Our Outlook for Health-Care Stocks
Election and potential sequestration emerge as key topics for health care.
Quarter-End Insights
- While the last hurdle to PPACA implementation was removed in early summer with the U.S. Supreme Court's ruling on the individual mandate, a Republican sweep could jeopardize the reform's rollout, although full repeal is unlikely.
- Sequestration is a real threat to numerous health-care industries, with Medicare cuts hitting providers particularly hard.
- While the number of uninsured patients is finally declining, the acceleration in commercial enrollment is still needed to stimulate health-care demand.
Elections to Determine Fate of PPACA
The U.S. Supreme Court upheld the individual mandate in a narrow ruling on June 28, clearing the main hurdle for health-care reform via the Patient Protection and Affordable Care Act. The reform's fate now depends on the upcoming election season, as the Republicans are still determined to unwind major (if not all) provisions of the reform. While we are not in the business of making electoral predictions, our sector analysis would be incomplete without some discussion of plausible scenarios. It is clear that any talk of a repeal is useless without either a Republican in the White House or a supermajority (two thirds) in both chambers of Congress to override a certain President Obama veto. The latter outcome is virtually impossible, as it would require a monumental sweep--13 out of 23 Democrat-controlled Senate seats must change hands. Democrats may be in danger of losing their majority status in the Senate, but they will be able to thwart any efforts to override a presidential veto.
If Mitt Romney takes the White House in the fall, the fate of the PPACA becomes a bit murkier. Romney has already suggested that he would be in favor of maintaining certain provisions of the law, while removing some less popular ones, but will he have mechanisms in place to accomplish this?
A full-blown repeal is unlikely, given the low probability of Republicans obtaining a filibuster-proof majority in the Senate. However, the Republicans might have another tool in their arsenal to effectively suffocate PPACA: reconciliation. Under this process, a debate on a particular bill would be limited to 20 hours with limited amendments, as long as it pertains to a budget. Considering that most provisions of the PPACA carry budget implications, the bill in theory could be stripped of most of its power, rendering it meaningless. In this scenario, we might see the future of the health-care system become much more cloudy, as some of the provisions of reform have already been implemented and many companies in health care have put plans in motion to incorporate changes from the PPACA. Unwinding these provisions and reversing preparations will once again wrap health care in a shroud of uncertainty, exacerbated by the lack of visibility surrounding GOP plans to reform health care.
While there are some PPACA provisions that are clearly punitive to certain sectors (a device excise tax, pharmaceutical industry fees), they are accompanied by provisions that at least mitigate the negative consequences of the reform (coverage expansion). If the entire system is back to square one, investor sentiment is likely to turn negative (investors hate uncertainty), suppressing earnings multiples across the sector.
A more likely outcome at this juncture is that despite Republican efforts, the PPACA is here to stay. Some of the reform's provisions could be tampered with (a Medicaid expansion for example), but at this point, we have incorporated the anticipated effects of the PPACA into all of our projections.
Sequestration Cuts Will Be Felt Throughout Health-Care Sector
A more imminent threat to the health-care sector is sequestration. It is becoming more and more likely that there will be no deficit reduction compromise attained before the deadline, and automatic budget cuts will take effect in January 2013. The magnitude of these cuts varies from 2% to Medicare to as much as 8.2% to nondefense nondiscretionary spending such as National Institutes of Health funding. We've been operating under the assumption that these cuts have a reasonable chance of happening, and as result, most of our valuations for health-care providers and to a lesser degree device suppliers have incorporated reimbursement reductions.
Ultimately, this is not a devastating outcome for many health-care industries, but some--mainly providers--will be reeling more, especially considering an already rather challenging reimbursement environment. If the sequester occurs, we estimate reimbursement growth will be essentially flat for most service providers in 2013 based on the current reimbursement levels set by the Centers for Medicare and Medicaid Services. Our investment thesis on the provider industry contends that slowing Medicare reimbursement growth is likely to erode most benefits obtained by the health-care providers from the decline in uncompensated care under the PPACA. This industry remains largely at a mercy of the government, and no current provider carries an economic moat as a result of the few levers available to combat any reimbursement headwinds.
The life science sector is the other area directly affected by sequestration. If the NIH does in fact lose 8.2% of its funding, it is very likely that new grant awards will come to a screeching halt, suppressing the demand for life science research instrumentation and consumables. Academic and government customers account for a meaningful chunk of most life science firms' revenue streams, but the extent of sequestration damage is probably overblown. First, most firms in the sector have been operating in a spending-constrained environment for the past 12 months, as research labs pre-emptively tightened their spending in anticipation of future cuts. Second, with the exception of a few firms ( Illumina (ILMN), for example), no life science company is at the complete mercy of the NIH budget; academia and government typically don't represent the majority of total revenue, mitigating a potential high-single-digit decline in orders from that end market. Our expectations for 2013 are muted for the sector, but there are a few interesting investment opportunities likely to stem from this uncertainty. Our top pick here is Thermo Fisher Scientific (TMO).
