Shares in Healius (ASX:HLS) already seem to pricing in hopes of future earnings upside. With the AGM coming up later this month, could it become a buying opportunity? Or is this one health care stock to stay away from?
Healius, formerly Primary Health Care (ASX:PRY) has three core businesses in pathology, medical centres, and imaging. It also has three emerging businesses in dental, IVF, and day hospitals. The Pathology division accounts for around 54% of overall earnings. It is the Company’s largest division, with a market share of around 33%. The Medical Centres and Diagnostic Imaging divisions account for approximately half of the remaining portion. Healius’ medical centre network comprises 73 medical centres (with dental practices in 61, day hospitals in five and IVF clinics in four), 13 Health & Co practices and nine stand‐alone day hospitals.
Key Factors Driving Improvement in Fundamentals
Over the last several months, we have reviewed HLS on two occasions: both prior, and subsequent to, its full year results release in August. The key observation we made is that FY19 was a tale of two halves. Whilst 1H19 results were negatively impacted by margin pressure in Pathology, external conditions and one-offs, there was a marked
improvement in EBIT across all three divisions in 2H19. This was a result of the benefits from a number of initiatives implemented in recent periods are starting to flow through.
Revenue Growth & Margin Trends Improving for Pathology
Divisional revenue growth in FY19 was 3.5%. This was above the industry growth rate, when normalised for the loss of the bowel screening contract in FY18. With pathology volumes in 2H19 returning to long term averages (~4-5%), the outlook for revenue growth in FY20 is much stronger (i.e. around 5-6%). The industry growth rate is expected to stabilise around the long-term average in the near term. To this end, Medicare data is supportive of strong operating conditions in early FY20.
There was a noticeable improvement in EBIT in 2H19 due to better cost control. In particular, the productivity programs are delivering their projected savings. Overall, EBIT growth (on a normalised basis) was above revenue growth. The division has seen margin pressures in recent years. This is due to factors such as significant rental cost inflation following deregulation of pathology Approved Collection Centres in 2010 as well as changes to referral rules for specific MBS items. While these pressures were evident as recently as 1H19 results, where EBITDA margin declined to 10.7%, from 12.5% in 1H18, margin growth is now expected to occur. Following sequential margin improvement in 2H19 relative to 1H19 (i.e. +270 basis points), further improvements in margin is expected from a number of avenues.
Improving Trend in GP Recruitment
Over the last few years, the core strategy for the Medical Centres division has been to improve the rate of net additions in the number of General Practitioners (GPs) recruitments. The strategy has necessitated a significant deployment of capital in a number of initiatives designed to improve GP relationships and enhance the operations of its medical centres.
Pleasingly, the Company has improved the rate of net addition in FY19. At present, the number of GPs (on a Full-Time Equivalent basis) is 992, with the Company targeting 1,400 GPs by FY21. We consider that it is still too early to tell if this target is achievable. In particular, given that the churn rate (i.e. the rate of GPs leaving) is stabilising, it is still around 8-10%. Further, only about 15% of the 36,000 GPs in Australia work in a large corporate practice.
Diagnostic Imaging Remains a Steady Performer
The Diagnostic Imaging division has benefitted from strong rates of revenue growth and higher rates of earnings growth. The key factors underpinning this include the opening of new sites, growth in existing sites, new contract wins, federal government funding support and the rollout of new software.
With the shares trading on a 1-year forward P/E multiple of ~18x, we consider that the market may be factoring in future earnings upside. This would be from areas such as further earnings growth in the Pathology division, as well as restructuring benefits, which are expected to deliver ~$70m in savings over the next several years.
We also consider that the market may be factoring another takeover bid from its major shareholder Jingo. Jingo holds approximately 18% of the total shares on issue.
Whilst HLS’s fundamentals are improving, we would prefer to see more sustained evidence of a turnaround. In particular,
i) There is significant execution risk around the GP number targets, and
ii) While the Company has achieved some productivity benefits in 2H19, the restructuring program remains ongoing. The implication here is that it may give rise to a further round of one-off costs, the extent of which is making it difficult to determine the underlying earnings of the business.
Further, the gearing level is still elevated given that the current investment phase requires high levels of capital to be deployed.
Adding to the uncertainty of earnings over the short-term, HLS guided to “higher” underlying NPAT in FY20. While no specific guidance was provided, there are many moving parts: the extent of the full-year contribution from productivity savings, higher Depreciation & Amortisation charges, as well as higher net interest expenses (from the higher net debt levels). Accordingly, we would prefer to see the Company provide more qualitative guidance at the upcoming AGM on 25 November – although this is a possibility rather than a probability.
Healius is finding resistance near $3.20 and the share price is unable to head higher. A break under $3.05 support will see it go back to retest $2.90. With HLS displaying a number of support and resistance levels nearby, investors should look for either support to come in much lower down, or for HLS to make a clear break away from the recent trading range.
Michael Gable is managing director of Fairmont Equities.
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