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Quarter-End Insights

Our Outlook for Health-Care Stocks

The Supreme Court decision will finally remove the uncertainty overhang and afford investors long-awaited clarity on the sector's prospects.

  • While hospital admissions are gradually improving, volume from commercial patients is still trailing Medicare, Medicaid and uninsured patient growth, which suppresses the overall health care spending expansion. 
  • The U.S. Supreme Court upheld the individual mandate in a narrow ruling in late June, clearing the main hurdle for the Patient Protection and Affordable Care Act. We had incorporated the anticipated effects of the PPACA in all of our projections, and as a result, the effect of the ruling on our valuations and recommendations across the health-care sector is immaterial.
  • M&A activity is picking up, with several biotech companies receiving unsolicited offers and a merger announced in the fragmented diagnostic field.


There has been plenty of chatter lately about the health-care spending growth trajectory being permanently bent or at the very least impaired, given the last few years of growth in line with general economy performance. The latest Centers for Medicare and Medicaid Services report adds more ammunition to this argument, suggesting a modest 4% growth in health-care expenditures between now and 2014, when the bulk of the PPACA goes into effect. The crux of the argument is that the system is evolving, shifting away from the consume-at-all-costs behavior (that led to runaway spending), to a more rational consumption of health care, with greater cost-sharing being the key stimulus for the change.

It is evident that health-care demand has slowed over the past few years, but we believe it may be premature to extrapolate any major systemic shifts from this rather cyclical pullback in consumption. We may, in fact, be entering an environment where employers shift more costs onto employees via higher deductibles and co-pays, thus making employees more sensitive to the no-longer-hidden cost of consumption. A recent study by PricewaterhouseCooper points to nearly 60% of employers considering increasing employee contributions to health plans (which would potentially drive more individuals into lower-cost/higher out-of-pocket options), with half of employers considering increasing cost-sharing (co-pays, deductibles) as part of a response to growing health-care expenditures.

But is this a secular or a cyclical change? Will this trend hold when unemployment declines and employers once again have to use benefit packages as mechanisms to lure in potential employees? What about Medicaid enrollees or the uninsured population, who tend to consume health care at a lower level than commercially insured individuals? Will they still be as hesitant to visit the doctor's office once they find a job (with health insurance)? Will individuals still do the same cost-benefit analysis with health care when their personal wealth improves, continuing to forgo more "elective" procedures, such as orthopedic surgery?

We aren't dismissive of certain trends that we believe have long-term implications for the cost curve, such as the likely future prominence of Accountable Care Organizations. We believe closed-end systems, such as ACOs, have great financial incentive to curb excessive spending and thus reduce the overall tax on the system, partially assisted by the "carrot" approach of the PPACA regarding the creation of ACOs. But the exact impact of these organizations on total health-care expenditures is still hard to measure given the novelty of ACOs and the uncertainty over their ability to influence patient behavior over time (although, arguably, this system isn't that different from the early 1990s HMOs).

Furthermore, with a potential bolus of new patients looming in 2014 and favorable demographics (mainly aging of the population), health-care demand in the U.S. has plenty of room to grow over the long term, even if greater cost-sharing is here to stay (and the CMS report does acknowledge that). Add to this strong demand for health-care services in emerging markets, and the investment outlook for the sector isn't quite as dire.

Meanwhile, Hospital Admissions Are improving, but the Pace Is Slow
While not out of the woods just yet, we are seeing signs of recovery in hospital admissions (adjusted) and surgeries for the hospitals we track, increasing 2.9% and 4.4%, respectively, in the first quarter of 2012. We anticipate similar trends in the second quarter and the remainder of 2012, assuming the broader economy can avoid stagnation.

Interestingly enough, it is the Medicare, Medicaid, and uninsured patients that are driving year-over-year volume increases so far, with commercial patient utilization improving at a slower pace. This dynamic is only marginally beneficial to health-care providers, as shifting the patient mix toward a government-insured population is actually generating a margin headwind. We expect this mix will flip eventually, as commercial volume gradually picks up, but the recent results suggest this may occur more slowly than previously expected. We note that commercial volume is critical to the health of the providers industry, given potential government reimbursement cuts already in place or looming in the near future.

Given the importance of commercial insureds to the entire health-care sector, not just providers, we are cognizant of the virtually flat sequential membership growth reported by the managed care companies we cover. The last three quarters showed 0.2%, 0%, and 0.3% sequential commercial volume growth, hardly indicative of a strong rebound. While year-over-year improvement is still present, the magnitude of growth has slowed, and with employment numbers flattening, further gains might be even more muted.

The Supreme Court Upholds Health-Care Reform; Valuation Impact on Health-Care Stocks Is Minimal
The U.S. Supreme Court upheld the individual mandate in a narrow ruling on June 28, clearing the main hurdle for health-care reform known as the Patient Protection and Affordable Care Act (PPACA). While it is possible that the battle over the fate of the health-care law will now shift to the legislature, given the low probability of Republicans gaining a filibuster-proof majority in the Senate, we now believe the PPACA isn't likely to be repealed. We've incorporated the anticipated effects of the PPACA in all of our projections, and as a result, the effect the ruling on our valuations and recommendations across the health-care sector is immaterial. 

