Australia’s Top 3 healthcare stocks

Australia’s healthcare sector is world class. Here we rank the best performers based on growth, margins, competitive advantages and more.

The S&P/ASX 200 Healthcare Index has returned 247% over the past 10 years, compared to just 54% for the All Ordinaries. Healthcare beat every other sector hands down.

Australia is blessed with plenty of high-quality healthcare companies, many of which have delivered great returns to members since we upgraded them, including Sirtex (271%), CSL (221%) and Nanosonics (151%) to name just a few.

But let’s forget about share prices for a moment and just focus on what makes a great company.

Good businesses tend to have a few things in common: pricing power, lots of free cash flow, high returns on capital, low debt and sustainable competitive advantages.

Like most ‘best of’ lists, this one requires a hearty dose of subjectivity, but by focusing on those few traits and sticking to the ASX200, we can narrow the list down to a ‘Top 10’: Cochlear (ASX: COH), Ramsay Health Care (ASX: RHC), Healthscope (ASX: HSO), Sonic Healthcare (ASX: SHL), ResMed (ASX: RMD), CSL (ASX: CSL), Fisher & Paykel Healthcare (ASX: F&P), Virtus Health (ASX: VRT), Sirtex Medical (ASX: SRX) and Ansell (ASX: ANN). At the right price, we would be happy to buy any of these healthcare stars.

Pricing power and FCF

The first of our measures – pricing power – differs widely between this set of businesses.

Top of the list is CSL, with an earnings before interest and tax (EBIT) margin of 32%. CSL manufactures dozens of life-saving medicines that, in many cases, have no viable substitute – some cost hundreds of thousands of dollars a year.

Sirtex Medical, with its novel cancer radiotherapy, is in a similar situation. Contrast these two with Ramsay Health Care and Healthscope, Australia’s two largest hospital operators, which must fight tooth and nail against the private health insurers and Government to squeeze out a profit.

What matters to shareholders, though, isn’t the company’s operating income – it’s the amount of cash that can be taken out of the business each year as dividends or share buybacks. Here, Sirtex takes the lead with an impressive free cash flow (FCF) margin of 29%, followed by CSL and ResMed, both with margins of 19%.

Company Mkt Cap ($bn) EBIT margin  FCF margin  ROE  ROIC EPS growth (5y, pa) Net Debt/ EBITDA  Net Debt/ Equity
Table 1: 2015 company financials
Ansell 2.5 15% 7% 16% 13% 6% 1.6 39%
Cochlear 5.7 22% 16% 43% 38% -1% 0.6 40%
CSL 44.8 32% 19% 47% 32% 11% 0.9 63%
F&P Health 4.9 25% 14% 26% 24% 9% 0.3 11%
Healthscope 4.5 12% -3% 8% 7% NM 2.5 42%
Ramsay 12.2 11% 4% 23% 15% 22% 2.6 155%
ResMed 10.5 24% 19% 21% 29% 15% 0.0 0%
Sirtex 1.6 31% 29% 35% 69% 19% 0.0 0%
Sonic 7.6 13% 8% 12% 8% 3% 2.7 59%
Virtus 0.5 22% 12% 13% 10% NM 2.1 54%
Source: Company reports, UBS, Capital IQ

Return on capital

In his 1992 letter to shareholders, Warren Buffett said: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”.

We love businesses that don't require much capital expenditure to operate and can reinvest profits at high rates of return. Both Sirtex and CSL earn excellent returns on invested capital (ROIC) of 69% and 32% respectively, but CSL's more leveraged balance sheet gives it a higher return on equity (ROE) of 47%, compared to Sirtex’s 35%. Cochlear, the world leader in hearing implants, also deserves some kudos with an ROE of 43% and ROIC of 38%.

Earning high returns on capital is one thing, but many businesses in decline can still pull off that feat – newspapers, for example. The best businesses can reinvest at high rates of return as they grow.

Growth and debt

Earnings per share growth is what matters most to shareholders. And here Ramsay takes the lead with a growth rate of 22% over the past five years thanks to its well implemented international expansion and a steadily aging population. Sirtex and ResMed aren’t too far behind with growth rates of 19% and 15% respectively.

Finally, the four-letter word that can destroy even the best of businesses: debt. ResMed and Sirtex have squeaky-clean balance sheets with sizeable cash piles and no net debt. ResMed, however, recently announced a large acquisition that will leave it with net debt of around US$500m on completion. That's around one times operating earnings, so the balance sheet will still be clean, just lacking that extra squeak. 

Drum roll

So where does that leave us? Sirtex Medical is the standout contender and made it to the Top 3 for all of our financial filters. CSL and ResMed followed close behind, and landed a place on most measures.

But there’s one thing we left out. Dozens of companies can earn high margins or returns on capital, and plenty more are growing rapidly and have conservative balance sheets. Financial metrics are only ever half the story.

What really sets the great businesses apart is that they can do it over long stretches due to sustainable competitive advantages, or what Warren Buffett likes to call a ‘moat’.

Despite Sirtex’s formidable financials, it's still a one-product company and is heavily exposed to regulatory changes, competition or – worse – a product recall and loss of reputation.

ResMed also has a relatively niche market in sleep apnea, which faces growing competition from the likes of F&P Healthcare and other providers. Its recent acquisition makes us nervous too.

CSL, on the other hand, is an economic powerhouse and one of only a few Australian companies with a history stretching 100 years. Talk about staying power.

CSL may not be growing as quickly as other healthcare stocks or have a best-in-class balance sheet, but it’s still conservatively geared with decent growth prospects.

It has economies of scale and operating leverage, patent protection and pricing power. It has a shareholder focused management and a diverse portfolio of products. CSL gets our vote as Australia’s best healthcare company.      

To see our recommended price guide for CSL and which healthcare stock listed above has a BUY recommendation, take a 15 day free trial of Intelligent Investor now.

Disclosure: The author owns shares in Virtus Health, Ansell, Nanosonics and ResMed. Other staff members own stocks mentioned above.

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