Our Outlook for Health-Care Stocks
Health-care reform and mega-mergers dominate the news.
Quarter-End Insights
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In contrast to the fourth quarter of 2008 when health-care stocks took a nose-dive along with the rest of the market, industry-specific developments were the main catalyst for the sector's largely negative performance in the first quarter of 2009. Two main themes dominated: health-care reform and the mega-merger activity in the pharmaceutical area. The news on the regulatory front carried particular significance, as the message sent by the Obama administration was clear: Health-care reform would not take a back seat to the economic crisis, and the system could undergo a significant overhaul as early as next year.
The news flow pertaining to the reform and the 2010 budget wreaked havoc across the sector. It wasn't necessarily what was explicitly stated in the budget proposal and corresponding supporting documentation, but rather the anticipation by the market of what could be forthcoming in the near future. The scant details of the Obama administration's plans that have emerged so far haven't quelled investor fears. Expectations of far-reaching proposals, such as direct price negotiations between the government and drugmakers, drug reimportation, competitive bidding, bundled payment system for hospital reimbursement, and (the bogeyman) socialized medicine, were rampant, sending shares of drugmakers and device makers, along with the rest of the health-care space, reeling.
To be fair, the 2010 budget contained a number of proposals that could directly or indirectly benefit various health-care sectors. The president's information technology proposal, for example, should meet little, if any, resistance and offers a way to reduce waste from one of the least IT-advanced sectors of the economy. One would be hard-pressed to find a reasonable argument for opposing the proposal that would computerize all the medical records in the United States over the next five years. The market took notice. Shares of Cerner Corp. , a health-care IT solutions provider, are up nearly 20% since the administration unveiled its plan. Investment in prevention and wellness programs could provide a boost to the diagnostic sector, although it potentially could be offset by the efforts to scale back on what could be deemed excessive patient testing. A pathway for advancement of generic biologics and efforts to restrict patent shelf of reformulated or "me-too" drugs are also to be lauded; the actual mechanisms of action on both fronts remain largely unknown, but the call for innovative technologies could be a sign that the Food and Drug Administration may be increasingly favoring drugs that address unmet needs or offer unique solutions to various ailments. Finally, President Obama is eager to deliver on his promise of expanded insurance coverage, which would add up to 46 million Americans to the insured population pool, potentially boosting enrollments for many managed care organizations (MCOs).
This potential enrollment expansion was seemingly the only positive news for the managed care industry, however. The administration has also unveiled its proposed means of paying for its health-care plan, and managed care, along with wealthy individual taxpayers, could be picking up the tab for the lion's share of the initial $630 billion plan cost. Our managed care analyst, Matt Coffina, in a recent article attempted to assess the impact of various proposals to alter the U.S. payer system on managed care companies we cover. Here are some key takeaways: The administration proposal pertaining to MCOs that is deemed most likely to succeed--reduction of reimbursements to Medicare Advantage plans provided by private payers--hasn't come as a surprise and has already been incorporated in our analysis. But other ideas, not explicitly in the budget but apparently deliberated by the administration, pertain to the overhaul of the entire payment provider system, and could have drastic implications on our thesis and valuation for the managed care sector.
The wave of mega-mergers in the pharmaceutical space has also made notable headlines in the first quarter. In a flurry of activity, the likes of which have not been seen since 1999-2000 when the Pfizer/Warner-Lambert, Astra/Zeneca Group, Glaxo Wellcome/SmithKline Beecham mega-deals were completed, the pharmaceutical space has undergone massive changes just over the past 90 days. Pfizer's (PFE) $68 billion planned acquisition of Wyeth , the shotgun marriage of Roche and Genentech , and the just-announced deal between Merck (MRK) and Schering-Plough have reshaped the industry environment and signaled that the consolidation wave triggered by patent expirations, earnings pressure, and regulatory uncertainty is gaining momentum. It is possible that a few other large deals could be in the making (rumors surrounding Bristol-Myers Squibb (BMY) and biotech giant Amgen (AMGN) as potential acquisition targets have been floating for quite some time), but the focus, in our opinion, is largely shifting toward smaller, more focused drug developers, such as Biogen Idec (BIIB) or Elan .
