We expect Malaysian healthcare players to benefit from demand fuelled by  favourable  demographics,  synergies  and  medical  tourism  in  2015.We  maintain  our  NEUTRAL  recommendation  on  the  sector  due  to limited  short-term  catalysts  and  unattractive  valuations.  We  like  KPJ and  Faber  for  their  higher  estimated  ROEs,  cheaper  valuations  and solid dividend payouts.

Earnings  improvement  for major  healthcare  players.  In 3Q14,  both IHH  Healthcare  (IHH)  (IHH  MK,  NEUTRAL,  TP:  MYR4.63)  and  KPJ Healthcare  (KPJ)  (KPJ  MK,  NEUTRAL,  TP:  MYR3.67)  reported  YoY earnings  improvements  on  the  back  of  the  increase  in  inpatient admissions numbers and revenue intensity per patient. Despite 3Q being a  seasonally  slower  quarter  due  to  the  festive  season in  Malaysia  and Singapore, and  summer in Turkey,  IHH and KPJ registered  10.4% and 26.4%  increases  respectively  in  terms  of  inpatient  admissions  against the  corresponding period last year, while revenue per inpatient grew by 7.8% and 4.9% respectively during the same time frame.

Favourable demographics. We expect demand in 2015 to be driven by favourable  domestic  demographics  such  as  an  increasingly  affluent population, rising health awareness and an ageing population.

Synergistic acquisitions and joint ventures (JVs).  We expect hospital operators to  look into acquiring  strategic  assets  and smaller healthcare players to extract greater synergies and improve their competitiveness in 2015. JVs are also highly probable  as players are able to  operate on an asset-light model while growing in other areas. 

Medical tourism to assist growth.  Medical tourism currently accounts for <10% and <5% of IHH’s  and KPJ’s revenues respectively, according to data provided by the two companies. Going forward,  we expect this proportion to increase as they open new hospitals in strategic locations across  the  country  to  tap  into  the  expected  rise  in  medical  tourism  in those areas.

Maintain  NEUTRAL  on  the  sector.  The  valuations  of  the  sector continue to be demanding with no meaningful re-rating catalysts in store, especially  for  the  smaller  players.  However,  we  believe  that  the healthcare  sector  remains  a  draw  given  its  defensive  nature  and attractive  long-term  growth  prospects  post  the  expansion  of  the  major healthcare players. Our Top Picks are KPJ and Faber.

3Q14 Results Snapshot 

Smooth sailing quarter.  The two  major healthcare players, IHH and KPJ, recorded relatively robust sets  of numbers in 3Q14. IHH  posted a YoY  increase in  revenue of 6.7% while core profit jumped 20.7%. At the same time, KPJ’s topline climbed 16.3% while  core  profit  shot  up  by  50%.  The  better  numbers  were  attributed  mainly  to growing inpatient admissions  and  an  increase in revenue intensity per patient. KPJ also declared a  2  sen interim dividend for the quarter  under review,  bringing its  YTD dividends  declared to  4.9  sen  –  in line with our FY14 assumption of  a  55% payout ratio  (7  sen).  No  earnings  revisions  were  undertaken  for  both  healthcare  service providers post the results announcement.

Meanwhile, Faber’s (FAB MK,  BUY, TP: MYR3.25) earnings came in below our and consensus  expectations  due  to  the  inderperformance  of  its  integrated  facilities management  (IFM)  concession  and  non-concession  divisions.  However,  we upgraded the stock to BUY  (from Neutral) following the  company’s results briefing on 5  Dec  –  together  with  our  new  SOP-based  TP  –  after  factoring  in  the  upward revisions  in our  earnings forecast,    the company’s  the  robust pipeline of projects,  its strong recurring revenue, decent 4.2% FY15F dividend yield and 22.6% ROE for next year.

As  for  the  pharmaceutical  players,  we  note  that  earnings  have  improved  for  Hovid (HOV MK, NEUTRAL, TP: MYR0.39) as it booked a MYR5.7m profit in 1QFY15 (Jun)vs  MYR4.6m in  4QFY14,  which made  up  26.4%  of  our  full-year  earnings forecast. 

The  better  showing  was  mainly  driven  by  the  appreciation  of  the  USD  (53%  of Hovid’s revenue is denominated in USD) and the increase in sales volume. However, we note that the improved performance was also the result of deferred sales from the previous  financial  year  due  to  capacity  constraints.  W e  maintain  our  earnings forecasts at this juncture.

