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The Top Ten Short List is a favorite haunt of seasoned value investors looking for potential bargain buys.   Shorting a stock is essentially making a bet the share price will fall, to the benefit of the short investor.  Newcomers to sharemarket investing quickly learn that shorting is an art best left to the experts.  The reason is simple.  If you buy a stock at $5 per share your potential loss is limited to the purchase price should the company go bankrupt.  But if you short that same stock at $5 your potential loss is infinite.  Eventually you have to cover your short position and if the share price continues to climb, so does your loss.

Shorts have the reputation of being “the smartest investors in the room” because of the rigorous research required to justify the short position.  However, sometimes they get it wrong and the rush to cover in an ascending price fuels the price rise.  Thus, bargain hunters look for shorted stocks with the potential to resurrect a falling share price forcing what is known as a “short squeeze.”

As one would expect the current Top Ten Short List is dominated by miners; mining service providers; retailers and a stray energy stock.  But the list contains one glaring surprise from one of the hottest sectors on the ASX over the last few years – Healthcare.  The stock is Primary Health Care (PRY) sitting at number four on the list with short interest at 11.5%.  

Frequent visitors to the Top Ten List are sure to recall another health care stock that made the list, and for a time was the most shorted stock on the ASX.  That stock is Cochlear Limited (COH).  The door opened when the company announced a recall of one of its flagship products and the both the analysts and the shorts piled in.  The price dropped from around $75 per share to $45 in a matter of days.  Here is a five year performance chart for COH showing its fall and rise.

Cochlear still has its sceptics as the analyst consensus rating for the stock is Underperform with eight analysts recommending investors sell the stock.  Obviously, investors who ignored the bearish sentiment and bought shortly after the drop have been handsomely rewarded.

Is Primary Health Care the next Cochlear?  Unlike Cochlear, PRY did not go south following a potentially cataclysmic event, making it much harder for the average investor to get even a remotely accurate assessment of the reasons the stock is in the cross-hairs of the short sellers.  A recent article in the Sydney Morning Herald quotes a fund manager at Aurora Funds Management attributing the increase in shorting on the ASX to international hedge funds.  This makes the task of looking into PRY even more challenging.  In addition, analysts still have a consensus Hold rating on PRY with five at Buy and 3 at Sell. Morningstar recently assigned an Accumulate Rating for PRY, a good sign for the bargain crowd.

If you look at a price chart for PRY you will find falls following both the company’s Full Year 2014 Results announcement and the Half Year 2015 Results.  Here is the chart.

In both cases the company’s financial results were solid if not spectacular.  Full Year 2014 profits rose 8.3% and revenues climbed 5.8%.  Half Year 2015 profit was up 6.1% while revenues were up 6.3%.  So what’s the problem here?

Governments around the world are struggling to keep up with rising health care costs and Australia is no exception.  Speculation about budgetary measures to deal with government funded health care programs has raised concerns about many health care providers.  One specific issue that had been under consideration is raising co-pays for GP (General Practice) Services, which could negatively impact Primary’s biggest source of earnings – Medical Centres.  The company is diversified, however, and also operates Pathology and Digital Imaging centres and provides a variety of Health Care Technology software.  At the moment the $7 increase in co-pay that had been under consideration appears to be off the table for the moment but this did not stop Primary management from making the following comment in the Half Year release:

•    “As we move into FY2015, we’re conscious that there remains considerable uncertainty on the proposed Federal Government co-payment initiatives – which may or may not be legislated. Given this significant uncertainty, Primary will not be providing further commentary on its possible competitive response to such changes. However, it is the strong view of the Board and Management that Primary’s model of healthcare delivery will be critical and more necessary in an environment of continued funding pressures.

