Three ASX stocks to play healthcare's return to normalisation

The Healthcare Industry has always been an attractive sector for investors given its defensive earnings stream that has compounded over the long term. The structural tailwinds from an aging population that is spending an increasing amount on their health needs is a key driver of this earnings growth. 

Prior to the pandemic, healthcare stocks enjoyed strong share price returns and premium valuations. However, as with all industries, the pandemic threw history out the window and forced businesses to adapt and investors to re-evaluate the industry’s long-term fundamentals. 

For Healthcare service providers, their cost structure and management expertise were built up based on a consistently rising revenue profile and so when non-essential healthcare services were shutdown, the full force of negative operating leverage played out across the industry.

Fig 1: Diagnostic imaging volume growth

The path out of the pandemic has been varied across all sectors. Travel has had a powerful return as revenge spending and limited capacity has delivered the best conditions in history for travel operators, while the retail sector is now suffering from a post-COVID hangover and tighter financial conditions. 

For Healthcare, the recovery has been inconsistent given elevated sick leave, patient cancellations and staff shortages. As a result, profits have been under pressure which has subsequently flowed through to share prices for the listed players. 

Looking ahead though, we believe that current operating conditions will prove to be cyclical in nature, and we expect to see a return to long-term growth levels in the period ahead. Demand is further supported by the pandemic-related backlogs that require more intensive medical services as a result of late diagnosis of chronic illness.

Medicare data for March showed that improving volumes for visitation and services are recovering back to more normalised levels. Excluding the COVID-19 categories (vaccine, tests, etc.), GP visits lifted by 7%, pathology volumes lifted by 13% and imaging volumes lifted by ~11%. GP visits are a key enabler to healthcare service provider volumes, and this is expected to receive a material boost from the recent Federal Budget. 

The government has announced a $3.5 billion package to incentivise GP clinics to bulk bill consultations which will make it cheaper and easier for children and pensioners to access GP services. This is the largest-ever increase to the bulk billing incentive. 

Additionally, the Australian Government has announced a +3.6% annual fee indexation to reflect the inflationary pressures in the healthcare system. This covers most GP service items, and diagnostic imagining and will provide a revenue uplift for participants from the 1^st of July 2023. Given this favourable backdrop, we see some compelling investment opportunities in the Healthcare space.

Fig 2: DI volumes by modality (3m rolling)

Capitol Health (ASX: CAJ) and Integral Diagnostics (ASX: IDX) are diagnostic imaging companies that are well-positioned for a return to more normalised trading conditions. Capitol holds a ~4% market share in the diagnostic imaging industry with a network of community-based centres across metropolitan Melbourne. 

Over the past three years, it has successfully rolled out nine greenfield sites (three per year), integrated two major transactions and executed well on a cost-out program. With a return to more normalised operating conditions, the company is on the cusp of delivering earnings growth in excess of 50% over the next two years and yet trades at a discount to historical averages. 

The industry is also a happy hunting ground for corporate activity with the most recent acquisition of PRP Diagnostic completed at 13x EV/EBITDA which compares favourably to Capitol which is currently trading on 7x prospective EBITDA.

Dental care provider Pacific Smiles (ASX: PSQ) is also set up for significant earnings growth and is trading at a valuation that does not reflect the earnings momentum, strategic nature of the assets and growth opportunities ahead. 

The group recently reported strong revenue trends (+17% pcp) from improving attendance levels and average spend per visit, which has had a positive impact on profitability for the 2H23. With these revenue trends continuing we will see the return of operational leverage delivering substantial earnings growth in FY24.

Against a challenging economic backdrop, where earnings growth will be more difficult to achieve, the Healthcare sector is well-placed to deliver growth in the coming years. This will be highly sought after by investors and should drive strong shareholder returns in the future.