Our Outlook for Health-Care Stocks
With health-care reform finally materializing, the uncertainty overhanging health care should be lifted.
Quarter-End Insights
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- With health-care reform nearing completion, regulatory uncertainty surrounding health-care stocks should largely dissipate.
- Reform implications vary by sector, but the overall impact is largely neutral.
- Investors' focus should shift to industry fundamentals which appear attractive. Health-care stocks remain undervalued.
After nearly 12 months of deliberations and wild swings in the scope of proposals and public sentiment, health-care reform is about to become a law. Passed by the slimmest margin of support in the House of Representatives and signed into law by President Obama late March, the reform bill will transform the health-care system in the United States during the next few years, albeit to the lesser degree than originally stipulated by many.
We have been in the "moderate changes" camp since the initial proposals surfaced shortly after the 2008 presidential election (see our May 2009 issue of Healthcare Observer). We were skeptical that the "Medicare-for-all" plan had legs, instead suggesting that the new system will build off the existing platform with moderate changes (cuts to Medicare Advantage and an introduction of an individual mandate along with a community rating, for example). As a result, throughout 2009 we were by and large dismissive of fears that the majority of health-care sectors and companies would see their earnings power evaporate, and we maintained our stock valuations and, in general, bullish recommendations despite the great deal of uncertainty surrounding the industry.
To the contrary, the market seemingly priced in worst-case scenarios for many health-care companies as investors chose to abandon even the steadiest businesses because of their exposure to regulatory efforts. Now, as the reform details are more clear (and nowhere close to being destructive), health-care valuations should steadily improve as investors turn to fundamentals that remain strong.
Our brief description of the bill is available here. The key outcome of the reform from the investors' standpoint should be the infusion of more than 30 million previously uninsured individuals into the system. This incremental volume factors by a varying degree into every health-care sector's growth trajectory, providing a strong tailwind to the industry already benefiting from favorable demographic trends. Also importantly, the final bill excludes a government-run insurance option, which previously stoked fears of direct price negotiation between health-care firms and the U.S. government, a potentially damaging development to firms' profitabilities. The overall impact of many of the bill's provisions on individual companies is difficult to quantify precisely, but even in very unfavorable scenarios, our valuations by and large hold.
Industry-Level Insights
Pharmaceutical companies appear to be the net beneficiary of the reform. With the exception of the $85 billion fee the industry will pay during the 10-year period, most of the reform language appears favorable to drugmakers. The volume boost, a stronger patent protection for biologics, and a closure of the "doughnut hole" provide drugmakers with a number of opportunities but only a few threats. The new patient windfall is likely to be fairly equally dispersed across the industry, but a few companies could see a benefit on the margin line in addition to the revenue boost.
As it currently stands, many patients who have life-threatening conditions requiring drug treatment and are unable to pay for them receive subsidies from drugmakers. This holds particularly true for cancer, immunology, and rare-disease therapies. With patients fully insured post reform implementation, drug firms will be able to recover a noteworthy chunk of this lost profit, even if a patient is covered under the Medicaid program. Some of these savings will be applied toward the $85 billion fee which explicitly addresses patient-assistance programs. Companies that stand to benefit from this development include Novartis (NVS), with its cancer/rare-disease drug portfolio, and Roche (RHHBY), with its strong cancer franchise. Roche also appears to be on the right side of the generic legislation; with two thirds of its pharmaceutical sales attributable to biologics, a newly enacted pathway for approval of generic biologics looks favorable to the firm along with other biotech companies such as Genzyme and BioMarin (BMRN).
The volume impact for devicemakers is likely to be more muted. Many recipients of devices, particularly cardiac rhythm management products, are typically already covered under various government programs (two thirds of implants for knee replacements and 80% of CRMs are reimbursed under Medicare Part B) and weren't likely deferring procedures because of the lack of coverage. Reimbursement is largely a nonfactor for the purchasing patterns of other devices such as surgical tools; hospital decisions are based on the demand for surgical procedures, and this typically is not largely correlated with insurance coverage or the state of the economy.
The excise tax to be imposed on the device sector appears disproportionately harsh, as the industry is being hit with a fee comparable to the one for drugmakers despite representing only a fraction of the drug industry's size. That said, this fee will not come into effect for several years, which should give device companies ample time to devise operating strategies to offset its impact. We are anticipating most of this industry fee will be passed on to consumers via price hikes, and even if unsuccessful, devicemakers should only see a mild (ranging from low- to mid-single-digit) reduction to their valuations. We remain bullish on device firms such as Stryker (SYK) and Covidien .
