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Quarter-End Insights

Healthcare: We See Value in the Drug and Biotech Industries

Overblown concerns over drug pricing in the U.S. are creating attractive valuations for the more innovative drug companies.

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  • Despite continued uncertainty surrounding potential for drug pricing reforms, market valuations in healthcare have stayed relatively flat over the past quarter with a recent aggregate price to fair value of 0.94, in line with last quarter, but we still see selective opportunities with several underappreciated stocks, including  Allergan (AGN),  Roche (RHHBY), and  Elekta (EKTA B).    
  • While presidential rhetoric remains elevated regarding plans to lower U.S. drug prices, we expect pricing power for drug and biotech companies to remain strong, especially for innovative new drugs.
  • Research-and-development productivity continues at a rapid pace, supporting strong drug launches and rapidly progressing clinical data with a focus in specialty-care areas, such as oncology and immunology.
  • Mergers and acquisitions continue at a steady pace, as large conglomerates look for external innovation and opportunities in smaller firms to redeploy capital to increase growth. 

 

As the U.S. presidential elections approach, we expect the rhetoric on lowering drug prices will continue as candidates vie for voters, but we don't see any major shifts in U.S. drug prices over the next several years. The last major healthcare reform of the Affordable Care Act didn't materially change the pricing power for drugs, and we don't expect new reforms will change the pricing landscape for innovative drugs. However, older generic drugs could face increased pricing pressure, but we don't expect this pressure to have a material impact on the generic-drug industry. Although drug pricing concerns may cause increased volatility in pharmaceutical and biotechnology stocks, without a major structural reform and a willingness by patients and doctors to limit treatment options, we don't see any major changes in U.S. drug prices.

Turning to the research-and-development landscape, the core pillar of economic moats of innovation in healthcare, drug, and biotechnology companies is rapidly increasing the speed of generating excellent clinical data in areas of unmet medical need, particularly oncology and immunology. Drugs in these therapeutic areas are reaching the market at half the time of drugs developed a decade ago, partly due to major advancements in science and clinical designs, but also due to more accommodative healthcare regulatory groups. We expect the shift to continue and to increase drug-development productivity and strengthen the moats for drug companies, especially as the productivity gains are in areas of unmet medical need, which hold strong drug pricing power and steep launch trajectories. Although the patient populations tend to be smaller in these specialty areas, the strong pricing power can easily turn the drugs into blockbusters. Also, payers tend to be more supportive of drugs in areas of unmet medical need over areas with minor drug advancement, such as allergies and blood pressure.

On the mergers and acquisitions front, healthcare companies continue to acquire and merge to increase their growth potential through creating scale, cutting costs, and focusing on key strategic areas. The persistent low interest rates are also fueling merger-and-acquisition trends because cheap capital is available to fund acquisitions.  Pfizer's (PFE) recent acquisition of Medivation showcases the high demand by Big Pharma firms for midsize, quickly growing companies, as the acquisition price of $14 billion was expensive by most valuation metrics. However, we are seeing regulators stymie several major acquisitions, including the tax department shutting down Pfizer's bid for Allergan and the antitrust regulators putting up major roadblocks for both managed care mergers ( Aetna (AET)Humana and  Anthem (ANTM)Cigna (CI)). Nevertheless, the low interest rates combined with the need for scale and growth should drive significant healthcare acquisitions over the next six months.

Top Picks

 Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $355.00
Fair Value Uncertainty: Medium
Consider Buying: $248.50

Unlike most of its peers in specialty pharma, Allergan retains one of the most attractive product portfolios and innovative pipelines, particularly in its core markets of aesthetics, ophthalmology, gastro, and central nervous system. Allergan's diverse portfolio, key durable products including Botox, and healthy pipeline support a wide economic moat and high-single-digit organic growth over the next five years, in our view. The firm has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with mergers and acquisitions, which creates numerous capital deployment opportunities following the $40 billion sale of its industry-leading generics unit to  Teva (TEVA) in August.

 Roche (RHHBY)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $42.00
Fair Value Uncertainty: Low
Consider Buying: $33.60

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics that conspire to create sustainable competitive advantages. As the market leader in both biotech and diagnostics, this Swiss healthcare giant is in a unique position to guide global healthcare into a safer, more personalized, and more cost-effective endeavor. Roche's collaboration between its diagnostics and drug-development groups gives Roche a unique in-house angle on personalized medicine. Also, Roche's biologics constitute three fourths of its pharmaceutical sales, and biosimilar competitors have seen development setbacks while Roche's innovative pipeline could make these products less relevant by their launch.

Elekta (EKTA B)
Star Rating: 3 Stars
Economic Moat: Wide
Fair Value Estimate: SEK 90
Fair Value Uncertainty: Medium
Consider Buying: SEK 63

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 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.

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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.