Morningstar confident of healthcare recovery as sector outperforms ASX 200 in Q3

Morningstar bullish on ability of ASX healthcare sector to come back
S&P ASX 200 Health Care Index outperformed S&P ASX 200 by more than 8% in Q3FY22
Morningstar picks Avita Medical and Sigma Healthcare as two standouts

Morningstar has upped its support for the struggling ASX health stocks, believing it is undervalued and represents good buying opportunities for investors.

Morningstar healthcare analyst Shane Ponraj told Stockhead many stocks in the sector which had a bullish run throughout the Covid-19 pandemic have fallen during 2022 market volatility.

“The sector looks definitely more attractive than earlier this year because what you’ve seen is a lot of the winners of the Covid-19 pandemic come back a lot,” he said.

“We used to view the healthcare sector as being overvalued by roughly 20% over the past couple of years.”

However, Ponraj said recent falls in the market have created strong buying opportunities.

“With the sell-off about half of our coverage is undervalued at the moment trading in four or five star territory,” he said.

Outperforming in June quarter

In the year to date the S&P/ASX 200 index has fallen 14.43%, while the S&P/ASX 200 healthcare index has fallen 14.11%; so, pretty much the same.

“But in the June quarter or the last three months it has significantly outperformed which we think highlights its defensive characteristics against rising inflation and interest rates concerns due to the essential nature of product and services,” he said.

Ponraj said as of June 22 the S&P ASX 200 is -13.2% for the June quarter versus -5.0% for the S&P ASX 200 Health Care Index, meaning healthcare outperformed by 8.2%.

“The majority of healthcare companies also don’t carry a huge amount of debt so rising interest rates is less of an issue as well,” he said.

However, he said margins in the healthcare sector in the short-term are feeling the pinch due to elevated freight costs, products cost and inflation along with staffing challenges.

“There still are a lot of hospital staffing challenges that some companies are working through with Covid-19 and influenza,” he said.

However, Morningstar is confident these pressures will subside over the long-term.

“While there is a risk of new variants… at the moment we think future disruption will be limited and hospitalisations should remain low given higher vaccination rates,” he said.

“Omicron is generally milder, there are newer treatments for Covid and hospitals are better equipped and experienced with treating Covid patients.”

Stand out companies

Ponraj said two ASX healthcare stocks which stand out as representing good value are regenerative medical company Avita Medical (ASX:AVH) and pharmacy wholesaler and distribution business Sigma Healthcare (ASX:SIG).

Avita was founded by preeminent Perth-based plastic and reconstructive surgeon Fiona Wood and was originally named Clinical Cell Culture and listed on the ASX under the ticker code C3. It was restructured under the name Avita Medical in 2008. It also trades on the US OTC under the ticker symbol AVMXY.

The company has developed spray-on-skin for the treatment of burns called ReCell. It also has ReNovaCell to improve appearance of pigmentation and scars and ReGenerCell for treatment of chronic wounds.

“We expect Avita to still be burning cash until calendar year 2025 and in this environment a lot of those loss-making companies are being sold off because of market concerns around inflation and interest rates,” Ponraj said.

“There’s always the potential for smaller companies to need more funds so broadly speaking there’s been a rotation out of them but we think Avita is undervalued for long term investors at the moment.”

Avita sells approved burns products in the US and is planning to tap into the bigger markets of vitiligo and soft tissue injuries.

Vitiligo is a long-term condition where pale white patches develop on the skin, caused by a lack of melanin, which is the pigment in skin.

“We expect the use of the ReCell product for the vitiligo treatment and soft tissue reconstruction to be the key for its growth and profitability,” Ponraj said.

“The product has already been used on more than 1000 vitiligo patients internationally on a charitable needs basis and is meeting an unmet need with currently known FDA approved products available.”

The company has a market cap of ~$220 million. Its share price today rose more than 18% on no news, while it’s up 10% for the month to $1.72/share.

Sigma undervalued as more growth forecast

Sigma is one of Australia’s largest full line pharmacy wholesalers in Australia, and has the largest footprint of branded pharmacies along with an expanding national hospital services business.

It has a market cap of ~$567 million with its share price defying the odds of many companies and rising 8% in the year to date and ~2% in the past year to 54 cents/share.

Ponraj said shares in Sigma Healthcare are undervalued. He said while elevated pandemic-related demand for medical consumables, personal protective equipment and rapid antigen tests are unlikely to be durable, Morningstar expect Sigma to continue its overall recovery and its sales growth to accelerate.

“Lockdowns have adversely impacted Sigma due to weaker cold and flu seasons, subdued daigou (Chinese) trade, reduced foot traffic at city and airport pharmacies, and increased safety and compliance costs,” he said.

“However, these pressures, particularly depressed cold and flu medication sales, are easing rapidly.

“Sigma’s operational issues after switching to its new IT system in August 2021, and moving to a new distribution centre in January 2022, have also largely been resolved, with the full benefits of its investments still yet to be realised.”