For the managed-care sector, the ruling is largely a positive, as alternatives were a lot more punitive, particularly for firms operating in the individual marketplace. We factor into our models the more than 30 million individuals who are expected to gain insurance coverage as a result of the law through a combination of expansions to the Medicaid program (although the Court's ruling on this issue may limit the magnitude of this expansion) as well as new subsidies that can be used to buy insurance in the state-based exchanges. Medicaid MCOs like  Amerigroup  are best positioned to benefit from broader Medicaid eligibility, adding to the already-robust growth story from increased outsourcing of Medicaid.

We expect most commercial insurers to compete for new individual members in the exchanges, but those with a strong historical position in the individual market and well-known brands, such as  WellPoint (WLP), seem particularly well positioned. On the other hand, MCOs will continue to face margin pressure from regulatory scrutiny of premium increases, minimum medical cost ratios, and cuts to Medicare Advantage reimbursements. However, we expected most of these headwinds to remain in place even without the PPACA, and we have incorporated deteriorating margins in our valuations.

The other group most affected by the ruling is health-service providers, such as hospitals, but our valuations already properly account for the anticipated effects from the law's provisions, particularly the expanded insured population. We consider the law's reduction of uncompensated care combined with an influx of newly insured patients into the health-care system as a positive for the health-services industry, while other components of the law, including lower Medicare payments and greater oversight of insurance premium increases, mostly mitigate such benefits. Overall, hospitals may breathe a sigh of relief, as without the mandate, the environment for providers would have been rather dire. Regardless of this ruling, we think reimbursement pressure is here to stay thanks to government incentives to curb health-care spending growth and an industry shift to quality-of-care-based payment methods, and health providers still will face an uphill battle to maintain profitability amid the ongoing uncertainty of reimbursements. 

For the Big Pharma group, we expect the increased demand for drugs as a direct result of the mandate largely will offset the increased fees and rebates associated with health-care reform. Our valuations are unchanged. However, since the costs related to health-care reform are front-end loaded (which started in 2010) and the increased demand will not likely begin until 2014 (when the mandate goes into effect), we believe investors' sentiment toward the drug group should improve as the tailwind of increased demand for drugs begins to materialize in 2014.

The generic drug manufacturers are largely unaffected, in our view. Most of the generic manufacturers have broad geographic operations, and generic drug pricing was relatively unaffected by the law. We think additional drug volumes from newly insured patients are relatively immaterial to our fair value estimates for the generic firms. The biosimilars approval pathway should remain intact.

The device side was viewed largely as a relative loser when the reform was passed, and the ruling doesn't much change our assessments of the industry's prospects going forward. We anticipate the additional insureds in 2014 will not significantly contribute to volume because many devices are concentrated among Medicare recipients. For example, an estimated 90%-95% of pacemakers in the U.S. are implanted in Medicare patients. However, there are some particular product lines that do skew somewhat younger, such as spine devices, which are split more evenly between Medicare and non-Medicare patients. Firms that are not highly tied to Medicare reimbursement should see the volume boost in some magnitude, but likely not to the extent of other health-care industries.

With the law upheld, it also appears that the 2.3% medical device excise tax will stand. We already baked that tax into our valuations two years ago, and at the time, we said it would cut into the long-term earnings power of medical device firms by 4%-10%, hardly a devastating impact. We believe the marketplace already baked this into its assumptions as well, and thus most device firms are currently trading in line with the market. The effect of the tax is being mitigated by several factors, particularly the sales mix by geography, which has generally been shifting away from the U.S. Medical device companies also have been preparing for this tax and additional pricing pressure (not necessarily only because of the ACA), which led to the restructuring of operations and investments in more manufacturing facilities in tax-advantaged locations outside of the U.S. Overall, we think a number of larger regulatory and customer issues--such as changes in the pathway to market and fiscal budget pressures in the developed world--are changing the competitive landscape for medical devices firms, and these changing dynamics should have a more substantial effect on this industry in the foreseeable future than the ACA will have.

For other sectors, the impact is also fairly muted. With regards to biotech, we are maintaining our view that health reform has an overall net neutral impact on our valuations as expanded coverage offsets new fees and drug rebates. However, within the spectrum of our biotech coverage, some firms have fared better than others under reform. Companies like  Gilead (GILD),  Amgen (AMGN), and  Roche (RHHBY) have seen the largest hit to their business due to larger rebates through Medicaid and industry fees due to a higher share of drugs reimbursed by Medicare. Conversely, reform has had little impact on companies with heavy exposure to orphan drugs like  Celgene  and  BioMarin (BMRN) that are exempt from the industry fee.

We expect drug supply chain companies, including retail pharmacies, pharmacy benefit managers, and distributors, to experience a modest revenue boost due to increased consumption of health care by the newly insured population. But any positive impact isn't likely to be material to our valuations. 

