As concerns surrounding pricing power for drugs is partially abating, market valuations in healthcare have increased over the past quarter, with drug companies rallying. The recent aggregate healthcare price to fair value of 0.98 is up from 0.87 last quarter, but Morningstar equity analysts still see a few undervalued stocks, including Express Scripts (ESRX), Roche (RO), and Allergan (AGN).
We continue to expect near-monopolistic drug pricing as a result of patent protection that supports the core of our moat ratings for the large drug and biotech companies.
While drug prices will likely continue to soften in therapeutic areas with less innovation such as respiratory and diabetes, the innovative therapeutic areas of cancer, immunology, multiple sclerosis, and vaccines are poised for strong pricing power as the innovation is powerful enough to provide the drug companies better leverage in negotiations with the payer groups.
Overall, we continue to see steady gains from research and development. Drugs in certain areas of cancer, especially immuno-oncology, are reaching the market at half the time of drugs developed a decade ago, partly due to major advancements in science and clinical designs but also due to more accommodative health-care regulatory groups. Recent approvals in lung cancer by immuno-oncology drugs look particularly well positioned to drive a major source of drug spending.
We expect immunooncology drugs to eventually cover most of the major cancer indications. On the political landscape side, seeking to fulfil the long-standing Republican promise to repeal the Affordable Care Act, Congress faces a tough road to success for several reasons. First, the reality of insurance markets and economics associated with adverse selection are in contradiction to Republican assurances that a replacement plan would cover everyone with quality insurance and cost less money.
Second, Republican reform ideas could lead to eliminating of coverage of more than 20 million Americans newly insured under the ACA, which would likely result in major political backlash. Third, Republicans only wield a narrow majority in the Senate, which means less than a handful of Republican senators are able to scrap a reform bill. Fourth, and perhaps most importantly, there is significant— potentially irreconcilable—disagreement among Republican camps about what policy should replace the ACA.
Dividend Outlook is Positive
Turning to the redeployment of capital allocation, large healthcare companies continue to support dividends, share buy backs, and acquisitions. Johnson & Johnson’s (JNJ) high-cost acquisition of Actelion in the quarter shows the heightened need of larger firms to acquire growth coupled with the low interest rate costs fuelling excessive takeover valuations.
Further, any change in lowering of the U.S. corporate tax rate by the new U.S. government would likely increase the acquisition activity as more international profits would be less restricted by tax losses in bringing the cash back to the U.S. Overall, the low interest rates combined with the need for scale and growth should continue to drive healthcare acquisitions over the next six months.
