Morningstar Advisor - August/September 2010 - 28

Spotlight

An Opportune Time to Bet the Pharm
By Damien Conover

Investors hammered drug stocks after health-care reform. They’re missing the more-important story: the move toward orphan drugs and emerging markets.

You wouldn’t know it by looking at stock prices, but good things are happening in the pharmaceutical industry. True, health-care reform will alter the way drug companies do business, but the changes won’t harm long-term profits. Over the next 10 years, we project that the cost of reform to pharma’s profits will be mostly offset by the new profits that reform brings to the industry. Postreform, pharmaceuticals is still a terrific business. Meanwhile, as sales flatten in the United States and Europe and patents expire, companies are targeting promising areas for growth, including niche drugs and emerging markets. When investors stop wringing their hands over the meaning of health-care reform and start to focus on all the opportunities ahead, the good values in pharma stocks will start drying up. Until then, there are good deals to be made in strong pharmaceutical companies ready to prosper in an era of reform.
For Pharma, It’s a Wash

companies will pay annual fees to the government based on market share in government programs such as Medicare and Medicaid. These industry fees will help pay for government drug programs and will total $28 billion over 10 years. Second, rebates to Medicaid will increase to 23.1% from 15.1%, costing the industry just more than $2 billion annually, according to the Congressional Budget Office. Third, the drug industry is on the hook for helping to close the so-called “doughnut hole” that occurs annually in Medicare Part D. After a patient has spent $2,700 on prescriptions, he or she must pay the full cost of drugs until spending reaches $6,154, when coverage resumes. The cost to the industry to help close the coverage gap is approximately $35 billion over 10 years, according to the Senate Finance Committee. Reform, however, will bring a stream of $76 billion in new profits to drug companies during the next decade. A couple of factors limit the windfall. Although we expect the number of insured people in the United States to increase by 14% under reform by 2019, we project that reform will bring only a 5% increase in U.S. drug sales. Most of these newly insured patients will be young, and we think that this relatively healthy group

will spend a fraction of what currently insured patients spend on drugs. Further, an uninsured person already spends a high percentage (70%) of the amount on health care that an insured person spends, according to a Kaiser Commission study. This fact limits the upside for the drug industry. In the end, the impact on the pharmaceutical industry is essentially neutral: $24 billion net negative over the next 10 years. For a business that we forecast to make close to $1.5 trillion in profits over the same period, reform does not materially alter the industry’s prospects. In the second quarter, however, investors didn’t share our view, but they were not seeing the whole picture. Investors pummeled pharma stocks (many were down by 15% to 18%) as direct costs associated with reform made their way onto financial statements and annual forecasts. For a number of big-pharma firms, especially Eli Lilly LLY, the charges were slightly higher than our expectations but consistent with our view that reform will weigh most heavily on the industry’s earnings per share—by as much as 5% annually— for the first few years of reform when the costs are high and the benefits of newly insured patients have yet to materialize.

We estimate that health-care reform will cost the drug industry $100 billion during the next 10 years. The largest costs come from three areas. Starting in 2011, pharmaceutical

