(By Damien Conover, CFA)
- A recent shift in sentiment is increasing valuations of health-care stocks.
- As wealth creation in emerging markets continues to develop, these geographies offer attractive areas of growth for Big Pharma firms and other health-care industries.
- Subsectors of consumer and animal health-care look attractive.
Shifting Sentiment Supports Recent Health-Care Rally
Although relatively late to the upswing in the stock market, health-care stocks have recently posted solid gains. With macroeconomic health-care trends improving and uncertainty over health-care reform-related costs subsiding, we believe the investment community has gained increased confidence in the health-care sector. Furthermore, as uncertainty with the overall market's outlook increasing, the defensive nature of health care is also appealing to investors. Even with the recent health-care rally, we continue to think there are attractive investment opportunities across a number of industries in health care.
Emerging Markets Offer Upside Growth for Big Pharma and Other Health-Care Industries
Emerging markets offer significant upside for the large pharmaceutical companies. However, we believe the market is discounting this opportunity for several reasons, including: one, the analyst tradition of focusing on the historically dominant U.S. market; two, mistaken investor perception that margins in emerging markets are too low to matter; and three the lack of understanding of sales growth in emerging markets.
Historically, emerging markets have not been attractive for branded drugs. Incomes in these geographies were too low to pay for drugs, and the lack of respect for the law along with poor law enforcement of intellectual property led to rampant counterfeit drugs. However, the wealth explosion and the importance of brands signifying quality have created very important new markets for the drug industry. These areas represent a paradigm shift for the investment community, which has long viewed the United States, Western Europe, and Japan as the sole contributors to pharmaceutical sales growth. Furthermore, while pricing is generally not as strong as in developed markets, even at an average discount of close to 30% compared with developed-market margins, these sales provide a strong contribution to the bottom line.
Emerging-Market GDP Growth Drives Pharmaceutical Spending
Growth in gross domestic product is directly correlated with drug spending. Based on a sample of 63 emerging and developed countries, World Markets Monitor calculated an 80% correlation between GDP per capita and pharmaceutical spending. Furthermore, the rapid growth in emerging-markets incomes during the last five years has led to dramatically higher drug purchases. From 2004 to 2009, the BRIC (that is, Brazil, Russia, India, and China) population with household income above $5,000 increased by 27% annually. Although this growth is expected to slow from 2009 to 2014, 16% annual growth is still expected. This massive expansion in wealth should directly increase the market opportunity for drug companies.
The Importance of Brands in Emerging Markets
In emerging markets, several factors have led physicians and patients to embrace branded drugs. Due to the perception of a high degree of variation in the quality of generics, these drugs are seen as generally inferior to branded drugs. In addition, counterfeit drugs have plagued emerging markets for decades, and we believe this has instilled a sense of distrust toward nonbranded drugs. The strong reputations of large multinational drug companies for manufacturing and safety also have supported branded drug sales, and such firms are able to provide a much higher degree of service to physicians and patients in the form of educational marketing relative to generics. (The educational marketing service is more valuable in emerging markets, where fewer resources are available.) Lastly, out-of-pocket pay comprises the majority of revenue in emerging markets, but patients are willing to pay more for a trusted manufacturer.
The importance of branded drugs not only allows companies to launch into emerging markets with less fear of counterfeits, but also gives the branded drug a much longer life cycle relative to developed markets. While branded drugs in developed markets tend to last 10-14 years on the market before patents expire and generic drugs destroy the branded drug market share, they can retain their market-leading positions for several years after losing patent protection in emerging markets.
Margins Lower but Still Attractive in Emerging Markets
Although pricing power is not as strong relative to that in developed countries, emerging-markets drug prices remain high enough to confer operating margins that represent about a 30% discount to operating margins in developed markets (excluding research and development and central administrative costs, as these require minimal incremental investment beyond base levels). While pricing power varies depending on the therapeutic class and specific market, branded drugs in emerging markets are typically priced at a 50% discount relative to developed-markets prices. However, operating costs are much lower in emerging markets. According to AstraZeneca (AZN), the cost of a sales representative is more than 50% cheaper in emerging markets; Brazil is 50% cheaper, Turkey and Russia are 60% cheaper, and Mexico and China are 80% cheaper. The lower marketing costs help offset the lower pricing power in emerging markets.
Leading Big Pharma Companies in Emerging Markets
Sanofi (SNY) and Abbott Laboratories (ABT) lead the Big Pharma industry with their exposure to emerging markets. We project the companies will generate 31% and 25%, respectively, of total sales from emerging markets in 2011. We believe these firms are best positioned to gain from the fast-growing emerging markets. Furthermore, we believe the growth potential in these geographies is underappreciated by the investment community.
