Portfolio Review: September 5, 2016

9/5/2016


AbbVie in, Gilead out

AbbVie's ($64; ABBV) greatest weakness — reliance on a single product for 62% of its revenue — is also its greatest strength. Humira treats a variety of types of arthritis, Crohn's disease, plaque psoriasis, and colitis, yet it may have even more to accomplish, as AbbVie continues to test for additional indications. Excluding the effect of exchange rates, Humira's revenue rose 20% in the first half of 2016 to $7.7 billion, on pace to top $15 billion for the year. Humira accounted for 62% of total company revenue during those six months, which puts a lot of pressure on the drug to keep delivering.

Rivals are attacking the patent — given the revenue potential, it's a tough target to ignore — but AbbVie expects to maintain exclusivity through 2022. The company plans to launch 20 new products or indications through 2020, with the pipeline delivering $30 billion in peak annual revenue. Even if these claims prove too grandiose, the pipeline is still impressive and the forward P/E ratio of 13 doesn't fully reflect AbbVie's growth potential. AbbVie, which yields 3.6% and scores 95 in Quadrix Overall, is being added to the Long-Term Buy List.


We're selling Gilead Sciences ($78; GILD) from the Long-Term Buy List. Growth has slowed dramatically this year, mostly because of sharply lower prices for the company's blockbuster hepatitis C drugs, Harvoni and Sovaldi. In July, Gilead lowered its full-year sales outlook, citing European price controls and the refusal of some U.S. health insurers to cover the drugs.

Gilead looks genuinely cheap at just six times trailing earnings, by far the lowest P/E ratio among S&P 1500 Index biotech stocks and among the cheapest 2% of the broad index. However, the consensus projects lower sales and profits this year and next year, and our confidence in Gilead's ability to exceed even those modest targets has eroded. Gilead, now rated B (average) on the Monitored List, should be sold.

Apple pounded on taxes, security, touchscreens

Big news about the European Union's $14.5 billion tax ruling against Apple ($106; AAPL) has distracted attention away from other developments, both positive and negative. First, let's look at the taxes.

On Aug. 30, the European Commission ordered Apple to pay up to $14.5 billion in back taxes to Ireland, ruling that the smartphone giant received illegal tax benefits. Both Apple and Ireland say the company's taxes satisfied both EU and Irish law, but EU Competition Commissioner Margrethe Vestager pointed out that Apple's Irish unit paid taxes equivalent to 0.005% of income in 2014. Most of Apple's non-U.S. profits flow through Irish subsidiaries.

You'd expect Ireland to welcome this windfall, but the country plans to appeal. Ireland has long relied on its low corporate taxes to draw multinationals, which now employ nearly 10% of Ireland's work force.

The U.S. Treasury Department responded to Apple's punishment by calling the EU's retroactive tax assessments "unfair" and warning that such unilateral action could hurt Europe's economy and dampen "economic partnership between the U.S. and the EU."  Expect this battle to drag on in the courts, possibly for years.

While taxes represent the biggest news about Apple, they're not the only news:

*Apple invited the media to a presentation on Sept. 7. The company is widely expected to release its iPhone 7 and 7 Plus models, which should feature only minor tweaks. A more serious makeover is expected next year.

*Owners of iPhone 6 and 6 Plus phones have sued Apple over an alleged design problem that can leave touchscreens unresponsive. The problem, which some now call "touch disease," renders the phones unusable because Apple cannot (or will not) fix them.

*A web analytics firm says more than 86% of iPhones are still vulnerable to a security hole that can allow a hacker using "Pegasus" software to take over the device with a text message. Apple has created a fix, but as of Aug. 29, most users had yet to update their operating systems.

Apple is a Buy and a Long-Term Buy.

Health-care update

Obamacare is ailing, with insurers bailing out and consumers likely to see another painful price hike in 2017. Managed-care giants Aetna ($117; AET) and UnitedHealth ($116; UNH) have announced plans to sharply scale back their participation in the health exchanges, citing operating losses.

The Affordable Care Act's insurance exchanges have run into trouble for several reasons. Participation among the healthiest people is lower than expected, with many opting to pay a penalty and remain uninsured rather than purchase pricey coverage. That shortage of healthy enrollees has skewed costs higher than many insurers expected, which in turn has made it more difficult to operate risk corridors designed to collect money from especially profitable insurers and share those funds with companies losing money. 

According to ACAsignups.net, ACA rate hikes have been approved for about 21% of enrollees; the weighted average rate hike is nearly 30%. Several large states with lower expected rate hikes should skew that number downward in coming weeks, but the weighted average requested rate hike for all 50 states is 24%.

What does this mean for investors? The Obamacare issue is far from settled. While Aetna and UnitedHealth will pull back, other insurers plan to enter new exchanges next year. Further legislation or rule changes are possible, a specter that could overhang managed-care stocks going forward — but should have little effect on our preferred stock in that group.

We recommend just one managed-care company, Centene ($68; CNC), which focuses on Medicaid plans. In July, Centene said it had a "favorable" experience with health exchanges, generating profit margins near the top of its target range. In the June quarter, 90% of its exchange members were eligible for subsidies. Centene is a Focus List Buy and a Long-Term Buy.


The Food and Drug Administration rejected Amgen's ($170; AMGN) application for Parsabiv, a drug that treats secondary hyperparathyroidism, a hormonal imbalance common in dialysis patients. Consensus estimates projected Parsabiv would provide less than 1% of company revenue next year, so the rejection should have little effect in the near term. The company plans to meet with the FDA about Parsabiv later this year. In other news, the FDA approved Novartis' ($79; NVS) biosimilar to Amgen's Enbrel painkiller. Amgen has sued Novartis to keep the biosimilar off the market, claiming patent protection for Enbrel until 2029. Amgen is a Buy and a Long-Term Buy. Novartis is rated C (below average).


Mylan ($42; MYL) cut the cost of its popular allergy treatment EpiPen roughly in half. Mylan originally agreed to provide patients with a savings card worth up to $300. Then, in response to criticism, announced plans for a generic version that will sell for $300 for a pack of two injectors, about half the current price. EpiPen's price has increased sixfold since 2007, and Mylan has been taking heat from both consumers and politicians, most notably Democratic presidential nominee Hillary Clinton. Mylan is rated A (above average).

Corporate roundup

It took four years and one failed contract proposal, but Southwest Airlines ($37; LUV) has agreed in principle to a four-year labor deal with its 8,400 pilots. The pact calls for retroactive pay increases back to 2013 and compensation comparable to that offered by the three largest U.S. airlines. Southwest's pilots, who along with other company employees have become more vocal about their displeasure in recent months, will meet in mid-September to vote on the deal.

The airline has been in talks with pilots and mechanics for four years and flight attendants for three years. While an agreement with the pilots would clear up a longstanding concern for Southwest, approval is far from certain. In July, Southwest's flight attendants voted down a contract proposal, with 87% opposing the deal. In August, unions that represent more than two-thirds of Southwest's employees called for the CEO to resign. Southwest is a Focus List Buy and a Long-Term Buy.


Rank Changes

AbbVie ($64; ABBV) is being added to the Long-Term Buy List, replacing Gilead Sciences ($78; GILD), which is being dropped from the Long-Term Buy List and cut to B (average) on the Monitored List.


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