Healthcare Sector Report

Nicole Puhl & Jenny Woulfe APM Spring 2008

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Table of Contents Recommendation………………………………………………………………….3 Sector Overview.......................................................................................................4 Business Analysis Health Care Providers and Services Life Cycle…………………………………………………………….5 External Factors……………………………………………………..6 Porter’s Five Forces………………………………………………..12 Pharmaceuticals Life Cycle…………………………………………………………...14 External Factors……………………………………………………16 Porter’s Five Forces………………………………………………..22 Financial Analysis Health Care Providers and Services……………………………………..26 Pharmaceuticals…………………………………………………………..33 Valuation Analysis Health Care Providers and Services……………………………………..41 Pharmaceuticals…………………………………………………………..44 Conclusion………………………………………………………………………..47 Works Cited……………………………………………………………………...47

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Recommendation We recommend weighted the healthcare sector in the APM portfolio 14%. This weight is 1.6% more than the weight of this sector in the S&P 500 of 12.4% and 4% more than the current APM portfolio weight of 10%. We believe that the class should overweight this sector for the following reasons: •

Previous class discussions have indicated that the class would like to take a defensive stance with the portfolio in light of recent market downturns. As a defensive industry with a beta of only .6, the healthcare sector will help protect the portfolio against negative market shifts.

•

Although many industries in this sector have reached the mature phase, other industries, such as biotechnology, show potential for growth as the world population reaches old age in the coming years.

•

Increases in Medicare coverage and a strong push for a national healthcare system promise high returns for the healthcare providers industry.

•

The largest industry in the sector, pharmaceuticals, has continued to provide high returns for shareholders compared to the S&P 1500, even during market downturns.

These, along with other reasons, support our decision to overweigh the healthcare sector. The following analysis will examine the different aspects of both the healthcare providers and services industry and the pharmaceutical industry which will further support overweighting the sector.

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Sector Overview The Health Care sector represents 12.4% of the S&P 500 and 10.4% of the APM Portfolio. The sector as a whole is valued at $2.197 trillion (Yahoo). The chart below illustrates the breakdown of the industries that formulate the sector. Health Care Sector (35)

Health Care Equipment and Services Industry Group (3510)

Pharmaceuticals, Biotechnology, and Life Sciences Industry Group (3520)

Equipment and Supplies (351010)

Biotechnology (352010)

Providers and Services (351020)

Pharmaceuticals (352020)

Health Care Technology (351030)

Life Sciences Tools & Services (352030)

The two industries focused on in this report are the Providers and Services and Pharmaceuticals industries. The largest companies in the Health Care Providers and Services industry include the class held UnitedHealth Group (UNH), Wellpoint (WLP), Aetna (AET) and Cigna (CI). The leaders of the Pharmaceuticals industry include Pfizer (PFE), Johnson & Johnson (JNJ), BristolMyers Squibb (BMY), Novatris AG (NVS), and the company currently in the APM portfolio, Genetech (DNA). The other industries accounted for in the APM portfolio are the Equipment and Supplies and Biotechnology industries. The major players of the Equipment and Services

Puhl/Woulfe 5 industry include Medtronic (MDT), Boston Scientific (BSX) and Zimmer Holdings (ZMH), the company in our portfolio. Under Biotechnology, APM is invested in GlaxoSmithKline (GSK), who competes against Amgen (AMGN) and Cephalon (CEPH).

Business Analysis: Health Care Providers and Services Phase of Life Cycle The Health Care Providers and Services Industry is currently in the mature growth phase of the company life cycle. Throughout this phase of the life cycle, the main concerns for healthcare providers will be cost and quality of services and products. Many analysts project strong growth for this industry based on U.S. population distribution and governmental programs that provide stimuli and support. The Baby Boomer generation constitutes the largest portion of our population and is quickly approaching the retirement age of 65, which makes them eligible for Medicare, health insurance that is provided by the government. The Medicare Prescription Drug Improvement and Modernization Act requires participants to either enroll in a Medicare coverage plan or enlist in a Prescription Drug Plan (PDP), which has promoted growth for health care providers (Health Policy Alternatives). In addition, many candidates for the 2008 presidential elections are promoting health care coverage for all U.S. citizens, providing yet another way that health care companies can grow through adding customers. Despite the growth of this industry, many problems need to be addressed otherwise it could face the possibility of decline. Problems concerning quality are rising to the forefront of this industry, as the Institute of Medicine reported that as many as 44.000 to 98,000 people die in hospitals per year as a result of medical errors (CMS). Past attempts to improve quality have been unsuccessful, leaving health care providers to explore new methods for improving quality. Many governmental, commercial and non-for-profit organizations exist that aim to improve the

Puhl/Woulfe 6 quality of this industry, which may take another 20-30 years when considering that it took the industry 100 years to reach maturation. Further problems arise from expected shortages of doctors and nurses in the future, which would create a large negative shock to the industry. The Federal Government projects a shortage of one million nurses and 24,000 doctors by 2020, figures that can dramatically change the cost and quality landscape of the industry (PWC). A report released by PricewaterhouseCoopers’ Health Research Institute demands reform for the entire workforce, specifically the way doctors and nurses are trained and physician and nursing programs. Although the industry is expected to remain stable in the short-term, this research should bear weight for long-term valuation. The Health Care Providers industry benefits from inelastic demand, as it is not dependent on the state of the U.S. economy for its success. It is considered a defensive market sector because it is not easily shaken by economic variables like unemployment, inflation, etc. because people will always need health care regardless of the state of the economy. Even if unemployment rises and people lose health care coverage through their employer, they typically secure coverage elsewhere, thus contributing to the industry’s steady demand. Furthermore, the health care industry is isolated from effects faced by foreign economies because the industry is centralized domestically. Typically each country has its own approach to health care, whether it be nationalized or not, and that has little bearing on the U.S.’s health care sector. External Factors Technology Healthcare technology plays a large role in the Health Care Providers and Services Industry. The industry is focused on reducing medical errors and improving patient safety, and those priorities can be achieved through developments in healthcare information systems. Many

Puhl/Woulfe 7 hospitals and delivery systems now use computerized practitioner order entry and electronic medical records to increase efficiency. These systems are accompanied with a time lag however, as some vendors discovered that system implementation and transition times are becoming longer, which means that companies must strategically handle the recognition of revenue from backlog (ValueLine). The largest looming technology change is online personal health records, which will likely occur over the next few years with the goal of having all records online by 2014. Last October, Microsoft released HealthVault, an online personal health record center. Google is expected to release GoogleHealth, a similar record repository in the near future (TechCrunch). Although there is increased risk to patient safety and identity theft, this movement will create many benefits to patients and health care providers. The first and obvious benefit is instant access to information on doctors’ visits, prescribed drugs and lab work or medical procedures, information that is not centrally maintained in the status quo (FederalTimes). Another benefit is avoiding common, yet life-threatening, medical errors, like prescribing conflicting drugs to a patient or prescribing a drug that a patient is allergic to (FederalTimes). If this technology can avoid ever-rising identity theft then it will likely be widely accepted, providing managed health care companies with the ability to provide better service to their customers. Technology is also contributing to the clinical information systems sub-industry by promoting the adoption of new systems. Additionally, some players feel that health care providers should fund the adoption of new clinical systems and are working to create financial incentives for hospitals and delivery services that do adopt the new technology.

