Profit from Obama's healthcare reforms
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Associate Editor
David Stevenson Apr 02, 2010
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After months of tussle and bile-filled debate, US healthcare policy has just seen its biggest reform for four decades. Last week, Barack Obama managed to push through big changes to the American health system in the face of substantial opposition. And despite what you might expect, one of the biggest beneficiaries could be Big Pharma. Indeed, Obama's changes could be just the catalyst needed to inject new life into the sector.
We'll have more on that later. First, let's take a look at those healthcare reforms. We covered them in detail last week, but in short The Patient Protection and Affordable Care Act aims to provide "quality health insurance coverage for all Americans".
Note the key word: 'coverage'. America hasn't introduced its own version of the NHS (which is what many health industry lobbyists had feared most). The Act is more like the healthcare "equivalent of Britain's compulsory car insurance", says Simon Jenkins in the Evening Standard.
Healthcare cover will be extended to the 32 million Americans who are now uninsured – typically because they can't afford rising premiums, or because insurers have already deemed them too ill to qualify for cover. An estimated 24 million who don't have health cover will be able to get tax credits to buy it on new state-approved insurance 'exchanges'. An extra 16 million will become eligible for Medicaid, the government-funded health scheme for those on low incomes.
See also:
• Healthcare: Obama's big reform goes through
• One interesting play on vaccines
The 'doughnut hole' is also being addressed. This is a gap affecting millions of over-65s who get Medicare health cover and currently have to pay prescription expenses over $2,700: they only re- qualify for cover if their costs top $6,154. The new rules will give them flat rebates and discounts on brand-name drugs.
Meanwhile, insurance companies will face more controls on stopping coverage, for example for those who become sick. But though the insurance industry faces tighter rules, it's relieved that one of its worst fears – a government-run scheme competing directly with the industry – hasn't happened. Increased coverage of course also means that insurers will get millions of new customers, while premiums are eventually likely to rise.
Insurers aren't the best healthcare play
That sounds good. And it might persuade you to buy shares in one of the major life and health insurers. For example, on a current year p/e of below 13, Aetna (NYSE: AET) doesn't look too expensive. And Cigna Corp (NYSE: CI), on a 2010 multiple of just nine, looks distinctly cheap.
But this isn't the best way to profit from US healthcare reform. First, although the valuations look fair, what you actually receive from holding these insurance stocks is downright poor. Aetna pays an annual dividend yield of only 0.6%. If you think that's bad, it's still three times the level Cigna shareholders get.
Second, investors have been steadily factoring much of the potential good news for insurers into their share prices. Both stocks have outperformed the overall indices by quite a distance over both the short and the long term. Indeed, since 1998, Cigna has beaten the S&P 500 index by more than 50%, while Aetna has shot the lights out with a near-200%
outperformance.
That takes us back to US big pharma. The contrast with the relative performance of the insurers is quite startling. Drug stocks have been underperforming for ages. The S&P Pharma index has undershot the overall market by 30% over the last seven years. So why has the sector fallen so far out of favour – and why should the new healthcare laws help?
Big pharma's big problems
In the market's eyes, the two main problems for medicine manufacturers have been what's known as the 'patent cliff' and possible damage from President Obama's healthcare reform.
The patent cliff is the likely loss of high-margin sales by the world's top drug-makers as many of their best-selling drugs (known as 'blockbusters') come off patent. When this happens, the drugs can then be copied by generic rivals and sold more cheaply. Industry experts reckon the global hit could be as big as $140bn by 2016. Even for a business that's likely to ring up worldwide sales in 2010 of more than $825bn, that's still a big bite.
Then there have been the fears over healthcare reforms. Analysts have been concerned about the danger of low-cost drug imports, and tough pricing deals and rebates being imposed by Medicare and Medicaid. So the sector's shares have suffered horribly.
Take a look at the chart on the right. The blue line is the stockmarket valuation of the US pharma sector. The left-hand scale shows how the price/earnings (p/e) ratio has dropped from more than 40 in 1999 to around 11.5 today. Investors have gone from expecting great things from the sector to constantly worrying about being disappointed. That sort of massive de-rating would normally go hand-in-hand with a collapse in profits.
