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Healthcare: Values Among Drug, Biotech, and Supply Chain Firms

Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

  • In the United States, the passage of tax reform is significantly reducing tax burdens and should boost cash flows over the long term. However, other newly passed U.S. regulations have caused drug pricing concerns in the most profitable region of the world, but we still expect strong drug pricing power in the U.S.
  • The healthcare consolidation trend continues, with several companies looking to increase scale for competitive positioning as new threats emerge and cost pressures continue.
  • In the Big Pharma and Big Biotech industries, innovation continues and supports strong pricing power despite the increased pricing pressures from governments and pharmacy benefit managers.

Regulatory changes in the U.S. have provided a mixed picture for healthcare, with the positive benefits of tax reform offsetting the minor negative legislation on drug pricing. With the U.S. corporate tax rate falling to 21% from 35%, many global companies' tax rates have fallen by several hundred basis points. However, changes to payments to some of the U.S. drug programs, including Medicare Part D, will create a minor headwind to prices in the U.S., but pricing should remain strong relative to other geographies.

On the mergers and acquisitions front, partly aided by tax reform as well as a need to increase scale to lower costs, companies continue to consolidate. The announcement of

On the innovation side, new advancements in drugs continue to support strong pricing power despite increasing pricing pressures from governments and insurance groups. In particular,

Top Picks

Allergan

AGN

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $263

Fair Value Uncertainty: Medium

5-Star Price: $184.10

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology, gastroenterology, and central nervous system. Allergan's diverse portfolio, key durable products including Botox, and healthy pipeline support a wide economic moat and mid-single-digit organic earnings growth over the next five years, in our view. The company has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with M&A, which creates numerous capital-deployment opportunities following the $40 billion sale of its industry-leading generics unit to

McKesson

MCK

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $210

Fair Value Uncertainty: Medium

5-Star Price: $147

Despite major near-term headwinds, McKesson will remain an essential link in the pharmaceutical supply chain. Several headwinds have pressured the firm's operations and stock. Increased competition for small/independent pharmacy market share has formed a confluence of negative variables that have built in significant near-term uncertainty for the drug distributor. However, we believe these are near-term issues and that McKesson will be able to power through the recent volatility as it is a critical partner to both retail pharmacy clients and drug suppliers. While there are some remaining headwinds associated with potential contract losses, we believe McKesson will be able to effectively offset this issue, win its share of contracts in the future, and thrive long term. Additionally, we believe near-term drug price inflation trends should not have any material impact on McKesson's valuation. McKesson has also positioned itself as a critical player in the lucrative specialty pharmaceutical market niche, bolstering its wide economic moat.

Roche Holding

RHHBY

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $43

Fair Value Uncertainty: Low

5-Star Price: $34.40

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics, which conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, more cost-effective endeavor. The collaboration between its diagnostics and drug-development groups gives Roche a unique in-house angle on personalized medicine. Also, Roche's biologics constitute three fourths of its pharmaceutical sales; biosimilar competitors have seen development setbacks while Roche's innovative pipeline could make these products less relevant by their launch.

Shire

SHPG

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $205

Fair Value Uncertainty: Medium

5-Star Price: $143.50

We view Shire's diversified rare-disease portfolio and neuroscience franchise as warranting a narrow moat rating, and while the pipeline is thinner than most large-cap biotechs, we think the portfolio is quite defensible, particularly the rapidly growing immunology franchise. We think the market has an overly bearish view on Shire's hemophilia portfolio, and even with more severe erosion from Roche's Hemlibra (launching 2018), we think Shire's valuation looks attractive. Given the stability of the firm's core businesses, we're not concerned about Shire's financial health. We believe synergies between Shire and recently acquired Baxalta on the top line--including Shire's ability to use Baxalta's international footprint for its own products, as well as the hospital overlap between Shire's hereditary angioedema and Baxalta’s immunology business--have not been fully appreciated. The immunology franchise--including what we see as the best portfolio of immunoglobulin therapies--appears to be gaining share internationally and seizing on trends for increased subcutaneous use in the U.S. Along with newer product launches (rare-disease drugs Gattex and Natpara), the launch of dry-eye drug Xiidra, the launch of HAE drug lanadelumab, and stabilization of generic pressure on GI drug Lialda, we think this will help Shire drive growth despite expected hematology losses.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains E-commerce market share gains present challenges for some, but trends continue to support healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Energy: Looming U.S. Shale Supply Should Temper Optimism Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous shale growth later.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Industrials: Healthy Demand, But Few Values Among a mostly fairly valued industrials sector, some good values remain.

Real Estate: Rising Rates Won't Derail Strong Fundamentals REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.

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