ASX healthcare stocks: Broker views and a fundie's top pick

Regarded as highly defensive, companies in the healthcare sector are often characterised by reliable revenues from high demand throughout the economic cycle. It’s also commonly regarded as expensive – but is it really? In this feature, I look at some of the latest ratings changes for stocks in the sector from Australian brokers.

I also speak to Anna Milne, CFA, a Wilson Asset Management equity analyst who’s invested in the space. In addition to explaining how she regards the pricing of the sector at current levels, Milne discusses WAM’s process for selecting healthcare stocks and a standout ASX healthcare name for 2023 and beyond.

WHAT THE BROKERS THINK

CSL Limited (ASX: CSL)

Just last week, Morgan Stanley equity analyst Sean Laaman reaffirmed his Overweight rating for the biotechnology firm. This followed the recent US Food and Drug Administration’s approval of CSL’s Hemgenix, a treatment for adults suffering from Hemophilia B.

Back in August, analyst Sean Laaman raised his price target for CSL Limited to $323, from $312, and maintained his Overweight rating. This was driven mainly by the strong FY22 result and the outlook for 2023, which includes gradual margin recovery in its flagship CSL Behring plasma business.

Morgan Stanley also saw further upside from CSL’s vaccine business Seqirus, which it acquired from Novartis in 2015. Also within this business unit, Laaman was buoyed by the $18.8 billion acquisition of Swiss renal therapy and iron deficiency products business, Vifor, a deal that closed in October.

J.P Morgan equity analyst David Low also retained the Overweight rating on news of the complete Vifor deal.

“We continue to expect a strong lift in FY24 group results, supported by the recovery in plasma product supply and a full-year contribution from Vifor,” he wrote in mid-October.

After CSL’s full-year 2022 results were delivered in August, Low lifted his price target for CSL to $330 from $315 a share.

He cited the following as key findings from the result:

• Higher margin deterioration from CSL’s core plasma business, driven by the slower recovery in collection volumes.
• This was offset by the strength of CSL’s flu and vaccine businesses.
• An expected lift in FY23 earnings to accelerate into FY24 with the switch to CSL’s Rika collection device.
• Lower operating costs for Seqirus, helped along to the tune of around $10 million by the currency exchange.

CSL shares were trading at $300.34 at the market close on Monday 28 November, up 12% since 12 October.

Sonic Healthcare (ASX: SHL)

The Sydney, Australia-based laboratory services, pathology and radiology services provider was downgraded to Sell from Neutral by Goldman Sachs on 28 August. The broker’s price target was also revised to $31.70.

On the back of the company’s FY22 earnings results, analyst Chris Cooper said the profitability gains Sonic made through the COVID period would be hard to maintain. And given consensus analysis was “skewing positive,” he believed there was greater chance shares would fall rather than rise from that point.

“While understandable, across most scenarios, SHL faces a declining growth/margin profile through to FY25, which will increasingly screen negatively,” wrote Cooper.

Cooper pointed to three broad reasons for the downgrade of Sonic, including:

• Doubts around a strong recovery from the company’s core business, which would also likely be offset by downward pressure on fees.
• The prospect of further pressures from COVID.
•  The underperformance of SHL’s share price between the first-half and full-year 2022, with the stock down 2% in that period versus a 9% gain across the broader ASX healthcare sector.

At SHL’s $35.63 share price on 28 August, the stock was trading on a forward PE multiple of more than 24 times – about 13% above its five-year average and 47% beyond that of its peer group, wrote Cooper.

The company’s share price is down around 11% since the FY22 results were announced on 25 August, closing at $32 on Monday 28 November.

Ramsay Health Care (ASX: RHC)

Analysts at Macquarie reaffirmed their Outperform rating for the ASX-listed multinational private hospital operator on the back of the group’s FY22 earnings result. The broker also maintained its $88 target price for RHC.

The FY22 result saw revenue roughly in line with the consensus view, as measured by research platform Visible Alpha. But earnings before interest, tax, depreciation and amortisation missed by between 4% and 5%, “reflecting higher than expected operating expenses,” wrote Macquarie analysts on 29 August.

Ramsay Health Care’s management at the time said it anticipated a gradual recovery in activity levels into FY2023 and a return to “more normalised conditions” in FY2024.

“While the timing of a recovery remains uncertain, we continue to see pent-up demand for services, public sector engagement and capital deployment into brownfield projects as supporting improved activity and earnings for RHC over the medium-longer term,” wrote Macquarie analysts in late August.

Since then, RHC’s share price has fallen around 20% to just above $56 by 17 October but has since recovered some of these losses. RHC stock closed at $64.90 on Monday 28 November, down 11% from the $73 closing price on 1 July 2022.

Cochlear (ASX: COH)

The designer, manufacturer and distributor of hearing aid medical devices was upgraded to Buy from Hold by broker Jefferies on 13 October, when Cochlear shares were trading at around $186.

Jefferies’ price target for the company was maintained at $219.30, about 18% above the mid-October share price, wrote analyst David Stanton last month.

Cochlear shares were trading at $213.72 at the market close on Monday 28 November, up around 7% since the start of FY2023 and almost 15% higher than the mid-October low.

A month earlier, on 8 September, Morgan Stanley downgraded Cochlear to an Underweight rating, from Equal-Weight. The target price was also revised down to $190 from $202.

And in August, following the FY22 results posted on 18 August, brokers CLSA and Macquarie downgraded their ratings for Cochlear.

