Our Outlook for Health-Care Stocks

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• The weak economy and increasing number of uninsured pushed health-care spending growth to its lowest level in decades. 
   
• Health-care stocks continue to retreat because of the lack of near-term catalysts for volume growth. Health care remains among the two most undervalued sectors in the Morningstar universe.
    
• Merger and acquisition activity is strong, and we expect more consolidation.

We considered health-care reform as fairly benign for the sector's long-term growth and profitability prospects, and we were anticipating a rally among health-care stocks following the bill's passage, as cheap valuations appeared to be the product of investors' anticipation of heightened regulatory scrutiny and uncertainty. Unfortunately, any potential boost from the removal of regulatory overhang was wiped out by the unprecedented slowdown in demand for health-care goods and services as a result of macroeconomic concerns.

Although we've been observing a slowdown in health-care spending during the past decade (the gap between growth in health-care expenditures and gross domestic product growth has been shrinking persistently since the early 1990s), we still viewed health care as the last target for consumer thriftiness, given that this sector's growth largely held up in prior economic recessions. This time appears to be different, and the recession-resilient tag no longer seems applicable for health care. In real dollars, personal consumption expenditures on health care declined sequentially by 0.1% in the first quarter of 2010 and increased a meager 0.2% in the second quarter. On a per capita basis, health-care spending declined 0.2% in the first half of 2010 (data from the Bureau of Economic Analysis).

We see a number of factors that are responsible for health-care expenditures increasing at their slowest clip since 1959, according to the BEA. The U.S. Census Bureau stated high unemployment ranks pushed the number of uninsured to 50.7 million last year, spiking by 4.3 million from 2008 levels. This means that 16.7% of the population lacked health-care coverage in 2009, and this number most likely expanded in 2010 with the expiration of COBRA subsidies and a continuing weak job market.

Furthermore, we saw a dramatic shift from private insurance to government programs such as Medicaid, putting downward pressure on health-care expenditures. Medicaid enrollment reached 15.7% of the total population in 2009, nearly double its 1987 level. Finally, skyrocketing premiums for commercial insurance (implemented ahead of reform restrictions) pushed an increasing number of individuals into plans with higher deductibles and copays, which manifested itself in slowing demand for physician visits. With an increasing number of individuals forgoing basic medical care such as preventative services, nearly every health-care company in our universe reported a slowdown in volume.

According to Morningstar Indexes, health care is one of the worst-performing sectors year to date, returning 0.58% and ahead of only energy and utilities. This is despite the intensifying level of merger and acquisition activity in the first half of 2010 and apparently the result of increasing investor dissatisfaction with the industry's growth prospects. Although top-line growth in 2010 for many health-care companies has been disappointing so far, we are not ready to carry this weak performance forward into our long-term projections for the sector. We still believe sector fundamentals are strong, and the secular-demand story is far from broken.

Even though we aren't anticipating a major ramp-up in health-care demand until at least 2011, we see potential catalysts on the near-term horizon. For example, we believe there is strong, pent-up demand for health-care procedures and that some of this volume, particularly for more costly procedures, could return in the fourth quarter of this year. (As deductibles become exhausted through routine visits, customers will have the incentive to undergo more expensive procedures.) In addition, the removal of copays for preventative care should boost demand for lab testing in the first quarter of 2011. Finally, if the economy (and particularly the jobs market) shows any sign of improvement, the uninsured trend is likely to reverse. Top-line growth should trigger significant earnings expansion, as most health-care companies spent a good portion of the past few years taking costs out of their operations and now stand to leverage their leaner infrastructures into strong bottom-line growth.

We anticipate the recent wave of acquisitions to persist throughout 2010, in part because of depressed valuations across the sector. Large pharmaceutical companies, in particular, are likely to remain active. We've seen a flurry of recent activity in the drug industry, most notably a saga surrounding  Genzyme  and takeouts of two smaller biotech firms  Zymogenetics  and  Crucell . With big pharma on the prowl to replace the revenue stream that will be lost to generic competition during the next few years, biotech firms with intriguing drugs in the pipeline are likely to find themselves as acquisition targets. Our top acquisition candidates in the biotech industry include  Vertex (VRTX) and  Human Genome Sciences . We also see potential for more acquisitions in the device and diagnostics market.  Mettler-Toledo (MTD),  PerkinElmer (PKI), and  Beckman Coulter  are lead stand-alone acquisition candidates in the medical-device market, while  Boston Scientific (BSX) is likely to sell its neuromodulation and neurovascular businesses to the likes of  Stryker (SYK) and  Johnson & Johnson  (JNJ).

