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Our Outlook for Health-Care Stocks

Market challenges the defensive nature of health care.

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The fourth quarter of 2008 saw market turbulence of historic proportions, and the near-collapse of the global financial system left the U.S. economy reeling. In the face of this challenging economic environment, the relative resistance of the health-care sector to market woes has once again validated the notion of health care as a "safe haven."

While not entirely immune to the financial and economic crisis, health-care stocks in general have held up: The year-to-date return of the  Health Care Select Sector SPDR (XLV) trails only the return of the consumer staples indicator, outperforming returns of every other major economic sector. Such resilience can be explained in part by the traditionally defensive nature of health-care expenditures. However, the solid financial health of many health-care companies has also been a key factor in this relatively strong performance. Many established drug, device, and service companies generate robust cash flows to finance their business growth and aren't relying on the currently frozen capital markets for their financing needs.

Nonetheless, the difficult economic landscape that is likely to persist in the near term has forced many firms in the health-care space to scale back on their 2009 forecasts, which in turn has shaken investor confidence in this area. Growing concerns of a prolonged recession, coupled with both rising unemployment levels and decreasing affordability of private insurance, are challenging the traditional view that health expenditures are immune to the broad state of the economy. Anecdotal evidence of consumers skipping medications and foregoing treatments is starting to trickle in, and numerous health-care firms have warned of a tough year ahead. Hospitals in particular have been affected by this malaise; not only have most hospital operators seen an increase in the number of uninsured and underinsured patients they are mandated to treat, but the number of "quality" patients (those with private insurance) has also shown signs of a decline. Hospitals, research laboratories, and drugmakers have responded by tightening their capital budget belts to reflect the uncertainty of the current environment, producing a wave of projection cuts from medical equipment makers, contract research firms, and other auxiliary service providers.

The uncertain regulatory and legal environment is also causing headaches for the health-care sector. As President-Elect Obama is about to be sworn in to office, the probability of sweeping health-care reform that encompasses many campaign promises is rapidly increasing. To our surprise, the breadth of proposed changes has not been whittled down, despite the economic challenges associated with implementing plans that could cost $50-$60 billion per year. The impact of reform would likely be felt across the entire sector. However, if Obama is able to slow the growth of health-care expenditures by legalizing drug reimportation and allowing Medicare to negotiate drug prices, the consequences for the pharmaceutical industry could be negative. On the flip side, Obama's proposal to drastically reduce the number of uninsured Americans would likely result in a massive influx of new patients into the system, which could provide an offsetting--if not a net positive--effect on overall health spending. We analyzed Obama's plan in detail in the September issue of Morningstar HealthcareObserver, our monthly publication that provides an in-depth look at trends in health care. We are providing this issue free of charge to all Morningstar Premium Members. You can access your copy by clicking here, and following the link to "Get Your Free Issue Now."

Valuations by Industry
Not surprisingly, the segments that depend on capital expenditures by hospitals and drugmakers have fared the worst in the fourth quarter, with price/fair value estimate ratios collapsing for research and medical service providers, as well as medical equipment manufacturers.

 Health-Care Valuations

Segment

 Price/Fair Value

Three Months Prior Change
(%)
Biotechnology 0.79 0.93 -15
Diagnostics 0.73 0.85 -14
Drugs 0.68 0.79 -14
Hospitals 0.62 0.96 -35
Managed Care 0.54 0.73 -26
Medical Equipment 0.59 0.88 -33
Medical Goods & Services 0.60 0.90 -33
Physicians 0.67 0.80 -16
Research Services 0.55 1.05 -48
Data as of 12-15-08 *Market-Weighted Harmonic Mean

Although these industries--particularly equipment makers--have elements of cyclicality to them, we believe the market's punishment of them in response to near-term demand weakness has been too severe. In fact, only a portion of most instrument makers' revenue streams depend on the high-ticket items that are particularly sensitive to tightened capital budgets, and recurring revenue from low-priced consumables and services frequently constitutes more than half of total sales. Even if purchasing delays persist over the next few quarters, it is unlikely that this cycle will extend for a prolonged period; scientists' demands for newer and better instrumentation are unlikely to fall on deaf ears for too long, given the increasing complexity of new drug research. With an average price/fair value now under 60%, we think this segment is significantly undervalued.

We are also becoming bullish on the research services industry, composed primarily of contract research organizations (CROs), which provide clinical development services for pharmaceutical and biotechnology firms. CRO stocks rose meteorically when times were good (from 2004 to mid-2008) only to collapse precipitously when key growth drivers showed some signs of near-term moderation. The clinical trials outsourcing growth story propelled CROs to the top, but has recently come under threat, as research activities are suddenly drying up. Small biotechnology firms that rely on capital markets for their financing needs are delaying trials to preserve cash, which is leaving CROs scrambling to fill capacity. We don't anticipate this clinical-trials vacuum can be sustained for more than a few quarters as the advancement of drug candidates through clinical trials is the only bloodline for many of these biotechnology companies. Pent-up demand will most likely result in explosive growth for CROs once capital markets thaw out, and now is the time to consider investing in this industry, which is seeing many of its stocks trading at 10 times or less their forward earnings estimates.

