Our Outlook for Health-Care Stocks
With two years of stellar returns behind us, our expectations for 2013 are more muted, but some opportunities persist.
Quarter-End Insights
- The developed world's health-care spending remains suppressed, with hopes pinned on employment growth in the U.S.
- The sector's performance has been robust despite the macro challenges, but a few investment opportunities persist.
- With plenty of cheap debt available, acquisitions and share buybacks are likely to remain the preferred strategies for cash deployment.
Developed World's Health-Care Spending Affected by Weak Utilization and Generic Drug Launches
Health-care utilization has not been immune to weak aggregate demand in the United States, and the sluggishness of the recovery continues to surprise us. The overall economy's slow pace of improvement and the ongoing fiscal spending tug-of-war guarantee some road bumps in 2013, but we anticipate the overall demand to recover as the U.S. economy strengthens and unemployment levels decline. We believe the pace of health-care expenditure growth should exceed that of the overall economy, with pent-up demand for health-care services, lower unemployment levels, and rising commercial insurance membership bolstering the sector, aided by the waning generic wave.
There are a few reasons the growth in demand has been so tepid--out-of-pocket spending on health care has picked up as health-care plans are shifting greater financial burden onto individuals, commercial enrollment continues to underwhelm with mix shifting toward lower-reimbursement government programs, volume in certain procedures continues to show gradual erosion, and the pricing pressures haven't subsided. The slow growth trajectory throughout the recovery recently caused the Congressional Budget Office to reduce its long-term growth expectations for the sector. While expectations of the new norm when it comes to health-care spending growth rates may be premature, given the post-reform patient inflow, eventual acceleration in commercial insurance memberships, and the tightening labor pool (which could reverse the trend of declining benefits offered by employers), the overall sector's heyday is more likely behind us. Exacerbating this pedestrian domestic growth are European woes, with austerity measures still casting a shadow in the upcoming year.
While the overall impact from sequestration on health-care spending remains a large unknown, we speculate that any Medicare spending cuts would be spread over a period of years. Medicare has largely been ignored by the lawmakers, and a number of major question marks surround the program's future spending--possible (likely) cuts to Part D drug spending on dual eligibles, status of provider payments to post-acute care, treatment of bad-debt payments, higher premiums for high-income beneficiaries, raising the Medicare age of eligibility, and changes to the sustainable growth rate, or "doc fix." Medicare has traditionally been a sacred cow for politicians, but structural changes to this program are no longer as unfathomable as they once were.
Valuations in the Sector Are No Longer Very Appealing
The health-care sector fared well over the past year, gaining more than 25% and outperforming both the S&P 500 and Russell 2000 TR by a sizable margin. This came on the heels of robust performance in 2011. Despite the worse-than-expected performance throughout the recession, the sector's five-year results have now exceeded the overall market. With the exception of managed care, most industries delivered solid performance relative to the market, with biotech in particular outperforming the overall market by a significant margin. With two years of stellar returns behind us, our expectations for 2013 are more muted. We think the investment community has recognized the many sector headwinds but has settled on a positive long-term outlook. Our coverage universe is now considered largely fairly valued, with a few exceptions, most notably in medical devices and managed care.
Pharmaceutical Industry: Growth Set to Return
As Big Pharma firms tend to attract the most interest among health-care investors, it is important for us to highlight our thinking on this largely fairly valued industry. At this point, we believe the Big Pharma group is facing an inflection point toward improving long-term growth rates. We project the five-year compound annual growth rate in earnings will improve from negative 0.3% in 2012 to 1.7% in 2013 based on less patent exposure, improving pipelines, growing contributions from fast-growing emerging markets, and cost-cutting. Since we expect these trends to continue beyond 2013, we project close to 100-basis-point improvement annually in our five-year CAGR for earnings beginning in 2013 and continuing at least through 2015.
Several key trends support the increasing growth potential of Big Pharma companies. Since patent losses peaked in 2012, generic competition is beginning to dissipate, removing the major growth obstacle for the Big Pharma group. Further, pipelines continue to focus more on innovation in areas of unmet need, creating a stronger platform of the next-generation drugs. In 2013, we expect several new blockbuster launches and important Phase III data releases; we expect a launch of more than 20 new potential blockbusters in 2013, with the highest potential likely to come from Bristol-Myers' (BMY) and Pfizer's (PFE) atrial fibrillation drug Eliquis. Also, despite lower margins, emerging markets will still contribute to growth for the industry as the wealth creation in these regions continues to drive increased drug utilization. Even the low-hanging fruit--cost cuts--should support earnings growth, although less room exists for cost cuts now after the aggressive restructuring programs of the past few years.
Buybacks and Acquisitions, Not Deleveraging, Are Key Cash Deployment Strategy
Reducing debt hasn't been the greatest point of emphasis for most health-care firms, considering their strong cash flows and manageable leverage. Buybacks remain the preferable cash deployment strategy outside acquisitions and reinvestments, although their pace has decelerated as of late. With growth prospects still uncertain given the macro environment in the U.S. and Europe, cheap debt remains the key source of capital to fund growth strategies, particularly acquisitions. We believe Big Pharma firms will probably continue to rummage around biotechnology for their next targets, and our top five biotech takeout targets all offer the combination of highly sought factors: pipeline potential, therapeutic area attractiveness, collaborative fit, and digestible size. Our top biotech picks are Onyx , Regeneron (REGN), Incyte (INCY), Biomarin (BMRN), and Seattle Genetics .
| Top Health-Care Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
 | |||||
| Covidien |  | $76.00 | Narrow | Medium | $53.20 |
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| Teva Pharmaceuticals | | $50.00 | Narrow | Medium | $35.00 |
| |||||
| Icon |  | $36.00 | Narrow | High | $21.60 |
| |||||
| VCA Antech | | $30.00 | Narrow | Medium | $21.00 |
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| Data as of 3-19-13. |
Covidien
The spin-off of the pharmaceutical business will complete Covidien's transformation from a health-care conglomerate into a pure-play device firm and should allow investors to appropriately judge the company and its core device business. We consider the shares undervalued, and Covidien remains our top pick in devices. Covidien's device growth prospects are compelling as the latest product launches have been well received by the marketplace. Moreover, while many device firms struggle to adopt to a changing regulatory and reimbursement environment in the U.S., Covidien's products address the growing emphasis on total value and thus shouldn't face the same level of scrutiny as those of some of its peers. We anticipate its growth prospects to be among the best in the industry, and with emerging markets also fueling growth, we expect strong revenue and earnings momentum despite ongoing investments in R&D and sales.
Teva Pharmaceutical (TEVA)
Teva plans to transition beyond Copaxone through cost-saving initiatives and small specialty pharma deals. In the generics segment, management will focus on improving operating costs in the company's sprawling manufacturing empire, while also retaining a focus on emerging markets to reduce risks from the U.S. patent cliff and pricing concerns in Europe. The branded segment possesses more uncertainty, in our view. We foresee little change to the respiratory and biosimilar products under development, but management has reshuffled other innovative efforts. Despite the recent setbacks with laquinimod for multiple sclerosis and tamper-resistant hydrocodone, we think Copaxone's upheld patents through 2015 and a reasonably healthy pipeline, including biosimilar, respiratory, and CNS products, leave us optimistic that management can successfully transition the company beyond its near-term challenges.
Icon (ICLR)
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.
VCA Antech
While the pullback in pet health-care spending has bottomed out, we have not seen a resumption of robust growth. The industry is creeping along with low-single-digit growth. Our thesis on VCA Antech primarily rests on our belief that, over time, consumers eventually will feel confident enough to spend on nonacute, preventive care again, allowing the firm to return to the 7% historical pet market rate. We expect a gradual recovery for VCA during the next few years, contingent upon incremental improvement in unemployment. Despite potential near-term bumpiness, we appreciate that VCA is poised to benefit from long-standing trends in greater pet ownership and consumer attachment to pets that can translate into a willingness to spend on pet health care. Furthermore, the growing application to the pet market of technology initially developed for humans will increase the sophistication and cost of pet health services.
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