Sunday, May 15, 2005

Health care futures

Health care makes strange political bedfellows. But investors are of one mind when it comes to what they like and don’t like about this trillion dollar industrial complex. And investor’s clarity should guide the future of the health care industry.

Who would have imagined 10 years ago that Newt Gingrich and Hillary Clinton would ever agree on anything? Well, it turns out that both are now promoting
a bill that would modernize medical record keeping. Their bill may have merit if it cuts costs while protecting privacy. And both believe that working together may help their 2008 prospects. Perhaps Newt thinks that promoting Hillary helps increase the chances that the Democrats will nominate her for 2008 – making it easier for Rove & Co. to defeat the Democrats in the next election. And Hillary may believe that a rapprochement with her former nemesis may blunt the effect of such Rovian attacks.

While it is unclear how this political maneuvering will pan out, investors have expressed a far clearer message on health care. According to a Peter S. Cohan & Associates analysis of the largest companies in eight health care industry sectors, investors pay a premium for rapid sales growth. They are eager to own biotechnology, medical instruments and generic drugs – whose 5-year revenues grew an average 32%, 13%, and 19% respectively. And they dislike drug wholesalers, and hospitals – which grew a relatively tepid 15% and 7% respectively. Big pharmaceutical companies (7%) and managed care organizations (2%) are stuck in the middle. And Pharmacy Benefit Managers (PBMs) are an interesting case – while their rapid revenue growth (+34%) has propelled their stocks upward, their razor-thin 2% net profit margins lead investors to value them less highly.

The stock market performance in these sectors over the last decade helps explain the variation in investor preferences. For example, biotechnology (+1,186%), generic drugs (+713%), PBMs (+480%), medical instruments (+473%), and managed care (+394%) generated the top 10-year stock market performances. While big pharma (+140%), hospitals (+180%), and drug wholesalers (+193%) were among the weakest performers in the sector. All these sectors outperformed the S&P 500 which rose about 110% during the decade.

But the prices that investors are willing to pay now for a dollar of sales in each sector provide clues as to investor’s assessment of the sectors’ future prospects. Investors pay a significant premium for a dollar of revenues generated by biotechnology, medical instrument, and generic drug manufacturers ($8, $4.50, and $3.61 respectively). Whereas revenues of drug wholesalers, PBMs, and hospitals sell at a discount -- 21 cents, 49 cents, and 95 cents respectively. Big pharma trades at a premium of $3.31 – reflecting the sector’s 29% return on equity (ROE) offset by its tepid revenue growth compared with 32% growth (and -2.5% ROE) in biotechnology. Finally, investors pay a middling $1.27 for each managed care revenue dollar.

These stock market dynamics have important implications for health care executives. For example, big pharma’s enormous profits have attracted faster-moving competitors. Biotechnology companies, such as Genentech, have attracted the world’s best researchers and given them a chance to bring new drugs to market fast that help treat devastating diseases. Meanwhile, generic drug manufacturers like Barr Pharmaceuticals grab market share by cutting the costs of making off patent drugs and challenging on-patent drugs with clever patent strategies. Meanwhile medical instruments makers, such as Medtronic, focus their expertise in specific markets, such as cardiac care, that create enormous growth and profit opportunities.

Big pharma executives are now on the hot seat to figure out how best to compete. Should they jettison their R&D and just focus on sales and marketing of their own patented drugs and in-license new ones? Can they make their drug development more productive by learning from biotech leaders like Genentech? Can they improve their margins by borrowing generic drug makers’ cost cutting techniques?

The answers to these health care questions will probably remain in flux long after Hillary and Newt’s 2008 political ambitions have played themselves out.

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