Shares digital

The sector’s fundamentals are looking pretty good. The long-term market for domiciliary care is set to grow and in these tricky times this sector can provide an element of security due to its more defensive characteristics

by Rachel Robson

The fundamentals of the healthcare equipment and services sector are looking pretty good. Demand for healthcare services is on the up, with advanced cures for illnesses, improved hygiene and formidable technology meaning that a higher percentage of the world’s population are now living longer.

According to the Office of National Statistics, in the UK, the proportion of people aged 65 and over is expected to increase from 16% in 2006 to 22% by 2031. This means that the need for care homes and care services is set to continue rising over coming years, proving highly beneficial to companies such as Southern Cross and Care UK.

In a similar way, thanks to advances in medical technology, a higher number of children with significant disabilities are surviving birth trauma and as a result, this is drumming up increasing demand for specialist social care services such as those provided by CareTech.

Demand for these services is also being exacerbated by the closure of hundreds of publicly funded care homes as local authorities find ways to cut costs by outsourcing work to privately run care homes.

Analysts at Brewin Dolphin say that the long-term market for domiciliary care ‘is set to grow significantly on the back of well-documented demographic factors, an increasing acceptance that early intervention and prevention is better than treatment, and a demand from consumers to be cared for in a familiar setting.’ But they also point out that in the short term, ‘increasing cost pressures and local authority funding constraints have placed headwinds on the sector and a squeeze on margins. The market remains highly fragmented and we see the trend towards concentration into the hands of fewer, nationwide operators continuing.’

Portfolio power

As a result of this fragmented market, larger companies such as Southern Cross are making the most of it by snapping up more and more homes to help expand their portfolio. For the half year period ended 30 March 2008, Southern Cross had increased the number of beds by 14.4% to 37,084 and the group intends to have added at least 2,000 beds to its portfolio by the end of the full year 2008.

However, despite this, it hasn’t all been plain sailing for the healthcare sector and over the past few months, the sector’s performance has been pretty poor. ‘The sector’s defensive characteristics have hardly shone through over the last few months, with performance continuing to be impacted by a number of company-specific issues,’ says Investec analyst Sebastien Jantet. ‘This, together with a sector wide de-rating, means that the healthcare equipment and services sector has underperformed the FTSE All-Share over both the last 12 months and the last three months.’

The healthcare sector has always been hindered by issues such as a lack of financing, poor sales, and product recalls, and these are problems that have continued to rear their ugly heads over recent months. Financing, for example, can be a big problem for certain healthcare companies. Many small firms have developed some unique and novel products, but they simply do not have the money to support them and bring their products to market. Too much dependence on larger firms can also lead to difficulties. Orthopaedic device manufacturer Corin is one example of this, having recently warned that revenues from its US business were unlikely to be more than £10 million this year after its US distribution partner Stryker reduced its anticipated purchasing requirements of Cormet instrumentation and implants.

‘Stryker’s recent decision not to reorder any Cormets until December 2008 was a real sucker punch for Corin, not only triggering downgrades to forecasts, but calling into question Stryker’s commitment to resurfacing,’ says Investec’s Jantet.

Healthcare detection and monitoring systems developer IDMoS has also been hit hard, with its shares recently suspended due to financial uncertainty which later saw the appointment of an administrator. The group suffered from lower than expected take up of its products, partly due to limited commercialisation resources, and also pointed to the cancellation of a planned issue of 6.6 million shares to raise around £1.5 million net of expenses.

Nestor too has faced problems, having issued a profits warning in November due to trading issues in both social care and primary care, causing the shares to lose half their value. The group also warned that it would breach one of its banking covenants although it has since renegotiated its bank facilities.

Setbacks are not only restricted to smaller firms either. Over the past year, FTSE 100 listed Smith & Nephew has been hit by product recalls and unacceptable sales practices at its Plus subsidiary which is set to cut its full-year sales by $100 million. Product recalls are not uncommon in the sector, but they certainly do little to boost investor and market confidence.

