Our outlook for health-care stocks

Apart from providing an insurance option for previously uninsured individuals, the new exchange markets will also bring greater transparency and competition. There has always been a level of ambiguity in the health-insurance market regarding price and differences among plans. Exchanges will now present all plans and prices on one platform. This dynamic will create more of a strong-form market versus the current weak-form market and act as a catalyst for competition.

Historically, an individual or small group would have to contact the separate health-insurance companies or contract with a broker in order to compare plans. Exchanges present all levels of plans, prices, covered benefits and provider networks in one location. After they input their age and ZIP code, the exchange presents shoppers with several choices from various payers, and individuals can select different levels of plan coverage options that range from Bronze (base level of insurance coverage) to Platinum (highest level). When coverage is selected, several vendor plans are shown and individuals can choose which plan they would like more information about, with the main difference being network and other plan options. After a vendor is selected, the details of the plan are provided in a standard format. This will make plan comparisons easier and more transparent.

In order to create standardization, the ACA has categorized plans into four main coverage levels. The determination of coverage levels will be based on the percentage of total medical costs that are expected to be paid by the insurers, or what is known in the health-insurance industry as a plan's "actuarial value."

• Level 1 - Bronze: 60% actuarial value
• 
  
• Level 2 - Silver: 70% actuarial value
• 
  
• Level 3 - Gold: 80% actuarial value
• 
  
• Level 4 - Platinum: 90% actuarial value

Plans can achieve these levels with varying deductible and copayment structures. The only requirement is that the estimated amount of health-care expenses paid by the health insurer should at least equal the minimum percentage. This does not mean that the insurer will pay the minimum percentage for every plan member, but rather pay the minimum percentage of total medical expenses for the entire plan.

With regulations governing state-based exchanges still in flux and private exchanges only beginning to emerge, there is significant uncertainty about what exchanges might mean for managed care organizations (MCOs). There appears to be a consensus emerging that state-based exchanges should carry relatively low margins for MCOs, given the high degree of transparency, standardization and regulation. On the other hand, regardless (to a certain degree) of margin levels we have tended to view state-based exchanges as an incremental positive for MCOs, considering that the vast majority of those enrolled will have been previously uninsured. As long as exchange enrollees weren't customers before, even a low-single-digit margin may be acceptable--assuming returns on regulatory capital are adequate.

That said, by establishing actuarial minimums the ACA has effectively built more commoditization into the MCO industry. The ease of use and transparency of the exchange websites also add to the competitive environment, and we wouldn't be surprised if large MCOs take a cautious approach, at least initially, to the exchanges.

We don't anticipate significant power grabs in 2014, as much uncertainty regarding the profitability level of individuals obtained through the exchanges is likely to persist and competition from smaller, regional plans is expected to be rather fierce. However, once the dust settles and individuals realize that an extensive provider network and scale of the large insurers is appealing enough to mitigate potentially slightly higher premiums, we expect individuals to drift more to the more established players. We remain confident in our bullish recommendation on   WellPoint  WLP, partially because of our belief that the company, along with   UnitedHealth Group  UNH, is best positioned to capture the sizable share of new market entrants because of its already extensive presence in the retail and small-group markets.

The key point of emphasis for the health-care providers is that the exchanges will bring in a previously untapped patient volume. We caution not to overestimate the benefit, as only nonacute, less-critical services are likely to see the utilization uptick. Nonetheless, there is a volume boost that can't be ignored. The question becomes at what pricing level would this volume arrive? So far, we've noticed two key elements to the price-volume dynamic when it comes to the exchanges. One is that providers are taking reimbursement discounts from conventional commercial insurance rates in exchange for more guaranteed patient volume from narrower networks. And two, is that the provider pricing in exchanges, while less than commercial rates, is better than Medicare. What that tells us is potential pricing pressure on commercial rates as exchanges grow could add to existing reimbursement headwinds in Medicare and Medicaid, leaving hospitals to battle over critical patient volume market share to drive earnings growth. Thus, the providers will go aggressively after the incremental volume from the exchanges, particularly as it comes (even after discounts) at an attractive enough reimbursement level.

