipped to increase to 17.5 per cent from 16.5 per cent.

"Fisher & Paykel is in a strong financial position with no net debt on the balance sheet at the interim fiscal 2020 reporting date," Quinn says.