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 UNDERWEIGHT from NEUTRAL. Furthermore, both IHH and KPJ are currently trading at lofty valuations compared to their net profit growth forecasts for FY14 and FY15. Overall, we believe that the healthcare industry in Malaysia will continue to enjoy stable growth supported by the growing healthcare expenditure, rising medical insurance and aging population demographics. The healthcare services sector is considered defensive for its higher predictability factor and captive earnings streams. In the recently-concluded 1Q14 results season, both IHH Healthcare and KPJ Healthcare came in within both our and consensus expectations. The main drawback at this juncture is that the healthcare stocks including IHH Healthcare (UP, TP: RM4.20) and KPJ Healthcare (UP, TP: RM2.89) are trading at rich valuations while offering low dividend yields at current levels.

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 with 50 additional clinics to 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. IHH’s solid 1Q14 results were largely underpinned by organic growth of existing hospitals, specifically higher inpatient admissions and revenue intensity across the board which is expected to continue in subsequent quarters. The recent 14% hike in medical fee has minimal impact to IHH’s bottomline considering that the vast majority of IHH’s specialists in Malaysia are independent doctors (selfemployed).

As such, IHH does not have any meaningful share of their professional fees. The solid 1Q14 result is offset by the stock’s rich valuation. The stock is currently trading at PERs of 46x and 42x on FY14E and FY15E earnings, respectively, compared to its average net profit growth of 15% p.a. over the next two years. The scarcity premium attached to IHH is due its bigger market capitalisation, dominant market position and superior growth potential compared to regional peers. We believe IHH’s plan to venture 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. 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 Malaysia, IHH is currently undertaking expansion projects in four hospitals, Gleneagles Medical Centre Penang, Pantai Hospital Kuala Lumpur, and Pantai Hospital Klang. Greenfield projects meanwhile, namely Gleneagles Kota Kinabalu, Pantai Hospital Manjung and Gleneagles Medini will add an estimated 650 beds by 2015; (ii) In Turkey, Acibadem is currently undertaking expansion projects for three hospitals, Acibadem Sistina Skopje Clinical Hospital, Acibadem Bodrum and Acibadem Maslak Hospital while Acibadem Altunizade, Kartal and Atasehir are all greenfield development with a total estimated 550 beds; and (iii) In overseas market - Gleneagles Hong Kong and Mumbai are expected to be completed by end 2016 and 2014 respectively.

KPJ Healthcare’s 1Q14 results came in within expectations after four consecutive quarters of disappointment. For illustration purposes, ceteris paribus, a 14% hike will raise KPJ’s revenue by 4.2% (on average doctors fees accounted for 30% of KPJ’s revenue. Correspondingly, since KPJ retains 10% of the doctors’ fees, the net impact from the hike to KPJ’s bottomline is 5% of our FY14 net profit forecast. However, the net effect to earnings could be neutral since a hike in medical fee could be offset by lower inpatient admissions. Despite the encouraging news that KPJ has won its appeal against the judgment of the Hospital Penawar civil law suit, the Plaintiffs have filed an Application for leave to appeal to the Federal Court against the Court of Appeal’s decision. This remains a threat to KPJ’s financial position. The expansion of existing hospitals will have a positive impact to KPJ, but this will be offset by its new greenfield hospitals, which have an average gestation period between three to five years. Hence, the openings of new hospitals in Sabah, Muar and Rawang scheduled for FY14 could further negate earnings upside in the medium-term. We maintain our earnings forecast and continue to reiterate our UNDERPERFORM recommendation because of: (i) rich valuations compared to its pedestrian net profit growth over the next two years. The stock is currently trading at PERs of 29x for FY14E and 27x for FY15E, which appear rich as compared to its expected average net profit growth of 11% p.a. over FY14 and FY15, (ii) start-up costs and losses from its new hospitals in Sabah, Muar and Rawang scheduled in FY14, which could negate earnings upside due to higher operating costs.

Source: Kenanga