Biotech's Position in Emerging Markets: Roche's Strategy in China
On the biotechnology side, we believe Roche Holding's (RHHBY) strategy in China offers a different approach to emerging markets that could become the typical biotech model. In contrast to its large pharma peers, we think Roche's key biologic therapies will have a tougher time penetrating the broad market in China, particularly in more rural settings largely because of pricing. However, we think there is plenty of room for the firm to drive growth at relatively high prices in the larger, coastal cities where it sells most of its products today. Roche is using innovative strategies to boost emerging-markets penetration (including comarketing with diagnostics, negotiating private insurance contracts, and funding charity programs), and we expect weak generic competition and Roche's innovative pipeline should reduce government price-setting power for Roche's portfolio in both developed and emerging markets.
Other Health-Care Industries With Exposure to the Fast-Growing Emerging Markets
In the life-sciences industries, emerging markets serve as both a cheap manufacturing locale and an area with growing demand for life-sciences instrumentation. Life-sciences firms are following their pharmaceutical, generic, and contract research organization customers into emerging markets, extending their relationships in mature markets to capitalize on pharmaceutical firms' needs for reliable/reputable sourcing of research equipment and burgeoning demand from local governments, particularly in the environmental and food-quality testing area. Steadily growing demand from local health-care services providers (such as hospitals and research facilities) should account for the lion's share of emerging markets' growth later down the road. One of our picks in the life-sciences space with exposure to emerging markets is Thermo Fisher (TMO) as the company holds scale advantages over smaller players as well as strong name recognition and an unparalleled breadth of products.
Turning to devices, we believe the cardiac companies are better positioned than the orthopedic companies to gain in the near term from the fast-growing emerging markets. Although a number of cardiac companies are making a lot of noises about the potential of emerging markets (especially China), Medtronic (MDT) was the earliest one to establish its presence in China. Also, St. Jude Medical (STJ) just opened a new training center in Beijing. These companies expect China to deliver double-digit growth for years to come as the middle class grows (China is already Medtronic's fourth-largest market). However in 2009, there were a total of 700 implantable cardiac defibrillators implanted in China, suggesting China is still a very underpenetrated market.
On the orthopedic side, device firms remain in the very early stages of expansion into emerging markets. We believe surgical proficiency (through surgeon education and training) in knee/hip/spine procedures in key emerging markets needs to expand first, along with financial resources (either middle-class wealth or insurance coverage) for these elective procedures to take off. Therefore, we see the emerging-markets trend becoming important in key orthopedic niches in the next 10 years (rather than in the next five years).
Subsectors of Consumer and Animal Health-Care Look Attractive
The consumer nutritional market represents a wide array of different products ranging from infant formula to adult vitamin supplements. Depending on the definition of what constitutes a nutritional product, the exact market size can vary. Using a broad definition--including pediatric formula, supplements, functional nutritional foods, organic food, and other natural and organic products--the worldwide market is just more than $300 billion. Based on reports from the Nutritional Business Journal and our analysis, we expect the nutritional market to grow by 6% annually during the next five years. The increasing growth is largely based on: one, an aging worldwide population; two, an increasing awareness of the importance of good health by patients (demand for more healthy nutrition); three, increased rates of obesity, cardiovascular, and other diseases (eventually leading to increased demand for better nutrition); and four, the fast-growing emerging markets (increases in income correlate directly with health expenditures).
Pediatric Nutritional Firms Carry Strong Narrow Moats
Within the consumer health-care market, we believe the pediatric market is particularly strong. Although actual product differentiation is minimal between branded nutritionals and private labels, the brands carry a powerful signal of quality and trust. Most of the infant brands have been around for decades, solidifying the trust of generations of users. In such a venerable group, parents feel particularly compelled to pay for the reassurance of quality that the brand confers. Brand pricing is close to double that of private-label products, and even more of a premium exists in specialty formulas.
In the U.S., the pediatric market is dominated by Mead Johnson Nutrition (MJN) and Abbott, both with close to 40% of the market. Nestle (NSRGY) controls about 10% of the market, with the remainder largely made up of private-label brands. We expect this market share breakdown to remain largely static during the next several years because of the strong narrow moats in this business, largely based on strong brand names. Outside the U.S., the market is much more fragmented, but branded nutritional makers book the majority of sales. We project the pediatric industry will grow 6% annually during the next five years, providing solid growth for these industry-leading firms.
Animal Health-Care Market Offers Steady Growth
The animal health market is composed of two key segments: companion animals and production animals. The market for companion animal products constitutes almost 45% of the total animal health-products market and earns higher operating margins because of stronger competitive advantages. However, valuations in these two segments are somewhat equalized by the fact that the production animal market is poised to grow more rapidly than the companion animal market during the next several years.
In the animal drug space, Big Pharma firms hold strong entrenchment in the industry. Based on steady growth expectations for animal health drugs and declining sales projections for key human health drugs because of patent losses, we expect animal health sales will represent 7% of total sales in 2015 for the top six Big Pharma firms (Pfizer (PFE), Merck (MRK), Sanofi, Bayer (BAYRY), Eli Lilly (LLY), and Novartis (NVS)) with an animal health segment, up from 5% in 2010. We believe these segments are undervalued by the investment community, and the increasing representation of sales could act as a catalyst to improve the valuations of the segments and consequently the value of the overall Big Pharma industry. Furthermore, based on Pfizer's plan to review its operating structure and possibly divest certain units, the valuation of its animal health segment might become transparent in the near term, not only unlocking value for Pfizer, but the entire Big Pharma industry.
