Our Outlook for the Health-Care Sector
The pendulum may have swung too far at the FDA.
Stock Strategist
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Fortunately, health-care companies are generally not subject to the cyclical vagaries of rising interest rates or tightening credit conditions. People still get sick as they get older, whether the macroeconomic picture is looking up or trending down. However, a whole swath of companies in the health-care sector--including biotech, branded and generic pharmaceutical, and device manufacturers--do have to contend with the Food and Drug Administration, which oversees manufacturing facilities, product safety and approvals, marketing practices, and post-approval quality measures.
Considering the FDA is often subject to changes in the political winds, we like to keep an eye on which way the regulatory agency could be leaning. The FDA generally seems to move back and forth between the priorities of caution and access to therapies. Coming out of the 1980s, AIDS activists engaged in high-profile PR events and actions to bring attention to the FDA's slow pace for reviewing and approving drugs that could help save the lives of HIV patients. When Dr. David Kessler took over the role of commissioner of the FDA in 1990, one of his key accomplishments was to speed up the drug-approval process during his tenure in order to boost patient access to potentially life-saving therapies. In 1996, Kessler's last year at the FDA, the agency approved 53 new branded drugs. This stands in contrast to the mere 18 approved in 2006.
Since the blowup of Merck's (MRK) Vioxx in 2004 when longer-term data suggested the drug raised the risk of heart attack and stroke, the FDA has shifted toward a more cautious stance and placed patient access on the back burner. Not only has the approval process slowed down, but the agency has also been quicker to add black box warnings (the strongest warnings possible) when there are signs of safety issues. For example, this summer the FDA sought to require black box warnings on GlaxoSmithKline's (GSK) Avandia and Lilly's (LLY) Actos diabetes drugs, following a new analysis published in June that suggested Avandia raises the risk of heart failure.
We're now seeing a few anecdotal instances that perhaps the agency has swung too far in its effort to reduce dangers from side effects. In one instance, focusing on reducing the risk of side effects may have left more patients vulnerable to leaving their disease untreated. After follow-up data in 2003 suggested that the use of popular antidepressants could raise the risk of suicide among teenagers, the FDA required a black box warning on those products in 2004. Consequently, use of those antidepressants among 5 to 18 year olds fell by 50% between 2003 and 2005. It was only this summer that the American Journal of Psychiatry published a study that demonstrated a corresponding 18% increase in teen suicides from 2003 to 2004, which clinical experts attribute to greater levels of untreated depression in teens. Now that more clinical practitioners are pushing for the FDA to moderate its stance on antidepressant use among teens, we could see the agency take a more measured approach in determining how to balance risk from the treatment and patient access. In this case (and others such as the use of ESAs), we expect to see more vocal grassroots participation from clinical practitioners, which could pull the FDA a few steps back from its focus on safety over access.
Valuations by Industry
Compared with the second quarter, the health-care industry has become fairly valued in general. Medical goods and services, diagnostics, and hospitals have been trading closer to their fair value estimates. However, managed care and assisted living continue to look slightly overvalued. We have also seen more acquisitions that have pushed up valuations of diagnostic and equipment makers. Siemens (SI) is in the process of buying Dade Behring at $77 per share, offering a heady premium to our $41 fair value estimate on Dade as a stand-alone company. Similarly, Roche (RHHBY) has extended a tender offer for Ventana at $75 per share, far above our $47 fair value estimate on an independent Ventana.
| Health-Care Valuations by Industry | |||
 | | | |
| Segment | Average | Median Price/Fair Value | Stocks Covered |
 | |||
| Assisted Living | 2.00 | 1.15 | 2 |
| |||
| Biotechnology | 2.74 | 0.97 | 64 |
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| Diagnostics | 2.75 | 1.00 | 4 |
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| Drugs | 3.03 | 0.94 | 64 |
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| Home Health | 3.25 | 0.99 | 4 |
| |||
| Hospitals | 3.25 | 0.91 | 8 |
| |||
| Managed Care | 2.27 | 1.18 | 15 |
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| Medical Equipment | 2.90 | 1.04 | 49 |
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| Medical Goods and Services | 3.18 | 0.87 | 11 |
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| Physicians | 2.63 | 1.12 | 15 |
| |||
| Research Services | 2.00 | 1.08 | 7 |
 | |||
| Data as of 9-19-07 |
Health-Care Stocks for Your Radar
Since the second quarter outlook, Medtronic (MDT) has moved out of 5-star territory, and FoxHollow is being acquired. However, there are other stocks that we are bullish on.
| Stocks to Watch--Health Care | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | P/FV |
| |||||
| Covidien |  | $58 | Narrow | Average | 0.71 |
| |||||
| Mannkind | | $23 | None | Speculative | 0.39 |
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| Mylan | | $25 | Narrow | Above Avg | 0.61 |
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| Data as of 09-25-07. |
We still believe Mylan (MYL) is trading at an attractive price for long-term investors. In the near term, we expect incremental debt taken on to finance the acquisition of Merck KGaA's generic unit could constrain the firm's finances. But the deal should pay off for Mylan in the longer term, thanks to greater economies of scale and entry into substantial European markets.
MannKind (MNKD) offers potential upside to investors who have an appetite for the speculative biotech companies we cover. MannKind has moved forward with late-stage clinical trials on its lead inhaled insulin product, Technosphere. The candidate's safety and efficacy data suggests, thus far, that the product could be superior to competitive products and could potentially reach blockbuster status. However, Pfizer (PFE) and Nektar's (NKTR) first-to-market inhaled insulin, Exubera, has delivered largely disappointing results. This caution has spilled over to depress MannKind's shares.
We think Covidien's spin-off from Tyco International should allow investors to reap more value from its health-care-focused business. Covidien is poised to benefit from the trend toward minimally invasive procedures with its portfolio of surgical and energy-based devices. Though the firm could see short-term turbulence as it shoulders higher marketing expenses and seeks to divest a less-profitable retail unit, we anticipate that plans to beef up spending on research and development should pay off with a more robust pipeline of innovative products in the longer term.
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