Government

Puhl/Woulfe 8 The government plays a prominent role in the Health Care Providers and Services Industry through its two programs: Medicare and Medicaid. Medicare is applicable to retired individuals over the age of 65, while Medicaid assists families with low income. These programs directly affect health care insurance companies in many ways. It is important to note that Medicare affects almost all sub-industries within this sector. Part A addresses patients’ needs for hospital stay, which is typically covered if certain criteria are met. Insurance providers are affected by Part B, which helps provide citizens with physician and nursing services (e.g. x-rays, organ transplants, chemotherapy, etc.) and medical equipment (e.g. wheelchairs, crutches, eyeglasses, etc). Medicare Part C allows for participants to receive Medicare benefits via private health insurance companies, a key part of this industry. Lastly, Medicare Part D helps subsidize the cost of prescription drugs and allows eligible citizens to receive prescription drugs for free. This section of Medicare has undergone many changes through the Medicare Prescription Drug Improvement and Modernization Act, which came into effect in January 2006 and had 11 million participants at that time (CMS). Part D greatly affects insurance companies like UnitedHealth, Humana and WellPoint, which are the largest insurance providers for Medicare (CMS). Health Care accounts for a large portion of the U.S. Budget, making it a hotly contested political issue. Spending for Medicare reached $440 billion during 2007, which represents 16% of the federal budget (third-largest for government spending behind Social Security and defense) (Health Policy Alternatives). The projections for health care spending show that it will increase both in absolute terms and also as a portion of the federal budget. As the graph below indicates, by 2017 the government is expected to spend $854 billion on health care, which implies the government will surely impact the industry in some fashion (Health Policy Alternatives).

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Source: Health Policy Alternatives

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One last governmental factor that will affect health care is the outcome of the 2008 presidential election. Each candidate has a different position on the issue, however, it seems to be universally recognized that politicians want to alleviate rising costs and help provide coverage for all citizens. Social There is a rising societal concern over obesity in America, with a focus on childhood obesity. Many nationwide programs have responded to help combat this problem by promoting healthier eating habits and physical activity. Additionally, T.V. shows like The Biggest Loser have inspired some Americans to lost weight and adopt healthier lifestyles. Regardless of these recent trends, obesity is still on the rise for Americans, which will translate into more spending on health care in the future. Obesity results in an estimated 400,000 deaths annually and costs nearly $122.9 billion annually in medical expenses (WIN). Seeing how nearly two-thirds of adults are classified as overweight, obesity results in many direct and indirect costs to Americans (Obesity in America). Direct health care costs come in the form of preventative, diagnostic and treatment services, which can often result in medications, medical equipment purchases and hospital or nursing home care- thus affecting almost every sub-industry in Health Care Providers and Services. Unless recent trends reverse, the obesity “epidemic” will provide sustainable demand for this industry.

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Demographic The health care industry relies heavily on America’s aging population as a source of growth. The age of our population is not evenly distributed across generational lines due to the Baby Boomer generation that is now approaching retirement age. It is estimated that by 2030 (when the first Baby Boomers reach age 84) that the number of Americans over 65 will grow by 75% to 69 million. This would imply that more than 20% of the population would be over the age of 65, contrasted to the 13% today (CBS). Furthermore, people are simply living longer due to advances in medical technology and practices, another positive stimulus for the health care industry. This increased longevity for Americans implies massive drains on Medicaid, but increases for health care costs overall. Foreign Each country typically has its own approach and infrastructure for health care, therefore the U.S. health care sector is not greatly influenced by other countries. The main possibility for a foreign impact lies with American consumer dissatisfaction concerning rising drug costs. This

Puhl/Woulfe 12 dissatisfaction launched a campaign for Americans to be able to procure cheaper drugs from other countries, specifically Canada and Mexico. This was a hotly contested Congressional issue in 2006; however, many politicians are now pushing for a better U.S. health care system to alleviate some of these concerns (USA Today). Although Canadian and Mexican markets may substitute cheaper drugs, the FDA claims that it cannot guarantee the safety of these drugs and therefore is against this initiative (FDA). Furthermore, these countries do not offer the same quality health care services and professionals that are available in the U.S. and covered by U.S. Health Care Providers. This implies that the U.S. health care sector as a whole will remain isolated from foreign influence unless dramatic reform is taken to make prescription drugs available in other countries. Porter’s 5 Forces Internal Industry Rivalry: Strong The Health Care Providers and Services industry experiences intense competition and rivalry. The industry is dominated by large companies, which may be illustrated below by their market capitalization. Leaders in Market Capitalization Feb. 2008 United Health Group [UNH] $61.1 B Wellpoint Inc. [WLP] $42.8 B Aetna [AET] $25.2 B Cigna [CI] $13.7 B Humana [HUM] $11.7 B Coventry Health Care [CVH] $8.4 B Health Net Inc [HNT] $5.3 B Sierra Health [SIE] $2.3 B Wellcare Health Plans[WCG] $2.3 B Amerigroup Corp [AGP] $2.0 B

It is evident that companies like UnitedHealth Group, Wellpoint, Aetna, Cigna and Humana have considerable margin over the other players in the industry, which contributes to the fierce competition of this industry. Additionally, the large companies often buy the small market capitalization companies in an effort to remain competitive.

Puhl/Woulfe 13 This industry also benefits from moderate to high switching costs. When a person signs a health care policy, they only use one provider (sometimes dependents may have two), thus preventing them from using another company. In addition these providers are typically tied to a person’s employer, meaning it won’t change frequently. Threat of New Entrants: Low The Health Care Providers industry is dominated by a few large companies, as mentioned previously, which makes the threat of new entrants low. Even if a small company is performing well and experiencing high growth, they will typically be bought out by a larger, more dominant firm. This was the case for PacifiCare, a rising company that UnitedHealth Group acquired in 2005. The threat for new entrants is expected to remain low in future years given the competitive nature of insurance premiums and time-consuming switching costs. Threat of Substitute Products: Low As indicated previously, many consumers have looked abroad for cheaper prescription drugs; however, that threat is not alarming. The Medicare Modernization Act’s changes to Medicare Part D is helping address many of these concerns for people over the age of 65 by paying for their prescription drugs, which decreases the threat for consumers venturing abroad to buy cheaper drugs. Furthermore, many stores like Wal-Mart and Target have started in-house pharmacies that help address this problem. Regardless of where patients receive their drugs, there is no substitute for health care coverage plans; therefore this industry is not at great risk in this area.

Puhl/Woulfe 14 Bargaining Power of Suppliers: High The Health Care Providers and Services industry, the suppliers, has high bargaining power simply because such high demand exists for its services. There are few suppliers relative to the number of buyers, which also contributes to their high bargaining power. Ideally, every American will someday have health care, which means that each person in the U.S. would be a customer of this industry. Although health care costs are rising, that does not decrease the demand for health care as people continue to pay for the services at whatever price the supplier (industry) dictates simply because they wish to stay in good health at whatever the cost may be. Bargaining Power of Customers: Weak Seeing that so much of the bargaining power in the health care sector lies with suppliers it is no surprise that the bargaining power of customers is weak. If someone wants health care coverage they must pay the price for it, which is relatively consistent from company to company. A person faces very high risk not being able to afford life-saving operations or medications if they do not own health insurance and is injured in an accident or develops a medical condition, and therefore many people are willing to pay health insurance costs at a price given by the supplier.