Despite this, the healthcare sector can be a very exciting place to be, with many areas holding plenty of potential. If a company with a unique technology gets snapped up by a larger firm with a good cash pile, or if a company secures a major distribution deal or contract, the group can be catapulted to stardom.

The fight against ‘superbugs’ such as methicillin-resistant Staphylococcus aureus (MRSA) is one area that is likely to gain more attention over coming months. As a result of an increasing need to find ways of preventing superbugs from spreading, companies in the field of sterilisation and decontamination services, such as Synergy Healthcare, Tristel, Bioquell and Puricore, may well start to see demand for their services rise over coming months.

‘Supported by both a carrot (central funding support) and a stick (Healthcare Commission spot checks and a new Hygiene Code), infection control has moved firmly up on the agenda and has created and encouraged a growing market for products and services to support the NHS efforts,’ say analysts at Brewin Dolphin.

M&A activity

Towards the end of last year and beginning of 2008 there has also been a rise in M&A activity in the healthcare sector, with companies such as Whatman, Gyrus and Cozart all being bought out. Some takeover discussions, such as those surrounding Nestor, have of course fizzled out, but even though M&A activity has quietened down a little over the past month or so, it is very likely that activity will pick up again at a later stage.

‘I think M&A will pick up again because, in this market environment, it is difficult to raise capital through the use of traditional equity funding options, and while many healthcare companies do have the ability to raise debt, most of the biotechs may find it difficult to do so,’ says Landsbanki’s Elizabeth Klein. ‘I am anticipating more M&A as companies with cash or the ability to raise cash, look at the relatively attractive historic valuations of companies that may find further funding difficult and take the opportunity for M&A with these companies. This may be able to fill in pipeline gaps and/or add business expertise and breadth.’

Ultimately of course, many companies are striving to achieve the much sought after FDA approval in the US, providing them with a gateway to the US market and greater success. Japan, too, is another important market in which to establish a presence, while the potential for the European market also continues to grow.

The healthcare sector is full of wonders and contains numerous niche markets which hold plenty of opportunity. As time progresses, the sector will no doubt continue to unveil many marvels and demand for its services is unlikely to slow down. Furthermore, given the difficult market conditions we are currently experiencing, the healthcare sector can provide an element of security due to its more defensive characteristics.

Key indicators

The economics:

• Government spending

• Product uptake

• Raw material costs

• Number of distribution agreements

• Product approval

• Competition in market place

• Global sales

TOP ANALYSTS

Sebastien Jantet - Investec Securities

An inquisitive mind

Prior to joining Investec in 2002, Sebastien Jantet worked at Robert W Baird for two years and at KPMG for eight years, in both audit and corporate finance.

He reckons the main features of a good analyst are ‘an inquisitive mind, willingness to challenge, attention to detail and conviction in one’s views.’

Although Jantet points to the healthcare sector’s recent underperformance, he also believes that there are some signs of improvement, ‘particularly in smaller capitalisation companies, where not only has there been considerable corporate activity, but the valuations are also looking particularly attractive, both in absolute terms and relative to growth.’

Jantet has selected CareTech and Synergy Healthcare as his top picks in the sector. Regarding CareTech, Jantet believes the stock has ‘been oversold and offers investors the combination of high revenue and profit visibility at a reasonable valuation, with scope for acquisition-led upgrades.'

Synergy, meanwhile, is in good shape ‘with contract wins accelerating and the group making good progress expanding overseas.’ Over the next six months, Jantet believes that forecast predictability and government policy will be the two key issues for the sector.

He adds that the key to predicting those stocks that are likely to outperform is ‘picking those that have the lowest forecast risk’. This comes down to revenue visibility, overall gearing and the company’s track record.

Elizabeth Klein - Landsbanki

The full package

Elizabeth Klein has covered the healthcare sector since 2000, providing her with plenty of experience to secure her one of the top positions on the StarMine leader board.

