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By Jason Stipp | 03-22-2010 12:54 PM

After Reform, Opportunity

Associate director for health-care analysis Alex Morozov on the uncertainty-overhang relief, biggest winners, and best values in post-reform health care.

Jason Stipp: I'm Jason Stipp for Morningstar. The U.S. House of Representatives passed a historic health care reform measure on Sunday, and on Monday health-care stocks were up. Here with me to dig into that a little bit and talk about the prospects for some of the industries in health care is Alex Morozov. He's associate director of equity analysis for the health-care sector. Thanks for joining me, Alex.

Alex Morozov: Thanks for having me, Jason.

Stipp: Typically you would say some government involvement, more regulation or legislation that comes through would have a negative effect on stocks, but yet we see health-care stocks were up today. Tell me a little bit about what you think is behind that lift that we saw in health care on Monday.

Morozov: Let's just step back a little bit and think what the government regulation could have meant for the health-care industry. If you look back 12 months ago, we saw all sorts of radical plans being thrown in the mix. We saw the potential for a single-payer system. We saw the potential of really great government oversight of our health-care reform.

None of that has really materialized. What we saw today, we saw this huge uncertainty being lifted. And if there is one thing that investors hate, it's the uncertainty. So when you have this regulatory oversight implemented to a certain degree, but it's no longer this big unknown that's hanging over the health-care sector, it really helps the valuations. And that's why we saw the rally across several sectors within the health-care industry.

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Stipp: Sure. So we have seen today that some areas of the market in health care have come up a little bit more than others. The insurers were a little bit mixed, though. They saw a rally last week. But we also see pharmaceuticals were doing pretty well and hospitals were doing pretty well today. Does that imply that the overhang over some areas of health care was greater, that some areas were more at risk from legislation? What's your take on that?

Morozov: You actually hit the nail on the head right here. Managed care saw a huge rally over the last six to 12 months. Actually, let's say since maybe mid-summer. A lot of stocks have run up quite nicely. There's still plenty of opportunity for stock appreciation in some of the names, like WellPoint and UnitedHealth, for example.

But nonetheless, a lot of managed care companies saw their stocks rally already quite a bit.

And why did that happen? It is because as we saw Democrats really losing ground in the health-care debate, we saw a lot of the more drastic proposals being removed. And I think what the investors started realizing is the managed care companies will still play a vital role in the entire health-care delivery process.

So a lot of those stocks were more or less priced for liquidation, and now you're seeing a lot of the managed care companies starting to be priced more in line with what their fundamentals suggest.

So we didn't necessarily see a lot of rally today in the managed care stocks. What we did see is the rally in the pharmaceutical companies. And if you were to ask me which sector would be considered a winner after Sunday's events, I would say that the drug industry is probably in the winner camp.

You have this massive inflow of previously uninsured folks coming in, without corresponding measures like direct price negotiation with government agencies like Medicare. You didn't see the drug re-importation. You didn't see a lot of other negative factors that could have been in play for pharmaceutical companies.

What you did see is, you saw $85 billion in taxes going to be implemented over the next 10 years. But on the flipside, you see this massive number of new patients coming in. You're seeing the closing of the donut hole, and you're seeing a much tighter regulation on generic entry into the biologics space.

Stipp: Certainly it seems to be a theme that reform has said, "Well, there may be some regulations over here, but you're going to have to more people in the system overall." So it sounds like for pharma that could end up being a good thing, the way it panned out for them.

What about for some of the other industries like devices or for the insurance? The fact that there might be more people into the system, is that going to help those areas of the health care market as much as you might see in pharmaceuticals?

Morozov: We've talked about insurance companies for a while now. They are very dependent on the inflow of new patients, and they're going to get those new patients. In addition, they finally got what they've tried to get for a long time. They're getting an individual mandate requiring everybody purchase insurance coverage, whether it's through your employer or on the individual market.

Starting in 2014, everybody will be mandated to purchase insurance coverage. Why is that a great thing for insurance companies? Because in order for them not to be able to medically underwrite sick and old, they need this inflow of a young, healthy population. Now, with a mandate in place, quite of few of young folks are going to opt to purchase insurance coverage, helping the managed care companies.

Stipp: So the fact that they were going to have to now underwrite some people that maybe they wouldn't have covered before, they can make up for that because now everyone--healthy people, younger people included--are going to have to be in the pool.

Morozov: Precisely.

Stipp: On the medical device front, are these companies going to benefit from the volume--the extra volume, the extra patients--as maybe we've seen in some other areas? What's the story for devices?

Morozov: The volume story in devices is a little bit less clear. Yes, some are definitely going to see a little bit of an inflow of new patients because more patients are going to have coverage. So they're probably going to opt to have more elective procedures that they otherwise have not have performed.

On the other hand, a lot of devices are presently reimbursed under government programs, or some of the devices that now fall into the med-tech devices group are used in the basic surgical procedures where reimbursement is really not the main criterion for choosing.

Stipp: So maybe the benefit's a little bit murkier for devices.

Morozov: Yeah, exactly. The volume is not necessarily going to be the story. The story here is going to be this 2.9% tax that's going to get implemented starting in 2014. On the surface it seems that they're just going to hit the device companies disproportionately, and probably going to go straight to the bottom line.

I don't necessarily think that's going to be the case. First of all, even if it does, the impact on our fair value estimates is going to be fairly minimal. We've run some scenario analysis and sensitivity analysis, and determined that even if this tax is fully implemented and goes straight to the bottom line, our fair values would only decline somewhere in the mid-single digits.

That said, the companies have three years to figure out the strategies of how to deal with this tax. Whether it's going to be through the price hikes implemented over the next few years. Whether it's going to be through implementing other operating efficiencies programs. Device companies are notorious for dealing with adversity, and I think that's just another situation that they just have to work through, and they will still come out a winner.

Stipp: So ironically, we may actually see some higher prices in the very short term. Even though this reform has just passed, they might try to capture some of those profits while they can.

Morozov: That is an unintended effect. I think we might see a little bit of price hikes on the device side. We might actually see the price hike on the managed care side, too. It is quite possible that before a lot of those rate restrictions go into place, managed care companies will try to raise their rates as much as they can to try to capture this market opportunity.

Stipp: Sure, make hay while the sun is still shining.

Morozov: Right.

Stipp: Last question for you then. We have seen a lot of areas beaten down; we've seen some bounce back. So if you had to look at valuations in the major industries today, where do we stand? We've seen a little bit of a bounce-back, you said, in managed care. Pharma has seen a little bit of an uptick recently, at least today, but you said that they also still look relatively attractive.

Give us the rundown on the major areas and where we're looking valuation-wise.

Morozov: You have to remember that health care, overall, is still very undervalued. Even by Morningstar rating standards, health care is the most undervalued sector. So if you look to invest, health care is definitely an attractive opportunity.

If you want to take a look at the pharmaceutical sector, you still see companies like Novartis that's right now a 5-star stock--a great company to invest in, to purchase. It definitely has a really good trajectory with the new reform in place, because of the uninsured volume.

On the med-tech side, we see companies like Stryker, we see companies like Thermo Fisher; they are very attractive. And we still remain very bullish on the largest managed care providers, like WellPoint and UnitedHealth.

Stipp: So even after the run-up there's still some room to run there.

Morozov: Even after the run-up they're still trading at attractive discounts to our fair value.

Stipp: Great. Alex, thanks for the overview. It was very important information.

Morozov: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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