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Quarter-End Insights

Our Outlook for Health-Care Stocks

While we remain bullish on the sector, health-care growth depends on the economy.

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  • Although office visits remain weak, we've had two quarters in a row of strong sequential growth in personal health expenditures. Improving unemployment should provide further tailwinds.  
  • Supercommittee's failure to resolve deficit debate will result in automatic across-the-board budget cuts, affecting a broad spectrum of industries within health care.
  • Share buybacks will likely bolster earnings growth.

 

Health-Care Demand Is Improving, but Recovery Is Gradual 
Although the health-care sector isn't out of the woods just yet, the last two quarters point to the improving demand, with personal health-care expenditures exceeding sequential gross domestic product growth in the second and third quarters of 2011. 

Sequential health-care spending should continue to outpace GDP growth through 2012 as private health-care spending continues to improve. Commercial insurance enrollment has improved sequentially, albeit at a pedestrian pace, and with unemployment levels gradually subsiding, the enrollment figures are likely to continue to grow. On the flip side, public health-care spending growth, which offset a considerable slowdown in private spending during the recession, should slow as Medicaid enrollment wanes, and the private/public mix should provide further boost to the overall growth given higher levels of utilization and reimbursement for private insurance. However, public spending will undoubtedly remain a significant contributor to overall health-care spending as long as unemployment remains high.

We note that physician office visits remain weak for now ( Quest Diagnostics (DGX) reported a 6% year-over-year decline in doctor office traffic in the third quarter), but hospital admissions are gradually recovering. Although we haven't seen a snap-back recovery in demand for surgical procedures, we have started seeing gradual improvement, in part because of easy comparables. 

Mandatory Budget Cuts to Have Broad Effect
The congressional supercommittee's failure to reach compromise on deficit reduction will result in automatic across-the-board budget cuts starting in January 2013. Funding for nondefense discretionary programs will be hit particularly hard, with a 7.8% reduction in 2013, dropping to 5.5% by 2021, according to Congressional Budget Office estimates. The Center on Budget and Policy Priorities estimates the 2013 hit for nondefense discretionary funding at an even steeper 9% rate. On the nondiscretionary side, Medicare providers will face a 2% cut.

Not all industries within health care will be hit equally by the proposed cuts. On the Big Pharma side, we expect only minor pricing pressure from the government payers and minor secondary pricing cuts as providers attempt to pass their own cuts onto suppliers. We project only minimal implications under this outcome for Big Pharma's earnings and fair value estimates. The same goes for our biotech coverage, though we note that some federal funding programs (such as HIV-testing federal assistance) are likely to be cut, which could negatively affect firms such as  Gilead (GILD). However, the impact isn't likely to be material for our valuation.

Other sectors will be hit harder. Health-care providers, such as hospitals, already face a strong headwind of reimbursement pressure from Medicare and Medicaid, and the upcoming cut will only exacerbate their vulnerability. We already saw rather Draconian measures imposed on skilled nursing providers earlier this year, and though we don't anticipate the magnitude of Medicare cuts for hospitals to equal those for skilled nursing, hospitals are definitely on the front line of the government reimbursement pressure. 

Hospital suppliers will feel a ripple effect of hospital payments cuts, and it will likely have a large impact on device makers, both on the cardiac and orthopedic sides. We've already incorporated our expectations for pricing cuts in valuations for companies in these industries, based on our expectation of a 2% cut. However, even though a 2% cut for device makers could be relatively easily absorbed, hospitals have razor-thin operating margins and would likely demand higher discounts from supplies firms. We believe device makers' moats are strong enough to withstand reimbursement pressure, so we don't anticipate any further adjustments to our margin expectations.

Another area under duress is government funding for the National Institute of Health. We don't anticipate the NIH budget will be slashed by the amount proposed, but we do see a potential for flat funding for 2012 and a slight decrease in 2013. We think academic institutions will be somewhat stingy with their capital spending, which could be a headwind for life-science companies. Although we continue to recommend a number of life-science companies, particularly  Thermo Fisher Scientific (TMO), we think the top-line growth both in the fourth quarter of 2011 and throughout 2012 will be suppressed by weak academic demand. That said, life-science companies have been increasingly turning to emerging markets for growth, and Thermo Fisher has a strong competitive position in China, which should allow it to mitigate domestic pressures. 