Klein’s career as a healthcare analyst began at Baird which merged with Bridgewell in 2005 and then merged with Landsbanki last year. She says that to be a good analyst, it is important to have an interest in businesses along with an analytical mind. ‘It can’t be one without the other,’ she adds.

Regarding the healthcare sector, Klein believes that if you want to invest in a safer area in the life sciences sector, then healthcare can be an attractive place to be. This is partly because many of the healthcare companies generate a profit, compared with biotech companies which tend to be more cash consuming.

Highlighting this, Klein points out that the healthcare sector has enjoyed a relatively strong performance, compared with the biotech sector which has not. When it comes to assessing whether a particular company is likely to perform well, Klein believes it is important to consider the valuation of the group, whether it has an attractive business model, what its cash level is like (and whether it will need to raise further funds), and whether it has a strong management team.

Klein’s top picks in the healthcare sector include Advanced Medical Solutions, Immunodiagnostic Solutions and Synergy Healthcare.

Jeremy Batstone-Carr – Charles Stanley

Home on the range

‘I don’t think it is easy to try and pigeon-hole people,’ says Charles Stanley’s Jeremy Batstone-Carr. ‘Good analysts come from a range of backgrounds.’

Prior to joining Charles Stanley in July 2004, Batstone-Carr worked at ‘various incarnations’ of Natwest from 1987, where he was Head of Research from 1994, before working at Fyshe Group for nine months.

Although many of the companies under his remit strictly fall under the pharmaceutical sector, Batstone-Carr is a frequent follower of medical device maker Smith & Nephew. On the back of the unacceptable sales practices at its Plus Orthopaedics subsidiary, Batstone-Carr recently downgraded the company from ‘buy’ to ‘hold’.

‘Just when we thought they had cleaned up their act, questions are being asked again,’ says Batstone-Carr, pointing out that two years ago Smith & Nephew faced an internal investigation by US authorities which uncovered evidence of collusion with rivals.

However, on the whole, Batstone-Carr believes that Smith & Nephew is an increasingly attractive stock due to a combination of demographics, an ageing population, and its range of new products that can be protected for a while. Regarding the healthcare sector in general, Batstone-Carr believes it is a good bet for investors looking for some insulation in their portfolio and some diversification thanks to the sector’s more defensive characteristics and its strong dividend yield.

BEST BUYS

Immunodiagnostic Systems - One for growth

Life should become quite exciting for the diagnostic testing kits manufacturer over the next year or so, partly thanks to last year’s acquisitions of Nordic Bioscience Diagnostics (NBD), a manufacturer of bone and arthritic diagnostic tests, and Biocode Hycel (BCH), a manufacturer of diagnostic test kits.

The purchase of BCH has provided Immunodiagnostic Systems with an opportunity to automate its existing product range, with much of the group’s future growth potential lying with the 3X3 platform. This automated immunoanalyser, which it gained through the acquisition, provides a highly cost-effective, closed-system instrument which can process 120 to 180 samples per hour, and the Immunodiagnostic Systems 3X3 is expected to launch later this year.

Although the company could be overshadowed by larger firms in a greater financial position, Immunodiagnostic Systems says it is looking to work closely with these groups in a bid to turn them into customers for its products rather than direct competitors. The shares have been a little volatile of late, and a recent sell-off by managing director Robert Duggan to help finance a house purchase did little to boost investor confidence. But with such great growth prospects, investors should certainly not be put off.

Back in April, the company announced that trading for the year to 31 March 2008 was expected to be around 90% ahead of last year’s figures, with operating profits expected to be in line with expectations. (results will be published in July.) Mike Mitchell at house broker Oriel Securities is forecasting pre-tax profits of £3.5 million for 2008 and £5.9 million for 2009.

Advanced Medical Solutions - Clean and simple

The woundcare specialist was founded in 1991 and joined Aim in late 1994. Its shares have started to pick up pace over the past year and a half, and have more than doubled since last January. The company targets the advanced woundcare dressings market which is thought to be worth £1.6 billion a year and its products include films, foams, hydrocolloids, hydrogels, alginates and silver dressings.

