Four healthcare stocks to benefit from Trump tax reform and demographic trends

A recent pullback in stock prices has left these wide-moat names trading at discounts to fair value.

Vikram Barhat 28 February, 2018 | 6:00PM
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U.S. President Donald Trump appears to be making good on his election campaign promise of sweeping tax reform to lower the tax burden on U.S. corporations. In one of the most drastic tax overhaul in the last 30 years in the United States, and after much political wrangling, the tax reform bill was passed in December last year, becoming law as of January 2018.

The new law, which reduces corporate tax rates from 35% to as low as 21%, is expected to significantly benefit domestic companies that pay the full or close to the full tax rate. Some of the biggest winners could be companies in the healthcare plan industry that pay some of the highest tax rates, well above 30%, across sectors.

Any savings resulting from lower taxes will likely provide these companies an earnings boost, and the additional capital could be returned to shareholders. Additionally, the recent weakness in the stock price of these companies has made them even more attractive and the margin of safety greater.

Fears over the potentially disruptive impact of a new partnership involving  Amazon.com (AMZN),  Berkshire Hathaway (BRK.B) and  JPMorgan Chase (JPM) to form an independent healthcare company for their U.S. employees have caused the stocks of healthcare services companies to fall materially. On a more positive note, though, Morningstar equity analyst Vishnu Lekraj believes these investor misgivings are unfounded and tend to undervalue the robust competitive advantages that protect these businesses against disruption. "All potential new competitors would face significant headwinds trying to break into any vertical along the chain because the dynamics of the healthcare market are very difficult to navigate," Lekraj argues.

The recent pullback in stock prices of the following healthcare services firms, therefore, has created an opportunity for investors to buy into formidable wide-moat names at discounts, according to Morningstar equity research.

 

Cardinal Health Inc.
Ticker: CAH
Current yield: 2.65%
Forward P/E: 13.8
Price: US$70.09
Fair value: US$84
Data as of Feb. 26, 2018

A major wholesaler of pharmaceuticals and medical supplies to pharmacies and hospitals,  Cardinal Health (CAH) stands out as an elite participant along the pharmaceutical supply chain.

The third-largest pharmaceutical distributor by revenue, and the main supplier to CVS Health's retail pharmacy network, the firm possesses a sustainable competitive advantage that stems from its significant size and market share.

"Cardinal plays a critical role within the pharmaceutical industry, given that many supply-chain participants depend on its services for streamlined product distribution and procurement," Lekraj says in a Morningstar equity report. Lekraj projects "the use of pharmaceuticals to increase over the next several years," providing a long runway for growth.

Management's strategic moves, including the agreement with CVS Caremark where the two firms will combine generic sourcing operations, "should allow it an opportunity to enhance profitability, as the combined sourcing entity will be able to garner greater pricing discounts from generic manufacturers," says Lekraj.

As a result, the partnership "will add materially to the bottom line, along with the firm's acquisition of Harvard Drug," adds Lekraj, noting that these operational measures "will yield excellent return on invested capital over the next several years."

Cardinal's recent push into medical equipment manufacturing and distribution, however, exposes the firm to a slow-growth area of the market, which could suppress ROICs, cautions Lekraj, who puts the stock's worth at US$84.

Regardless, positive secular trends in the U.S. pharmaceutical industry continue to support a growth outlook. "The confluence of an aging U.S. population, the influx of previously uninsured people into the healthcare market, and greater use of pharmaceuticals," could provide solid top- and bottom-line growth, says Lekraj.

 

McKesson Corp.
Ticker: MCK
Current yield: 0.81%
Forward P/E: 11.8
Price: US$153.20
Fair value: US$210
Data as of Feb. 26, 2018

One of three major distributors of pharmaceuticals in the U.S.,  McKesson (MCK) has significant specialty drug and medical product wholesaling operations.

The firm is able to source and deliver drugs in a more cost-effective and efficient manner than its pharmacy client and pharma manufacturing suppliers, a "fundamental factor [that] has formed a strong foundation for McKesson, as its core drug wholesaling operations will be needed no matter how any market dynamics shift," Lekraj says in a Morningstar report on the stock.

McKesson stands out as a premier player in the pharmaceutical industry as "many supply chain participants depend on its services for streamlined product distribution and procurement," the report says.