Business Analysis: Pharmaceutical Industry Life Cycle The pharmaceutical industry is by far the largest industry within the healthcare sector. It comprises 51.79% of the sector according to its market allocation within the S&P 500. The next largest industry, healthcare equipment, only makes up 15.14%. The leaders in this industry include Pfizer, Glaxosmithkline, Johnson & Johnson, and Merck & Co. The class currently

Puhl/Woulfe 15 holds 510 shares of the British company Glaxosmithkline. Pharmaceuticals are both an industry and a sub-industry with the GICS codes of 352020 and 35202010 respectively. The pharmaceutical industry is still in the growth stage of the business cycle, although it has begun to enter the mature stage. Drug companies continually develop a new drug that before people did not know that they needed. For example, before the development of drugs like Mirapex, no one knew that they had restless leg syndrome and that it needed to be treated. For thousands of years humans lived without today’s modern medicines, but many new drugs create fads of illnesses that people feel the need for which to seek treatment. Drug companies spend billions of dollars each year searching for the next cure. If the companies can persistently develop new drugs, their profits will increase into the future. Nevertheless, growth has slowed in the United States in recent years (Valueline). The number of untreated ailments keeps decreasing, so pharmaceutical companies cannot maintain the fast introduction of new medicines. Also, as patents expire, generic drug manufacturers capitalize on the profits from selling the drugs at cheaper prices. However, the pharmaceutical industry has begun to grow in emerging markets, so this should help to offset slowing growth trends in the United States and other developed countries (Valueline). The pharmaceutical industry is a more defensive industry and usually a good investment during a market downturn. Analysts recommend pharmaceutical stocks in times of financial uncertainty (Patterson). In the past three months, the pharmaceutical industry has had a return of -1.83% (Morningstar). While under most conditions this return is unsatisfactory, the aggregated U.S. market returned a disappointing -8.96% during this time period. The betas of pharmaceutical companies demonstrate their defensive position in the market. Glaxosmithkline, Pfizer, Merck, and Johnson & Johnson have betas of .85, .85, .75, and .60 respectively

Puhl/Woulfe 16 (Valueline). These numbers indicate that although their returns correlate with the market, these companies’ stock prices do not fluctuate, up or down, as strongly as the overall market itself. External Factors Technology The success of the pharmaceutical industry depends heavily on its ability to develop new medicines and technologies. Therefore, it invests billions each year on research and development. The average new medicine takes fifteen years to develop and costs $800 million (PhRMA). In order to remain competitive in the pharmaceutical industry, companies have increased their spending on research and development by about 8% per year since 1980. By contrast, sales margins have only grown about 4% per year in that time period. Therefore, the increased spending in research and development has failed to produce superior returns in profits for the industry, but instead has increased the average development cost per drug. This is in part due to the increasing complexity of molecular structures used in new medicines. The types of drugs that pharmaceutical companies are trying to test also contribute to the increased research and development costs. Companies have focused their efforts on developing drug for chronic illnesses instead of acute ones. Because chronic pain medication must be taken over a long period of time, researchers must spend more time testing the final product and thereby accruing more costs (U.S. Congress).

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*PhRMA’s estimates differ from those of the National Science Foundation because the NSF excludes expenditures on post-market introduction testing and the development of the manufacturing process. Some of the major advances in the pharmaceutical industry have come in the classes of antihypertensives, antibiotics and antidepressants. Researchers measure the areas that have seen the greatest development by looking at how many name brand drugs a class contains. If it contains a lot, then it is relatively new because generics have not had time to reproduce the drugs. These classes contain eleven, nine, and eight name brand drugs respectively (U.S. Congress). Some of these new drugs include Adderrol, Lexapro, and Paxil. Government The upcoming election may have negative affects on the profitability of the pharmaceutical industry. Many of the candidates support the importation of cheaper foreign drugs into the United States. Any legislation such as this could greatly reduce the sales of the already established drug companies like Pfizer and Glaxosmithkline. Also, many want to give

Puhl/Woulfe 18 Medicare the power to negotiate with the drug companies for lower prices. Barack Obama poses the largest threat to the big drug companies. He not only agrees with the previously stated positions, but he also want to increase the use of generic drugs by programs such as Medicare. John McCain, on the other hand, has a more favorable position towards pharmaceuticals. He only advocates reducing the damages granted to those who sue drug companies. November’s election could definitely affect the returns on the stocks of major drug companies (Lawler). Because of the power government has over the functions of drug companies, they spend a lot of money annually in order to promote their interests. The Center for Responsive politics reports that the pharmaceutical industry spent $1.3 billion dollars in lobbyists over the past nine years (Huckman). The pharmaceutical industry’s biggest governmental perk, patent protection, has started to wane. An estimated $20 billion worth of brand name drugs will lose their patent protection this year, allowing makers of generic drugs to start selling the formulas at deeply discounted prices. In addition, the large pharmaceutical companies have not discovered enough new drugs to offset the expiration of their patents. The FDA only approved 69 new drugs in 2007, a 26% drop from 2006. While some argue that the FDA has tightened it requirements on new drugs after disasters such as Vioxx, others still say that the drug companies are not coming up with enough new ideas. Either way, the pharmaceutical industry will suffer from a lack of new medications to replace the old ones that will lose their patent protection (Smith). Social American society provides both positives and negatives for the drug industry. On the positive side, people feel the need to have a medicine to cure all their ailments. Prescription drug expenditures totaled $200.7 billion in 2007, up from just $40.3 billion in 1990. This high growth

Puhl/Woulfe 19 indicates an increasing demand for prescription drugs. The increased coverage of insurance providers for prescription drugs and coverage by government programs have helped to increase the demand as the following graph demonstrates.

Prescription drug coverage by private insurers increased from 26% in 1990 to a projected 42% in 2006 while consumer out-of-pocket expenditures decreased from 56% to a projected 39%. Finally, prescription drug prices increased by an average 7.5% per year from 1994-2006, which contributed to rising expenditures (Kaiser). Nevertheless, the numbers show that Americans are spending an increasing amount of money on prescription drugs each year. Although consumers are willing to pay more for prescription drugs, they also do not appear hesitant to sue drug companies for unfair business practices or damaging products. Merck just recently settled its legal battle over the mis-pricing of the drugs Vioxx, Zocor, Pepcid, and Mevacor to induce doctors into prescribing their product. Merck will now have to pay an approximate $649 million dollars plus interest to various claimants (Rubenstein and Johnson).

Puhl/Woulfe 20 This lawsuit occurred right behind the class action lawsuit against Merck which alleged that the company failed to disclose health risks from its product Vioxx. The company has had to spend hundreds of millions on these suits. From 2000-2006, consumers filed over 65,000 product liability lawsuits against the pharmaceutical industry, more than any other industry (Schmit). Therefore, drug companies have to be prepared to defend themselves in court against charges such as the ones Merck has faced and also to survive the financial strain they put on the company. LAWSUITS PLAGUE INDUSTRY Drug makers faced the most product liability lawsuits last year of any industry. (2005)

Industry

Cases

Pharmaceutical

17,027

Manufacturing

3,236

Chemicals

2,875

Construction

2,717

Financial services

2,636

Insurance

1,926

Source: Thomson West

Demographics Current demographic trends bode well for the pharmaceutical industry. The American population is getting older, thanks to the baby boomers who have begun to move towards the retirement age. In 2007, 12.6% of the population was over 65 (CIA). In 2011, the first of the baby boomers will begin to retire and cause this number to increase dramatically. Also, people in the United States, and throughout the world, are living longer. The average life expectancy of

Puhl/Woulfe 21 a child born in 2007 in the United States is 78 (CIA). These older people will demand more medications for longer periods of time which will boost sales of the pharmaceutical industry. Also, older citizens can now afford prescription drugs because of the implementation of Medicare Part D. This program began paying for the prescription drugs of American seniors in January 2006 thereby making prescription drugs available for all retirees. Once the baby boomers hit retirement, demand for prescription drugs will increase further under this program.

