Be Careful With Health Care

12/6/2010


U.S. health-care spending rose 5.7% to a record $2.5 trillion in 2009, accounting for 17.3% of gross domestic product. That percentage is likely to be up for 2010 — and is widely expected to be up sharply over the next decade, partly because of this year's landmark health legislation. Yet the health sector has been among this year's worst performers, especially when measured by total stock-market value.

The capitalization-weighted S&P 1500 health-care sector index is down 1.6% in 2010, versus a 7.1% gain for the broader S&P 1500 Index and a 6.4% increase for the average S&P 1500 health-care stock. The equipment-group index's year-to-date decline of 6.7% ranks worst among S&P 1500 health groups, reflecting disappointments from former stalwarts like Medtronic ($34; MDT), Zimmer Holdings ($49; ZMH), and Intuitive Surgical ($260; ISRG). Large equipment players that have met expectations have been rewarded, with St. Jude Medical ($39; STJ) up 5.2% and Varian Medical Systems ($66; VAR) up 40.5%.

Patent expirations have weighed on the S&P 1500 drug group, which accounts for 46% of the sector's total stock-market value. Patent cliffs on top sellers threaten the nation's six largest drugmakers over the next five years. Recent drug-approval trends suggest drug giants will be hard-pressed to replace the revenue from these blockbusters — one reason Abbott Laboratories ($47; ABT) is the only one of the six projected to deliver double-digit growth in per-share earnings over the next five years.


Patent-expiration analysis

We are approaching one of the sharpest patent cliffs in history, as 18 of the world's 20 biggest drugs are set to lose their patents between 2010 and 2014. Once generic versions hit the market, prices often plummet more than 80%.

Many drug companies are having trouble developing enough new drugs to offset the likely loss of revenue over the next few years.

Lacking a reliable stream of new drugs to come through the pipeline, the industry has experienced high-profile takeovers in the past two years, headlined by Pfizer ($16; PFE) agreeing to spend $68 billion to acquire Wyeth and Merck ($34; MRK) pledging to pay $41.1 billion for Schering-Plough. There has also been a steady flow of smaller deals.

Below, we look at key drugs coming off patent in the next six years at major U.S. drugmakers.

— Revenue —
Company
Drug
9 Mos.
Ended
Sept. (In $Mil.)
As % of Total
Company
Revenue
U.S.
Patent
Expiration
Abbott Laboratories 
Humira
4,670
19
2016
Kaletra
914
4
2016
Bristol-Myers Squibb 
Plavix
4,951
34
2011
Avapro/Avalide
924
6
2012
Sustiva
1,008
7
2013
Abilify
1,858
13
2015
Baraclude
667
5
2015
Eli Lilly 
Gemzar
906
6
2010
Zyprexa
3,691
22
2011
Cymbalta
2,477
15
2013
Humalog
1,505
9
2013
Alimta
1,640
10
2016
Johnson & Johnson
Levaquin/Floxin
957
2
2011
Merck
Singulair
3,638
11
2012
Nasonex
917
3
2014
Pfizer
Lipitor
8,104
16
2011
Xalatan
1,287
3
2011
Viagra
1,429
3
2012
Celebrex
1,752
3
2014

In contrast, rising use of generic drugs helps fatten the razor-thin profit margins of drug distributors. Industry leaders AmerisourceBergen ($31; ABC) and McKesson ($64; MCK) have seen operating profit margins rise in each of the last three years.

Health-care distributors and managed-care companies earn the highest average Quadrix® Overall scores, with distribution at 67 and managed care at 81. Amerisource is a Buy and a Long-Term Buy. We are wary of the large managed-care stocks, but our sister publication Upside likes niche players, such as HealthSpring ($27; HS), Magellan Health Services ($49; MGLN), and Metropolitan Health Networks ($4; MDF).

For the 551 health-care stocks in our 4,302-stock Quadrix universe, the average Overall score is a mediocre 41. But that number is skewed lower by very poor scores from microcap health stocks. Among the small, midcap, and large health stocks in the S&P 1500, the average Overall score is 63. Among the big stocks in the S&P 500, the average is a robust 73.

Investor concerns

The weak labor market has left many Americans without insurance coverage. Even the insured — saddled with rising deductibles and tight budgets — are electing to delay medical treatment. Medical utilization often dips during recessions. But if high deductibles remain in place, Americans could permanently alter their treatment habits, potentially slowing growth for the entire sector.

While investors need to emphasize companies capable of thriving in an increasingly cost-conscious environment, we see plenty of opportunities among the larger companies. The table below lists 13 A-rated health-care stocks. Three of our favorites are reviewed below.

AmerisourceBergen ($31; ABC) distributes generic and branded drugs to hospitals and pharmacies, supplies vaccines and blood products to specialty clinics, and repackages bulk drugs into blister packs and bottles. The stock, up 18% for the year, trades at 14 times trailing earnings, 36% below its five-year average.

