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Quarter-End Insights

Our Outlook for Health-Care Stocks

Med-tech multinationals look to the East for growth in China.

  • Though investors often have a vague impression that the emerging Chinese market for health care will be large, we found the potential size of this market to be eye-opening once we sat down to examine reasonable scenarios for growth.
  • China's medical-technology market is already $21 billion--second in size only to the U.S.--and has been growing in the high teens. We think there is plenty of room for further growth in cardiology, orthopedics, and neurology.
  • We think multinationals in the narrow-moat business of making drug-eluting stents will face major challenges to establishing the efficient scale that characterizes their economic moats in developed markets. On the other hand, we are confident the orthopedic multinationals can translate their wide moats in developed markets to the burgeoning Chinese market.


Potential to Tap Into Immense Growth by Digging Med-Tech Moats in China
As medical-technology companies shift their attention to emerging markets, we think China's potential for growth in its health-care market is the key growth opportunity spurring multinationals to set up shop there. We size the Chinese health-care market at $1.7 trillion in 2022. Using international and Chinese data sets on health spending, income, and demographics, we find the growth potential for Chinese health spending is far greater than that for GDP. If China follows the typical path as it grows richer and older, we expect health care’s share of GDP to grow by 40% by 2022.

The Med-Tech Market in China Is Poised for Growth
China has already overtaken Japan as the second-largest med-tech market, and we anticipate robust double-digit growth to continue, especially considering the still-low penetration rates of common medical procedures such as angioplasty, hip replacement, and cardiac resynchronization.

There are an estimated 11,000–12,000 domestic medical-technology companies in China, fueling 15%–20% annual growth in this med-tech market. Up until recently, local med-tech companies have concentrated on manufacturing low-tech and disposable devices, but we now see them making inroads with more technologically advanced and higher-risk implantable devices.

We expect Chinese companies to continue moving up the value chain thanks to government emphasis on the development of the native med-tech industry. The central government has specifically called out med-tech as a key area for increased expertise and growth. Consistent with this mandate, China has made substantial progress in the last decade toward reaching global manufacturing standards for medical devices. More and more facilities are ISO 13485-certified, which means they have demonstrated the ability to produce medical devices that consistently meet customer and regulatory requirements. By no means have all the quality issues been resolved, but China is on the path toward global standards. We think this will be helped along as more Chinese device makers set their sights on exporting these higher-value products outside of China, and Western-trained ethnic Chinese return to China to set up shop.

Historically, infectious disease and infant mortality were the largest public health concerns. Thanks to the aging population, high smoking rates, lifestyles that are more sedentary, and pollution, we have seen a shift in the disease burden in China. Cardiovascular disease and cancer have grown more prominent. Moreover, there is pent-up demand for these treatment options and devices because the technology was not accessible until relatively recently. First, there were few physicians and hospitals with the training and expertise to do large joint replacements or implant coronary stents. Second, there were few patients who could afford these interventions on an out-of-pocket basis.

China has now reached a point where we see a window that is extremely favorable for the spread of med-tech. On the demand side, we think patients are increasingly interested in spending on health now that insurance has spread to cover more people, rising incomes can better absorb out-of-pocket expenses, and there are heightened consumer expectations for quality. On the supply side, more doctors have been trained to perform these procedures and more hospitals now offer them.

While the Chinese regulatory process for medical devices is similar to that in the U.S., the regulatory landscape still changes with some frequency as the China Food and Drug Administration, or CFDA (formerly known as the State Food and Drug Administration, or SFDA), makes modifications along the way to address new dynamics in the growing medical-technology industry. Fortunately, there is some consistency in how the CFDA and the U.S. Food and Drug Administration classify medical devices. Unfortunately, China's regulatory process is not completely centralized, and manufacturers may need to apply to other governmental bodies for clearance. Lower-risk lower-tech products may need to seek provincial or municipal approval, resulting in the need for additional resources to gain approval through a patchwork of geographies. So far, the more sophisticated, implantable therapeutic devices have not run into any particular pitfalls with the CFDA. We think this is because most of these higher-risk, highly engineered products are produced by multinationals that have already met developed-world regulatory standards.

The Reimbursement Picture Is Mixed
Accessibility to health care in China has improved greatly over the last few years. Thanks to historic and comprehensive health-care reform that was rolled out in 2009, nearly 95% of Chinese citizens now have basic medical coverage under some sort of health insurance plan (and many receive subsidies to pay for coverage). One major goal of the reform was to lessen the disparity between urban and rural residents' access to care. The introduction of these new programs has helped address that gap.