As the above graph indicates, the bulk of the U.S. population is middle-aged. Therefore, the demand for pharmaceutical drugs should grow as this group advances into older age and increases the average age in the United States. Foreign The growth of income in developing nations will give pharmaceutical companies new markets in which to expand from the slowing growth U.S. and European markets. Also, countries like Brazil and China supply drug manufacturers with a large amount of raw materials for their products. Their low cost structures, low wages and abundant resources, help keep input prices down for pharmaceutical companies.

Puhl/Woulfe 22 On the other hand, as these countries develop further, they augment their ability to produce their own pharmaceutical drugs, usually at much cheaper prices. The FDA recently granted a Chinese pharmaceutical company the right to sell in the United States. Also, two Asian manufacturers of generic medications have begun increasing their research and development budgets in order to produce their own patented drugs. Development in the pharmaceutical industries of these countries does not bode well for the already established industry participants. India, for example, can develop a drug for about one-fifth of the cost to develop one in the United States (Valueline). These events could increase the competition in the pharmaceutical industry and drive down profit margins. Porter’s Five Forces Internal Industry Rivalry: High With billions of dollars invested in receiving that new patent in order to capitalize on research and development costs, companies compete fiercely in the pharmaceutical industry. Being the first move in this industry can mean the difference between survival and failure. Heavy advertising in the industry demonstrates the level of competition. Drug ads flood televisions and magazines across the nation. In 2005, the pharmaceutical industry spent $11.4 billion in advertising, compared to only $.8 billion in 1996 (Kaiser). When a drug company finally develops a new medication, it is essential that it recovers its heavy research and development costs and makes a profit. Therefore, firms strive to push their product in the market. From the original S&P 500 in 1957, only six healthcare firms have to today in their original corporate form (Siegel). This fact just shows then immense pressure put on pharmaceutical companies in the pursuit of survival.

Puhl/Woulfe 23 Pharmaceutical companies often pit their products against each other in order to gain market dominance. After spending hundreds of millions in developing a new medication, a pharmaceutical company will not cede sales to another company who developed a different formulation for the same ailment. Often, drug ads will reference a competitor’s product in an effort to prove itself as the better of the two. Lipitor and Vytorin provide an excellent example of two drugs that compete head-to-head. Both Pfizer’s Lipitor and Merck’s Vytorin are designed to combat high blood pressure, and each company is determined to have the highest sales possible. Threat of New Entrants: Low to moderate Due to the extremely high start-up costs in the pharmaceutical industry, new companies do not often enter the industry. Most investors would not want to wait fifteen years on a multimillion dollar investment before they see returns. Also, consumers demonstrate a high level of brand loyalty in this industry. People feel better when they recognize the name of a company who has their health in its hands. Therefore, any new entrants would have to establish their name in a market already dominated by well known firms. This being said, drug companies from developing nations are threatening to move into the markets of such big names as Glaxosmithkline and Johnson & Johnson. Pharmaceutical companies in countries such as China and India have begun raising their standards in an effort to be in accordance with the regulations of the FDA. As previously stated, one Chinese company has already gained approval for sales in the United States (Valueline). Companies in these countries have access to many natural resources that are components in medications and have much lower labor costs than pharmaceutical companies in the United States and Europe. If they are successful in conforming to the standards of the FDA and the drug standards of other

Puhl/Woulfe 24 developed nations, the current drug companies will lose the long-lived protection that they have had from new entrants. Threat of Substitute Products: High Generic drugs have plagued the pharmaceutical industry for decades. Makers of generic drugs copy the formulas used by other pharmaceutical companies and send the drugs to market without incurring the high research and development costs. Without these costs, generic drug manufacturers can severely undercut the prices of the pharmaceutical companies, thereby destroying their sales. The U.S. Government, and many other governments around the world, issue patents in order to protect drug companies from the high loss of sales. These patents last for twenty years after the drug is invented, but getting the drug approved by the FDA and to market often takes up eight years of the twenty. This situation leaves the company with about twelve years to recover its research and development costs and make a profit before losing out to generic manufacturers. After a patent expires and generic drugs enter the market, the pharmaceutical company will often lose 80% of its sales within the first year (Herper). Therefore, once it loses it patent protection, a drug basically stops making money for a company because the likelihood of being copied is high. In 2006, approximately three fourths of drugs approved by the FDA had generic counterparts (Kaiser). This year, $20 billion worth of pharmaceutical drugs will lose patent protection, including the most successful drug of all time, Pfizer’s Lipitor (Smith). This will induce many generic manufacturers to start producing the drug which will severely lower the pharmaceutical industries sales. Bargaining Power of Suppliers: Low The pharmaceutical industry has a significant level of control over its suppliers. In order to manufacture a drug, a company must produce a number of highly specialized chemicals and

Puhl/Woulfe 25 compounds, but scientists who work for the companies produce most of these compounds inhouse because their patents are owned by the companies themselves. Therefore, the drug companies only need to purchase basic raw materials for use in their formulations. Most raw materials for drug production come from the Amazon forest or the Far East. Because of the low economic standards in these countries, they willingly accept low prices for their goods. This situation is comparable to the relative cheapness of consumer goods made in China. Because of low labor costs and abundant resources, Chinese companies can sell their products at a much lower cost. The pharmaceutical companies provide much needed income to these countries, so the suppliers are reluctant to fight for better prices. The loss of revenue from the pharmaceutical companies could devastate these people. Therefore, the pharmaceutical industry should be able to maintain a high degree of control over its suppliers. Bargaining Power of Buyers: Low to moderate Because a person’s health is the most important aspect of his or her life, the pharmaceutical companies exercise a lot of power over their buyers. These companies literally have control over a consumer’s life or death. As a result, pharmaceutical companies can charge a high price for their products. The average prescription drug cost $68.26 in 2006, compared with $28.67 in 1994. Of this price, 78% went to the drug manufacturer (Kaiser). This high growth in costs demonstrates the low level of power buyers have in determining the price of drugs. People will pay high costs when it comes to their health. Although buyers of pharmaceutical products do not have a large influence on the price that drug companies charge, they are not totally powerless. Some American consumers attempt to import drugs from other countries, such as Canada, where governments restrict the price that pharmaceutical companies can charge. This practice is illegal, but the government does not

Puhl/Woulfe 26 always act against individuals who do this. In 2003, Americans imported $700 million worth of drugs from Canada, .3% of pharmaceutical sales, and approximately the same amount from the rest of the world (Kaiser). Pharmaceutical consumers also demonstrate their power when generic drugs become available. When a consumer has more choices, they can begin to demand better prices now that supply has increased. Nevertheless, drug companies still have a lot of power in pricing their products. One large buyer of prescription drugs may soon gain some power in negotiating with pharmaceutical companies. Many politicians favor giving Medicare the ability to negotiate with drug companies for better prescription prices. Some of these politicians include presidential frontrunners Barack Obama and Hillary Clinton (Lawler). Currently, Medicare does not have this power but instead relies on private Part D plans to acquire lower costs (Kaiser). If Medicare gains this power, the pharmaceutical industry will have no choice but to offer discounts and rebates.

Financial Analysis: Health Care Providers and Services Industry Sales Growth By examining the sales growth rates of the Health Care Providers and Services industry we can easily see whether or not this industry is performing well for the sector. The graph below shows that Health Care Providers and Services kept pace with and outperformed the Health Care sector since 2003. Additionally, the Health Care Providers and Services industry has outperformed the S&P 500 on a consistent basis, with the exception of 2004. In 2006, Health Care Providers beat S&P 500 sales growth by 12.99% and also outperformed the Health Care industry by 8.10%. These margins, coupled with the past few years of competitive growth rates indicate strong sales growth for the industry.

