Health sector not quite cured

9/1/2008


The health-care sector has outperformed the broader market over the last year, though investors who own shares of managed-care providers and small drug companies may have missed that news.

Capitalization-weighted S&P 1500 Health Care Sector Index is down 4% over the last year. In contrast, the broader S&P 1500 Index is down 13%. However, not all groups within health care have outperformed.

Biotech companies and providers of medical equipment and supplies rallied over the last year, yet drugmakers and service providers — such as health insurers — performed poorly, dragging down the sector. The next few months could be rough for health-care stocks without well-defined growth avenues. But the sector’s overall prospects for 2009 look solid, with the average S&P 1500 health-care company expected to boost per-share profits 19%.

Historically, the health-care sector has manifested both growth and defensive characteristics. But over the last year, the average health-care stock in the S&P 1500 is down 8%, and more than half lost value. Solid returns from some of the largest medical-device makers and biotechnology companies have lifted the cap-weighted index relative to the performance of the average stock.

Investors looking for gems in health care should avoid bottom-feeders and most of the big-name drug companies. Many managed-care stocks trade at low valuations. But given their poor growth outlooks, the shares are no bargain. And most of the drug giants — such as Pfizer ($19; NYSE: PFE), Merck ($35; NYSE: MRK), and Bristol-Myers Squibb ($22; NYSE: BMY) — face serious issues ranging from weak product pipelines to generic competition, stunting their profit-growth potential.

The Forecasts is taking few chances with health care, in particular avoiding the small drug and biotech companies that earn subpar Quadrix® scores. At the moment, we only recommend four health-care stocks for purchase. All four are included in the table below, with our two favorite drug companies and two to avoid discussed in the following paragraphs.

HEALTH STOCKS WITH SOLID QUADRIX SCORES
Market
Value
($Mil.)
12-Mo.
Price
Chg.
(%)
12-Mo.
EPS
Chg.
(%)
Est.
2008
EPS
Chg.
(%)
P/E
On
2008
Est.
Quadrix
Overall
Score *
Advice
Biotechnology
Amgen ($64; AMGN)
67,109
3
28
2
15
84
Neutral
Genentech ($98; DNA)
103,844
12
34
18
28
88
Neutral
Gilead Sciences
($54; GILD)
52,405
16
47
18
27
85
Neutral
Equipment & Supplies
Baxter International
($68; BAX)
43,735
27
30
19
21
72
Neutral
Medtronic ($55; MDT)
60,204
9
3
18
19
73
Neutral
St Jude Medical
($46; STJ)
15,561
31
4
25
20
90
Focus Buy †
Stryker ($67; SYK)
27,401
21
0
20
23
84
Neutral
Waters ($67; WAT)
6,869
24
9
21
20
88
Neutral
Zimmer Holdings
($72; ZMH)
16,174
10
(6)
1
18
66
Neutral
Pharmaceuticals
Abbott Laboratories
($58; ABT)
90,103
18
11
15
18
73
Neutral
Astrazeneca ($49; AZN)
70,801
4
1
4
11
94
LT Buy
Eli Lilly ($47; LLY)
55,006
10
(17)
11
12
90
Neutral
Johnson & Johnson
($71; JNJ)
198,968
11
15
9
16
81
Buy †
Pfizer ($19; PFE)
132,868
12
(22)
8
8
82
Neutral
Wyeth ($42; WYE)
56,964
6
(10)
0
12
78
Neutral
Providers & Services
Cardinal Health
($55; CAH)
19,288
13
(21)
1
15
62
Neutral
Cigna ($42; CI)
11,610
15
(16)
5
10
70
Neutral
Coventry Health Care
($35; CVH)
5,777
(1)
(40)
(9)
10
81
Neutral
Express Scripts
($72; ESRX)
17,831
39
32
31
24
78
Neutral
Henry Schein
($59; HSIC)
5,341
25
1
16
20
82
Neutral
Humana ($46; HUM)
8,215
38
(30)
(11)
10
94
Neutral
Laboratory Corp.
($72; LH)
8,024
13
(4)
10
16
62
Buy †
Medco Health
($48; MHS)
24,091
16
10
27
20
60
Neutral
UnitedHealth Group
($29; UNH)
38,839
1
(40)
(15)
10
75
Neutral
WellPoint
($52; WLP)
28,497
5
(33)
(1)
10
76
Neutral
* Percentile ranks, with 100 the best.      † Also qualifies as a Long-Term Buy.

