While  we  expect  the  overall  healthcare  sector  to  benefit  from  a  pickup in  GDP  growth  and  a  benign  macro  environment,  valuations  of  the larger  cap  hospital  owners  are  not  compelling.  Execution  risk  and speed  of  turnaround  at  their  new  hospitals  will  be  key  in  2014.  Our stock picks are in the small cap space of pharmacy operators and drug manufacturers.  Maintain  NEUTRAL,  with  our  top  sector  pick  being CARiNG Pharmacy (CARiNG MK, BUY, FV: MYR2.28).

No spark in 3Q13 results but stronger 4Q factored in. Both IHH  (IHH MK,  NEUTRAL,  FV:  MYR3.87)  and  KPJ  (KPJ  MK,  NEUTRAL,  FV: MYR4.12) posted the usual lower patient admissions in July-Sept, during which hospitals’ admissions drop as the period coincides with the festive and holiday season. The only bright spot was IHH’s Singapore operation, which chalked up a nominal 0.7% EBITDA expansion q-o-q. We expect both  stocks  to  report  stronger  4Q13  numbers  in  February  2014.  Faber (FAB  MK,  NEUTRAL,  FV:  MYR2.28),  too,  will  benefit  as  government hospitals utilise their budgets before the year-end.

Limited  catalysts  among  larger  caps.  While  we  are  positive  on  both hospitals’  (IHH  and  KPJ)  upcoming  expansion  plans,  we  keep  our NEUTRAL stance as; i) both stocks are pricey, and ii) face earnings risks in  the  event  their  expansion  plans  encounter  delays.  We  are  less enthusiastic  on  KPJ  due  to  its:  i)  delays  in  hospital  openings,  ii)  slower overseas  expansion,  and  iii)  choice  of  target  markets  vs  IHH.  We  see Faber becoming less of a healthcare proxy post Opus and Propel M&A.

Seeking relative performance among hospital operators. Among the larger  cap  stocks,  notwithstanding  their  valuations,  we  feel  IHH  offers investors:  i)  stronger  operating  performance,  ii)  greater  exposure  to  the lucrative medical tourism business, and iii) the stock consistently enjoys institutional buying. While pricey at a 37x 2014 P/E, we feel this valuation underpins IHH’s potential to be an acquirer in potential M&A plans.  

We like CARiNG. We like CARiNG for its quasi consumption-healthcare driven business profile, strong management and rapid expansion plans. A rerating could come from the reported potential listing of Watson’s Personal Care Stores SB, or even Cosway (M) SB. We also notice that the  earnings  of  small  cap  drug  manufactures  like  Hovid  (HOV  MK,  NR) and  Kotra  (KTRI  MK,  NR)  are  recovering  and  the  companies  are beneficiaries of the latest round of National Key Economic Area (NKEA) Healthcare initiatives.

Maintain NEUTRAL. Our FVs, calls and forecasts for all four healthcare stocks  remain  unchanged  after adjusting for KPJ’s bonus,  rights  and warrants issue. CARiNG Pharmacy is our top sector pick.

Strong  capacity  expansion  plans.  Both  IHH  and  KPJ  are  boosting  bed  capacity, with IHH planning for an 80% increase by 2017 by adding more than 4,000 new beds to its current 5,000+. Of the new beds, more than 75% will be in the group’s overseas hospitals  overseas.  KPJ  will  add  1800  –  or  68%  more  new  beds  by  2017  –  to  its existing 2,700 beds. However, of those, only 250 are located overseas.  Drilling into the qualitative aspects, IHH’s expansion is more urban centric. We note that there is a more urban slant in IHH’s domestic (Malaysia) plans. Of  the group’s planned 980  new  beds  for  Malaysia,  only  100  are  for  the  small  town  of Manjung,  with  the  rest  in  urban  centres.    KPJ,  meanwhile,  plans  to  open  six  new greenfield hospitals in the smaller towns with a total bed count of 739 (or 41% of new capacity).  Thus,  we  worry  that  KPJ  may  experience  a  slide  in  average  inpatient charges  per  day  as  revenue  intensity  falls  as  the  new  hospitals  handle  “lighter” cases.  

