We are downgrading IHH Healthcare from Market Perform to UNDERPERFORM as its share price has exceeded our target price. Coupled with our UNDERPERFORM call on KPJ Healthcare, our rating on the healthcare sector is DOWNGRADED to UNDERPERFORM from NEUTRAL. Furthermore, both IHH and KPJ are currently trading at lofty valuations compared to their net profit growth forecasts for FY13 and FY14. Overall, we still believe that the healthcare industry in Malaysia will continue to enjoy stable growth supported by the growing healthcare expenditure, rising medical insurance and an aging population demographic. The healthcare services sector earnings are considered defensive for its high predictability and captive earnings streams. The recently-concluded 1HCY13 results saw IHH Healthcare coming in within our expectations but KPJ Healthcare performed below our estimates. The main drawback at this juncture is that the healthcare stocks including IHH Healthcare (UP, TP: RM4.04) and KPJ Healthcare (UP, TP: RM5.75) are trading at rich valuations while offering low dividend yields at their current market price.

IHH Healthcare. IHH recorded 1HCY13 results which came in marginally within expectations. The key highlights from its 1HCY13 results included: (i) Mount Elizabeth Novena achieved positive EBITDA in line with our expectation and (ii) 1H13 core topline grew 20% due to consolidation of 35.8%-owned PLife REIT being reclassified as a subsidiary from being an associate and higher inpatient admission and average revenue per inpatient across the board. Looking ahead, IHH’s venture into overseas markets is expected to continue with the opening of its 320-bed City International Hospital in Vietnam following its earlier planned foray into Hong Kong.

The stock is currently trading at 50.1x and 41.7x on FY13 and FY14 earnings compared to its average net profit growth of 30% p.a. over the next two years. Despite the scarcity premium that we have attached to IHH given its bigger market capitalisation, dominant market position and superior growth potential compared to its regional peers, IHH is already trading above our target price. We believe IHH’s recently announced foray into Hong Kong to build, own and operate a 500-bedroom hospital is in line with its management strategy to expand its international presence apart from the three key markets that it is currently in. We believe this could have a positive impact on the group’s margins given the higher ROI expectations as compared to its hospital ventures in Malaysia and Singapore. IHH’s growth driver in the next five years will come from a pipeline of new beds to be delivered through new hospital developments and the expansion of its existing facilities. In Singapore, the first phse of Mount Elizabeth Novena Hospital comprising 150 of total 333 beds (all single-bed rooms) capacity and 13 operating theatres has commenced operations in July 2012. The remainder of the second phase is projected to be operational in 2H2013. In Malaysia, PPL is currently undertaking expansion projects in four hospitals; namely, Gleneagles Medical Centre Penang, Pantai Hospital Kuala Lumpur, Pantai Hospital Klang and Gleneagles. The three greenfield projects above will add an estimated 500 beds to its network by 2014. In Turkey, Acibadem is currently undertaking expansion projects in two hospitals, Acibadem Sistina Skopje Clinical Hospital, Acibadem Bodrum and Acibadem Maslak Hospital while Acibadem Altunizade is a greenfield development.

Expect a de-rating in KPJ Healthcare. Over the medium-term, KPJ’s outlook appears unexciting on the back of its poor 1H13 results, which came in below expectations and the recently announced litigation case* where KPJ was to pay legal damages. The weak results on account of higher-than-expected losses incurred in its newly opened hospitals and additional cost associated with a new college and moving to its new office prompted us to downgrade our target price. The opening of new hospitals is expected to be a drag to its earnings due to the gestation period of three to five years. However, we are positive on KPJ’s long-term prospect, asset-light business model and defensive earnings. That said, we think these factors are already reflected in its share price. Based on our forecasts, the stock is currently trading at 28.0x for FY13E and 25.0x for FY14E, which appear rich as compared to its average net profit growth of 7% p.a. over FY13 and FY14.

*Recall, on 26th July 2013, the Johor Bahru High Court had allowed the claim by Dr Mohd Adnan bin Sulaiman and Azizan Sulaiman (plaintiffs) against KPJ wherein both plaintiffs alleged that KPJ had breached the Joint Venture Agreement dated 30th May 1995 whereby the said High Court had awarded the sum of RM70.6m including costs. A notice of appeal against the whole judgement has been filed at the Court of Appeal and is now fixed for hearing on 12 Dec 2013. In the meantime, the above-mentioned judgement sum has not been provided for in this quarterly result. However, for illustrative purposes, the RM70.6m (damages and costs) would reduce KPJ’s 30 June 2013 NTA by 8% or by 11 sen/share from RM1.35 to RM1.24. Our FY13 net profit forecast would be reduced by 50%. Earnings contribution over the next two years is expected to come from the setting up of new hospitals as well as the expansion of its existing capacity and services. The planned capex in FY13 and FY14 are estimated at between RM200m and RM250m p.a. 

Source: Kenanga