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Our Outlook for Health-Care Stocks

Health-care is on the brink of a first-in-decades overhaul.

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After months of intense discussions and negotiations, the U.S. Senate passed its version of the health-care reform bill on Dec. 24, likely clearing the way for reform passage in the first quarter of 2010 (the House and Senate bills must be merged first). The U.S. is now on the brink of a major health-care overhaul not seen in decades.

While the magnitude of changes may seem too narrow for some and too overreaching for others, the health-care system in this country will definitely be altered once the ramifications of reform start taking shape. At this point, the only thing that stands in the way of reform is an unexpected resistance from the House (which we consider highly unlikely) or President Obama's refusal to sign the bill (which we consider improbable).

In our December issue of Morningstar Healthcare Observer we have discussed in great detail key tenets of the reform and their implications on our health coverage universe. However, one common overarching theme that should reign supreme for any health-care investor is the removal of uncertainty that had been a major overhang on stock valuations in this sector. 

To borrow a quote from an ancient Roman playwright Terence, "When the mind is in a state of uncertainty, the smallest impulse directs it to either side." Well, over the past 12 months, the market has chosen the side of exodus. Health-care stocks across the industry were trading at their cheapest levels in decades (the industry bellwether  Johnson & Johnson (JNJ) is currently trading at 14 times trailing earnings, while its 10-year average exceeds 20). As reform language and its direction started to materialize, the veil covering health-care stocks is lifting, and investors' sentiment is starting to improve.

This momentum should lift the entire sector in the upcoming year, but there will also be a number of individual, industry-unique trends to be on the lookout for in 2010.

Volume vs. Pricing
While it applies to virtually any sector of the economy, the volume/pricing relationship will be heavily scrutinized in the post-reform health-care sector. If accomplished, the reform's key goal--universal coverage--should result in an inflow of newly insured individuals into the market. A volume boost should balance the weakening pricing environment stemming from reimbursement pressure and industry taxes. The equilibrium is rather delicate, though, and any attempt to gain market share by succumbing to pressure could result in devastating effects for all the industry participants. We will be watching managed care and devices in early 2010 for any signs of a disruption.

In devices,  Boston Scientific (BSX) was the soft-pricing culprit in the third quarter of 2009 (in its stents and the CRM business), which had caused us to dial down some of our projections and lower the firm's fair value estimate. If its peers,  St. Jude Medical (STJ) and  Medtronic  (MDT), choose to go down the same path (they haven't so far) and price wars ensue, our fair value estimates (and potentially our moats) for all three could prove to be too optimistic.

In managed care, annual contract renewals (currently under way) set up the industry's pathway for the entire year. Our impression, so far, is that pricing in the 2010 selling season has been strong. Our long-run thesis is that it is in the best interest of managed care organizations (MCOs) to price rationally (i.e., raise prices in line with medical costs). Large membership gains would be needed to make up for lower margins from rate cuts, but customers are generally too sticky to allow for such dramatic market share swings. Overall medical cost trends are difficult to predict, making future medical cost ratios uncertain. However, as long as all of the MCOs are setting prices in line with their rational expectations for medical costs, we think there will be no swings in memberships.

The wildcard in this sector is the impending end of the Medicare Advantage private-fee-for-service program (PFFS). If a large provider of PFFS, such as  Humana (HUM) or  UnitedHealth (UNH), attempts to make up for the upcoming large PFFS member loss by setting aggressive rates, the entire industry may suffer. However, we consider this scenario unlikely.

New Drug Approvals
While the conclusion of reform efforts in 2010 should be a positive for the pharma industry regardless of whether a bill successfully passes, performance of the biggest pharma firms in 2010 will also be driven by several factors at the individual firm level, primarily new drug launches and cost-cutting. Johnson & Johnson leads the way with six new potential blockbuster launches on tap from late 2009 through 2010, including rheumatoid arthritis drug Simponi, cardiovascular drug Xarelto, epilepsy drug Comfyde, immunology drug Stelara, pain drug Tapentadol, and antibiotic ceftobiprole.

Additionally, game-changing clinical data is expected throughout 2010. We believe strong data could shift negative investor sentiment surrounding pharma industry pipelines, leading to better valuations for the entire group.

On the cost-cutting front, many of these efforts have already commenced and should continue throughout the year, as mega billion-dollar acquisitions get digested. We anticipate 2010 will mark a turning point from the bloated cost structures of the heyday of primary-care drugs in the late-1990s to more efficient drug companies of the future that are prepared for three years of difficult patent losses. We believe drug firms will emerge beyond the patent cliff as more productive companies with strong prospects.

 

Acquisitions
The health-care sector made some notable merger-and-acquisition splashes in 2009, and we believe the wave of M&A activity isn't likely to subside in 2010 (although the likely targets will pale by comparison to Schering-Plough, Genentech, or Wyeth). We think many biotechs with market capitalizations in the single-digit billions will look like attractive targets for big pharma companies, as these firms tend to have marketed drugs, strong pipelines, or a lucky combination of both. For instance, rare disease expert  BioMarin  (BMRN) looks interesting as a takeout candidate to us.

