Health care gets a mixed diagnosis

From gold medallists to a mixed bag of mediocrity. That pretty much sums up the performance of the Australian health care sector in the latest round of earnings.

But, as you’d expect, that rather average overall relay performance overshadowed some stunning individual achievements that remain worthy of consideration as investment vehicles. A few others, however, may be past their prime or at the very least are overrated.

After 2012, a year in which the health care sector raced ahead of the general market, the last few months has seen the sector return to earth with a thud, barely managing to maintain pace with the ASX 200. In December Adam Carr pointed to problems in the sector in his article Why healthcare is unhealthy.

If the latest round of half-year earnings was remarkable for the sheer range of sectors and previously unloved stocks to deliver the goods, it was also noteworthy for several high-profile disappointments.

Among them were Cochlear and Ansell. In a market desperately seeking out anything positive, both were dealt with harshly by investors, with massive price falls after failing to live up to expectations. Resmed, too, was admonished despite a lift in earnings as concerns emerged about the market in which it operates.

CSL and Primary Health Care, in contrast, were amply rewarded for their better-than-expected earnings and brighter full-year outlooks. Ramsay Health Care, meanwhile, was pushed higher despite a lacklustre performance, while Sonic maintained an even keel on relatively weaker-than-expected earnings.

While they are all are lumped together, the health care sector contains a divergent bunch of outfits largely split between pharmaceutical and health manufacturers to service groups offering aged care and hospital services.

Sunshine

Among the standouts, CSL remains a clear favourite. Macquarie, JP Morgan and Credit Suisse all rate it a buy or overweight while CIMB, Deutsche and Merrill Lynch have a hold on the stock. Citi is the only broker with a sell.

It managed another impressive sales lift in the most recent half, up 11%. But even more admirable was the expansion of its margins, primarily due to more efficient plasma collection and its product mix.

Most brokers believe the company will not be capable of maintaining such impressive margin growth. But Macquarie disagrees, arguing yield improvements will continue to drive margin growth. In addition, there are healthy prospects for continued market growth while CSL has plenty of scope for cost reductions if necessary.

Like many health care stocks, CSL is trading on a huge multiple. Despite being priced at 26 times earnings, most brokers cannot see that premium being eroded in the short term.

The other interesting performance came from Resmed. Net earnings jumped 24%, bettering most analyst expectations.  Like CSL, the result featured an attractive combination of improved revenue and vastly enhanced margins.

Most of the concerns about Resmed relate to the future of the sleep industry, particularly cuts from US medical authorities on reimbursement – known as competitive bidding – for the kind of pressurised airway equipment the company makes.

Macquarie has a hold on the stock, given the new round of competitive bidding doesn’t begin for another nine months. It sees upside in the stock for another six months.  JP Morgan and Citi have a buy on Resmed while most others rate it a hold.

Among the health providers, Ramsay Health Care and Primary both delivered reasonably solid earnings, with both forecasted to bring in full-year earnings per share growth of 23 and 24% respectively.

Primary did particularly well in imaging while its medical centres lagged. A major issue for Primary, however, is its free cash flow, which again came in at around half reported earnings. While it was enough to cover dividends, this has been a continuing trend for several years.

Ramsay Health Care disappointed some analysts with slightly lower revenue growth but added that it has more brownfield developments coming on stream. But it still is indicating up to 15% earnings growth in the second half, with Macquarie tipping that it could easily beat that target by a significant amount.

“We believe Ramsay will continue to grow earnings per share in the mid-teens for some time, a very attractive proposition. We also see regulatory risk fading and attractive propositions a real possibility.”

The only downside to this compelling argument is Ramsay’s current valuation. Trading on a multiple of more than 22 times full-year earnings, it is looking expensive and hence is a hold in the eyes of most brokers.

Storms

Cochlear was the great disappointment for the sector, and for the stockmarket as a whole. Earnings per share are forecast to slip 5% this year and sales growth, outside of China, slowed sharply.

That’s put the wind up investors – despite forecasts for a return on equity in excess of 38% – who now are concerned that the company cannot justify its enormous price premium.

The biggest concerns relate to the long-term effect of the global product recall last year and the reputational leg-up this has delivered to competitors.

With competing product launches due in coming months, there is a risk that Cochlear’s earnings, and certainly its share price, will come under attack, particularly given it is trading at 28 times earnings, around twice the market average.

At least six brokers have sell recommendations on the stock, with BA Merrill Lynch and CIMB rating it a hold.

Ansell also stunned the market with a massive miss on earnings forecasts. It did manage to convince some investors that it will be able to maintain its earnings guidance for the full-year. But that will require it to pull in a bumper second half.

Earnings per share dropped 14% in the first half. To achieve even the bottom end of its guidance, it will need to deliver a 25% growth in earnings per share this half.

“Management does have a good history of delivering, but with a relatively unconvincing explanation given for weakness in the medical and sexual wellness divisions, we see plenty of risk,” Macquarie analysts argue.

Sonic Health Care was another that copped a battering after its results hit the screens, dropping 8.5% that day. Scepticism as to whether the company can hit its targets overwhelmed any arguments management could muster.

Interestingly, though, some brokers saw the massive price fall as an attractive opportunity, with relative value now restored. Unlike most of its contemporaries, Sonic trades at a relatively benign 15.7 times full-year earnings.

Macquarie this week upgraded it to a buy while almost everyone else has it as a hold, citing its impressive margin expansion in pathology and radiology divisions while noting the downturn in the US would probably make it difficult to achieve full-year earnings.