CSL still too expensive

PORTFOLIO POINT: The healthcare stock’s underperformance since March last year suggest market expectations had been too high.

Australia led the world into this post-April downturn. Shortly after global equity markets peaked in April, I made the observation that profit growth expectations in Australia had stopped rising (see Have shares run too hard?).

Two months earlier, during the interim results season in February, market expectations for healthcare stocks had received some significant downgrades. In hindsight, fully priced healthcare stocks were showing the way forward for the broader market.

The February results season has had a material impact on how investors in general perceive the healthcare sector in Australia. Not every healthcare company is equal and investors have since again learnt the value of successful stock-picking.

This may well be lesson number one from observing the healthcare sector over the past four months: when things get tough the weak get separated from the strong. No mercy involved. This means stock-picking, rather than sector-allocation, becomes all-important.

Earnings risk has once again become a major feature for the stockmarket. Lesson number two from the February experience is that healthcare stocks are not immune.

This second lesson is more important than one would be inclined to think at face value. Despite healthcare often being categorised as “defensive” by stockbrokers, it is not always appreciated that the sector historically commands higher multiples than most other sectors.

The reason behind these above-market price/earnings (P/E) multiples is simple: companies such as CSL (CSL), ResMed (RMD), Cochlear (COH) and Ramsay Healthcare (RHC) have long grown faster than other companies.

And if there's one thing the stockmarket does very well, it is rewarding companies for high growth performances. This easily explains why these stocks have been top of the list of favourites for many investors and stockbrokers: high earnings growth multiplied by high P/Es makes for an almost watertight guarantee of high investment returns.

What is not always appreciated, however, is that high P/Es become a time-bomb when earnings growth stalls. This is what has happened to CSL over the past year.

Last year I made myself unpopular with CSL shareholders when I suggested the shares were expensive (see Why defensive CSL is trailing). I agree with almost everything that is being said and written about CSL in a positive sense, but I always end up adding, “but the shares are too expensive”.

CSL's underperformance since March 2009 proves my point.

CSL's share price held up well during the 2008 stockmarket meltdown, but what is seldom mentioned (and so easily forgotten) is that the company managed to grow its earnings per share by nearly 35% in 2008-09 – when most companies saw their profits plummet!

At $38 in March 2009, CSL's P/E multiple had gone past 22, which by anyone's standards was far more than was appropriate. The problem that then arose, however, was that profit growth for the years ahead started to look bleaker and bleaker, especially after management had to give up on acquiring US competitor Talecris.

The combination of slower growth and therefore a lower multiple has made CSL one of the biggest underperformers throughout what may well have been the strongest stockmarket rally we will all witness in our lifetime.

I remain unconvinced the tide is about to turn for CSL. My motivation? At about $32, CSL shares are still trading on more than 17 times projected consensus earnings for fiscal 2010.

While this is well below the multiple of 22 mentioned previously, one also has to appreciate that CSL – if it meets this year's consensus expectations – will only grow its earnings per share by 10%, or less than a third of growth for the previous year.

What about fiscal 2011?

Current consensus forecasts only assume 6.5% growth. One old standard rule for the stockmarket is that investors had better not pay for a higher multiple than what can be expected in terms of earnings per share (EPS) growth. I acknowledge this is a rough rule, and that it certainly does not always apply to all companies under all circumstances, but CSL’s shares are valued at more than 16 times 2010-11 consensus EPS. That seems a lot to me for a company whose earnings growth seems in decline, and rather sharply so.

While many analysts are expecting major improvement from 2011-12 onwards, that is still such a long time away. In the meantime, dividend yield is about 2.5%. I’m sorry, but that's simply not enough for my liking.

My view on CSL is simply confirmed when I compare with valuations for other stocks in the sector. Ramsay Healthcare, for example, is trading at a similar P/E multiple, but with projected EPS growth numbers of 12% and 10.5% for 2009-10 and 2010-11 respectively. Ramsay's anticipated dividend yield is 3% and more.

The real standouts, however, are Cochlear (COH) and ResMed (RMD). Both are trading on multiples well above 25, but look at what both should bring to the table in terms of EPS growth for 2009-10 and 2010-11: 19% and 12.4% for Cochlear; 33.1% and 20.2% for ResMed.

As things stand right now, Cochlear is slightly more expensively priced than ResMed, but the mentioned consensus growth projections suggest ResMed shares seem the better option.

At multiples above 25, however, I wouldn't be chasing any of these two, regardless of what future growth expectations might be. History shows that, in case of disappointment, the combination of weaker growth and contracting multiples can be devastating for the share price.

Maybe the best strategy regarding both would be to wait for pullbacks and/or more certainty about future growth? Note that Cochlear's present multiple seems high in relation to what is expected in terms of 2010-11 growth. Is this the next CSL in the making?

Glove and condom manufacturer Ansell (ANN) trades at a multiple not far below those for CSL and Ramsay, but at least earnings growth is expected to accelerate from 9% in 2009-10 to 15% in 2010-11.

Most other stocks in the sector, including Sigma Pharmaceuticals (SIP), Biota (BTA), Primary Health Care (PRY) and Sonic Healthcare (SHL), are nowadays trading on lower multiples in line with sharply lowered growth expectations. The market is not expecting any growth from Healthscope (HSP) but takeover appeal is keeping the shares at relatively high multiples of 15-plus, indicating significant downside exists if nothing materialises.

All of the above are observations and conclusions based on consensus forecasts, but we know from the February interim results that healthcare companies are not immune to profit disappointments. So where does this take us?

I believe the market has already made up its mind about which companies are more likely to disappoint and which ones carry less risk. This risk-assessment, I believe, is at present reflected in the triangle-combination of the 60-day moving average, the 200-day moving average and share prices for the companies mentioned.

For those not familiar with these tools: the 60-day moving average is usually used as a gauge for short-term momentum, the 200-day moving average marks the underlying, long-term trend and if the first one breaks below the second one this is usually very bad news (it's called the “cross of death”).

As such, I observe that only ResMed, Cochlear, Ramsay and Ansell are still trading (well) above their respective 200-day moving averages, suggesting the market maintains the longer-term outlook for these companies remains healthy. This is in line with what P/E multiples and consensus forecasts are telling us.

Shares of Sigma, Biota, Primary and Sonic, however, are not only trading well below the 200-day moving averages, the 60-day moving average is also below the 200-day moving average. This at least suggests the market is either suspecting more troubles, or the risks are simply too high.

For CSL, the picture is rather mixed. The shares are below the 200-day moving average, but the 60-day moving average (blue) is still above the long-term trend line (green), which perhaps means not everybody has yet given up on the potential for a positive surprise.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.