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Quarter-End Insights

Health Care: Some Healthy Bargains Still Remain

While the sector looks fairly valued overall, we still see several stocks that offer attractive valuations across the different industries, including pharmacy benefit managers.

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  • While the health-care sector is fairly valued in aggregate, some stocks still look undervalued, particularly in the pharmacy benefit manager (PBM) industry.
  • Mergers and acquisitions continue at a rapid pace, as large conglomerates are looking for growth avenues and opportunities to cut costs, especially through lowering taxes for U.S.-based companies.
  • Drug development in specialty-care areas, including virology and oncology, is increasing the productivity of drug and biotech companies, with several recent launches with very high prices reminding the investment community of the strong moats of large pharmaceutical and biotech firms.
  • Even though several years have passed since the worldwide economic downturn, overall health-care utilization remains tepid, but we see early signs of improvement partly spurred by health-care reform in the U.S.

 

While the past few years have increased the valuation of the health-care sector to meet our fair value estimates in aggregate, we still see several stocks that offer attractive valuations across the different industries. Most notably, we believe the pharmacy benefit manager industry offers the most appealing valuations. In the table below, we highlight a few of our top picks, including two PBMs. However, we believe the current environment for health care lends itself to a stock-pickers' market rather than a focus on industries.

In the pharmaceutical and device industries, companies are acquiring and merging to create scale and focus in key strategic areas, in addition to deploying their previously trapped overseas cash, as are the cases with the pending acquisitions of  Covidien (COV) by  Medtronic (MDT) and of  Shire (SHP) by  AbbVie (ABBV). These deals also showcase the desire to reduce the tax rate of the acquiring firms. While the completion of some major acquisitions is still not certain--such as  Valeant's (VRX) bid for  Allergan (AGN) and  Pfizer (PFE) potentially returning to an  AstraZeneca (AZN) bid--we believe the deals show an increased focus by firms to create scale in order to cut costs as well as to concentrate on high-return business lines. Also, several of these deals are focusing on a tax inversion to lower the overall tax rate. While increased rhetoric has come out of Washington D.C., we don't expect any material near-term change in U.S. tax laws that will limit tax inversions of U.S. firms acquiring firms in low-tax countries and inverting to lower the overall tax rate.

Turning to innovation in health care, the focus of drug companies is shifting toward specialty-care areas, which should increase drug-development productivity. The pipelines of the major biotech and pharmaceutical companies are focused on smaller patient populations in areas such as immunology, virology, and oncology. We believe these areas offer unmet medical need, which should lead to better approval odds and stronger pricing power. Further, despite treating smaller patient populations, these indications can turn into major blockbusters.  Merck's (MRK) recent approval of Keytruda in melanoma is a good example of a small patient population, but an annual price of about $150,000 should turn the drug into a major commercial success.

While the economic downturn passed several years ago, health-care utilization remains tepid, but recent signs are pointing to a pickup of the market. Historically, a lag of a couple of years tends to follow a recession before health-care spending returns. However, the magnitude of the recession and increasing cost-sharing with patients has delayed a sharp rebound in health-care use. The increase in U.S. hospital admissions in the second quarter suggest a turning point in health-care usage; U.S. health-care reform is likely driving part of the uptick. With the mandated health-care insurance and expanded government insurance in the U.S., more people are seeking out treatment. We expect a continual, gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

Top Health-Care Sector Picks

Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Catamaran $57.00 Narrow Medium $39.90
Baxter $84.00 Wide Low $67.20
Express Scripts $89.00 Wide Medium $62.30
Data as of 09-24-2014

 Catamaran (CTRX)
Catamaran is the third-largest pharmacy benefit manager, with more than 250 million adjusted claims processed in 2013. The firm was recently formed through the merger of PBM information technology provider SXC Health Solutions and pure-play PBM Catalyst Health Solutions. The company manages the cost of prescription drugs for its clients. Catamaran is poised to produce solid economic profits over an extended period, as its robust claim volume gives it the opportunity to take advantage of two key industry drivers: supplier pricing leverage and centralized cost scale. We believe these factors are underappreciated by the market, making the stock look undervalued.

 Baxter (BAX)
While competition is increasing for Advate, Baxter's highly profitable hemophilia A product, we think this diversified firm's competitive advantages remain strong and the stock looks undervalued. We think this diversified health-care firm has earned a wide economic moat, stemming from economies of scale in plasma processing, injectable therapies, and dialysis products. Intangible assets--like Baxter's strong brands, patent protection, and pipeline productivity--also allow the firm to remain remarkably profitable in tough industries. More than 70% of Baxter's sales come from products with market-leading positions, and the safety and quality of its biologic therapies allow it to charge a price premium over competitors.

 Express Scripts (ESRX)
Express Scripts is the largest pharmacy benefit manager in the United States. Through its mail-order pharmacy and network of retail pharmacies, the company manages the cost of prescription drugs for its clients. We expect Express Scripts to administer around 1.5 billion adjusted prescriptions in 2014. In our opinion, market participants are underestimating the long-term growth potential for the firm and overestimating the effects of a maturing industry. Near-term uncertainty regarding the effect of private exchanges in the U.S. upon Express Scripts has also pressured the stock. We believe private exchange health insurance providers will still need the negotiating leverage and pharmacy benefit management expertise of the PBM. Additionally, we believe the pace of movement--and the total number of businesses moving--toward private exchanges will be materially less than what some market participants currently expect.

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