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 ageing population demographic. The latest 3QCY19 results season saw a mixed bag of results. KPJ and Pharmaniaga’s earnings came in line with expectations. However, IHH’s 9MCY19 earnings were impacted by lacklustre performance from Acibadem and wider 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% discounts compared to historical average of 27.5x and regional peers of 35x, respectively.

Steady allocation for healthcare sector under Budget 2020. The Government allocated RM30.6b (+7% Y-o-Y) for the health sector under operating and development expenditure of which RM1.6b is for hospital upgrading including Tengku Ampuan Rahimah Hospital in Klang, Kampar Hospital and Labuan Hospital. The expansion includes expanding cardiology centres at existing hospitals such as Queen Elizabeth II hospital in Sabah while an amount of RM319m is for the construction and upgrading of health and dental clinics. In line with the principle of 3R culture, Repair – Replace – and Restore, a total of RM227m will be provided to upgrade medical equipment while RM95m will be allocated for renovation of medical infrastructure and facilities such as at Pontian Hospital. Medical tourism in Malaysia continues to gain traction. Among the VMY2020 programmes is Malaysia Year of Healthcare Travel 2020. The Government will allocate RM25m (+25% YoY) for the Malaysia Healthcare Tourism Council (MHTC) to strengthen the position of Malaysia as the preferred destination for health tourism in ASEAN for oncology, cardiology and fertility treatments. The proposal to promote medical tourism is mildly positive to KPJ Healthcare and IHH Healthcare considering that both derived 5% and 6% of revenue, respectively, from medical tourism.

Fortis is a concern for IHH. IHH’s 9MFY19 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 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 non-Turkish 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’s supply concession ceases, but concession for logistics and distribution extended. The Government has agreed to provide a 25-month interim period for procurement of drugs to Pharmaniaga Bhd after its concession ends on 30th Nov 2019. The interim period from 1st Dec 2019 to 31st Dec 2021 is to ensure no supply chain disruption in the supply and distribution of medicines nationwide while an open tender and appointment of a new concessionaire is developed. However, starting from 1st Dec 2019, the government will award Pharmaniaga a five-year contract extension for logistics and distribution of medicines based on its capabilities and performance. We highlight here that PBT margin for Logistics & Distribution segment is razor-thin averaging at 0.8% over the past 13 quarters. We believe the contract extension for logistical support is based on Pharmaniaga’s capability in the development of a procurement and logistical computerised system i.e. Pharmacy Information System (PHIS) which plays a vital and integral role in ensuring the distribution of drugs to patients and effective management of stock levels.

KPJ’s valuation appears to be attractive again, Reiterate OP. The group 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. As indication, start-up losses are only seen in KPJ Perlis and KPJ Bandar Dato Onn. Earnings growth is expected to come from narrower losses and earnings from hospitals built 2-3 years ago. 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% discounts compared to historical average of 27.5x and regional peers of 35x, respectively.

Source: Kenanga Research - 6 Jan 2020