The Supreme Court's decision on the individual mandate is looming, but its effect on stock valuations shouldn't be devastating in any scenario.Health-care demand should come out of its slump, buoyed by easy comps and deferrals, but the recovery is likely to be rather gradual. With mature geographies in stagnation, health-care firms continue to turn their focus to emerging markets.
Supreme Court Ruling Expected in 2012: We See Four Potential Outcomes,
No Devastating Impact on the Sector
The Supreme Court's early-Spring decision on the individual mandate is the key event on the horizon for the health-care sector, as much of the Patient Protection and Affordable Care Act's fate hinges on the ruling.
The Court has several questions to answer in reviewing the PPACA. Does Congress have the constitutional authority to require individuals to purchase health insurance, or else pay a penalty? If it does not, what parts of the reform law, if any, can stand without the individual mandate? Can the Court even rule on this matter before the individual mandate is enforced starting in 2014? The Court will also consider whether the Medicaid expansion will infringe on state sovereignty, although an appeals court dismissed this argument as the federal government is expected to pick up a big chunk of the total cost. The Court will not consider issues such as employer mandate or the validity of a health benefit exchange requirement.
Although we aren't making any predictions on the outcome of the Court's ruling, we stipulate the Court, particularly its "swing" judges, may take a pragmatic approach considering the total potential costs of unwinding provisions already in place. Some of the costliest programs are not scheduled to commence until 2014, but several important changes to the health-care delivery process have already been implemented. A number of them are also targeted for 2012, such as the rollout of Accountable Care Organizations (ACOs) and the implementation of Electronic Health Records.
We see four possible directions the Court could take. It could strike down the entire law; it could strike down just the individual mandate and related insurance market regulations while upholding the rest of the law; it could uphold the entire law; or it could postpone judgment until after 2014.
Even if the entire law is deemed unconstitutional, some aspects of reform will likely persist. For example, state-run online insurance exchanges have gained acceptance as a better way to organize the individual and small-group health insurance markets. Enhanced state scrutiny of premium increases is also probably here to stay. ACOs have established a foothold as the care delivery systems of the future. However, other major changes such as the expansion to Medicaid and individual insurance subsidies are unlikely to be resurrected in the current political environment, where health care has taken a back seat to concerns about budget deficits and the economy.
Alternatively, it is possible that only the individual mandate will be deemed unconstitutional. In this case, insurance market regulations such as guaranteed issue (forcing insurers to offer policies to all applicants) and modified community rating (only allowing premiums to vary within tight bands based on characteristics such as age and family size, while forbidding medical underwriting) would also almost certainly have to be eliminated from the law. Otherwise, people would wait until they became sick to purchase insurance, destroying the market for individual insurance nationwide. However, other major provisions of the law, including the Medicaid expansion and insurance subsidies, could be allowed to stand.
If the Supreme Court upholds the law, participants in the health-care system will have gained some much-desired clarity about the future regulatory environment. We believe most companies have been proceeding under the assumption that the law will stand. Preparation will likely accelerate as we approach the biggest changes in 2014.
Finally, there is some possibility that the Supreme Court will conclude that it cannot rule on the law because taxes used to enforce the individual mandate have yet to be collected. We view this as the least favorable outcome, as it would prolong the current state of uncertainty for years and create a tremendous potential mess if the law were later struck down after being fully implemented.
Enactment of the PPACA resulted in few changes to our fair value estimates, and it is unlikely that any of these outcomes would have a material effect on our valuations now, although a further delay and lack of clarity and certainty will likely steer investors away from the sector. With 2012 being an election year, any meaningful changes to the Senate composition and the White House could also complicate this issue. But barring wholesale political changes, we don’t anticipate the political environment to factor heavily into the health-care sector's performance in 2012.
Is Health-Care Demand Finally Returning? Yes, but the Recovery Has Hardly Been Gangbusters
We've been expecting health-care demand to recover in tandem with broad economic improvements, but the pace of the recovery has been surprisingly lackluster. Several factors are at work here, but the biggest issue remains a stubbornly high number of uninsured individuals as well as Medicaid recipients. Our stipulation for the demand bounce-back has long been tied to the decline in these two categories (and a corresponding rise in the volume of commercial insurance members).
With the latest nationwide unemployment rate at 8.3%, the prospects of a steep decline in the ranks of the uninsured are rather bleak; according to the latest Gallup-Healthways Well-Being Index, we are still looking at roughly 17% of the population without health insurance. Medicaid enrollment growth has tempered substantially since reaching its peak in 2009, but the current forecast by Kaiser still indicates a 4%-plus increase in 2012. On the plus side, commercial ranks are increasing, but at a rather pedestrian pace. With the private sector increasingly looking to shift a burden of health-care costs onto employees via higher deductibles and co-pays, demand improvement is rather tepid. (This is not a new trend but something that has been in the works for quite some time; however, its impact was less noticeable when the economy was booming.)
The good news? Demand for health-care services has been so bleak over the prior few years, it wouldn't require gargantuan efforts from health-care firms to post respectable (relative to prior years) volume growth in the current environment. In fact, thanks mainly to easy volume comparisons, most health-care firms expect the revenue to grow in the low- to mid-single-digits (ahead of the broad economy). And that's without an anticipation of a snap-back in many elective procedures that have now been deferred for three-plus years. This growth is partially due to the increasing efforts by health-care firms to penetrate emerging markets, where the emergence of a middle class is stimulating demand for better health care.
