15 Cash Flow Kings in Healthcare

by: Hedgephone

With so much attention focused on Obamacare and the headwinds for health related stocks, I wanted to publish my research on healthcare names which have not performed in line with the overall market given the uncertainty created by the new government legislation and also from undue pessimism.

Healthcare costs have risen at an average rate that is well above the CPI and economic growth rate of GDP while the stocks in the sector have gone nowhere. In fact, the healthcare sector has underperformed the S&P 500 by nearly 20% over the past year. Employers included in the National Business Group on Health survey estimate that on average, their health care costs would increase by seven percent in 2010, and by nearly nine percent in 2011 -- could it be that the market has gotten it wrong on this sector?

Healthcare is a booming industry with the retirement of the baby boomer generation hitting full swing -- demographics are going to make the situation far more complex going forward as Medicare will be stretched to the bone to pay the obligations that our society has made to the retirement community and to future plan recipients. Clearly, healthcare will be on the forefront of economic policy for the next few decades in America and will be an area of strong growth going forward.

  • Total health spending in the U.S. reached $2.1 trillion in 2006-$7,026 per capita.
  • By 2016, total health spending is projected to rise to $4.2 trillion.
  • Between 2005 and 2006, total health spending increased 6.7 percent, more than double the rate of overall economic growth (2.9 percent) and will increase to 9% this year.
  • Of every dollar spent on health services in the U.S. in 2006, 46 cents came directly from government sources.

Healthcare insurance companies, HMO plans, home care companies, and device manufacturers will all be affected in the coming years by Obamacare, but the larger companies should also benefit from economies of scale and from the overall growth in the market. Medical device makers are said to be hitting a saturation point for growth, but as the boomer generation hits their 70's and 80's, the growth rate in this market segment should inevitably increase from current levels.

Additionally, the trend from brand name drugs to the generic pharmaceutical companies like TEVA will likely continue as those paying for their own medical care will likely continue to be price conscious and with the budget difficulties of Medicare, generics should see increased share in reimbursement revenues.

HUM -- Humana is trading at at just 7.9X this past year's earnings. Although companies in this space have not made great investments with their operating cash flows (to paraphrase Bruce Berkowitz), Humana is a consolidator in the space trading for under ten times free cash flow. HUM looks undervalued here as the company has increasingly gained monopoly status in the industry.

GILD -- Gilead Sciences is a strong company which has exhibited reliable growth over the past decade. GILD is trading for just 8.45X forward earnings according to Thomson, making the shares attractive for longer term investors.

BMY -- Bristol Myers is paying a large dividend yield of nearly 6% while trading at a 9.6X P/E ratio. Investors looking for income should consider the shares, although better values may be found elsewhere in the space.

ABT -- Abbott Labs is a lot like GILD in that the company has been a strong performer over the past two decades, but ABT also offers a nice dividend yield and a forward P/E ratio in the 9's.

WLP -- WLP is a fairly cheap name as well trading at a 5.6X TTM P/E ratio. Look to sell a cash secured Jan. 2012 put on WLP for a nice 15% or so yield.

JNJ -- JNJ is a classic stalwart; a steady Eddie type of investment which, along with Pepsi (NYSE:PEP) and McDonald's (NYSE:MCD), should perform well in the current environment. JNJ has a P/E of around 12 with an EV/EBITDA of 8X.

MDT -- Medtronic is a stock I have been admiring in these articles for around 6 months now, and the stock appears to be somewhat cheap at 11X forward earnings. The company is well managed, and the device market is growing.

NWLI -- National Western is a life insurance company, but the stock is so cheap at just half book value and 9X earnings that I wanted to include it in this list of cheap health-related stocks. NWLI has a large amount of insider ownership and a strong long term track record of shareholder wealth creation. I think annuity sales are going to be a huge growth area right now, so look for NWLI to outperform.

KCLI -- Kansas City Life is another cheap life insurance name, so look to buy into any weakness and sell shares when they trade closer to book value.

KND -- Kindred is a long term pick I highlighted last September and has since risen from around $12.50 to the current buyout price of around $22 per share. KND was a cheap name at $12 (then trading at half book and 8X earnings) and shows why the Ben Graham approach really works when looking to grow long term wealth.

WAG -- Walgreen is another derivative play on the growing prescription business and is arguably a cheap stock at 14X forward earnings.

CVS -- CVS is cheaper than WAG on a cash flow basis and on forward earnings multiples (around 10.5X forward earnings) but has a much higher debt burden. Personally, I prefer shopping at CVS and find them to be on a more wholesale model than WAG, which is a positive.

TEVA -- Generic drugs look to gain share versus the major pharma names, and as TEVA is selling everything from generic ADD meds to birth control pills the company stands to benefit from budgetary pressures being placed on Medicare. TEVA is relatively cheap at around 10X cash flows and 10X forward earnings.

MRK -- Merck is one stock that has seen its share of adversity over the years, but the company rebounded strongly in 2009 putting up over 12BN in profits. MRK could end up being a good value if earnings can regain their 2009 momentum. Analysts have their forward P/E ratio pegged at 8.3X, which could make MRK a potential buy at current prices. MRK pays a nice dividend as well.

PFE -- Pfizer is pegged to trade at an 8.4 P/E ratio next year and boasts a 6.5X EV/EBITDA multiple. Although I was personally disappointed with the Wyeth purchase, I think the company has integrated operations quite smoothly and PFE could end up being one of the better investments to own in 2011.

A note on birth control: a company in Switzerland called Valley Electronics has been working on a revolutionary new birth control technique that could change the contraceptive industry in the years ahead. We all know about the health pitfalls of the Pill on women and how decreased fertility and health risks make the Pill a short term solution for a longer term issue.

From the lady-comp website:

Valley Electronics GmbH, headquartered in Eschenlohe, Germany, was established in late 1986 by Dr. Hubertus Rechberg. The purpose of the company was the worldwide sale of Lady-Comp, the first family planning computer in the world.

This is where I see the market headed -- open source technology, high tech software developed by new players in the tech space such as Lady Comp, new breakthroughs in robotic technology, and advances in medicine that come from DNA research, gene mapping, and other analytical frameworks that are relatively untapped as of right now.

So, in essence, the future of healthcare will largely unfold as a function of Medicare, technological achievements, legislative changes, and overall secular growth trends. In conclusion, healthcare stocks look undervalued relative to the overall market, as do staples and insurance companies in my opinion, so look toward some of these out of favor areas to add exposure to your long portfolio. But be very careful in your allocations as equities look to be a bit extended right now.

Disclosure: I am long ABT, JNJ, PEP, KO, MCD, WLP, GILD.