Healthcare Meets Technology: A New Age

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AI has its supporters and its critics, but one area in which AI can be a force for good is healthcare.

-UBS looks for under-appreciated upside for healthcare
-Citi sees population growth driving pathology
-Morgan Stanley heralds a new age of beneficial AI for the sector

By Greg Peel

Healthcare has long been considered a defensive sector in any stock market on the basis that whatever the economic climate, people will still get sick. Over the course of a year, the ASX200 healthcare sector has risen 10%, while the ASX200 index is as good as flat.

It has not been a smooth ride nevertheless. Defensive as they may be, healthcare stocks still get roped in with all others at times of macro turmoil, when “sell everything” is the mantra. The most recent example is the period of early February to mid-March, when global stock markets tumbled first on central bank hawkishness, before being exacerbated by the US regional bank crisis.

Over that period, the ASX200 healthcare sector fell -8%.

Over the course of one year the global economic climate has been dominated by a lingering covid hangover, a war, and most notably, by surging central bank interest rates, inducing widespread talk of recession in the US, Europe, and maybe even Australia. While people do still tend to get sick in recessions, there are the more discretionary, or elective areas of healthcare that will suffer in tough economic times.

For Australian healthcare stocks, the other issue is that of currency. The large cap stocks in the sector earn the bulk of their revenues offshore, particularly in the US. Hence, the Aussie dollar exchange rate is more critical than for domestic-based corporates.

Thanks to a more aggressive Federal Reserve (current cash rate 5.00%) compared to the RBA (3.85%), and a lack of post-lockdown economic rebound from China, over the past year the Aussie has fallen -9% to the low end of the historical range.

Then as in the case of any listed stock, there is the matter of valuation. If too many investors decide healthcare is the best place to hide in an economic downturn, stock valuations risk being overblown.

Which underpins a recent initiation of coverage of the healthcare sector by UBS, and specifically the larger stocks therein. UBS’s title for its sector-wide overview is “Buy under-appreciated earnings upgrade risk”.

Dissecting the Sector

Fundamentals for Australian healthcare look generally strong, UBS attests. Average earnings per share growth for those stocks under the broker's coverage look set to outstrip the ASX by 10% in FY24 (12% versus 2%).

The broker “leans” towards growth over value given the revenue-driven nature of global healthcare, but not at any price, favouring stocks for which consensus looks too bearish near term, particularly at sales level.

UBS notes ResMed ((RMD)) is priced for high single-digit near-term revenue growth but the broker can still see 12% upside, believing the market still underestimates the degree to which the company can capitalise on the absence of the other major global player (Philips) in sleep devices, following the latter's safety recall and seemingly long road back. Gross margin is expanding and supports UBS’ forecast double-digit compound annual growth rate of earnings.

The broker has initiated with a Buy rating on ResMed, but with a non-comparable US dollar target that at the time (May 22) suggested 29% upside. The FNArena database of leading brokers shows the equivalent of five Buy ratings and one Hold, for a consensus target of $38.00 suggesting 15% upside (30/05/23).

CSL ((CSL)) also scores a Buy rating from UBS, which sees commercial tailwinds in all divisions. UBS expects Behring's immunoglobulin (IG) franchise to recover strongly and gene therapy Hemgenix to become a “blockbuster”. Vifor should deliver on 10%-plus per annum sales growth guidance and Seqirus (flu vaccines) remains underappreciated, in the broker’s view.

UBS has a $350 target on CSL, which is now the high-marker in the database target range. The database has five Buy and one Hold rating for a consensus target of $336.

UBS also has a Buy rating on Telix Pharmaceuticals ((TLX)), expecting first asset Illuccix (prostate cancer diagnostic) to outperform leading to an inflection to profitability in FY23.

UBS becomes only the second database broker to cover Telix (Bell Potter), and both have Buy ratings and $14.00 targets.

For Cochlear ((COH)), UBS has set a Neutral rating and $255 target. The broker acknowledges Cochlear is the undisputed leader in the cochlear implant space with some 60% market share, and most revenue growth is from the adult market, including older adults, where UBS sees long-term volume growth of around 7%, but limited pricing power.

On current valuation, UBS suggests it is difficult to argue for PE multiple expansion, but given a lack of near-term negative catalysts does not see much to provoke a downward re-rating either. The database shows only the one Buy rating for Cochlear, three Hold and two Sell, for a consensus target of $223.43. That suggests -9% downside, but interestingly, UBS has also set a new high mark with its target.

For Ansell ((ANN)), UBS has set a Neutral rating and $30.00 target. As a manufacturer of gloves and other personal protection equipment (PPE), Ansell saw significant growth during covid and record sales, but FY22-23 has seen unpredictable demand especially in exam/single-use gloves, Ansell's largest sub-segment.

UBS sees negative growth for exam/single-use sequentially in the second half as pricing continues to deteriorate, but a modest return to growth at group level in FY24. All six database brokers covering Ansell have Hold ratings, for a consensus target of $26.93, which is where the stock is currently trading. Once again, UBS’ target is a high-marker, albeit matching Ord Minnett.

Then we come to Sonic Healthcare ((SHL)). Sonic polarises database brokers, as evident from a split of three Buy and three Sell ratings, and a target range of $31.00 to $40.00 for a consensus of $35.20 – not far off the current trading price.

