Our Outlook for Health-Care Stocks
The fourth-quarter should see health-care demand improve from its suppressed levels.
Quarter-End Insights
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- Health-care demand should come back on line in 2011.
- We don't anticipate reform repeal following midterm elections.
- The merger and acquisition landscape likely will remain active.
- Valuations should improve, and the sector offers a number of compelling investment ideas.
During the past year, the health-care sector tested widely believed notions of its recession resistance. While broad spending on health care held up relatively well in the midst of the last recession, the sector has fared worse than what we anticipated as the macroeconomic environment started to improve. Personal consumption of health care on a per capita basis grew a measly 0.3% year over year in the first quarter, 0.2% in the second quarter, and 0.9% in the third quarter of 2010 (data from Bureau of Economic Analysis)--the longest streak of such low quarterly growth in decades.
Moreover, personal spending on health care has been persistently sliding since the early 2000s, and the current environment is starting to resemble the constrained health-care spending environment of the early 1990s during the rise of HMOs and capitated plans. The HMO model placed a primary-care physician as a gatekeeper. High unemployment rates and rising out-of-pocket costs became the gatekeepers of 2010.
The Key Drivers of Health-Care Spending Weakness
High unemployment is the main culprit for the weak year-over-year health-care consumption. 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 in the first half of the year (data for 2010 is not available). The expiration of COBRA subsidies was particularly damaging to health-care demand, as this put an undue burden on individuals to fund out-of-pocket costs before they were able to enroll into Medicaid, contributing to the deferral of even basic medical procedures.
Moreover, we have seen a dramatic shift during the past two years from private insurance to Medicaid, putting downward pressure on health-care expenditures (Medicaid reimburses at a lower level than private payers). Medicaid enrollment reached 15.7% of the total population in 2009, nearly double its 1987 level. While high unemployment contributed to bloated Medicaid ranks, we have also seen an increasing number of businesses dropping health-care coverage entirely, pushing their labor force into government programs. Skyrocketing premiums for commercial insurance (implemented ahead of reform restrictions) pushed an increasing number of individuals into plans with higher deductibles and co-pays, which manifested itself in slowing demand for physician visits even in this typically less price-sensitive population.
Patient Demand Should Come Back in 2011
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. However, while 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. Demand for health-care services isn't as inelastic as it has been historically. However, this behavioral change isn't likely to persist unless the cost-sharing structure is permanently altered so that the patient bears a greater portion of overall costs (in contrast to the current environment, where a shift of costs to individuals is more a product of high unemployment rates). We still believe sector fundamentals are strong and the secular-demand story is far from broken.
We don't anticipate a major ramp-up in health-care demand, but the situation is bound to improve from current, severely depressed levels as a result of a number of factors. There is strong, pent-up demand for health-care services caused by several quarters of procedure deferrals, and some of this volume could come back on line as early as the first half of 2011. Patient admission rates for nonelective procedures are starting to slowly improve, and this stabilization is even evident for some elective procedures (though deferrals of these procedures will likely continue until we see a broad improvement in unemployment). The removal of co-pays for preventative care should boost demand for lab testing in the first quarter of 2011. Finally, if the economy (and particularly the job market) shows any sign of improvement, the uninsured trend is likely to reverse.
We Don't Anticipate Reform Repeal
While the Republican Party was able to obtain a majority in the House and chip away at the Democratic majority in the Senate during the midterm election, we don't consider the fate of health-care reform in danger even as the recent federal court ruling declared the individual mandate unconstitutional. We believe the constitutionality of the mandate will eventually be settled by the Supreme Court and, assuming the court decides to take on this case, the resolution is unlikely to occur in the near future. Considering that rendering the mandate unconstitutional will likely cause the insurance industry to withdraw its support for the bill, which in turn will threaten the fate of expansion in coverage and community rating (both very popular provisions of the bill), the Supreme Court may take a path of least resistance and punt on the issue. We are not in a position to make a judgment call on the court's potential decision, but we note that potential negative ramifications of the insurance companies' withdrawal of support could sway the court's decision in favor of the Obama administration.
If the newly elected House repeals the Patient Protection and Affordable Care Act outright, this event will likely be a symbolic gesture, as Republicans lack a filibuster-proof majority in the Senate and President Obama would most likely veto any move that takes aim at the bill. An attempt to partially repeal the bill or attack certain provisions (such as the individual mandate) is a more likely scenario. Republicans may also try to suffocate the bill by cutting off funding for certain provisions or rejecting some at the state level (setting up insurance exchanges, for example). These measures, however, are still unlikely to garner enough votes to pass or may cause budgetary constraints for states that chose to opt out of government funds. If Democrats lose the Senate and the White House in 2012, it is plausible that the repeal of the PPACA will once again become a political priority for the GOP. But by that time, many of the bill's most popular provisions will have already been implemented (some have already gone in effect), and repealing the bill would effectively remove insurance from 30 million-plus people scheduled to be covered by 2014, which is not likely to be a political risk Republicans would want to bear. Adding costs that would be required to unwind the bill makes the likelihood of its repeal less likely.
Revenue Growth Is Critical for Valuations to Improve
The combination of a higher margin of safety required to hold health-care stocks resulting from regulatory concerns and fears of deflationary pricing (which influences the P/E component of valuation equation) and stagnant volume suppressing future earnings growth (E) are main factors behind cheap valuations across the health-care sector. The conservative multiple bestowed by investors on health-care stocks is in part attributable to the lack of clarity surrounding reform. Our take is that reform in itself won't materially affect most health-care firms.
