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Quarter-End Insights

Our Outlook for the Health-Care Sector

Health-care spending is likely insulated from larger economic bumpiness.

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As the general market has fallen in the latest quarter, so too has the entire health-care sector. Further, growing fears of the U.S. entering a recessionary period have also cast a pall on the larger market, and we expect the forces buffeting the entire market will likely send some reverberations through the health-care arena.

In an effort to take a closer look at just how vulnerable health care might be to a downturn in economic growth, we recently dug into the data on GDP growth and health-care spending over the period of 1961 through 2006, which covered six periods of recession. We found little relationship between dips in GDP during recessions and health-care spending. For two of the recessions, health-care spending fell as GDP fell. During another two recessions, health-care spending stayed flat, and in the remaining two recessions, health-care spending actually rose. Thus, in four of the last six recessions, health-care spending was relatively insulated from general economic declines.

Further, we think health care has become even more removed from the general economic cycles because out-of-pocket spending has declined from 47% of total health-care spending in 1960 to a mere 12% in 2006. The currently low proportion of out-of-pocket spending will likely rise in the future as more employers and insurance firms seek to push more health-care costs directly on the shoulders of consumers, but we expect most of this movement will be gradual and incremental.

If health care is less exposed to general economic downturns, it is certainly more vulnerable to political changes. With the distinct possibility of a Democratic administration taking over the White House, as well as potential gains in Congressional seats, we expect there may be some real changes on the longer-term horizon. This may be a mixed bag for health care. Managed care firms could benefit if Democratic proposals to extend insurance coverage to all or some portion of the 47 million uninsured Americans come to fruition. Generic drug firms could see a boost if Congress manages to establish a legal pathway for biosimilar large molecule therapies to be approved. Pharmaceutical companies could lose if the Centers for Medicare & Medicaid Services is authorized to wield its immense buying power and negotiate prices directly with drug firms. Even though we anticipate there will be some big issues facing health care after the 2008 election, we also believe that history has shown most changes in the arena tend to take place in a gradual and moderate fashion, despite much saber-rattling in the debate process.

As we had mentioned last year, we think the difficulty and unpredictability of manufacturing protein-based biologic therapies would likely limit competition from biosimilars. In a recent meeting with  Novartis (NVS) management, we learned that the European uptake of the firm's biosimilar version of  Amgen's (AMGN) Epogen has been slower than expected since it was launched in fall 2007. This suggests that physicians may also be very cautious about switching patients from the name brand to the biosimilar epo agent. In studying this issue, we think market adoption of biosimilars will depend heavily on the individual class. For example, biosimilar insulin may be more interchangeable with the name-brand products because there are fewer risks for patients. However, there are enough safety concerns with name-brand epo products that practitioners may shy away from trying the biosimilar version from a company that just got into the tricky business of making it.

Valuations by Industry
With the first quarter wrapping up, the health-care sector as a whole has become slightly undervalued. Physicians, research services, home health, managed care, and medical goods and services are all trading just at or a hair under their fair value estimates. But diagnostics, drugs, hospitals, assisted living, and medical equipment valuations are all becoming more attractive.

 Health-Care Valuations by Industry

Segment

Current Median Price/Fair Value

Three Months Prior Change
(%)
Assisted Living 0.82 0.95 -13.7
Biotechnology 0.87 1.00 -13.0
Diagnostics 0.79 0.91 -22.0
Drugs 0.79 0.91 -13.2
Home Health 0.90 0.91 -1.1
Hospitals 0.79 0.98 -19.4
Managed Care  1.00 1.10 -9.1
Medical Equip 0.86 1.00 -14.0
Medical Good/Svs 0.92 0.97 -5.2
Physicians 0.92 1.12 -17.9
Research Svs  1.05 1.15 -8.7
* Data as of 03-14-08

Health-Care Stocks for Your Radar
As the market downturn ripples its way across the health-care sector, we've seen a number of companies with economic moats go on sale. We see this as an opportunity to buy some high-quality companies at appealing prices.

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

P/FV

J&J  $80 Wide Below Avg 0.81
Amgen $66 Wide Average 0.61
Waters $76 Wide Below Avg 0.71
Mentor $45 Narrow Above Avg 0.55
Mannkind $18 None Speculative 0.27
Data as of 03-19-08.

 Johnson & Johnson (JNJ) is about as close as you can get to a health-care mutual fund in a single stock. Although we expect patent expirations to weigh on growth for the pharmaceutical division in 2008, we remain confident that the company's diverse operating lines in medical devices, over-the-counter medications, and consumer goods can help the firm get through the near term. Those business segments along with a robust late-stage drug pipeline with eight potential blockbusters in Phase III development should drive long-term growth.

 Amgen's (AMGN) shares have been beaten down due to safety concerns surrounding its anemia franchise, particularly when the drugs are used in cancer patients. We've witnessed several changes to the prescribing labels of Epogen and Aranesp and severe restrictions on the government's coverage of these products in chemo patients. However, we think the worst is over for Amgen. We had already modeled in Epogen and Aranesp declines, but blockbusters Neulasta and Enbrel are still going strong. Additionally, the market seems to be ignoring both Amgen's ability to trim costs as its anemia franchise shrinks and its pipeline with several promising new products, including platelet booster NPlate and denosumab for osteoporosis.

 Waters (WAT) hit a rocky quarter as demand from large customers softened and Japanese operations slowed down. But we think the market overreacted as Waters' business has shifted away from large pharma clients to more generic drug firms and contract research organizations. Further, Japan is not a key growth market for Waters. Demand remains impressively strong for the firm's flagship ACQUITY product franchise and its recently released Synapt MS platform, and both businesses are growing north of 20%. Lastly, analyst Alex Morozov recently attended an industry conference where he gleaned that Waters is already prepared with its next generation products but is not compelled to launch them yet because competitors are still trailing this generation's products. We're confident that Waters is staying a step ahead of rivals.

 Mentor Corporation (MNT), whose aesthetic treatments and devices are often paid for out-of-pocket, may seem like a counter-intuitive pick as discretionary consumer spending dries up. But Mentor has benefited greatly from the recent reintroduction of high-margin silicone breast implants into the U.S. market. Also, we expect Mentor to launch three new dermal fillers by 2010, and Puretox by 2012, rounding out its plastic surgery offerings. Even in economic downturns, anti-wrinkle injections tend not to drop off, as consumers trade down from pricier face lifts. Finally, we forecast total breast implant volumes to grow an average of 3.5% per year through 2015, despite a 15% cumulative decline over the next two years due to weak economic conditions.

For those who can tolerate risk, we think  Mannkind (MNKD) offers a favorable risk-reward ratio. This speculative biotech is still developing its lead product: an inhaled insulin. Now that several large competitors, including  Pfizer  (PF)E,  Eli Lilly (LLY), and  Novo Nordisk (NVO), have dropped their inhaled insulin programs, we think Mannkind could have the market to itself if its Technosphere insulin is approved. Currently in Phase III trials, Technosphere has demonstrated that it may hold an efficacy advantage over fast-acting injectable insulin, as well as a respiratory safety advantage over Pfizer's Exubera. We currently put the probability of Technosphere's approval at 60%.

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