We maintain our UNDERWEIGHT rating on the sector. 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 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 2QCY14 results season, both IHH Healthcare and KPJ Healthcare came in within both consensus’ expectations and ours underpinned by intensities from inpatient volume and average revenue per inpatient. The main drawback at this juncture is that healthcare stocks including IHH Healthcare (UP, TP: RM4.20) and KPJ Healthcare (UP, TP: RM3.31) are trading at rich valuations while offering low dividend yields at current levels.

Growth in healthcare supported by ageing population. It is estimated that during the period of 2010-2040, Malaysia's population aged 65 and over is projected to increase more than three folds of the 2010 population. The increase will lead Malaysia to become an aging population in 2021 when the population aged 65 years and over reach 7.1%. Based on the United Nations’ (UN) definition, the aging society is when the population aged 65 and over to achieve 7% of the total population. Population for the age group 0–14 years is projected to decline from 27.4% to 19.6% for the period of 2010–2040. However, the population for the age group 15–64 years and 65 years and over is expected to increase by 1.4 and 6.4 percentage points respectively for the same period. Longer life spans also resulted in a larger number of people aged 65 and above. This improvement has been attributed mainly to advances in medical technology, higher personal wealth and growing awareness of the importance of healthcare and disease prevention.

IHH Healthcare. IHH’s solid 2Q14 results were largely underpinned by the revenue and EBITDA grew 6% and 12%, respectively, underpinned by organic growth of existing hospitals specifically higher inpatient admissions and revenue intensity across the board as well as the strong ramp up of Acibadem Atakent and the opening of Pantai Manjung in May 14. This brings core net profit to RM192m (+11%) thanks to double-digit EBITDA growth. The stock is currently trading at PERs of 54.0x and 49.1x on FY14E and FY15E earnings, respectively, compared to its average net profit growth of 13.5% p.a. over the next two years. The scarcity premium attached to IHH is due to 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 developments: (i) In Malaysia, IHH is currently undertaking expansion projects in four hospitals, Gleneagles Kuala Lumpur, Pantai Hospital Kuala Lumpur, Pantai Hospital Klang and Pantai Hospital Ayer Keroh. Greenfield projects, namely Gleneagles Kota Kinabalu and Gleneagles Medini will add an estimated 500 beds by end 2014 to end 2016, (ii) 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, and (iii) In overseas market - Gleneagles Hong Kong and Mumbai are expected to be completed by end 2016 and 2014, respectively.

KPJ Healthcare’s 2Q14 results came in within expectations after four consecutive quarters of disappointment. QoQ, 2Q14 PATAMI rose 12% to RM33.7m thanks to: (i) higher average in-patient volume (c.5-7%) and average revenue per in-patient (c.4-5%) in Malaysia as well as commencement of two new hospitals namely KPJ Rawang (full quarter contribution) and KPJ Muar (in Jun 14), (ii) higher contribution from 49%-owned KPJ Al-Aqar Healthcare REIT, which (iii) more than offset higher losses at the aged care facility (RM8m compared to RM5m in 1Q14). 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 34.1x for FY14E and 31.5x 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 for FY14, which could negate earnings upside due to higher operating costs.

Source: Kenanga