We  downgraded  Caring  Pharmacy  (Caring)  (CARING  MK,  TP:  MYR1.27)  to  SELL (from Neutral)  as it  recorded a  second consecutive quarter of disappointing earnings due  to  the  poor  performance  of  its  new  outlets  and  higher  opex.  Our  earnings downgrade  was  based  on:  i)  the  lower  revenue  assumption  for  new  outlets  of MYR2m  annually  per  outlet  (from  MYR2.8m),  ii)  higher  advertising  and  marketing costs, and iii) increasing personnel costs.

Improvement  in  earnings  to  continue  into  4Q.  Despite  3Q  being  seasonally weaker due to the festive seasons in Malaysia and Singapore as well as the summer season in Turkey, we  still  saw  an  increase in  YoY  revenue and core profit for both IHH  and  KPJ.  We  expect  both  healthcare  providers  to  continue  the  growth momentum into  4Q14. This is because  4Q is a historically a stronger quarter  for both players  in  terms of their  Malaysia,  Singapore  and Turkey operations.  This is mainly due to the fact that, traditionally, more people in the two ASEAN countries  take the opportunity provided by the year-end holiday seasons to undergo medical check-ups 
and procedures while – at the same time – the onset of winter in Turkey often results in an increase in cold weather-related health issues.

Increasing Demand To Benefit Hospital Operators 
Supportive industry trends.  We see the healthcare industry being  supported  by  a few  domestic  factors,  mainly:  i)  the  growing  affluence  of  the  population,  ii)  rising health awareness, and iii)  the  rise in the number of elderly in Malaysia.  According to the  Ministry of Health’s 2013 data, there  were some  355 hospitals  nationwide  (40% public, 60% private)  providing ~55,000 beds in total (75% public, 25% private).  This number is expected to grow in line with the increase in the aforementioned factors.

Additionally, Frost & Sullivan is expecting private healthcare players to  post  topline growth  of  10-15%  annually,  supported  by  the  anticipated  increase  in  Malaysia’spopulation  to  31.8m  by  2018.  We  believe  the  scarcity  of  inpatient  facilities  and extended waiting list at public hospitals should contribute to the increase in demand.

We also view the healthy increase in inpatient admissions and revenue per inpatients by  both  IHH  and  KPJ  as  a  reflection  of  the  strong  underlying  demand  for  private healthcare. As at 3Q14, IHH’s Malaysian operation registered a 10.5% and 7.7% YoY growth in inpatient admissions and revenue per inpatient respectively. At the same time,  KPJ  posted  a  26.4%  in  inpatient  admissions  and  4.9%  rise  in  revenue  per patient.  Both  companies’  commendable  growth  was  on  the  back  of  the  hospitals’ aggressive expansion.

Synergistic  acquisitions  and  JVs  the  way  moving  forward.  Due  to  the  rapid expansion  by both hospital groups,  we see  potential for further M&As  and  JVs.  As earnings growth  is  capped by their  expansions, hospital operators  have  resorted to acquiring smaller players, eg providers of medical imaging and laboratory services, to extract greater synergies  and expand their product offerings. Also, entering into a JV ensures that the balance sheet remains light, providing room for expansion into other areas. We anticipate this trend to continue in 2015 onwards.

Medical tourism to supplement growth.  Over the next 3-5 years, and on the back of  KPJ’s  and  IHH’s  ongoing  expansion,  we  believe  the  sector’s  growth  will  be supplemented  by  medical  tourism.  According  to  Malaysia  Health  Tourism  Council (MHTC) data, the number of medical tourists coming to Malaysia to use the country’s hospitals  rose  by  a  CAGR  of  23%  in  2009-2013  to  770,000.  By  2016,  the  MHTC expects this figure to rise to 1.1m.

Both  IHH  and  KPJ  are  ramping  up  their  capacities  in  locations  that  attract  more foreign  patients,  ie  near  the  country’s  borders  as  well  as  major  commercial  hubs. These include cities in Johor, Perlis, Penang and Sabah.

While medical tourism currently makes up less than  10% and 5% of total revenue for IHH  and  KPJ  respectively,  we  understand  that  the  latter  has  an  internal  target  to increase this to 25% by 2020. Both IHH and KPJ have guided for  an annual capex of MYR1.65bn  and  MYR350m  respectively  until  2016  in  order  to  facilitate  their expansions.