But has this happened with drug stocks? Not at all. In fact, it's the exact opposite. Despite all the market's fears, American big pharma has kept delivering the goods. Look at the red line on the chart. This shows the earnings per share (EPS) generated by the S&P Pharma index over the past 12 years (rebased to 100): it's an increase of some 175%. Even better, this is a near-straight upward line, too.
That means drug-stock profits and cash flows have grown consistently year-on year. Compare that to the green line. This shows the earnings generated by the overall S&P 500 index. Not only are these more variable than the pharma sector, they're up just 60% over the same period. What's more, the 'normalised' p/e on the S&P 500 index – which measures the average of ten years' earnings – is now 21.3. That compares with the long-term average of 16.4. This means investors are valuing American shares overall at almost twice the level of US big pharma.
In other words, even if the patent cliff causes a hiccup in drug companies' profits, the damage is fully "baked into the stocks", says Timothy Fidler at Ariel Investments. He adds that the big US pharma firms with their strong profits, cash flows and high returns on capital, are "good, contrarian investments", with some now trading at, or even below, the value of their drug pipelines.
And as for healthcare reform, not only have most of the industry's fears proved groundless, the new deal is actually likely to prove very good news for America's drug firms. "Pharma came out of this better than anyone else," says Washington health analyst Ramsey Baghdadi. "I don't see how they could have done much better."
"Costly brand-name biotech drugs won 12 years' protection against cheaper generic competitors, a boon for products that comprise 15% of pharmaceutical sales," points out Alan Fram in Associated Press. And although "the industry will have to provide 50% discounts beginning next year to Medicare beneficiaries in the 'doughnut hole' gap", cheaper drugs and rising subsidies mean more elderly people will end up purchasing pills.
The overall impact isn't entirely certain, says Fram, but "Goldman Sachs suggests the overhaul could mean 'a manageable hit' of tens of billions of dollars over the coming decade while bolstering the value of drug company stocks". And others expect profits, not losses, "of the same magnitude". Baghdadi projects a "$30bn, ten-year net gain for the industry". In a nutshell, it looks like the stockmarket's view of US drug stocks is about to change. Healthcare reform should be the catalyst for kick-starting the performance of this neglected sector.
The best US big pharma stocks to buy
So which stocks should you buy? Here are four, all with low p/es and well-above-average yields. The largest of the US drug makers is Pfizer (NYSE: PFE). At $17.21, it's on a 2010 p/e of below eight, and has a prospective dividend yield of 4%. That's not bad when you consider that the S&P 500 average is closer to 2%. "Pfizer is more a cost-cutting than growth story," says The Motley Fool. It has "massive economies of scale... and financial resources, all of which are advantages in the pharma space".
The slightly more expensive Merck (NYSE: MRK) is on a multiple of 11 this year, and also yields 4%. "It's my favourite pharma stock," says John Dorfman in BusinessWeek. "It has 20 drugs in Phase III trials, the most advanced stage of drug development, and another 20 in Phase II. Pre-tax margin, 56% last year, could fall a lot and still dwarf insurers' profit margins."
Meanwhile, Bristol-Myers Squibb (NYSE: BMY) at $26.70 is the most expensive of the group, on a current year p/e of 12, with a 4.8% prospective yield. But that's still hardly expensive as "longer-term, the company expects a period of sustained earnings growth beginning in 2014", says Chris Schott at JP Morgan. The cheapest of the four is Eli Lilly (NYSE: LLY), which at $35.56 is on a 2010 p/e of just 7.5, and a prospective yield of 5.7%.
Of course, there's a currency risk in buying non-UK shares – you lose out if the pound climbs. But the average valuation here in p/e terms works out at below ten. If that were to rise only as high as the wider market's long-run valuation level of 16.4 – hardly an unreasonable ask – then even on unchanged earnings you could be looking at a 70% dollar profit.
• For another way to play the pharmaceutical sector, see One interesting play on vaccines
• This article was originally published in MoneyWeek magazine issue number 480 on 02 April 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
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