9 Healthcare Sector Rotation Buy Ideas

by: Investment Underground

By Jack Fuller

Following up on our article on 8 promising biotechs, we decided to explore nine more healthcare stocks who we think could benefit from sector rotation. Here they are:

Merck & Co Inc. (NYSE:MRK): One of the largest players in the pharmaceutical field, this $100 billion company develops a variety of treatments for conditions ranging from cardiovascular disease to osteoporosis, and also develops vaccines to prevent conditions such as hepatitis B, HPV, and shingles. Merck currently has a strong portfolio of products including three recently released blockbusters in Januvia, Isentress, and Gardasil, but patent-losses on other blockbusters could lead to sales volatility soon.

Merck lost patent protection on two of its major drugs in 2010, Cozaar and Hyzaar, and the upcoming patent loss in 2012 on Singulair, which makes up over 10% of Merck’ sales, will cause Merck to lose one of its main sources of revenue. The company has no reliable late-stage drugs in the pipeline to offset the loss; four of Merck’s late-stage drugs in the last three years have either not received approval by the FDA, or have had poor clinical data. It is that potential revenue drop-off that drove Merck to acquire Schering-Plough for $40 billion in 2009, a deal that we believe positions Merck for very strong future growth. Schering-Plough boasts a strong pipeline of late-stage drugs, many of which have blockbuster potential, and faces limited patent-loss in the near future. Merck is also improving growth prospects by taking steps to increase its presence in emerging markets.

Merck’s India unit and Sun Pharmaceutical Industries LTD, an Indian multinational pharma company, recently formed a joint venture to focus on emerging markets, which are expected to drive 90% of world pharmaceutical growth. The combination of Merck’s clinical expertise and global footprint with Sun’s proprietary technologies and manufacturing capability should improve Merck’s future growth, and should help offset some of the loss of revenue from Singulair. The acquisition of Schering-Plough, combined with Merck’s new partnership with Sun Pharmaceuticals, makes us bullish on Merck’s future prospects, despite patent loss on Singulair. Merck trades at $33.56 at the time of this writing.

HCA Holdings Inc. (NYSE:HCA): HCA is the largest private hospital owner and operator in the U.S., operating 164 hospitals and 106 outpatient centers across the South. HCA went public in 2011 with a $3.8 billion IPO, and shares currently trade at $31.53 with an EPS of 2.34. HCA has opportunities to increase revenue generation in the next few years. Its focus on fast-growing urban areas, combined with an aging population and increasing obesity rates, should lead to increased hospital admissions. HCA is well positioned in Florida, whose 65-and-over population is projected to form nearly 30% of the state’s total population by 2030. Health care reform should also help nearly 30 million uninsured patients in the U.S. gain health-care coverage, which would also increase HCA’s admissions prospects. However, slowed Medicare reimbursement growth and weak capital structure will likely offset any gains HCA experiences.

Even though HCA may accrue $2.4 billion in equity capital off of its IPO, it will still have a negative book value, and will likely maintain about a 1.3 debt/capital ratio. Nearly one third of HCA’s EBITDA goes towards its $2 billion annual interest expense, and the rest barely covers capital expenditures. We can’t recommend the stock based on its financial health alone, despite potential increases in admissions and revenue.

Bristol-Myers Squibb Company (NYSE:BMY): Between 2012 and 2013, Bristol-Myers will lose patent protection on blockbusters Plavix and Avapro, which will result in a loss of over 40% of sales. Bristol-Myers will also lose protection in 2015 on blockbuster antipsychotic drug Abilify, which will further erode Bristol-Myers’ operating margins and revenue streams. Despite the grim news, we believe Bristol-Myers has enough strength in its pipeline to weather the coming storm. Bristol-Myers has established profitable partnerships in the past with other drug makers to create blockbusters such as Plavix and Avapro. That partnership strategy, which reduces risks and development costs, should help with future products such as Onglyza and Apixaban, which are currently being developed in conjunction with AstraZeneca (NYSE:AZN) and Pfizer (NYSE:PFE) respectively.

Increased cash reserves from the sell-off of the company’s medical-imaging group, wound-care division, and nutritional business also give it some room to make an acquisition if necessary (and also make it an attractive acquisition target). In the short-term, expect sales volatility with minor growth due to patent loss. In the long-term, expect Bristol-Myers to bounce back once potential blockbusters start rolling off its pipeline. BMY trades at $27.44 with an EPS of 1.79. We give it a fair value rating of $28.

Biogen Idec Inc. (NASDAQ:BIIB): Biogen and Idec merged in 2003, and each entity brought a star product to their combined portfolio that makes the company the specialty-market drug maker it is today; multiple sclerosis drug Avonex for Biogen, and cancer drug Rituxan for Idec. The $17 billion company enjoyed sales of $2.5 billion from Avonex in 2010, and $6 billion in shared annual sales with partner Roche (OTCQX:RHHBY) from Rituxan. While both products maintain steady profitability, Rituxan’s patents begin to expire in Europe in 2013, and Avonex faces strong competition from established drugs and the recently approved multiple sclerosis treatment Gilenya from Novartis (NYSE:NVS). Therefore, Biogen Idec will become increasingly reliant on Tysabri, a novel treatment for MS whose sales surpassed $1.2 billion in 2010. However, the drug comes with risks; Tysabri earned approval in 2004, but was pulled from the market in 2005 after two patients died from progressive multifocal leukoencephalopathy (NYSE:PML).

