Sector Analysis - Health Care

Maisy LamFIN 431 – Lawandy April 20, 2016

Sector Analysis – Health Care

Executive Summary

Health Care companies provide products and services related to health and medical care. The Health Care sector can be argued as having the most critical role in daily life compared to other sectors. Typically, the Health Care sector is economically less sensitive and less volatile than the broad market, resulting in consistent performance. Given the current state of the bullish market, Health Care can be expected to perform above the S&P 500 by the end of the year. However, with the global environment characterized by low to negative interest rates, devaluing currencies, and low oil prices, sector performance is at risk because Health Care operates in a large, global market where external circumstances affect all players. The Health Care team recommends still investing in the Health Care sector. Since global environments are a key driver in the short term, Health Care may see an increase in price since cost increases on the supply side are passed down to U.S. consumers. The current price of the S&P 500 Health Care index as of April 14, 2016 was $810.05.

Composition and Industries

The healthcare sector consists of two main industry groups: 1) Pharmaceuticals, Biotechnology, and Life Sciences as well as 2) Health Care Equipment and Services. The Pharmaceuticals, Biotechnology, and Life Sciences industry group is involved in discovering, developing, manufacturing, and distributing prescription drugs. The Health Care Equipment and Services industry group consists of health insurance firms, pharmacy benefit managers, hospitals, technology firms, and medical equipment makers.

Each industry group consists of three industries. Under the Pharmaceutical, Biotechnology, and Life Sciences industry group, the three industries are: 1) Pharmaceuticals, 2) Biotechnology, and 3) Life Sciences Tools and Services. Under the Health Care Equipment and Services industry group: the three industries are: 1) Health Care Equipment and Supplies, 2) Health Care Providers and Services, and 3) Health Care Technology.

The Health Care sector has a total market cap of $4.51 trillion. Within the overall Health Care sector, the ten largest constituents by market capitalization are: Johnson & Johnson, Pfizer Inc, Novartis AG (ADR), Merck & Co Inc, Gilead Sciences Inc, UnitedHealth Group Inc, Amgen Inc, Sanofi SA (ADR), Novo Nordisk A/S (ADR), and Bristol-Myers Squibb.

Pharmaceuticals

The Pharmaceutical industry includes firms that discover, develop, manufacture, and sell prescription drugs to treat animals and humans. Pharmaceutical drugs are composed of small molecules (i.e. chemicals), and pharmaceutical companies tend to offer a more diversified offering of drugs compared to biotechnology. The three largest firms within the pharmaceutical industries are: Johnson & Johnson, Novartis, and Pfizer.

Biotechnology

The Biotechnology industry includes firms that also discover, develop, manufacture, and sell prescription drugs to treat animals and humans. Biotech drugs are composed of large molecules (i.e. living organisms such as protein). Biotech drugs attempt to treat specific diseases that currently do not have a cure (i.e. HIV). As a result, biotech drugs are typically much more expensive, and the majority of biotech’s revenue comes from a small handful of drugs. The three largest firms within the biotechnology industries are: Gilead, Amgen, and Biogen.

Life Sciences Tools and Services

The Life Sciences Tools and Services industry supports both the pharmaceutical and biotech industries by providing equipment, analytical tools, and supplies in addition to

research services such as clinical trials. The three largest firms within the life sciences tools and services industries are Danaher Corp, Thermo Fisher, and Illumina Inc.

Health Care Equipment and Supplies

The Health Care Equipment and Supplies industry has firms that manufacture medical equipment and general medical supplies. The three largest firms within the health care equipment and supplies industries are Johnson & Johnson, General Electric, and Roche HLDG-GENUS.

Health Care Providers and Services

The Health Care Providers and Services industry have firms that offer a range of service-based products that are sold to individuals as well as other companies. The three largest firms within the health care providers and services industries are: UnitedHealth Group, Express Scripts Holding Company, and Aetna.

Health Care Technology

The Health Care Technology industry consists of firms that help gather and process data as well as firms that provide software to streamline operations of the healthcare industry. The three largest firms within the health care technology industries are: Cerner Corporation, Premier Inc, and Chemed Corporation.

