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Best Positioned for Health-Care Reform

This screen finds companies ready to take advantage when major provisions of law take effect in 2014.

David Krempa, 03/05/2013

This article originally appeared in the February/March 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000.  

In this issue’s stock screen, we search for attractive health-care stocks that could be a beneficial addition to investors’ portfolios.

Sector = Healthcare

With major provisions of the Patient Protection and Affordable Care Act set to take effect starting in 2014, the health-care sector is set to see its biggest change in decades. The new law, which is more commonly referred to as Obamacare, will present opportunities for firms that are positioned to take advantage of the new regulations. As a whole, our analysts believe that the impact on the sector will be largely neutral, as the inflow of newly insured patients will boost volumes, but it will be offset by new taxes and price controls.

However, some individual companies are in a position to benefit from the law, creating opportunities for investors.

And ( Economic Moat = Narrow
Or  Economic Moat = Wide )

Firms with economic moats have sustainable competitive advantages that limit the impact of competition. A moat can take the form of intangibles, such as pharmaceutical firms with patented products, scale advantages, or high switching costs like the robotic surgery machines made by Intuitive Surgical ISRG. Surgeons have been trained extensively on the machines, and hospitals have already sunk cost into purchasing the expensive machines, so it would be extremely burdensome to switch to a competing machine. With the new law, we expect pricing pressure to increase, which will highlight the importance of moats. Firms selling a commoditized product without scale advantages are the most likely to experience a negative impact.

And PCF = 12

In addition to identifying strong businesses, we also want to make sure we are paying a reasonable valuation for the companies. We set the cutoff at companies trading at less than 12 times last year’s price to cash flow.

And Morningstar Rating >= 4

For a second valuation-related screen, we used the Morningstar Rating for stocks. We search for only stocks with a 4- or 5-star rating, which means they are trading at a significant discount to their estimated intrinsic value. The ratings are forward-looking based on analysts’ explicit forecasts for the company, so they factor in the anticipated impact of the health-care law.

And Stewardship >= Standard

Our final screen is for businesses run by a quality management team. Morningstar analysts assign each company a Morningstar Stewardship Grade based on a number of factors, including capital-allocation decisions. Management teams that have made wise acquisitions, bought back stock at opportune times, or have a history of value creation will earn high marks. Managers who have made value-destroying acquisitions and have wasted shareholder’s capital will earn a poor rating. With the changing dynamics going on in the healthcare sector over the next few years, we think quality of management will be critical. Strong managers will be able to spot potential opportunities or challenges and reposition their firms to take advantage of these.

We ran this screen in December using Morningstar Principia. Here are some of the results.

UnitedHealth Group UNH
UnitedHealth’s scale endows the firm with significant competitive advantages. With underwriting and regulatory concerns fading to the background, we think UnitedHealth will continue churning out free cash flow and creating value for investors for the foreseeable future.

We think UnitedHealth’s scale results in a narrow economic moat for several reasons. The company’s 36.5 million medical members allow it to spread out fixed administrative costs and negotiate large discounts with health-care providers. The company’s extensive database of claims improves underwriting and can be used to identify the most cost-effective health-care providers. Finally, UnitedHealth’s industry-leading position across geographies and product lines— including commercial insurance, Medicare, Medicaid, data services, pharmacy benefit management, and specialty benefits— reduces its risk, differentiates its products, and allows management to be opportunistic about its allocation of effort and capital.

Becton Dickinson and Co. BDX
Becton Dickinson’s needle and surgical tool empire has provided investors with robust returns on capital for years. While operational performance has been lackluster over the past few years, our confidence in the company’s moat and ability to drive long-term exceptional returns remains intact. We concede that the recovery might extend into 2014, especially considering soft demand in the United States and Europe, in addition to a number of other headwinds, such as the U.S. medical excise tax and pricing pressure.

However, we anticipate the company will maintain its leading positions across the board, and with demand floodgates bound to open sooner rather than later, BD should return to its historical norms of mid-single-digit top-line and double-digit earnings growth.

Express Scripts ESRX
After its merger with Medco, Express Scripts is the only wide-moat company among health plans and drug-supply-chain middlemen. We expect Express Scripts, supported by a superb management team, to use its new-found scale to pressure suppliers and drive down administrative costs—creating value for both clients and shareholders.

VCA Antech WOOF
VCA Antech’s narrow moat is built primarily on scale. It remains by far the largest operator of free-standing animal hospitals in a highly fragmented field that is mainly composed of independent vet practices. VCA has already purchased virtually all of the next-largest privately owned regional animal hospital chains (including Healthy Pet and Pet’s Choice) and targets the larger independent practices. VCA has cultivated a solid reputation for quality medical practices among veterinarians and is seen as an amenable option (if not the only one) when retiring vets seek to sell their practices. It’s much easier for an independent practitioner to sell to VCA than to cobble together a group of vets to buy the practice out.

Vertex Pharmaceuticals VRTX
Vertex Pharmaceuticals is in the process of launching Incivek, a novel hepatitis C treatment on track for blockbuster status. While we like that the firm has made strides to diversify outside of the hepatitis C virus, competition from larger pharma companies and smaller biotechs alike is heating up.

Vertex is attempting to use its skill at developing protease inhibitors to unlock the multibillion-dollar hepatitis C market. Incivek—approved in the United States and abroad in 2011—substantially improves upon the current standard of care, which is associated with severe side effects and limited efficacy. Vertex has maintained the rights to telaprevir at home, and the firm receives royalties on sales abroad from partners Janssen Pharmaceuticals (a Johnson & Johnson JNJ company) and Mitsubishi Tanabe. Although Incivek seems to be handily beating Merck’s MRK competing protease inhibitor Victrelis, next-generation products that seek to top Incivek’s convenience and efficacy (including promising candidates from rival biotech Gilead Sciences GILD) are close on its heels.

David Krempa is an associate analyst with Morningstar.

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