Our Outlook for Health-Care Stocks
While we remain bullish on the sector, health-care growth depends on the economy.
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- Weak patient volumes are likely to persist, providing a headwind for most health-care companies. Nonetheless, thanks in large part to easy comps and a weak dollar, our forecast calls for moderate revenue and earnings growth.
- Changes on the regulatory landscape could threaten device companies. Damage, however, is likely to be less punitive than what the market anticipates, and device stocks present compelling investment opportunities.
- M&A activity is likely to remain strong as health-care firms are flush with cash. We are somewhat skeptical that the Medco/Express-Scripts deal will gain regulatory approval.
Resilient Unemployment Levels a Key Culprit to Low Patient Volume
This may sound like a broken record, but the return of demand for non-acute health-care services appears to be directly tied to the improvement in the macro environment. A fairly muted economic recovery and stubborn unemployment levels have so far successfully suppressed any sort of pickup in demand for health-care services (particularly against the backdrop of the easy comps of 2010).
With a larger portion of total health-care costs borne by a patient (due to the sizable number of uninsured individuals as well as a trend toward greater out-of-pocket costs for commercial insurance plans), demand for health care has become more cyclical than in the past. A significant boost to consumer sentiment and a reduction in unemployment will be seemingly necessary to see a recovery in health-care consumption.
Hospital patient volume is a key barometer of consumer sentiment as it pertains to health care, and the numbers weren't encouraging in the second quarter: The adjusted admission growth among the top publicly-traded hospitals clocked in at a pedestrian 0.3% year-over-year increase. Moreover, surgical procedures (both inpatient and outpatient) have barely moved so far in 2011 despite a drastic volume decrease seen in 2010, mainly as a result of the continuing deferral of elective procedures. This dynamic has lasted much longer than we were anticipating, postponing recovery for many firms reliant on surgical procedure volumes, particularly orthopedic device makers that count on elective procedures for the bulk of their growth. A weak patient volume also manifested itself in stagnant demand for preventive care: Diagnostic test volume in the second quarter and year-to-date reported by both Quest Diagnostics (DGX) and LabCorp was virtually flat year-over-year.
Weak volume is one part of the equation, but similarly weak pricing has also factored in the overall lackluster growth. A payer mix tilted toward Medicaid is the main culprit: As Medicaid tends to be the "stingiest" payer and membership in this program remains at historically high levels, the P component of the total spending equation remains depressed.
We have seen some positive signs, coming mainly from improving year-over-year commercial insurance enrollment trends (albeit aided notably by easy comps). Commercial enrollment growth tends to lag reductions in unemployment; with unemployment levels below the peak, commercial membership grew 1.2% year-over-year in the second quarter. While a positive, that number isn't overly inspiring, considering that total commercial enrollment was down 4% from its peak in 2006 to 2010, according to the Census Bureau.
All that said, most health-care firms should still post positive top-line growth in the second half of the year, buoyed largely by easy comps and a weak dollar. The latter dynamic is particularly favorable for multinationals with a large fixed cost base in the U.S. While this top-line expansion is somewhat artificial, it is also needed for a sector desperate for growth. With valuations once again attractive (as momentum has been sucked out of the sector), even a mild uptick in revenue is welcome news. However, a broad economic improvement will remain the key catalyst for health-care stocks.
Regulatory Environment Remains Tough for Device Firms
The latest Institute of Medicine recommendations on the device approval process, such as creating a Class IIb category, has the potential to significantly hurt the financial prospects of many device firms, mainly orthopedics. However, while the IOM's recommendation is expected to heavily influence the FDA's final changes to the 510(k) approval process, we don't believe the end result will be as punitive as the market seems to bake into device manufacturers' stock prices. (Of note, the cardiac device makers are less vulnerable to some of the potential changes because the majority of their devices are already subject to more rigorous and costly regulatory requirements than other device firms.)
We believe the FDA will take into consideration that a drastic change to the approval process may have an unintended consequence of slowing down innovation, and higher hurdles may prove to be too costly for new industry entrants and startups. But even if the FDA takes a very conservative stance, we believe our valuations already adequately account for potential repercussions for the industry. Our models for device firms incorporate higher R&D costs going forward associated with longer approval processes and clinical trials, and even under these scenarios, device stocks are attractive, with our top recommendations being Zimmer (ZMH) and Medtronic (MDT).
M&A Activity Should Boost Stock Prices
In prior quarters, the health-care sector saw a number of midsized acquisitions in the pharmaceutical and life science space, with Teva (TEVA) acquiring Cephalon for $6.8 billion, Thermo Fisher Scientific (TMO) picking up Phadia for $3.5 billion, and KCI agreeing to be taken private. But they were overshadowed by the mid-July announcement of the merger between Medco and Express Scripts , a deal that could be valued at $30 billion if cleared by regulators.
