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. However, we still believe that the healthcare industry will continue to enjoy stable growth, supported by the growing healthcare expenditure, rising medical insurance and an aging population demographic. The latest 2QCY19 results season saw a mixed bag of results. KPJ and Pharmaniaga’s earnings came in line with expectations. However, IHH’s 1HQ19 earnings were impacted by lacklustre performance from Acibadem and widened losses in its India operation. On picks, we like KPJ because: (i) start-up costs from new openings will be absorbed by incremental ramp-ups from earlier openings and steady contributions from matured hospitals, and (ii) the stock is currently trading at 20% and 40% discount compared to historical average of 27.5x and regional peers of 35x, respectively.

Growth in healthcare supported by ageing population. It is estimated that for the 2010-2040 period, Malaysia's population aged 65 and over is projected to increase more than three-fold of the 2010 population. The increase will lead Malaysia to become an ageing population nation 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 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 same period. However, the population for the age group 15–64 years and 65 years and over are expected to increase by 1.4 and 6.4 percentage points, respectively. Longer life spans have 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.

Fortis is a concern for IHH. IHH’s 1H19 earnings were impacted by lacklustre performance from Acibadem and higher losses in its India operation. Overall, revenue per inpatient increased across the board. However its India hospitals’ revenue per inpatient admission decreased 16% due to Fortis’ generally lower revenue intensity compared to Parkway Pantai’s existing operation in India. As such, the losses have continued to widen. We are concerned over issues at Fortis, including an auditor’s qualified audit report in FY18, which has been carried forward into the quarterly review on 13 Feb 2019, risk of more provisions, and lapses in internal controls, which led to regulatory probing, which could well mean execution risk exposure. Meanwhile, its earnings continued to be dragged down by foreign exchange losses on Acibadem Holding’s nonTurkish Lira denominated borrowings. The stock is expected to continue to be weighed down by marked-to-market volatility on translation of non-Turkish Lira borrowings. Looking ahead, over the medium term, IHH is expected to face tough operating conditions on the back of: (i) the uncertain Turkish Lira which has depreciated against USD, Euro and MYR with continued volatility, and (ii) execution risk at Fortis as well as uncertainty over its timeline in terms of a turnaround to profitability.

Pharmaniaga clouded by uncertainty in the renewal of medical supplies concession, being re-rated. The de-rating is on concerns of Government reviewing all medical supplies concession agreements of which Pharmaniaga has a 10-year contract ending soon in November 2019. We are uncertain on the renewability of the contract but Pharmaniaga has the track record, platform and systems in place for the distributions of medical supplies. Its Indonesian operation 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 revenue and lift earnings. We upgrade Pharmaniaga from Underperform to Market Perform as its share price has retraced close to our target price.

KPJ’s valuation appears to be attractive again, Reiterate OP. 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. As indication, start-up losses are only seen in KPJ Perlis and Bandar Dato Onn. Earnings growth is expected to come from narrower losses and profitability from hospitals built 2-3 years ago including KPJ Rawang, Maharani, Pasir Gudang and Pahang. We like KPJ because: (i) start-up costs from new openings will be absorbed by incremental ramp-ups from earlier openings and steady contributions from matured hospitals, and (ii) the stock is currently trading at 20% and 40% discount compared to historical average of 27.5x and regional peers of 35x, respectively.

Source: Kenanga Research - 4 Oct 2019