Long/Short Equity, Contrarian, Portfolio Strategy
Contributor Since 2019
In recent years, healthcare stocks have generally had good fundamentals, but nevertheless have been trading at low P/Es. Though the sector has recently shown glimmers of share price growth, underlain by improved Q3 earnings for some companies, the market is still underpricing this category, largely because of regulatory fears.
In recent months, perceptions of this risk have centered on potential impacts of the 2020 presidential election--though some of the uncertainty has abated as previously ascendant poll numbers for Elizabeth Warren of Medicare-for-all renown have subsided. And no matter what happens in the election, demand for healthcare won’t change: Americans will continue to demand the planet’s highest high level of care, regardless of how it’s paid for.
Before primary election campaigns were launched, the sector was already a political punch bag, and the pummeling has depressed prices of many companies despite good earnings. Prices have been stagnant—or, at least, sloppy—for several years. For example, the Pharma ETF XPH is roughly the same price it was in 2012. Broad healthcare ETFs such as XLV and VHT have done OK, as have medical device ETFs (IHI and XHE). Yet the sector’s P/E ratios have remained well below long-term historical averages.
This should have already changed as a result of market demand of aging baby boomers. But now, keyed by developing new drug and biotech therapies tapping into this demand, the healthcare tide may be rolling in over the next year, lifting many sector boats. And the water may already be rising. As of mid-December, more than 90% of healthcare issues were posting prices above their 50-day moving averages, suggesting possible forward momentum.
As the sector lumbers into gear for what may be a sustained shift, there are still values aplenty. In particular, CVS Health and Bristol Myers (BMY) stand out as being poised for growth after taking long, hard beatings.
CVS shares are priced about 20% lower than they were five years ago, though earnings are up 35% for that period and sales are up a whopping 65%. At 10X, its P/E is still quite low (compared with the industry’s 14X), with a dividend yield of 2.7%.
The nation’s largest drug store chain has expanded its lines of business in recent years, in 2018 buying Aetna (one of the nation’s largest health insurers), and is now acting on a strategy to make CVS consumers’ first thought, not just for prescriptions, but also for treatment of minor health issues. The company has begun setting up in-store clinics called Healthhubs, staffed with nurse practitioners who can provide relatively inexpensive treatment for minor issues and referrals to walk-ins—and for Aetna customers, to physicians in their network. The idea is to give consumers a convenient alternative to the annoyance of trying to get a doctor’s appointment on short notice.
The Healthhub concept was conceived as part of the company’s transformation from drug store to healthcare company. CVS has become an uber-pharmacy by taking on extended roles: pharmacy benefit manager, handler of mail-order pharmacy services; provider of specialty pharmacy services, plan design and administration; formulary manager; and claims processor.
Wall Street initially failed to wrap its head around synergistic advantages of the HealthHub concept, instead focusing on its costs, as well as the $8 billion in debt CVS took on to buy Aetna. Now, after an eight-month test in Houston has resulted in outperformance in prescription volume, front-store sales, foot traffic and margins, the HealthHub concept is gaining favor as the company implements it nationwide. This, and a faster-than-expected payoff of the Aetna-purchase debt, has put some wind in CVS sails. Q3 EPS ($1.84) was above estimates of $1.81, and a 6.3% increase over Q3 2018, auguring likely forward momentum.
As with CVS’ Healthhubs, investors have been slow to see the benefits of a major move by Bristol-Myers Squibb (BMY): its acquisition of Celegene.
Though BMY sales and earnings have risen in recent years, the stock price has recently hovered at levels lower than those of 1999! With a P/E of only 14, BMY’s is below the average pharma industry of 16 and well below the S&P’s 20.
Like CVS, BMY performance has perked up a bit lately, with Q3 adjusted EPS of $1.17—about .10 above estimates and a 7.3% increase over Q3 2018. Various projections call for substantial earnings and sales growth in 2020. And unlike some pharma companies, BMY has an apparently low opioid risk, and few Chinese connections.
But it does have the market boogeyman of concentrated strategic risk because more than 60% of its revenue comes from only a few drugs (compared with 10% for competitors such as Johnson & Johnson and Pfizer). Though negative for many Wall Streeters, concentration in things medical often involves specialization that can increase market penetration and, with it, profits. Regarding BMY’s oncology therapies, one of the company’s marquis areas, the company increased its specialization profile in November with its acquisition of Celgene Corp., combining the two companies’ expertise in therapies for cancer, among other illness categories.
Despite BMY’s good Q3 performance, shares still lag behind fundamentals, probably from the market’s initial failure to see the full potential of the Celegene acquisition and the perceived onus of a contingent value rights arrangement that was stuck to make it happen.
Celgene has three promising drugs in late-stage development, two of them cancer drugs. This, along Celegene’s value as an R&D asset, was primarily why BMY agreed to a deal involving commensurate shares for Celegene shareholders, along with a publicly traded contingent value right (CVR), whose value ultimately hinges on BMY’s securing regulatory approval of the three new Celegene drugs by certain deadlines.
More than 700 million of these CVRs are outstanding, creating a potential payout of more than $6 billion if all three drugs meet their approval requirements. Some skeptical analysts have suggested that this contingent liability might be a disincentive to shepherd the drugs to approval. But, given the value that regulatory approval will signal, this is like saying that individuals aren’t motivated to earn substantially more money because they don’t want to pay more income tax.
Though illogical, this view—along with negative associations from the mixed results of other pharma CVRs—is doubtless weighing on BMY shares. The impact of these market perceptions may ultimately redound to the benefit of investors who were/are early believers in the Celegene acquisition.
As did CVS, BMY made a major move wasn’t fully understood, at least initially. And though the market, focusing on Q3 results, may be catching up, shares of both companies remain undervalued.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.