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This high-quality ASX healthcare stock is in the Buy zone

Nicholas Grove  |  26 Sep 2017Text size  Decrease  Increase  |  
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As any regular visitor to Morningstar.com.au would know, the Economic Moat Rating is the foundation stone upon which Morningstar's long-term investment methodology is built.

 

In addition to being a body of water surrounding a medieval fortification that once acted as a deterrent to enemies or would-be usurpers, the term "moat"--as it applies to the world of investing--was first coined by legendary investor Warren Buffett.

An economic moat is a structural feature that allows a company to sustain excess profits over a long period of time. Morningstar defines excess profits as returns on invested capital (ROICs) above our estimate of a company's cost of capital, or WACC (weighted average cost of capital).

Without a moat, profits are more susceptible to competition. Companies with a narrow moat are those we believe are more likely than not to achieve normalised excess returns for at least the next 10 years.

Wide-moat companies are those in which we have very high confidence that excess returns will remain for 10 years, with excess returns more likely than not to remain for at least 20 years.

Using the Stock Screener tool on Morningstar.com.au, investors may discover that there is one healthcare stock that not only carries a narrow moat rating, but is, at present, the only moat-rated ASX-listed stock that is sitting in the Buy zone.

Market too focused on short-term issues

There are plenty of reasons to like a company such as private hospital operator Healthscope (ASX: HSO), specifically the myriad long-term competitive advantages that underpin its narrow economic moat rating.

Healthscope boasts both substantial scale and geographic reach, with several "tier 1" hospital assets in major Australian cities.

Also, as Morningstar senior equities analyst Chris Kallos points out, capacity constraints within Australia's public hospital system, coupled with the government's focus on cost-containment, bode well for continued support for the private hospital sector.

"Solid market fundamentals continue to fuel demand for the Australian private hospital sector, with supportive government policy helping to underpin growth," Kallos says.

"In our view, the federal government's supportive stance on private health insurance and the potential streamlining of the two-level (federal and state) regulatory system proposed in the May budget are both positive for the industry.

"Given Healthscope's size and geographic reach, it is well positioned to benefit from these attractive market dynamics."

In late August, Healthscope reported a full-year result that was broadly in line with Morningstar's forecasts. But the Australian Hospital division, which represents 87 per cent of group revenue, fell slightly short of expectations due to site-specific underperformance in Victoria.

Specifically, a slower-than-expected ramp up in volumes at the newly relocated Holmesglen Private and Frankston Private developments in Victoria, along with increased competition in the catchment area of Geelong Private and Victorian Rehabilitation Centre, led to a $10 million decline in earnings before interest, tax, depreciation, and amortisation (EBITDA).

Operations in Victoria and Tasmania represent almost a third of group EBITDA for Healthscope.

Investors punished the stock following the release of the earnings results on 24 August, sending shares in Healthscope down over 15 per cent to a record low.

However, Morningstar's Kallos believes the market is too focused on the short-term site-specific issues in the company's Victorian hospital portfolio, which he thinks should improve in the 2018 calendar year.

"Management is addressing these issues with programs to attract doctors and bolster admissions but expects the challenges in Victoria to persist into first-half 2018. As such, we think the weakness is temporary," he says in a recent note.

"We remain comfortable with our medium-term 8 per cent growth outlook for the hospital division, given management initiatives in Victoria and the combination of brownfield and construction projects expected to complete in the next two years."

Kallos maintains his $2.60 fair value estimate and Buy recommendation for narrow-moat-rated Healthscope. Shares of the company were trading at $1.65 as at 1351 AEST on 26 September 2017.

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Nicholas Grove is a senior content editor at Morningstar.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

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