As the pandemic shifts from a medical crisis to a broader economic malaise, the defensive attributes of several healthcare stocks will again come to the fore, says Morningstar's Nicolette Quinn.

The Australian economy shrank 0.3 per cent in the March quarter, according to ABS data released on Wednesday. This means the country will slide into recession – the first in 29 years – given the full effect of coronavirus shutdowns were felt in the current June quarter.

"The crisis is at the point of moving on, certainly in Australia, from being in the healthcare sector to becoming more of a general economic cycle," says Quinn.

"And we know in a general economic cycle, the healthcare space is defensive."

Two locally listed companies among the 14 healthcare names inside Morningstar's Australian research purview hold 5-stars: spray-on-skin maker Avita Medical (ASX: AVH) and Australian Pharmaceutical Industries (ASX: API).

But in the case of Avita, a relatively new addition to Morningstar's coverage list, it has a Very High uncertainty rating and lacks an economic moat.

And for API, a pharmaceutical distributor that owns the well-known Priceline chain, Quinn last month cut her fair value estimate by 6 per cent on the back of weak interim 2020 results. The fair value downgrade reflects Morningstar's 18 per cent cut to the company's earnings outlook for fiscal 2020 and 2021.

The companies within Quinn's coverage list that have no economic moat have continued to trade at a discount, whereas those with moats have seen their share prices appreciate further.

Quinn expects pathology and lab services company Sonic Healthcare (ASX: SHL) and medical device designer and manufacturer Cochlear (ASX: COH) to be among the slowest local healthcare names to rebound.

This is largely because they each derive a majority of their revenues from the US, where private healthcare dominates. Because medical insurance is usually linked with employment in the US, healthcare spending is more cyclical than in Australia and many other countries.
Though it isn't the cheapest on the list, blood plasma company CSL (ASX: CSL) is one of Quinn's top picks at the moment.

"CSL at 3-stars is not a bad buy," she says. Barring any major changes within the company, the fair value estimate will continue to increase each financial year in line with the rising cost of equity.

CSL Limited (ASX: CSL)

Quinn has left her fair value estimate for CSL unchanged at $282, and made no adjustments to her outlook for fiscal 2021.

"We expect current plasma shortfalls will be offset by increased donations as a result of the economic downturn once travel and social distancing restrictions are alleviated," she says.

"Beyond 2021, we continue to forecast five-year compound revenue growth of 9.4 per cent and EPS growth of 11.5 per cent."

The expected short-term delays in research and development spurred by the pandemic have no significant impact on the company's long-term valuation, according to Quinn, because the pipeline contributes less than 10 per cent of Morningstar's fair value estimate.

Quinn also notes CSL's solid financial position, with net debt-to-trailing EBITDA of 1.6 and $1.1 billion of cash on hand.

She expects this debt metric to fall to 1.2 for fiscal 2021, and anticipates the company will maintain its 45 per cent dividend payout ratio for the full financial year.

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.

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.

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

Morningstar's star rating for stocks is calculated by comparing a listed company's current market price with Morningstar’s estimate of the stock’s fair value.

The further the market price is below the fair value, the higher the star rating. A 5-star rating means the stock is trading meaningfully below fair value.

healthcare stocks

Source: Morningstar Direct