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Our Outlook for Health-Care Stocks

While we remain bullish on the sector, health-care growth depends on the economy.

Alex Morozov, 12/29/2011

--Although office visits remain weak, we've had two quarters in a row of strong sequential growth in personal health expenditures. Improving unemployment should provide further tailwinds.

--Supercommittee's failure to resolve deficit debate will result in automatic across-the-board budget cuts, affecting a broad spectrum of industries within health care.

--Share buybacks will likely bolster earnings growth.

Health-Care Demand Is Improving, but Recovery Is Gradual
Although the health-care sector isn't out of the woods just yet, the last two quarters point to the improving demand, with personal health-care expenditures exceeding sequential gross domestic product growth in the second and third quarters of 2011.

Sequential health-care spending should continue to outpace GDP growth through 2012 as private health-care spending continues to improve. Commercial insurance enrollment has improved sequentially, albeit at a pedestrian pace, and with unemployment levels gradually subsiding, the enrollment figures are likely to continue to grow. On the flip side, public health-care spending growth, which offset a considerable slowdown in private spending during the recession, should slow as Medicaid enrollment wanes, and the private/public mix should provide further boost to the overall growth given higher levels of utilization and reimbursement for private insurance. However, public spending will undoubtedly remain a significant contributor to overall health-care spending as long as unemployment remains high.

We note that physician office visits remain weak for now (Quest Diagnostics DGX reported a 6% year-over-year decline in doctor office traffic in the third quarter), but hospital admissions are gradually recovering. Although we haven't seen a snap-back recovery in demand for surgical procedures, we have started seeing gradual improvement, in part because of easy comparables.

Mandatory Budget Cuts to Have Broad Effect
The congressional supercommittee's failure to reach compromise on deficit reduction will result in automatic across-the-board budget cuts starting in January 2013. Funding for nondefense discretionary programs will be hit particularly hard, with a 7.8% reduction in 2013, dropping to 5.5% by 2021, according to Congressional Budget Office estimates. The Center on Budget and Policy Priorities estimates the 2013 hit for nondefense discretionary funding at an even steeper 9% rate. On the nondiscretionary side, Medicare providers will face a 2% cut.

Not all industries within health care will be hit equally by the proposed cuts. On the Big Pharma side, we expect only minor pricing pressure from the government payers and minor secondary pricing cuts as providers attempt to pass their own cuts onto suppliers. We project only minimal implications under this outcome for Big Pharma's earnings and fair value estimates. The same goes for our biotech coverage, though we note that some federal funding programs (such as HIV-testing federal assistance) are likely to be cut, which could negatively affect firms such as Gilead GILD. However, the impact isn't likely to be material for our valuation.

Alex Morozov is the director of the health-care team at Morningstar.

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