Valuations by Industry
Not surprisingly, given the overall negative tone of regulatory news flow, shares of drug developers and hospital service providers didn't fare well in the quarter. Further, tough economic conditions continue to weigh down the industry, as rising unemployment and rapidly deteriorating consumer wealth are causing individuals to scale back on health-related expenditures.
| Health-Care Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty | |
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| Biotechnology | 3.80 | 0.71 | 0.79 | -8 | 18.9 |
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| Diagnostics | 4.90 | 0.65 | 0.73 | -8 | 17.3 |
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| Drugs | 4.80 | 0.59 | 0.68 | -9 | 6.3 |
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| Hospitals | 3.80 | 0.59 | 0.62 | -3 | 85.0 |
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| Managed Care | 4.30 | 0.48 | 0.54 | -6 | 49.6 |
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| Medical Equipment | 4.70 | 0.56 | 0.59 | -3 | 5.5 |
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| Medical Goods & Services | 4.80 | 0.55 | 0.60 | -5 | 15.0 |
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| Physicians | 3.70 | 0.58 | 0.67 | -9 | 79.5 |
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| Research Services | 4.70 | 0.50 | 0.55 | -5 | 68.5 |
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| Data as of 3-13-09. *Market-Weighted Harmonic Mean **Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage. |
Hospital operators are bearing the brunt of the downturn, and the stress on this sector will likely continue throughout 2009. Cash-strapped patients are delaying care for nonemergency conditions, putting pressure on hospital admissions. With unemployment on the rise, bad-debt expense is climbing, cutting into hospital profitability. Exacerbating the problem, hospitals are losing lucrative patients who are covered by commercial insurance as job cuts pile up. Internal strategic mishaps--massive financial leverage attributed to the roll-up strategy many operators deployed in the early 2000s--are also magnifying the effect of this downturn. Despite some help from the stimulus package in the form of increased Medicaid funding, we don't see many positive catalysts on the horizon for the hospital industry.
On top of current troubles, we think regulators may attempt to squeeze hospitals in the near future. One proposal in President Obama's budget specifically targets hospitals with high readmission rates, threatening to limit Medicare reimbursement via bundling payment for initial visits and any follow-ups within 30 days. However, the decline in uninsured patients that is also part of the president's plan would mean lower bad debt and charity care for hospitals. Until more details emerge, the net effect is hard to quantify.
Shares of many drug developers also tumbled immediately following the budget release (many have recovered in the weeks since), as the president's harsh rhetoric toward branded-drug makers stoked fears of pricing control. We think there is definitely some stigma attached to manufacturers of prescription drugs, which would allow the passage of certain measures aimed to curb drug costs, such as uniform reimbursement under both Medicare and Medicaid. But more radical actions--drug reimportation primarily--would yield only limited, if any, results in our opinion, as drugmakers could potentially simply restrict drug shipments to lower-cost areas to negate the government's efforts. The safety concerns would also likely render the reimportation idea ineffective. All bets are off, however, if the U.S. government consolidates purchasing to achieve greater pricing power and the country moves closer to a single-payer system--the once-unthinkable idea that is now gaining steam. A government payer wielding unequivocal bargaining strength would do irreparable damage to the drug developers' earnings power.
