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Quarter-End Insights

Healthcare: Stock Selection Key as Valuations Rise

Valuations in the healthcare sector in aggregate look fair, increasing the importance on stock selection where innovation and redeployment of capital weigh heavily.

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  • In aggregate, valuations in the healthcare sector have slightly increased to a price/fair value of 1.02, up from 1 at the end of the last quarter and 0.87 at the start of the year as solid clinical data and the falling risk of higher payer pressure on branded drug prices are helping drug stock valuations. Against this backdrop, stock selection is increasingly important in healthcare. Our top picks are Express Scripts, ConvaTec, and Allergan.
  • In the United States, we expect the failed attempt to repeal and replace the Affordable Care Act by the Republican-led Congress will lead to less focus by the U.S. government on major changes in healthcare. 
  • Strong clinical data in the drug and biotech industries should support the next generation of innovative drugs while also helping to mitigate pricing pressures from pharmacy benefit managers and government payers.
  • The larger healthcare companies should continue to redeploy strong cash flows through stock buybacks, steady dividends, and potentially accelerated mergers and acquisitions. 

Despite Republican control of the U.S. government, the failure to repeal the Affordable Care Act means the government is likely to focus on smaller healthcare changes. Overall, we find this development positive for the managed-care and hospital sectors as volume increases due to expanded coverage will remain in place.

On the other end of the spectrum, the elimination of various ACA fees and taxes for pharmaceutical and device companies is now off the table. We expect the government to focus on shoring up the weak public exchange marketplace in order to maintain a functioning private individual insurance market over the near term.

On the innovation front, drug and biotech companies continue to generate impressive data, supporting the moats of several key companies. The new advances in cardiology, oncology, and immunology are rapidly changing the treatment paradigms.

In particular, in  Bayer's (BAYRY) Compass study for coronary and peripheral artery disease, Xarelto combined with aspirin, reduced the rate of cardiovascular death, stroke, or myocardial infarction by 24% compared with aspirin alone, a major improvement over standard of care.  Bristol-Myers Squibb's (BMY) positive data in renal cancer showed Opdivo plus Yervoy reduced risk of death by 37% versus standard of care with fewer major side effects, which should transform the treatment pathway for renal cancer.

The solid clinical data coming out of the drug industry helps reinforce moats across the group and push back against pharmacy benefit managers and world governments that are looking for ways to cut costs on drugs.

We expect steady cash flows by the large healthcare companies to continue to support dividends, share buybacks, and acquisitions.  Gilead Sciences(GILD) recent announcement that it intends to acquire  Kite Pharma (KITE) is a good example of what we expect to see with acquisitions by larger companies. The majority of large healthcare companies need to augment slowing internal organic growth with acquisitions of high-growth smaller companies with innovative new products.

Top Picks

 Express Scripts (ESRX)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $89.00
Fair Value Uncertainty: Medium
5-Star Price: $62.30

The potential loss of the  Anthem (ANTM) relationship and drug price transparency concerns have weighed on Express Scripts' stock over the past year. Nevertheless, we believe the shares trade at a deep discount to the current market price as the company should still play a critical role in the healthcare market for years to come. Given the significant level of concentration in the pharmacy benefit management market, Anthem's alternative PBM vendors are extremely limited.

Drug price transparency has also been an overhanging issue for many investors related to Express Scripts; however, we believe this concern is not rooted in facts. All clients have transparency surrounding the total costs of the drug plans that Express Scripts manages on their behalf because these companies underwrite for the risk of providing healthcare insurance to their members. From our perspective, the 98% annual client renewal rate for Express is evidence its clients are largely satisfied with the transparency they receive.

ConvaTec (CNVVY)  
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $19.50
Fair Value Uncertainty: Medium
5-Star Price: $13.65

ConvaTec's well-established footprint in the U.S. ostomy market has paved the way for the company to forge solid contracts with large group purchasing organizations, including Premier and Vizient. Also, ConvaTec is well positioned to extend the Aquacel technology into the foam and disposable negative-pressure wound therapy subsegments in wound care, which should expand its market potential. If ConvaTec could further narrow the gap between its cost structure and that of  Coloplast (COLO B), there would be upside to our intrinsic value.

 Allergan (AGN)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $290.00
Fair Value Uncertainty: Medium
5-Star Price: $203.00

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, gastroenterology, 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 company has used a nice mix of focusing on core internal research and development strengths while supplementing its pipeline with M&A, which creates numerous capital-deployment opportunities following the $40 billion sale of its industry-leading generics unit to  Teva Pharmaceutical (TEVA) in 2016.

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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.