With Demand Still Slow in Developed Markets, Emerging Markets Offer Growth Opportunity
With U.S. demand still low and Europe reeling from austerity measures, emerging markets have become a crucial growth contributor for the sector in 2012 and beyond. China in particular has been in focus, given its tremendous overall potential as well as the government's growing emphasis on investment in health-care infrastructure. The Chinese health-care system is still characterized by gaps in access and quality between urban and rural markets, coastal and inland regions, and insured and uninsured patients. However, two years ago, the central government embarked on a reform effort, with an investment of $125 billion to accomplish five specific goals, including universal medical insurance by 2020 and improving infrastructure.
We see several dynamics that we think should contribute to continued robust growth of health-care spending in China. For example, new technology serves as the key profit center for providers, leading to quick uptake and extensive usage that correlates with improving patient wealth levels. The government also intends to improve health-care delivery through the renovation and construction of thousands of hospitals, health-care centers, and clinics, and we think medical device and equipment companies that can win a bid in the tender process at either the provincial or central level can benefit.
The latest five-year plan also identifies two sectors that will receive particular support: green energy and biotechnology. We anticipate a rapid build-out of research and drug development centers, which should be a boon to the lab-supply industry. With more clinical trials also migrating to China, demand for life science products should accelerate. Finally, China is set to become one of the most important growth drivers for Big Pharma over the next decade. Drug spending has grown at a compound rate of 22% per year over the past six years, and Big Pharma is poised to gain market share in this highly fragmented market. China is only the seventh-largest prescription drug market in the world, but it is expected to become the second-largest market in the world by 2015.
Our Top Health-Care Picks
Our top health-care recommendations cover most of the sector's industries, ranging from pharmaceuticals to managed care. These firms remain undervalued as the appetite for health-care stocks has yet to improve, despite favorable long-term dynamics.
Top Health-Care Sector Picks
Data as of 03-23-12.
Icon PLC(ICLR)
Star Rating: 4 Stars
Fair Value Estimate: $32.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Price/Fair Value: 0.68
ICON's growing scale has helped it gain entrance into the upper echelon of the contract research industry, and we think the firm will continue to benefit from industry tailwinds provided by drug companies' increasing tendency to outsource clinical trial work. However, a slowdown in drug development spending has led to capacity underutilization and losses in the firm's central lab division, and hiring in anticipation of an uptick in demand has weighed on earnings. As demand comes back online, ICON should see high-single-digit top-line expansion and its operating margin return to the double digits by the second half of 2012 as it leverages its new staff and infrastructure across an expanded revenue base.
Abbott Laboratories(ABT)
Star Rating: 4 Stars
Fair Value Estimate: $70.00
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 0.86
In an effort to unlock value, management has decided to split Abbott into two--a branded drug company and a diversified health-care company. Although we don't expect the breakup to significantly change our fair value estimate, we still believe the company is undervalued, and the breakup could draw more attention to Abbott's attractive valuation. In the pharmaceutical industry, Abbott faces relatively minor patent losses during the next five years and is well-positioned to ride a strong tailwind of demand for its products. Most important, we expect continued strong demand for the company's top drug, Humira, based on low drug penetration in immunology diseases. Abbott's strong competitive position in nutritionals and diagnostics creates additional avenues of growth.
Covidien(COV)
Star Rating: 4 Stars
Fair Value Estimate: $76.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Price/Fair Value: 0.71
As we've been advocating for several years, Covidien is spinning off its underperforming pharmaceutical business. We believe this transaction will allow investors to appropriately judge the company and its core device business. Covidien's device growth prospects are compelling as the latest product launches have been well-received by the marketplace, and the company successfully integrated a number of sizable acquisitions. Although a weak macro environment continues to hamper elective procedure volume, the company's revenue growth in the device segment remains strong, particularly in energy and vascular where Covidien continues to gain market share. With emerging markets also fueling growth, we expect strong revenue and earnings momentum despite ongoing investments in R&D and sales.
Roche(RHHBY)
Star Rating: 4 Stars
Fair Value Estimate: $52.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 0.83
The long patent life of Roche's portfolio puts it among the biotechs least exposed to generic competition. Patents don't begin to expire until 2013--when Rituxan loses protection in Europe--and to counteract future competitive pressures, management is implementing strategies that we think will enable the firm to achieve 5% five-year earnings growth. Subcutaneous versions of Roche's blockbuster antibodies are in the works, which could reduce hospital costs and add to convenience. Novel drugs are in development that could improve on the efficacy of Roche's current products or represent new, personalized treatments for cancer patients. Roche also has a solid pipeline beyond oncology, including drugs to treat schizophrenia and hepatitis C. With the Genentech integration starting to yield synergies, we think Roche's drug portfolio and industry-leading diagnostics conspire to create sustainable competitive advantages.
WellPoint(WLP)
Star Rating: 5 Stars
Fair Value Estimate: $105.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Price/Fair Value: 0.64
WellPoint's 14 Blue Cross and Blue Shield plans provide the company with a unique combination of regional and national scale. The former is the key to negotiating favorable provider rates, while the latter is essential for leveraging administrative costs. Investors remain fearful about the regulatory and economic headwinds facing WellPoint, causing the stock to trade at barely 8 times earnings and with a greater than 35% discount to our fair value estimate. However, we think these concerns are overblown, as the recent health reform law should have only a modest impact on WellPoint's future profits. Although we expect ongoing medical cost pressure, this should be partly offset by revenue growth opportunities and potential SG&A leverage. In the meantime, WellPoint generates copious free cash flow, which it is using to repurchase shares at a breakneck pace.
Alex Morozov, CFA, has a position in the following securities mentioned above: ABT
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