We maintain our UNDERWEIGHT rating on the sector which is expected to be dull in terms of earnings growth and further capped by expensive valuations. The recently-concluded 3QCY18 results season was a mixed bag. IHH’s 3Q18 earnings came in above expectations due to low base effect in 2017. KPJ came in within expectations. KPJ is confident that start-up costs from new hospital openings will be absorbed by: (i) incremental ramp-ups from earlier openings, and (ii) steady contributions from matured hospitals. The stock is currently trading at 15% and 40% discount compared to its historical average of 28x and regional peers of 35x, respectively. The 40% discount to regional peers is wider compared to the historical average of 30%. Pharmaniaga came in within expectations as well. All in, healthcare stocks under our coverage are already trading at rich PER valuations in contrast to their expected low-teens earnings growth.

Mixed bag of 3QCY18 results. The just-concluded 3QCY18 results season saw a mixed bag of results. IHH’s 3Q18 earnings came in above expectations due to low base effect in YTD 2017. KPJ came in above expectations due to better-thanexpected improvement in newly opened hospitals. Pharmaniaga came in within expectations. Over the longer term, growth is expected to be supported by an ageing population and growing awareness of healthcare maintenance and disease prevention. It is estimated that during the 2010-2040 period, Malaysian population aged 65 and over will increase to more than three-fold the 2010 population. The increase will categorise Malaysia as 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.

IHH meets expectations after five consecutive quarters of disappointment. The 3Q18 quarter marked the first quarter of earnings coming above expectations after five consecutive disappointments. However, earnings continued to be dragged down by foreign exchange losses on Acibadem Holding’s non-Turkish Lira denominated borrowings. The stock is expected to continue to be de-rated and weighed down by marked-to-market volatility on translation of non-Turkish Lira borrowings. Looking ahead, over the short-to-medium term, IHH is expected to face higher operating costs arising from wage inflation as a result of increased competition for trained personnel and start-up costs on pre-opening of hospitals, including Gleneagles Hong Kong (GHK) which will put pressure on cost and margins. Since June 2018, the Turkish Lira has depreciated significantly against USD, Euro and MYR, with continued volatility in the currency. This will result in foreign exchange translation losses on the Group’s balance sheet and income statement.

Pharmaniaga clouded by uncertainty in the renewal of medical supplies concession. The de-rating is on concerns of Government reviewing all medical supplies concession agreements of which Pharmaniaga has a 10-year contract ending in November 2019. We are uncertain of the renewability of the contract but Pharmaniaga has the track record, platform and systems in place for the distributions of medical supplies. Its Indonesian operations remain a key area of growth, while further progress is being made in the European Union as the Group seeks to expand its global presence. In tandem with this, the Group is focused on implementing continuous cost optimisation measures across its operations. Over the longer term, we expect its manufacturing division to propel earnings growth. The group aims to add about 200 new products over the next 10 years to its existing portfolio of around 500 products, which should boost demand for its products and lift earnings.

KPJ’s valuation appears to be attractive again, Reiterate OP. Earnings growth is expected to come from narrower losses and profitability for hospitals built 2-3 years ago including KPJ Rawang, Maharani, Pasir Gudang and Pahang. KPJ Perlis (greenfield, 90 beds) commenced operations in 2Q 2018. Elsewhere, brownfield expansions include KPJ Miri (96 beds) and KPJ Kuching (150 beds) which are expected to start operating by 2Q 2019. KPJ Bandar Dato Onn is expected to open in early 1Q2019. The group is confident that start-up costs from new openings will be absorbed by: (i) incremental ramp-ups from earlier openings, and (ii) steady contributions from matured hospitals. The stock is currently trading at 15% and 40% discount compared to its historical average of 28x and regional peers of 35x, respectively. The 40% discount to regional peers is wider compared to the historical average of 30%.

Source: Kenanga Research - 4 Jan 2019