These healthcare stocks are a prescription for profit

Marc Whittaker | IML

We have been saying for some time that we believe there are attractive long-term investment opportunities in Australian small cap healthcare – high-quality stocks with strong prospects trading at reasonable valuations.

The healthcare sector is growing faster than the Australian economy overall due to our ageing population that requires greater, earlier, and more frequent medical care. The sector has taken considerable time normalising after the peculiarities of Covid, so for many healthcare companies it is only in recent months that the market has been able to determine exactly what their typical operating profile looks like. There are three healthcare companies currently in our portfolios that we believe are particularly well placed for the future. All three companies:

• Reported improving results during the recent reporting season;
• Continue to have resilient business models;
• Are in different health sectors all of which will continue to consolidate over time; and should
• Benefit from increased government expenditure.

Australian Clinical Labs (ASX: ACL)

ACL is the third largest pathology company in the country. Its share price has been up considerably since reporting season, but we believe it still has plenty of room to run as the company’s operating performance continues to improve. What really stood out to us in ACL’s August result was its margin recovery in the second half. This margin recovery was a function of increasing pathology volumes and fixed-cost operating leverage. ACL, and many other healthcare stocks, have been suffering from low GP visitation since Covid. We have finally seen GP visitations recover, which has meant more referrals for pathology, but also radiology and other medical tests. This has directly benefitted ACL which reported that its revenue grew 7 to 8% over the past year and it expects revenue to grow at a similar rate of 5 to 6% next year.

For a company like ACL revenue growth is particularly encouraging because around 70-80% of its costs are fixed, so a significant percentage of increased revenue flows through to profit. Its operating margins in the second half of FY24 were close to 10%, which puts the company on track to achieving its longer-term margin targets of over 11%. ACL has always been a strong cash generator with a strong balance sheet and it has now announced a plan to buy back 10% of its shares over the next 12 months, which should provide a further boost to its share price. ACL remains good value, currently trading at 17.5 times fiscal 2026 earnings with a 3.8% dividend yield*.

Regis Healthcare (ASX: REG)

Regis is one of Australia’s largest aged care operators. The aged care sector has struggled for profitability for some time. However, Regis as one of the scale operators in the market has remained profitable. Improved government funding and a growing cohort of older Australians seeking to enter aged care means that conditions are finally improving for the sector generally. Around 40-50% of the aged care sector is currently unprofitable, but this should change with the increased government funding announced as part of the Federal Government’s Aged Care Reforms. Regis is one of the operators which is best placed, both from a financial and operational standpoint, to benefit from these reforms.

The aged care sector has taken some time to get back to normal post-Covid, but we believe we are now able to get a true picture of the sector and the relative strength of the main players. The baby boomer generation is ageing, in fact Australia’s 85+ population is predicted to grow by 68% in the next 10 years. Many of these people are likely to need to move into an aged care retirement home but supply has not been meeting demand over the last 10 years, so more aged care places are urgently needed.

This significant increase in both demand, and funding, means well-managed aged care operators are likely to perform extremely well over the next 3 to 4 years. Current occupancy for Regis sits at 95%, a level last seen around 2015. Back then its operating margins were over 20%, whereas right now they are at 10.5%. While it will be difficult for Regis to return to those margin levels – the sector now rightly bears significantly greater compliance, reporting and staffing requirements – we expect its margins to move from the current 10.5% to around 12% to 15% over the next couple of years. It also has a strong balance sheet, which leaves it well placed to grow through acquisition as we saw recently with its purchase of two new aged care homes. Regis’ share price is up strongly since August, but it is still trading at a reasonable valuation of 15x fiscal 2026 operating earnings and a dividend yield of 2.6%*.

Integral Diagnostics (ASX: IDX)

Integral Diagnostics is one of Australia’s largest diagnostic imaging providers. Over the last two years it has been difficult to maintain consistent profit margins recently due to cost pressures and a lower number of referrals from GPs.

Like ACL, the increase in GP radiology referrals is seeing higher volumes. Additionally, a continued mix shift in radiology work towards higher value and higher margin imaging such as CT and PET scans, as well as higher government indexation on Medicare radiology benefits, allowed IDX to report improved margins in its latest result. Its margins improved from 18% in the first half of FY24 to 20% in the second half of FY24.

IDX’s balance sheet is also improving. Two years ago, it was close to three times net debt to EBITDA and now it is at around two and a half times. Like the other companies mentioned in this article IDX has a high percentage of fixed costs – staff is a big component of this – so if it can reduce its variable costs, then its earnings will benefit significantly from higher revenue growth. We believe IDX can continue to grow its revenue at 5-8% and moderate its cost growth to around 4-5% so it can continue to increase its margins and reduce its debt.

IDX has also proposed a highly complementary merger with fellow listed radiology provider Capitol Health (CAJ.ASX). Such a merger would give IDX greater geographical penetration in areas such as the faster-growing metropolitan Melbourne market, while also delivering benefits around costs and procurement. Integral Diagnostics’ share price has appreciated significantly this year, but it is still trading at a very reasonable valuation of 8.6x fiscal year 2026 operating earnings, well below the multiple paid recently for Healius’ radiology business, and a dividend yield of 3.8%*.

Source: IML, as of 23 October 2024

Learn how the industry leaders are navigating today's market every morning at 6am. Access Livewire Markets Today.

All prices and analysis at 29 October 2024.  This document was originally published in Livewire on 29 October 2024. This information has been prepared by Natixis Investment Managers Australia Pty Limited ABN 60 088 786 289 AFSL 246830 and includes information provided by third parties, including Investors Mutual Limited (“IML”) AFSL 229988. The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer.  This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice.  Past performance is not a reliable indicator of future performance.  Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB.  Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.