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This article first appeared in The Edge Malaysia Weekly on October 14, 2019 - October 20, 2019

KPJ Healthcare Bhd’s valuations have become cheap following a roughly 13% drop in its share price year to date. The price-earnings ratio of Malaysia’s largest private healthcare provider by number of hospitals has also dipped below its 10-year mean level.

The counter closed at 88.5 sen last Thursday. On a trailing 12-month basis, it is trading at 21.23 times its earnings, below its 10-year mean of 25.05 times.

In spite of its attractive valuation, investors are not warming up to KPJ, which hit RM1.07 on Feb 18, its highest level so far this year.

Analysts covering the stock are mostly bullish on its prospects with 12 out of 18 calling a “buy” on it, five a “hold” and only one a “sell”. Their average target price for the stock is RM1.11, which means an upside potential of 26.1% based on last Thursday’s closing price of 88.5 sen. Cheah King Yoong of AllianceDBS Research has the highest target price of RM1.35.

Why the diverging opinions on value and price, and is KPJ currently a good buy?

An analyst who covers the private healthcare sector attributes the counter’s lacklustre performance to the government’s recent comments on a price control mechanism for drugs.

“The government’s efforts to ensure people have access to affordable drugs have led to talk of a drug price-control mechanism. This will affect private-sector hospitals and we feel the effect would be felt more by KPJ than IHH Healthcare Bhd,” the analyst tells The Edge via email.

This is because unlike its bigger rival, KPJ concentrates on the domestic market. In fact, in the financial year ended Dec 31, 2018 (FY2018), Malaysia contributed more than 95% to KPJ’s total revenue compared with 17.5% for IHH, which has operations in Singapore, India and Turkey.

KPJ’s planned organic expansion could be another reason for investor apathy as this route requires a longer earnings gestation period compared with mergers and acquisitions.

“Currently, KPJ is at the tail end of its green field expansion plan, after which there will be no more new hospitals in Malaysia. Upon completion of the plan, KPJ will have one hospital in every state except Terengganu,” says Nabil Zainoodin, an analyst with MIDF Research who covers the stock. “Given that there is no significant growth catalyst for the company, we expect the upside potential for the share price to be limited.”

Nabil has a “neutral” call on KPJ and a target price of 96 sen.

Another analyst believes the company has become too cheap in terms of valuation, especially compared with IHH.

Both private healthcare providers have similar four-year earnings per share compound annual growth rates of 4% to 5% but KPJ’s return on equity (ROE) and dividend yield are higher at 9.28% and 2.16% respectively while they are 4.15% and 0.51% for IHH.

IHH and KPJ are the two largest listed pure play private healthcare providers on Bursa Malaysia. TMC Life Sciences Bhd is a much smaller player while for Sime Darby Bhd, Sunway Bhd and TDM Bhd, healthcare is only a fraction of their business.

Although not using M&A to expand, KPJ is still adding capacity to boost future growth. However, in the short term, new capacity will dampen earnings due to start-up costs.

Two new hospitals are slated to commence operations in the second half. They are KPJ Batu Pahat with 60 operating beds by 3Q2019 and KPJ Kluang Specialist with 90 operating beds by 4Q2019.

The group is also expanding its existing hospitals, such as KPJ Seremban and KPJ Ampang, adding 87 operating beds to them each in 3Q and 4Q respectively.

“KPJ currently leads the local private hospital operator market with a 19% share. In order to improve this, the group will sustain its efforts to increase new hospital developments as well as expand the capacity of its exiting hospitals,” says Nabil in a Sept 3 report. “The aggressive opening of green field and brown field developments will accelerate the revenue growth rate for the year. However, we are expecting the higher start-up costs to drag down earnings in the short term.”

Yet another analyst maintains that there is a mismatch between the fundamentals and market perception of KPJ and IHH. “We feel that the valuation gulf between KPJ and IHH is not justified, given the former’s stronger ROE and dividend yield,” the analyst tells The Edge via email.

IHH’s share price trend indicates better investor attention. At its close of RM5.67 last Thursday, the counter had appreciated 5.74% year to date.

According to the analyst, the market ascribes a premium valuation to IHH due to its heftier market capitalisation and international exposure. “However, as the global economy is shaky, exposure to emerging markets (India and Turkey) is a double-edged sword. In our view, there are more downside risks to IHH’s share price and earnings than to KPJ’s.”

KPJ’s less than sterling share price performance aside, analysts believe the Malaysian private healthcare industry will continue to grow due to efforts by the government and private sector to promote the country as a regional medical tourism destination.

Furthermore, the strengthening of the baht against the US dollar — and consequently the ringgit — will benefit Malaysian private hospital operators, they say, adding that perhaps, now is the time to accumulate KPJ shares.

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