Healthcare: ACA Repeal Efforts Unlikely to Yield Major Legislative Changes

• While the Republican-led Congress continues to push forward new healthcare legislation aimed at repealing the Affordable Care Act, we still see challenges in passing any new legislation, since the ACA has provided millions with healthcare insurance that will be difficult to strip away.
• Innovation within the drug and biotech industries remains robust, with pipelines continuing to bring forward the next generation of drugs, helping mitigate pricing pressures from pharmacy benefit managers.
• We expect mergers and acquisitions, stock buybacks, and steady dividends to continue from the larger healthcare companies as steady cash flows surrounded by moats should enable continued redeployment of capital.

Across the political landscape for the healthcare sector, the dynamics are most robust in the United States as Republicans try to push forward legislation to repeal the Affordable Care Act, but we continue to see challenges for any attempt to significantly change the healthcare system.

While legislation was passed in the House of Representatives, Republicans wield only a slight majority in the Senate, which means fewer than a handful of Republican senators could scrap a reform bill or cause major concessions. This narrow majority is further in jeopardy, because there is significant disagreement among Republicans about what policy should replace the ACA. Further, Republican reform ideas could lead to more than 20 million Americans newly insured under the ACA losing coverage, which would probably result in major political backlash.

As the largest industry in the healthcare sector, the drug and biotechnology group continues to innovate and create new drugs, helping mitigate the pricing pressures from pharmacy benefit managers (PBMs). Drug development in areas of complex treatment, such as in oncology and immunology, is bringing forward new drugs with strong pricing power.

In particular, new immuno-oncology drugs are creating a paradigm shift in treating cancer as the drugs work by helping the body's immune system recognize tumor cells that had been evading the body's response mechanisms. These drugs carry strong efficacy in an area of unmet medical need, which enables the strong pricing power of over $100,000 per year of treatment. The steady drug development in oncology and other specialty treatment areas is helping offset the weakness in less innovative areas, such as diabetes and respiratory disease, which are facing heavy pricing pressures.

On the capital allocation front, we expect large healthcare companies to continue to support dividends and buy back shares while engaging in heavy acquisition activity. However, the highly competitive landscape for acquisitions is leading to potential overpayments for smaller targets as several large-cap firms would like to augment internal growth with smaller firms. The recent high-cost acquisitions of Actelion by

Additionally, any change that lowers the U.S. corporate tax rate by the Republican-led Congress would likely free up international capital for U.S. firms, leading to the likely increase in acquisition activity. Overall, the low interest rates combined with the need for scale and growth should continue to drive healthcare acquisitions over the next six months.

Top Picks

Express Scripts

ESRX

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $89.00

Fair Value Uncertainty: Medium

5-Star Price: $62.30

The likely loss of the Anthem relationship and drug price transparency concerns have weighed on Express Scripts' stock over the last year. Nevertheless, we believe the firm's stock trades at a deep discount to its current market price as the company will still play a critical role within the healthcare market for years to come. Given the significant level of market concentration in the PBM market, Anthem's alternative PBM vendors are extremely limited. Drug price transparency has also been an overhanging issue for many investors related to Express; however, we believe this concern is not rooted in facts. All clients have transparency surrounding the total costs of the drug plan Express manages on their behalf since these firms underwrite for the risk of providing healthcare insurance to their members. From our perspective, the 98% annual client renewal rate for Express is evidence its clients are largely satisfied with the transparency they receive from the PBM.

Roche

RHHBY

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $41.50

Fair Value Uncertainty: Low

5-Star Price: $33.20

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics that conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, and more cost-effective endeavor. The collaboration between Roche's diagnostics and drug-development groups gives the firm a unique in-house angle on personalized medicine. Also, Roche's biologics constitute three fourths of its pharmaceutical sales, and biosimilar competitors have seen development setbacks while Roche's innovative pipeline could make these products less relevant by their launch.

Allergan

AGN

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $300.00

Fair Value Uncertainty: Medium

5-Star Price: $210.00

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology, gastro, and central nervous system. Allergan's diverse portfolio, key durable products including Botox, and healthy pipeline support a wide economic moat and high-single-digit organic growth over the next five years, in our view. The firm has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with M&A, which creates numerous capital deployment opportunities following the $40 billion sale of its industry-leading generics unit to

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