Healthcare Sector Poised for Growth and Profitability

Includes: BAX, BMY, ISRG, PFE, XLV
by: Andrew Corn

March 2008, the U.S. Food and Drug Administration was forced to recall the drug Heparin after a number of deaths were linked to the product’s use. According to the agency, the root of the problem was traced to contaminated Chinese factories that supplied the raw materials needed to manufacture the popular blood thinner. By the time the recall ended, the Heparin contamination had claimed at least 81 lives and affected more than 700 patients. Fortunately, such healthcare product deficiencies are uncommon. This was major headline news and Baxter International Inc. (NYSE: BAX) saw its stock drop significantly as well as all the additional ramifications of this event.

While the FDA insists that it’s underfunded and insufficiently staffed to be able to police such potential problems, both the responsibility for monitoring these products and the blame for any errors lie at the agency’s door. All too often, though, it is companies and their investors that take the blame. In the case of the heparin contamination, Baxter International was vilified for their role in outsourcing production of the drug’s inputs to Chinese factories and it’s been a public relations nightmare for the company ever since.

Was it Baxter’s fault? Could they have supervised their vendor more carefully, chosen a different supplier? In the healthcare industry, and for those who suffered, from the sick and their families to investors, it hardly matters. In dealing with life and death, healthcare companies play a risky - albeit important - role. In no other industry are the stakes so high or the expectations so stringent. Perfection is imperative and mistakes are intolerable. In the business of saving lives, there’s no wiggle room.

Public relations disasters and product recalls are not the only risks that face healthcare companies. Government intervention is ever-present, as no other industry on the planet is as heavily regulated as the healthcare industry. Pharmaceutical companies and others are forced to navigate a regulatory maze that affects all their activities, ranging from manufacturing processes to sales practices. I acknowledge that many firms have stretched the law as far as they can when it comes to sales.

Currently, the Obama administration is wrestling with its universal healthcare plan, which promises to impose a new suite of rules and restrictions on the industry’s players. Already, the U.S. pharmaceutical industry has been coerced into offering $80 billion in cost reductions over the next ten years. They may also be forced to compete with generic imports, which would effectively put a cap on domestic drug prices. Any new regulations pose the threat of cutting into profits and reducing international competitiveness.

These new rules may bring innovation to a crawl as the risk/reward scale of discovery tilts the wrong way. Or perhaps innovation will be the best route to success. The world has a lot riding on the new legislation.

Despite all its risks and drawbacks, though, healthcare is still a very good business. Aside from helping people and saving lives (no small feat), there are notable benefits to being part of the industry. As discussed in my last post, healthcare is a quintessential defensive sector. People still get sick during recessions and they will often continue paying for medicine and treatment even when they cut back on other things.

We are pleased to own share of innovative firms such as Bristol-Myers Squibb Co. (NYSE: BMY), Pfizer INC (NYSE: PFE) and Intuitive Surgical, Inc. (NasdaqGS: ISRG) which is the company behind the da Vinci surgical system.

While profits for the S&P 500 have dropped roughly 30% in the past quarter, healthcare earnings have barely moved. Not bad for the worst recession in sixty years. Additionally, the same regulations that sometimes threaten the industry’s global competitiveness often serve as a barrier to entry and an impediment to potential competitors. Blockbuster drugs have historically provided a consistent earnings flow throughout the entire twenty-year lives of their patents. Lastly, U.S. healthcare expenditures are massive, consuming roughly 16% of the country’s economic output. The Obama administration seems set on mandating universal healthcare, which will extend health coverage to the 49 million Americans that are currently excluded. That effectively means 49 million new customers and a host of other benefits (along with its costs).

Additionally, although frightening from a fiscal point of view, America’s aging population may provide an additional engine for industry growth. Demand for healthcare is tremendously robust and will only continue to grow as the baby boomers age.

While it’s easy to be cynical about the industry’s prospects in the face of product recalls and pending regulatory reform, the advantages in the healthcare sector are significant.

Aside from being an ideal way station in the midst of recession, the healthcare sector could be poised for considerable growth and profitability.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long BMY, PFE and ISRG.

Special footnote: As a society we need to balance human risk and the advancement of treatments and therapies for the betterment of humankind. I am sensitive to all life and for this blog which focuses on stocks, deaths are viewed as statistics. I understand fully there are real people and families behind the statistics, and I wish them the best while hoping the industry does well and helps bring new cures to the world.

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