We maintain UNDERPERFORM on the Healthcare sector. Both IHH and KPJ are currently trading at lofty valuations relative to their net profit growth potentials for FY14 and FY15. 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’s earnings are considered defensive for its high predictability factor and captive earnings streams. The recently concluded 9MCY13 results season saw IHH Healthcare coming in within our expectations, but KPJ Healthcare performed below our and consensus estimates. The main drawback at this juncture is that the healthcare stocks including IHH Healthcare (UP, TP: RM4.04) and KPJ Healthcare (UP, TP: RM3.33) are trading at rich valuations while offering low dividend yields at current market prices.

Budget 2014 an impetus for growth in the Healthcare industry. The Government allocated RM22.1b (+13% Y-o-Y) for the health sector under operating and development expenditure. The allocation will be channelled to programmes and projects, including the construction of Hospital Tanjung Karang and additional blocks for Hospital Jeli, as well as the upgrading of Hospital Kuala Lipis and 30 rural clinics. The Government has set up 234 1Malaysia clinics, and another 50 additional 1Malaysia clinics will be established in 2014. Other allocations include: (i) RM66m for the purchase of equipment and the construction of additional blocks in Hospital Queen Elizabeth in Kota Kinabalu, (ii) RM150m to appoint 6,800 more nurses, (iii) RM3.3bn for the purchase of medicines and medical equipments, including expanding the cardiothoracic services in Hospital Ipoh, Kuala Terengganu, Kuantan and Kuching.

IHH Healthcare. The stock is currently trading at 41x and 34x on FY14E and FY15E earnings compared to its average net profit growth of 20% p.a. over the next two years. Despite the scarcity premium 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 its existing three key markets. 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. Growth driver in the next five years will come from the following drivers: (i) In Singapore, the first phase of Mount Elizabeth Novena Hospital comprising 150 (of total 333) beds (all singlebed rooms) and 13 operating theatres, which have already commenced operations in July 2012. (ii) In Malaysia, PPL is currently undertaking expansion projects in four hospitals, Gleneagles Medical Centre Penang, Pantai Hospital Kuala Lumpur, Pantai Hospital Klang and Gleneagles. Greenfield projects meanwhile, namely Gleneagles Kota Kinabalu, Pantai Hospital Manjung and Gleneagles Medini will add an estimated 500 beds by 2014. (iii) In Turkey, Acibadem is currently undertaking expansion projects for 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 9M13 results. 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. On an outstanding legal case; despite the Court of Appeal unanimously allowing the appeal by KPJSB against the decision of the Johor Bahru High Court*, we are unsure whether the plaintiff will further pursue/appeal the case. We maintain our earnings forecast and continue to reiterate our Underperform recommendation because: (i) of KPJ’s third consecutive earnings disappointment in 3Q13 which suggest potential earnings downgrade going forward, (ii) start-up costs and losses from openings of hospitals in Sabah, Muar and Rawang scheduled in FY14 could negate earnings upside as well as resulting in higher operating costs, and (iii) the stock is currently trading at 27x for FY14E and 26x for FY15E, which appear rich as compared to its expected average net profit growth of 12% p.a. over FY14 and FY15.

*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.

Source: Kenanga