Health care: A few stocks still offer upside

Despite the sector looking slightly overvalued, we still see stocks with attractive valuations across the different industries.

Damien Conover, CFA 10 July, 2015 | 5:00PM
Facebook Twitter LinkedIn

While the market valuation of the health-care sector remains slightly above our fair value estimates in aggregate, we still see several undervalued stocks across the different industries. As has been the case for several quarters, we believe the current environment for health care continues to lend itself to a stock-pickers' market rather than a focus on industries.

After the severe recession and increased cost sharing by insurance companies with patients, health-care utilization is increasing. The magnitude of the recession and increased cost-sharing has delayed a sharp rebound in health-care use. However, the increase in U.S. hospital admissions starting in mid-2014 suggests a turning point, and U.S. health-care reform is likely driving part of the uptick. With the mandated health-care insurance and expanded government insurance in the U.S., more people are seeking treatment. We expect a continual, gradual increase in demand for health care, but probably not a return to 2007 levels anytime soon.

Across health-care industries, companies are acquiring and merging to increase their growth potential through creating scale, cutting costs and focusing on key strategic areas. Further, the persistent low interest rates are also fueling the M&A trends, because cheap capital is available to fund acquisitions. Beyond the heavy prevalence of M&A in the drug space, with large drug firms acquiring Hospira, Salix and Pharmacyclics, we are seeing further consolidation in health-care services.  UnitedHealth's (UNH) acquisition of Catamaran significantly increases its supplier pricing power and scale advantages.

Turning to innovation in health care, drug companies continue to shift their focus toward specialty-care areas such as oncology. We expect the shift to increase drug-development productivity and strengthen the moats for drug companies, since these areas of development carry strong drug pricing, a more accommodating stance from regulatory agencies and steep launch trajectories. While some of these specialty indications have smaller patient populations than primary care areas, the strong pricing power can easily turn the drugs into blockbusters. In oncology, recent approvals carry price tags over US$100,000 per year, opening the door to major market opportunities even in the less prevalent cancers.

Top Health-Care Sector Picks

Star Rating

Fair Value
Estimate

Economic
Moat

Fair Value
Uncertainty

Consider
Buying

Baxter

$79

Wide

Low $63.20
Merck & Co

$69

Wide

Low $55.20
Amgen

$189

Wide

Low $151.20
Data as of June 22, 2015. All figures are in U.S. dollars.

 Baxter (BAX)
Although competition is increasing for Advate, Baxter's highly profitable hemophilia A product, we think this diversified firm's competitive advantages remain strong and the stock looks undervalued. We think Baxter has earned a wide economic moat, stemming from economies of scale in plasma processing, injectable therapies and dialysis products. Intangible assets -- like Baxter's strong brands, patent protection and pipeline productivity -- also allow the firm to remain remarkably profitable in tough industries. More than 70% of Baxter's sales come from products with market-leading positions, and the safety and quality of its biologic therapies allow it to charge a price premium over competitors.

 Merck & Co Inc (MRK)
Merck's combination of a wide lineup of high-margin drugs and a pipeline of new drugs should ensure strong returns on invested capital over the long term. Further, Merck is through the worst of its patent cliff, which should remove the heightened generic competition the company has experienced over the last five years. However, Merck's research and development strategy has yielded only moderate results, which will likely reduce the company's near-term growth rate. Merck's efforts to develop a reliable late-stage pipeline have yielded moderate results as the company has focused more on incremental improvements in diseases with several treatment options instead of areas of unmet medical need. On the bottom line, Merck has been cutting costs. The 2009 merger with Schering-Plough opened the door for close to US$5 billion in annual savings, which should be realized by 2015.

 Amgen (AMGN)
Amgen markets several blockbuster biologic therapies in the oncology and immunology markets, giving it the intangible assets that form the foundation of its wide moat. Additionally, Amgen's improved manufacturing efficiency will not only benefit gross margins, but could also give the firm a cost advantage in the nascent biosimilar market, where it plans to launch five products by 2019. Looking ahead, we're confident that Amgen will be capable of defending its bottom-line growth through a key period of weakness for legacy products, buying it time to develop the sales potential for newer products and pipeline opportunities.

More quarter-end insights:

TAGS
Facebook Twitter LinkedIn

About Author

Damien Conover, CFA

Damien Conover, CFA  Damien Conover, CFA, is director of healthcare equity research and equity strategy for Morningstar.

© Copyright 2022 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy