Sector Spotting: Improving Health

It’s been cold and raining in New York since spring started on March 20. But we aren’t complaining, since April showers bring May flowers, with warmer weather coming in the summer. It may be springtime for the S&P 500 Health Care sector too. Since March 17 through Tuesday’s close, Health Care has outperformed the other nine sectors in the S&P 500, rising 4.9% while none of the others returned more than 1.4%.
 
This outperformance is notable for two reasons. First, it’s a radical change. Until recently, Health Care had dramatically underperformed the market. From August 5, 2015 through March 17, Health Care declined 14.2%, while the S&P 500 was down only 2.8%. Second, the sector’s strength comes despite a barrage of mostly miserable headlines. Politicians are ranting about soaring prescription drug prices. Profits from Obamacare are slim. And the US Treasury has just put an end to inversions. Yet seven industries in Health Care are among the top 20 best-performing industries in the S&P 500 since March 17.

Let’s take a closer look at the sector’s green shoots:
 
(1) Payback. For years, drug companies had the ability to increase prices with impunity, and more recently they began skirting U.S. taxes with inversion deals. Well, it’s payback time. A drug company raising prices aggressively now risks becoming a piñata in the presidential campaign festivities. And the Treasury just proposed rules that will block inversions, killing the proposed $160 billion acquisition of Allergan by Pfizer, as we discussed on Monday.
 
A 4/6 Bloomberg editorial noted: “The [inversion] deals got so big they were impossible to ignore. The departure of Pfizer and other pharma companies, and their potential to provoke further tax-fleeing, represented a real threat to the U.S. tax base. The size of these deals, along with the dismal reputation of the industry over drug-pricing shenanigans, made targeting them politically expedient. … The result is that all sorts of tax-minimization strategies and deals are in upheaval, and Pfizer CEO Ian Read is likely an unpopular man in boardrooms the world over.”
 
The damage was immense. Shares of Valeant Pharmaceuticals, the poster child for inversions and aggressive pricing, cratered to just over $30 a share, down from a high of $263 on August 5, as the company is late filing its 2015 financials and questions have been raised about its accounting practices. Allergan’s shares are down 27% ytd, though Pfizer’s stock is essentially flat.
 
While those are the best-known Health Care ailments, other areas of the sector faced equally painful issues. Earlier this week, Insys Therapeutics said sales of Subsys, a highly addictive, opioid painkiller, would come in at $61 million to $62 million, below the consensus forecast of about $88 million, The Street.com reported Monday. Attention to the overdoses and deaths caused by opioid drugs “in the US is spurring calls from politicians and law enforcement agencies for new restrictions on how painkillers are prescribed in this country. This, in turn is putting pressure on companies like Insys and Endo [International] which sell opioid-based painkillers.”
 
Insys shares have had a breathtaking fall of almost 70% since last summer, to $13.61 a share from $44.92. Endo, a member of the S&P 500 Pharmaceuticals industry, has tumbled to $26.25 from $95.92 over the past year. Separately, shares of Horizon Pharma fell 26% on Tuesday after the company said Q1 sales would be $200 million, below analysts’ estimate of $226 million, the 4/12 WSJ reported.
 
Health Care Services has been dragged down by Express Scripts Holding, which is in danger of losing its largest client, health insurer Anthem. In January, Anthem threatened to leave unless Express Scripts could deliver $3 billion a year in additional savings on drug costs, a 1/12 Bloomberg article stated. Anthem kicked in about 14% of Express Scripts’ 2014 revenue. Anthem then filed a lawsuit against Express Scripts to recover $15 billion in damages, alleging that Express violated their contract through excessive charges and failures in its operations, the 3/21 WSJ reported. Express has stated the suit is without merit.
 
The company received more bad news when Walgreens Boots Alliance partnered with UnitedHealth Group’s OptumRx, which manages prescription drug insurance, the 3/17 WSJ noted. OptumRx will charge its customers less for certain drugs if patients fill their 90-day prescriptions for chronic conditions at Walgreens stores. The WSJ explained that deal “damped anticipation that [Express Scripts], the largest PBM, might forge a new partnership or even merge with Walgreens, which now seems unlikely in the near-term.” Express shares have lost ­­19.6% ytd through Tuesday’s close.
 
(2) The upside. The upside of dour news and lower stock prices is more reasonable valuations. Health Care’s forward P/E multiple has fallen sharply to 15.3, down from 17.5 a year ago, and much worse than the multiple contractions for the Consumer Discretionary, Financials, and Materials sectors. In addition, only Telecom and Financials boast lower earnings multiples than Health Care.
 
