Our Outlook for Health-Care Stocks

• Health-care demand is gradually returning. 
   
• Big Pharma is entering the patent cliff, but valuations should improve.
   
• Medical device regulation might not be as punishing to the sector as originally thought.
   
• Merger-and-acquisition volume should accelerate.

As expected we saw the health-care spending environment improve slightly in 2010, although the sector has yet to return to its pre-recession growth. With macro trends improving and uncertainty over health-care reform-related costs subsiding, we think there are attractive investment opportunities across a number of sectors in health care.

Big Pharma's 2011 Expectations Are conservative, but Valuations Are Compelling Across the Board 
The peak of patent expirations will begin in 2011, with several major blockbusters losing exclusivity.  Pfizer's  (PFE) Lipitor, the top-selling drug in the world, will lose patent protection in November 2011 in the U.S. and around the same time in most other major markets. While  GlaxoSmithKline (GSK) still expects to keep its patent protection on Advair through 2017 based on device patents, we expect generic competition will begin to emerge in 2011, which will bring down another drug currently among the top-five bestsellers.

Despite patent losses for both of these drugs in developed markets, we expect they will retain over 10% of their total sales in emerging markets, where brand name is just as important as patent protection. Given the massive sales of these drugs, this fraction translates into over $1 billion for each drug. Nevertheless, patent losses will blunt cash flows. On top of these bellwether drugs, several other key blockbusters lose patent protection in 2011. The loss of these drugs will force drug firms to cut costs while continuing to develop the next generation of blockbusters.

Facing major patent losses and with a lack of new products emerging from pipelines, all Big Pharma firms have begun to sharply cut costs. Overall, we expect the industry's bottom line to benefit from major improvements in efficiencies. Based on the bloated infrastructures that the industry is bringing to the patent cliff, we believe the majority of cost cuts will improve margins without damaging the core competencies of these organizations.

Most of the Big Pharma group posted in-line results for 2010, but well-documented issues with   Johnson & Johnson (JNJ) caused us to lower our fair value estimate slightly for this pharmaceutical giant, although we continue to recommend the stock. Setbacks--slowing nonbranded drug sales and weaker-than-expected device sales due to manufacturing problems--weighed on the company, but we remain comfortable with the firm's long-term competitive positioning, particularly given its lack of major patent expirations.

Across the entire Big Pharma group, a theme of conservative guidance emerged, and in most cases the guidance was below our expectations. We believe drug companies are setting conservatively low bars as we think that firms still feel somewhat uncertain about the full impact of U.S. health-care reform. In 2011 the drug industry is responsible for paying an industry fee of $2.5 billion as well as rebating 50% of the cost of drugs purchased in Medicare Part D's gap coverage. We estimate these costs will cut Big Pharma firms' earnings by 1%-6% with the magnitude depending on each individual company's focus on branded-drug sales. While U.S. health-care reform is causing a near-term drag on drug companies' earnings, over the long run, we expect the reforms will be a net neutral to the group as mandated health insurance starts in 2014, likely bringing increased demand to offset the new fees.

Large pharma performance has been subpar for quite some time, but we expect the market will begin to reward the drug industry with a higher earnings multiple in 2011 as growth prospects begin to improve following massive patent losses. With cost-cutting mitigating some of these losses, earnings declines will be more manageable for most firms. Increased clarity on the impact of U.S. health-care reform in 2011 should largely remove the uncertainty overhang on drug stocks, and we expect the incremental costs of U.S. health-care reform will cut only 1%-3% off the top line with a slightly bigger impact to the bottom line. Our favorite recommendations in the Big Pharma space include  Abbott (ABT) and Pfizer.

FDA's Initial Changes to 510(k) Device Regulations Could Indicate a Friendlier Stance Toward Devices
The Food and Drug Administration recently released its first round of changes to the 510(k) approval process, which is a commonly used regulatory pathway for many medical devices. Most of them appear minor in terms of the potential costs to the industry, and some of the worst fears surrounding the approval process are becoming less likely.

The FDA appears to have listened to industry concerns and deferred decisions on controversial initiatives until the Institute of Medicine can weigh in on those matters in the summer. The IOM's recommendations on these controversial issues--such as creating a Class IIb category that has the potential to significantly hurt the financial prospects of many device firms, including orthopedic firms--are expected to heavily influence the FDA's final changes to the approval process (the cardiac device makers such as  St. Jude Medical ,  Medtronic (MDT), and  Boston Scientific (BSX) are less vulnerable to some of the potential changes because the majority of their devices are already subjected to more rigorous and costly regulatory requirements). While not guaranteed to be positive, we are encouraged by the agency's apparent willingness to consider the feasibility of proposed changes for industry players before finalizing the regulations.