Investors are rarely encouraged by statements along the lines of we are not going to talk about this anymore.  In addition, the Half Year release spelled out a complicated change in accounting policy that will impact PRY’s already bloated Goodwill and Intangible amounts on its balance sheet.  Goodwill most often is claimed following acquisitions and Primary has been growing by acquiring smaller practices for some time.  As a result, 87% of the total assets listed on the FY 2014 balance sheet are attributed to Goodwill and Intangibles.  The problem with this is at some point Goodwill gets written off and that can hurt the share price.  The change reduces how much of the cost of an acquisition goes towards Goodwill and how much goes towards Other Intangible Assets.  The Balance Sheet for the Half Year now shows 85% of Total Assets stemming from Goodwill and Intangibles.

Primary is not alone in facing future funding pressures for health care nor are they alone in a business model calling for growth by acquisition.  The following table lists the closest comparison companies we could find in an attempt to further understand why PRY is so heavily shorted.

Company

(CODE)

Market Cap

Share Price

(52 Wk % Change)

P/E

(F/PE)

P/EG

(5 Yr Expected P/EG

2 Year

Earnings Growth Forecast

Sonic Healthcare

(SHL)

$8.2b

 

$20.46

(+20%)

 

21.66

(17.8)

 

2.31

(2.56)

+8.9%

Primary Health Care

(PRY)

 

$3.6b

 

$5.02

(+8%)

15.29

(17.86)

 

10.0

(2.56)

 

-7.7%

Capitol Health

(CAJ)

$554m

$1.06

(+80%)

53

(35.83)

 

Capital Health (CAJ) operates in one segment only – digital imaging.  Despite the lack of diversification, this company has posted massive total shareholder return since it began trading in 2006.  Over five years the average annual rate of total shareholder return is 88.5% over five years and 183.9% over three years.  The five year average earnings growth rate is 41%.  Here is a share price chart for CAJ since its inception.

The company operates 52 Diagnostic Imaging Clinics across Victoria.  CAJ has also grown by acquisition, but its Full Year 2014 Balance Sheet showed Goodwill comprising 48% of its Total Assets.  Of the two major analysts covering the stock, one has a Buy recommendation and the other is at Overweight.

When you consider that the P/E for the Healthcare Sector is 24.07, Capital Health seems a bit over priced but the company has posted impressive results, beginning with the Half Year 2013 Results that launched the stock upward.  The 11.3% rise in revenue and the 13.7% increase in profit were records for the company at that time.  Full Year 2013 results were even better with a 19% revenue increase and a 70% profit rise.  FY 2014 saw more of the same, only better still.  Revenue was up 45% and profit rose 99%.  Half Year 2015 Results were still solid, with 14% revenue increase and a 53% rise in profit.  The company pays a small but fully franked dividend that has grown from .4 cents per share in 2012 to .9 cents in 2014.

Sonic Healthcare (SHL) is closer to Primary in that it is also diversified.  However, while Primary operates exclusively in Australia, Sonic has an international presence.  Sonic has two major divisions – Pathology services operating here and in New Zealand, the UK and the US, and Europe.  The Diagnostic Imaging Division operates in Australia and New Zealand.  The company also operates a network of primary care centres through a subsidiary company, Independent Practitioner Network (IPN).

When comparing SHL and PRY it is interesting to note that Primary actually posted better profit results for the Half Year 2015.  Sonic’s Half Year profit declined 1.9% while Primary’s was up 6.1%.  This should not have surprised investors as the company had lowered its guidance in late 2014.

Due to its international operations Sonic stands to benefit from a lower dollar, but its network of primary practice centres exposes the company to the same funding risks faced by Primary.  And if the shorts are focused on Goodwill and Intangibles, Sonic lists no Goodwill but its intangible assets represent 70% of its Total Assets.   Analysts prefer Sonic as well, with an Overweight consensus rating with six analysts rating the stock a Buy.  

Granted that Primary has a negative two year earnings growth forecast, but its P/E and Forward P/E are far lower than the Sector average and its Five Year Expected P/EG matches that of Sonic.  In addition, Primary recently is expanding into private health insurance with its recent acquisition of Transport Health.  So why is PRY number four on the Top Ten Short List?  

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.