S&P: Getting healthy, wealthy and wise

May 4, 2010 @ 12:01 am

By Standard & Poor's

Standard & Poor's Equity Research's fundamental outlook for the health care services industry for the next 12 months is positive. S&P's health care equity analytical group thinks most services, including home health care, rehabilitation services, clinical laboratory services, and dialysis, will continue to benefit from favorable demographic trends. S&P also believes the health care reform bills signed into law by President Obama in late March will expand the customer base of certain services. However, S&P notes many benefits from health care reform will not be realized until 2013/2014.

S&P's life sciences equity analyst Jeffrey Loo is optimistic on clinical labs. Although Loo sees continued softness in employee-related drug testing, as weak employment markets adversely affect volume, he believes the angle of the decline is moderating. Meanwhile, labs have benefited from an increase in tests per requisition, and Loo is encouraged by the increase in the volume and variety of esoteric and genomic tests, which, in his opinion, should spur stronger revenue growth in the future. Loo also thinks clinical labs will continue to seek acquisitions to supplement organic growth, but views the number of potential sizable acquisitions as limited.

Meanwhile, in lieu of a health care reform tax, clinical labs agreed to an across-the-board 1.75% cut to the Medicare clinical lab fee schedule in each of the next five years starting in 2011. There will also be a productivity adjustment, which will probably lead to lower rates. However, Loo believes the expansion of coverage of an additional 32 million Americans will more than offset the impact from lower reimbursement rates.

S&P's health care facilities equity analyst Jeffrey Englander and London-based pharmaceutical equity analyst Sho Matsubara are positive on the dialysis group, as they view the proposed bundled dialysis payment rates announced in September 2009, which are effective in 2011 and would result in rate cuts of about 4.1% if implemented immediately or 3.1% if implemented over four years, as manageable. The two analysts expect revenue per treatment to continue its gradual rise. While reimbursement rates have been under pressure and increased Heparin costs could constrain margins, the analysts expect these trends to be offset by stabilizing erythropoietin drug use. Separately, both are also favorably inclined toward respiratory therapy services. The analysts believe Medicare reimbursement issues may continue to pressure sales growth, but the impact on revenues could be mitigated through expense management and market share gains of the large, better financed public companies in the industry.

Meanwhile, S&P's managed health care equity analyst Phillip Seligman remains positive on pharmacy benefit managers (PBMs), which help managed care organizations, governments, and employers control drug spending. Although the weak economy reduced pharmaceutical consumption, Seligman believes it is spurring generic drug use, which is a positive for PBM profitability. He also thinks health care reform will further boost sales through the health insurance coverage of 32 million additional Americans. Seligman also sees PBMs increasingly benefiting from the $100.7 billion in branded drugs that are slated to lose their patents and face generic drug competition from 2009 to 2015, as estimated by one of the PBMs, and from the PBMs' moves to increase higher-profit mail-order delivery of drugs.

For investors interested in benefiting from the continued growth S&P sees for health care services, there are many different investments – depending on investment objectives and risk tolerance. For individual health care services stocks, S&P Equity Research has strong buy (5-STARS) recommendations on pharmacy benefit managers Express Scripts (ESRX) and Medco Health Solutions (MHS), and buy (4-STARS) recommendations on clinical labs Laboratory Corporation of America Holdings (LH) and Quest Diagnostics (DGX), dialysis service providers DaVita (DVA) and Fresenius Medical AG ADS (FMS), and respiratory services company, Lincare Holdings (LNCR). S&P's STARS recommendations are subject to change at any time, as are its ETF and mutual fund recommendations.

COMPANY/TICKER ‡STARS ‡QUALITY RANKING *RISK STYLE CURRENT PRICE 12-MONTH TARGET PRICE P/E RATIO YIELD %
DaVita / DVA 4 B+ Medium Growth 63 69 14.3 Nil
Express Scripts / ESRX 5 B+ Medium Growth 99 125 19.8 Nil
Fresenius Medical / FMS 4 NR Medium Foreign 54 60 16.8 1.1
Laboratory Corp America / LH 4 B+ Low Growth 78 94 14.3 Nil
Lincare Holdings / LNCR 4 B+ Medium Growth 47 54 16.7 Nil
Medco Health Solutions / MHS 5 NR Medium Blend 57 80 16.9 Nil
Quest Diagnostics / DGX 4 B+ Low Growth 57 70 13.6 0.7

*Based on our analysts' assessment of qualitative factors, including financial strength, potential share volatility, competitive position, industry cyclicality, regulatory/legal issues, and other factors. Please note that all investments carry risks. Specific risks to each stock recommendation and target price can be found in each company's individual stock report. ‡See definitions on page 2. †Based on S&P estimated fiscal 2010 earnings. Source: S&P Equity Research.

Investors looking for exposure to health care services who also want to benefit from holding a diversified security (which may also include exposure to other health care industries, such as pharmaceuticals, biotechnology companies, health care equipment companies, health care supplies companies, health care distributors, managed health care, life sciences tools and services), may consider exchange-traded funds or mutual funds. S&P rankings on ETFs and mutual funds incorporate a rigorous analysis of each portfolio's underlying holdings to assess valuation and risk, and are not based simply on past performance. Note: most health care ETFs and mutual funds have relatively small positions in health care services stocks since they account for a small percentage of the total market cap of the overall health care sector.

On the ETF front, S&P recommends iShares Dow Jones US Health Care Providers Index Fund (IHF) and Dynamic Healthcare Services Sector Portfolio (PTJ), as both have relatively high percentages of health care services stocks, in addition to stocks of other health care industries.

FUND NAME / TICKER S&P RANKING YTD *1-YEAR *3-YEAR **CURRENT PRICE EXPENSE RATIO
Dynamic Healthcare Services Sector Portfolio / PTJ MW 5.4 38.0 -8.5 22 0.80
iShares Dow Jones US Health Care Providers Index Fund / IHF OW 3.5 43.8 -4.8 50 0.48

Data through April 30, 2010. *Total returns include reinvested dividends and capital gains, all annualized; calculations do not reflect the effect of sales charges. **As of May 3, 2010. OW-Overweight. MW-Marketweight. Source: S&P ETF Reports.

As for mutual funds, S&P has a top five-star ranking on these equity funds, which have total net assets valued in excess of $500 million and a top-ten holding in one of the health care stocks recommended by S&P Equity Research: Fidelity Select Medical Equipment & Systems Portfolios (FSMEX), T. Rowe Price Health Sciences Fund (PRHSX), and Blackrock Health Sciences Opportunities Portfolio (SHSAX). All three funds are also open to new investors.

FUND NAME / TICKER S&P RANKING YTD *1-YEAR *3-YEAR *5-YEAR CURRENT PRICE EXPENSE RATIO
Blackrock Health Sciences Opportunites / SHSAX 5 4.6 37.4 6.0 10.9 29 1.38
Fidelity Select Medical Equipment & Systems / FSMEX 5 7.1 37.3 6.2 7.2 26 0.87
T. Rowe Price Health Sciences Fund / PRHSX 5 7.6 44.4 3.3 10.3 28 0.86

Data through April 30, 2010. *Total returns include reinvested dividends and capital gains, all annualized; calculations do not reflect the effect of sales charges. Source: S&P Mutual Fund Reports.

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