S&P 500 Sector Breakdown

The Health Care sector represents 14.3% of the S&P 500 market cap.

The Health Care Sector and Historic Returns

Historical Performance

Total Returns

Standard Deviation of Annualized Risk-Adjusted Returns

Total Returns by Industry

The Health Care sector outperformed the S&P in the three, five, and ten-year returns, but underperformed the S&P trailing 12 months and the current year-to-date 2016. Health care has a higher standard deviation, but that is due to the volatility within biotechnology and health care technology industries. Within industries, four out of the six are underperforming year to date, but overall every industry generates positive returns in the long run. The Health Care sector’s recent under performance can be attributed to global market conditions that have affected currencies, oil prices, interest rates, and emerging markets which ultimately impact the sector. However, the S&P has been performing very well, indicating a strong U.S. market.

Financial Analysis (See Valuation Graphs)

Gross Margin Compared to the S&P, gross margin for Health Care is slightly higher, indicating that the sector as a whole does not retain significantly more revenue per dollar of sales. This can be explained by the high costs associated with discovering, developing, manufacturing, and distributing health and medical goods and services. Interestingly, aside from the Health Care Providers and Services industry, every other industry within the Health Care sector outperforms the S&P by a substantial amount. The two most notable industries with the highest gross margins are biotechnology and health care technology. Their high margins can be explained by the surge in demand for technology and biotechnology, which allows firms to generate large amounts of revenue.

Operating Margin

Compared to the S&P, operating margin for Health Care is underperforming, indicating that there is a discrepancy between selling/pricing and operating efficiency. Either firms are not selling enough/not charging consumers the right amount, or they may have high variable costs (e.g. labor or materials) that decreases overall operating income. Again, aside from the Health Care Providers and Services industry, every other industry within the Health Care sector outperforms the S&P. Biotechnology again has a significantly higher operating margin amongst all industries. Their high margins can be attributed to charging a premium for biotech products and services, which allows for higher revenue.

Profit Margin

Compared to the S&P, profit margin for Health Care is also underperforming, indicating that Health Care has a larger cost/expense structure associated with its operations. Health Care firms are known for having high investment and maintenance costs. However, industries such as biotechnology and pharmaceuticals have the highest margins. The prescription drug market is extremely profitable, with power given to the producing firms; so higher profit margins are expected.

Return on Assets

Compared to the S&P, ROA for Health Care as an overall sector as well as its industries are all outperforming the market. This can be explained by the notion that given higher cost structures, firms are more inclined to efficiently manage their assets in order to generate earnings. In addition, in high performing industries such as biotech and healthcare technology, certain assets have limited timelines, so firms must generate as much earnings as they can within a specific time frame before the asset goes obsolete. Return on Equity

Compared to the S&P, ROE for Health Care as an overall sector is outperforming the market, indicating that firms are using shareholder’s invested capital to effectively generate a profit. With the exception of Life Sciences and Health Care Equipment and Supplies, Health Care industries are also outperforming the sector and the market. Most notably, Biotechnology is again the strongest performing industry as much of the cutting edge medical research and treatment options come from biotech, allowing the industry to attract significant capital investments.

Debt to Equity

Compared to the S&P, D/E for Health Care as an overall sector is significantly lower than that of the market. The low D/E ratio can be attributed to Health Care firms who generally do not use a lot of debt as part of their capital structure, with the exception of Health Care Providers and Services. Health Care Providers and Services include health

care facilities, which usually require more debt financing to build facilities such as hospitals and clinics.

R&D Expense

Interestingly, compared to the S&P, R&D expense for Health Care as an overall sector is significantly lower than that of the market. The low R&D expense be explained by the little to no R&D spending acquired within the Health Care providers and services, life sciences, and health care technology industries. Not surprisingly, R&D expense for biotech is extremely high given the experimental nature of the industry in trying to discover new drugs and treatments for incurable diseases.

