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Quarter-End Insights

Our Outlook for Health-Care Stocks

Reform and M&A activity are key themes in health care.

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The key development on the health-care reform front occurred just before the end of the third quarter. The long-anticipated proposal from the Senate Finance Committee finally materialized and, as is typical of any proposal that attempts to take a centrist approach, was greeted with a barrage of criticism from both ends of the political spectrum. We're planning to give an overview of Sen. Baucus' bill in a separate article at a later time (especially as we anticipate a number of modifications to the original bill will emerge in the near future), but we've already discussed the core components of the plan--guaranteed issue, individual mandate, excise taxes on lucrative plans, and creation of nonprofit co-ops--in our May issue of Morningstar Healthcare Observer.

The relatively new component of Baucus' proposal (and the one that most directly hits a vast majority of health-care companies)--taxes on the pharmaceutical, device, diagnostic, and insurance industries--came as somewhat of a surprise to both us and industries targeted by this special assessment. We're not certain at this point how the government intends to assess this levy; according to the bill this tax will be parceled out based on the market share, but it appears to give limited distinction to the nature of medical devices (stents versus scalpels, for example), market share abroad as opposed to in the U.S., or relative profitabilities of individual companies. The proposal also seems to favor pharmaceutical companies--new taxes disproportionately impact devicemakers, laboratories, and insurance companies, while the biggest component of the industry gets a relative break. In our opinion, this proposal is an attempt to force devicemakers' hand and extract concessions out of the industry, similar to $80 billion offered by drugmakers to close the "donut hole" earlier in the year. However, if the government is firm in its determination to double-tax devicemakers, it would, in our opinion, have an undesired effect of increasing costs, as undoubtedly the biggest industry players would attempt to pass the tax hike on to consumers.

The idea of nonprofit co-ops, while getting a lukewarm reception from managed care, will have only a minimal impact on the insurance industry, in our view. While co-ops would have a relative advantage over private insurers in the form of cheaper capital--explicit government subsidies and lower cost of capital due to the co-op's implicit backing by the government--the massive scale advantage of private insurers (as a reminder,  UnitedHealth (UNH), for example, has 32 million members across whom to leverage its operational costs) would allow them to survive this onslaught of competition. We believe the insurance industry breathed a huge sigh of relief as it became clear that the real threat--a government-managed plan--isn't likely to materialize, and as a result managed-care stocks have rallied off their early spring lows (our top pick  Wellpoint  (WLP) is up close to 40% since March 30). The introduction of co-ops hasn't thwarted the rally, which appears to validate our take on their limited competitive threat.

While the reform and its implications have been the main determinant of the direction of health-care stocks in 2009, another broad industry trend is emerging quietly. Mergers and acquisitions in the health-care sector have picked up, signaling that the relatively quiet second quarter was not indicative of an unattractiveness of the sector from an M&A perspective. We've noted in our February issue of Morningstar Healthcare Observer that the health-care industry is ripe for consolidation, and we're starting to see interest from both insiders and non-health-care companies pique. We're particularly intrigued by the activity of conglomerates-- General Electric (GE) and  Danaher (DHR) have made sizable investments in health care in the third quarter, and our expectation is that both companies are only starting to dabble in this space, and more acquisitions will be under way shortly. We've also witnessed  Johnson & Johnson (JNJ) purchasing a stake in  Elan (ELN),  Agilent (A) acquiring  Varian (VARI), and  Bristol-Myers Squibb (BMY) buying  Medarex (MEDX), in addition to a number of smaller transactions. The sectors we consider to be predisposed to further consolidation are biotechnology, medical instruments, and diagnostics.

Valuations by Industry

 Health-Care Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%) Uncertainty
Percentile**
Biotechnology 3.25 0.91 0.82 +11 33.0
Diagnostics & Research Services 3.56 0.85 0.77 +10 14.9
Drug Manufacturers 4.10 0.78 0.70 +11 4.3
Hospitals 2.59 1.37 1.01 +36 92.6
Managed Care 4.11 0.71 0.62 +15 3.2
Medical Appliances & Equipment 4.44 0.80 0.70 +14 1.1
Medical Instruments & Supplies 3.43 0.83 0.77 +8 21.3
Generic Drugs 3.41 0.85 0.79 +8 22.3
Health Care Services 3.76 0.81 0.57 +13 8.5
Data as of 9-14-09. *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.

The sector that witnessed a particularly strong rally in the third quarter was, once again, hospitals, but we encourage investors to take a very close look at their holdings in this segment and consider trimming their exposure. While bankruptcy concerns have abated since early 2009 as credit markets eased and hospitals were able to refinance their short-term obligations, we don't see many positive catalysts for this beleaguered industry. Further, we believe that if the overall economy doesn't experience a rapid bounceback and unemployment numbers don't recover, hospitals could be in a very precarious position by the end of 2009. We have noticed a pickup in charity care ("free" service hospitals disperse to uninsured and unemployed patients), but this trend could accelerate in the latter part of 2009 and early 2010, as COBRA benefits start to expire.