The drug distributor has had its share of challenges, too. It lost a material portion of its revenue with the acquisition of half of Rite Aid stores by  Walgreens (WBA). Further, major pricing pressure has crimped profits. McKesson, however, has moved nimbly to neutralize these headwinds "The firm has correctly adjusted its cost basis, reformulated the pricing of its contracts, and has largely worked through these issues," says Lekraj, whose US$210 fair value for the stock indicates the firm will "manage through this headwind and continue to produce robust free cash flow over the next several decades."

The recent restructuring and "the expansion of its key Wal-Mart contract to include the wholesaling of generic drugs will significantly offset" any negatives of contract losses, while enabling the business to "continue to produce robust free cash flow over the next several decades," says Lekraj.

 

CVS Health Corp.
Ticker: CVS
Current yield: 2.93%
Forward P/E: 10.9
Price: US$68.28
Fair value: US$99
Data as of Feb. 26, 2018

 CVS Health (CVS) is one of the largest retail pharmacy chains in the U.S. with one of the largest pharmacy benefit managers. This combination makes it one of the premier healthcare firms in the U.S.

The company, which processes approximately 1.3 billion prescriptions annually and operates more than 10,000 retail pharmacies across the U.S., plans to acquire major managed-care firm  Aetna (AET), which will create the most integrated healthcare player in the U.S, says a Morningstar report.

"If CVS can successfully close on this deal, it will have transformed itself into one of the most powerful players within the healthcare space," says the report.

The wide-moat firm's strategy of expanding beyond its legacy retail pharmacy operations and become a healthcare services company will position it as a major player within the U.S. healthcare ecosystem. "We view this strategic move as a positive from an operational standpoint and view the new CVS/Aetna entity as a healthcare services behemoth with the infrastructure to sell insurance and manage/treat members through every aspect of their healthcare treatment regimens," says Lekraj, who believes, however, that the firm is paying over the odds to buy Aetna, prompting him to recently lower the stock's fair value from US$109 to US$99.

Yet, given that the stock is trading at a significant discount to its estimated fair value, CVS represents "an excellent opportunity for investors seeking to own a high-quality healthcare player," he contends.

CVS's pharmacy-benefits management operations position it for long-term success. "The combination of a solid business model and positive secular industry trends will drive excellent returns on capital for the healthcare behemoth," says Lekraj.

 

Express Scripts Holding Co.
Ticker: ESRX
Current yield: -
Forward P/E: 9.9
Price: US$77.79
Fair value: US$89
Data as of Feb. 26, 2018

The largest pharmacy benefit manager in the U.S.,  Express Scripts (ESRX) processes approximately 1.3 billion prescriptions annually through its mail-order pharmacy and network of retail pharmacies.

Express is one of the most dominant and critical players in the pharmaceutical industry. "Even with a tumultuous last several quarters," says a Morningstar report, "Express remains in a solid long-term position as its cost saving and efficiency services will be needed by drug benefit plan sponsors for years to come."

The colossal claim volume processed by the company affords it superior supplier pricing leverage and unmatched centralized cost scale, key industry drivers and the building blocks of its robust competitive edge. "[These] significant advantages have produced outsize economic profits, and this trend will remain in place over an extended period," says Lekraj, who appraises the stock's worth at US$89.

There are concerns, though, that the loss of its largest client,  Anthem Inc. (ANTM), when its contract expires in 2019, could erode the pharmacy benefits manager's valuation as the contract constitutes a significant percentage of both revenue and profit for Express. Lekraj concedes this contract loss is a "major headwind," but says "the firm's outlook post-Anthem remains solid, as its cost saving and efficiency services will still be needed by drug benefit plan sponsors."

Furthermore, the expansion of medical coverage to the previously uninsured and aging U.S. population are "positive operational pillars [that] will remain steadfast and will drive substantial economic profitability for shareholders over the coming decades," asserts Lekraj.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Amazon.com Inc2,261.10 USD5.73Rating
Anthem Inc486.45 USD0.40Rating
Berkshire Hathaway Inc Class B310.36 USD0.75Rating
Cardinal Health Inc55.61 USD1.15Rating
CVS Health Corp97.48 USD-0.78Rating
JPMorgan Chase & Co119.09 USD0.89Rating
McKesson Corp324.24 USD0.69Rating
Walgreens Boots Alliance Inc43.55 USD0.90Rating

About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry. He also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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