This new coverage whetted patient appetites for more and better health-care services. It has allowed them to receive care for ailments that they might have simply ignored in the past. We note that the current coverage is many miles wide but only an inch deep at this point. The Chinese government intends to improve depth of coverage by adding new disease states and treatments as they are proved to be cost beneficial, but will likely roll out these improvements selectively in order to keep a tight rein over medical spending.

Another change in reimbursement that we view positively for med-tech companies is the government’s intention to keep the proportion of out-of-pocket spending at roughly 30% of total health-care outlays over the longer run. This is a marked change from 10 years ago when out-of-pocket spending accounted for more than 50% of total health-care spending. Meeting this objective will necessitate increasing government-funded health-care spending through the midterm. Even as health-care inflation may cause total spending to rise faster than GDP, targeting out-of-pocket outlays at 30% should help the accessibility and affordability issue for Chinese patients.

Health-Care Provider System: On Balance, Favorable for Med-Tech
The provider system in China remains motivated to use more med-tech, which bodes well for the multinationals. On the whole, we think the tangled factors that have created this incentive system will be quite difficult to unwind and may require a wholesale reinvention of the financing of health care, which is unlikely in the midterm.

As China made its move to a market economy over the last 30 years, the former state-supported provider system, which focused on primary care and geographical reach, withered. As a result, most of China's provider resources are concentrated in hospitals and in the urban areas, though health-care reform efforts have managed to redirect some resources to less urban areas most recently. The critical turning point came when public hospitals were expected to be economically self-sufficient.

This, coupled with a fee-for-service framework, greased the skids for the current incentive system where most procedures and services are reimbursed at low levels. To compensate, hospitals and doctors rely on selling high-margin drugs and medical devices. This activity enhances both hospital profitability and doctors’ incomes. This has led to documented overprescription of antibiotics, injections, and corticosteroids in China.

The government has countered with its Essential Drug List, which puts price controls on key commonly used or high-health-benefit drugs to keep them affordable to the general public. There is the distinct possibility that the government might institute similar measures for medical devices in the future. In the meantime, physicians continue to press the use of certain drugs and devices for economic gain. These financial incentives are also conducive to crossing the line into corruption, including kickbacks and bribes by multinational firms.

Despite the risks, the sheer size of this market, along with its robust growth potential, has led most of the multinational med-tech firms to set up shop in China, though the level of investment has varied. Some firms, including  Medtronic (MDT),  Abbott (ABT), and  General Electric (GE), see China as a strategic priority and invested heavily to put down roots there. On the other hand,  Edwards (EW) and  C.R. Bard  have invested far less extensively in China and do not seem to view penetration of this market as a corporate priority. Overall, we think greater presence and investment in China translates into greater familiarity with regulatory agencies, distributors, and customers that can pay off in many ways.

Orthopedics Can Dig Deeper Moats in China
We contend that it will be substantially more difficult for multinational drug-eluting stent makers to construct narrow moats in China, primarily because the business environment is less conducive to moat-digging. There are plenty of native competitors well skilled at reverse-engineering these products. Further, the easy substitution of one coronary stent for another leaves multinationals like Abbott and  Boston Scientific (BSX) vulnerable to quick share losses in China. We have already seen multinationals go from strong dominance in this market to a peripheral role as native companies act as fast-followers and exploit their extensive networks into the secondary and tertiary hospitals outside the largest urban areas. The main avenue left for multinationals is to introduce more sophisticated innovation as a means to protect their Chinese business and fend off native rivals.

In contrast, we think orthopedic implant makers will fare better in China. It’s important to note that orthopedic companies’ wide moats are rooted in high switching costs, and we think this aspect of the moat will translate well in China. Unlike drug-eluting stents, reconstructive joint replacements involve using extensive sets of instrumentation that are specific to each competitor. Moreover, surgeon skill and experience are major factors in the clinical outcome. Unfortunately, high switching costs can be a double-edged sword. On one hand, this means surgeons tend to be very loyal and companies can expect most surgeons trained on their systems to stay put. On the other hand, this dynamic also makes it very difficult to pull orthopedic surgeons away once they are committed to competitive brands.

We expect recent mergers and acquisitions to also bolster orthopedic moats in China. Multinationals, including Medtronic and  Stryker (SYK), have purchased a number of the larger Chinese orthopedic firms. We think this strategy makes a lot of sense, especially considering most of the Chinese orthopedic firms are focused primarily on trauma, and the value segment of large joint replacement—offering a nice complement to the premium-tier, more sophisticated reconstruction implants that the multinationals specialize in. Teaming Stryker up with Trauson translates into a more comprehensive product portfolio with something to offer hospitals at all levels. Most importantly, Stryker has also purchased access to Trauson's distribution network, which depends highly on local market knowledge to ferret out which distributors are worthy partners—a task that is extremely difficult for any multinational that lacks deep connections in the local market.

Overall, we think Medtronic is best positioned to take advantage of the Chinese infrastructure it has built up because it has such a wide-ranging product portfolio.  With the acquisition of Kang Hui, Medtronic now has an avenue through which to distribute not only its spinal products but also its cardiac rhythm management devices, diabetes equipment, and surgical technologies. Further, CEO Omar Ishrak has made penetration of emerging markets a strategic priority, and thanks to Medtronic's early investments in China, the company is in a strong position to deepen its moat in that market.

Valuations in the Sector Are No Longer Very Appealing
With the impressive gains experienced in the U.S. stock market this year (the S&P 500 is up 21% year to date), we peg the average price/fair value ratio for our health-care coverage at 1.06, which leaves few bargains. However, we do still see a few relatively undervalued firms that offer an opportunity to investors.

Top Health-Care Sector Picks
Star Rating Fair Value
Fair Value
Express Scripts $89.00 Wide Medium $62.30
Sanofi $65.00 Wide Medium $45.50
Teva $48.00 Narrow Medium $33.60
WellPoint $100.00 Narrow Medium $70.00
Data as of 12-13-13.

 Express Scripts
The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and among the numerous players Express Scripts stands out as an elite participant. The firm’s strong competitive advantages have churned out excellent returns on invested capital and have given it a wide economic moat. We anticipate robust growth for the pharmaceutical industry over the long term, which should provide Express Scripts with a solid platform for continued success. With more than 1.3 billion adjusted claims processed in 2012, Express Scripts is the largest PBM. This dynamic positions the firm positively as it is able to negotiate favorable supplier pricing and solid spread retention. The power of the firm’s negotiating position was demonstrated recently with its  Walgreen (WAG) contract negotiations. Even though Walgreen is the largest retail pharmacy chain, it had to relent to Express Scripts’ pricing demands. More critically, however, the colossal claim volume processed by Express Scripts allows it to scale its centralized costs and leverage its asset-light capital structure into solid economic profits. The firm has some of the lowest selling, general, and administrative costs and highest operating profit per claim. These metrics have translated into ROICs well above its weighted average cost of capital.

 Sanofi (SNY)
On the pipeline, Sanofi is making strides, which increases our confidence in the company's wide moat. We remain most bullish on next-generation insulin U300 and cholesterol-lowering drug alirocumab as both drugs will likely enter very large markets with leading efficacy and clean side effect profiles, which should set up strong pricing power. Additionally, the company's emerging multiple sclerosis franchise should further propel long-term growth as a large portion of these patients fail on current treatments and are seeking new drugs. The company also harnesses its research and development group to bring new drugs to emerging markets. While pricing in emerging markets is not usually as strong as in developed markets, the company can still leverage its investment in developing new drugs for developed markets by bringing the drugs to emerging markets. The rapid economic growth in emerging markets has created new geographic markets for Sanofi's drugs.

 Teva Pharmaceutical (TEVA)
Teva faces a difficult transition phase over the next few years, but we think the company's narrow economic moat can sustain its leadership in the specialty pharma industry. 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 risk of branded and generic competition on Copaxone creates a more severe headwind in Teva's branded segment. Copaxone's patent protection through 2014 and a reasonably healthy pipeline, including biosimilar and respiratory products, leave us optimistic that management can successfully transition the company beyond its near-term challenges. Although these hurdles will subdue Teva's growth, healthy free cash flow leaves opportunities for acquisitions, dividend growth, and share repurchases.

 WellPoint (WLP)
Although WellPoint has faced a tough time over the past few years, we believe this MCO has a solid membership and network base that it can take advantage of to produce long-term outsized returns. The firm participates in 14 states under the Blue Cross Blue Shield brand, which gives it unparalleled recognition among consumers of health-care services. We believe this will serve the firm well once the individual exchange markets go live in 2014 and beyond. WellPoint also has the ability to negotiate advantageous pricing with its provider network given its sizable and geographically dense membership base. Scale will also be a positive for the MCO as it can utilize its robust membership base to spread costs. In our opinion, the firm has failed recently to take advantage of its inherent advantages and investor pressure lead to a CEO switch.

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