Managed-care organizations will be negatively affected by reductions to Medicare Advantage reimbursements, though we expected these cuts to occur even in the absence of comprehensive reform. Some of the more profitable MCOs could be negatively affected by explicit limits on gross margins, though they should be able to offset this effect by reclassifying some administrative costs as medical costs. We expect industry taxes and fees to generally be passed on to customers. On the positive side, MCOs stand to benefit from increased demand for individual insurance. Companies that participate in Medicaid managed-care programs will benefit from expanded Medicaid eligibility.
We expect drugstores and pharmaceutical and medical supply distributors to be net beneficiaries of the legislation, as they gain from increased demand for health-care goods, especially prescription drugs. Diagnostic companies and makers of generic drugs should also see higher utilization rates, providing strong support to these industries' growth.
Our Top Health-Care Picks
Our health-care top recommendations cover most of the industry's sectors, ranging from pharmaceuticals to managed care. We maintain that many of these firms remain undervalued even as the appetite for health-care stocks has already improved and the share prices of many of them rallied in the past few months.
| Top Health-Care Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/Fair Value | |
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| Novartis |  | $71.00 | Wide | Low | 0.77 |
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| Abbott Laboratories | | $68.00 | Wide | Low | 0.79 |
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| Thermo Fisher Scientific | | $73.00 | Narrow | Medium | 0.70 |
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| Stryker Corporation | | $72.00 | Wide | Low | 0.81 |
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| UnitedHealth Group | | $50.00 | Narrow | Medium | 0.66 |
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| Data as of 03-25-10. |
Novartis (NVS)
Novartis is one of the best-positioned companies for growth within the large pharmaceutical industry. Novartis is in front of all the positive tailwinds moving the group during the next decade. In particular, Novartis holds the third-best market share in emerging markets, which should help the company capture strong future demand from these countries. The company's entrenched vaccine platform should benefit as pricing power has returned to new vaccines. Novartis' generic division, Sandoz, should benefit from patent losses on major blockbuster drugs as well as strong international demand for generic drugs. Further, the company's strategy of targeting unmet medical needs with its drug pipeline should yield several drugs with strong pricing power. Considering the company's relatively modest patent exposure, Novartis should see fairly stable growth during the upcoming years relative to its competitors.
Abbott (ABT)
Unlike many of its industry peers, Abbott faces only a few patent losses during the next five years and is well-positioned to ride a strong tailwind of demand for its products. Taking advantage of many drug firms' decisions to leave primary-care indications such as cardiovascular disease, Abbott is becoming a leader with several new drugs to treat heart disease. We believe the less competitive environment should bode well for Abbott. Most importantly, we expect continued strong demand for the company's leading drug, Humira. With drug penetration in rheumatoid arthritis reaching only 20% and even less in psoriasis and Crohn's disease, Humira could expand at double-digit rates for the next four years. Abbott's strong competitive position in nutritionals and diagnostics reduces the volatility of its earnings and creates additional avenues of growth.
Thermo Fisher Scientific (TMO)
Thermo Fisher weathered a tough 2009 better than many of its peers, as its one-stop-shop business model and sizable recurring revenue shielded the company from capital-spending freezes across its end markets. The company hasn't been immune to the downturn, but its superior access to customer channels, its broad product lineup, and the value it provides to customers has allowed the firm to survive the storm and capture market share. Its relative financial stability also allowed Thermo Fisher to spare many of its strategic investment initiatives, particularly its research-and-development budget. Furthermore, the company was also able to accelerate its restructuring program, which should provide earnings momentum once revenue growth returns in 2010. Thermo Fisher will likely use its sizable accumulated cash and robust free cash flows to intensify its acquisition strategy and share buybacks in the upcoming year.
Stryker (SYK)
Stryker's orthopedic implant business has been chugging along quite nicely. In our opinion, the most striking part of this performance is that Stryker's U.S. operations are leading the charge, even when excluding negative foreign currency effects in international markets. Despite the recession that has constricted elective surgery growth, Stryker's product set appears to be in high demand in the U.S. The balanced success of Stryker's orthopedic product lines in 2009 has been a welcome change after several years of underperformance in its hips business. In particular, we are happy to the see the firm bounce back from the Trident hip recall in 2008. We've also been impressed with Stryker's spine business, as the firm is gaining steam in this key niche. This momentum looks promising for new product introductions, such as the two artificial discs Stryker hopes to launch by the end of 2010.
UnitedHealth (UNH)
UnitedHealth's stock has doubled from its lows, but we still see significant value in this industry-leading managed-care organization. UnitedHealth's best-in-class auxiliary businesses and unmatched scale should enable it to grow faster than its industry, which already benefits from the tailwind of health-care spending growth. The threat of comprehensive health-care reform has kept investors wary of the managed-care sector, but this risk should now dissipate as reform in its current form should have only a modest impact on UnitedHealth's future earnings. Reform aside, underwriting results appear to be stabilizing, administrative costs seem to be under control, and UnitedHealth continues to throw off massive free cash flows.
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