This time, UBS is the low marker, with a Sell rating. UBS foresees revenues returning to modest growth in FY24 following FY23’s decline in covid-testing revenue. The broker does not think this will be enough for investors to look through the FY24 earnings trough, particularly since risk appears skewed to the downside for the largest sales line, US Pathology.

Citi has its own thoughts on the pathology sector.

Blood Lines

Citi forecasts the Australian pathology industry will grow at a compound annual rate in excess of 5% over FY23-30, compared to around 4.4% over FY09-19, based on population growth projections, a continued increase in the number of tests per capita, and minimal price/mix contribution.

The Australian population is expected to grow at a rate of 1.2% per annum to FY30, with potential upside from higher levels of immigration. The use of pathology services per capita grew at a compound annual rate of 2.3% over FY09-19. Citi expects this to accelerate to 3.3% on population ageing and post-covid recovery in tests per capita.

As a result, the broker has increased mid-term revenue assumptions and discount cash flow-derived valuations across its coverage.

Subsequently, Citi is one of the aforementioned database brokers that has a Buy on Sonic Healthcare. The broker also has a Buy on Australian Clinical Labs ((ACL)), alongside a Neutral rating for Healius ((HLS)).

Margins beyond the covid-testing boom have been a key area of concern for investors, Citi notes, as employee cost is the biggest expense line at some 45-50% of revenue, and revenue is not indexed to inflation. At this stage, both Sonic and Australian Clinical Labs have guided to margins returning to pre-pandemic levels, and this is the broker’s base case.

Higher inflation for longer without an increase in funding could negatively impact margins, Citi notes, but higher volume growth could be beneficial to margins given the high fixed cost nature of the industry.

Don’t Mention AI

It’s the potentially over-hyped, hot-button topic at present, particularly on Wall Street, but the reality is artificial intelligence cannot be avoided. And despite AI seemingly springing out of nowhere a few months ago thanks to Microsoft’s ChatGPT, AI development has been in train for years and is already impacting everyday lives.

Observers see AI as offering outcomes both good and evil. Healthcare is nevertheless one the of the areas in which analysts see major benefits to AI adoption.

Coming out of the pandemic, a universal theme among healthcare companies under Morgan Stanley’s Australian coverage, if not globally, is cost and access pressures related to the lack of appropriately trained staff — mostly nurses. The broker sees such constraints extrapolating across the entire medical workforce.

In essence, aging demographics drive demand growth for medical products and services at a higher rate than the growth in the medical workforce.

Cue: technology.

Across the pandemic, the Australian government introduced funding for GP telehealth consults and electronic prescriptions (eScripts) while in the US, Remote Patient Monitoring and Remote Therapeutic Monitoring codes were introduced.

Morgan Stanley believes such initiatives have the potential to permanently shape clinical pathways and drive efficiencies in staff utilisation while also, in some cases, deliver upfront revenue maximisation with back-end cost savings via ultimately reduced hospitalisations.

And where there’s technology, there’s AI.

Adoption of AI to read diagnostic imaging scans and pathology tissue samples has the potential to reduce requisite staff with improved accuracy of outcomes, Morgan Stanley notes. The broker sees AI utilisation at the point of diagnosis as only the beginning, and achieving true benefits at scale requires broader AI involvement in the entire clinical pathway.

Morgan Stanley believes AI has the potential to completely transform the diagnostic industry with the most progressed company under the broker’s coverage being, wouldn’t you know, Sonic Healthcare. With human capital the largest company cost, AI adoption could see long-term earnings expectations as materially too low.

Improved patient access and greater care at the beginning of the clinical pathway leads to reduced high-cost hospitalisations and lesser disease severity at the back-end, the broker notes. Improved GP access (GP telehealth) and better medicine utilisation (eScripts) could see revenue increases for diagnostic providers and exposed medication providers.

Among diagnostic providers, Morgan Stanley has an Overweight rating on Sonic and Monash IVF ((MVF)), an Equal-weight on Integral Diagnostics ((IDX)) and an Underweight on Healius.

In the case of medication providers, Morgan Stanley has Overweight ratings on Ebos Group ((EBO)) and CSL, Equal-weight on ResMed, and Underweight on Sigma Healthcare ((SIG)).

In the case of Cochlear, remote patient monitoring initiatives allow maintained focus on increasing new implantees with positive economic outcomes, the broker suggests. Morgan Stanley has Equal-weight on Cochlear.

Bear in mind broker ratings are shorter term and current valuation-based, while the whole AI story is longer term.

That said, aside from improved economic productivity via better medication management driving reduced sickness, Morgan Stanley estimates telehealth consults, which represent in excess of 20% of total GP visits in Australia, have delivered $4.8bn in Australian productivity gains since their introduction.

In most healthcare sub-sectors, the broker observes current and emerging staff-related bottlenecks. But telehealth as a funnel is driving better GP access, eScripts lessen demand for bricks & mortar pharmacies, which will benefit Ebos and Sigma, AI will create radiologist/pathologist capacity, which will benefit Sonic, Healius and Integral Diagnostics, and remote patient monitoring will reduce pressure on specialists, benefiting Cochlear and ResMed.

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