Health-Care Stocks for Your Radar
Here are some of our favorite picks from the medical equipment and research services sectors, along with two health-care stalwarts that are presently trading at a substantial discount to our fair value estimates.

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

Recent Price

Thermo Fisher  $73 Narrow Medium $33
Covidien Ltd. $65 Narrow Medium $38
Charles River $60 Narrow High $22
Stryker $72 Wide Low $40
Novartis AG $73 Wide Low $49
Data as of 12-18-08.

 Thermo Fisher Scientific  (TMO)
Similar to other instrument manufacturers, Thermo Fisher recently noted a rampant pullback in large-ticket purchases, coinciding with the credit crisis hitting the broad economy. The pullback will likely cascade well into 2009, but we believe our long-term bullish stance on Thermo Fisher has not been affected. First, nearly half of the company's revenue is recurring, and its instrument consumables and catalog business are by and large unaffected by the souring economy. Thermo Fisher enjoys pricing power over its consumers in this area evidenced by the history of successful annual price hike implementations. Second, although recessionary fears have resulted in tightening belts all across the research and industrial sectors, capital expenditure delays can't be extended for a prolonged period. We have seen several pullbacks in capital spending over the past years, and the troughs rarely extend for more than a few quarters. Certainly, this tight budget environment could be different, but a growing complexity of drug research and increasing demand for air- and food-quality testing, should propel the uptick in instrument sales toward the latter part of 2009. Thermo is also very adept at swiftly managing its cost structure, evidenced by its ability to grow its bottom line even despite some top-line pullbacks.

 Covidien (COV)
The company appears to have been thrown into a hospital discretionary spending bucket even though most of its instruments address anything but discretionary needs. The vast majority of the company's surgical device product lines have to be replenished on an ongoing basis, and even elective procedures, such as bariatric surgeries, are unlikely to be delayed given immediate health concerns for patients suffering from obesity and requiring surgery. The company has also made tremendous strides in new product development, sales efforts, and cost efficiency since its spin-off from Tyco International more than a year ago. As a result, it will likely see a remarkable double-digit earnings expansion in 2009 despite the challenging economic environment. Yet, Covidien's stock trades at the below post-spin-off level, which, in our opinion, is nearly 40% below its true worth.

 Charles River Laboratories (CRL)
We think the market is too preoccupied with a recent uptick in study delays related to the reorganization of pipelines at big pharmaceutical firms and a dry-up in funding for small biotechnology firms to see the great long-term story of Charles River. Recent delays are temporary in nature and growth prospects related to increasing outsourcing penetration should outweigh any near-term worries. Drugmakers cannot afford to put off preclinical work for too long, as this would lead to depleted pipelines (and revenue opportunities) down the road. The market also is not giving the company enough credit for its highly lucrative research model business, which generates more than 45% of the company's revenue. Charles River is the premier provider of laboratory animals with 50% of worldwide market share, and operating margins in this segment exceeds 30%.

 Stryker (SYK)
We think Stryker has built one of the widest moats in the medical device industry, and recent share prices represent a compelling entry point for this growth company. Stryker excels in several niches. We especially like its top-tier position in the highly profitable orthopedic implant market, which typically possesses high barriers to entry and sticky surgeon relationships. We think this market should continue growing at a fast clip due to favorable demographic and lifestyle trends; including the aging of the developed world, higher expectations for activity levels throughout the aging process, and the obesity epidemic that is straining joints. In addition to its prowess in therapeutic devices, the firm also outfits surgical suites and regular hospital rooms with various tools and equipment. It is particularly prolific in operating room products, including cutting tools and irrigation devices, and it is even a top provider of medical beds and emergency equipment, such as stretchers. Given these market opportunities, we expect Stryker's sales to grow 12% compounded annually through 2012 and operating margins to expand slightly from 22% in 2007 to 23% in 2012. To reach recent share prices, we'd have to assume that Stryker's orthopedic segment growth falls well below our industry expectations and that its medical equipment business can't make up the difference, resulting in a 5% compound annual growth rate in total sales through 2012. We'd also have to assume operating margins contract to 19% in 2012 from 22% in 2007. We think those assumptions are too pessimistic, and the market appears to be giving investors an excellent opportunity to invest in this admirable firm.

 Novartis AG (NVS)
Novartis offers a strong investment opportunity as the market has taken down the stock price based on recession fears and liquidity concerns. However, Novartis offers a diverse platform of economy-resistant products, including branded drugs, generic drugs, vaccines, and consumer products. Further, this range of products should reduce the company's relatively minor patent exposure in its branded drug space. Additionally, the company boasts a strong balance sheet and robust cash flows that should eventually remind the market that Novartis does not heavily depend on the capital markets to run its business. Lastly, Novartis offers one of the best collections of late-stage pipeline products and recently launched drugs that we believe will drive superior long-term growth.

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Alex Morozov does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.