Our Outlook for Health-Care Stocks

• Like it or not, Obamacare is here to stay.
• Less uncertainty creates more opportunity for the health-care industry.   
• Sequestration can still be avoided, but if not, expect a rather challenging year for health care. 

 

PPACA: Nearly 3 Years Later, It Is the Law
Regrets? He might have had a few, but he did what he said he would and saw it through without exemption. Indeed, President Obama did it his way, and the Patient Protection and Affordable Care Act is the law of the land after the Democrats retained the White House and majority in the Senate in the November elections. So now, we are about to witness the biggest overhaul of the U.S. health-care system since the Medicare introduction back in 1965. Below is the timeline for some of the more important provisions of the law (note: a few PPACA provisions have been already quietly introduced during the past few years): 

2013:

• Excise tax on medical devices
• Further subsidies to close the Medicare Part D "doughnut hole"
• Elimination of tax deduction for employers receiving retiree drug subsidy payments

2014 (a key year for reforms):

• State-based health insurance exchanges (note that this is probably the most contentious piece of the puzzle now since the repeal is off the table with many states taking a stance against exchanges, though we believe that at the end of the day, most if not all states will have exchanges set up).
• Premium and cost-sharing subsidies
• Regulations on health insurers: community rating, guaranteed issue and renewability, standardization of coverage, and so on. 
• Expansion of Medicaid eligibility (states may, however, opt out as a result of the Supreme Court ruling)
• Individual mandate (and penalties based on the 2014 taxable income)
• 85% floor on Medicare Advantage plans
• Health insurance industry fees

2018:

• "Cadillac" tax--excise tax on high-value employer-sponsored health plans

We've written ad nauseam about what the PPACA means for the health-care sector in detail, so here's a quick summary:

Managed Care: It Could Have Been Way Worse
Although most managed-care firms were probably secretly hoping that the PPACA would get the boot, the industry evaded a major kick in the gut in June when the individual mandate requirement got upheld by the Supreme Court. While the PPACA doesn't offer many positives for the industry, we note that managed care has long been in the crosshairs of politicians and regulators, so the PPACA's passage in itself hasn't made the future overly bleak for companies everyone loves to hate. What the reform did give the industry, however, is an option to capture a sizable chunk of new patients coming into the system starting in 2014. Even with the industry fees and MCR floors (calculations which allow MCOs plenty of wiggle room), health insurers, particularly the ones with Medicaid operations, aren't faced with extinction. Even more so, there is definitely more clarity on the regulatory front now than there had been during the past decade. With most insurers having ample time to prepare, the industry prospects are actually fairly decent, and the stocks by and large appear to reflect that. The lone exception,  WellPoint (WLP), has been plagued by execution issues and recently ousted its CEO; the company's business model and scale still position it as one of the top names in the industry, so we view its operational mishaps as repairable and shares as attractive.

Pharmaceutical Industry: Pay Up and Wait for the Next Shoe to Drop
The reform in itself doesn't materially affect most pharmaceutical firms, with fees levied on the industry largely offset by the inflow of new patients. A much bigger deal, however, is the likely sequel, "Health Care 2.0: The Attack on Dual Eligibles," which, surprisingly, gets enough love from both sides of the political aisle. Getting 9 million patients who qualify for both Medicare and Medicaid yet reimbursed at Medicare pricing levels which are switched to Medicaid pricing (roughly 20%-30% below Medicare) would save the overall system $86 billion-$135 billion during the next 10 years (sources: House Oversight and Government Reform Committee, CBO, and the President's Plan for Economic Growth). Although we still anticipate less than a 50% chance that the conversion will actually happen, the magnitude of the impact on individual companies' earnings is somewhat material, particularly for companies with significantly greater exposure to Medicare Part D. We estimate  Bristol-Myers (BMY),  Eli Lilly (LLY),  Celgene , and  Actelion  could see a 7% or greater hit to earnings if the legislation is passed. The impact on most other pharmaceutical and biotechnology companies is far less meaningful. 

Devices: Reform Is a Blessing in Disguise
Clearly, the medical-device segment fared worse than any other part of the health-care industry as a result of the PPACA, and we struggle to find many positives directly related to the reform. But the increased regulatory and reimbursement scrutiny, along with the 2.3% excise tax commencing in 2013, at the very worst provided a nice wake-up call for the industry previously mired in complacency. Even before the PPACA, we had seen some warning signs flashing regarding the Food and Drug Administration's changing stance on the device-approval process and hospitals balking at the device makers' insistence to charge higher prices for products providing limited benefits to patients. At the same time, the device industry wasn't very swift to adjust its cost structure to align it more closely with both the shifting demand for technological advancement as well as demographic patterns. The horse is out of the barn now, and while device companies will probably point to the device tax as key reason why they are moving more of their operations overseas, particularly into emerging markets, it is clear that the developed world isn't quite as lucrative for the industry now as it was a decade ago, and the bloated infrastructure in the U.S. needed to be adjusted sooner or later. The emphasis on emerging markets as well as truly innovative products is a positive for an industry desperate for growth, so at the very least, the reform serves as a catalyst for these changes. Arguably, the reform actually widens the moats of some of the larger device players; raising the costs for start-ups/emerging technologies has in turn put more power in the hands of industry behemoths, making them even more appealing as partners or acquirers of intriguing technology at earlier stages. Thus, we still have a number of recommendations in the device space, most notably  Covidien ,  St. Jude  and  Abiomed .

Health-Care Providers: Not All Roses
Hospitals' stocks popped with the Democrats' win as investors decided that close to one fifth (depending on the hospital) of the revenue service providers previously wrote off to charity care/uninsured discounts is coming back straight to the bottom line. Well, first of all, it isn't quite that simple. Hospitals are clearly better off now than they were before the PPACA (particularly with unemployment soaring and the commercial insurance ranks tanking). But not all individuals will enroll in 2014, and many of the ones who do are likely to receive Medicaid reimbursement (which is much stingier than that of private payers or Medicare). Second, hospitals have an unenviable stuck-in-the-middle position, where reimbursements in general are coming down, yet the hospitals' ability to pass down these cuts in the form of ASP decreases and lower salaries is generally limited. As such, hospitals, being the no-moat industry, are likely to bear the brunt of federal government's health-care cost-squeezing efforts. Additionally, new efforts to tie provider payments to quality-control measures have also forced hospitals to invest in IT.  The segment doesn't have much positive going for it, from our perspective. At this point, we don't recommend any hospital stocks. 

Sequestration Cuts Will Be Felt Throughout Health-Care Sector
It is becoming a real possibility that there will be no deficit-reduction compromise attained before the end-of-the-year 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 left reeling, especially given an already-challenging reimbursement environment. If sequestration 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 segment 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 preemptively 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).

Top Health-Care Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Covidien		$76.00	Narrow	Medium	$53.20
Express Scripts		$73.00	Wide	Medium	$51.10
Icon		$32.00	Narrow	High	$19.20
WellPoint		$91.00	Narrow	Medium	$63.70
Data as of 12-18-12.

 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. Although a weak macroeconomic 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 research and development 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 endow 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. The company has failed to capitalize on its competitive strengths in recent years, which we attribute to poor execution. WellPoint is on the hunt for a new CEO, with several promising external candidates available. In the meantime, the management team is being strengthened with acquired talent. Following President Obama's re-election, investors are as fearful as ever about the effects of health reform. We see opportunities as well as risks under the reform law but believe investors enjoy a substantial margin of safety at current stock prices. Long-term investors should benefit from the depressed stock, which is facilitating highly effective share repurchases.

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