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Sales Growth 25.00% 20.00% 15.00% S&P 500

10.00%

HC Sector 5.00%

HC Providers

0.00% -5.00%

2000

2001

2002

2003

2004

2005

2006

-10.00% Year

Earnings Earnings per Share (EPS) indicates the profitability of an industry or firm and is computed by dividing net income, less dividends, by the number of shares outstanding. EPS growth is then seen as increases in profitability. The graph below shows that Health Care Providers had faster EPS growth than the industry as a whole in every year since 2001, with exception to 2004. In 2006, EPS growth for Health Care Providers and Services was 8.88% higher than the health care sector, suggesting sustainable profit growth for the industry. The reasons for these growth rates can be attributed to the aforementioned external factors of an aging Baby Boomer population and push for nationwide healthcare coverage.

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EPS Growth 40.00% 30.00% 20.00%

HC Sector HC Providers

10.00% 0.00% 2001

2002

2003

2004

2005

2006

-10.00% Year

Margins Although this industry is experiencing growth, its margins indicate a level of prevailing weakness which may be a result of the rising cost of health care across the nation. First, it is important to analyze the gross margin to tell us the amount of each dollar of sales that the company keeps as profit. The gross margin for Health Care Providers has been growing since 2003, but is still considerably behind the sector and market as a whole. This difference indicates the sector is not profitable, however, later analysis suggests otherwise.

Gross Margin S&P 500 HC Sector HC Providers

2000 35.53% 38.32% 13.60%

2001 34.27% 35.33% 12.81%

2002 31.56% 35.70% 14.65%

2003 33.27% 35.56% 12.85%

2004 33.70% 35.29% 13.29%

2005 32.17% 35.84% 14.04%

2006 35.04% 36.08% 15.05%

Next, we examine operating margin to help evaluate the industry’s operating efficiency. The operating margin for Health Care Providers was 6.72% in 2006, which means that for every dollar of sales, the industry keeps $.0672 after costs of goods sold and operating costs are deducted. This margin is also low compared to the sector and market, which can be influenced by the rising costs of prescription drugs and medical costs.

Puhl/Woulfe 29 Operating Margin S&P 500 HC Sector HC Providers

2000 17.61% 16.71% 6.99%

2001 15.47% 16.01% 6.79%

2002 15.68% 15.82% 7.46%

2003 15.97% 15.69% 7.08%

2004 16.47% 16.39% 7.01%

2005 16.51% 15.60% 7.10%

2006 16.94% 14.71% 6.72%

Lastly we will look at the net profit margin to determine the percentage of sales retained after costs are deducted. The net profit margin for Health Care Providers in 2006 was 3.14%, which was less than both the sector and the market, once again indicating weakness. Net Profit Margin S&P 500 HC Sector HC Providers

2000 6.44% 7.09% 1.87%

2001 2.42% 8.13% 2.13%

2002 0.90% 7.39% 1.66%

2003 5.89% 6.90% 2.93%

2004 6.35% 7.37% 2.79%

2005 7.28% 7.68% 3.37%

2006 7.80% 7.65% 3.14%

Although the margins presented do not indicate high profitability for the Health Care Providers industry, many large companies are effectively handling rising health care costs and yielding competitive margins. For example, WellPoint posts a five-year average operating margin of 9.03% and a net profit margin of 5.31%, which is notably higher than the industry (Reuters). In addition, UnitedHealth Group posts a five-year average operating margin of 10.25% and a net profit margin of 6.19% (Reuters). This indicates that the larger health care providers can adequately handle rising health care costs, whereas the industry averages may be tainted by smaller firms that are easily susceptible to price fluctuations. ROE Decomposition Ratios Asset Turnover Leverage Op. Profit Margin Interest Burden Tax Burden Return on Equity Net Income Margin

Health Care Providers & Services 2000 2001 2002 2003 1.1097 1.2285 1.3096 1.3626 4.4431 3.9868 3.8603 3.6225 5.08% 4.83% 5.87% 5.82% 0.5935 0.7639 0.7533 0.8027 0.6207 0.5783 0.3742 0.6268 9.22% 10.45% 8.37% 14.46% 1.87% 2.13% 1.66% 2.93%

2004 1.4042 3.1818 5.67% 0.7992 0.6157 12.46% 2.79%

2005 1.5319 2.7739 5.90% 0.8986 0.6359 14.31% 3.37%

2006 1.6221 2.8285 5.68% 0.8754 0.6322 14.42% 3.14%

Puhl/Woulfe 30

Ratios Asset Turnover Leverage Op. Profit Margin Interest Burden Tax Burden Return on Equity Net Income Margin

2000 0.9704 2.7962 13.65% 0.7864 0.6609 19.25% 7.09%

Health Care Sector 2001 2002 0.9671 0.9658 2.6633 2.5902 13.53% 13.43% 0.8207 0.8746 0.7320 0.6293 20.94% 18.49% 8.13% 7.39%

Ratios Asset Turnover Leverage Op. Profit Margin Interest Burden Tax Burden Return on Equity Net Income Margin

2000 0.8580 2.9279 12.03% 0.8681 0.6167 16.17% 6.44%

2001 0.7871 2.9280 9.45% 0.4860 0.5272 5.58% 2.42%

S&P 500 2002 0.7619 3.2714 10.46% 0.5362 0.1604 2.24% 0.90%

2003 0.9039 2.3991 13.18% 0.7353 0.7119 14.97% 6.90%

2004 0.9062 2.2672 13.37% 0.8061 0.6836 15.13% 7.37%

2005 0.9700 2.1277 12.61% 0.8853 0.6873 15.84% 7.68%

2006 0.9986 2.1413 11.85% 0.8317 0.7761 16.35% 7.65%

2003 0.7633 3.0318 11.02% 0.7819 0.6838 13.63% 5.89%

2004 0.7976 2.9111 11.83% 0.8115 0.6610 14.74% 6.35%

2005 0.8387 2.7673 12.16% 0.9002 0.6647 16.89% 7.28%

2006 0.8531 2.6662 12.58% 0.9062 0.6836 17.73% 7.80%

The tables above contain the DuPont Analysis for the Health Care Providers and Services Industry, the Health Care Sector and the S&P 500 Index (WRDS). The first ratio considered in this analysis is the asset turnover ratio, sales divided by assets, which appears strong for the Health Care Providers industry compared to the sector and S&P 500. This implies that the Health Care Providers industry uses its assets efficiently to generate revenue. Additionally, the asset turnover ratio for the industry has been increasing since 2000, indicating solid growth. The next ratio is the leverage ratio, assets divided by equity, which is higher for Health Care Providers than for the sector or market. Although high leverage ratios can sometimes be interpreted as unacceptably risky, the leverage ratio for Health Care Providers has been declining since 2000, which shows the industry is stabilizing The following three ratios contribute to net profit margin. The Operating Margin ratio, operating profit divided by sales, is relatively low for Health Care Providers compared to the Health Care sector. This can be attributed to the high operating margins earned by the biotechnology and pharmaceutical industries that help inflate the operating margin of the sector. Additionally, operating margin tells us what proportion of a company’s revenue remains after

Puhl/Woulfe 31 paying variable costs (Investopedia). A high operating margin indicates ability to cover fixed costs, however, the Health Care Providers industry has fewer fixed costs than the rest of the sector (i.e. Health Care Equipment and Supplies, Pharmaceuticals, etc.) and therefore its relatively lower operating margin should not be cause for alarm. Next, we consider the Interest Burden, pretax income divided by operating profit. The interest burden for Health Care Providers is close to that of the sector. Interest burden rose for five years and peaked in 2005 for the Health Care Providers industry, and then declined in 2006. As the number approaches one it shows that interest is having less of an effect on pretax income of companies within this industry. The Tax Burden, net income divided by pretax income, remained relatively flat for the Health Care Providers industry and was consistently less than the sector since 2003. These numbers indicate that tax may be a burden on net income for the industry. Since the tax burden has not decreased significantly in the past few years taxes may continue to impact the sector and industry. The Return on Equity (ROE) can be computed using DuPont Analysis by multiplying the previously mentioned five ratios. The ROE for Health Care Providers appears healthy, although it is slightly lower than the sector and market, as illustrated below. It is important to note the growth of this industry, which can be seen as the industry’s ROE grew 14.9% in 2005, compared with the 4.7% ROE growth for the sector as a whole. This indicates vast potential for the industry in upcoming years, especially when coupled with the external factors previously discussed.