Turning to animal diagnostics, there are two companies that we have awarded with narrow moats: VCA Antech (WOOF) and Idexx Laboratories (IDXX). We are big fans of Idexx Labs from a strategy standpoint. From a valuation standpoint, we think VCA Antech currently offers a more compelling discount than Idexx Labs, partly because the firm has had a harder time weathering recent recessionary conditions. Because of its animal hospitals, VCA was more vulnerable to the pull back in consumer discretionary spending. As consumers slowly return to spending and pet owners resume preventive care for their pets, we should see VCA shares appreciate.
On the animal-health-distribution side, roughly 20% of total revenue at both Henry Schein (HSIC) and Patterson (PDCO) comes from animal-related products. However, we feel that investors underappreciate the ultimate value of the veterinary businesses. Growth rates and margins tend to hover in the midsingle digits for veterinary supply segments. Given that veterinary segment growth rates are actually higher than those of both dental and medical segments (which are core businesses for Schein and Patterson), it is arguable the veterinary segments could be slightly undervalued relative to the other business units for both Patterson and Schein.
Our Top Health-Care Picks
Our top health-care recommendations cover most of the sector's industries, ranging from pharmaceuticals to managed care. Although several of these firms' valuations have improved over the year, we believe the stocks still have room to run based on favorable long-term dynamics and attractive valuations.
| Top Health-Care Sector Picks|
|Data as of 6-15-11. |
As the largest pure-play medical-device firm, Medtronic manages to maintain an even keel as a result of its diversification. Most recently, the cardiac rhythm management and spinal businesses have slowed down as patient volume has fallen off, Medtronic's products have aged, and managed care has begun to push back on reimbursement. Now, Medtronic is poised to launch its new product cycle, kicking it off with the recent European launch of the first-to-market MRI-compatible pacemaker. Medtronic is also set to roll out its next-generation spinal products this year, which should solidify its leadership position in that market. In the meantime, the firm has focused on what it does best: innovating internally and augmenting its product lines with acquired technology. All of these initiatives should generate healthy cash flows over the longer term, even as product cycles in each segment wax and wane. Additionally, Medtronic recently revealed that Omar Ishrak of GE Healthcare would become the cardiac giant's next CEO. We think his appointment will be favorable for Medtronic as Ishrak was known as a rising star at GE with strong successes in emerging markets, which should bode well for Medtronic's emerging-markets strategy.
Abbott Laboratories (ABT)
Unlike many of its industry peers, Abbott faces only a few patent losses during the next five years and is well-positioned to ride a strong tailwind of demand for its products. Most importantly, we expect continued strong demand for the company's leading drug, Humira. With drug penetration in rheumatoid arthritis reaching only 20% (and even less in psoriasis and Crohn's disease), Humira could expand at double-digit rates for the next four years. Also, Abbott's strong competitive position in nutritionals and diagnostics reduces the volatility of its earnings and creates additional avenues of growth. Lastly, with close to 25% of Abbott's sales derived from emerging markets, the company is well-positioned to ride the tailwind from these fast-growing geographies.
VCA Antech (WOOF)
Although recessionary economic conditions kept pet health-care spending on a short leash from 2009 through 2010, we think the market has bottomed out and VCA should benefit as pet owners gradually resume the routine preventative care they've postponed. As the nation's largest operator of animal hospitals and veterinary diagnostic labs, VCA is poised to take advantage of the $43 billion market for pet products and services. Spending on pets has seen 8% compound annual growth since the mid-1990s, as pets have come to be thought of as valued family members. Animal health care (veterinary services and medicines) accounts for nearly half of the total spent on pets each year. Like health-care procedures for humans, pet health services and treatment options have expanded substantially in recent years as the result of research and technological advances. It is no longer uncommon to see humans willing to shell out hundreds of dollars for specialized pet treatment. These shifting trends bode well for the long-term outlook for VCA Antech.
The long patent life of Roche's portfolio puts it among the biotech firms least exposed to generic competition. Patents don't begin to expire until 2013--when Rituxan loses protection in Europe--and management is implementing strategies to counteract future competitive pressures that we think will enable the firm to achieve 7% 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 its 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.
Despite rebounding significantly from its lows in late 2008 and early 2009, WellPoint's stock remains undervalued, in our opinion. The company generates significant free cash flow, and health-care spending growth provides a mid-single-digit tailwind to future earnings growth. With the passage of comprehensive health reform, uncertainty surrounding WellPoint has diminished substantially. We don't think the new law will have a particularly negative impact on WellPoint's future earnings. Commercial medical cost ratios will come under pressure from regulated minimums starting in 2011, but we estimate that the new rules are unlikely to raise consolidated medical cost ratios by more than 100 basis points. On the other hand, WellPoint has low selling and administrative expenses, and it has the chance to cut costs further through systems integration and redesigned broker commissions.