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Quarter-End Insights

Healthcare: Specter of ACA Repeal Hangs Over Fairly Valued Sector

We expect appeals to delay any impact but revoking the ACA would likely create the most pressure for the healthcare services companies.

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Healthcare stocks were among the strongest performers in 2018 (Exhibit 1). As of Dec. 20, the Morningstar Global Healthcare Index was essentially where it started the year, far better than the market as a whole (down 10%). We attribute the relative outperformance to diminished concerns around pricing pressures.

Exhibit 1: Healthcare sector index vs market index

Overall, we view the healthcare sector as slightly undervalued. The median stock we cover trades at a 7% discount to our fair value estimate. Not surprisingly, we see comparably few buys in the sector, with only 6% of our coverage rated 5 stars (Exhibit 2).

Exhibit 2: Star rating distribution and average P/FV for sector and key industry groups

We see a relatively higher share (9%) of 5-star stocks in the drug manufacturing industry. While concern over drug pricing pressures has abated to some extent, we believe the market has still placed too much pressure on potential drug pricing concerns, opening up a couple of significantly undervalued stocks.

In looking at the key pricing trends (Exhibit 3), the recent U.S. drug pricing changes are decelerating, and net prices in the U.S. actually increased less than inflation in 2017. We believe the lower price increases will increasingly reduce the political pressure to lower drug prices. Also, strong drug innovation should support steady pricing.

Exhibit 3: List drug pricing suggests more reasonable recent pricing trends

All our valuations are based on discounted cash flow analysis, but looking at the price/earnings trend (Exhibit 4), the drug stocks look more expensive than the bargain basement prices of 2010, but less expensive than 2014 (before pricing pressures became more of a concern).

Exhibit 4: Valuation versus the P/E multiple over the last 10 years

Another development that could weigh on healthcare stocks is the potential repeal of the Affordable Care Act in the U.S., a concern that resurfaced after a Texas judge ruled it unconstitutional in December. We expect appeals to delay any impact, but revoking the ACA would likely create the most pressure for the healthcare services companies.

Consolidation continues to be a major theme, and we expect larger firms to acquire more smaller device and drug companies to increase access to innovation. Also, the consolidation in the medical supply chain should continue, with companies like CVS and Cigna looking for ways to lower healthcare costs and provide value for stakeholders.

Top Picks
 Allergan (AGN)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $245
Fair Value Uncertainty: Medium
5-Star Price: $171.50

Unlike most of its peers in specialty pharma, Allergan retains an attractive product portfolio and innovative pipeline, particularly in its core markets of aesthetics, opthalmology, gastro, and central nervous system. Despite concerns about generic competition on Restasis and new entrants in the aesthetics market, Allergan's diverse portfolio, key durable products, including Botox, and healthy pipeline support a wide economic moat and mid-single-digit organic growth over the next five years, in our view.

 Bayer (BAYRY)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $32
Fair Value Uncertainty: High
5-Star Price: $19.20

Despite increasing concern steming from litigation around Bayer's glyphosate business, we believe the company will navigate the legal challenges with much less damage than the market expects. We believe the support by key regulatory agencies and a large amount of scientific studies showing no causal relationship between glyphosate and cancer will lead to Bayer prevailing in the legal cases. Further, largely on the basis of the strong competitive advantages of the healthcare group and to a lesser extent the crop science business, we believe Bayer has created a wide economic moat that supports steady cash flows that will drive valuation.

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

McKesson should remain an essential link in the pharma 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 that McKesson can offset using its strong positioning in the drug supply chain.

Exhibit Sources: Morningstar, IQvia. Data as of Dec. 20, 2018.

Damien Conover does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.