On the flip side, medical devices continue to lag the overall recovery pace, and, as of today, is considered the "cheapest" segment (based on our star rating) in the entire universe of stocks. Several reasons are at play here, in our opinion. As discussed above, devices appear to have the government's target on their back. In addition to the newly proposed tax, several other regulatory efforts are under way that have a potential to damage devicemakers in the long run-- push for comparative effectiveness, more extensive clinical trials, product recalls, and investigations into marketing practices (for a detailed analysis of these issues click here). While concerning, these issues have taken an undue toll on the industry valuations, and these cash-flow machines represent compelling investment opportunities, in our opinion. Thus, three out of four of our best investment ideas come from the device and instruments space.

Our Top Health-Care Picks

 Top Health-Care Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Price/
Fair Value
Covidien $65 Narrow Medium 0.63
St. Jude Medical $51 Wide Low 0.76
Wellpoint $95 Narrow Medium 0.56
Zimmer $78 Wide Medium 0.68
Data as of 9-22-09.

 Covidien (COV)
The bulk of Covidien's products doesn't fall in the treacherous capital equipment category, yet the company was thrown in the same bucket with manufacturers of high-end and expensive instrumentation. Covidien has now had two years of operating as an independent company, yet its stock is still bouncing around its post spin-off level--an unfair treatment for the company that has made tremendous strides since it was able to take the reins of its capital-allocation decisions. Covidien's heavy investment in research and development, sales, and marketing is starting to bear fruit, as the company is re-establishing itself as an innovator and market leader. Yet, the market seems to be preoccupied with historic earnings per share trends, and placing too much emphasis on near-term struggles of its imaging business. In our view, an intense investment in its devices business has given the company a strong growth platform, and as sales momentum picks up, earnings expansion will follow.  

 St. Jude Medical (STJ)
As the health-care reform discussion reaches a fevered pitch with the unveiling of Senator Max Baucus' bill from the Senate Finance Committee, medical device companies like St. Jude Medical have felt a sudden frostiness now that Baucus is proposing an annual $4 billion medical device fee. We have often seen these types of legislator-industry negotiations water down the initial proposal, and we expect this new tax will eventually be whittled down considerably and then likely passed on to customers (hospitals and, ultimately, patients via higher insurance premiums). In the meantime, we do not think the external legislative debate has diminished St. Jude's competitive advantage. As one of only three major cardiac device makers, St. Jude offers life-saving therapies and exercises substantial bargaining power thanks to similar, but not completely identical products in its portfolio, as well as strong relationships with the medical practitioners who make the brand decision. Importantly, St. Jude is taking the lead in developing transcatheter ablation to cure atrial fibrillation through its sponsorship of the CABANA study currently under way. Considering there are more than 2 million Americans with atrial fibrillation and many are untreated because effective pharmaceutical options are limited, tapping into this market offers attractive longer-term growth potential. A recent meta-analysis of catheter-based ablation suggests this therapeutic approach is significantly more effective than drug therapy; we expect the comparative effectiveness of ablation in the CABANA study should also be favorable.

 WellPoint (WLP)
As health reform has taken over as the primary risk keeping managed care investors up at night, WellPoint has remained at the depressed valuations of 2008 despite a stabilization of its medical cost trends. We still think the shares are a bargain, as the market appears to be pricing in an unrealistically pessimistic reform scenario. The biggest threat to the MCOs would be the creation of a government-run insurance program that shares Medicare's administrative infrastructure and below-market provider rates. We don't think such a plan could garner enough votes to overcome a filibuster in the Senate. Most of the other proposals would be neutral to marginally positive for the MCOs, as the potential to add 46 million new customers who were previously uninsured makes up for possible business losses resulting from provisions such as a tax on high-value plans. Additionally, we think investors are protected on the downside by the value of WellPoint's soon-to-be-sold pharmacy benefit management business, its sizeable investment portfolio, and the fact that any legislation is likely to take five years or more to implement, during which time we expect WellPoint to generate significant free cash flows. 

 Zimmer (ZMH)
Uncertainty surrounding U.S. health-care reform has created an opportunity to invest in this wide-moat orthopedic firm's stock, as the shares remain below our worst-case reform scenario even after their recent run. As the top provider of knees and hips in the world, we think Zimmer remains in a great position to capitalize on long-term demographic trends, including the aging population in developed countries. Also, market share shifts related to increased regulatory scrutiny appear to have stabilized, and we'd expect those head winds to dissipate for Zimmer in early 2010, allowing it to return to mid- to high-single-digit growth rates. It is attractively priced, trading at a greater than 30% discount to our fair value estimate.

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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.