Emerging Value in Three Health-Care Stocks?

Morningstar provides in-depth research reports for a universe of approximately 200 health-care stocks, but only  25 of these firms have been granted the coveted wide-moat designation. Many of our readers are familiar with how we assign economic moats--in a nutshell, it's a process in which we assess the long-term competitive advantages of a firm, as well as its ability to generate strong returns on investment in its business. However, these moats aren't set in stone. Industry dynamics, internal company evolution, and big acquisitions can cause moats to change with time.

When we boost a company from no moat to narrow--or from narrow to wide--it can have a meaningful effect on our fair value estimate. To reflect the firm's improved position, we make various changes to our valuation models; most importantly, we lengthen the time that it can generate superior returns, and we discount future cash flows at a lower rate. For example, taking a look at the health-care sector, we recently boosted  Genzyme's  economic moat from narrow to wide, and simultaneously raised our fair value estimate by almost 20%. While this biotech has its roots in rare disease treatments, we now see long-term strength in other segments of its business, increasing our confidence in the firm's continued solid performance.

Of course, firms seldom prove they are worthy of a wider economic moat overnight. In fact, as profiled in our GrowthInvestor newsletter, we cover several companies that we think are digging wider moats. These "emerging moat" companies are often at a transitional phase, and we aren't quite ready to jump on board and assume new products or recent acquisitions will perform as well as management hopes. In future articles, we'll be taking a look at stocks in other sectors that we think are also on the cusp of achieving a wider moat.

All three of the health-care firms we've chosen to profile today are currently trading in 3-star (fairly valued) territory. However, we would advise investors to stay tuned; there could be significant upside to their long-term values in the future.

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Amylin Pharmaceuticals  
Business Risk: Above Average
Economic Moat: None
Amylin's simultaneous launch of two novel injectable diabetes drugs in 2005 quickly brought the firm to the attention of biotech investors. The company just reported $430 million in 2006 sales of Byetta. This drug's ability to control blood glucose while promoting weight loss gives it a unique position in an increasingly competitive market. A long-acting version of Byetta is in the works, which would make the drug more convenient to the 3.5 million patients who aren't well controlled on oral drugs.

However, most of Amylin's value is still riding on the success of Byetta and its long-acting counterpart, known as Exenatide LAR. As I discussed in a recent  Analyst Report, "If pipeline development is fruitful and Amylin proves that its competitive advantage extends beyond the exenatide molecule, we believe this biotech would warrant a narrow economic moat." We're waiting to see if Amylin's other marketed drug, Symlin, can begin to see better market uptake with an expanded label this year, and if the firm's potential for finding a safe and effective obesity treatment starts to unfold as planned.

Alkermes  (ALKS)
Business Risk: Above Average
Economic Moat: None
A specialist in novel drug-delivery technologies, Alkermes has shown that its injectable extended-release technology has market appeal. Alkermes' improved version of  Johnson & Johnson's (JNJ) Risperdal is seeing strong market uptake, and investors are waiting to see if the same technology can make Amylin's Byetta an even more successful product. In addition, Alkermes has pulmonary technology that is being used to develop an inhaled form of insulin.

However, the company only retains a small portion of profits from these programs, and Alkermes' success is riding on Vivitrol, an injectable alcohol dependence drug. Until we see evidence of strong sales from this product, we're not quite ready to say that Alkermes will be able to sustain a high level of profitability for the long-term. As Heather Brilliant states in her  Analyst Report, "We think Alkermes may be on its way to digging a narrow moat, with several proven applications of its technology now on the market, solid partnerships with leading pharmaceutical firms, and a respectable pipeline of potential future products."

Kyphon  
Business Risk: Above Average
Economic Moat: Narrow
Kyphon's niche in spinal orthopedics has been a valuable one--its patented kyphoplasty devices turned the firm profitable in 2003, and operating margins have been in the midteens ever since. Kyphon's patent portfolio and foundation of successfully treated patients gave us confidence in the sustainability of Kyphon's profitability, and we assigned the firm a narrow moat. However, with spinal market leader  Medtronic (MDT) showing an interest in fighting its way into Kyphon's niche, the firm's dependence on one product line kept us from expanding the moat too wide.

Kyphon's recent acquisition activity has the potential to transform the company, and if successful, could very well provide the diversification necessary to expand this moat. Newly acquired spinal assets from Disc-O-Tech Medical Technologies, as well as the acquisition of St. Francis Medical Technologies, fit well with Kyphon's established niche. As Julie Stralow discusses in her  Analyst Report, "We think Kyphon is uniquely suited to address this potential market and take St. Francis' devices to the next level. Adding this new growth driver to its product lineup also should temper some of the risks facing Kyphon."