Puhl/Woulfe 32

ROE 25.00% 20.00% HC Providers

15.00%

HC Sector 10.00%

S&P 500

5.00% 0.00% 2000

2001

2002

2003

2004

2005

2006

Year

Net Income Margin Net Income Margin can be calculated by multiplying operating margin, interest burden and tax burden together. By looking at the charts used for the ROE decomposition, we see that the Net Income Margin for the Health Care Providers industry is less than that of the sector and market. Although the net income margin is not very high, like ROE it experienced large growth in 2005 of 20.8%, compared to the sector’s 4.19% growth for net income margin. The sector as a whole has been increasing slowly or flattened for the past four years, implying that that profitability is sustainable and that there is capital available to invest in future projects.

Puhl/Woulfe 33

Net Income Margin 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00%

HC Providers HC Sector S&P 500

2000

2001

2002

2003

2004

2005

2006

Year

Financial Analysis: Pharmaceutical Industry Sales and Earnings The pharmaceutical industry is a defensive industry and investors should consider it in times of recession. Earnings have grown in every year from 1996-2006, except for 2003; sales have grown in every year. The industry even grew during the 2001 recession. Lower nonoperating income and a large expense for special items contributed to the drop in income in 2003 when sales remained steady. Growth in this industry, however, has slowed in the past few years. Throughout the nineties, sales grew each year by close to 10% but since then have leveled off to about 3%. This could indicate that the market is becoming saturated because, by contrast, the S&P 1500 has had increasing sales growth since 2003 from 3.84% to 8.95%. This growth shows that sales in the overall market are not slowing down, just sales in the pharmaceutical industry. Earnings, on the other hand, remain volatile. Earnings growth ranged from -24.22% in 2003 to 32.10% in 2001 throughout the ten year period. Uncertain earnings make investment decisions more difficult, but, once again, earnings growth was only negative in one year. Also, this

Puhl/Woulfe 34 volatility follows the pattern of the overall market. The S&P 1500 declined -31.55% in earnings in 2002 only to bounce back in 2003 by growing 192.47. Therefore, unstable earnings growth should not trouble investors too greatly. Finally, the industry has achieved positive earnings per share since 1996, which have grown in every year except for 2003. However, the EPS of the pharmaceutical industry have been less than the overall market in certain years. This loss in earnings may only be temporary due to the increase in expenses on special items in the drug industry, but it may also reflect the saturation of the pharmaceutical market and slowing sales growth in the industry.

Sales Growth per Year 12.00% 10.00%

Percentage Sales Growth

8.00% 6.00% 4.00% Pharmaceutical Industry

2.00%

Market

0.00% -2.00%

2002

2003

2004

-4.00% -6.00% -8.00% Year

2005

2006

Puhl/Woulfe 35

Earnings Growth per Year 250.00%

Earnings Growth

200.00%

150.00% Pharmaceutical Industry

100.00%

Market

50.00%

0.00% 2002

2003

2004

2005

2006

-50.00% Year

Earnings per Share 20 18 16 14 EPS

12 Market

10

Pharmaceuticals

8 6 4 2

19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06

0

Ye ar

Margins The pharmaceutical industry has returned profit margins much higher than those of the overall market average (measured by the S&P 1500). In 2006, the industry had a net income margin (net income/sales) of 20.42% compared to only 8.49% for the market. This number

Puhl/Woulfe 36 indicates that the pharmaceutical industry earned 20.42 cents on every dollar of sales. As the difference between the two margins implies, this is very good. The industry has consistently earned high profit margins such as this for the past twelve years. It averaged a 16.27% net income margin from 1995-2006. More recently, the margin has averaged 17.04% compared to only 5.92% in the market (2001-2006). The comparison between operating margins (operating income/sales) produces similar results. In 2006, the pharmaceutical industry had an operating margin of 24.11% compared to the market’s 16.46%. The six-year average for the pharmaceutical industry was 25.45% and 14.24% for the overall market. These dramatic spreads may indicate that the pharmaceutical industry does a much better job controlling its costs than the majority of other industries. It also could reflect the high mark-ups on pharmaceutical drugs. Either way, it shows strong profitability in the industry. Operating Margins per Year 30.00%

Operating Margin

25.00%

20.00% Pharmaceutical Industry

15.00%

Market

10.00%

5.00%

0.00% 2001

2002

2003

2004 Year

2005

2006

Puhl/Woulfe 37

Net Income Margins per Year 25.00%

Net Income Margin

20.00%

15.00% Pharmaceutical Industry Market 10.00%

5.00%

0.00% 2001

2002

2003

2004

2005

2006

Year

Finally, the pharmaceutical industry spends a lot of money on research and development, so it will hopefully continue to receive high gains from this spending as it has in the past. In 2006, the industry spent 19% of sales on research and development, which is a much higher percentage than most other industries. Pharmaceutical companies spend about fives times as much money on research and development as the average manufacturing company (U.S. Congress). While this spending brings the benefit of newer, better drugs, it also carries a high cost for the companies. DuPont Analysis The pharmaceutical industry has achieved a much higher return on equity (net income/total equity) than the overall market in the past. Throughout the nineties, drug companies earned about 30% ROE which has since dropped starting in 2003 to about 20%. The S&P 1500, on the other hand, has increased its ROE throughout the past seven years, but still only tops out at 16.16% as of 2006. Therefore, in the past, pharmaceutical companies have earned higher returns for their shareholders than the average firm.

Puhl/Woulfe 38 The DuPont analysis examines the different components of return on equity to search which are strengths and which are weaknesses. The first, operating income margin (operating income/sales), has already shown to be a strength of the industry. In 2006, the pharmaceutical industry had an operating income margin of 24.11% compared to only 16.46% for the market. This shows that the drug companies receive a good return from their operating activities. The next component, asset turnover (sales/total assets), measures the amount of sales per dollar of assets of the company. Once again, in 2006, the pharmaceutical industry had a higher asset turnover than the S&P 1500. This indicates that the industry generates more sales per dollar of assets than the average company, so asset turnover is not a weakness in the pharmaceutical industry. Next, leverage (total assets/equity) measures the amount of debt used to finance operations, the higher the number, the more debt a company uses. The leverage ratio for the S&P 1500 was 5.377 in 2006 compared to only 1.973 for the drug industry. Therefore, most companies in the market use a lot more debt than the average pharmaceutical company. The use of debt can amplify gains to shareholders, but it can also amplify losses. Because the pharmaceutical industry uses less debt, it is a safer investment based on financial risk than the overall market. The next component, interest burden (pretax income/operating income), measures the effect interest payments have on net profit (before taxes). In 2006, the pharmaceutical industry had an interest burden of .9180, and the S&P 1500 had an interest burden of .7525. The pharmaceutical industries higher interest burden shows that the industry looses less operating income to interest payments than the average company. The leverage ratio is indicative of this result because the drug industry uses less leverage relative to equity than the S&P 1500.