PML risk increases with the number of treatments patients have received, and so the drug was reintroduced in 2006 with more limited dosages and durations of therapy. The number of PML infections have continued to grow since the drug’s reintroduction, but trials have began testing for the JC virus antibody, which could predict a patient’s chances of developing PML. If the new studies can eliminate the risk of PML in patients, Tysabri sales could reach upwards of $2 billion annually. Biogen Idec’s strong pipeline should also boost sales.

Multiple drug candidates have entered phase III clinical trials, including Ampyra, a new MS treatment. Acorda received FDA approval for the drug in January 2010, which indicates it should be approved in Europe for Biogen Idec as well.

Additionally, MS drug ocrelizumab will enter phase III trials in 2011 after showing in phase II trials that efficacy was superior to products on the market. Much of Biogen Idec’s growth rests on Tysabri, but we are optimistic that more specific patient targeting will lead to increased safety and sales. When combined with promising products in its pipeline, we see Biogen Idec’s stock going up. BIIB trades at $78.19 with a 19.9 PE Ratio compared to the industry average 66.7, and 3.94 EPS following 13.12% 1-year EPS growth.

Stryker Corporation (NYSE:SYK): Stryker primarily develops medical equipment for orthopedic procedures, with 60% of its revenue derived from reconstructive implants. We remain high on Stryker’s future prospects because of a growing aging population and the orthopedic industry’s high barriers to entry. Stryker is a top quality provider of knees and hips, and predicted volume growth for surgical joint procedures in the 65 and over demographic should propel Stryker’s sales. The only uncertainty lies in medical reform, which may cause the U.S. to revisit medical costs, potentially forcing Stryker to lower prices and hurt revenue.

Regardless, increased need for orthopedic products should keep Stryker’s returns on invested capital higher than capital costs. Factor in Stryker’s abundant sales of operating room products, medical beds, and emergency equipment with its ample amounts of free cash, and the company has many avenues for growth. Planned acquisition should make hospitals more efficient and serve underpenetrated markets as well. Shares trade at $59.69 with a PE Ratio of 18.7.

Zimmer Holdings Inc. (ZMH): Like Stryker Corporation, Zimmer Holdings maintains a presence in orthopedic niches with high barriers to entry. Zimmer should expect increasing demand with an increase in the aging population over 65 from the baby boomer generation.

Two other factors should also help Zimmer’s bottom line; baby boomers maintain high-intensity activities for longer than previous generations, meaning more wear and tear on their joints, and increasing obesity levels mean joints are under added stress from the extra weight as well. However, like Stryker, Zimmer faces increasing uncertainty in the payment for orthopedic replacements. Most orthopedic replacements are sold under Medicare, and scrutiny on the costs of orthopedic products and their reimbursement means prices could be lowered, which would hurt margins and growth. Many patients have delayed orthopedic procedures as well because of economic and unemployment uncertainty. We remain positive on Zimmer, but decisions from Washington D.C. could severely undermine Zimmer’s future profit. Shares trade at $59.66 with a PE Ratio of 20.1, close to the industry average. Expect earnings per share growth to exceed sales growth as the company benefits from share repurchases and interest income.

Elan Corporation PLC ADR (NYSE:ELN): This leading neuroscience firm comes with many risks for those looking to invest in it. The company has many positives: shared rights to Tysabri, royalties from firms licensing technologies for 25 marketed drugs, and 12 drug candidates in its pipeline as of February 2011. However, the uncertainty surrounding the company outweighs many positive signs it has shown. Like Biogen, much of Elan’s future prospects ride on the success of Tysabri, which recorded $1.2 billion in revenue in 2010. The drug can cause a rare brain infection in patients, and despite more stringent guidelines for prescriptions, the rate of new cases is still increasing.

We remain optimistic over new trials that could identify patients susceptible to the disease, but Elan has less of a cushion than Biogen if the drug does not perform well. Elan is more reliant on Tysabri revenue, and its high levels of debt give it little room to maneuver. Elan does have a promising product in the pipeline in bapineuzumab, an Alzheimer’s drug candidate with $1 billion potential, but phase II data showed mixed results in patients. If Elan can improve Tysabri’s safety and bring bapineuzumab to market, the firm could reward investors. However, concerns about both drugs make them a risk, and Elan doesn’t have much room to maneuver if they fail. This is one risk we aren’t willing to take. Shares trade at $7.43 at the time of this writing.

AEterna Zentaris Inc. (NASDAQ:AEZS): AEterna is a late-stage oncology drug development company that investigates treatments for various types of cancer. The company currently markets Cetrotide, and has twenty new drugs or treatments in development. AEterna’s single most promising product is Perifosine, an oral treatment for patients suffering from colorectal cancer and multiple myeloma. The drug presents huge market opportunities. Colorectal cancer is the fourth most common cancer in men and third in women, while multiple myeloma is the second most prevalent form of blood cancer. Phase III trials for Perifosene have been extremely promising, and the drug has started a Phase II program for the treatment of other forms of cancer. Technicals on AEterna look bullish, and could be ready to break above its 52 week-range high of $2.19 in the coming weeks. JMP Securities recently gave AEZS an outperform rating with a $5 price target. Shares currently trade at $1.86.

Health Management Associates Inc. (NYSE:HMA): HMA owns and operates 56 rural, acute-care hospitals across 15 states in the southeastern and southwestern United States. Health Management’s stock has risen greatly since September, increasing 48% from $7.04 per share on September 10, 2010 to $10.44 at the time of this writing. That price still makes it a relative bargain compared to its peers; SmarTrend Market Surveillance recently compared performance between a share and its peers to determine under performance and ranked HMA fourth in the Healthcare sector. SmarTrend also places HMA in an uptrend. Health care reform may affect future profit, but most analysts remain bullish on HMA. HMA has an EPS of .60 and PE Ratio of 16.06.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.