Earnings per Share

Compared to the S&P, earnings per share for the Health Care sector drastically underperform the market. This phenomenon can be explained by the low betas associated with Health Care compared to other sectors in the market. With lower risk come lesser returns. However, biotech is the only industry where EPS are significantly higher than the market earnings. The nature of biotech as an industry is much more risky and therefore lends itself to yield greater earnings for investors.

Valuation Multiples and Analysis (See Valuation Graphs)

Price to EarningsHealth Care as a sector consistently has a higher P/E ratio than the S&P. The higher ratio indicates the market’s belief in the growth potential of the Health Care sector. However, upon further investigation, the primary industries driving this growth are Health Care Technology and Life Sciences Tools and Services.

Price to Cash FlowPrice to cash flow ratios across all Health Care industries are higher than the P/CF ratio for the S&P. The significantly higher P/CF ratios indicate potential overvaluation due to growth prospects placed within the Health Care industries.

Price to SalesCompared to the S&P, the Health Care sector is on par with the market in terms of the P/Sales ratio, indicating that the overall sector is adequately priced. However, when individual industries are explored, biotechnology and health care technology are the two industries that have the highest P/Sales ratios. The high ratios are consistent with the dynamic nature of both industries. However, the high ratios can potentially raise the question of overvaluing stocks within both industries. However, the market is showing confidence in the growth potentials of both industries.

Price to Book The Health Care sector has a consistently higher price to book value compared to the S&P, indicating that health care stocks are valued higher than the market. However, the

sector’s higher P/Book ratio is primarily driven by the biotechnology and health care technology industries. The P/Book value for both industries is significantly higher than the other industries within the sector, indicating a current sentiment of over-valuation in the stocks within both industries.

ConclusionsAll the valuation multiples indicate that stocks within the Health Care sector are valued higher than the market. Although growth potential in biotechnology and health care technology industries are high, a higher valuation may raise potential concerns. Investors should be aware of the risks that are associated with investing in high growth industries, as they have a tendency to form bubbles and pop. Technology is a constantly changing industry where technologies can become obsolete overnight and biotechnology industries are only successful if positive results come from the experimental drugs and treatments.

Macroeconomic Analysis

The Health Care sector is plagued by limited supply and increasing demand. Interestingly, because Health Care is relatively economically insensitive, the sector as a whole tends to be described as defensive meaning that it can perform well when economies contract and broader markets decline. However, there are additional economic and social factors for investors to consider.

Economic

GDP

Government spending plays a large role within the Health Care sector as government spending subsidizes a large portion of health care products and services. In 2015, government spending on health care totaled $937 billion dollars and was the largest government expenditure. If government spending is expected to decline, then there are large implications for all industries within the health care sector.

Interest Rates

The Health Care sector is characterized by high capital investment and expensive cost structures. As interest rates are anticipated to rise in the US, financing becomes more costly for the health care industries such as health care providers and services. Higher interest rates may decrease incentives for health care providers and services to expand their portfolio of businesses in order to serve the increasing demand for health care products and services.

Government Regulation

The Health Care sector is highly regulated by the government, but the upcoming Presidential election will have a large effect on the sector. The outcome of the presidential election may affect Obamacare with the potential for insurance companies to

exit the current system, increasing premiums and decreasing insurance providers provided to Obamacare users. In addition, rumors of price regulation of drugs and services may have large implications for the sector and shift the bargaining power away from suppliers.

Global Dependence on US Market

The Health Care sector is a large global market that is dominated and centered on the US. With the unstable global market, the US market may see an increase in price within the health care sector as firms pass the cost increases down to US consumers in order to continue providing products and services at a lower cost to global markets.

Social

Inelastic Demand

The Health Care sector is characterized by inelastic demand, meaning that regardless of the economic environment, consumers will always possess a need for health care. Currently, demand for health care products and services exceed the supply, and this discrepancy shows no sign of slowing down. This phenomenon has serious implications for consumers and the sector may experience overall price increases.

