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Get Four
|  | MARCH 11, 2005
 INDUSTRY IN FOCUS By Barney Brodie Health Care's Mixed Signals Hospitals and managed-care outfits are hale and hearty. As for Big Pharma, it needs therapy What were the health-care sector's vital signs in the most recent quarter? S&P analysts believe that fourth-quarter results for the companies in the group were mixed, with the medical-device and managed-care subindustries reporting better-than-expected profits, while the biotechnology and hospital groups reported mixed results. The real weak spot in the sector: pharmaceuticals, which generally posted subpar results. But S&P thinks that overall, the positives in the sector outweigh the negatives. On Mar. 8, S&P raised its recommended allocation on the sector -- which makes up 12.7% of the S&P 500 index -- to overweight, with an emphasis on nonpharmaceutical groups, such as medical equipment, managed care, and healthcare facilities. S&P has a positive outlook on the medical device, managed care, and hospital sectors. However, it finds the outlook for pharmaceutical companies uninspiring because of pricing pressures, the upcoming expiration of many patents, and the implications of negative news about certain painkiller drugs. Pharmaceutical stocks comprise more than half of the health-care sector's weighting within the S&P 500. BIG PHARMA'S TONIC? In the first two months of 2005, pharmaceutical stocks were flat. "We think that the poor performance, year-to-date, of pharmaceuticals generally reflects uninspiring December-quarter earnings by the major drug stocks, lack of or downward revisions in 2005 guidance, and more clouds on the regulatory front," says Standard & Poor's pharmaceutical analyst Herman Saftlas. "The industry's prospects remain clouded by looming patent expirations at nearly all major players, with uncertainties continuing to hamper new products," he says. Pricing pressure from managed-care outfits and state Medicaid agencies is another issue that concerns Saftlas. However, he thinks big pharmaceutical companies will become much more aggressive in cost cutting and restructuring this year. What's more, he notes, favorable currency exchange continues to boost profits. Large pharmaceuticals get about 40% of their revenues abroad. Fourth-quarter results for the biotechnology industry were mixed, according to Frank DiLorenzo, S&P's biotech analyst. "The less-than-stellar fourth quarter reverses a positive trend of strong quarterly results that began in the second half of 2002," he says. Looking forward, S&P lowered its annualized earnings growth rate for the next five years for the biotech group to 20.9%, from a previous estimate of 22.2%, in part because of lower-than-expected forward-looking guidance from biotech companies and also due to the Food & Drug Administration delaying approval of some drugs. In general, the entire FDA approval process has been taking longer than in the past. CREAKY HIPS. S&P also believes that the requirement for expensing stock options by the second half of 2005 could lead to investor questions about future earnings strength for many smaller-cap biotechs, which are more likely to use stock options in their compensation plans. Based on all of these concerns, S&P turned neutral on the biotechnology industry on Feb. 8, a change from the positive stance maintained by S&P throughout 2003 and 2004. S&P is positive on makers of medical devices. "Fourth-quarter results were almost universally ahead of my expectations, as modest upside on the revenue line joined with across-the-board expansion in gross profit margins, as well as well-managed tax rates," says Rob Gold, head of health care equity research at S&P. He estimates that revenue growth for the medical-device companies averaged 18% in the fourth quarter, with the most robust growth rates evident in sales of coronary stents, implantable defibrillators, breast implants, and reconstructive joint replacement devices. Hip-replacement devices, pacemakers, and medical sterilization equipment did not experience the revenue growth Gold had expected. Overall, Gold thinks that currency exchange boosted fourth-quarter revenue growth by about 2%. "Gross profit margins across the group were aided by favorable currency swings and some manufacturing efficiencies, along with higher prices received on newer devices launched during the year," Gold says. Because of the build-up of low-cost manufacturing locations overseas, along with buybacks of common shares, companies in S&P's medical-device coverage universe posted per-share earnings that were 20% to 23% higher in the fourth quarter than in the previous year, Gold says. HIGH REIMBURSEMENTS. Managed health-care companies reported fourth-quarter results that were ahead of S&P expectations. "Most managed care organizations benefited from mid- to upper-single digit enrollment growth, which was better than we expected, given continued employment weakness," says S&P's managed care analyst Philip Seligman. He adds that many managed health-care companies have also been benefiting from acquisitions, a trend he expects will continue for the next three years to five years. Fourth-quarter results for the hospital group were mixed, according to S&P analyst Cameron Lavey. He attributes the mixed results to high Medicare and managed-care reimbursement revenues, offset by the effect of fewer patients sick with the flu. Because of improving fundamentals, Lavey changed his outlook for this industry group from negative to positive on Feb. 28. There are six stocks from the health care sector in S&P's PowerPicks portfolio for 2005: Cooper Companies (COO ), Invitrogen (IVGN ), Kinetic Concepts (KCI ), Protein Design Labs (PDLI ), Waters Corp. (WAT ), and WellPoint (WLP ). Each is ranked 5 STARS (strong buy). For investors who want a broader focus, there are several exchange-traded funds that track various health care indexes: Vanguard Health Care VIPERs (VHT ), S&P Select Sector SPDR Health Care (XLV ), and iShares Dow Jones U.S. Health Care (IYH ).  Brodie is a reporter for S&P Global Editorial Operations All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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