A key theme for many of the exchange programs is to focus on keeping premiums low. Unfortunately for individuals who need drugs, that means higher out-of-pocket deductibles and cost sharing. However, with the average drug deductible for current exchanges of $250, individuals with chronic needs will probably exhaust that amount fairly quickly, encouraging ongoing drug use. The formulary cost sharing through the exchanges so far looks similar to current private plans, with the cost share for the first-, second-, and third-tier drugs at $13, $40, and $62, or 40%-50% cost share, respectively, which isn't prohibitive for many newly insured individuals. Further, under the current rules, exchange programs must offer at least one drug in each drug class or the number of drugs in a class covered by a bench plan (whichever is greater). This should benefit the generic makers more than the branded drugmakers, as the formularies will push patients to lower-cost drugs, and patients, given their financial interest in the process, would be inclined to consume the generic or lower-cost drug. This dynamic becomes a bit more convoluted in the case of specialty drugs, where often there aren't many treatment alternatives and where patients will likely still bear a sizable portion of the total cost of the drug (up to the maximum out-of-pocket level set up by the ACA).

While it is too early to figure out where on the drug-pricing continuum exchanges would sit, our expectations are that the pricing there will be somewhere between the Medicare and the Medicaid level, thus offering pharmaceutical companies the benefit of both volume and to a lesser extent price. Considering there aren't many negatives associated with the exchanges, we anticipate pharmaceutical companies will view them as accretive to both profitability and returns on capital.

It is the manufacturers of picks and shovels, not the gold diggers themselves, who benefited the greatest from the Gold Rush. And in the case of drug-supply middlemen, exchanges represent just another wave of gold seekers for the industry counting mainly on volume for its profits. Pharmacy benefit managers (PBMs) are among the key beneficiaries of the ACA, in part because of their abilities to extract cost savings for the overall system, and the uptick in prescription drug utilization expected in 2014 would be a nice tailwind for an industry facing questions about its growth prospects.   Express Scripts  ESRX is our favourite name in the space.

The exchanges' impact on the device industry is less pronounced. While it is possible to see an uptick in nonacute care and elective procedures as a result of more individuals obtaining coverage through the exchanges, relative to the overall customer population, this amount is immaterial. Much of the surgical procedure volume pertains to acute care, where devices are reimbursed regardless of whether the provider is, so we aren't baking in any significant revenue growth stemming from the exchanges in our device companies revenue expectations.

Valuations in the sector are no longer very appealing

Health-care stocks continue to defy expectations, and, for the year to date, health care, along with consumer cyclicals and technology, is the top-performing sector in the U.S., gaining nearly 30%. Despite the worse-than-expected performance throughout the recession, the sector's five-year growth now stands at 13%. Outside the medical instruments and supplies industry, other areas of health care all delivered north of 20% gains so far in 2013, with biotech (44%) and health-care plans (38%) in particular outperforming the overall market by a significant margin. With two years of stellar returns behind us, there aren't many exciting investment opportunities in the sector. We think the investment community has recognized the many sector headwinds but has settled on a positive long-term outlook. Our coverage universe is now considered largely fairly valued, with a few exceptions, most notably in medical devices and managed care.

Even with major headwinds swirling through the managed-care industry, we believe players with economic moats will churn out strong long-term profits. Narrow-moat firm WellPoint is our top pick in the space. We think a large and diverse membership base is the key driver in the creation of its economic moat, as it allows MCOs to more effectively leverage fixed costs, gain population management expertise, diversify risk and gain negotiating power over providers. With the bulk of the ACA set to come on line in 2014, the operating environment will be pressured, but there are a few opportunities on which, in our opinion, top MCOs will capitalize.

We are also very bullish on Express Scripts. The firm alone processes well over 1 billion adjusted claims annually and has established a wide economic moat as a result. The firm has been able to translate its substantial claim volume into powerful supplier negotiating leverage and premium scale advantages. Currently Express Scripts trades at a material discount to our fair value estimate, and we believe it offers a prime investment opportunity. We believe market participants are underestimating the long-term growth potential for the firm and are overestimating the effects of a maturing industry.

