What's Healthiest in Health Care


If you think health-care stocks will be healthy for your portfolio, the place to look is hospitals, HMOs, and medical-device companies. That's the advice of Robert Gold, Standard & Poor's group head of analysts covering consumer staples and health-care stocks.

Gold says the big pharmaceutical companies are not the best bets, because of "lackluster" product pipelines and patent expirations. However, S&P does give an accumulate ranking to Pfizer and Johnson & Johnson. In the sectors of health care Gold does recommend, he singles out as among the buys Tenet Healthcare, HMO company Anthem, WellPoint Health Networks, UnitedHealth Group, drug distributor Cardinal Health, and medical-device producers Varian Medical Systems, and St. Jude Medical.

These were among the points Gold made in an investing chat presented Oct. 22 by BusinessWeek Online and Standard & Poor's on America Online. He was responding to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A complete transcript is available from BusinessWeek Online on AOL at keyword: AOL.

Q: Robert, first, can you give us your take on the broad market? Has it touched bottom and started up for good?

A: It's our feeling that the economy will make a gradual but slow recovery over the next 6 months to 12 months and that the stock market will move higher as well. But we have very modest expectations for the S&P 500 over the next six months. Our present expectation is that the S&P 500 will retrace to the 1,000-point mark [it closed at 890 on Oct. 22], assuming interest rates remain low and reported earnings come in as we currently expect. We're looking for 2002 reported EPS [earnings per share] of $30.71 [on the overall S&P 500].

Q: And how about the health-care sector? Will it outperform?

A: Health care as defined by the S&P 500 is dominated by the pharmaceutical sector, which represents approximately two-thirds of the total health-care sector's weight of the index. Given the overall drug-pricing pressures that have significantly reduced both sales and earnings growth rates, we don't expect the pharma group to lead the market higher over the near term. We do, however, have a number of recommended stocks in areas such as hospitals, HMOs, and medical devices -- and believe that these stocks will significantly outperform the S&P 500. As such, we continue to recommend that investors maintain the market weight in health care -- or about 15% of a diversified portfolio.

Q: How about HRC

[HealthSouth]? Its EPS is 0.80 to 1.00, and it's selling for 4.40 a share.

A: We presently have an avoid rating [2-STARS in S&P's Stock Appreciation Ranking System] on HealthSouth. We're concerned about near-term risks, including a broadening SEC inquiry, shareholder lawsuits, rating-agency downgrades, and management credibility. Although the valuation would appear low, we think there are still significant risks to current sales and earnings estimates. In addition, we don't think a spin-off of the surgical unit provides any incremental benefits to shareholder wealth.

Q: What about AmerisourceBergen (ABC)?

A: Amerisource is one of our favorites in the distribution group. However, we recently downgraded the stock to hold [3-STARS], as its internal growth rate appears to have slowed below the industry averages. With much of the earnings growth being generated from acquisitions, we have some concerns about ABC's ability to maintain its mid-double-digit growth.

Q: What do you know about Anthem (ATH)?

A: Anthem was recently brought into our analytical coverage with a 5-STAR, or strong buy, opinion. We are very bullish on the HMO group in general, and Anthem is now one of our top picks in the group. We think its strategy of leveraging the Blue Cross/Blue Shield name will allow the company to generate growth, very similar to another of our favorites -- WellPoint Health Networks (WLP), which is also a 5-STAR.

Q: What do you feel is the healthiest stock in the sector? You've just named two 5-STARS.

A: I would answer that by breaking the group down by subsector. Within the hospital group, our longtime favorite is Tenet Healthcare (THC) -- a stock that we've had on our buy list since May, 2000. Tenet is generating annual free cash flow upwards of $1.5 billion on sales of about $16 billion. We think the stock will continue to outperform the broader markets, regardless of economic conditions. [For more on Tenet, see this video Q&A with CEO Jeffrey Barbakow.]

In medical devices, we recently raised our opinion on Varian Medical Systems (VAR), a company that develops and sells equipment used in cancer radiation treatments. Varian is experiencing very strong demand for its IMRT devices that are used to improve the outcomes of cancer radiation while minimizing side effects.

Within the HMO space, our favorite right now is Anthem, but we also have 5-STAR opinions on WellPoint and UnitedHealth Group (UNH).

Q: A choice here between two pharmas -- would you rather buy Abbott (ABT) or Pfizer (PFE)?

A: We currently have an accumulate [4-STARS] opinion on PFE, and although our outlook for the pharma group is not overly bullish, the company offers the highest growth rate in the industry and an expansive product pipeline. However, we do have concerns about its ability to accelerate its growth, given its size. We have a hold opinion on Abbott -- a company that recently posted sales growth and earnings growth below our expectations.

Q: What is your opinion of Cardinal Health (CAH)?

