US Healthcare Demand, Part 1: ‘Baseline’ Growth

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This note quantifies a ‘baseline’ rate of real growth in US healthcare demand, which we define as the rate of growth one would expect sans any upcoming secular, cyclical, or reform effects

We estimate baseline growth of 4.8% +/- 0.9% through 2021. This consists of 80bp population growth, 70bp population aging effect, 2.1% increase in age-adjusted per capita utilization, and 1.2% real pricing

This 4.8% estimate of forward real demand growth is 80bp higher than occurred since 1990, but on par with real demand growth since 1970. Most recent (2Q12) real demand growth (for health services only) was just 1.8%, well below historic averages and our forward ‘baseline’ estimate. The current (2Q12) growth rate in age-adjusted per capita utilization (1.2%) is almost half the ‘normal’ or ‘baseline’ rate, reflecting high rates of unemployment (and thus low penetration of employer-sponsored health insurance)

Healthcare trades at a relative (trailing) PE of 0.95x the broader SP500; below the longer-term trend of 1.06x. If the market genuinely expected our baseline of 4.8% real demand growth the relative multiple should be >1.0x. This suggests the market believes the net impact of secular, cyclical, and/or reform effects will be to reduce demand growth below the baseline rate

Judging by the pattern of valuations across healthcare sub-sectors, the market has confidence in underlying unit demand, but skepticism regarding future contributions of innovation and pricing

Non-Rx Consumables (e.g. BCR, BDX, OMI, CFN) and Diagnostic Laboratories are far more reliant on underlying volume demand than on innovation or real pricing power; these sub-sectors trade at parity to the SP500, which implies market faith in underlying demand volumes

Hospitals and Commercial HMOs trade at steep discounts to the SP500 (0.7x and 0.8x, respectively); given the market’s apparent expectation of strong unit demand, the discount almost certainly reflects non-volume related concerns. Hospital valuations imply negative real pricing; this assumption is too severe, and we see Hospitals as a value. Commercial HMOs imply some combination of rising MLRs near-term and disintermediation middle- to longer-term; we expect stable MLRs and see the Commercial HMOs as a value in front of the reform roll-out; however after the roll-out of reforms disintermediation pressures are likely to build steadily if employers shift employees to health insurance exchanges

Major Pharmaceuticals trade at a discount to healthcare and the SP500, implying either or a combination of two scenarios: continued mix erosion even after the current generic ‘wave’; and/or lost real pricing power. Both of these pressures are likely, so the discount makes complete sense. In contrast Biotech trades at a premium; we believe this fairly reflects longer product lifecycles and more sustainable pricing power than is the case with more traditional drugs. Current valuations give Biotech only limited credit for probable levels of innovation and pricing power, and if anything appear too low

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