Puhl/Woulfe 39 Finally, the tax burden (net income/pretax income), measures the effect of taxes on final profits. The pharmaceutical industry looses much less income to the government than the average company. Its tax burden was .9225 in 2006 compared to .6843 for the market. The difference in the tax payments are due in part to the high tax breaks drug companies receive for their research and development. This DuPont analysis concludes that the pharmaceutical industry performs better than the overall market in all components of the ROE decomposition except for the leverage ratio (which equates to less financial risk in the industry). These results support the higher ROE for the pharmaceutical industry than for the S&P 1500 and also support investment in the industry because of its superior performance in these areas. The following charts show the consistency of the pharmaceutical industry’s numbers compared to the S&P 1500 from 2001-2006.

2001 2002 2003 2004 2005 2006

OI Margin 0.2607 0.2482 0.2553 0.2728 0.2487 0.2411

2001 2002 2003 2004 2005 2006

OI Margin 0.1204 0.1312 0.1425 0.1447 0.151 0.1646

DuPont Analysis: Pharmaceutical Industry Asset Turnover Leverage Interest Burden 0.804 2.2 0.8513 0.7737 2.2503 1.0117 0.6191 2.0604 0.6867 0.5837 2.0368 0.8111 0.592 1.9791 0.9311 0.5742 1.9728 0.918

Tax Burden 0.7939 0.7305 0.7781 0.7172 0.7046 0.9225

DuPont Analysis: S&P 1500

Cash Flows

Asset Turnover 0.4157 0.3638 0.3469 0.371 0.3744 0.3542

Leverage 5.3003 5.8999 5.6619 5.2029 5.2269 5.377

Interest Burden 0.4593 0.5135 0.6841 0.7382 0.7657 0.7535

Tax Burden 0.5781 0.3464 0.6743 0.6629 0.676 0.6843

Puhl/Woulfe 40 The pharmaceutical industry generated 24.012 in net cash flows from operating activities in 2006. This cash flow is greater than the cash flow for the S&P 1500 which was only 17.423. The industry’s cash flow shows that not only does it generate cash flow from its operating activities, but also that it generates more than the average company in the S&P 1500. The cash flows of the pharmaceutical industry have also consistently grown over the few years. In 2001, they were only 16.026. This trend differs from the S&P 1500 whose cash flows have remained relatively constant around 18 since 2001. The drug companies appear to have found a way to increase their cash flows from operations while other industries have not. Cash flow from investing activities has been negative throughout the entire watch period for the pharmaceutical industry (1996-2006), but it has also been negative for the overall market since 2001. In 2006, the pharmaceutical industry had a cash outflow of -17.551 and the S&P 1500 had a cash outflow of -23.614. This result shows that both the pharmaceutical industry and the overall market spend considerable amounts of cash (comparable to cash inflows) on investments in their businesses each year. The investment expenditures for the pharmaceutical industry vary widely from year to year, so predicting the net cash flow from investing activities is a difficult task. For example, in 2005, the net cash inflow was -2.715 compared to the -17.551 in 2006. On the other hand, the overall market seems to hover around the high teens/low twenties. Finally, the pharmaceutical industry has expended much more cash in the recent past on financing activities than the S&P 1500. In 2006, its net cash flow from financing was -15.736 compared to 6.278 for the overall market. These numbers indicate that the drug companies, on average, have spent more money on paying of loans, redeeming shares, etc. While the lowering

Puhl/Woulfe 41 of debt could help the industry to reduce interest expenses, investors should be concerned with the large outflow of cash for financing activities.

Valuation Analysis: Health Care Providers and Services Industry Price to Earnings Ratio Analysis of the P/E ratio helps determine if a sector is overpriced based on its past earnings. The table below provides a summary of historical P/E ratios for all firms in Compustat, the Health Care Sector and the Health Care Providers industry.

Market Health Care Sector Health Care Providers

2003 23.11 32.20 21.02

P/E 2004 20.26 31.57 22.71

2005 18.37 28.64 24.97

2006 15.67 25.96 20.94

The current P/E ratio for 2008 for Health Care Providers is 18.7, which is 15.8 points lower than the Health Care Sector, which has a current P/E ratio of 34.5 (Yahoo). Given both the historical and current P/E ratios of the Health Care Providers Industry, it appears the industry is reasonably priced because it is less than the sector. This is reflected in the fact that the Providers industry is mature, whereas the sector may be influenced from the high growth phase for biotechnology and pharmaceuticals. The Health Care Providers industry may experience a period of growth in the future as the Baby Boomer generation ages, which could stimulate P/E metrics in upcoming years. As far as leaders for the industry are concerned, APM’s company UnitedHealth Group is pretty competitive. There are few firms above 17, with many clustering around 14 mark, which is where UnitedHealth comes in. Leaders in P/E Ratio February 2008 Health Net Inc. [HNT] 27.21 Sierra Health [SIE] 21.99 Magellan Health Serv [MGLN] 20.12 Molina Healthcare [MOH] 18.94 Amerigroup Corp [AGP] 17.38 Aetna Inc. [AET] 14.63

Puhl/Woulfe 42 Humana [HUM] UnitedHealth Group [UNH] Coventry Health Care[CVH] WellPoint Inc. [WLP]

14.01 13.96 13.73 13.51

Yahoo

Price to Book Ratio The P/B ratio compares market valuation against book valuation, meaning the higher the ratio the more the market is willing to pay above the book value of equity. The table below provides past data for the P/B ratio of all firms in Compustat, the Health Care Sector and the Health Care Providers industry.

Market Health Care Sector Health Care Providers

2003 2.44 4.44 2.65

P/B 2004 2.48 3.95 2.75

2005 2.54 3.94 3.07

2006 2.55 3.78 3.05

WRDS

The current P/B ratio for 2008 Health Care Providers is 13.2, which is .91 points higher than the sector and 10.8 points higher than the market (Yahoo). These difference make the Providers Industry and Health Care sector appear extremely overpriced, however, P/B may not be a good valuation tool for the health care sector because it typically valued by its intellectual capital, including patents, intellectual property, etc. versus the tangible capital that is seen in other sectors. The P/B ratios for the Health Care Provider industry are compiled below. We can see that many companies cluster around 3 points, with exception to Sierra Health. Again, UnitedHealth Group is seen as a competitive company, but its high P/B ratios relative to competitors may indicate overpricing. Leaders in P/B Ratio February 2008 Sierra Health [SIE] Metropolitian Health Networks [MDF] Wellcare Health Plans [WCG] Cigna [CI] UnitedHealth Group [UNH]

7.75 3.41 3.33 3.19 3.05

Puhl/Woulfe 43 Humana [HUM] Health Net Inc[HNT] Aetna [AET] Coventry Health Care[CVH] Health Spring Inc. [HS]

2.9 2.8 2.65 2.54 2.38

Yahoo

Price to Sales The P/S ratio examines how much the market pays for each unit of sales, with the desire for the metric to be low (reflecting a low cost per each unit of sales). The table below provides past data for the P/S ratio of all firms in Compustat, the Health Care Sector and the Health Care Providers industry. 2003 1.25 2.31 0.58

Market Health Care Sector Health Care Providers WRDS

P/S 2004 1.31 2.30 0.68

2005 1.32 2.22 0.77

2006 1.43 2.21 0.65

The current P/S ratio for Health Care Providers is 1.03, which is 1.38 points less than the market and .37 points less than the health care sector (Yahoo, Compustat). This current valuation reflects the historical ratios above, meaning that the industry is competitive in its P/S metric. 2006 Market Health Care Sector Health Care Providers

P/E 15.67 25.96 20.94

P/B 2.55 3.78 3.05

ROE 17.73 16.35 14.42

P/S 1.43 2.21 0.65

Net Profit Margin 7.79 7.65 3.14

P/B Analysis Overpriced Overpriced

P/S Analysis Overpriced Fairly Priced

By combining these metric valuations we can further analyze the drivers of these ratios and determine if the sector and industry are fairly priced. We know that ROE is a driver of the P/S ratio, therefore if the ROE is lower than the market, but the P/B ratio is higher, we know that overpricing has occurred, which was the case for the sector and industry in 2006. This is not alarming because, as mentioned previously, P/B analysis may not be as fitting for the health care sector. P/S Analysis shows us that the Health Care Providers industry was fairly priced because

Puhl/Woulfe 44 its P/S metric was lower than the market, as was its net profit margin. The large health care provider companies do not vary greatly in their valuation ratios from the industry as a whole. Most of these providers post P/S metrics less than one, which is considered competitive in the market and likely driven by rising industry costs.