Woundcare dressings containing silver are widely used because silver is a safe and effective anti-microbial agent for control of infection from a wide range of micro-organisms such as MRSA. The company’s ActivHeal advanced woundcare range continues to expand and, sold direct to the NHS, the products are now used in more than 100 Hospital and Primary Care Trusts, providing the NHS with substantial savings in woundcare budgets.

Advanced Medical Solutions is also making solid progress in the key US market, having signed up US giant Kimberly-Clark in 2005 which launched its surgical skin sealant in America last year. The group’s LiquiBand tissue adhesive range is also continuing to progress through the FDA approval process and clearance is expected to be obtained later this year, allowing the product to be sold in the US market and opening up a range of opportunities.

The group also continues to invest in its R&D programme to help build on current technology platforms.

CareTech – Taking care of business

CareTech provides quality housing and support services to more than 1,200 adults and children in 141 homes, with a range of learning and physical disabilities. The company was formed in 1993 by two brothers, Farouq and Haroon Sheikh, who are still on the board as chairman and chief executive. The group, which floated in October 2005, benefits from having many long-term occupants providing CareTech with long revenue visibility.

In addition, consolidation opportunities are plentiful thanks to the highly fragmented nature of the social care market, with around 70% of the private sector owning three or fewer homes. Most recently the company acquired Beacon Care Investments, a provider of specialist services for adults with learning difficulties, for up to £22.5 million. The deal has added an extra 10% of capacity and is expected to be earnings enhancing in the first full year of ownership.

Analysts at house broker Brewin Dolphin say that a notable feature of the company since its IPO has been ‘its ability to broaden the range of services to include childcare services (via Delam Care), supported living (via One Step) and day care services.’

The broker goes on to point out that ‘Commissioners are looking increasingly for “one stop shop” care solutions, implying operators such as CareTech with a broader offering are best placed to benefit.’ The broker is forecasting profits of £9.4 million for the full year 2008, going up to £11.9 million in 2009.

STEER CLEAR

Personal Screening – Over the hill

With a market value of just £0.67 million and a share price of 0.22p, Personal Screening certainly doesn’t look like a particularly attractive investment. But it is not only its size that is the problem. The group, which supplies a range of self-test medical kits, floated on Aim in February 2006 having raised gross funds of £799,500. However, it has been plagued by disappointing sales mostly due to a shortage of working capital which previously restricted the company’s ability to fulfil orders.

Personal Screening raised further funds in April 2006 in an effort to resolve the problem, but it was unable to prevent a further deterioration of business as it continued to lose customers whom it had previously been unable satisfy.

At its interim results last September, the group reported that, after attempts to build up its customer base, sales were starting to pick up, but they have yet to reach required levels. As a result, the group has yet to move into profitability.

In December Personal Screening acquired Over50s.com, a web portal most of whose members are also part of that demographic group. The portal is expected to help the group to sell medical kits as well as a wider range of health and lifestyle products to the rapidly growing sector. However, it is still too early to see what impact the acquisition will have on the company and until the outlook improves significantly, the stock is best avoided.

DawMed Systems – Spent force

The company designs, manufactures and distributes a cost-effective range of washer disinfector dryers for decontaminating a wide range of medical devices used in hospitals and primary care. Although this is an interesting market, the group has suffered from a lack of NHS spending and its share price has plummeted, falling from a high of 30.5p at the end of 2003, to its current 3.75p. At its preliminary results in March, the company posted a pre-tax loss of £0.6 million against a loss of £0.09 million a year earlier.

This was due to several reasons, including a considerable investment in its new IT system, which took longer to install than originally envisaged, as well as substantial costs associated with the litigation arising from the breach of contract by a trade debtor (and its settlement last June), and an unexpected continuation of a lack of NHS spending.

The company has noted an increased level of interest for its products and believes it can return to profitability this year, but the group still has a long way to go and for the moment, the stock remains high risk.