Life sciences and equipment sectors also remain highly fragmented despite major acquisitions in 2009, offering further opportunities for consolidation. Large conglomerates such as General Electric  (GE), Siemens  (SI), and Danaher  (DHR) have already expressed keen interest in expanding their life-science operations, and we expect they will increasingly look at external sources to enhance their presence.

We think GE could be the next firm to make a splashy acquisition; as the firm battles to restore its beleaguered financial and industrial operations, it could increasingly turn to health care for revenue expansion avenues. Among its targets could be PerkinElmer (PKI), a life science firm with a strong presence in diagnostics (through prenatal and neonatal testing), pharmaceutical, and industrial (petro-chemical and environmental) end markets. All of these areas correlate well with GE's strategy and existing market positioning.

Valuations by Industry
 

 Health-Care Industry Valuations
   Star Rating Price/Fair
Value*
P/FV Three
Months Prior
Change (%) Uncertainty
Percentile**
Biotechnology 3.17 0.88 0.91 -3.3 60.2
Diagnostics & Research Services 3.12 0.91 0.85 7.1 51.1
Drug Manufacturers 3.75 0.85 0.78 9.0 11.4
Hospitals 3.00 0.83 1.37 -39.4 96.6
Managed Care 3.89 0.76 0.71 7.0 61.4
Medical Appliances & Equipment 3.85 0.88 0.80 10.0 5.7
Medical Instruments & Supplies 3.37 0.88 0.83 6.0 9.1
Generic Drugs 3.00 0.95 0.85 11.8 63.6
Health Care Services 2.90 0.93 0.81 14.9 43.2
Data as of 12-14-09. *Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

Medical devices and supplies had a strong third quarter. As recently discussed in this article, the medical equipment industry has been suffering from a massive pullback in hospital spending throughout 2009. As the environment eases (expansion of credit availability and stabilization in the uninsured ranks), hospital spending is coming back online, and medical equipment stocks such as  Becton, Dickinson (BDX) should benefit.

Generic drugs manufacturers also had a strong performance. This sector has generally been in the good graces of legislators and should benefit twice from any health-care reform efforts: first from expanded coverage, and second from incentives to prescribe cheaper drugs. The sector is, on average, fairly valued right now.

Our Top Health-Care Picks

 Top Health-Care Sector Picks
   Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Price/
Fair Value
Genzyme $82 Wide Medium 0.60
St. Jude Medical $47 Wide Low 0.80
Wellpoint $95 Narrow Medium 0.63
Abbott $68 Wide Low 0.79
Data as of 12-21-09.

 Genzyme (GENZ)
Genzyme's manufacturing struggles were at the heart of the firm's biggest challenges in 2009. Adequate supply of established rare disease drugs Cerezyme and Fabrazyme as well as FDA approval of a larger-scale version of Pompe disease drug Myozyme proved elusive. Now that Genzyme has filed a new Lumizyme application with the FDA--and fresh supplies of Cerezyme and Fabrazyme are becoming available--we think the firm is poised to make a strong recovery in 2010. Although firms like  Shire (SHPGY) and Protalix (with new partner  Pfizer (PFE)) are taking aim at Genzyme's rare disease dominance, we think limited near-term supply of these new drugs and the hesitancy of patients to switch therapies will make it difficult for these firms wrest control of the market. In addition, Genzyme's diverse portfolio outside of the rare disease realm--and promising pipeline of late-stage drug candidates in areas like cholesterol control and multiple sclerosis--add stability and growth potential.   

 St. Jude Medical (STJ)
As one of only three major cardiac device makers, St. Jude offers life-saving therapies and exercises substantial bargaining power thanks to similar, but not completely identical, products in its portfolio, as well as strong relationships with the medical practitioners who make the brand decision. Importantly, St. Jude is taking the lead in developing transcatheter ablation to cure atrial fibrillation through its sponsorship of the CABANA study currently under way. Considering there are more than 2 million Americans with atrial fibrillation and many are untreated because effective pharmaceutical options are limited, tapping into this market offers attractive longer-term growth potential. A recent meta-analysis of catheter-based ablation suggests this therapeutic approach is significantly more effective than drug therapy; we expect the comparative effectiveness of ablation in the CABANA study should also be favorable.

 WellPoint (WLP)
With health reform taking over as the primary risk keeping managed care investors up at night, WellPoint has remained at the depressed valuations of 2008, despite a stabilization of its medical cost trends. We still think the shares are a bargain despite the recent runup, and uncertainty surrounding our projections has diminished substantially with the removal of a public-plan option.

 Abbott Laboratories (ABT)
Abbott has several positives going for it: a very diverse product lineup and a drug portfolio that faces only a limited patent expiration cliff. Abbott's pharmaceutical division contains a diverse set of growing blockbusters across many therapy groups, and the company's active research and development efforts have created the next generation of drugs, including psoriasis treatment ABT-874 and cardiovascular drug Trilipix, which both have blockbuster potential. Abbott's success in the vascular market with stent Xience, as well as a strong performance of its nutritional and diagnostic business, shield the company from any negatives ramifications of health-care reform. 

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Alex Morozov does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.