Are Drug Stocks Cheap Enough Yet?
Starting with the presidential election last fall, the Democratic leadership has made health care reform and providing coverage to the 48 million uninsured Americans their top domestic priority. Insuring more people would be accomplished by significantly expanding the federal-state Medicaid program and creating new insurance markets with subsidies for low- and middle-income people. Democrats propose increased government intervention as the solution to our uninsured problem. Financing this coverage would come mostly from higher taxes for upper-income Americans and new taxes on the health care industries that would see volume benefits from the newly insured.
The Obama Administration and Senator Max Baucus (D-Montana) negotiated new taxes over ten years from drug and biotech companies worth $80 billion, medical device manufacturers of $20-25 billion and lower Medicare rate increases for hospitals worth $150 billion; they are also targeting $60 billion of new taxes for health insurers and $120-150 billion of cuts to the Medicare Advantage program. After months of debate in House and Senate committees, lively citizen protests at town hall meetings, primetime presidential speeches on national television and the romancing of key senators to jump on board the Baucus/Reid/Pelosi health care bandwagon, we are still only halfway through the legislative process of overhauling health insurance in this country and there isn’t good visibility on the final outcome. As we move toward 2010, the calendar is not a friend to the White House or the Democrats’ agenda.
Three Democrat-lead health care bills have been floating through the halls of Congress over the last four months. The large $900 billion-plus price tags to cover 29 million people and some polarizing features — such as the public-plan option and individual mandates — have made it difficult for these bills to gather wide support. Within the congressional Democrats there are disagreements between liberals and moderate members, as they favor different approaches on federal spending and market competition. Now entering the fray are House Republicans with a lower-cost and smaller-reaching bill, but it is not expected to get far. On November 4, 2009, the Senate leadership all but admitted that its timeline for passing a bill is delayed again, now into December, as they wait for bill scoring from the Congressional Budget Office and then more negotiations.
What does the American public think about the proposed health care overhaul? Respected pollster Rassmussen Reports this week found that 42% of voters polled favor the health care bill proposed by the president and congressional Democrats, and this support has stayed between 41% and 46% since July. So today 54% of voters polled oppose the current Democrat effort, and 4% are undecided. When you look at the party affiliations of the voters polled, 69% of Democrats support the bill, while 80% of Republicans and 48% of unaffiliated voters oppose it. Of voters polled, 55% say passage of the bill would increase the cost of health care and 52% say it would hurt the quality of care. Other recent polling shows that 49% would rather see no health care legislation passed this year than see the current bill become law. That’s interesting, and you would think gives the politicians something to think about.
The remaining journey for a bill to the president’s desk is looking like a tough struggle, as today the Democrats do not have the necessary 60 votes in the Senate to move forward into a House/Senate conference. This delay is a setback for the Democrats’ agenda because leadership wants to pass a bill and move on to other domestic issues before many Congress members enter campaign season for the fall 2010 elections. If we move into late December and the bill is stuck in the Senate, I think the probability rises that a smaller, less expensive health care reform bill emerges as the leading bill. If such a change in strategy occurred, I think investors would revisit the health care sector and in particular push the depressed managed care stocks higher.
How Has the Great Health Care Debate Impacted Health Care Stocks?
As the U.S. and other world economies show signs of a recovery, defensive sectors like health care are naturally going to be out of favor. But the Democrat reform bills and their reliance on new industry taxes has definitely been a large overhang on health care stocks. Year to date, the S&P 500 Index has risen 15.9%, but many health care sectors have not kept pace with the overall market. For example, the U.S. pharmaceuticals group is up 11.7%, managed care is up 11.3%, medical devices is up 12.2%, and large-cap biotech is up 5%. The outperforming health care sectors in 2009 include life science tools (up 45.5%), generic drugs (up 40%), and hospital stocks (which have more than doubled after a huge sell-off in late 2008 on high balance sheet leverage concerns).
Low P/E Multiples, Attractive Dividends and High Free-Cash-Flow Yields Favor U.S. Drug Stocks
You are probably wondering how the pharmaceutical and biotech industry lobbying groups determined that $80 billion in new taxes over ten years to help finance health care reform was acceptable. It’s clear that most health care industries wanted to be part of the dialogue in shaping a health insurance overhaul this time around, and the drug industry wanted to avoid any efforts to put price controls on drugs. $8 billion per year represents approximately 2.7% of current annual U.S. drug industry revenues and 6.7% of theoretical pretax profits. In the current bills, drug companies have positive volume offsets, as new insured people are likely to consume more medicines and seniors in Medicare will have greater drug coverage during the “donut hole”.
In U.S. pharmaceuticals, 2009 has been a transformational year, with the two mega-mergers of Pfizer/Wyeth and Merck/ScheringPlough. Both of these new organizations are focused on integrating and cutting costs to create more efficient business models that can better weather the coming patent expirations of key blockbuster drugs in 2011-12. In recent weeks, new multi-billion dollar cost-cutting efforts have been announced by Eli Lilly and Johnson & Johnson as they also prepare for drug patent cliffs and a changing global environment. These cost-cutting programs and other efforts will help many drug companies generate mid- to high-single-digit EPS growth over the next five years. Many U.S. pharma companies have potentially exciting new drug therapies in late-stage development; if any of these hit, this group could spark new interest from investors. With dividend yields of 3.3-5.8%, investors are rewarded for waiting as the business transformations and product pipelines develop.
Today, the U.S. pharmaceutical sector trades at 10.2 times estimated 2010 EPS and 9.4 times 2011 EPS, representing 30% discounts to the S&P 500 market multiple. On a free-cash-flow basis, many drug stocks are yielding a hefty 7-9%. Looking at the chart below, you see that U.S. pharma stocks today sell at lower P/E multiples than they did during the scary Clinton health care reform effort in 1993.
U.S. Pharmaceuticals are Attractively Valued
Low valuations, high dividend yields, strategies to deliver mid- to high-single-digit EPS growth over the next five years, and the possibility of good pipeline news all combine to make U.S. pharmaceutical stocks an interesting group for patient investors.
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