It was the compression in the S&P 500 Biotech P/E that caught our attention a few weeks ago. The industry’s forward P/E has fallen to 12.9, down from 17.2 a year ago and a recent peak of 24.0 in January 2014. The decline has left Biotech industry valuations near 20-year lows. The forward P/E in Pharmaceuticals has dropped a bit less to 15.9 from 17.2 over the past year.
 
Two other Health Care industries have experienced even more dramatic compression in their forward multiples. The forward P/E on Health Care Technology has dropped by almost a third, or 10 points, to 22.4 over the past year. Health Care Distributors has a forward P/E of 14.3, down 4.9 points from about one year ago.

There’s only one company in the S&P 500 Health Care Technology industry, Cerner, and it develops, installs, hosts, and supports software and hardware for health care providers. The company benefits from a growing industry and high customer-switching costs, but it also faces increased competition from current and new players, according to a Morningstar 2/19 report. The company acquired Siemens Health Services roughly a year ago for $1.3 billion.
 
The shares have come under pressure as Cerner’s guidance and results have missed expectations. The 2/16 WSJ reported that the company expanded its targeted range for revenue after Q4 bookings were below estimates. The company has revised earnings downward for more than a year. The shares, which traded as high as $75 in April of last year, are now $55.
 
(3) Still growing. Despite the nasty headlines and the lower multiples, the Health Care sector continues to provide some of the best earnings growth in the S&P 500. This year, Health Care is the second-fastest-growing sector of the 10 sectors in the S&P 500, with earnings expected to rise 7.9%, while most other sectors are growing earnings in the low single digits or are experiencing earnings declines. In 2017, Health Care is in the middle of the pack, but many of the estimates are grouped close together.
 
Here’s how the sectors are expected to grow operating earnings in 2016: Consumer Discretionary (11.3%), Health Care (7.9), Utilities (3.6), Tech (3.1), Staples (2.5), Industrials (2.5), Telecom (2.2), Financials (1.9), S&P 500 (1.3), Materials (-3.7), and Energy (-64.2).

Next year’s targets for operating earnings growth follow: Energy (187.4%), Materials (17.5), S&P 500 (13.8), Consumer Discretionary (12.8), Tech (12.4), Financials (11.5), Health Care (11.3), Staples (10.3), Industrials (9.4), Utilities (3.5), and Telecom (3.2).
 
Because Health Care stocks have declined, many industries in the sector sport earnings multiples that aren’t much higher than the expected earnings growth over the next 12 months. For example, Biotechnology is expected to grow earnings by 9.1% over the next 12 months and 13.1% over the long term, leaving its PEG ratio below 1.0.
 
Managed Health Care is expected to grow earnings 12.6% over the next 12 months, as rising revenue has been mostly offset by shrinking margins. Its forward P/E is only 15.0. Likewise, Health Care Facilities is expected to grow earnings 10.2% and has a P/E of 13.3. Health Care Services should grow earnings 9.3% and has a 12.4 P/E, while Distributors has a 10.2% forward earnings growth estimate and a P/E of 14.3.

The Health Care Technology industry, which is Cerner, trades at a 22.4 forward P/E, but it’s expected to grow 11.4% this year and 15.0% in 2017. Barron’s recently gave Cerner a thumbs-up: “Cerner sports a decade-long record of 15% sales growth and 20%-plus growth in earnings per share. Perhaps sales growth has slowed to 10%, and EPS growth, to 15%. But both are growing much faster than the broad market.” The company’s P/E does not have to expand for the stock to perform nicely. Indeed, the shares have risen 11% from their March lows.
 
(4) Green shoots. Despite the negative headlines, Health Care began to show signs of recovery as of March 17. Since that date through Tuesday’s close, the Biotech industry is up 9.4%, Health Care Facilities has climbed 8.1%, Health Care Equipment is up 6.2%, and Health Care Technology is close behind, up 6.1%. Those industries have far outpaced the S&P 500, which has climbed 1.0% over the same period.
 
One potential reason for the turn of fortune is the collapse of the Pfizer/Allergan deal. As independent companies, they’ll be on the prowl to purchase smaller drug companies to help boost their pipeline of drugs and their earnings growth, Reuters speculated on 4/6. “We could act immediately if we saw the right opportunity with the right growth profile and the right strategic logic,” Allergan CEO Brent Saunders told the WSJ on 4/6.
 
Investors also received a reminder that many Biotech stocks have the potential for huge upside if their drugs succeed. Shares of Regeneron Pharmaceuticals, a member of the Biotechnology industry, had fallen by more than a third from the start of the year through the end of March. But since it announced on April 1 strong Phase 3 clinical results for dupilumab, an experimental treatment for atopic dermatitis, its shares have climbed 13.2%. To paraphrase Chauncey Gardner, Peter Sellers’ character in the film “Being There”: “In the spring, there will be green shoots.”

We are starting to see them in Health Care.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.