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Market view: Is now the time to buy into the Healthcare sector?

Dan Mahony (pictured) and Gareth Powell, managers of the Polar Capital Healthcare fund assess the recent drug pricing and M&A activity in the market and ask whether there is an improving outlook for the Healthcare sector?

Within the healthcare sector valuations have fallen to very compelling levels, this is both on a relative and absolute basis based on the strong fundamentals and earnings growth outlook. Investors have been turning to healthcare for returns that are uncorrelated but the sector does of course have some risks. The main one is the political situation in the US and there is a chance that there may not be much clarity until after the Presidential election result in November, but arguably the risk and reward is compelling.

Drug pricing continues to be a lingering concern for investors with the worry that this could become a political issue as we move to the final phase of the Presidential election. With respect to drug pricing, the Centers for Medicare and Medicaid Services (CMS) announced a new programme in March that will evaluate the use of value-based drug pricing for Medicare Part B drugs. These are drugs such as those to treat cancer or injectable antibiotics that are administered in a physician’s office or hospital outpatient department. The major impact of this change will fall on physicians and hospitals as they currently make a 6% mark up on the actual selling price (ASP) of a drug. This clearly creates an incentive to use expensive drugs over lower cost alternatives. This new programme replaces the 6% mark up with a flat fee of $16.80 and a 2.5% mark up.

The programme will also evaluate different tools to help physicians choose the best value treatment for patients, provide the potential for companies to charge different prices for the same drug used in different diseases (based on its relative effectiveness) and an opportunity for drug manufacturers to share risk with CMS where the price paid for a drug is linked to patient outcomes.

The initial reaction to this programme from the industry and most market commentators, was negative but this is just another step along the path towards paying for performance.

Another area of interest for investors in the healthcare sector are the new digital health technologies. These are now entering the market and enable governments or insurers to evaluate the effectiveness of therapy in the “real world” and so will allow them to adjust reimbursement accordingly. While this is not a near-term threat to the pharmaceutical industry this is an area that is evolving rapidly. On a five-year view, it is a possible risk that the use of data and analytical tools to evaluate products and services will create unexpected pricing pressure for healthcare companies that have not grasped the scope of the impending structural change across the industry.

Two key catalysts

However, there are two key catalysts shifting the focus away from politics. The first is the Q1 earnings season, where, on a relative basis, healthcare had a much better earnings season than most other sectors and while earnings expectations for the broader market have been revised downwards expectations for healthcare are largely unchanged.

Generally the Q1 earnings season was very positive for most large companies outside of the drug sector. Medical device companies have had a much stronger start to the year than expected, as have most of the US hospitals.

The second catalyst is M&A activity which was firmly back on the agenda for the healthcare sector during April. At the beginning of the month, the US Treasury Department issued new proposed rules related to tax inversions, this is where a US company acquires a target company located in a low-tax geography in order to move its tax domicile out of the US. It appeared as though the proposals were written to target specifically Pfizer’s proposed acquisition of Allergan.

Given the uncertainty created by the US Treasury proposals, Pfizer decided to terminate the acquisition, which led to a significant fall in Allergan’s share price. The break-up of this deal was a boost for the biotechnology sector as it sparked speculation that Allergan would now become a potential acquirer, the company is in the process of selling its generics business to Teva for $40 billion.

However, the major M&A news came on the last Thursday of April when Abbott announced that it would acquire St Jude in a $25 billion transaction; Sanofi announced a hostile bid for Medivation; and AbbVie announced the acquisition of Stemcentrx, a private company, for $5 billion. These deals highlight the need for a dual-pronged investment strategy that focuses on the consolidators and the innovators in the sector.

Abbott’s move to acquire St Jude is possibly a response to the success that Medtronic has had in taking market share and delivering top-line growth, following its acquisition of Covidien. Hospitals are trying to reduce the number of suppliers and looking to the larger companies to provide a broader range of products, especially across a therapeutic speciality. Within cardiovascular medicine, Abbott had a strong position in stents and certain areas of cardiac surgery; with St Jude it can add devices for heart failure, atrial fibrillation and cardiac rhythm management.

For investors, it is important to appreciate that companies that fail to generate sufficient scale or the small and mid-sized companies that have “me-too” products or services are likely to be big losers in this changing environment.

It is possible that healthcare companies, across a number of different sub-sectors, are seeing consolidation as a route to improving efficiency for the healthcare system. Companies can create economies of scale, broaden product portfolios, standardise products and processes, lower cost of goods, take market share and deliver cheaper solutions to their customers.

While healthcare looks attractive on a growth and valuation basis, the US Presidential election is likely to remain a headwind in the near term. However, the fundamentals for healthcare are strong and the political uncertainty provides an attractive entry point for investors in the sector.

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