Two picks
For most of the last two years, AstraZeneca ($49; NYSE: AZN) has traded at a discount to the average large pharmaceutical stock. While a legal victory and strong June-quarter results sparked a rally over the last two months, the British drugmaker still trades at an attractive 11 times expected 2008 earnings, below the peer-group average of 12.

A series of high-profile research failures have weighed on AstraZeneca in recent years. But the pipeline remains promising, with 100 drugs under development, including 34 in late-stage trials. This year, AstraZeneca successfully defended the patents on it its best-selling drugs, Nexium ($5.2 billion in 2007 sales) and Seroquel ($4 billion). The company faces no major threat from generics over the next two years.

Cholesterol drug Crestor ($2.8 billion in 2007 sales) could face generic competition in 2010, but a study showing that the drug significantly reduces the risk of death from heart attack or stroke in certain patients with normal cholesterol could boost sales. Full results from the trial are slated for release in November. A positive outcome could boost AstraZeneca’s earnings by 10% or more. AstraZeneca is a Long-Term Buy.


Shares of Johnson & Johnson ($71; NYSE: JNJ) have performed well despite stock-market turmoil. The stock is up 6% so far this year.

Pharmaceutical sales accounted for 41% of 2007 revenue. Risperdal, with $4.6 billion in sales, began facing generic competition this year. In response, J&J is trying to develop injectable or extended-release versions of the drug. In August, the Food and Drug Administration went against the advice of one of its panels and rejected J&J’s request to approve the antibiotic Doribax as a treatment for hospital-acquired pneumonia, asking for more data. The FDA also asked for more information on a schizophrenia drug, but did not seek additional trials. J&J’s rich pipeline contains new drugs for cancer, pain, AIDS, and psychological conditions. New drugs should support decent growth over the next few years.

Drug sales are slowing (U.S. revenue fell 2% in the June quarter) because of patent expirations. Increased competition in the market for drug-coated stents also weighs on J&J. However, the company expects to save $1.3 billion to $1.6 billion a year in costs through a restructuring plan. J&J has also repurchased $6.5 billion in stock over the last year, shrinking the share base by nearly 3%. J&J, a Buy and a Long-Term Buy, sells for 15 times 2009 earnings, reasonable considering the industry leader’s growth history.

Two pans
Merck ($35; NYSE: MRK) has run into trouble with its newest drugs. The FDA did not approve cholesterol drug Cordaptive, while a study found another cholesterol treatment, Vytorin, performed no better than a cheaper drug for slowing heart disease. After the Vytorin study in July, Merck suspended its earnings guidance. In addition, the company lowered its sales guidance for other drugs because of difficulty expanding their approved patient populations.

The combination of a weak pipeline and heavy generic competition should limit Merck’s top-line growth over the next several years. To support profit margins, Merck is cutting costs aggressively, including shedding more than 4,000 positions since 2007 in hopes of cutting annual costs by $2 billion. Despite the aggressive cost-cutting, consensus earnings estimates have fallen slightly over the last month. Wall Street expects per-share profits to rise 3% this year and 8% in 2009. Merck is rated Neutral.


Per-share earnings at Mylan ($13; NYSE: MYL) are expected to fall more than 50% this year, though sales could climb more than 70%, lifted by an October 2007 acquisition. The purchase of a German drugmaker’s generic business made Mylan the world’s third-largest generic company, with about 600 products and nearly $5 billion in annual sales. However, the market remains skeptical that Mylan can achieve its forecast of $300 million in annual cost savings from the deal.

The consensus projects nearly 100% growth in per-share earnings in 2009 — to levels roughly in line with 2006 profits. Mylan earns a poor Quadrix Overall score of 23, hurt by weak operating results and a balance sheet bloated with debt. Competition in the generic-drug business should only get stiffer, as branded drugmakers increasingly produce their own generics or sign exclusivity agreements with generic firms. Mylan, rated Neutral, sells for a rich 26 times estimated 2008 earnings.


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