As CLSA’s preferred stock with specific exposure to the reopening of elective surgery, the analyst Andrew Paine also noted the outlook for COH was cautious because of near-term disruptions. For this reason, the company was downgraded to Underperform from Outperform, but the price target was lifted to $235 from $230.

Macquarie analyst David Bailey downgraded the stock to Underperform from Neutral – referring to the stock as “priced for perfection”. Among downside risks, he cited the prospect of market share recovery from Cochlear rival AB, staffing constraints, and share price dilution from the company’s acquisition of Oticon Medical in April. Cochlear purchased the subsidiary of Danish multinational Demant for $170 million earlier this year.

Fisher & Paykel Healthcare (ASX: FPH)

The manufacturer, designer and marketer of respiratory medical devices was on Morgan Stanley’s coverage list on 16 November, with a rating of Overweight and price targets of $21 and NZ$22.90 for the dual-listed ASX and NZX company.

FPH shares closed at $19.29 on Monday 28 November, down around 38% from their $31 price at the start of January but up almost 9% since 1 July.

Macquarie retained its Neutral rating of FPH on 14 October but reduced its price target by 6% to NZ$20.15, “reflecting earnings per share revisions and the 3.1% risk-free rate MTM.” (Note: A risk-free rate is a theoretical rate of return of an investment with zero risk. It’s used to calculate a potential share price return in a Goldilocks scenario. Mark to market (MTM) is a method of measuring the fair value of accounts. But particularly during periods of volatility, it may not accurately represent an asset’s true value during more stable market environments.)

In a recent note, Macquarie analysts described FPH as a “quality business with a solid medium-term growth profile.” But they also emphasised the stock’s forward earnings multiple of around 43 times, which is around twice the average NZX 50 average and 1.6 times higher than the S&P/ASX 200 Healthcare index.

Fisher & Paykel’s valuation is one reason for the broker’s caution on the stock, alongside management’s focus areas of reducing inventory levels, device utilisation and gross profit margins. “We suspect it could be 1H24 until we see true customer usage patterns post-COVID … And input product inflation may temper gross profit margin reflating in FY24,” wrote Macquarie analysts.

A buy-side perspective

Zooming out to the broader ASX healthcare sector, Wilson Asset Management’s Anna Milne notes that its forward price-to-earnings multiple is currently around 40% higher than that of the local Industrials sector.

“When we compare it with the five-year average for the healthcare sector, it’s about the same. And for us, that feels fair, because there’s the benefit of being such a defensive sector,” she says.

“Then at the same time, with financial conditions getting tighter, those multiples are compressing. So, both those aspects largely offset each other.”

But the same broad dispersion in returns from ASX healthcare stocks, as alluded to at the start of this article, also applies to the PE ratios of specific large-cap stocks in the local sector. For example, Fisher & Paykel Healthcare and Ramsay Health Care are trading on PE multiples that are more than 30% and 50% above their five-year average.

“But that’s for different reasons and it’s largely earnings-driven. FPH had bumper earnings over the last two years, which has compressed the multiple that it’s been compared to,” Milne says.

“And Ramsay is still under-earning versus the pre-COVID period. So, it overstates the current multiple.”

As Milne also points out, the other large companies of the local healthcare space – Cochlear, ResMed, CSL and Sonic Healthcare – are all trading at around 5% below or above their five-year averages. “Which again, feels fair to us,” she says.

What are the red flags?

The ageing population in Australia and most other developed markets means the demand for healthcare products and services is in most cases either stable or growing. For this reason, Milne and her team look primarily at the supply side for any red flags.

“Competitors are a big focus – are they launching a new product that could take market share? Are they growing organically or inorganically – for example, via acquisition – at a faster rate?" She said. 

On the demand side, potential concerns around healthcare companies usually stem from changes to government funding of either the public or private parts of the system.

Outside of these, she looks at all the usual metrics in weighing up companies for potential inclusion in the WAM Leaders portfolio, including:

• Are there any working capital discrepancies?
• How does revenue growth compare to costs?
• Management’s capital allocation decisions.
• The tenure of the management team.
• Any material shareholding reductions by management or directors.

What about FX?

The large-cap healthcare companies mentioned above sell their products and services across not only Australia but also the US, European and emerging markets, meaning foreign exchange movements must be monitored.

“Most of these companies have a degree of natural hedging, given revenues and costs are generated in the same jurisdictions,” Milne says.

For CSL Limited, Cochlear, and Fisher & Paykel Healthcare, a 10% increase in all currencies versus the US dollar, the Aussie dollar, and the New Zealand dollar result in earnings rising by no more than around 3%. Ramsay Health Care’s use of foreign exchange swaps and forward hedging strategies means there’s no material shift in earnings due to currency moves.

“The only one of these stocks where foreign exchange really moves the dial is Sonic Healthcare,” Milne says, with a 10% rise in all pairs versus the Aussie dollar resulting in an earnings per share upgrade of around 9%.

Milne’s pick of the sector

“I know it probably feels like a consensus call but it’s got to be CSL,” says Milne.

"Earnings are set to grow almost 30% next year, 15% the year after that and 10% in FY2025 and beyond.”

Looking across the biotech’s largest businesses of Behring and its flu vaccine division, Seqirus, she points to the strong data from its plasma collection even as costs fall.

“Seqirus is also set up for a strong year from flu season, and Vifor is a compelling medium-term growth lever. It’s a stock that’s hard to fault," she adds.

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