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2 healthcare stocks at risk of a correction

Nicki Bourlioufas  |  29 Jul 2019Text size  Decrease  Increase  |  
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Australian investors have enjoyed healthy gains on healthcare stocks, but some analysts are warning that companies such as CSL (ASX: CSL) and Cochlear (ASX: COH) are at risk of a correction.

Morningstar has a fair value of $195 a share on narrow moat CSL, Australia's largest healthcare company, below its price of $228 on 26 July.

Nicolette Quinn, healthcare analyst for Morningstar, recently downgraded that fair value from $212, based on a more moderate growth outlook due to long-term threats to the plasma industry from alternative therapies.

Having said that, CSL shares have soared 23 per cent since January, compared to around 20 per cent for the S&P/ASX 200.

Wide moat Cochlear too has jumped 29 per cent to $224 over the year, compared to Morningstar’s fair value of $180.

ResMed has rallied hard too. On 25 July, US-based ResMed reported that its revenue increased 11 per cent to US$2.6 billion ($3.7 billion), in the 2018-19 financial year with organic revenue growth of 6.8 per cent, boosted by acquisitions.

Shares in narrow moat ResMed (ASX: RMD) jumped to a record high of $19.12 on the day, compared to Morningstar’s fair value of $14.90.

Risk of disappointment

Morningstar’s Quinn says the market has pushed these stocks higher without any corresponding upgrades to earnings forecasts. There is a risk that CSL and Cochlear will be sold down in August, as they were in February, if their results disappoint.

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“There remains a risk of disappointment going into this reporting season. Analysts have been revising upwards price targets for these stocks without their earnings outlook being revised upwards or based on fundamentals.

"So, any change in sentiment could result in these share prices correcting,” says Quinn.

Based on Morningstar’s star system, ResMed and Cochlear – both with two stars – are slightly overvalued, while CSL, with three stars, is trading within its fair value range.

The Morningstar Rating for stocks identifies companies trading at a discount or premium to their fair value estimate. Five-star stocks trade at the biggest risk-adjusted discount to their fair values, whereas 1-star stocks trade at premiums.

Another analyst, Citi, recently revised its Cochlear rating to Sell given it thinks the stock is overvalued and at risk of a price fall. While its $198 target price is unchanged, Citi has marginally reduced its financial year 2019-21 earnings per share forecasts given some market share loss of Cochlear implants to competitor Sonova.

The broker has also downgraded CSL to Neutral, from Buy,though it has raised its target price to $239.60 from $236.60. It says the stock is trading at 36 times its forecast fiscal 2020 EPS, above the 3-year average of 29 times.

A defensive role for healthcare

Some experts believe, however, that healthcare stocks are still cheaper than other growth stocks including technology companies and have a role to play in investors’ portfolios given their defensive earnings.

Jun Bei Liu, portfolio manager with Tribeca Investment Partners, says healthcare businesses are screening cheaper on her radar than other sectors within the growth bucket, such as technology.

The earnings of the sector “are underpinned by multi decades of demonstrated growth. [Healthcare] ranks relatively more expensive than the rest of the index mainly due to the high certainty of earnings growth,” she says.

Healthcare businesses are defensive given the health needs of the population are largely uncorrelated with economic conditions. That is especially true of CSL.

“CSL’s therapies treat serious, potentially fatal, conditions. As a result, its revenues are largely immune to economic conditions. It does supply tender markets in Europe and elsewhere but again as most countries will not stop treating patients, sales into such regions rarely if ever decline.

"It's also worth noting the bulk of CSL sales will be for therapies used to treat chronic conditions and hence are not contingent upon finding new patients,” says Liu.

In terms of Cochlear, the company is more vulnerable to a downturn. “I expect the increasing proportion of sales to seniors, principally in Western markets, will see a great sensitivity in future. The decision to seek out an implant in this patient cohort is discretionary, especially given the high cost. It also worth noting over 70 per cent Cochlear revenues are from sales to new patients rather than from repeat business, increasing the sensitivity to a downturn,” says Liu.

In terms of ResMed, it is also more vulnerable to a downturn than CSL given the treatment of sleep apnoea is discretionary and hence its sales have been correlated to economic conditions, especially in the US.

“I expect this to remain the case into the future. The software business is also contingent upon the success of the segments it serves so Brightree is likely to be highlight correlated to conditions in ResMed’s core sleep business,” she says.

 

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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