Companies and industries we like (and dislike) within health care, financial services, business services, and consumer services.
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By Haywood Kelly, CFA | 01-09-07 | 02:00 PM | Email Article

Health-care Sector
Although the median health-care stock is slightly overvalued in our opinion, we're very excited by the prospects of the health-care sector. Demographics--especially older, wealthier populations--give many of the firms we cover a strong outlook in 2007 and beyond.

Haywood Kelly, CFA, is head of global research at Morningstar. He'd love to hear from you, and promises to read all your e-mail (even if he can't respond to it all).

We're excited about companies like  GlaxoSmithKline  and  Medimmune  that can benefit from increased vaccine demand (think flu and bird flu). Firms that focus on diabetes also stand to do well in upcoming years. Diabetes is one of the most prevalent diseases around the world, and with expanding waistlines and an aging population in the developed world, the disease appears destined to only grow in prevalence.  Novo Nordisk  is the leader in diabetes care. We also like the prospects of  Amylin  and  Mannkind . Several companies are coming up with new "game changing" ways to attack diabetes and hepatitis. Here, we like  Johnson & Johnson ,  Abbott Laboratories , and  Medtronic  (which is working on an artificial pancreas), although given the size of these firms, such new treatments will take awhile to materially affect results. Finally, the market for hepatitis C drugs is more than $2 billion and growing, and more than 40% of patients do not respond to current treatments.  Vertex  is the company we're most excited about in this area.

 Services Super Sector Valuation Measurements--Health Care
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Medical Goods and Services
3.10
0.98
10
Research Services
3.00
1.01
7
Medical Equipment
2.86
1.00
39
Drugs
2.79
1.01
54
Biotechnology
2.63
1.00
52
Diagnostics
2.50
1.04
2
Home Health
2.50
1.11
4
Hospitals
2.44
1.05
10
Physicians
2.43
1.02
7
Managed Care
2.06
1.20
16
Assisted Living
1.50
1.26
2

 

Democratic control of Congress could open a generic pathway for biologics, which means that biotech firms could start to behave more like big pharma and face the same kind of generic competition. This could lead to more acquisitions and in-licensing deals. We expect to see more "seedling" biotechs in Europe and Japan, and we expect to see U.S. firms pick and choose which ones to acquire. We're skeptical that bit generics firms can jump in and benefit. We're bullish on  Teva Pharmaceuticals , for example, but bearish on  Watson Pharmaceuticals .

An industry where we expect to see continued rapid growth is research services. Pharmaceutical and biotech firms are outsourcing more of their drug development, which is why we expect double-digit revenue growth from firms like  Covance ,  ICON , and  Pharmaceutical Product Development .

Financial Services Sector
In the financial services sector over the next five years, we expect to see further consolidation, interest-rate spreads widen and revert to normalized levels, consumer credit quality to deteriorate, continued choppiness in the mortgage market, and insurance pricing to trend weaker.

 Services Super Sector Valuation Measurements--Financial Services
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Insurance (Title)
4.00
0.84
3
Reinsurance
3.33
0.93
12
Super Regional Banks
3.22
0.95
9
Insurance (General)
3.13
0.94
15
Savings and Loans
3.00
0.99
13
Regional Banks
2.81
1.04
54
Securities
2.65
1.02
26
Finance
2.63
1.00
27
Insurance (Life)
2.59
1.04
17
Insurance (Property)
2.58
1.06
38
Money Management
2.47
1.09
17
International Banks
2.38
1.06
38
Real Estate
2.25
1.19
5
REITs
2.04
1.21
76

 

Given this environment--and the negative sentiment on the mortgage market--we expect those companies with durable competitive advantages in the mortgage industry, such as  First American Financial ,  Wells Fargo , and  Countrywide Financial , to handily weather the ups and downs of the housing market. Given our view that spreads will eventually widen, we think large banks like  Bank of America  will benefit. On the flip side, companies leveraged to the sub-prime sector, such as  Gramercy Capital , a commercial mortgage specialist, will likely suffer once credit quality takes a turn for the worse.

We're very bearish on the REIT and real estate industries, mainly because of valuation. REITs as a group rose sharply in 2006 and sport some of the highest prices relative to fair values in our coverage universe. Because of the runup in stock prices, many REITs are now yielding in the neighborhood of 4%, which is less than rates on Treasury bills, which carry far less risk. That's a good sign that valuations are at unrealistic levels. Another sign that worries us: Sam Zell, one of the savviest real estate investors around, decided to sell  Equity Office Properties  to Blackstone Group late in the year. If Sam Zell is selling, do you want to be buying?

