We maintain our UNDERWEIGHT rating on the sector. The just-concluded 3QCY16 results season saw both IHH and Pharmaniaga coming in below expectations. However, KPJ came in within expectations. Pharmaniaga had to contend with higher-than-expected operating expenses and amortisation of the Pharmacy Information System (PHIS) system. IHH was hit by higher-than-expected operating costs. Overall, over the short-to-medium term, on the back of escalating costs pressure as well as a slower-than-expected economic outlook, margins could come under pressure. All in, healthcare stocks under our coverage are trading at rich PER valuations in contrast to their expected low-teens earnings growth. We believe their growth potentials are already reflected in the valuations. 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 main drawback at this juncture is that healthcare stocks including IHH Healthcare (UP, TP: RM5.42) and KPJ Healthcare (MP, TP: RM4.38) are trading at rich valuations while offering low dividend yields. Despite performing below expectations due to higher-than-expected promotional expenses and amortisation of the PHIS system, Pharmaniaga offers decent dividend yields of 4-5% and with a defensive earnings stream being the sole concession holder to purchase, store, supplies and distribute approved drugs and medical products to Government hospitals and clinics nationwide.

Robust inpatient growth, supported by ageing population. 9M16 inpatient volume growth of both IHH (+5-16% YoY across the board) and KPJ (+1% YoY) in Malaysia continued to show improvements despite the implementation of GST. We expect growth to be supported by an ageing population and growing awareness in healthcare prevention. It is estimated that during the 2010-2040 period, Malaysian population aged 65 and over will increase to more than three-fold of the 2010 population. The increase will lead Malaysia to become an aging population society in 2021 when the population aged 65 years and above reach 7.1%. Based on the United Nations (UN)’s definition, an aging society is when the population aged 65 and over constitutes 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 same period. 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 result 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 boosted by intensities in patient volume growth. Overall, over the short-to-medium term on the back of escalating costs pressure as well as slower-than-expected economic outlook, margins could come under pressure. As an indication, EBITDA margin fell from 25% in 9M15 to 23% in 9M16, arising from escalating costs. The start-up costs on preopening of hospitals, including Gleneagles Hong Kong (expected to commence in 1Q17) are expected to put pressure on cost and margins at least over the short-term. Elsewhere, the opening of Mumbai Hospital is put on hold pending negotiation with its partner. We believe IHH’s plan to venture into Hong Kong to build, own and operate a 500-bed hospital is in line with its management’s strategy. Growth driver in the next five years will come from the following:- (i) In Malaysia, PPL is currently undertaking expansion projects in four hospitals, namely Pantai Hospital Ayer Keroh (160 beds, completion in end 2017), Pantai Hospital Klang (80 beds), Pantai Kuala Lumpur (120 beds). Meanwhile, greenfield projects are Gleneagles Medini (phase 1b, 160 medical suites), and (ii) in Turkey, Acibadem, is currently undertaking expansion in Acibadem Sistina Skopje (81 beds) and Acibadem Maslak (200 beds, target completion 2017). The greenfield projects are Acibadem Altunizade (325 beds, target completion 2017) and Acibadem Kartal (120 beds, target completion 2018). Over at the North Asia side, its operations in Chengdu and Hong Kong are expected to commence in 2H17. The stock is currently trading at PERs of 56x and 50x on FY16E and FY17E earnings, respectively, compared to an average net profit growth of 11% p.a. over the next two years.

KPJ Healthcare’s valuations looking stretched as well. We continue to reiterate our MARKET PERFORM 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 28x for FY16E and 27x for FY17E, which appear rich as compared to its pedestrian growth for the two financial years.

Saving grace for Pharmaniaga is 4.8% dividend yield. Despite performing below expectations due to higher-than-expected promotional expenses and amortisation of the PHIS system, Pharmaniaga offers a decent dividend yield of 4-5% and with defensive earnings being the sole concession holder to purchase, store, supplies and distribute approved drugs and medical products to Government hospitals and clinics nationwide.

Source: Kenanga Research - 6 Jan 2017