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Quarter-End Insights

Health Care: Recent Pullback Opens Door to More Compelling Valuations

We see several stocks with attractive valuations across the different health-care industries.

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  • The recent market pullback has pushed the valuation of the health-care sector to slightly undervalued from slightly overvalued valued, with the group trading close to 5% below our fair value estimates in aggregate and some stocks looking significantly undervalued, including  Amgen (AMGN),  Allergan (AGN), and  Elekta (EKTA B).
  • Despite global macro concerns about slowing growth, we expect overall health-care utilization to remain largely stable given the inelastic nature of health care.
  • 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, are increasing the productivity of drug and biotech companies.

We believe the recent overall market pullback has created some opportunities for health-care companies. The valuation of the health-care sector now is slightly below our fair value estimates in aggregate, and we 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 recent market pullback on concerns of slowing growth from China and several other regions outside the U.S., we believe the downward pressure on health-care stocks is overdone. With the majority of health-care companies selling inelastic goods and services, we expect demand to remain strong for these products. Further, the majority of health-care companies derive most of their profits from developed markets, which should post more stable growth relative to emerging markets. 

Within health care, companies are continuing to acquire and merge 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 and  Aetna's (AET) acquisition of Humana show the increasing importance of gaining scale advantages.

Turning to a core element of moats with 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. Although 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
Allergan $370 Wide Low $296
Elekta SEK 90 Wide Medium SEK 63
Amgen $194 Wide Low $155.20
Data as of 09-24-15

 Allergan (AGN)
Allergan has utilized acquisitions to transform into a major pharmaceutical contender, and we award the company a wide moat based on a diverse product portfolio, key durable products with limited competitive risks such as Botox, and a healthy pipeline. Management's decision to sell its generics segment to  Teva (TEVA) looks prescient and will deleverage the balance sheet with ample cash to pursue more acquisitions. Low competitive risks, new product launches, and a keen focus on expanding its branded pipeline and salesforce productivity through both small and large acquisitions and licensing partnerships should support high earnings growth, which appears underappreciated by the market. Further, the concerns surrounding the slowing global growth should have less impact on Allergan's core health-care products.

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. Additionally, despite concerns over slowing global growth that are causing the market and Elekta to decline recently, we believe the critical-care element of Elekta's products will insulate it from demand decline. Further, we think 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 has several innovative biologic therapies that have turned into blockbuster products and generated consistently high returns on invested capital, and we think Amgen's pipeline turnaround will continue to support the firm's wide moat. Although Amgen has heavy exposure to biosimilars--close to 40% of total sales are at risk to biosimilars over the next five years--we think the firm is well-positioned to grow throughout upcoming U.S. biosimilar launches. In the near term, fast-growing approved drugs like Prolia/Xgeva and Kyprolis, as well as Amgen's emerging cardiovascular drug Repatha, will counter biosimilar pressure. In the long term, we expect better pipeline productivity (via the deCODE human genetics database) and an internal biosimilar pipeline will drive stronger growth. We expect the firm's reputation for quality biologics manufacturing and large biosimilar pipeline will allow it to gain a more than 10% share of the global biosimilar market. Additionally, given the market pullback, we view Amgen in a particularly strong position as its more inelastic product portfolio should feel less pressure if global market growth slows.

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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.