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Quarter-End Insights

Healthcare: Pick Carefully as Valuations Head Higher

Innovation and redeployment of capital are factoring heavily in the sector.

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  • In aggregate, valuations in the healthcare sector have slightly increased to a price/fair value of 1.04, up from 1.02 at the end of the last quarter and 0.87 at the start of the year, as risks of deflating drug pricing power are abating and new clinical data supports new drugs. Against this higher valuation backdrop, stock selection is important in the healthcare sector, and our top picks are  Allergan (AGN),  Roche (RHHBY), and  Shire (SHPG).
  • In the United States, following the failed attempt to repeal and replace the Affordable Care Act by the Republican-led Congress, tax reform has passed and will lower corporate tax rates. 
  • Further consolidation within the healthcare industries is likely as the larger healthcare companies continue to redeploy strong cash flows and tax reform could accelerate this trend.
  • Pricing pressures from pharmacy benefit managers, pharmacies, and government payers continue to weigh on drug companies, but in the branded pharmaceutical segment, solid clinical data should support the pricing power of new innovative drugs.

 

Following the failure to repeal the Affordable Care Act, Congress passed tax reform, bringing down the corporate tax rate. The corporate tax reduction will help earnings and give U.S. healthcare companies more flexibility with their global cash reserves.

We expect the increased cash flexibility, and the need for scale and steady cash flows by the large healthcare companies, to continue to drive further consolidation in the sector. The recent announcement of the CVS (CVS) merger with  Aetna (AET) shows the growing importance of scale within the healthcare supply chain.

Further, the majority of large healthcare companies need to augment slowing internal organic growth with acquisitions of high-growth smaller companies with innovative new products. Beyond mergers and acquisitions, we expect the cash flows to continue to support dividends and share buybacks.

Turning to research and development, the drug industry continues to post innovative data, supporting differentiated and meaningful advancements. The new advances in oncology are particularly impressive. Roche's immuno oncology drug Tecentriq generated strong data in lung cancer, and the company also posted significant advancements in treating blood cancers with Venclexta. The solid clinical data coming out of the drug industry helps support pricing power for new branded drugs and reinforce moats across the group.

Top Picks

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

We think the market underappreciates Roche's drug portfolio and industry-leading diagnostics, which 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, more cost-effective endeavor. The 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; biosimilar competitors have seen development setbacks while Roche's innovative pipeline could make these products less relevant by their launch.

 Shire (SHPG)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $205.00
Fair Value Uncertainty: Medium
5-Star Price: $143.50

We view Shire's diversified rare-disease portfolio and neuroscience franchise as warranting a narrow moat rating, and while the pipeline is thinner than most large-cap biotechs, we think the portfolio is quite defensible, particularly the rapidly growing immunology franchise.

We think the market has an overly bearish view on Shire's hemophilia portfolio, and even with more severe erosion from Roche's Hemlibra (launching 2018) than we currently model, we think Shire's valuation looks attractive. Given the stability of the firm's core businesses, we're not concerned about Shire's financial health.

We believe synergies between Shire and recently acquired Baxalta on the top line--including Shire's ability to use Baxalta's international footprint for its own products, as well as the hospital overlap between Shire's hereditary angioedema and Baxalta’s immunology business--have not been fully appreciated. The immunology franchise--including what we see as the best portfolio of immunoglobulin therapies--appears to be gaining share internationally and seizing on trends for increased subcutaneous use in the U.S. Along with newer product launches (rare-disease drugs Gattex and Natpara), the launch of dry-eye drug Xiidra, the upcoming launch of HAE drug lanadelumab, and stabilization of generic pressure on GI drug Lialda, we think this will help Shire drive growth despite expected hematology losses.

 Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $263.00
Fair Value Uncertainty: Medium
5-Star Price: $184.10

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 earnings 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.