Three healthcare stocks on deep discount

These stocks are each trading at over a 30% discount to our fair value estimates

Vikram Barhat 19 June, 2019 | 2:55AM

Healthcare

The healthcare sector is suffering a dramatic a reversal of fortunes. It went from being one of the best performing sectors last year to the second worst performing so far this year, ahead of energy. The sector’s subpar performance is evidenced by a modest 6% gains for the Morningstar US Healthcare index relative to a far more robust 16% returns for both the Morningstar US Market index and the S&P 500 benchmark index, as of June 13.

The current swoon in healthcare stocks, however, doesn’t detract from the positive long-term outlook for the sector supported by secular trends. Aging demographic, higher incidents of critical illness, rapid advances in digital healthcare are expected to continue to propel healthcare demand and costs. In fact, global healthcare expenditures are projected to continue to mount at an annual rate of 5.4% between 2017 and 2022, going from US$7.724 trillion to US$10.059 trillion, according to a Deloitte report.

The current weakness in the sector has created attractive valuations and entry points for stocks pickers. These names may appear attractive to opportunistic investors scouring the sector for stocks with sizeable mismatch between price and prospects. These companies also appear well-positioned to capitalize on increased health care and medical spending among the aging baby-boomer cohort, according to Morningstar equity research.

Bayer AG ADR
  Ticker: BAYRY
  Current Yield: 5.22%
  Forward P/E: 7.72
  Price: US$14.83
  Fair Value: US$31
  Fair Value Uncertainty High
  Value: 52% Discount
  Moat: Wide
  Moat Trend: Stable
  Star Rating: *****
Data as of Jun. 14, 2019

German healthcare giant, Bayer (BAYRY) makes pharmaceutical drugs, vitamins and animal health products. The company also has agriculture business that includes seeds, pesticides, herbicides, and fungicides.

A diverse portfolio of patent-protected drugs and a growing number of biologic drugs position Bayer well for a steady long-term growth. Bayer’s biologics -- Betaferon for multiple sclerosis and Kogenate for hemophilia -- add to the firm’s sustainable competitive advantage as “the manufacturing complexity of these drugs deters generics from entering the market,” says a Morningstar equity report, adding that demand for the firm’s cardiovascular and ophthalmology drugs remain strong and could continue to drive growth.

Bayer’s consumer health business, part of its healthcare segment, boasts such household names as Aspirin and Aleve, for which consumers continue to pay a premium. “Brand recognition is key in this segment, as evidenced by the company’s iconic Aspirin, which continues to produce strong sales even after decades of generic competition,” says Morningstar sector director, Damien Conover, who puts the stock’s fair value at US$31 per ADR.

"The divestment of no-moat Covestro, the minor synergistic impact of adding the wide-moat Monsanto business to Bayer's crop science business, and the wide-moat drug unit at Bayer lead to our overall wide moat rating for company," he says"

DaVita Inc
  Ticker: DVA
  Current Yield: -
  Forward P/E: 11.72
  Price: US$48.88
  Fair Value: US$79
  Fair Value Uncertainty Medium
  Value: 39% Discount
  Moat: Narrow
  Moat Trend: Stable
  Star Rating: *****
Data as of Jun. 14, 2019

A leader in the global dialysis market, DaVita Inc (DVA) controls more than 35% share of the U.S. dialysis market. The firm operates 2,905 facilities worldwide, of which 2,664 located stateside, and treats over 225,000 patients globally each year. DaVita receives approximately 69% of U.S. sales at Medicare and Medicaid reimbursement rates, with the remaining 31% coming from commercial insurers.

“DaVita’s narrow moat stems from its dominant and essential position within the U.S. dialysis market, accounting for over one third of all dialysis facilities and patient treatments,” says a Morningstar report.

Morningstar equity analyst, Jake Strole, cautions that investors overly concerned about closer regulatory scrutiny of patients assistance programs maybe missing the big picture. “DaVita provides lifesaving healthcare services to chronically ill patients in a lower-cost, outpatient setting,” he says, noting that it’s unlikely that regulatory disruption will have a meaningful impact on the company given that “the alternative to outpatient dialysis is higher cost, less efficient, and more burdensome acute therapy.” He appraises the stock to be worth US$79.

Surgery Partners Inc
  Ticker: SGRY
  Current Yield: -
  Forward P/E: 227.27
  Price: US$8.32
  Fair Value: US$19
  Fair Value Uncertainty Very High
  Value: 56% Discount
  Moat: None
  Moat Trend: Stable
  Star Rating: *****
Data as of Jun. 14, 2019

One of the few remaining independent ambulatory surgery centre operators in the U.S., Surgery Partners (SGRY) operates 123 surgical facilities across 31 states in partnership with physician groups and larger local healthcare systems. Surgical procedures account for 95% of the firm’s revenue.

“As a pure-play operator of ambulatory surgery centers, or ASCs, Surgery Partners benefits from the long-term trend toward outpatient and away from inpatient surgery, along with improved technology and treatment methodologies that have allowed higher acuity procedures (that bring more per-procedure profit dollars) to move to the outpatient setting,” says a Morningstar equity report.

The company has been plagued by debt and investors have been concerned about its organic growth. However, that’s about to change after a wholesale replacement of top management last year. “[New] management’s initial portfolio assessment has begun to chart the right course for the firm, focusing on divesting noncore facilities and de-emphasizing its struggling ancillary services,” says Strole, who pegs the stock’s fair value at US$19. While the company hasn’t been assigned a moat outright, it does possess “traces of intangible assets, given the firm’s position in states with more stringent regulatory requirements for building or expanding healthcare facilities,” argues Strole.

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.