28 Morningstar Advisor August/September 2010



Morningstar Advisor - August/September 2010

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2010

Morningstar Advisor - August/September 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What Aspects of Health-Care Reform Will Most Affect Your Clients?
Bonds, Chicago Style
Investment Briefs
Which Risk Are You Managing?
Eye on the Prize
Advisors Can’t Rely on Fidelity Alone
Health Care Gets Back to Business
An Opportune Time to Bet the Pharm
Reform’s Impact on Other Health-Care Industries
Top Takeover Targets in Biotech
After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Health-Care Investing Alive and Well
Quest for Knowledge
Four Picks for the Present
How to Make Your Bond Portfolio Inflation-Resistant
Weeding Through the Energy Patch
Uncertainty and Value in Basic Materials
Stock Market Doom-Busters
Hunting Down European Debt-Dodgers
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks With Wide Moats
VA Sales Slip a Bit in First Quarter
New at Morningstar
Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Morningstar Advisor - August/September 2010
Morningstar Advisor - August/September 2010 - Cover2
Morningstar Advisor - August/September 2010 - 1
Morningstar Advisor - August/September 2010 - 2
Morningstar Advisor - August/September 2010 - Contents
Morningstar Advisor - August/September 2010 - 4
Morningstar Advisor - August/September 2010 - 5
Morningstar Advisor - August/September 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - August/September 2010 - 7
Morningstar Advisor - August/September 2010 - Contributors
Morningstar Advisor - August/September 2010 - Letter From the Editor
Morningstar Advisor - August/September 2010 - What Aspects of Health-Care Reform Will Most Affect Your Clients?
Morningstar Advisor - August/September 2010 - 11
Morningstar Advisor - August/September 2010 - Bonds, Chicago Style
Morningstar Advisor - August/September 2010 - 13
Morningstar Advisor - August/September 2010 - Investment Briefs
Morningstar Advisor - August/September 2010 - 15
Morningstar Advisor - August/September 2010 - Which Risk Are You Managing?
Morningstar Advisor - August/September 2010 - 17
Morningstar Advisor - August/September 2010 - 18
Morningstar Advisor - August/September 2010 - Eye on the Prize
Morningstar Advisor - August/September 2010 - 20
Morningstar Advisor - August/September 2010 - 21
Morningstar Advisor - August/September 2010 - Advisors Can’t Rely on Fidelity Alone
Morningstar Advisor - August/September 2010 - 23
Morningstar Advisor - August/September 2010 - 24
Morningstar Advisor - August/September 2010 - 25
Morningstar Advisor - August/September 2010 - 26
Morningstar Advisor - August/September 2010 - Health Care Gets Back to Business
Morningstar Advisor - August/September 2010 - An Opportune Time to Bet the Pharm
Morningstar Advisor - August/September 2010 - 29
Morningstar Advisor - August/September 2010 - Reform’s Impact on Other Health-Care Industries
Morningstar Advisor - August/September 2010 - 31
Morningstar Advisor - August/September 2010 - 32
Morningstar Advisor - August/September 2010 - Top Takeover Targets in Biotech
Morningstar Advisor - August/September 2010 - 34
Morningstar Advisor - August/September 2010 - 35
Morningstar Advisor - August/September 2010 - After Reform, Narrow-Moat Firms Have Strong Prospects in Diagnostics
Morningstar Advisor - August/September 2010 - 37
Morningstar Advisor - August/September 2010 - 38
Morningstar Advisor - August/September 2010 - 39
Morningstar Advisor - August/September 2010 - 40
Morningstar Advisor - August/September 2010 - Health-Care Investing Alive and Well
Morningstar Advisor - August/September 2010 - 42
Morningstar Advisor - August/September 2010 - 43
Morningstar Advisor - August/September 2010 - 44
Morningstar Advisor - August/September 2010 - 45
Morningstar Advisor - August/September 2010 - 46
Morningstar Advisor - August/September 2010 - 47
Morningstar Advisor - August/September 2010 - 48
Morningstar Advisor - August/September 2010 - Quest for Knowledge
Morningstar Advisor - August/September 2010 - 50
Morningstar Advisor - August/September 2010 - 51
Morningstar Advisor - August/September 2010 - Four Picks for the Present
Morningstar Advisor - August/September 2010 - 53
Morningstar Advisor - August/September 2010 - How to Make Your Bond Portfolio Inflation-Resistant
Morningstar Advisor - August/September 2010 - 55
Morningstar Advisor - August/September 2010 - 56
Morningstar Advisor - August/September 2010 - 57
Morningstar Advisor - August/September 2010 - Weeding Through the Energy Patch
Morningstar Advisor - August/September 2010 - 59
Morningstar Advisor - August/September 2010 - 60
Morningstar Advisor - August/September 2010 - Uncertainty and Value in Basic Materials
Morningstar Advisor - August/September 2010 - 62
Morningstar Advisor - August/September 2010 - 63
Morningstar Advisor - August/September 2010 - Stock Market Doom-Busters
Morningstar Advisor - August/September 2010 - 65
Morningstar Advisor - August/September 2010 - Hunting Down European Debt-Dodgers
Morningstar Advisor - August/September 2010 - 67
Morningstar Advisor - August/September 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - August/September 2010 - 69
Morningstar Advisor - August/September 2010 - 70
Morningstar Advisor - August/September 2010 - 71
Morningstar Advisor - August/September 2010 - 50 Most Popular Equity ETFs
Morningstar Advisor - August/September 2010 - 73
Morningstar Advisor - August/September 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - August/September 2010 - 75
Morningstar Advisor - August/September 2010 - VA Sales Slip a Bit in First Quarter
Morningstar Advisor - August/September 2010 - 77
Morningstar Advisor - August/September 2010 - 78
Morningstar Advisor - August/September 2010 - New at Morningstar
Morningstar Advisor - August/September 2010 - Star Wars, the Sequel
Morningstar Advisor - August/September 2010 - Cover3
Morningstar Advisor - August/September 2010 - Cover4
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