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Quarter-End Insights

Our Outlook for the Health-Care Sector

We think big pharma's pipelines are looking healthier--it's time to buy.

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Against the backdrop of market turbulence from the credit crunch and subprime mortgage meltdown, the health-care sector is looking downright safe and stable--a haven from all the market gyrations. While the S&P financial services index took it on the chin with a 15% decline in the last three months, the S&P health-care index ended the third quarter flat. We expect health care to hold up fairly well going into 2008, as many of the companies we cover tend to throw off steady cash flows.

The fate of big pharma often rides on the state of its product pipelines. Following a burst of research productivity in the 1990s that resulted in huge blockbusters like Plavix, Zocor, Neurontin, and Celebrex launching by the end of that decade, the big drug companies hit a dry spell in R&D productivity. We believe this has been a dark cloud hanging over big pharma for the last few years, especially as some of those earlier blockbusters started to lose patent protection without many ready candidates to take their places. However, we think that the worst of that lull is over and that previously skimpy pipelines are on the upswing thanks to a change in research strategy and solid acquisition activity.

Rather than aim for the widespread diseases that were popular in the 1990s, like cardiovascular issues or arthritis, big pharma has shifted to focus on more tightly defined diseases--including lupus, Crohn's disease, and Alzheimer's--with smaller patient populations where there are fewer effective therapies in existence.

We expect that as these new products are launched, the drug companies will be able to wield substantial pricing power. Aside from drugs for chronic conditions, big pharma has also embraced vaccines, which had fallen off the map for a while due to intense pricing pressure from multiple rivals. Once the smaller players left the scene, a handful of big pharma companies were able to take advantage of more rational pricing, as well as advances in genomics that allowed for new, more targeted (and effective) vaccines for pneumococcal disease, human papillomavirus, and rotavirus. With ongoing development taking place on vaccines for HIV-AIDS, malaria, and tuberculosis, we anticipate vaccines will be a substantial growth driver going forward.

Further, big pharma firms have been on a tear snapping up biotech companies to bolster their presence in large-molecule biologic therapies, which are not only extremely profitable, but also benefit from current regulatory guidelines that keep generic competition at bay.  AstraZeneca (AZN) picked up MedImmune,  Novartis (NVS) purchased Chiron, and recently  Biogen Idec (BIIB) has made moves to put itself up for sale. At this point, we fully expect that as more Democrats come into power in 2008, there will be further legislative movement toward greater competition with biosimilars. But we also think that full-fledged biosimilar competition is still a ways off because the manufacture of these relatively unstable proteins is difficult, and efficacy from protein to protein (or even from batch to batch) can range substantially. For these reasons, we anticipate the potential regulatory pathway will include some level of expensive clinical trials for any biosimilar competitors, which will limit competition.

Valuations by Industry
Coming off the third quarter, the health-care sector remains fairly valued overall. Medical goods and services, equipment, hospitals, and biotech are trading at just around their fair value estimates. However, physicians, managed care, and research services remain slightly overvalued. On the other hand, we see some compelling bargains in the drug area.

 Health-Care Valuations by Industry

Segment

Median Price/Fair Value

Three Months
Prior
Change
(%)
Assisted Living 0.95 1.15 -17.4
Biotechnology 1.00 0.97 3.1
Diagnostics 0.91 1.00 -9.0
Drugs 0.91 0.94 -3.2
Home Health 0.91 0.99 -8.1
Hospitals 0.98 0.91 7.7
Managed Care 1.10 1.18 -6.8
Medical Equipment 1.00 1.04 -3.8
Medical Goods and Services 0.97 0.87 11.5
Physicians 1.12 1.12 0
Research Services 1.15 1.08 6.5
Data as of 11-16-07

Health-Care Stocks for Your Radar
Since the third-quarter outlook, we've seen some very attractive, moaty companies move into 5-star territory. We believe this is a great opportunity to pick up some very high-quality names that go on sale only occasionally.

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

P/FV

Novartis  $73 Wide Below Avg 0.78
Medtronic $62 Wide Below Avg 0.80
Pfizer $31 Wide Average 0.77
Zimmer $87 Wide Below Avg 0.78
Data as of 12-11-07.

Novartis (NVS) faces near-term patent expiration on a few key products, including hypertension drug Lotrel. But the firm's diverse operating platforms of branded pharmaceuticals, generics, vaccines, diagnostics, and consumer products give the firm plenty to fall back on. Further, Novartis distinguishes itself from the field by the impressive number of potential blockbusters that are soon to emerge from its pipeline--Galvus for diabetes, Aclasta for osteoporosis, and Exforge and Tekturna for hypertension. We expect the firm to file drug applications on an additional six products in 2008.

After climbing out of the 5-star range,  Medtronic (MDT) landed back there with a thump following a new recall of its latest connecting wire for implantable cardioverter defibrillators (ICDs). Although Medtronic has already switched over its manufacturing lines to increase its supply of older and safer wires, we expect this latest alarm could take a couple more quarters to work through, and Medtronic likely won't regain midsingle-digit ICD growth until the middle of 2008.

Even though  Pfizer (PFE) is facing patent expiration on its largest single product, cholesterol drug Lipitor, in 2011, the firm has made notable progress with several new products with blockbuster potential, including Sutent for kidney and gastrointestinal cancer and Chantix for smoking cessation. Further, Pfizer is currently offering a dividend yield of 5.2%, and the potential for capital appreciation is just icing on the cake, in our view.

Lastly,  Zimmer (ZMH) has become attractively priced since it stumbled in the third quarter on soft sales of knee and hip implants. This leading provider of orthopedic implants ran into some trouble as its new knees for women did not draw as many surgeons away from competitive products as we had anticipated. Additionally, Zimmer is currently at a disadvantage because it does not have the hip resurfacing product that competitors have already launched. As a result, we've trimmed our estimates for 2008 and our fair value estimate, but shares remain appealing, in our eyes.

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