Population and Demographics

Population growth and the aging population are growing. Growth in these two areas will further increase the demand for health care products and services. As a result, prices within the Health Care sector may increase as well.

Income and Accessibility

When consumers have more disposable income, they are more likely to have access to more health care products and services and as a result, spend on health care. With the US markets showing strength and consistent growth in the foreseeable future, the Health Care sector may see an increase in health care investors.

Education

Education plays a large role in the Health Care sector. Currently, the US tends to over prescribe and over treat patients for medical conditions. If this trend continues, profits in the Health Care sector can be anticipated to grow. However, if education increases, consumers may be less inclined to invest as much in the health care industry.

Sector Outlook

Fidelity

Fidelity’s 2016 outlook for the Health Care sector is that performance will be similar to that of 2015. However, there is greater policy risk because it is an election year, but the risk is not threatening enough to initiate to a structural change. The aging global population, emerging middle class in developing countries, and new innovation are three long term trends that are expected to boost revenue on par with 2015 revenue. Notably, medical equipment stocks will benefit from innovation. A decline in the US unemployment rate and the Affordable Care Act increase the amount of people that visit the doctor. Fewer patents are expected to expire in 2016, and specialty pharmaceutical companies could potentially have a positive impact on sales. The election year poses questions pertaining to new prescription drug pricing. Lastly, uncertainty will create volatility in the short term, which long-term investors may choose to take advantage of.

S&P Global Market Intelligence

According to S&P Global Market Intelligence, the Health Care sector has reasons to continue outperforming the market as well as face challenges in its performance ahead. Earnings growth deceleration from 14.7% to an expected 10.7% may cause investors to turn to other sectors. M&A activity and the debate over drug prices will continue to be a topic throughout the upcoming election, with both situations likely to hinder performance. High deductible and high co-payment plans will deter citizens from enrolling for health insurance, forcing a miss in Congress's projections. Overall, there will be an increase in volatility in the Health Care sector due to the vastly differing opinions present throughout the presidential election and the sentiment of uncertainty. On the other hand, continued sales growth and NME approval are a reason for optimism. Global expansion and the aging population will continue to drive demand. A win for the Democratic Party, preferably Hillary Clinton, would be the best scenario for the sector, as there is certainty in her inability to pass the initiatives that could threaten the sector. For the first time since 2011, the Health Care sector is trading at a discount to the market. Most notably biotechnology companies are outperforming by the greatest amount, and are expected to continue to do so.

Deloitte

Deloitte believes the macroeconomic issues of the global health care ecosystem are based upon decreasing costs as sector fragmentation, population health, and volume to value make the current situation unsustainable in the long term. As the population ages and people need more medical attention, managing patients needs and meeting their high expectations is key. As demand rises, many countries are looking to reform their health care systems to keep government expenditure manageable. Overall efficiency regarding every aspect of the industry, especially within the value chain and technology will become even more imperative.

Fox Business

At the end of the first quarter, FactSet published that 61% of analysts recommend health care as a buy since they anticipate revenue growth of 8.9% for Q1 2016. S&P Global Market Intelligence estimates 2.9% earnings growth for Q1. Health care technology is anticipated to have sales growth of 17% with biotechnology close behind at 12%. There are many ETF’s that are weighted accordingly including: XLV, IYH, VHT, IHI, XHE, etc., all of which the authors of Fox Business recommend for investors.

Wall Street Journal

UnitedHealth Group, the largest U.S. health insurer, is exiting Obamacare from a few states in 2017 due to the instable costly nature of the Act. According to CEO Stephen Hemsley, UnitedHealth Group’s expected Affordable Care Act losses for 2016 are $650 million dollars, up from $475 million last year, and has continued increasing since the beginning of the year. Among other reasons, the increase in loss is due to the fact that people can seek Obamacare’s medical coverage in anticipation of incurring a medical expense, with the option to drop it after. Blue Cross Blue Shield Association has estimated that Obamacare consumers in 2015 had medical costs that were 22% higher on average than those with employment based coverage. If UnitedHealth quits all Obamacare markets, it will cause higher premiums for Obamacare, and further increase the potential for other insures to follow suit and drop Obamacare. Although Obamacare may not be meeting its original expectations at implementation, exiting would not be good for the market. Democrats Hillary Clinton and Bernie Sanders are actively looking towards a single payer system, which continues to be a main topic of debate in the upcoming election.

