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Quarter-End Insights

Health Care: A Few Stocks Still Offer Upside

Despite the sector looking slightly overvalued, we still see stocks with attractive valuations across the different industries.

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  • While we view the health-care sector as slightly overvalued, with the group trading close to 5% above our fair value estimates in aggregate, some stocks still look undervalued, including  Amgen (AMGN),  Baxter (BAX), and  Elekta (EKTA B).
  • Overall health-care utilization is increasing slightly after a prolonged pullback due to lingering impacts from the recession and insurance pushing more costs to patients. We expect this trend to continue because of a strengthening economy and increased insurance coverage driven partly by health-care reform in the United States.
  • Further adding to health-care valuations (especially smaller potential health-care targets), mergers and acquisitions continue at a rapid pace, as large conglomerates are looking for growth avenues and opportunities to cut costs, partially through lowering taxes.
  • Strong drug launches and excellent clinical data in specialty-care areas, such as oncology, is increasing the productivity of drug and biotech companies.

While the market valuation of the health-care sector remains slightly above our fair value estimates in aggregate, we still see several undervalued stocks across the different industries. In the table below, we highlight a few of our top picks. As has been the case for several quarters, we believe the current environment for health care continues to lend itself to a stock-pickers' market rather than a focus on industries.

After the severe recession and increased cost sharing by insurance companies with patients, health-care utilization is increasing. The magnitude of the recession and increased cost-sharing has delayed a sharp rebound in health-care use. However, the increase in U.S. hospital admissions starting in mid-2014 suggests a turning point, and 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 treatment. We expect a continual, gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

Across health-care industries, companies are acquiring and merging to increase their growth potential through creating scale, cutting costs, and focusing on key strategic areas. Further, the persistent low interest rates are also fueling the M&A trends, because cheap capital is available to fund acquisitions. Beyond the heavy prevalence of M&A in the drug space, with large drug firms acquiring Hospira, Salix, and Pharmacyclics, we are seeing further consolidation in health-care services.  UnitedHealth's (UNH) acquisition of Catamaran significantly increases its supplier pricing power and scale advantages.

Turning to innovation in health care, drug companies continue to shift their focus toward specialty-care areas such as oncology. We expect the shift to increase drug-development productivity and strengthen the moats for drug companies, since these areas of development carry strong drug pricing, a more accommodating stance from regulatory agencies, and steep launch trajectories. While some of these specialty indications have smaller patient populations than primary care areas, the strong pricing power can easily turn the drugs into blockbusters. In oncology, recent approvals carry price tags over $100,000 per year, opening the door to major market opportunities even in the less prevalent cancers.

Top Health-Care Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Baxter $79 Wide Low $63.20
Elekta SEK 90 Wide Medium SEK 63.00
Amgen $189 Wide Low $151.20
Data as of June 22, 2015

 Baxter (BAX)
Although 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 Baxter 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.

Elekta (EKTA B)
We believe Elekta is well-positioned in the radiotherapy market, which has tremendous growth potential as improvements in technology, increasing awareness of the clinical benefits, and a favorable cost/benefit proposition should dramatically increase global adoption over the next decade. Further, we feel that Elekta carries a wide moat based on a solid position in a market that is characterized by high barriers to entry, high switching costs, and strong intellectual property. This field has evolved into a duopoly over the past decade with virtually no new entrants, and the main two players, Elekta and  Varian (VAR), have built durable franchises and are well-positioned for growth.

 Amgen (AMGN)
Amgen markets several blockbuster biologic therapies in the oncology and immunology markets, giving it the intangible assets that form the foundation of its wide moat. Additionally, Amgen's improved manufacturing efficiency will not only benefit gross margins, but could also give the firm a cost advantage in the nascent biosimilar market, where it plans to launch five products by 2019. Looking ahead, we're confident that Amgen will be capable of defending its bottom-line growth through a key period of weakness for legacy products, buying it time to develop the sales potential for newer products and pipeline opportunities.

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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.