	Top Health-Care Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	Express Scripts		$89.00	Wide	Medium	$62.30
	Teva Pharmaceuticals		$48.00	Narrow	Medium	$33.60
	Gilead		$71.00	Narrow	Medium	$49.70
	WellPoint		$100.00	Narrow	Medium	$75.00
	Data as of 9-20-13

  Express Scripts  ESRX The delivery of pharmaceuticals to consumers encompasses many firms along the supply chain, and among the numerous players Express Scripts stands out as an elite participant. The firm's strong competitive advantages have churned out excellent ROICs and have given it a wide economic moat. We anticipate robust growth for the pharmaceutical industry over the long term, which should provide Express Scripts with a solid platform for continued success. With more than 1.3 billion adjusted claims processed in 2012, Express Scripts is the largest PBM. This dynamic positions the firm positively as it is able to negotiate favourable supplier pricing and solid spread retention. The power of the firm's negotiating position was demonstrated recently with its   Walgreen  WAG contract negotiations. Even though Walgreen is the largest retail pharmacy chain, it had to relent to Express Scripts' pricing demands. More critically, however, the colossal claim volume processed by Express Scripts allows it to scale its centralized costs and leverage its asset-light capital structure into solid economic profits. The firm has some of the lowest selling, general and administrative costs and highest operating profit per claim. These metrics have translated into ROICs well above its weighted average cost of capital.

  Teva Pharmaceutical  TEVA Teva faces a difficult transition phase over the next few years, but we think the company's narrow economic moat can sustain its leadership in the specialty pharma industry. In the generics segment, management will focus on improving operating costs in the company's sprawling manufacturing empire, while also retaining a focus on emerging markets to reduce risks from the U.S. patent cliff and pricing concerns in Europe. The risk of branded and generic competition on Copaxone creates a more severe headwind in Teva's branded segment. Copaxone's patent protection through 2014 and a reasonably healthy pipeline, including biosimilar and respiratory products, leave us optimistic that management can successfully transition the company beyond its near-term challenges. Although these hurdles will subdue Teva's growth, healthy free cash flow leaves opportunities for acquisitions, dividend growth and share repurchases.

  Gilead  GILD Strong sales surrounding Gilead's core tenofovir molecule--in the forms of Viread, Truvada, and Atripla--have made the firm the dominant player in the market for HIV therapies and produced stellar operating margins. Gilead's Complera and Stribild are seeing rapid uptake and strong reimbursement, and they should help Gilead both retain market share beyond the first HIV patent expirations (starting in 2018) and improve its profitability (particularly Stribild, an all-in-house product carrying the firm's highest HIV product price tag). While Gilead paid a steep premium to bring Pharmasset's hepatitis C pipeline under its wing, it puts the firm in prime position to introduce the first all-oral drug regimen in 2014. We think Gilead could see peak hepatitis C sales in 2020 of $10 billion, 41% of our global market estimate that year, and this franchise should allow it to counter maturing HIV sales beyond 2022.

  WellPoint  WLP Although WellPoint has faced a tough time over the past few years, we believe this MCO has a solid membership and network base that it can take advantage of to produce long-term outsized returns. The firm participates in 14 states under the Blue Cross Blue Shield brand, which gives it unparalleled recognition among consumers of health-care services. We believe this will serve the firm well once the individual exchange markets go live in 2014 and beyond. WellPoint also has the ability to negotiate advantageous pricing with its provider network given its sizable and geographically dense membership base. Scale will also be a positive for the MCO as it can utilize its robust membership base to spread costs. In our opinion, the firm has failed recently to take advantage of its inherent advantages and investor pressure lead to a CEO switch.

Please see our detailed take on each sector in the reports that follow.

•  Our outlook for the U.S. economy
•  Our outlook for the U.S. stock market
•  Consumer cyclical
•  Basic Material
•  Energy
•  Consumer defensive
•  Tech&Telecom
•  Financials
•  Utilities