Amerisource has exceeded consensus profit estimates by at least 4% in the past four quarters. For the December quarter, Wall Street projects earnings of $0.54 per share, up 4% on 3% higher revenue. The distributor's long-term outlook looks brighter, with analysts predicting that profits will grow by an average of 13% over the next five years. Amerisource is a Buy and a Long-Term Buy.


Varian Medical Systems ($66; VAR), a maker of radiation-therapy and X-ray equipment, has grown revenue at an annualized rate of 11% over the last five years. The stock has rallied and is no longer cheap. But rising earnings estimates, strong stock-price momentum, and an excellent track record of sales growth suggest the stock has further upside potential.

In fiscal 2010 ended September, operations outside of North America accounted for the majority of Varian's sales (57%) and all of its growth (up 22%, versus a 9% decline in the North American business). Varian Medical Systems is a Focus List Buy and a Long-Term Buy.


Abbott Laboratories ($47; ABT) is better positioned than most of its large peers in terms of patent expirations, with none of its major drugs losing exclusivity before 2016. Abbott has sued to block Impax Laboratories ($18; IPXL) from launching a generic extended-release version of Abbott's Simcor cholesterol drug. The extended-release patent expires in 2013, but Impax intends to launch as soon as regulators approve its version. Abbott is a Buy and a Long-Term Buy.

 

QUADRIX SCORES FOR HEALTH-CARE STOCKS
Among the 551 health-care stocks in the 4,302-stock Quadrix universe, the percentage of stocks with Overall scores above 80 stands at 17% — above the norm of 14% since 2000. Roughly 10% of health-care stocks score above 90, versus the norm of 6%. The smallest stocks account for the sector's weak average Overall scores.
————————— Average Quadrix Scores —————————
% of
Stocks
W/Overall
Above 80
No. of
Stocks
W/Overall
Above 80
% of
Stocks
W/Overall
Above 90
No. of
Stocks
W/Overall
Above 90
Sector/Industry
(No. Of Stocks)
Momen-
tum
Value
Quality
Fin'l
Str.
Earns.
Ests.
Perfor-
mance
Overall
Biotech (163)
45
17
29
23
52
39
22
8
13
5
8
Distribution (12)
41
74
71
39
66
33
67
17
2
0
0
Drugs (81)
54
42
50
48
54
43
48
30
24
22
18
Equipment (99)
42
39
51
47
42
41
40
11
11
2
2
Facilities (30)
36
69
48
32
44
44
52
20
6
13
4
Life Sciences (40)
45
40
52
49
47
45
43
10
4
5
2
Managed Care (18)
63
87
68
40
72
53
81
67
12
56
10
Services (56)
44
60
65
49
47
37
57
21
12
11
6
Supplies (34)
39
42
56
55
40
40
44
12
4
6
2
Technology (18)
65
33
71
67
60
52
58
28
5
11
2
Health Care (551)
46
39
48
40
50
41
41
17
93
10
54

 

HEALTH-CARE PLAYS
Below, we list all 13 A-rated stocks in the health-care sector. Quadrix scores are percentile ranks, with 100 the best. The 12-Factor Sector score considers statistics that work well within a sector, while the Reranked Overall score reweights Quadrix category scores that work well in a sector. Recommended stocks are presented in bold.
— Sector Scores —
Current-Year
——— Estimate ———
– Next-Year Estimate –
Company (Price; Ticker)
Div.
Yield
(%)
Quadrix
Overall
Score
12-
Factor
Sector
Reranked
Overall
EPS
($)
Growth
(%)
P/E
EPS
($)
Growth
(%)
P/E
Health-Care
Industry
Abbott Laboratories
($47; ABT)
3.8
89
55
77
4.17
12
11
4.66
12
10
Pharmaceuticals
AmerisourceBergen
($31; ABC)
1.3
83
89
78
2.37
9
13
2.69
14
11
Distributors
AstraZeneca ($47; AZN)
5.1
93
23
86
6.62
5
7
6.68
1
7
Pharmaceuticals
Baxter International
($49; BAX)
2.6
84
39
78
3.98
5
12
4.24
7
11
Equipment
Biogen Idec ($64; BIIB)
0.0
99
64
95
4.98
21
13
5.64
13
11
Biotechnology
Eli Lilly ($34; LLY)
5.8
96
67
92
4.71
7
7
4.41
(6)
8
Pharmaceuticals
Express Scripts
($52; ESRX)
0.0
86
67
65
2.50
40
21
3.21
28
16
Services
Gilead Sciences
($37; GILD)
0.0
97
49
90
3.67
20
10
4.04
10
9
Biotechnology
Laboratory Corp.
($82; LH)
0.0
78
56
66
5.55
13
15
6.10
10
13
Services
St. Jude Medical
($39; STJ)
0.0
95
49
84
2.99
23
13
3.26
9
12
Equipment
Stryker ($50; SYK)
1.2
81
42
59
3.29
12
15
3.64
11
14
Equipment
UnitedHealth Group
($37; UNH)
1.4
97
96
94
3.97
23
9
3.64
(8)
10
Managed Care
Varian Medical Systems
($66; VAR)
0.0
75
38
42
3.35
13
20
3.80
13
17
Equipment

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