Porter’s Five Forces Model

Threat of Entry

The threat of entry is low because the Health Care sector is characterized by high initial capital investments, large cost/expense structures, and strong regulation. In addition, industries are dominated by a small number of firms, each of which hold tremendous market share in their respective industries. Given the high M&A nature of the sector, even if a small company is performing well and experiencing high growth, they will typically be acquired by a larger, more dominant firm.

Threat of Substitutes

Depending on the industry, the threat of substitutes varies. Within the pharmaceutical, life sciences tools and services, and health care equipment and supplies industries, the threat of substitutes is high because products and services tend to be generic, resulting in competitive price wars. On the other hand, in industries such as biotechnology, health care providers and services, and health care technology, the threat of substitutes is low, but innovation is key to maintain profitable.

Power of Suppliers

The power of suppliers is high within the health care sector because demand for healthcare products and services tremendously exceeds the supply. Specifically, within the Health Care Providers and Services industry, the suppliers have high bargaining power simply because such high demand exists for services such as insurance and physicians. In addition, drug companies who have product patents on medications allow firms to charge a price premium.

Power of Buyers

The bargaining power of buyers in the healthcare sector is weak because the bargaining power of suppliers is so high. If a consumer wants health care coverage they must pay the asking price, with little to no negotiation power since insurance companies deal directly with companies rather than individuals. In addition, consumers are at the mercy of pricing advantages that suppliers have on medication. Overall, there is a high opportunity cost of forgoing health products and services, so individuals are more willing to pay the price set by suppliers.

Rivalry Among Existing Competitors

Rivalry among existing competitors is high within health care industries. Within the pharmaceutical and health care equipment and supplies industries, most products and services are generics. Since generics can be essentially treated as a commodity, price wars to gain market share and revenue are typical within these two industries. Within the health care providers and services industry, rivalry among existing competitors such as insurance companies is high. Since demand exceeds supply, there are large opportunities for profit and every player wants to capture as much of the market as possible.

Recommendation

Given the defensive nature of the Health Care sector and inelastic demand for health care products and services, we recommend investing in the Health Care sector for generating consistent long-term returns that surpass market returns. Within industries, biotechnology and health care technology are the primary drivers of growth and sector performance. However, with greater performance comes greater risk. Volatility within biotech and health care technology industries is higher compared to other health care industries. Investors should invest in biotechnology and health care technology firms, but should also diversify some of the added risk associated with those industries by investing in less risky health care industries.

Sources

Bloomberg

Deloitte (http://www2.deloitte.com/jo/en/pages/life-sciences-and-healthcare/articles/global-health-care-sector-outlook.html and http://www2.deloitte.com/us/en/pages/life-sciences-and-health-care/articles/2015-health-care-providers-outlook.html)

Fidelity (https://www.fidelity.com/viewpoints/investing-ideas/2016-outlook-healthcare)

Fisher Investments on Health Care

Fox Business (http://www.foxbusiness.com/markets/2016/04/11/unloved-health-care-etfs-may-surprise-this-earnings-season.html)

Google Finance

S&P Dow Jones Indices (http://us.spindices.com/indices/equity/sp-500-health-care-sector)

S&P Global Market Intelligence (http://www.spcapitaliq.com/our-thinking/ideas/healthcare-our-2016-outlook )

Wall Street Journal (http://www.wsj.com/articles/a-big-obamacare-exit-1461106087)

Financial Graphs

http://www.spcapitaliq.com/our-thinking/ideas/healthcare-our-2016-outlook

http://us.spindices.com/indices/equity/sp-500-health-care-sector

http://us.spindices.com/indices/equity/sp-500-health-care-sector

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Sector Analysis - Health Care