Health-Care Stocks: A Beleaguered Haven?

The medical sector is supposed to be a defensive bulwark. But Walgreen results and bids to reform health care say this isn't your dad's recession

By Ben Steverman

In the stock market, a constant refrain over the years has been that health care is a "defensive" sector because it resists recession. Whatever ails the economy, people still get sick and need medical care.

With the U.S. economy experiencing its biggest pullback in nearly 60 years, that notion is being put to the test. The result? More than a year into a nasty recession, health-care profits have barely budged. In the current scheme of things, that's a pretty good performance.

According to Thomson Reuters (TRI), analysts expect health-care earnings to fall 2% in the second quarter, far less than any other sector in the broad Standard & Poor's 500-stock index. By contrast, profits for the entire S&P 500 are predicted to drop 34%.

But will the sector's defensive position hold? On June 19, another 850-page plan was floated to reform the health-care sector—this time by a U.S. House of Representatives working group.

And on June 22, President Barack Obama announced a deal by which pharmaceutical companies agreed to spend $80 billion on lowering health-care costs over the next 10 years.

Walgreen Disappointed Investors

The deals, proposals, and counterproposals—it seems another is unveiled each week—could create major and unpredictable shifts in the way health care is paid for in the U.S. Adding to the uncertainty is the bad economy. Despite health care's reputation as a defensive sector, many companies are unquestionably feeling the effects of the economic slowdown.

All this was demonstrated on June 22, when the quarterly results from pharmacy giant Walgreen (WAG) showed the dizzying complexity of the current environment. Walgreen disappointed investors with lower-than-expected earnings. Earnings per share were 53¢ last quarter, 3¢ below Wall Street estimates and 8.6% lower than a year ago. Higher costs ate into profit margins at Walgreen.

Like some other health-care companies, certain parts of the chain's business seemed untouched by the recession. Walgreen's pharmacies filled 8.3% more prescriptions than a year ago. But sales results were weighed down by slow consumer spending in the rest of the store. "We continue to see consumers save more, use less credit, and spend closer to payday," Walgreen Chief Executive Gregory Wasson told analysts on June 22.

Excluding prescriptions, same-store sales were up just 0.9%, compared to a 4.6% increase a year ago. Same-store prescription sales growth actually accelerated, from 2.7% a year ago to 3.8% last quarter.

Walgreen execs say they want to widen profit margins by launching a range of initiatives. Stores are being renovated, corporate expenses are being cut, and the chain is planning to slow down growth so less money is spent to open new outlets.

Stiffer competition, reform pressures

But a severe economic downturn is a tough time to make big changes like these. "In our view, the quarter indicates the continued challenges of fixing the model amid a difficult economy," wrote UBS (UBS) analyst Neil Currie. Discounts and promotions that are needed to draw reluctant shoppers probably bear much of the blame for the quarter's disappointing earnings, Currie said.

The recession has only heightened competition between Walgreen and its rivals, Citigroup (C) analyst Deborah Weinswig points out. She cites Wal-Mart's (WMT) aggressive offering of $4 generic drugs.

Even as it deals with the bad economy and a tough competitive landscape, Walgreen—like other health-care-related stocks—could be hugely affected by Obama's health-care reform plans. The cost-cutting deal between Obama and drug companies is one sign of how much the sector's profitability could be squeezed.

"Financially, this is obviously not good news for pharma, but it's the new and inevitable reality that pharma has been anticipating and preparing for— Democrat in the White House—for years," wrote Rodman & Renshaw analysts Simos Simeonidis, Elemer Piros, and Ren Benjamin on June 22.

Greater prescription volume?

Asked about all of the action on health care in Washington, Walgreen's Wasson said: "There's certainly some threats and there's opportunities."

Among the threats are cost-cutting in the industry, he noted. "So we'll be focused on margin pressure and reimbursement pressure," he said. But he said to expect higher prescription volume, too, both from coverage for an extra 47 million people and from further efforts to improve health through drugs, which are far more cost-efficient than hospital visits.

Walgreen shares fell 5.7% on June 22, to 29.64. Also on June 22, according to Standard & Poor's, stocks in the pharmaceutical industry dropped 1.23%.

Obama has asked Congress to pass a health-care reform bill by August. But even when—and if— a massive overhaul is approved, health-care investors will still be left contemplating how other forces will play out: the full impact of the recession on credit-starved consumers; increased competition in different health-care industries; and especially how any reform plan will be implemented in the practical realm. The questions surrounding the sector could persist for years.

Steverman is a reporter for BusinessWeek's Investing channel.

Business Exchange

Track and share business topics across the Web.