IHH’s overseas expansion has a stronger regional flavour, with focus on more affluent  markets.  We like IHH’s plans,  which  will  take  the  group  to:  i)  four  new markets  -  China,  Vietnam,  Hong  Kong  and  the  UAE,  ii)  split  between  the  medical tourism  hubs  of  Hong  Kong  and  UAE,  and  rapidly  developing  countries  with increasing demand for better healthcare, iii) overall better international exposure and stronger  branding.  Upon  completion,  IHH’s  bed  capacity  mix  will  rise  to  67% overseas from 61% at present, thus boosting its regional profile.

As for KPJ, since the completion of its acquisition of  the group’s second Indonesian hospital, PT Khidmat Perawatan Jasa Medika (92 bed capacity) in March 2013, KPJ has only ventured into Bangladesh via a 250-bed hospital on the outskirts of Dhaka. While  KPJ  has  expressed  its  intention  of  growing  its  Indonesia  presence  since  the Indonesian  healthcare  market  is  expected  to  enjoy  a  secular  growth  trend  in  the coming years, we are uncertain on the outlook as: i) domestic operators (eg Siloam International, SILO IJ, NR) are also on an aggressive expansion drive, and ii) the lofty valuations of listed local operators may limit KPJ’s potential to carry out M&As. Risks  from  the  hospital  expansion  bear  watching.  While  the  issue  of  gestation cost  is  obvious,  we  are  more  concerned  that  the  potential  pressure  to  fill  the  extra beds could result in operators competing on pricing by putting price increases on hold (hospitals  normally  need  to  pass  on  rising  utility  and  wage  costs  etc).  This  may exacerbate the current compression on margins.

Looking across the causeway for a sign of things to come, IHH’s Singapore operation is publishing the average charges for 30 of its most common procedures, including a breakdown of doctor’s fees and hospital charges. While we understand that this is aimed  at  increasing  billing  transparency  and  has  actually  helped  to  attract  new patients, we do discount this as a pre-emptive move to ward off competition from the new 220-bed Connexion at Farrer Park, scheduled for opening in mid-2014. Between  the  two,  IHH  has  demonstrated  its  ability  to  quickly  turn  around  its  new hospitals (ie Singapore and Turkey) while KPJ is plagued by start-up costs that have resulted in earnings contraction owing to higher interest and operating costs. IHH  to  have dividend  policy  in 2014,  but  may  leave  some  room  for M&As.  IHH will  formalise  its  dividend  policy  in  February  next  year,  but  we  expect  the  group  to conserve  the  bulk  of  its  profits  for  reinvestment.  Hence,  we  think  there  may  be excitement  emanating  more  from  the  prospects  of  its  corporate  actions.  We  think IHH’s 2014 valuations - at a 37x P/E and 20x EV/EBITDA - while pricey, underpin its role as an acquirer  in any M&A. We note that the Employees Provident Fund (EPF) has reportedly emerged as a 30% shareholder in Columbia Asia SB, which operates 10 hospitals in Malaysia and has recently received approval for an 11 th hospital in PJ.

Assuming that either operator (ie IHH or Columbia Asia) seek to boost their presence in  Malaysia,  their  combined  hospitals  in  Malaysia  would  come  to  22,  just  behind KPJ’s 26 hospitals.

We  note  too  that  IHH  has  a  divergent  asset  ownership  policy  across  its  Singapore and  Malaysia  operations.  The  assets  originally  under  Pantai  group  are  on  the balance  sheet  while  the  Singaporean  assets  from  Parkway  are  parked  under Parkway Life REIT. If IHH were to synchronise its ownership to one that is asset-light, we  estimate  that  MYR4.8bn  cash  (equivalent  to  15.7%  of  its  market  cap)  could  be raised from “REIT-ing” just its 10 largest properties (mostly valued at 2010 prices).