Valuation Analysis: Pharmaceutical Industry Price to Earnings The pharmaceutical industry is properly valued according to its current P/E ratio of 15.90. Although this number is much smaller than the P/E ratio of the entire healthcare sector (34.46), the sector’s high ratio could indicate than many firms in healthcare are overvalued. It also may reflect the high price premiums given to stocks such as biotechnology because of their high expected growth. Growth drives the P/E ratio, so firms with high ratios should, according to investor expectations, grow faster than the overall market. When a company does not grow as quickly as expected, however, its past P/E ratio turns out to have been too high because investors bid up the price. The industry’s P/E ratio compares to the overall market’s (measured by the S&P 500) of 13.6. As indicated earlier, the earnings growth in the pharmaceutical industry has begun to decline, and it has started to move towards the maturity phase. Therefore, its growth should begin to closely mirror that of the market because a mature firm grows at the rate of the market. It still deserves a slightly higher P/E ratio, however, because its earnings have still grown faster than the market. In 2006, earning grew by 29.25% in the pharmaceutical industry and only 18.27% in the overall market. The following chart compares the P/E ratios and earnings growth

Puhl/Woulfe 45 of both the healthcare sector and the pharmaceutical industry compared to those of the S&P 1500. It demonstrates the tendency in the past for both to be overvalued compared to the overall market.

2003 2004 2005 2006

Market P/E 23.11 20.26 18.37 15.67

Health Care P/E 32.2 31.57 28.64 25.96

Drug P/E 37.12 26.19 21.25 18.76

Price to Earnings Ratio Analysis Market Health Care Drug Earnings Earnings Earnings Growth Growth Growth 192.47% 3.47% -24.22% 18.46% 16.60% 18.14% 22.14% 14.50% 6.15% 18.27% 12.13% 29.25%

Health Care overvalued overvalued overvalued overvalued

Drug overvalued overvalued overvalued overvalued

The firms that make up the pharmaceutical industry mostly have P/E ratios near the average for the entire industry. GlaxoSmithKline, Johnson & Johnson, and Pfizer all have P/E ratios of 12.04, 17.31, and 18.67 respectively. Merck & Co. stands out among the industry leaders with a P/E ratio of 31.81. These results show that most companies are expected to follow the path of the overall industry as their implicit expected growth indicates (Yahoo Finance). Price to Book Unlike its P/E ratio, the pharmaceutical industry has a P/B ratio much greater than that of the market, but it still appears to be properly valued. The current P/B ratio of the pharmaceutical industry is 10.25 while the overall market has a P/B ratio of 2.4. ROE drives the P/B ratio; stocks with higher ROE’s should have higher P/B ratios. The previous ROE decomposition of both the pharmaceutical industry and the S&P 1500 demonstrated the superior return on equity of the pharmaceutical industry (23.13% in 2006 compared with 16.16%). Therefore, the P/B of the industry should be higher than that of the overall market. The following chart compares the P/B ratios and ROE’s of the healthcare sector and the pharmaceutical industry with the S&P 1500 to determine their values based on this ratio.

Puhl/Woulfe 46 Price to Book Ratio Analysis Market Health Care Drug ROE ROE ROE

Market P/B

Health Care P/B

Drug P/B

2003

2.44

4.44

5.09

12.92%

14.97%

17.40%

2004

2.48

3.95

4.14

13.67%

15.13%

17.44%

2005

2.54

3.94

3.89

15.30%

15.84%

19.12%

2006

2.55

3.78

3.86

16.16%

16.35%

23.13%

Health Care properly valued properly valued properly valued properly valued

Drug properly valued properly valued properly valued properly valued

The P/B ratios of the pharmaceutical industry and the healthcare sector relate closely, 10.25 and 12.29 respectively. However, the healthcare industry has a much lower ROE, currently 15.07%, compared to the pharmaceutical industry’s current ROE of 24.20%. Therefore, the healthcare sector may be overvalued according to its P/B ratio. The major firms in the pharmaceutical industry have significantly lower P/B ratios than the overall industry. GlaxoSmithKline, Johnson & Johnson, and Pfizer all have P/B’s of 6.31, 4.15, and 2.29 respectively. Except for Pfizer with an ROE of 12.13%, these firms had higher ROE’s of 54.92% and 25.52% respectively. Therefore, GlaxoSmithKline and Johnson & Johnson appear to be undervalued. However, ROE is not the only driver of stock price, so this result is not conclusive. Price to Sales The pharmaceutical industry has a significantly higher P/S ratio compared to the S&P 500, but it is still properly valued by this ratio. According to Morningstar, the pharmaceutical industry has a current P/S of 3.81 compared to 1.4 for the S&P 500.

The firms in the

pharmaceutical industry display similar results for their P/S ratios. GlaxoSmithKline, Johnson & Johnson, Merck, and Pfizer reported P/S of 2.98, 3.15, 4.33, and 3.33 respectively. Net income margins drive the P/S ratios. As demonstrated earlier, the pharmaceutical industry has returned a much higher net income margin than the overall market. In 2006, the

Puhl/Woulfe 47 pharmaceutical industry had a net income margin of 20.42% compared to only 8.49% for the overall market. These dramatic results highly support investing in this industry. The entire healthcare sector, on the other hand, does not have as good of a net income margin. Its margin hovers close to that of the S&P 1500. The following chart shows the comparison in these ratios. Price to Sales Ratio Analysis Market P/S

Health Care P/S

Drug P/S

Market NI Margin

Health Care NI Margin

Drug NI Margin

2003

1.25

2.31

4.02

6.58%

6.90%

13.64%

2004

1.31

2.3

3.7

7.08%

7.37%

15.87%

Health Care properly valued properly valued

2005

1.32

2.22

3.41

7.82%

7.68%

16.32%

overvalued

2006

1.43

2.21

3.57

8.49%

7.65%

20.42%

overvalued

Drug properly valued properly valued properly valued properly valued

Conclusion The class should weight the healthcare sector by 14% in the portfolio, an increase from its current weight. This sector will provide the necessary defense in a market that looks poised for a recession. Both the healthcare providers and services industry and the pharmaceutical industry show good investment opportunities to not only protect against any economic downturns but also to increase the returns of the portfolio.

Works Cited Burke, John, and Pierce, Adam. Health Care Sector Report. John Cook School of Business, Saint Louis University. St. Louis, 2006. 1-45. CIA. “United States.” The CIA World Fact Book. 7 Feb. 2008. . Compustat 2007. Wharton Research Data Services. . Congressional Budget Office. “Research and Development in the Pharmaceutical Industry.” U.S. Congress. Oct. 2006.

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