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Finding Value in Health Care After the Election

Jeremy Glaser
Alex Morozov, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. What impact will the election have on health-care stocks? I'm here today with Alex Morozov and Matt Coffina to take a look.

Gentlemen, thanks for joining me today.

Alex Morozov: Thanks for having us.

Glaser: So it seems like, when it comes to health-care reform, we've had a lot of barriers to wondering exactly how much could get implemented, first with the Supreme Court's decision, and secondly was what would happen with this election. But now it seems that with the Democrats keeping the White House and the Senate that the bill will probably be implemented as written. What impact do you think that's going to have on the health-care industry?

Morozov: Well first things first. The election was pretty much all about status quo. So the Affordable Care Act gets passed, the individual mandate gets upheld. So now everybody who has any kind of interest in the health care now can just look at it and say, "OK, what's next?" We finally went beyond the uncertainty over the reform's fate, and we are now looking at the fundamentals of the industry and how they're going to change following the reform.

We've thought that all along Obamacare is not going to have a significant impact on our valuations across the sector, our takes on the fundamental positions of companies within the sector, and our takes on competitive advantages within the sector. But there are a few instances, a few minor may be marginal changes that we are making to some of our assumptions. Nothing, however, is material to our overall take on the sector. So, I guess the summary is Obamacare now is going to be a law, and the companies in the health-care industry that had a couple of years to prepare for it are now going to look at it and say, "Well this is a certainty. So now what?"

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Glaser: Let's take a look at the industry and see what some of kind of the winners and losers will be, if you will. Matt, I know in the past you've said that for managed care, the Affordable Care Act could be a net positive. Do you still think that's the case?

Matt Coffina: Managed care is definitely one of the most affected sectors by the law. My take is that stocks were all down Wednesday, except for the Medicaid providers. I think that investors have overreacted. I think they're taking perhaps an overly simplistic view of the law without really looking at all at the nuances that are in there. So for example, there are going to be cuts to Medicare advantage providers, and we saw Medicare-focused companies like Humana trade down, especially a lot Wednesday. And I do agree that that's a headwind for Humana, but those are something that we had expected to take effect even before the Affordable Care Act was passed. So it's a little surprising that investors are surprised at this point about those cuts that we really knew about for four or five years at this point.

Similarly in the commercial market, there's definitely going to be some margin pressure. It's possible that the exchanges are going to be relatively low-margin business for managed care and that those could take the place of some existing higher-margin employer business. But at the same time, there is a lot of upside on the revenue front for these companies; 30 million people that didn't have insurance before are going to be gaining coverage both through Medicaid and through the exchanges. And so companies that are prepared for that and are relatively well-positioned in the individual market, including companies like WellPoint, which is one of our best ideas in the space, I think they'll do relatively well when all is said and done.

Glaser: How about medical-device manufacturers, what's the impact of the law on them?

Morozov: We've long considered medical-device manufacturers as relative losers under Obamacare. The primary issue is that the fees that the industry is going to incur as a result of the reform. This fee is very front-end loaded. Starting in 2013, so next year, every device company is going to pay a 2.3% excise tax on their sales generated in the United States. What does that mean for the device sector as a whole? It means that most likely, considering that most device companies are fairly well geographically diversified, they are going to see a hit somewhere between 80 to 150-plus basis points to their operating margin. It's hardly a devastating effect, but something that we've factored in our models for a long time.

Now the benefit is a little bit less pronounced. It's pretty clear to see how the companies like health-care providers or managed-care companies are going to see the benefit of this additional inflow of formally uninsured folks. For device companies, it's not quite that simple. Some device companies like Medtronic and St. Jude rely very heavily on the Medicare population for their devices. So, the inflow of newly insured patients is really not going to move the needle for those companies.

On the flip side, there are definitely some companies like orthopedic companies, such as Stryker and Zimmer, that tend to rely a little bit more on the younger population, not necessarily a population that is fully covered by Medicare. So for those companies, they might see this as somewhat of a smallish upside and utilization trends as a result of more folks getting insurance.

So, all in all, as you can see by the market reaction for device stocks today, Obama's win is probably a slight negative for the industry, but we also think investors have been so unfavorable to this industry for a long time. This industry has been pretty much discarded for a long time; there are definitely some interesting opportunities for investment.

Glaser: Certainly the national debt and the deficit were big topics during the election, and they are going to be even more discussed as we approach the fiscal cliff. Certainly health-care spending is a big part of that problem. Do you think that any of the potential cost-reduction measures in Obamacare now or potential ones that could be passed later are going to have a large impact on the industry?

Morozov: Well, the interesting thing about some of those cost reductions, if you look at the reaction of some stocks Wednesday, particularly hospitals, a lot of hospitals are up 6%, 7%, or 8% because they are viewed by and large as beneficiaries of Obamacare. Now, that said, if we do see this major draconian cut, a 2% Medicare cut in January, that's really going to hit those hospital stocks disproportionately. Hospital operators tend be disproportionately squeezed by any kind of reimbursement cuts. As they struggle sometimes to pass some of those cuts to providers, they are going to feel a brunt of that 2% Medicare cut. But it really is something that we don't think is 100% certain at this point.

I think the election results essentially reaffirmed the status quo. So, I think that there is a less of incentive for Congress and the president to kick the can down the road, and they are going to try to resolve this as soon as possible. Maybe we're not going get to the point where it's Jan. 1, nothing is done, and there is this blunt cut across the board.

Glaser: What are some of your best ideas in health care right now?

Coffina: On my list I already mentioned WellPoint. We also like Express Scripts as one of our favorite companies. It's a company that should really benefit from the volume boost that comes with having more people with insurance, and it doesn't have quite as much exposure on the margin side. Outside of my list?

Morozov: We also like Covidien in the medical-device space. We think that the company overall has a very strong growth profile, especially once it spins out its underperforming pharmaceutical segment come 2014.

Glaser: Well, Alex and Matt, thanks so much for talking with me today.

Coffina: Thanks for having us.

Morozov: Thanks.

Glaser: For Morningstar, I'm Jeremy Glaser.