 

Industry-Level Insights
Pipeline events, product portfolios, and cost-cutting will remain prominent themes for pharmaceutical companies in this quarter. Most firms already took a reform-related earnings hit, and income statements will look tidier in the third quarter. We anticipate strong results considering the backdrop of weak health-care demand, as currency headwinds and restructuring costs abate. The industry has annualized most of its significant patent losses but is only starting to see benefits from massive restructuring programs undertaken during the past 12 months. On the new-drug front, data for J&J's rivaroxaban and  Merck's (MRK)TRA are expected during the next few months; both drugs have blockbuster potential if approved.

Medical-device makers and diagnostic companies are likely to continue seeing weak top-line growth, but the lackluster volume appears to be already baked into valuations of most firms in this industry. Thus, any potential near-term catalysts noted above could give these stocks strong momentum. Meanwhile, the downside is limited, as many of these high-quality, moat-worthy firms trade at levels consistent with our worst-case or even doomsday valuation scenarios. We don't believe demand for health care is permanently dead, and we continue to recommend shares of many of these companies.

Our Top Health-Care Picks
Our top health-care recommendations cover most of the sector's industries, ranging from pharmaceuticals to managed care. These firms remain undervalued as the appetite for health-care stocks has yet to improve despite favorable long-term dynamics.

Top Health-Care Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/Fair Value
Baxter		$67.00	Narrow	Medium	0.71
Abbott Laboratories		$68.00	Wide	Low	0.77
Covidien		$67.00	Narrow	Medium	0.59
Thermo Fisher Scientific		$73.00	Narrow	Medium	0.66
UnitedHealth Group		$50.00	Narrow	Medium	0.70
Data as of 09-21-10.

 Baxter  (BAX)
We remain impressed by the firm's new products and pipeline prospects. In medication delivery, Hylenex for subcutaneous injections and new nutritional products are starting to boost the segment's growth. In renal, the company's focus on home dialysis could pay off in 2011 and beyond with the expansion of peritoneal dialysis to more eligible patients and a new product launch in home hemodialysis. Both options would greatly improve convenience for end-stage renal disease patients eligible to receive treatment outside clinics, and expanded use of peritoneal dialysis could actually reduce overall health-care costs, making it a potential winner. Beyond 2014, we think Baxter's BioScience segment looks highly promising, and the firm's long-term pipeline may include game-changers in Alzheimer's disease and Type I diabetes.

 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 increase 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 for growth.

 Covidien  
Covidien's investment in medical devices is yielding a number of promising product launches and technological advancements. The company's research-and-development prowess that had wilted under the Tyco roof is starting to flourish again, and Covidien is re-establishing itself as a powerhouse in surgical instruments. The company's segments outside devices face a challenging near-term environment, but Covidien is taking steps to return these businesses to value accretion in the near future. With sales momentum ramping up, bottom-line-oriented investors should be amply rewarded as a favorable product mix and operational leverage should result in strong double-digit earnings growth during the next few years.

 Thermo Fisher Scientific (TMO)
A revenue recovery hasn't fully materialized for Thermo Fisher in 2010, as weak health-care spending and tight pharma budgets offset robust demand from industrial and emerging markets. The second half of the year doesn't offer many positive catalysts, as lukewarm demand for health care is likely to persist until the broader economy improves. However, we continue to recommend Thermo Fisher's shares, as long-term competitive dynamics and the firm's growth trajectory (both revenue and earnings) remain compelling. Thermo Fisher's superior access to customer channels, the firm's one-stop shop value it provides to customers, and its leading exposure to emerging markets should yield above-market long-term revenue growth. Meanwhile, an ongoing commitment to operational improvement, increased sourcing from low-cost regions, operating leverage, and robust share buybacks should generate strong earnings momentum once top-line growth returns.

 UnitedHealth Group (UNH)
Although UnitedHealth's stock has doubled from its lows, we still see significant value in this industry-leading managed-care organization. UnitedHealth's best-in-class auxiliary businesses and unmatched scale advantages should enable it to grow faster than its industry, which already benefits from the tailwind of health-care spending growth. The threat of earnings erosion from the health-care reform bill has kept investors wary of the managed-care sector, but we think the risk has been overblown. We expect the legislation to have only a modest impact on UnitedHealth's future earnings, as Medicare cuts and limits on profitability are offset by significant new membership. Reform aside, underwriting results appear to be stabilizing, administrative costs are under control, and UnitedHealth continues to throw off massive free cash flows.

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