CSL v Ramsay
When two of Australia’s best companies come up against each other, who wins?
Good businesses tend to have a few things in common: pricing power, high returns on capital, low debt and strong growth prospects. CSL and Ramsay Health Care both ranked in our list of Australia’s 10 best businesses. Both possess these characteristics in spades, despite having little overlap in their business models and industry. But which is the superior investment?
“The single most important decision in evaluating a business is pricing power,” Warren Buffett has said. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.” CSL has incredible pricing power in some areas of its business and practically none in others.
Most of CSL’s antibody products treat rare disorders of the immune system and its specialty products division mainly works on therapies that have “orphan drug status”. In many cases, these drugs have no viable substitutes. That, sadly, is the ultimate pricing power – a disease that means life or death for the affected person yet has only one option for treatment. CSL charges thousands of dollars per dose for these medicines.
On the other hand, the company’s albumin and vaccine products have little pricing power. These are known as “commodity products” because there’s nothing to distinguish the output of one manufacturer from another. Hospitals shop for the lowest price and, as such, CSL earns thin margins at these divisions. Thankfully, albumin and vaccine sales only make up a quarter of CSL’s revenue, so the company has high pricing power overall and an excellent profit margin of 22%.
TWO OLIGOPOLIES
Despite Ramsay’s other attributes, which we’ll get to shortly, the company has only moderate pricing power and earns a profit margin of just 4%.
Although many of Ramsay’s hospitals are regional monopolies, there are two things working against it. First, most of its revenue comes from a few big private health insurers. They can’t walk away from negotiations and leave policyholders without a hospital option – Ramsay owns one in four private beds, after all – but nor can Ramsay. It’s one oligopoly versus another and neither side has a stronger arm.
Second, Ramsay competes against the public health system. Many patients value a nicer room or choice of doctor but there is only so much Ramsay can charge before they choose the free option. Things are even worse for Ramsay’s French
Raising prices is tough when your competitors aren’t trying to turn a profit
operations – a third of total revenue – where a large slice of the private market is run by charities. Raising prices is tougher when your competitors aren’t trying to turn a profit.
RETURN ON CAPITAL
In his 1992 letter to shareholders, Buffett wrote that “leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”.
Both Ramsay and CSL earn excellent returns on invested capital (ROIC) of 15% and 31% respectively. Although CSL earns a higher return, it also has more volatile earnings. Hospitals have stable, predictable revenue, so when building a new hospital and putting that capital to work, management has a better idea of what it’s getting into.
CSL, while still stable relative to most businesses, takes on extra risk when deciding whether to expand a manufacturing hub because forecasting demand is harder. To some extent, its higher returns on capital compensate for the added risks when putting that capital to work.
Earning high returns on capital is one thing but many businesses in decline can still pull off that feat – newspapers, for example. The best businesses can reinvest at high rates of return as they grow.
GROWTH AND DEBT
Earnings per share growth is what matters most to shareholders and both CSL and Ramsay are evenly matched, with a growth rate over the past five years of 9% and 8% respectively.
As for which company has superior prospects, it’s hard to make a case that one is better positioned than the other. Ramsay has decent growth opportunities due to the ageing population and its expansion in Europe. CSL has a few blockbuster drugs in clinical trials which, if successful, could add billions in revenue. We’d say Ramsay has more certain growth prospects, while CSL has greater upside but also a higher probability of flatlining.
Finally, the four-letter word that can destroy even the best of businesses: debt. Ramsay has a more leveraged balance sheet than CSL, both in terms of debt to equity and the ratio of operating profits to interest expense. We aren’t concerned by either balance sheet – Ramsay, after all, is the more stable business so can afford to take on a little more debt – but we prefer CSL’s conservative management.
So where does that leave us? Both Ramsay and CSL score highly in terms of business quality. While Ramsay has stable revenues and predictable growth, CSL offers more pricing power, a cleaner balance sheet and superior returns on capital.
But there’s one thing we left out. What distinguishes great businesses from great investments is how much you pay. Although CSL is a slightly better business, Ramsay is trading at a larger discount to its intrinsic value, with an underlying price earnings ratio of 20 and a free cash flow yield of 4.7%. For this reason, we’re keeping CSL a “hold” while Ramsay remains a “buy”. Graham Witcomb is senior analyst at Intelligent Investor, part of the InvestSMART Group. To unlock more stock research and buy recommendations, register for a free trial at investsmart.com.au/money. This article contains general investment advice only under AFSL 226435.