Our Top Health-Care Picks
| Top Health-Care Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ | |
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| Medtronic |  | $50 | Wide | Low | 0.59 |
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| Elan Corporation PLC | | $13 | None | High | 0.47 |
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| AmerisourceBergen | | $52 | Narrow | Medium | 0.62 |
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| Fresenius Medical Care | | $59 | Narrow | Medium | 0.61 |
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| Data as of 3-24-09. |
Medtronic (MDT)
Now that the Department of Justice has settled its cases with the orthopedic companies, we expect Medtronic and other peers in the spinal device market will be within the DOJ's sights and will withstand greater scrutiny of its sales practices and physician relationships going forward. Further, Medtronic is also dealing with a slow recovery in the key implantable cardioverter defibrillator market. Although 2008 ICD sales have moved back into the mid-single-digit range after suffering declines brought on by large-scale competitive product recalls, the market is unlikely to return to the 20%-30% growth that took place as the devices were introduced in the early 2000s. However, we're not ready to completely write off the ICD market. Medtronic continues to dominate the field of three major players with approximately 50% market share. We expect the market to continue growing in the midsingle digits as ICDs are one of the few devices that have substantial clinical data to demonstrate their clear superiority on mortality compared with optimal medical therapy for certain heart disease patients. As health-care reform moves closer to using comparative effectiveness data to justify the price of certain therapies, Medtronic's ICD business should be left standing tall. Moreover, Medtronic continues to invest in emerging technologies in order to lay the groundwork for future growth. Most recently, the firm has made a series of purchases in the atrial fibrillation (both radio-frequency and cryo-ablation technology) and minimally invasive catheter-based heart valve spaces. These two therapeutic areas with considerable unmet needs could grow into a combined $2 billion to $3 billion market over the next five to seven years, and Medtronic is well-positioned to exert a formidable presence in each.
Elan
Until late last July, Elan was riding high on Tysabri's stellar relaunch and the promise of its lead Alzheimer's disease drug candidate, bapineuzumab. However, a perfect storm of events has driven Elan's stock to lows not seen in years. New cases of the potentially deadly brain infection PML have since been discovered in a handful of multiple sclerosis patients taking Tysabri, and bapineuzumab's efficacy and safety across a broad spectrum of Alzheimer's patients in Phase II studies were disappointing in light of the market's high expectations. We think PML will become an increasingly manageable (and preventable) side effect, and that Tysabri's efficacy will continue to put it among the leading treatments in the $8 billion (and growing) global MS market.We also see enormous potential in Elan's core Alzheimer's R&D pipeline; if any of its diverse development programs reach the market, the firm could dominate a $5 billion global market that currently lacks any disease-slowing treatment options. Elan is also exploring strategic alternatives--such as the sale of a minority stake in its equity or the firm in its entirety--in order to continue to aggressively feed its R&D pipeline and make payments on its sizable $1.8 billion debt balance. We think Elan is likely to either find a larger drug firm eager to establish a relationship or extend its current partnerships with Biogen Idec or Wyeth.
AmerisourceBergen (ABC)
AmerisourceBergen, along with other drug distributors, is relatively insulated from the economic climate, as demand for pharmaceuticals tends to hold up in any environment. Although the stocks of these companies have outperformed the general market over the past year, they were down sharply in the past month, as concerns arose that pharmacy customers could face financial distress, and specifically, that one of McKesson's (MCK) biggest customers, Rite Aid (RAD), could be near bankruptcy. While the loss of a major customer can have a severe effect on distributors' bottom lines, AmerisourceBergen's low customer concentration make it less susceptible to any individual client loss, which should alleviate investor fears.
Fresenius Medical Care (FMS)
Fresenius has experienced a sharp decline in share price over the last several weeks, and we are somewhat perplexed by the recent deterioration; our long-term view on the company is still intact. We think that investor concerns have been sparked primarily by regulatory fears. We concur that Medicare could change how it compensates dialysis clinics for administering anemia drugs, such as Epogen, which would have an effect on the company's margins; the health-care reform discussion likely reignited this fear. However, there are no imminent changes on the regulatory front as of yet, and Fresenius' position as the dominant player in both dialysis products and services remains secure. We continue to believe that the company will take advantage of the growing demand for dialysis treatments overseas, and we expect the current global recession will have little to no effect on demand for the company's services.
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