Healthcare: Buy, Sell or Hold

Last Sunday, the House passed a historic $938 billion health care bill and on Tuesday, President Obama signed the bill into law. The Senate will try to pass a second measure passed by the House on Sunday amending portions of the bill through a process called reconciliation. This massive health care overhaul is expected to guarantee insurance coverage for 32 million uninsured Americans. The cost of covering these currently uninsured citizens is expected to be covered by a combination of taxes on wealthy individuals and companies and through Medicare cost cuts.

One could spend pages and pages debating this legislation. Democrat and Republican lawmakers were bitterly split on it. Monday’s lead editorials from the New York Times and the Wall Street Journal do a nice job of highlighting the polar opposite views held by Democrats and Republicans, respectively. As investors, our opinion about this bill is not all that relevant. Our job is to assess the impact of this bill on the investment landscape in general and on our companies in particular. It is too early to put hard and fast numbers into our earnings models. There are many details left to be worked out and many of these taxes don’t begin to take effect until 2013 or 2014. However, the following is our initial take on this situation:

The health care legislation does not appear all that onerous for the health care companies that we own. The removal of the public option from an earlier version of the bill was a big positive for most of these companies. The passage of the bill, even though it increases taxes on many healthcare companies, removes the uncertainty that has been acting as an overhang for the sector over the past year. Here are some thoughts on the specific sectors that we currently care about in our client portfolios (please note the disclaimer at the bottom regarding any company-specific comments):

Medical Device Companies

In 2013, the Medical Device companies are expected to begin paying a 2.3% excise tax on medical devices sold in the U.S. This provision is expected to raise $20 billion over the 10 years covered by the bill. The initial estimate for this tax was $40 billion over 10 years and it would have started in 2010. Medtronic, Stryker, and Johnson & Johnson will likely be impacted by this tax. Our initial assessment is that this tax will be manageable for all three of these companies. Let’s take Medtronic as an example. Please keep in mind that these estimates are very rough in nature given the number of moving parts! Medtronic will have about $16.5 billion in sales in fiscal 2010. U.S. sales are about 60% of the total sales number, or ~$10 billion. If we tax the U.S. sales at 2.3%, this would equate to a total annual tax of $230 million. This tax is expected to be deductible which means that the approximate hit to company profits would be $172 million. Though $172 million is not a small number, it represents only about 4.5% of expected fiscal 2010 profits. Medtronic has stated that it will lay off employees and take other measures to partially offset this tax if it is ultimately enacted in 2013. Also, Medtronic would likely benefit from the 32 million newly insured Americans.


Drug Makers

The pharmaceutical companies are expected to pay $27 billion in annual fees over the next 10 years. The total amount committed by the pharmaceutical industry, in the form of industry surcharges and lower prices from government programs, could go as high as $85 billion over the next 10 years. This sounds like a big number and frankly, it is a big number. However, global spending on prescription drugs topped $643 billion in 2006, with nearly half of this number coming from spending in the U.S. Pharmaceutical companies have suffered from slower revenue growth in recent years due to significant patent expirations but remain extremely profitable. Most importantly, the drug companies stand to benefit significantly from the wave of newly insured Americans over the next 10 years. Drug companies got involved with this legislation from the very beginning in an effort to head off deeper regulation that could have come in the form of price controls. As an aside, we are looking closely at some of the global pharmaceutical companies as potential additions to our client portfolios.

Hospital, HMOs, Biotechs, PBMs, Etc.

We don’t currently own hospital companies or HMOs. Hospital companies have committed to $155 billion over 10 years. HMOs will face harsher regulation but should benefit from the new customers and the lack of a public option, which could have ultimately driven them out of business completely. Biotech companies (we own Celgene, Gilead, and Genzyme) shouldn’t be impacted too much by this legislation. PBMs, such as CVS, shouldn’t be impacted too significantly either. Life Science Tool companies, such as Waters Corporation, should not be directly affected. Patterson Companies, which is a primarily a dental distribution company, should not be significantly impacted.

Pricing Pressure?

All of these observations are very preliminary in nature. Though the healthcare companies generally, in our view, could have done a lot worse than the current legislation, pricing pressure is almost certainly coming through the entire healthcare chain. In order for the healthcare legislation to not add to the budget deficit over the 10 year period, the legislation calls for significant cuts in the growth of Medicare spending. These cuts are not particularly well-defined at this point and Congress doesn’t have a great history of following through on proposed cuts that are politically unpopular. Still, the U.S. is currently spending about 16% of its GDP on healthcare. This number is much larger than the amount spent by other developed nations. If something can’t keep going up forever, it won’t keep going up forever. In other words, health care costs will eventually get curbed, one way or another. The mechanism and the timing are not clear but as investors, we believe that we need to assume that pricing pressure is coming for most of the companies that we own. We take this into consideration when we are looking at each company’s long-term growth rate.

We Remain Overweight Healthcare

We like our current overweight position in healthcare. Our healthcare companies currently trade at 15.8x 2010 estimated earnings per share, representing only a slight premium to the S&P500. These companies have great balance sheets, generate high returns on capital, have solid organic growth prospects, and are less cyclical than the average company in the S&P500. Earnings for the S&P500 FELL 29% from 2007 to 2009. Earnings for our portfolio of healthcare companies, excluding the biotech companies which grew significantly faster, GREW 16% on average over this two year period. Long-term growth rates should remain above average due to an aging U.S. population. Clarity on the healthcare legislation should remove an overhang and help valuations as investors begin to appreciate that these companies should continue to grow faster, and in a more stable fashion, than the overall market over the coming years.

Peace,

Michael