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Quarter-End Insights

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms

Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

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  • In aggregate, valuations in the healthcare sector have slightly decreased to a price/fair value of 1.01, down from 1.04 at the start of the year, but the differences in industry valuations suggest drug, biotech, and drug supply chain industries are the most undervalued areas. Within these industries, our top picks are  Allergan (AGN),  Roche (RHHBY),  McKesson (MCK,) and  Shire (SHPG).
  • In the United States, the passage of tax reform is significantly reducing tax burdens and should boost cash flows over the long term. However, other newly passed U.S. regulations have caused drug pricing concerns in the most profitable region of the world, but we still expect strong drug pricing power in the U.S.
  • The healthcare consolidation trend continues, with several companies looking to increase scale for competitive positioning as new threats emerge and cost pressures continue.
  • In the Big Pharma and Big Biotech industries, innovation continues and supports strong pricing power despite the increased pricing pressures from governments and pharmacy benefit managers.

Regulatory changes in the U.S. have provided a mixed picture for healthcare, with the positive benefits of tax reform offsetting the minor negative legislation on drug pricing. With the U.S. corporate tax rate falling to 21% from 35%, many global companies' tax rates have fallen by several hundred basis points. However, changes to payments to some of the U.S. drug programs, including Medicare Part D, will create a minor headwind to prices in the U.S., but pricing should remain strong relative to other geographies.

On the mergers and acquisitions front, partly aided by tax reform as well as a need to increase scale to lower costs, companies continue to consolidate. The announcement of  Cigna (CI) buying  Express Scripts (ESRX) signals the need for firms to increase scale to lower costs. This deal follows the merger announcement of  CVS Health (CVS) with  Aetna (AET), which also is looking to scale their business lines. Outside of the healthcare supply chain, we expect further consolidation within the drug and biotechnology industries as large firms look to redeploy strong cash flows by buying smaller firms with new drugs, augmenting internal research and development efforts.

On the innovation side, new advancements in drugs continue to support strong pricing power despite increasing pricing pressures from governments and insurance groups. In particular,  Merck (MRK) reported positive data for its immuno-oncology drug Keytruda in the large unmet medical need area of first-line lung cancer. Also,  Sanofi (SNY) and  Regeneron Pharmaceuticals (REGN) reported positive outcomes data for the cholesterol-lowering drug Praluent. We expect further data like these studies to support strong long-term pricing power of drugs despite pressures to lower drug costs by payers.

Top Picks

 Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $263
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 mid-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.

 McKesson (MCK)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $210
Fair Value Uncertainty: Medium
5-Star Price: $147

Despite major near-term headwinds, McKesson will remain an essential link in the pharmaceutical supply chain. Several headwinds have pressured the firm's operations and stock. Increased competition for small/independent pharmacy market share has formed a confluence of negative variables that have built in significant near-term uncertainty for the drug distributor. However, we believe these are near-term issues and that McKesson will be able to power through the recent volatility as it is a critical partner to both retail pharmacy clients and drug suppliers. While there are some remaining headwinds associated with potential contract losses, we believe McKesson will be able to effectively offset this issue, win its share of contracts in the future, and thrive long term. Additionally, we believe near-term drug price inflation trends should not have any material impact on McKesson's valuation. McKesson has also positioned itself as a critical player in the lucrative specialty pharmaceutical market niche, bolstering its wide economic moat.

 Roche Holding (RHHBY)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $43
Fair Value Uncertainty: Low
5-Star Price: $34.40

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: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $205
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), 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 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.

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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.