Filling a Gap in Healthcare Stocks
Gino Rossi, Back-up Global Portfolio Manager, Healthcare Analyst.
Health care stocks have historically traded at a price to earnings premium compared to the broader market. Earnings are resilient to the economy, barriers to entry are high, and an ageing population and rising health care budgets in emerging markets provides plenty of market growth. However, political uncertainty in the US, the largest health care market by far, has sent investors heading for the exit.
The chart below shows that the only other time in recent history when health care traded at a discount was during the global financial crisis. Health care outperformed during this period. However, its price to earnings multiple lagged the rest of the market as stocks in other sectors priced in a rebound in earnings from depressed levels.
There is a wide disparity within healthcare as investors perceive hospital operators, biotechnology, and pharmaceutical companies as most at risk from regulatory uncertainty. Investors have switched to medical device manufacturers and life science tools who are one step removed from the end customer, the Government and insurers. Better yet, many investors have piled into stocks with minimal reliance on Government funding. Examples include dental and animal health stocks. The disparity between stocks in the Government’s cross hairs such as pharmaceutical companies, and those perceived to be free from this regulatory risk is now quite extreme. Our analysis suggests that these “crowded trades” are factoring in unrealistic growth expectations and current prices are unjustifiable. Two stocks we have looked at closely in an effort to find opportunities for our investors are Zoetis and Straumann.
Zoetis is the world’s largest animal health company. The attraction of animal health is clear: It has little reliance on Government funding, generic competition is less fierce than in human health and new drug approval is far less onerous. Large animal health businesses are tucked up in some of the largest pharmaceutical companies such as Merck, Eli Lilly and Bayer, but there are few stand-alone companies such as Zoetis, and none to match its scale.
Zoetis was spun off from Pfizer in 2013. As is often the case, the smaller more focused spin-off, free from the bureaucracy of a large parent, can find greater efficiencies and newfound innovation. In the case of Zoetis, it has achieved this and then some. We are surprised by the margin expansion achieved since the spin-off. The same longstanding CEO has been in charge since prior to the demerger and we ask the question, why weren’t some of these initiatives implemented earlier? Our fear is that the company is cutting costs too aggressively and the margins may not be sustainable in the long-run. We also find it surprising that market consensus is factoring in very little impact from some large upcoming patent expiries, and the earnings multiple that investors are currently paying does not seem to factor in the volatility inherent in agriculture from events such as drought and epidemics (e.g., foot and mouth disease). We value Zoetis 15% below the current share price.
The dental industry is another area health care investors have flocked to, because of the high proportion of revenue that comes directly from the consumer. One stock that has done particularly well is Straumann. Headquartered in Switzerland, Straumann is the global leader in dental implants with 23% market share. For those unfamiliar with these devices, a dental implant is a prosthetic tooth which is screwed into the jawbone of the patient, permanently fixing it there. Once fixed, the implant is almost imperceptible from a normal tooth and requires no special maintenance or attention from the patient. This is a high growth industry as penetration levels, even in developed countries, are still quite low. Furthermore, in what is a rare phenomenon in healthcare, the US appears under penetrated in dental implants compared to many other developed countries. As a result, North America contributes only 28% of revenue.
Straumann has recently had some excellent product launches and it is gaining market share as evidenced by revenue growth of 17% in North America and 26% in Asia Pacific. Sustaining this will be difficult given the strength of competitors such as Nobel Biocare (now part of Danaher) and Biomet 3i (now part of Zimmer Biomet). The market’s revenue growth expectations appear to ignore the complexities of distribution and the many product segment niches in dentistry. More difficult still will be achieving consensus expectations for margins. The company itself acknowledges a trend to cheaper implants and this mix shift to low-end implants will be difficult to offset. Gross margins are currently a whopping 78%. Yet consensus has EBIT margins increasing 1.7% over the next two years. This is an excellent company, but we think expectations are too high and the valuation is at least 20% too rich.
If you’ve had a good idea, chances are others have had it too. It is a risky strategy to rotate to an industry because of its relative safety, or short-term growth prospects, without first considering what the market has already priced in. For health care stocks such as Zoetis and Straumann, investors seem to be trading off regulatory risk for the risk of over-paying. We will continue to monitor these two stocks closely with the expectation that valuations will become more attractive in the future.
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© Arnhem Investment Management, 2017