Regional  forex  rates  bear  watching.  We  are  cautious,  however,  on  current  forex movement  trends  and  their  potential  impact  on  IHH.  YTD,  the  Indonesia  IDR  has depreciated  vs  the  SGD  and  MYR  by  21%  and  17%  respectively.  While  IHH continued to report robust admissions from Indonesia patients for October, we would be  cautious  of  the  impact  of  a  prolonged  decline  of  the  IDR  vis-a-vis  the  local Indonesian operators opening a rising number of new hospitals.

Meanwhile, as the SGD vs MYR movement has been a nominal 3% YTD and up to 37.5%  of  IHH’s revenue  is  from  Singapore,  the  gains  to  be  made  will  be  limited. What’s worse is, the Turkish Lira (TRY) has plunged 38.2% vs the MYR, and 38.2% of the group’s revenue is in TRY.

Seeking relative outperformance. Weighing the merits of the two operators, we feel that  IHH  offers  investors:  i)  stronger  operating  performance,  ii)  greater  exposure  to the lucrative medical tourism business, and iii) the stock enjoys continued institutional buying.  As  of  23  Dec  2013,  the  stock  has  declined  14.3%  from  the  MYR4.40  high reached on 20 Sept.

Pharmacies In Vogue

CARiNG on a roll.  Founded 19 years ago by dedicated owner-operators, CARiNG is Malaysia’s third largest pharmacy chain with 87  outlets  and  competes  neck-and-neck with regional chains such as Guardian and Watsons locally. CARiNG currently controls a 3.9% share of Malaysia’s pharmacy outlets and targets to open 30-35 new outlets  by  FY16.  The  group  has  maintained  its  competitive  edge  in  this  highly fragmented market.

M&A  catalyst.  CARiNG  has  shown  an  appetite  for  inorganic  growth  in  the  past.  In 2011, to boost its Johor presence, the group acquired Medi-home SB, which owned four  outlets  at  the  time.  Now  a  51%-owned  JV  named  CARiNG  (IDR)  SB  operating five  outlets  in  Johor,  this  operation  broke  even  in  FY13,  its  second  year  after acquisition.  Thus,  we  think  that  CARiNG  will  capitalise  on  strong  brand  recognition and  financial  profile  post  listing  to  expand into  other  regions  such  as  the east  coast states, as well as Sabah and Sarawak, either organically or via M&As.

More listings in the offing? It has also been reported that Hong Kong conglomerate Hutchinson Whampoa Ltd  (13  HK,  NR)  is  contemplating  a  listing  of  its  A.S. Watson Group  and/or  Watson’s  Personal  Care  Stores  SB  next  year.  We  see  these developments as further potential catalysts that may perk up CARiNG’s valuations.

Drug Manufacturers The New High?

A  new sub  sector  to  ride  on  in  2014?  Smaller cap  drug manufacturers  like  Hovid and  Kotra  Industries  have  seen  a  recovery  in  earnings  after  falling  into  losses  in 2011.  Both  companies  have  been  named  as  beneficiaries  in  the  latest  round  of National Key Economic Area (NKEA) Healthcare initiatives.

Under  the  Malaysian  Pharmaceuticals’ entry  point  projects,  Kotra  will  undertake  the production of “metered  dose  inhalers” for asthma treatment and collaborate with French  multinational  Pharmaceutical  company  Servier  to  manufacture  patented drugs such as Diamicron and Vastarel, which are used to treat heart diseases.

Hovid  will  be  working  alongside  Australia-based  AFT  Pharmaceuticals  to manufacture  orphan  drugs  (drugs  granted  special  incentives  as  they  are  meant  to treat rare diseases) under the NKEA.

Overall,  we  expect  Malaysia-based  export  orientated  drug  manufacturers  to  report better earnings going forward due to: i) USD appreciation vs MYR, as 30-50% of their sales are denominated in USD, ii) an increasing number of “blockbuster” drugs falling off  patent  (eg  Viagra  etc)  allow  generic  manufactures  to  boost  their  product  range, and iii) normalising costs post implementation of minimum wage.

Source: RHB