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Quarter-End Insights

Healthcare: Drug Pricing Concerns Weigh on Valuations, Creating Opportunities

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

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  • Overall, healthcare valuations have slightly fallen to a price/fair value of 0.98, down from 1.01 at the end of the first quarter and 1.04 at the start of the year, but the differences in industry valuations continue to suggest drug, biotech, and drug supply chain industries are the most undervalued areas. Within these industries, our top picks are  Allergan (AGN),  Roche Holding (RHHBY), and  McKesson (MCK).
  • U.S. governmental reforms addressing drug pricing should not have a material impact on the most profitable region of the world, which should ease pricing concerns that are weighing on the drug and biotechnology industries.
  • Research and development trends continue to deliver strong data in areas of unmet medical need, such as cancer and immunology, which should drive strong long-term growth for drugs with solid pricing power.
  • The strong cash flows of the largest healthcare companies continue to focus on acquisitions and share repurchases and we expect an acceleration of acquisitions through the reminder of the year.

U.S. governmental rhetoric on bringing drug pricing down will not likely have a major impact on the largest drug market in the world, despite concerns that we believe have weighed on valuations. The Trump administration’s policy paper titled "The Trump Administration Blueprint to Lower Drug Prices and Reduce Out-of-Pocket Costs" largely supports increasing generic drug competition, slightly strengthening Medicare drug price negotiations, improving drug price transparency, and providing more information to help patients lower out-of-pocket costs, all of which we believe have a limited impact on branded U.S. drug prices. In aggregate, we think the proposals would likely impact less than 1% of U.S. drug spending, excluding the potential changes to negotiations for Medicare Part B drugs, which could offer another 1%-2% reduction in U.S. drug spending depending on the exact implementation.

Within the backdrop of pricing concerns, drug and biotech firms are focusing development on innovative drugs in areas of unmet medical need where pricing power remains strong. Major advancements in immuno-oncology drugs from  Merck (MRK), Roche, and  Bristol-Myers Squibb (BMY) should change the paradigm of treatment for lung cancer, one of the most prevalent deadly diseases. Additionally, drug advancements in immunology led by  AbbVie (ABBV),  Johnson & Johnson (JNJ),  Eli Lilly (LLY), and  Novartis (NVS) are offering new treatments that are significantly more effective and safer in areas of rheumatoid arthritis, psoriasis, and inflammatory bowel disease. 

Turning to capital redeployment, acquisitions, share repurchases, and dividends continue to be the focus for the larger healthcare companies. Mergers in the healthcare supply chain, including  Cigna (CI) buying  Express Scripts (ESRX) and  CVS Health (CVS) acquiring  Aetna (AET), remain on track and both look to create scale to lower costs. Additionally, share repurchases continue with AbbVie's recent $7 billion-plus share repurchase showing an example of significant capital use in buying back stock. We expect the large healthcare firms will continue to buy back shares and likely accelerate acquisitions to boost earnings-per-share growth. 

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) back in 2016.

 McKesson (MCK)  
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $210
Fair Value Uncertainty: Medium
5-Star Price: $147

Despite major near-term headwinds, McKesson should remain an essential link in the pharmaceutical supply chain. Several headwinds have pressured the firm's operations and stock. The loss of material volume as a result of customer consolidation, slowing branded drug price inflation, a mix shift toward specialty drug products that are costlier to distribute, and increased competition for small/independent pharmacy market share have 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 McKesson will be able to power through the recent volatility, as it is a critical partner to both retail pharmacy clients and drug suppliers. This has given investors an opportunity to acquire shares of a wide-moat company at a material discount. While there are some remaining headwinds associated with a changing pharmaceutical supply chain, we believe McKesson will be able to effectively offset this issue, win its share of contracts in the future, and thrive long term. McKesson is in the process of better positioning itself as a critical player in the lucrative specialty pharmaceutical market niche, which will eventually bolster its wide economic moat.

 Medtronic (MDT)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $105
Fair Value Uncertainty: Medium
5-Star Price: $73.50

As the market-leading pure play in medical technology, Medtronic has an unmatched, extensive product portfolio, stretching from surgical consumables to implantable devices for cardiac conditions. We think the market is overly focused on the waning of some of Medtronic’s product cycles in key cardiac device markets and underappreciates how the firm has shifted the dynamics of competition away from innovation exclusively. Medtronic has pioneered ways to benefit from the shift to value-based reimbursement through risk-based contracting, which has gained a foothold with providers and payers. We expect Medtronic's efforts to solidify preference at that level should better insulate its products from competition, even when the firm is in an unfavorable product cycle.

 Roche Holding (RHHBY)  
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $41
Fair Value Uncertainty: Low
5-Star Price: $32.80

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.

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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.