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03/16/2010

Outlook for Healthcare Reform and Healthcare Stocks


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MorningstarU.S. Healthcare Spending Appears Unsustainable 

The U.S. spends twice the average of most other developed nations on health care for only comparable care, which has led many to question the efficiency of the U.S. health-care system. Further, the high health-care spending represents approximately 17% of U.S. GDP and has grown faster than GDP over several decades. These high costs--along with the desire for universal health-care coverage and the U.S. government's dwindling resources for funding health-care programs--are driving the calls for major health-care reform. 

Healthcare Reform Likely on the Way 

While at the beginning of the year the economy was consuming the bulk of the U.S. government's efforts, President Obama and several folks in Congress appear ready to switch gears and implement significant health-care reform. In February, the president laid out an aggressive health-care agenda in his proposed budget. Further, with the Democrats in control of both the House of Representatives and the Senate, we expect to see important changes to the U.S. health-care system over the next 18 months, regardless of the recent vocal, but inconsequential opposition at the town hall meetings. 

Healthcare Plans under Consideration 

While President Obama appears open to the various health-care reform plans coming from Congress, we expect the ultimate reform package is likely to include several of the main points he detailed during his presidential campaign and in his budget proposal. Large cohorts of industry lobbyists as well as the American people appear to favor small changes rather than a major transformation, and we therefore expect evolutionary, not revolutionary, changes to health care. As a result, we don't expect a shift to a national plan resembling European plans. However, we do expect changes designed to control costs and expand insurance coverage. 

Healthcare Reform and the Managed Care Industry 

Our relatively bullish outlook on the managed-care industry rests on two assumptions regarding health-care reform. First, our fair value estimates incorporate a middle ground between several potential outcomes of the mainstream proposals. Second, we believe the probability of a dramatic shift to a single-payer system is very small. A shift to a single-payer system would cause a sharp decline in our fair value estimates for managed-care stocks. 

Cuts to the Medicare Advantage Program appear to be the most likely near-term headwind for the group, impacting Humana HUM, HealthSpring HS, Coventry Health Care CVH, Wellcare WCG and UnitedHealth UNH. Additionally, reforms could be passed supporting guaranteed issue (requiring insurers to cover all applicants), community rating (forbidding insurers from charging premiums based on health status) and individual mandate (requiring individuals to buy health insurance). If all three are passed, we think these reforms would generally be a positive for the MCOs, as they would result in significant new membership from the previously uninsured population.

Healthcare Reform and the Pharmaceutical and Biotech Industries 

We expect two major reforms to impact the pharmaceutical industry. First, we believe legislation will increase Medicare's negotiating power, which could lead to across-the-board price cuts on drugs reimbursed by Medicare (currently approximately 20% of U.S. drug spending). It's worth noting that the drug industry's proposed $80 billion in price concessions over the next 10 years would account for a portion of these price cuts, in our opinion. Second, we expect expanded insurance for the 46 million uninsured U.S. citizens, which should increase drug sales by as much as 15%. We believe these two factors will largely offset each other, resulting in no net effect on our fair value estimates for Big Pharma. As a reminder, our fair value estimates for Big Pharma firms are approximately 25% above current stock prices. Additionally, while drug reimportation and comparative effectiveness programs are great for political campaigns, we don't expect these programs to significantly impact the drug industry. Pharmaceutical firms benefiting most would be Novartis and Johnson & Johnson. 

From a biotech standpoint, health-care reforms appear less significant, because most biotechs focus on serious, chronic or life-threatening diseases, which haven't been the target of most reform. While new laws creating a path for generic biologics could cause some challenges, we don't believe generic biologics will impact branded sales to nearly the same extent as witnessed with generics for branded small molecule pharmaceuticals. Additional clinical trial requirements, higher manufacturing costs, and significant marketing efforts will likely be needed for generic biologic approval and commercial success, reducing the number of viable competitors and the degree of price discounting.

Given all of the challenges facing the potential launch of generic biologics in the U.S., we expect much smaller revenue declines for biologics losing patent protection as compared to traditional small molecules.

For more information on U.S. Healthcare Reform, please click on the link just below. 

Thereafter, click on “Free Issue”, which will give you the opportunity to download our 54-page journal, Morningstar Healthcare Observer. It’s yours free with our compliments. http://healthcare.morningstar.com/Purchase.aspx 

--Damien Conover, CFA, Morningstar Equities Strategist and Editor 

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