Considering KPJ’s recent share price surge (+22% since our upgrade), we believe its risk-reward profile is now more balanced. The run-up could be due to increasing market appetite for defensive stocks and the view that KPJ is a potential beneficiary from the switchback to the SST regime. That said, the company is trading at its five-year forward mean PE and share price is now close to its three-year high. Downgrade to HOLD but maintain target price of RM1.07. Entry price: RM0.90.

WHAT’S NEW

• Good capital appreciation. Seeing that KPJ Healthcare’s (KPJ) share price has shot up 22% post our upgrade to BUY in early-April, we are now re-examining our investment thesis and risk-reward profile of the stock.

STOCK IMPACT

• Recap of 1Q18 results. KPJ’s revenue and earnings growth chugged along well in 1Q18 (+5-6% yoy), largely led by its Malaysian operations, which made up more than 95% of topline. Domestically, the company was firing on all cylinders where: a) the number of inpatients and outpatients grew 4-5% yoy, b) fees charged per patient were also higher by ~1% yoy, and c) occupancy rate rose 1ppt yoy to 69%. Collectively, these aided in Malaysia’s revenue and PBT expansion of 6-14% yoy. That said, other country operations (like Indonesia) were lacklustre, capping KPJ’s overall progress.
• Indonesian arm still not out of the woods. KPJ’s Indonesian operations continued to be poor. Revenue dropped 19% yoy, dragging 1Q18 performance into the red for the second consecutive quarter (from a low base). The competitive environment has led to the number of patients and fees declining 4-28% yoy at Rumah Sakit Medica Bumi Serpong Damai. Also, occupancy rate dropped to a low of 37% (-12ppt yoy). Nevertheless, growing the Indonesian’s presence (via JVs) remains a part of KPJ’s regional aspiration despite some short-term pain.
• Delay in hospital openings. The hospital opening timelines at Bandar Dato’ Onn, Miri and Kuching were all pushed back by one quarter to 3Q18, 2Q19 and 2Q19 respectively; this is not a huge concern as KPJ still has space for inpatients. Separately, Jeta Gardens (57%- owned aged care business in Australia which was acquired in 2010 for RM19m) is still up for sale. The disposal could free up KPJ’s capital to pare down debts or for reinvestment purposes. In 1Q18, group net gearing stood at 0.7x (1Q17: 0.8x).
• Transition back to SST has a net positive impact. The new ruling government, Pakatan Harapan (PH), has kept its manifesto promise to switch back the sales and services tax (SST) system from the good and services tax (GST) regime. To recap, the GST partially led to a rise in medical cost as the 6% input tax on drugs under the non-National Essential Medicine List is absorbed by private healthcare providers. According to Willis Towers Watson, Malaysia’s 2016-17 real healthcare inflation shot up by 8-9%. That said, medicines were not subjected to tax under the previous SST system. Hence, we believe the transition back to SST has a net positive impact on KPJ.

EARNINGS REVISION/RISK

• No change to our forecasts. Key downside risks include: a) market share losses, b) delay in hospital openings, and c) inability to pass on higher operating costs to customers.

VALUATION/RECOMMENDATION

• Risk-reward profile now more balanced. KPJ’s share price has shot up 22% since our upgrade in early-April. We believe this was due to a combination of the market developing an affinity towards defensive stocks post Malaysia’s 14th general election and the healthcare sector being viewed as a potential beneficiary of the switch back to the SST regime. It is still the cheapest proxy to the healthcare sector in our coverage (28x PE vs sector mean of 36x). As a standalone, KPJ is trading at its five-year forward mean PE. However, stock price now is close to its three-year high.
• Downgrade to HOLD but maintain target price of RM1.07, based on 28x 2019F PE. This is in line with its five-year forward mean PE of 28x but below the sector's 36x. We believe the discount is fair as KPJ has a stretched balance sheet (net gearing of 0.8x vs sector’s 0.4x) and generates an anaemic ROE of 10% vs the sector's 15%. Similarly, our PE-ROE regression analysis suggests pegging the stock at 26-28x forward PE. Despite the HOLD call, we acknowledge KPJ still appeals to long-only investors, given it is blessed with positive structural trends like: a) an ageing population, b) ‘lifestyle’ diseases, and c) rising affluence that will continue to support and drive organic growth. Entry level is RM0.90.

Source: UOB Kay Hian Research - 14 Jun 2018