The fortunes of two of the ASX’s largest healthcare names diverged markedly during the reporting season just finished. Before it reported CSL traded on 29 times fiscal 2019 earnings; now the multiple is 32 times. Ramsay Health Care in contrast used to trade on 22.5 times but now the multiple is 21 times. This means the market was already highly confident about CSL’s earnings growth and now is extremely confident, while the market is less sure about Ramsay but still rates the stock more highly than the ASX 100 index with its 15 times earnings multiple. All this happened because CSL’s result and guidance beat expectations while the composition of Ramsay’s result disappointed though the guidance was reiterated.
Many earnings results meet market expectations (‘consensus’) but the size of the share price moves when stocks please and disappoint, relative to consensus, leaves many investors wondering what has changed, if their original investment thesis for holding a stock is still valid – and whether the stock is now over- or undervalued.
This is the approach we take to earnings results and subsequent share price moves. The cost base for the original investment is not relevant; to focus on this as a reason for buying, holding or selling is anchoring bias. The only question about a stock is whether it can achieve the investor’s return target from the current share price and how much risk there is to this.
CSL’s result, dividend and guidance surprised above consensus expectations, which goes to the power of this business model, the staff and management team, the R&D program, CSL’s market leadership and the growth available in its end markets. Net earnings surged 35 per cent, the interim dividend was increased 23 per cent and guidance for fiscal 2018 earnings was raised to US$1,550-1,600 million, up four per cent at the midpoint. Reported revenue was up 11 per cent but constant currency revenue jumped 31%, indicating strong profit margin expansion.
The reasons for this superb performance are now well-understood by the market. In IG (immunoglobulins) CSL extended its competitive advantage by investing in a larger plasma collections network before competitors, so it could meet constant growth in patient demand for IG while improving per litre profitability. The vaccine business Seqirus is becoming profitable, assisted by the worst US influenza season on record and a switch from egg-based development of vaccines to cell-based. Uptake of CSL’s new hemophilia B treatment Idelvion has been rapid with no slowdown. The Haegarda treatment for angioedema has been very popular, assisted by supply difficulties at a competitor. And US hospitals can’t get enough of CSL’s Kcentra, which treats postoperative bleeding.
Even after the upgrade, CSL’s guidance is still too conservative because it implies a second-half loss for Seqirus whereas a positive contribution is more probable. This the market also understands: consensus earnings for fiscal 2018 are US$1,635 million, above the top end of the guidance range, and the super-premium earnings multiple implies certainty CSL will upgrade.
It also means the stock is priced for perfection, so any disappointment would trigger a substantial pullback. We can value the stock at $174 a year from now; a rally to this level today would be difficult to justify.
Ramsay Health Care held its guidance for 8-10 per cent growth in fiscal 2018 ‘core’ earnings per share, but the interim result was at the low end of the range (+7.8 per cent) and the composition and dividend disappointed, hence the derating in the market. Ramsay only reached the low end of its guidance range due to lower interest expense and France’s corporate tax cut. UK and French revenue and earnings went backwards as guided but the scale of the falls was worse than consensus expected due to pricing constraints and volume pressures. To sustain French earnings Ramsay has had to find cost savings in a new back office centralisation program but this came at the cost of a restructuring provision nearly five times the recurring annual cost savings. The earnings pressure in Europe put more pressure on the Australian operations to prop up the group result, so management had to pull hard on costs.
Our impression is the UK and French governments are gaming private hospital operators by promising higher outsourced volumes in return for tariff (reimbursement rate per procedure) cuts, but the volume growth is either slow (France) or keeps getting pushed out into the future (UK, where the NHS is adding to waiting lists to deal with its underfunding). The attractive demographic story of rising demand for healthcare due to population ageing is diluted by how governments manage the high cost of funding healthcare. Ramsay is finding cost efficiencies to support earnings but the market wants organic revenue growth. UK tariffs will increase this year, providing some relief.
In Australia, growing private hospital admissions by over-65s are partly offset by the withdrawal of young people from private health insurance, while slow wages growth and cost pressures on household disposable income have pushed some patients to defer elective surgery. There was a first-half hiatus in extending hospitals to provide more capacity, which should improve in the second half.
Ramsay continues to grow faster than the market in Australia due to its superior hospital portfolio and appeal to doctors. There is no doubt population ageing will drive higher demand for hospital services; the question is whether the stock can return to former rates of growth of 12 per cent or better when the UK could well improve but France will remain a grind. The current global procurement cost savings program is going well but will cease supporting earnings growth after it ends in fiscal 2019.
We think Ramsay’s sustainable annual growth rate is rebasing lower to eight per cent and the stock is worth $66.50 a year from now. A rally towards $70 could therefore be an opportunity to consider other stocks with growth and undervaluation. Ramsay still trades at a premium to the market because despite the company’s recent difficulties there are few other large-caps able to compound earnings at high single-digit rates.
Clime Asset Management owns shares in RHC & CSL for and on behalf of various mandates for which it acts as investment manager.