Caring  needs  more  tender  care.  We  remain  cautious  on  the  outlook  for  the pharmaceutical  sector  and,  in  particular,  Caring.  The  pharmaceutical  chain  is witnessing a combination of lower-than-expected contributions  from new outlets  and rising competition from independent pharmaceutical outlets that have sprouted in key market centres.  Nonetheless, we see some reprieve for  the company  in  2H15 when such  outlets  (opened in 2013  and/or  early 2014)  start to  mature while, at the same time, their  operational costs are contained  via an increase in efficiencies through the implementation  of  new  IT  systems.  Similarly,  Caring’s  marketing  costs  for  these outlets is also expected to be cut as the company will not need to invest so much to promote them.

Goods  and  services  tax  (GST)  could  lead  to  higher  medical  cost.  The  Royal Malaysian  Customs  Department  recently  provided  an  updated  GST  healthcare services  guide  that  stipulates  that  drugs  and  medicines  –  other  than  those  listed under  the  National  Essential  Medicine  List (NEML)  –  will be  subjected  to  GST  (as opposed  to  being  zero-rated).  At  the  same  time,  healthcare  services  provided  by registered  practitioners  with  licensed private healthcare facilities are  exempted  from the  tax.  However,  services  provided/rendered  healthcare  professionals  that  are  not resident  at  a  registered  medical  facility  (eg  consultant  physicians  not  based  at  a particular hospital) will be subjected  to a standard GST rate. Other ancillary services 
supplied by  a private healthcare provider, such as  the sale of medical aids, are also not tax-exempt. e expect the healthcare players to pass on the GST to  consumers in order to mitigate the impact of the tax on their bottomlines. 

With regards to the impact of the GST on the local healthcare sector, the Association of Private Hospitals Malaysia (APHM) has called  on the  Government to  classify the industry  as  zero-listed.  This  is  because  private  healthcare  providers  typically  raise their  cost  of  services  by  3-5%  annually  to  factor in  inflation.  The  APHM’s  concern here  is  on  increasing  healthcare cos as a result of the  implementation of the GSTcoupled  with  inflation-adjusted  pricing  going  forward.  Media  reports  state  that  the Government  has  acknowledged  the  APHM’s  concerns  that the  GST  will result in  a rise in hospital fees. However, it has yet to confirm the exact quantum.

Key  risks.  The  major  risks  to  the  sector  are:  i)  lower-than-expected  patient admissions, ii) less complex cases  (the more complex a case, the more revenue is garnered), and iii)  the  decline in revenue intensity per patient. Additionally, a longerthan-expected gestation period for newly-opened hospitals and delays in the opening of  newly-constructed  medical  facilities,  rising  cost  of  living,  inflation  and  a  higher interest rate environment are factors that could limit consumer discretionary spending and, hence, potentially hurt the sector’s outlook.

Maintain NEUTRAL.  Although the sector remains  a NEUTRAL  on the  grounds of its unattractive  valuations,  we  believe  the  defensive  nature  of  healthcare  services  in general  and the promising  longer-term growth prospects  of the sector  –  on the back of capacity expansions  by the  operators  –  are good enough reasons to stay invested in selected healthcare stocks.  This is further  supported by the  growing awareness of health issues, rising medical costs and the increasing affluence of the population.

Among the hospital operators, our Top Pick is KPJ, being a cheaper healthcare proxyat  25.3x  FY15  P/E  (IHH :  32.3x).  In  addition,  KPJ  offers  a  higher  dividend  yield  of 2.2% in  FY15F  vs IHH’s  0.8%.  We  expect  the  former to  deliver  higher  FY15F  and FY16F ROEs of 11.9% and 12% respectively. By comparison, we expect IHH to book 6.4% in FY15F and 7.1% in FY16F. Note that IHH’s 3Q14 performance was impacted by the weakening of the TRY and the SGD against the MYR.  By comparison, given that  90% of KPJ’s revenues  are locally-derived, it is inherently less predisposed to external risks, in our view.

We  turn  positive  on  Faber  post  the  completion  of  its  acquisitions  of  Projek Penyelenggaraan  Lebuhraya  (PROPEL)  and  Opus  Group  (Opus)  in  October.  We recently upgraded the stock to BUY (from Neutral) with a revised SOP-based TP of MYR3.25.  We  like  this  counter  for  its  strong  recurring  income,  robust  pipeline  of projects,  4.2%  FY15F  dividend  yield,  22.6%  FY15F  ROE  and  undemanding valuation at 11.8x FY15F

Source: RHB