ADL – In the soup

The shares of the owner and operator of residential care homes have lost almost half their value since the group reported its interim results in December, which revealed that it had plunged into the red. The group posted a pre-tax loss of £78,000, against a profit of £0.2 million a year before and was also forced to forego its interim dividend.

Last September, two of the group’s directors, Jeremy Davies and Pearl Jackson, were charged with wilful neglect under the Mental Health Act in September following police enquiries stemming from the raid on Newsham House in July 2005. Although the group has stressed that the charges are being defended, the action has restricted the further development of the company, particularly the proposed acquisition of five homes in Bradford.

As a result, the group has written off more than £310,000 in corporate finance costs incurred on this project. A further £51,554 in legal fees has also impacted the company, while further exceptional costs of £55,000 were incurred following the company’s unsuccessful defence of a claim for wrongful dismissal by a former executive director of the group.

The company says the business continues to operate ‘satisfactorily’ and it continues to maintain occupancy levels, but the outlook remains too uncertain and a lack of

positive newsflow is likely to send the share price further southwards.

RISING STAR - LiDCO

Room to improve

Despite a few wobbles, LiDCO has the heart to be a winner

LiDCO may not look like the most obvious pick considering hiccups such as delayed sales and a lack of funding have dragged down the share price over the past couple of years. However, with the company finally out of the development stage and now in commercialisation, signs of improvement are on the horizon.

Chief executive Terry O’Brien, who helped found the company in 1991, is confident about the company’s future success. ‘If you take a look back over the last four years we have increased sales by 79% and reduced costs by 16%,’ he says.

LiDCO, which floated on Aim in 2001, researches, develops, manufactures and sells innovative medical devices primarily for critical care and cardiovascular risk hospital patients who require real-time cardiovascular monitoring while undergoing major surgery, intensive care or cardiology procedures.

The company is exploring a $1.2 billion market opportunity for minimally invasive haemodynamic monitoring in surgery and intensive care at a time when the global market is making the switch from older invasive catheters to less invasive approaches. ‘Until relatively recently, the market was dominated by the pulmonary artery catheter (PAC),’ say analysts at house broker Panmure Gordon. ‘The market dynamics are now changing with the advent of less-invasive technologies, eg the LiDCOplus and the LiDCOrapid, and such products are expected to drive the growth of haemodynamic monitoring equipment in surgery.’

LiDCO’s technology is becoming more widely adopted across UK hospitals, with 40% of UK hospitals now using it. This year has already seen the company launch its LiDCOrapid monitor, which is specifically designed to help surgical teams maintain a patient’s optimal haemodynamic profile. It is easy to use and the company is confident that widespread adoption of LiDCOrapid will have a major impact on improving outcomes after major surgery by reducing complications and shortening hospital stays.

LiDCO’s technology has already been shown to reduce the average hospital stay by 12 days, as well as cut the infection rate by 40%.

Open market

O’Brien says the introduction of LiDCOrapid ‘addresses an additional $800 million market that will increase sales above the run rate (with existing distributors) we have been enjoying.’

The launch is also helping it to address its need to improve distribution networks, given its lack of sufficient presence in key healthcare markets of the US, Australia, Germany and France. ‘[LiDCOrapid] is very easy to sell so has allowed us to appoint additional distributors in Canada, USA, Israel, [and] Turkey,’ says O’Brien.

The group has also addressed its funding issues, successfully raising £2 million last November. O’Brien believes this will be the last fundraising the company will need to carry out and that it has helped the group to secure ‘the last need for cash to take us into profitability’. Analysts concur that the company is now much better positioned financially and should move into profitability next year.

With these extra funds, O’Brien hopes this has stopped its main competitor Edwards Lifesciences ‘from thinking we’d fall over and disappear.’

Edwards poses the biggest threat to LiDCO in terms of competition, primarily due to the fact that it is well capitalised. O’Brien remains confident that LiDCO’s technology is more accurate and easier to use. Analysts, too, believe that LiDCO has a competitive product.