However, the regulatory environment overall is getting stricter as the Food and Drug Administration is growing more risk-averse. This will likely result in higher thresholds for drug and device approvals, but this dynamic is not likely to be as disruptive to business models as valuations seem to imply. Comparative effectiveness programs could also disrupt the long-term payer-provider dynamic, but these efforts are only in their infancy and their viability is questionable.
Overall, we contend that the uncertainty has subsided significantly during the past year, yet valuation multiples have yet to reflect this. The marketplace appears to be extrapolating near-term suppressed revenue growth onto long-term projections for the sector, and we disagree with this practice. As noted above, we believe a relatively cataclysmic demand trend isn't likely to persist far beyond 2010, and we should see a recovery in the U.S. in 2011. Long-term demographic trends remain favorable, and emerging markets should provide a strong growth pathway that offsets somewhat-maturing demand in the U.S. and Western Europe. Revenue growth commencing in 2011 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 expect valuations across the sector should rebound once the uncertainty clears and earnings growth returns.
M&A Landscape Likely to Remain Active
We expect M&A activity will remain a vital attribute of the 2011 environment. Big Pharma firms will be keen on replacing the revenue stream that will be lost to generic competition during the next several years. Crucell , ZymoGenetics, King Pharmaceuticals , and Genzyme (among others) have either already been acquired or in the process of being acquired by Big Pharma firms in 2010. Robust pipelines in niche therapeutic areas and emerging-markets exposure are two themes that increasingly appear in analyzing acquisition targets. These two go hand-in-hand with the rhetoric coming from the acquirers' camp. Niche diseases provide pharmaceutical firms with drugs more resistant to competition, pricing pressure, FDA's risk-aversion, and patent exposure, while emerging markets offer virtually untapped growth opportunities. Meanwhile, cost-cutting and synergies still factor into buying decisions, as the patent cliff still looms and earnings of major pharmaceutical firms will still take a noteworthy hit in the upcoming years.
Emerging markets and innovation are also key themes for medical devices and instruments, albeit on a lesser scale. We see a continuing stream of deals focused on technology as well as product and geographic gaps that are unlikely to cross the $5 billion threshold. As device firms, both large and small, are likely to see increasing regulatory scrutiny, innovation--often obtained through bolt-on acquisitions--will become even more critical for their ability to grow and sustain competitive advantages. In other industries, themes of consolidating fragmented marketplaces and expanding market shares are more prominent; we see more activity in managed care, generics, medical distribution, and diagnostics driven by consolidation.
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 | |
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| Medtronic |  | $46.00 | Wide | Low | 0.78 |
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| Abbott Laboratories | | $68.00 | Wide | Low | 0.71 |
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| Covidien | | $67.00 | Narrow | Medium | 0.68 |
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| Roche | | $57.00 | Wide | Medium | 0.64 |
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| WellPoint | | $95.00 | Narrow | Medium | 0.59 |
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| Data as of 12-16-10. |
Medtronic (MDT)
As the largest pure-play medical-device firm, Medtronic manages to maintain an even keel as a result of its diversification. Most recently, the cardiac rhythm management and spinal businesses have slowed down as patient volume has fallen off, Medtronic's products have aged, and managed care has begun to push back on reimbursement. Now, Medtronic is poised to launch its new product cycle, kicking it off with the recent European launch of the first-to-market MRI-compatible pacemaker. Medtronic is also set to roll out its next-generation spinal products this year, which should solidify its leadership position in that market. In the meantime, the firm has focused on what it does best--innovating internally and augmenting its product lines with acquired technology. All of these initiatives should generate healthy cash flows over the longer term, even as product cycles in each segment wax and wane.
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 the primary-care indications like 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.
Covidien
Fiscal 2010 was challenging for Covidien as struggles in its pharmaceutical unit offset a strong performance across the bulk of its device product lines. Comparisons will remain tough in pharmaceuticals in the early part of 2011, but the company's overall growth prospects are compelling considering a wave of new product introductions and likely share gains in vascular treatment following the integration of recently acquired ev3's operations. The company should see an uptick in elective procedures as surgery deferrals witnessed during the past few years are unlikely to sustain throughout 2011. With emerging markets also fueling growth, we expect strong revenue momentum despite likely continuing struggles in pharmaceuticals. A shift in product mix toward devices and the firm's focus on efficiency supports our margin-expansion and double-digit earnings growth forecast; we continue to recommend Covidien's shares.
Roche (RHHBY)
The long patent life of Roche's portfolio puts it among the biotechs least exposed to generic competition. Patents don't begin to expire until 2013--when Rituxan loses protection in Europe--and management is implementing strategies to counteract future competitive pressures that we think will enable the firm to achieve 9% five-year earnings growth. Subcutaneous versions of Roche's blockbuster antibodies are in the works, which could reduce hospital costs and add to convenience. Novel drugs are in development that could improve on the efficacy of its current products or represent new, personalized treatments for cancer patients. Roche also has a solid pipeline beyond oncology, including drugs to treat schizophrenia and hepatitis C. With the Genentech integration starting to yield synergies, we think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages.
WellPoint (WLP)
Despite rebounding significantly from its lows in late 2008 and early 2009, WellPoint's stock remains undervalued, in our opinion. The company generates significant free cash flow, and health-care spending growth provides a mid-single-digit tailwind to future earnings growth. With the passage of comprehensive health reform, uncertainty surrounding WellPoint has diminished substantially. We don't think the new law will have a particularly negative impact on WellPoint's future earnings. Commercial medical cost ratios will come under pressure from regulated minimums starting in 2011, but we estimate that the new rules are unlikely to raise consolidated medical cost ratios by more than 100 basis points. On the other hand, WellPoint has low selling and administrative expenses, and it has the chance to cut costs further through systems integration and redesigned broker commissions.
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