Combine that action with President Obama's recent stance on trying to enact appropriate regulations to protect the population but still promote economic growth, and we remain hopeful that our harsh reform-related scenarios for orthopedic device firms such as  Smith & Nephew (SNN),  Stryker (SYK), and  Zimmer (ZMH) are becoming less likely. One of the biggest concerns of industry players is that new legislation could stifle new technology introductions by lengthening timelines and increasing costs associated with new device approvals. While they are not completely out of the woods, industry players appear to have made their voices heard by regulators, which could bode well for them in future regulatory changes. Even if reform has a more drastic negative effect on the industry than we're anticipating, the ultimate impact on near- and long-term earnings growth should be minimized by strategies to grow revenue in underpenetrated emerging markets, alter capital allocation, and aggressively cut costs in anticipation of some of the upcoming changes.

Meanwhile, device firms have started to turn the corner operationally, buoyed both by the end-market demand returning but also by weak comparisons. Industrywide internal growth targets for 2011 also support our expectations of a recovery, although we note that management teams have erred on the conservative side with their assumptions and are seemingly unwilling to bet on a more robust economic recovery and end-market demand.

Nonetheless, the market has cheered the news of the device industry returning to growth, pushing shares of most device companies into 4- and 3-star territory for the first time in several quarters. We still think shares of companies like Medtronic and Zimmer are undervalued, but the upside is less attractive now.

Our 2011 Outlook for Mid-Tier MCOs Has Proven to Be Conservative
We have been raising our fair value estimates for most of the mid-sized managed care organizations we cover, as management outlooks for 2011 earnings have fallen generally above our expectations. This has important long-run implications since several key components of the Patient Protection and Affordable Care Act take effect this year. We raised our fair value estimates for  Humana (HUM) (in part due to the firm retaining its TRICARE contract),  Coventry ,  Health Net , and  Centene (CNC).

Two primary factors caused us to underestimate 2011 earnings. First, it appears that we overestimated the impact of health reform's minimum commercial medical cost ratio (MCR) requirements on smaller managed care companies. For the purposes of enforcing the health-reform legislation, MCRs will be calculated and applied in a way that is substantially different from what managed care organizations normally report, which has made it difficult to nail down the precise impact of the new MCR floors. We believe one particular aspect of the calculation methodology, the "credibility adjustments," will mitigate the impact of the MCR floors on smaller managed care organizations to a greater extent than we previously realized.

Beyond this technical point, our long-term concerns about the lack of economic moats surrounding mid-sized managed care organizations may have caused us to be overly conservative in our near-term assumptions for these companies. Interestingly, the two narrow-moat managed care companies,  WellPoint (WLP) and  UnitedHealth (UNH), both issued earnings outlooks that were below our expectations. The credibility adjustments are less relevant for these larger companies, and we also may have been somewhat less conservative in modeling 2011. Even so, we believe our earnings estimates will still be attainable.

While not reflected in our valuations, we believe there is another theme that could become more prevalent in 2011 and beyond for MCOs: mergers and acquisitions. Deals were largely absent in the industry last year given a reluctance to irritate regulators, but with public pressure subsiding, MCOs will increasingly look toward acquisitions to offset pressures brought on by health-care reform. Consolidation is the key to reducing administrative costs in the managed care sector over the long run. Consolidation could also help to lower the growth rate of health-care spending, as larger MCOs exert greater bargaining power over health-care providers. In our opinion, regulatory concerns and depressed valuations of potential acquirers have prevented major acquisitions in the past two years. We see these factors beginning to turn, which makes M&A increasingly likely in 2011.

 

M&A Intensifying Across the Board
After several months of gridlock, the boards of  Sanofi-Aventis (SNY) and  Genzyme  have unanimously agreed upon Sanofi's offer of $74 in cash plus one contingent value right, or CVR, per share of Genzyme. This marked the first mega-deal of 2011.  Danaher's (DHR) acquisition of  Beckman Coulter  for $6.8 billion indicated to us that the M&A activity will not be limited to the biopharmaceutical space, and improved macro prospects for the sector will result in a broad consolidation wave.

Big Pharma will likely be the main acquirer in 2011, as this group needs to propel long-term growth in the face of massive patent losses and relatively poor R&D productivity, and we expect firms will redeploy their strong cash flows for biotech acquisitions.  Biogen-Idec (BIIB) tops our list of likely acquisition targets in 2011, as the firm is renewing its focus on its strength in neurology, making Tysabri a safer, more personalized MS therapy, and advancing several late-stage pipeline candidates. Other biotech firms that we think could be attractive targets include  Seattle Genetics  and  Human Genome Sciences .

We believe life science players like  Thermo Fisher (TMO) will also be very active on the deal front and set their sights on firms with emerging-markets presence or applied technologies. We still think smaller life science players like  Mettler-Toledo (MTD) and  PerkinElmer (PKI) can woo potential acquirers with their strong positions in various instrumentation niches, though their current stock prices might make deals too expensive. Firms with a strong molecular diagnostic presence, like  Qiagen (QGEN), could also show up on takeout radars.

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
Medtronic		$46.00	Wide	Low	0.81
Abbott Laboratories		$68.00	Wide	Low	0.70
Covidien		$67.00	Narrow	Medium	0.77
Roche		$49.00	Wide	Medium	0.73
WellPoint		$95.00	Narrow	Medium	0.70
Data as of 3-23-10.

 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 support our margin-expansion and double-digit earnings growth forecast.

 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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