Share Buybacks to Bolster Earnings Growth
Share buybacks became the preferred capital-allocation strategy for the sector in 2011 as many firms were trying to take advantage of depressed share prices as well as artificially inflate the subpar earnings growth. Average cash deployment toward buybacks among the largest health-care firms in our coverage universe increased from approximately 30% in 2009 to more than 50% year to date in 2011. 

This strategy was particularly prevalent among medical-device and instruments makers, as this sector was particularly reeling from weak earnings growth and share prices on average traded in the attractive range. Instrument and equipment makers deployed on average nearly 80% of their free cash flow toward share buybacks. Further, this cash flow usage isn't subsiding, with a number of massive buybacks already announced for 2012.  Covidien (COV),  Stryker (SYK),  Becton Dickinson (BDX), and others intend to prop up their earnings growth by as much as midsingle digits as a result of this strategy.

Our Top Health-Care Picks
Our top health-care recommendations cover most of the sector's industries, ranging from pharmaceuticals to managed care. These firms remain undervalued as the appetite for health-care stocks has yet to improve, despite favorable long-term dynamics.

Top Health-Care Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Price/
Fair Value
Medtronic $46.00 Wide Medium 0.69
Abbott Laboratories $68.00 Wide Low 0.75
Covidien $76.00 Narrow Medium 0.60
Roche $52.00 Wide Medium 0.64
WellPoint $100.00 Narrow Medium 0.63
Data as of 12-17-2011.

 Medtronic (MDT)
After estimating Medtronic's exposure to Medicare cuts and baking in a 2% default reimbursement reduction, we've recently modestly lowered our fair value estimate.  Compared with rivals Boston Scientific and St. Jude, Medtronic is actually less vulnerable to Medicare thanks to its large spinal, diabetes, and neuromodulation businesses that are less reliant on Medicare patients. We estimate 23% of Medtronic's total revenue base is subject to indirect Medicare reimbursement. In our expected case, we also assume the providers are successful in passing the entire cut onto their vendors, and Medtronic is unable to reduce its manufacturing or operating costs in response. 

 Abbott Laboratories (ABT)
In an effort to unlock value, management has decided to split Abbott into two--a branded drug company and a diversified health-care company. Although we don't expect the breakup to significantly change our fair value estimate, we still believe the company is undervalued and the breakup could draw more attention to Abbott's attractive valuation. In the pharmaceutical industry, Abbott faces relatively minor patent losses during the next five years and is well-positioned to ride a strong tailwind of demand for its products. Most important, we expect continued strong demand for the company's top drug, Humira, based on low drug penetration in immunology diseases. Abbott's strong competitive position in nutritionals and diagnostics creates additional avenues of growth.

 Covidien (COV)
Covidien's overall growth prospects are compelling despite struggles in its pharmaceuticals business. The company's latest product launches have been well-received by the marketplace, and Covidien successfully integrated a number of sizable acquisitions. Although a weak macro environment continues to hamper elective procedure volume, the company's revenue growth in the device segment remains robust as a result of market share gains. With emerging markets also fueling growth, we anticipate strong revenue momentum despite expected ongoing struggles in pharmaceuticals. We remain convinced this unit will be sold, but the presence of several underperforming assets could prolong the process. Even if it remains part of the company, a shift in product mix toward devices and the firm's focus on efficiency support our margin expansion and double-digit earnings growth forecast.

 Roche (RHHBY)
The long patent life of Roche's portfolio puts it among the biotechs least exposed to generic competition. Patents don't begin to expire until 2013--when Rituxan loses protection in Europe--and to counteract future competitive pressures, management is implementing strategies that we think will enable the firm to achieve 5% five-year earnings growth. Subcutaneous versions of Roche's blockbuster antibodies are in the works, which could reduce hospital costs and add to convenience. Novel drugs are in development that could improve on the efficacy of Roche's current products or represent new, personalized treatments for cancer patients. Roche also has a solid pipeline beyond oncology, including drugs to treat schizophrenia and hepatitis C. With the Genentech integration starting to yield synergies, we think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages.

 WellPoint (WLP)
WellPoint's 14 Blue Cross and Blue Shield plans provide 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. Investors remain fearful about the regulatory and economic headwinds facing WellPoint, causing the stock to trade at less than 9 times earnings and with a 35% discount to our fair value estimate. However, we think these concerns are overblown, as the recent health reform law should have only a modest impact on WellPoint's future profits. Although we expect ongoing medical cost pressures, this should be partly offset by revenue growth opportunities and potential selling, general, and administrative leverage. In the meantime, WellPoint generates copious free cash flow, which it is using to repurchase shares at a breakneck pace.

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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.