Doppler effect

On the whole competition in the market is actually relatively small. Deltex Medical poses an element of competition with its CardioQ Oesophageal Doppler Monitor, as does Pulsion’s Pulse contour cardiac output method (PiCCO), though this requires a more invasive procedure.

O’Brien, who has been in the industry for 30 years, is aware that the company has made mistakes in the past but says that the group has learned to control costs. ‘This is something you can control as opposed to the sales line, which can be unpredictable. The problem for UK medical companies is that the UK market is subject to occasional delays and frustrations, so you are quite vulnerable until this risk is lessened.

‘We now have the majority of our sales in a increasingly larger export market and this reduces risk and brings highly profitable sales at low cost to us.’

Importantly, the company does not have any technology challenges or scale-up problems. ‘We know what we are doing,’ O’Brien adds.

LiDCO still has a fair amount of work to do, but its technology is promising full of potential.

CHARTING THE SECTOR

There could be the early signs of stirrings of bullish sentiment in the healthcare sector. Having risen by some 80% in value during the 2003 to 2007 bull market (as against the FTSE 100 index which gained just over 104%) the sector has seen something of a sharp sell-off subsequently with declines from the peak at end of October 2006 to the recent low point in mid-March generating a fall of some 35%. This down move took the index to a test of key Fibonacci support derived from the 78.6% retracement of the preceding 2003 to 2007 up move. Any further decline would have called for a full retracement back to the 2003 low.

However, this level also coincided with previous lows from which the market made significant recoveries going all the way back to 1998 and for now at least it seems to have curtailed the selling. Indeed, just as the sector could be said to have led the broader market in the decline so it might be set to turn upward ahead of the rest of the market.

Recent price action is suggestive of an inverse head and shoulders pattern though we seem to have experienced an aborted upside breakout in mid-May which is concerning for bulls. If the inverse head and shoulders pattern completes successfully then we would expect the sector to rise by 14%.

Provided the March lows remain intact, the sector could well be set for something of a recovery in the coming months though of course any broad selling in the wider UK market might retard such a prospect.

Smith & Nephew (SN.)

BUY - 570p

TARGET - 640p

STOP LOSS - 558p

The chart of the largest player in the healthcare sector by market capitalisation, Smith & Nephew’s shares seem to relish returning to previously significant price levels as can clearly be seen. The 558p level capped the upside during 2005 and bar an aborted spiked up move did so again in the following year.

Once it was broken above in 2007 the same level became support in August and November, and has seemingly ridden to the rescue once more as the shares appeared reticent to remain below it for long in May. Add in the increasing proximity of the super long-term bull trend line which represents the shares long-term growth rate when drawn, as this chart is, on a log scale, and there seems good reason to feel that the downside risk is limited despite the key moving averages having crossed in a bearish ‘dead cross’ pattern last week (quite often a lagging indicator).

The upside will find strong resistance close to 640p and again at 650p and the twin tops seen in 2007 at 691p will also be expected to offer a test for bulls. Nevertheless those who follow a Wyckoff approach to market analysis will feel confident that an accumulation phase during May has been completed and the rise in volume with the upside breakout will encourage the expectation of further gains to come.

Optos (OPTS)

BUY - 180p

TARGET - 244p

STOP LOSS - 160p

The market seems to like retinal imaging systems developer Optos given the high PE they trade off, though their chart shows it hasn’t always been favoured. In their short quoted life, the shares more than halved in value from where they stood this time last year, hitting a low of 114p early this year.

The shares have been recovering since – against the backdrop of general uncertainty the shares have outperformed the FTSE 100 by some 60%. The correction that followed seems to have the characteristics of a bull pennant formation and last week’s upside breakout adds weight to it targeting a further up move to 244p. This would take the shares through another level that seems to have influenced over a protracted period, that of 236p.

However, with moving averages set to cross positively in the near future, even a re-test of the post- floatation high at 284p cannot be discounted. Only a fall through the apex of the pennant and a drop below the 200-day average, currently close to 160p, would cause a re-think.