Healthcare: Valuations Improve as Concerns Over Drug Pricing Pressures Begin to Abate

• Overall, healthcare valuations have slightly risen to a price/fair value of 1.07, up from 0.98 at the end of the second 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  Cardinal Health (CAH),  McKesson (MCK), and  Roche Holding (RHHBY).
• Innovative new drug launches combined with strong advancements in drug pipelines are supporting a steady growth outlook for the drug and biotech industries.
• Concerns around U.S. governmental reforms addressing drug pricing appear to be easing on the valuations for drug manufacturers with the majority of reform concerns still surrounding potential changes to the drug supply chain.
• Corporate restructuring and redeployment of capital represent key strategy decisions within the healthcare sector as noncore assets are increasingly divested and strong cash flows are supporting continued acquisitions both within the healthcare supply chain and within the drug and biotech industries.

Within the healthcare's largest industry of drug and biotech companies (by market capitalization), we expect the recent strong launches of innovative new drugs and pipeline advancements to reinforce the economic moats in the industry and support steady growth. We expect several recently launched drugs to continue to gain market share and grow not dependent on pricing, but on strong efficacy data that will displace older drugs. In immuno oncology, several recently launched drugs exemplify this trend. The immuno oncology drugs offer some patients a near cure over older drugs that typically just delay progression of certain cancer types. In addition to tracking well with the initial indications, these immuno oncology drugs are also posting excellent data in new indications, setting up a strong outlook for future growth. Beyond immuno- oncology, advancements in other therapeutic areas, such as immunology and cardiology, are also supporting major innovative advancements that are driving strong sales growth.

While innovation remains strong, concerns regarding the U.S. government's rhetoric on bringing drug pricing down has weighed on the group, but we believe these pressures are beginning to dissipate. With the U.S. market representing the largest drug market in the world, the potential changes to U.S. drug pricing have global implications. However, with the Trump administration increasing its focus on improving the drug supply chain, increasing generic drug competition, slightly strengthening Medicare drug price negotiations, and providing more information to help patients lower out-of-pocket costs, we expect only a mild impact on branded U.S. drug prices.

Within the entire healthcare sector, corporate restructuring and redeployment of capital will likely continue to be critical drivers of strategy with the U.S. healthcare supply chain likely to continue to consolidate while the global drug and biotech markets continue to focus on core strengths. Within the healthcare supply chain,  Cigna's (CI) purchase of  Express Scripts (ESRX) and  CVS Health's (CVS) acquisition of  Aetna (AET) remain on track and should create more scale in efforts to lower costs. Within the drug and biotech industries, the announced divestiture of the eyecare business Alcon by  Novartis (NVS) as well as  Eli Lilly's (LLY) decision to spin off the animal healthcare business Elanco show a continuation of major drug firms focusing on the core human branded drug businesses. Further, we expect the large cash flow generation at both drug companies and device companies to continue to be redeployed through healthy dividends and acquisitions of smaller firms with emerging innovative technology.

Top Picks

 Cardinal Health (CAH)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $82
Fair Value Uncertainty: Medium
5-Star Price: $57.40

Although there may be some material changes over the next several years to how the various parts of the U.S. pharmaceutical market operate, the need to source and deliver drugs in a cost-effective and efficient manner will not change. We believe this fundamental factor has formed a strong foundation for Cardinal, as its core drug wholesaling operations will be needed by both drug manufacturers and retail pharmacies. Further, we have remained unenthusiastic about Cardinal's push into medical equipment manufacturing/distribution and believe the previous management team’s efforts to expand into this business was a strategic misstep. We expect new management to place a greater focus on optimizing its drug wholesaling operations and expansion of specialty pharmaceutical operations, which should yield stronger overall results.

 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 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. 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.

 Roche Holding (RHHBY)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $42
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.