Acquisitions Are Picking Up
While investor appetite for health-care stocks has been hampered by regulatory uncertainty, suppressing earnings multiples for the industry, most firms in the space are still enjoying robust operating margins and cash flows. Capital deployment has been rather evenly split between share buybacks and acquisitions over the past few years, and the past few months produced several high-profile acquisitions (and attempted acquisitions) in the space.

Among the ones that make sense to us,  Novartis (NVS) announced the $1.5 billion acquisition of dermatology company Fougera.  Human Genome Sciences reported that it has received an unsolicited takeover offer from longtime partner  GlaxoSmithKline (GSK) for $2.6 billion.  Watson Pharmaceuticals , in order to become the world's third-largest generic drug manufacturer, announced that it will acquire Switzerland-based Actavis for EUR 4.25 billion ($5.6 billion).  Amylin Pharmaceutical rejected a $3.5 billion offer from  Bristol Myers Squibb (BMY), but the company is clearly in play.  Gen-Probe is being acquired by  Hologic (HOLX) for $3.7 billion. On the flip side, the acquisition that strikes us as misguided is  Walgreen's (WAG) announced purchase of Switzerland-based Alliance Boots for $6.9 billion.

The Walgreen deal aside, none of the acquisitions was particularly surprising to us, as we identified most of these firms as possible takeout targets in our annual Mergers & Acquisitions issue of Morningstar Healthcare Observer in early 2012. Other firms we identified as possible targets are  Actelion and BioMarin in biotech, Amerigroup in managed care,  Abiomed in devices, and  Icon in contract service providers.

While it's not an acquisition, an initial public offering of  Pfizer's (PFE) animal health business, which is now called Zoetis, has been announced. Due to antitrust concerns limiting the amount of buyers, we expected Pfizer would take this path in divesting the unit, which we value at $11 billion. This marks a third major spin-off in health care over the past 12 months, following  Abbott's (ABT) split into two firms and the separation of  Covidien's pharmaceutical business.

Top Health-Care Sector Picks
  Star Rating Fair Value
Fair Value
Covidien $76.00 Narrow Medium $53.20
Express Scripts $73.00 Wide Medium $51.10
Icon PLC $32.00 Narrow High $19.20
Roche Holding AG $52.00 Wide  Medium $36.40
WellPoint $105.00 Narrow Medium $73.50
Data as of 06-22-12.

As we've been advocating for several years, Covidien is spinning off its underperforming pharmaceutical business. We believe this transaction will allow investors to appropriately judge the company and its core device business; we consider the shares undervalued. The company's moat trend is now positive. Covidien's device growth prospects are compelling, as the latest product launches have been well received by the marketplace and the company successfully integrated a number of sizable acquisitions. While a weak macro environment continues to hamper the elective procedure volume, the company's revenue growth in the device segment remains strong, particularly in energy and vascular, where Covidien continues to gain market share. With emerging markets also fueling growth, we expect strong revenue and earnings momentum despite ongoing investments in R&D and sales.

 Express Scripts
Express Scripts has done a phenomenal job of boosting margins on its existing business, but it has come up short in winning new clients and expanding revenue. Instead, the company has relied on acquisitions, which have boosted its scale and enhanced its competitive position. The acquisition of WellPoint's NextRx was a great success, and two years later Express Scripts was ready for its next big deal. The acquisition of Medco Health Solutions more than doubles Express Scripts' revenue and gives the company stronger competitive advantages than any pharmacy benefit manager in history. We think Express Scripts has established a wide economic moat that will allow it to create value for shareholders for a long time to come.

 Icon PLC
Icon's growing scale has helped it gain entrance into the upper echelon of the contract research industry, and we think the firm will continue to benefit from industry tailwinds provided by drug companies' increasing tendency to outsource R&D work. However, a slowdown in drug-development spending has led to capacity underutilization and losses in the firm's central lab division, and hiring in anticipation of an uptick in demand has weighed on earnings. We think the firm's results hit a low point in the third quarter of 2011 and earnings will regain traction throughout 2012 as central labs pass break-even and new partnership deals begin to meaningfully contribute to revenue. As demand returns, Icon should see high-single-digit top-line expansion and operating margins return to the double digits by the second half of this year as it leverages new staff and infrastructure across an expanded revenue base.

 Roche Holding (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 7% 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 cardiovascular disease. With the Genentech integration yielding synergies, we think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages.

 WellPoint (WLP)
WellPoint's 14 Blue Cross and Blue Shield plans provide the company with a unique combination of regional and national scale. The former is the key to negotiating favorable provider rates, while the latter is essential for leveraging administrative costs. Investors remain fearful about the regulatory and economic headwinds facing WellPoint, causing the stock to trade at barely 8 times earnings and with a greater than 35% discount to our fair value estimate. However, we think these concerns are overblown, as the recent health reform law should have only a modest impact on WellPoint's future profits. While we expect ongoing medical cost pressure, this should be partly offset by revenue growth opportunities and potential SG&A leverage. In the meantime, WellPoint generates copious free cash flow, which it is using to repurchase shares at a breakneck pace.

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