Recession Proof? Not These Health-Care Stocks

As my colleague Alex Morozov points out in his article "Sizing Up the Heath-Care Haven," overall health-care spending has moved independently of general economic activity throughout U.S. history, making the health-care industry a relative safe haven for investors during recessionary times. While this knowledge underpins our valuations for firms in pharmaceuticals, cardiac devices, and diagnostics, a separate health-care niche exists where the exact opposite holds true. Here, medical insurance is not accepted, procedures and products are elective rather than essential, and demand fluctuates wildly around economic conditions. This is the reality for firms competing in the laser vision correction and plastic surgery markets.

With consumer confidence readings at multiyear lows and unemployment rates rising, stocks in the luxury health-care sector have been uniformly beaten down, as investors anticipate large cutbacks in discretionary spending. However, we expect the markets for LASIK, breast implants, and Botox to each behave differently during an economic downturn. In this article, we'll separate the winners from the losers, and use scenario analysis to explain why one 5-star stock is a particularly compelling value.

The Luxury Health-Care Market
Both the laser vision correction and plastic surgery markets require large out-of-pocket expenses for patients, making price a key selling point for these procedures. While a disproportionate number of patients fall in upper income brackets, making them somewhat insulated from an economic downturn, the majority are average wage earners. In the event of a recession, these average patients could see a reduction in their discretionary income, forcing them to either put off procedures until later or trade down to cheaper alternatives.

That said, it's difficult to quantify the impact of a recession. The laser vision correction and plastic surgery markets remain relatively immature, with LASIK, Botox, and silicone breast implants all rising to prominence within the last decade. While some notable precedents exist, most of the luxury health-care industry operates outside of any valid historical context.

Fortunately, we can predict which markets will fare relatively better or worse during a recession based on two factors--trade-down options and chain purchases. In doing so, we can use the most susceptible market as a backstop for the rest, and we can find value where other investors have failed to differentiate between them.

The Trade-Down Option
Given lower discretionary income and the need to cut back spending, we think consumers will first give up those goods or services with an easy trade-down option. For instance, in a pinch, consumers can forgo a new car purchase in favor of a relatively cheaper used car, without any major sacrifice. While less luxurious, the individual can still get from point A to point B. Similarly, a family planning a vacation can opt for a road trip instead of a tropical getaway.

In luxury health care, we think prospective LASIK patients have multiple trade-down options, in stark contrast to patients who want Botox and breast implants. In difficult times, a patient considering LASIK can put off the surgery until later and trade down to glasses or contacts lenses, with little sacrifice. While the surgery may be preferable, the patient can still function and see clearly without LASIK. On the other hand, there is no substitute for Botox injections or breast augmentation, making it nearly impossible to trade down from these procedures. Even if the economy worsens, patients who want fewer wrinkles or larger breasts have no choice but to pay up for the procedure.

The Chain Customer
We think goods or services that require upgrades or chain purchases will fare better during a weakening economy than those goods that require only a single, one-time purchase. Most often, this is because the repeat customer faces an opportunity cost to break the chain of purchases.

For instance, a person who makes an initial purchase of antivirus software must continue to upgrade the software as new viruses are discovered. If the customer does not upgrade, or waits to upgrade, the computer is left open to viruses. Similarly, if a student drops out of college, he or she doesn't get a partial degree for the years completed, but must forgo the diploma altogether. As a result, both antivirus software and college enrollments tend to hold up relatively well during recessions, as people are reluctant to break the chain. This contrasts to one-time purchases, such as refrigerators or computer hardware, that can easily be put off until economic times improve.

Turning to luxury health care, we think Botox benefits from a loyal base of chain customers, while LASIK and breast implants do not. Botox patients receive injections about every six months. At that time, if a patient elects to stop using Botox, previously treated wrinkles will return, regardless of the number of prior injections. As a result, if Botox patients want to keep their hard-earned look, they have to pay up for the procedure on a regular basis in both good times and bad. Quite the opposite, both LASIK and breast augmentation procedures require only a single, one-time purchase. In these cases, patients are likely to postpone procedures until they're more confident in their financial condition.

Putting It All Together
Given these factors, we expect discretionary products or services that benefit from a lack of trade-down options and have a chain customer base to perform the best relatively during a recession, and we expect goods with the opposite traits to perform the worst. In recessions that affect luxury health care, this means that Botox should hold up better than breast implants, which do not benefit from chain customers, but breast implants should perform better than LASIK, which lacks chain customers and has multiple trade-down options.

The LASIK Backstop
We think a 20%-25% decline in LASIK volumes is a reasonable expectation for the next two years, given the 20% cumulative LASIK volume decline from 2000-03, our analysis of consumer confidence readings then and now, and other factors. With LASIK volumes as the backstop in our framework of the luxury health-care market, we'd expect breast implant volumes to fall less than 20% to 25% cumulatively, and Botox volumes to fall even less, if at all, during a prolonged economic downturn with depressed consumer sentiment.

A Compelling Value
Mentor  generates two thirds of its sales through its roughly 50% share of the U.S. market for breast implants. Not surprisingly, our fair value estimate for Mentor relies heavily on the severity of the impact of a recession on breast implant volumes.

At our current fair value estimate of $45, we assume Mentor will suffer cumulative breast implant volume declines of 15% over the next two years. Based on the population of women ages 20 to 64, we expect Mentor to return to prerecession market penetration rates by 2012. But, what if we're wrong?

Let's say Mentor's breast implant volumes fall 30% over the next two years (even more than our LASIK backstop), with market penetration rates staying below prerecession levels until 2015. Even assuming this worst-case scenario, we think Mentor is worth $32 per share, still 15% above its recent closing price of $28. This means that even if the worst-case scenario for Mentor hits, which is unlikely, we still believe the shares are undervalued at current prices. While it may seem counterintuitive to invest now in Mentor, whose fortunes are tied to the struggling U.S. economy, we think the stock has limited downside risk and will be among the first to rally when confidence in the economy returns.

If You Like Mentor, You May Also Like:
Advanced Medical Optics  makes medical devices for the eye and holds the top spot in the U.S. LASIK market. While its LASIK business is susceptible to the weakening economy, AMO generates nearly two thirds of its sales from the economically resilient cataract and consumer eye-care sectors. Like Mentor, we think AMO is being unfairly punished by the market and expect the shares to rally when consumer confidence rebounds.

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