Patient Volume Trends Have Improved Since Mid-2011, but We Have Modest Expectations
Patients are slowly returning to hospitals, as adjusted admission and surgery procedure growth at hospitals we track has improved slightly from late 2011. However, this growth slowed considerably during the last quarter and will probably remain lackluster over the near term as unemployment, underemployment, negative home equity, and higher cost-sharing provisions with insurance companies continue to pressure patient health-care utilization decisions. The continual decline in inpatient admissions stems from hospital efforts near the beginning of the recession to place more visit and procedure volume in lower-cost outpatient clinics.
Most patient volume growth remains from less favorable patient categories, namely Medicare, Medicaid, and the uninsured. Although Medicare patient volume has been relatively stable, commercial volume (the most preferred reimbursement) is still weak and is tied directly to surprisingly stubborn unemployment. Although growth in uninsured patients has slowed (and based on recent Kaiser research has turned negative), the rate remains high--more than 17% of the population, according to estimates by Gallup survey data.
In Absence of Domestic Growth, Health-Care Firms, Particularly Big Pharma, Turn to Emerging Markets
Emerging markets carry significant barriers to entry for Big Pharma firms, and their importance to valuations and moats has been emphasized over the past several years. However, we still believe the investment community is discounting the strategic upside from these markets because of recent economic slowdowns that have increased volatility in emerging markets, a historical focus on the dominant U.S. market, and the mistaken investor perception that emerging markets' margins are too low to matter. We expect this discount will dissipate as economies in emerging markets stabilize and the sales contribution from emerging markets increases.
Growth in GDP is directly correlated with drug spending. Based on a sample of 63 emerging and developed countries, World Market Monitor calculated an 80% correlation between GDP per capita and pharmaceutical spending. With the rapid growth in emerging market incomes over the past five years, drug purchases have accelerated. This massive expansion in wealth should directly increase the market opportunity for drug companies.
A brand is very important in emerging markets; it tends to reduce generic and counterfeit threats and gives Big Pharma an upper hand in these geographies. Given the perception of a high degree of variation in quality of generics, these drugs are seen as generally inferior to branded drugs. Counterfeit drugs have also plagued emerging markets for decades, and we believe this has instilled a sense of distrust toward nonbranded drugs. The strong reputations of large multinational drug companies for manufacturing and safety have supported branded drug sales, and such firms are able to provide a much higher degree of service to physicians and patients in the form of educational marketing relative to generics. Lastly, out-of-pocket pay constitutes the majority of revenue in emerging markets, but patients are willing to pay more for a trusted manufacturer. The importance of the branded drugs not only allows companies to launch into emerging markets with less fear of counterfeits, but also gives the branded drug a much longer life cycle in emerging markets relative to developed markets.
While pricing power is not as strong relative to developed countries, emerging-market drug prices remain high enough to confer 20%-plus operating margins (excluding research and development and central administrative costs, as these require minimal incremental investment beyond base levels). Over the past few years, Sanofi (SNY), GlaxoSmithKline (GSK), and AstraZeneca (AZN) have all presented operating margin data on emerging markets. These companies reported operating margins in emerging markets (after incorporating any drug discounts) of 23%, 28%, and 41%, respectively, relative to developed markets and excluding R&D and central administrative costs. While pricing power varies depending on the therapeutic class and specific market, branded drugs in emerging markets are typically priced at a 50% discount relative to developed markets. However, operating costs are much lower in emerging markets. According to AstraZeneca, a sales representative is more than 50% cheaper in emerging markets; Brazil is 50% cheaper, Turkey and Russia are 60% cheaper, and Mexico and China are 80% cheaper. Therefore, lower marketing costs help offset lower pricing power in emerging markets.
| Top Health-Care Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Covidien |  | $76.00 | Narrow | Medium | $53.20 |
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| Express Scripts | | $73.00 | Wide | Medium | $51.10 |
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| Icon | | $32.00 | Narrow | High | $19.20 |
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| WellPoint |  | $91.00 | Narrow | Medium | $63.70 |
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| Data as of 09-18-12. |
Covidien
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
We're big fans of Express Scripts' high-return-on-capital business model as well as its exemplary management. The company has established a wide economic moat through a series of acquisitions, which have granted Express Scripts unmatched bargaining power over suppliers, the ability to leverage fixed costs, and differentiated pharmacy benefit management capabilities. With the Medco integration barely under way, Express Scripts has already stared down major suppliers like Walgreen (WAG) and the pharmaceutical distributors and made progress toward realizing at least $1 billion in synergies. We see the company continuing to create shareholder value for the foreseeable future.
Icon
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.
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 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 selling, general, and administrative expense 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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