The StocksInValue model share portfolio has its eye on two blue-chip healthcare stocks which have become substantially cheaper and therefore more attractive. Ramsay Health Care and CSL have derated for unrelated reasons and are not far from levels where conservative investors could consider them. We like Ramsay below $70 and CSL below $95 because these prices are at reasonable discounts to our respective $76 and $105 valuations. At $70 and $95 the closure of the share prices to our valuations, plus the dividend yields, should yield CPI plus six per cent over the year ahead – a reasonable return benchmark for the ASX’s largest companies.
Not helped by last week’s slide in the broader market, Ramsay shares are trading some 10 per cent lower than before competitor Healthscope’s profit warning at its AGM on 20 October. Healthscope warned weak patient volumes and a less profitable casemix in September would, if sustained, mean flat hospital earnings for 2017. The problems include deferral of orthopaedic surgery, private health insurance policyholders downgrading their cover and public hospitals competing for volumes.
The market was relieved when Ramsay reiterated its existing earnings guidance, for 10-12 per cent earnings growth in 2017, six days later despite Healthscope’s report the headwinds are industrywide. We think this indicates the greater quality and diversification of Ramsay’s hospital portfolio and a commitment to conservative guidance.
The challenge for Ramsay is different: to prove it can deliver sustainable earnings growth from its French expansion when the Australian portfolio is approaching maturity. Ramsay has possibly found France harder going, due to a volatile economy and some uncertainty about public funding of private hospitals, than when it made its first acquisitions there in 2010. Most likely the French portfolio will not deliver its best growth until 2018 but the discount to our valuation is becoming interesting so it could pay to watch the stock. The recently announced plans to enter pharmacy would be fruit for the sideboard if delivered. Investors should think carefully about their desired weightings to private hospital stocks given the annual political risk to the rate of increase in health insurance premiums allowed by government.
CSL also confirmed its guidance, for ~11 per cent constant-currency earnings growth, at its recent AGM but the stock slipped below $100 on more realism about how soon the acquired Novartis influenza vaccine business will turn around. This is now looking like a 2018 event, with losses from Novartis dragging on the faster-growth CSL Behring division in the meantime. Consensus earnings estimates for 2017 have declined some $150-200 million. Meanwhile the five-year share buyback, renewed at the AGM, has ceased to drive the stock higher.
There is steady, resilient growth in demand for plasma products and CSL’s R&D pipeline contains a wealth of opportunity, though this is longer-dated. CSL is the lowest-cost and dominant producer in its markets and one of the few ASX 20 stocks capable of consistently growing earnings faster than GDP. The next catalyst should be announcement of Phase 2 trial results for CSL-112, an anti-heart disease compound and a potential new blockbuster drug, at the American Heart Association’s conference on 15 November. Favourable Phase 2 results and a commitment to Phase 3 trials would probably send the stock 5-10% higher but consensus earnings upgrades would only be for the year 2022 and later, as Phase 3 trials would run for four years. Share price downside from poor Phase 2 results is limited after the stock’s recent fall.
The drag from Novartis and uncertainty about the value of the R&D pipeline are why the stock is soft in the market. A long-term buying opportunity could be in the making but investors will have to be patient.
Originally published in The Australian on Tuesday 2nd November 2016.