The Prescription For Good Returns

Sydney Morning Herald

Wednesday November 15, 2006

By Beth Quinlivan

Shares have risen in the health sector as investors anticipate more private equity interest and further consolidation.

Can the price of healthcare companies keep rising at above market rates? Ask the brokers and analysts and the answer is probably no.

That hasn't deterred investors, who are betting that private equity groups will continue to focus on the sector, which in turn will drive further acquisitions and asset reshuffles at premium price levels.

"In the three months to the end of October, the healthcare sector has outperformed the market by 6 per cent although there has been no change in earnings," says Michael Carmody, a healthcare analyst for Merrill Lynch. The result, he says, is that it is harder to find value in the companies and he is cautious on the immediate outlook. Carmody is not alone among the leading brokers in not seeing too many bargains.

Andrew Goodsall, a healthcare analyst for broker UBS, believes most companies are trading either at or above valuations. "If you look at some of the underlying performances, strip out recent acquisitions and other changes, they haven't been too exciting," he says. Across all the major companies in the sector, he has just two "buy" recommendations: CSL and ResMed.

David Stanton, a health specialist for broker ABN Amro, is also of the view that most of the stocks are fully priced and the outlook not necessarily exciting.

The companies which focus purely on the domestic market, he says, could struggle more than those with internationally focused businesses to maintain previous growth rates. The only companies to offer value at the moment are ResMed and CSL.

Two things have been responsible for the higher share prices. One is the expectation that the cashed-up private equity firms will continue to look closely at the sector. In the past couple of years, they have made a fortune out of health companies - the best example being the $500 million profit made by the private equity and management consortium which bought a portfolio of hospitals from Mayne Group and sold them, less than three years later, to Ramsay Healthcare. The recent bid by private equity firm CVC for health company DCA Group confirms an ongoing interest.

In September, just before its high-profile involvement in the re-structuring of PBL's media assets, CVC offered $2.4 billion for DCA. The bid was timed to take advantage of DCA's lower share price, which had fallen following negative news in the middle of the year. Pitched at $3.50 a share, it was well above DCA's September price but lower than the level of the stock earlier in the year. The board of DCA has recommended the offer and it is almost certain to be approved by shareholders.

DCA is a big player in the domestic healthcare market, with strategic positions in both radiology and aged care. It has spent the past five years building its business, mostly by buying smaller aged care and radiology companies or independent practices. It is one of the largest local operators of aged care beds (it has 6000 in Australia and New Zealand) and is the largest radiology company, with about 25 per cent of the private market. DCA's share price dipped earlier this year, partly because it missed out on contracts to provide radiology services in Britain and partly because operating margins were under pressure following, among other things, hefty wage rises to professional staff.

But private equity is just one factor. Around the world, pharmaceutical and health companies are consolidating, looking for greater efficiencies and marketing power.

The two recent bids in the Australian market are part of that trend. In September, US specialty pharmaceuticals company Hospira bid for local drug developer Mayne Pharma. Struggling pharmaceutical distributor API is being targeted by rival company Sigma Pharmaceuticals.

The locally listed healthcare companies fall into two main categories. One group, which consists of Cochlear, ResMed, CSL, Mayne Pharma and Ansell, has focused its business outside Australia. Cochlear, for example, is the world leader in cochlear implants and CSL is a major player in the international blood plasma business.

The other companies, including Sonic Healthcare, Ramsay Health, DCA, Healthscope, Primary Health, Symbion and Vision Group, are all domestically focused (although in the case of Sonic, it is rapidly building up its operations outside Australia).

The domestic companies have so far enjoyed a greater degree of certainty in income but after a decade of consolidation their growth options are more limited. In pathology, for example, more than 90 per cent of the private market is held by one of four listed health companies.

The Government has agreed to index its total Medicare payments for pathology (and radiology) at 5 per cent a year. But if one of the companies wants to increase its income from pathology at a greater rate than 5 per cent - and with very few small practices left to buy - it can do that only by taking business off competitors.

The only way a company is going to be able to dramatically increase its pathology income is by acquisition of one of its rivals. Symbion recently indicated its interest in buying Primary Health and there are rumours that one of the other companies is also interested.

In radiology, the situation is different because the healthcare companies control less than 60 per cent of the total private market, which means it is still possible to increase market share by acquiring independent practices.

But one of the recent trends in radiology is that a growing number of radiologists appear to be leaving corporate practices and going back to work in private partnerships. Companies wanting to keep high-quality staff are having to pay more.

One of the key reasons that Sonic, and to a lesser degree DCA and Symbion, have been looking offshore for business is because of limited growth opportunities locally. But whether they can transfer their local business models into offshore markets is not clear at this stage.

Sonic has 40 per cent of the local private pathology market and about 13 per cent of the radiology market; Symbion has about 29 per cent of private pathology business and 14 per cent of the radiology market; Healthscope has about 15 per cent of pathology market and is the second largest hospital company (after Ramsay Healthcare). Primary Health's main business is operating medical centres but it has also about 7 per cent of the private pathology market.

© 2006 Sydney Morning Herald

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