Healthcare stocks performed within expectations: The two healthcare stocks under our coverage – KPJ Healthcare Bhd and IHH Healthcare Bhd – reported FY14 core earnings that were within both our and market expectations. Both companies reported earnings growth as a well as margin improvements.

- 20%-29% earnings growth on higher revenue: Core earnings for KPJ and IHH grew by 20% and 29% YoY, respectively, on the back of 13% and 9% topline growth. The topline growth could be attributed to increased patient volume, ramp-up of beds in existing hospitals and commencement of new ones last year. Recall that KPJ opened the Rawang Specialist and Maharani Specialist hospitals in March and June, while IHH had opened the Aicibaden Atakent Hospital and Pantai Hospital Manjung in January and May.

- EBITDA margin improvements of ~2ppts: Both companies saw EBITDA margins improved by ~2ppts each. KPJ’s EBITDA margin improved to 12% (vs. 10% in FY13), while IHH recorded a margin of 26.4% (vs. 24.5% in FY13). We believe the improved margins could be attributed to better operational efficiency, continued ramp-up of beds and price reversions.

- Healthcare demand remains robust: We believe that healthcare demand remains healthy on the back of an ageing nation (10% of population over 60 years old by 2020), increasing health awareness and improving economic wellbeing. According to Frost & Sullivan, healthcare expenditure in Malaysia is expected to surpass USD20bil (RM72bil) by 2025. It also projects the healthcare industry to register a CAGR of 11% until 2020.

- …but margins may come under pressure: While margins had improved last year, we foresee some pressure in the coming quarters as GST is rolled out in April. Both KPJ and IHH expect input costs to increase by 2%-4% when GST is implemented but this will be partially mitigated by price reversions. With new hospitals coming on-stream and expanding capacity, we expect flattish margin growth this year.

- GST leads to rise in medical costs: According to the Customs Department, services provided by healthcare professionals employed by private healthcare facilities are tax-exempt. However, the majority of the doctors who provide services at IHH and KPJ hospitals are independent practitioners – i.e. not under the hospitals’ payroll – and thus, their services are GST standard-rated. Ancillary services (e.g. prescription, food, mortuary services) are considered exempt supplies. Standard-rated supplies include non-related healthcare services (i.e. food catering, parking, laundry services), rental/leasing (operation theatre, clinics), seminars/training by doctors, fitness programmes (gym, spa), and medical aids for patients. Medicines listed on the National Essential Medicine List (NEML) are zero-rated; other medicines are GST standard-rated. (See Exhibit 9). In general, we expect some margin pressure in the near term, as the healthcare players will have to absorb the cost increase, namely for the exempt supplies.

- Forex impact: The weakening MYR has little impact on KPJ as its entire borrowings are MYR-denominated and 90% of its revenue are derived from domestic hospitals. For IHH, only 1.7% of its total borrowings of RM4.3bil as at end-Dec 2014 were MYR-denominated. The strengthening SGD is positive for IHH; however it continues to be partially offset by the weakening Turkish Lira. While the exchange rate is expected to be volatile, this is hedged by IHH’s borrowings in the domestic currencies of its operations.

- Medical tourism on the rise: The weakening MYR is expected to result in an influx of medical tourists in the country. According to the Malaysia Healthcare Travel Council, healthcare travelers recorded a CAGR of 12% to 770,000 from 2007-2013. Foreign patients make up ~30% of revenue for IHH’s Singapore operations with patients mainly from Indonesia, the Middle East and China. Only ~5% of its Malaysia operations are contributed by foreign patients, which is similar to KPJ’s 5%. KPJ’s medical tourism will be spearheaded by the upcoming Bandar Dato’ Onn Specialist hospital; we expect continued growth at IHH’s three main markets – Malaysia, Singapore, and Turkey.

- Maintain NEUTRAL: While demand for healthcare will continue to rise, we see possible margin pressure for KPJ due to GST as well as new hospital openings in the pipeline (KPJ Pahang and Perlis slated for completion in 1H15 and 2H15, respectively). Hence, we maintain HOLD on KPJ with a DCF-based fair value of RM4.10/share. Meanwhile, IHH continues to achieve growth in inpatient and revenue intensity and has better margins compared to those of peers; but we deem its valuations to be fair at this juncture at 51x FY15F PE. Thus, we maintain our HOLD call for IHH with a fair value of RM5.40/share. We have a NEUTRAL call on the sector.

Source: AmeSecurities Research - 24 Mar 2015