At this point, we believe there is a 40% chance of the merger clearing the antitrust hurdle, as we anticipate major opposition and concerns to emerge. The merger would create a PBM powerhouse that in 2010 would have managed in the neighborhood of 1.7 billion adjusted prescriptions and controlled about 35% of pharmaceutical spending in the United States. We expect intense lobbying from the pharmaceutical manufacturing and retail drugstore industries to prevent the deal from going through, as the combined company would have unprecedented bargaining leverage over its suppliers. We also expect opposition from competitors such as CVS Caremark (CVS) and UnitedHealth (UNH), which would be left at a severe competitive disadvantage.
Judging by the market reaction so far, investors are also hesitant about the prospects for the deal's eventual success. Medco's stock now trades at below $50 per share, below our stand-alone fair value estimate for the firm (which incorporates the loss of the UnitedHealth contract), and more than 30% below the initial proposed value (based on Express Scripts' stock price at the time of the announcement). If the deal does go through, we think Medco's stock could be worth $87 per share, as synergies from the deal are significant, given the potential market power that the combined company would wield.
A key determinant for M&A activity in most other health-care industries remains the relative health of balance sheets of potential acquirers. Health-care firms are flush with cash, and with free cash flows for most firms in the billions and balance sheets relatively debt-free, consolidation activity in the sector is unlikely to be deterred by the uncertainty surrounding capital markets. Arguably, as the sector as a whole experienced rapid valuation deterioration over the past month, we may see share buybacks accelerate as firms take advantage of depressed prices. However, acquisitions remain a vital component of the growth strategy, so even with a pickup in share repurchases, the M&A environment will remain active. Smaller biotechs, such as Seattle Genetics and BioMarin (BMRN), as well as life science and diagnostic firms, such as Myriad Genetics (MYGN), could be potential acquisition targets.
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 |  | $48.00 | Wide | Low | 0.69 |
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| Abbott Laboratories | | $68.00 | Wide | Low | 0.75 |
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| Covidien | | $76.00 | Narrow | Medium | 0.60 |
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| Roche | | $58.00 | Wide | Medium | 0.64 |
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| WellPoint | | $100.00 | Narrow | Medium | 0.63 |
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| Data as of 09-22-11. |
Medtronic (MDT)
As the largest pure-play medical device firm, Medtronic manages to maintain an even keel thanks to its diversification. Most recently, the cardiac rhythm management and spinal businesses have slowed down as those markets have been dogged by clinical concerns, as Medtronic's products have aged, and as managed care has begun to push back on reimbursement. We think a lineup of new products will allow Medtronic to stave off pricing pressure over the next couple of years. However, we don't expect accelerating top-line growth until after 2013 when more of the emerging technologies currently in the pipeline begin to roll out. In the meantime, the firm pumps out about $1 billion in free cash flow each quarter. Our near-term concerns about U.S. regulatory reform have eased as the political winds seem to have become more sensitive to concerns about industry innovation.
Abbott (ABT)
Unlike its industry peers, Abbott faces relatively minor patent losses over the next five years, and is well-positioned to ride a strong tailwind of demand for its products. Most importantly, we expect continued strong demand for the company's top drug, Humira. With drug penetration in rheumatoid arthritis reaching only 25% and even less in psoriasis and Crohn's disease, Humira should grow at double-digit rates for the next four years. Humira's growth is critical as the drug represents almost 20% of the company's top line and over one third of the bottom line. Outside of the drug group, Abbott's strong competitive position in nutritionals and diagnostics reduces the volatility of its earnings and creates additional avenues of growth. Also, Abbott's recent acquisitions of Piramal and Solvay give the company a good position in the fast-growing emerging markets.
Covidien
Covidien's overall growth prospects are compelling despite struggles in its pharmaceutical business. The company's latest product launches have been well-received by the marketplace, and it successfully integrated a number of sizable acquisitions. While a weak macro environment continues to hamper elective procedure volume, the company's revenue growth in the device segment remains robust due to market share gains. With emerging markets also fueling growth, we expect strong revenue momentum despite expected ongoing struggles in pharmaceuticals. We remain convinced this unit will be sold, but the presence of several underperforming assets could prolong the process. Even if it remains part of the company, 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)
With the passage of health-reform legislation, the 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 (MCRs) will come under pressure from regulated minimums starting in 2011, but we estimate that the new rules will raise the consolidated MCR by less than 50 basis points. On the other hand, WellPoint has low selling and administrative expenses, and has the chance to cut costs further through systems integration and redesigned broker commissions. WellPoint benefits from its lack of exposure to Medicare Advantage, and the company is well-positioned to gain market share as insurance exchanges are implemented in 2014. In the meantime, WellPoint generates tremendous free cash flow, which the company is using to repurchase a massive number of its shares.
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