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Our Outlook for the Health-Care Sector

Political and regulatory changes could sway biotech and drug stocks.

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Compared with other industries, health care is more vulnerable to external forces including political and regulatory actions. We have recently seen a few potential changes on the horizon that could blow a cool wind over pharmaceutical, biotech, and medical device companies.

With the Democrats gaining political power, there has been new talk of creating a pathway for generic biologics to be approved. Although cost-conscious legislators may desire an easy way to apply the same framework that exists for approving generic drugs (made of chemical compounds), the sometimes unpredictable and highly sensitive nature of manufacturing biologic medicines (usually made of animal proteins) is likely to warrant a more complex approval process for biogenerics. Any firms that seek to participate in making biogenerics will also have to convince physicians that the biogeneric is equivalent with the name-brand therapy. We believe these two hurdles will require biogeneric manufacturers to invest in some minimal level of clinical studies that goes beyond what's required of generic drugmakers today. Hammering out the details of exactly how many and how large the studies need to be could turn into a lengthy process. However, we think that politicians will eventually have to take action to bring down the bill for biologic therapies, as Medicare spent approximately $3.52 billion on cancer and anemia medications in 2005 (one of the most expensive therapy areas). Laying out and approving a pathway for biogenerics will likely take several years. For our financial models, we generally err on the conservative side and assume name-brand therapies will decline once patent protection expires and more competitors enter the scene. However, we also take into account new products that often compensate for the expired products.

Potential changes in the ground rules for patents could also damp prospects for the health-care companies that rely heavily on intellectual property for their moats. The U.S. Patent and Trademark Office is seeking to raise the quality of patents by potentially requiring applicants to detail how the patent is a significant innovation over existing technology. This is a higher standard than the current need to demonstrate a product is sufficiently original to deserve protection. The higher standard would make it more difficult for rival pharmaceutical companies to protect me-too drugs and could raise the costs of pursuing development of more unique (and riskier) products. It would also make life harder for medical device companies, which typically follow strategies of making small, evolutionary improvements to existing devices rather than wholesale revolutionary changes. This issue remains nascent at this point, so we have not explicitly accounted for any changes in our financial models. However, we are watching closely to gauge the potential threat to the health-care industry.

Valuations by Industry
We still think the health-care industry is generally slightly overvalued. Since the first quarter, we've seen valuations in the diagnostics industry become less attractive. Although we still like the prospects for these firms as drug and biotech companies continue to develop more targeted therapeutics that will require diagnostic testing to identify patients, we're less enthusiastic about the valuations at this point. Investors will benefit from patiently waiting for some of these companies to take a short-term stumble before scooping up shares.

 Health-Care Valuations by Industry
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Medical Goods and Services 2.80 1.02 10
Research Services 2.25 1.15 8
Medical Equipment 2.72 1.07 47
Drugs 2.84 1.03 57
Biotechnology 2.87 1.00 63
Diagnostics 2.40 1.11 5
Home Health 2.50 1.09 4
Hospitals 2.44 1.06 9
Physicians 2.83 1.03 7
Managed Care 2.50 1.07 15
Assisted Living 1.00 1.45 2
Data as of 06-15-07

The research services industry continues to see robust business prospects, but we think this is already baked into share prices. One of our favorite contract research organizations,  Covance (CVD), is well-positioned to benefit from increasing outsourcing of clinical trials by drug and biotech companies. We expect Covance to outperform projected 12%-13% industry growth with its comprehensive menu of services and large scale. Although Covance is fairly valued right now, we believe it is worth waiting for.

Health-Care Stocks for Your Radar
Even though we think the health-care industry is slightly overvalued, this doesn't stop us from cherry-picking a handful of very attractive stocks. Our health-care favorites are mainly focused in drugs and medical devices, and range from small, emerging companies to well-established stalwarts.

 Stocks to Watch--Health Care
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Angiotech $14 None Above Avg 0.51
FoxHollow Tech $39 None Above Avg 0.54
Johnson & Johnson $80 Wide Below Avg 0.76
Medtronic $64 Wide Below Avg 0.81
Mylan $25 Narrow Average 0.76
Data as of 06-22-07.

We're bullish on  Angiotech (ANPI) and the prospects for its pipeline of medical devices combined with pharmaceutical compounds to enhance product performance. The firm is best known for its royalty stream from  Boston Scientific's (BSX) drug-coated stent Taxus. However, in just a few years, Angiotech has laid the groundwork to go from a component supplier to a manufacturer and marketer of its own propriety products, including a vascular wrap and wound-closure devices. We also like  FoxHollow Technologies (FOXH) and its innovative SilverHawk device to treat peripheral artery disease. We haven't yet assigned a moat to either of these wild-card companies. But for investors who can stomach a hefty dose of risk, we like the growth opportunities Angiotech and FoxHollow offer at very attractive valuations.

On the other end of the spectrum, we're big fans of  Johnson & Johnson (JNJ). Its recent acquisition of  Pfizer's (PFE) consumer products business has provided more diversification for the company. So, the recent controversy and potential reimbursement changes that could hurt J&J's Procrit sales do not have a material effect on our fair value estimate. In addition to its drug and consumer segments, J&J also offers a robust medical device business that is in fast-growing areas like hip and knee implants. We believe J&J represents a compelling value at today's prices.

 Medtronic (MDT) remains our top pick in medical device firms with a moat. A cloud has been hanging over Medtronic thanks to a slowdown in the implantable cardioverter defibrillator (ICD) market, spurred by a series of large-scale recalls that Guidant (now a part of Boston Scientific) implemented nearly two years ago. However, Medtronic has built thriving franchises in the neurological, diabetes, and spinal markets, which means it is less reliant on any single cardiac product. We expect Medtronic to launch its drug-coated stent and three spinal discs in the U.S. over this calendar year. If the ICD market recovers faster than we project in 2008, there would be upside to our fair value estimate.

 Mylan Laboratories (MYL) has catapulted itself into the third-largest manufacturer of generic drugs with its acquisition of Merck KGaA's generic drug division. It now has the scale and geographic footprint to compete with the likes of industry leaders  Teva (TEVA) and Sandoz (the generic drug division of  Novartis (NVS)). Although this purchase saddles Mylan with considerable debt in the near term, we believe the long-term benefits, including access to the European markets for generic biologics, should pay off for shareholders.

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Debbie Wang has a position in the following securities mentioned above: PFE. Find out about Morningstar’s editorial policies.