A: Another S&P 5-STAR. Cardinal Health is our favorite name in the drug-distribution group -- and one of the reasons that we like it is its broad exposure to medical products and supplies, which is allowing for well-above-average sales and earnings growth. Cardinal is expecting to generate about $1 billion in operating cash flow in fiscal '03 (ending in June), which provides it with a high amount of financial flexibility to pursue acquisitions, share buybacks, or debt paydowns. At 22 times our fiscal '03 estimate, the stock trades roughly in line with its 20% long-term growth rate. Our price target on Cardinal is $85 per share.

Q: Are major drug equities at risk with a new policy on patent expirations?

A: We believe that they are. This issue has been an overhang on the group for the past two years, and although some companies have been able to offset the negative impact of generic competition, by introducing new drugs and extending patents on some of their existing drugs, we see little relief for the industry over the near or long term.

Yesterday's proposal by President Bush, aimed at increasing the availability of lower-cost generics, signals something of a sea change in the political landscape that does not bode well for the pharma industry. It's our expectation that generally lackluster product pipelines, combined with the overall health-care cost pressures evident throughout the U.S. economy, will significantly hamper the group's ability to boost their sales growth rates.

Q: What's your opinion on JNJ

[Johnson & Johnson] and MRK

[Merck]?

A: We have an accumulate recommendation on JNJ. The stock is probably our favorite in the pharma group, but that somewhat reflects the company's diversification away from pure pharma sales and toward both medical devices and some more basic consumer products.

This afternoon, the FDA has been reviewing JNJ's application to market a drug-coated coronary stent. This product represents a significant new avenue of growth for JNJ, and we fully expect that the FDA will grant approval at its meeting. However, the stock has been among the strongest performers in the drug industry, and its valuation somewhat reflects the coronary stent's growth prospects. Over the long term, we think JNJ is one of the best investments in health care, but near-term valuation expansion may be difficult.

For Merck, we remain concerned about their significant exposure to patent expirations, along with ongoing weakness in Vioxx. Pharma sales in the third quarter were flat year-to-year, and we're hard pressed to find any sales catalyst on the horizon. Although Merck is priced toward the bottom end of its historical valuation range, we think this is warranted by the lack of organic growth.

Q: Your view on IDPH

[IDEC Pharmaceuticals] and DNA

[Genentech]?

A: IDEC is rated accumulate by our biotech analyst, and the Rituxan penetration in non-Hodgkin's lymphoma continues to expand. We project Rituxan sales of $1.04 billion in 2002 and $1.2 billion in 2003. IDEC is one of the few profitable biotech companies, and our net present value analysis points to a fair value of $50 per share. We have a hold opinion on Genentech. Although the company also benefits from increasing sales of Rituxan, we feel the stock is fully priced relative to its peers, at approximately 1.8 times its long-term growth rate (vs. the peer average of 1.3 times).

Q: Is Humana [HUM

] a possible takeover?

A: We do expect to see consolidation in the HMO industry. And among the candidates, Humana would definitely rank high. It's our feeling that the smaller regional players will be consumed by the national giants in order to more fully leverage their operating costs. In terms of acquisition pricing, there hasn't been a significant takeover in the group of late, so we don't have a takeover price target in mind for Humana. But that scenario is plausible. We currently carry a 4-STAR or accumulate opinion on the stock.

Q: What do you think of Quest Diagnostics [DGX

]?

A: S&P had a strong buy opinion on both Quest and Laboratory Corp. (LH) for many months during 2002. We recently downgraded both stocks, though for different reasons. For Quest, we have become concerned about their reliance on acquisitions for growth. Management has reiterated its 30% EPS growth targets. However, internal sales growth in the third quarter fell below the overall industry growth rate, suggesting to us that the upcoming UNILAB (ULAB) acquisition is critical to sustaining their 30% growth. This deal has faced some challenges, and the stock could be at risk should it not be consummated.

Q: Any new and innovative health-care service-provider stocks you like?

A: We're not finding names in the service area that you could regard as innovative. Where we find exciting new ideas is primarily within the medical-device sector. Areas that offer the most exciting product pipelines and introductions include cardiology, orthopedics, and oncology. Some of our favorite names include Varian Medical, Boston Scientific (BSX), and St. Jude Medical (STJ).

Some other small-cap emerging growth ideas include Given Imaging (GIVN), Intuitive Surgical (ISRG), and Hologic (HOLX). The only concern that we would have with the smaller-cap names such as these is that the equity and debt markets have effectively been closed, and many of these companies will require additional funding toward the end of 2003 and certainly into 2004.

Q: Why is there a lack of new products in the big caps' pipelines?

A: What we find is that the sheer size of a company such as Pfizer dictates that a new drug [needs to] come out of the gate with sales well above $1 billion in order to have a meaningful impact on the overall company growth rate. In addition, pricing pressures rippling through the U.S. health-care system make it imperative that new drugs show enormous improvements in efficacy vs. existing products before insurance companies will reimburse for them.

Q: Do you hear anything in the market about rivals to Pfizer's Viagra?

A: Eli Lilly (LLY) is developing a drug called Cialis with partner ICOS (ICOS). The drug may be held up by FDA manufacturing concerns, so we see no near-term rival to Viagra.


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