Friday, March 30, 2012

Health Care Stocks in a Maelstrom

Following up on yesterday's note on my meeting with Zimmer management:

I went to go hear Barclay Capital's health care analysts Tony Butler and Ying Huang yesterday.

I won't go into their specific stock picks other than to say that they are cautiously optimistic on their group.

 Big pharma offers good dividends, low valuations, but meager new drugs in the pipeline.

Biotech stocks traditionally trade on news of a new drug discovery, which by definition is basically defies traditional stock valuation work. Still, several biotech companies have some exciting new drugs in the testing phase, which could mean outsized returns if everything plays out.

What I wanted to mention today was their thoughts on the current debate in Washington on the fate of President Obama's health care plans.

The Supreme Court is not expected to announce their ruling on the legality of so-called Obamacare until June, but their decisions could have a wide-ranging impact on our society not to mention health care stocks.

While not necessarily endorsing their views, I thought I would share some of the comments that Messrs. Butler and Huang made yesterday:

Despite the fact that 80% of the pharmaceutical drugs sold in the United States are generics - compared to just 30% in Europe - US pharmaceutical companies still enjoy margins and profits that most industries could only dream about.

The pharmaceutical industry argues that the wide margins they make on branded drugs are necessary in order for them to fund very expensive research and development efforts.

The reason that Europeans use more branded drugs than generics is simple: European governments put a cap on what manufacturers can charge.  Given the choice between a branded or generic drug, most would choose the branded if prices are essentially the same, which is the case in Europe.

However, the European price controls have lead European drug manufacturers to move much of their R&D efforts offshore, largely to the United States. 

If Obamacare is struck down, it seems likely that the next step the government will take will be to try to impose some sort of price controls on pharmaceutical drugs.  The rate of growth of health care costs in this country is simply too high.

It seems logical, then, that price controls in this country will lead to either drastic cutbacks in R&D efforts in the U.S., or possibly moving R&D efforts to other parts of the world such as Asia.

The effect on the valuations of the pharmaceutical stocks could be significant.  The reason that European pharma sells at a significant discount to U.S. companies boils down to the superior R&D efforts at U.S. manufacturers.  

Absent a robust drug development effort, then, US pharma becomes nothing more than distributors,  meaning serious declines from current valuation.

 They also made the following points regarding health care providers:

If Obamacare is ruled unconstitutional, the US health care system is faced with the problem of how to deal with the large group of citizens that do not have health care insurance.

Bad debt expense is an enormous problem for most hospitals.  At some large metropolitan hospitals, bad debts can run as high as 20% of revenues.  This is not saying that the uninsured are deadbeats; no, it is simply that they do not have the funds to pay for medical treatment or insurance.  

To put it bluntly:  If Obamacare passes, it will be a huge benefit to hospitals, and to the hospital stocks that are publicly traded.  On the other hand, HMO stocks will suffer, since their main advantage of lower costs goes away.

If Obamacare is struck down, hospitals are tanked, while HMO stocks soar.

Yesterday HMO stocks were among the best performers in the market on a generally down day.  The market's verdict seems to be that the Supreme Court is leaning towards striking down Affordable Health Care Act.

It should be an interesting time between now and June, when the Supreme Court's decision is actually announced.