Increased participation by large institutional investors has been one major force pushing REITs higher. For years, these institutions had very little of their portfolios dedicated to real estate. For the past few years, these big investors have been ramping up their real estate exposure to reach allocations of between 5% and 10%, which is the optimal allocation that most analysts recommend. Speculation has been another factor behind the extended rally in REITs. In recent years, a number of REITs have been taken private at above-market prices. Those private investors were willing to pay a premium because the purchase price was still cheaper than the cost of constructing new buildings. For a time, this activity fueled speculation that more takeovers were eminent, which also helped lift REITs higher.

Business Services Sector
Several industries within the business services sector appear undervalued to us, particularly firms in the transportation area. In the transportation-miscellaneous industry, firms like  Expeditors International  and  United Parcel Service --both wide-moat firms--appear particularly attractive.

 Services Super Sector Valuation Measurements--Business Services
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Transportation--Misc.
3.57
0.91
15
Land Transport
3.55
0.87
11
Distributors
3.44
0.93
9
Data Processing
3.19
1.02
21
Waste Management
3.11
1.02
9
Business Support
3.00
0.94
15
Security Services
3.00
0.95
1
Consultants
2.67
0.92
13
Employment
2.33
1.09
18
Environmental Control
2.25
1.18
5
Advertising
2.22
1.10
9
Water Transport
2.11
1.25
9
Engineering and Construction
2.09
1.18
11
Business/Online Services
1.96
1.20
24
Air Transport
1.85
1.56
20
Printing
1.67
1.19
3

 

By contrast, we think that airlines are overvalued as a group, and we maintain our belief that this is a highly commodified business. This phenomenon has contributed to the steady decline in real yields (passenger revenue per revenue passenger mile on a constant dollar basis) over many decades. But over any short time period, it's a crap shoot which airlines will perform best. We actually wouldn't be surprised to see some of the restructured (though still higher-cost) legacy carriers do a bit better than the low-cost airlines over the next three years, and we are watching with interest as the industry consolidates and the legacy carriers appear to have learned valuable lessons about capacity restraint.

Elsewhere in the business services sector, we would highlight a few companies and trends that stand out. First, utilities commissions across the country are calling for more investment in infrastructure, which is good for some companies peripheral to the utilities sector--firms like  Fuel Tech  in the environmental control industry. In the distributors industry, we expect to see much more consolidation as customers look to cut costs by sourcing from fewer suppliers. Firms like  MSC Industrial  and  Fastenal  should benefit.

In the employment industry, we expect the next few years to be tougher than the last few, as an already-low unemployment rate and increased wage inflation may indicate a cyclical peak for the industry. Temporary staffing growth has been in decline for 18 months and turned negative for the first time in three years in November 2006. Longer term, we think demographic trends will help staffing firms--as baby boomers retire, firms will be pressured to find workers--but this won't be enough to offset a cyclical downturn over the next few years. One area that's immune: health-care staffing. This niche promises to remain strong regardless of the economic cycle as we expect worker shortages into the foreseeable future driven by demand for care by the aging baby boomers.

In the data-processing industry, we think  Global Payments  and  Heartland Payment Systems  are well positioned. Acceptance of credit and debit cards among small merchants is increasing. Plus, smaller merchants have less pricing power, allowing these companies to better maintain their margins.  First Data , with its STAR network, stands to benefit from debit-card use, which is increasing faster than credit-card use. First Data is also the best positioned in the industry to exploit international markets, which is the next platform for growth for payment processors. China and India have only 0.2 and 0.1 payment cards per capita, respectively, compared with 2.6 in the U.S. Finally,  Western Union  is one of our favorite stocks in the industry; with cross-border money transfers growing at a rapid clip, we expect Western Union to increase revenues about 10% annually through 2010.

Consumer Services Sector
Several industries within the consumer services sector appear attractive to us--including what's probably our biggest contrarian call: homebuilding.

 Services Super Sector Valuation Measurements--Consumer Services
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Home Supply
3.50
0.93
2
Homebuilding
3.35
0.89
17
Auto Retail
3.33
0.93
15
Electronics Stores
3.33
1.00
3
Restaurants
3.33
0.96
21
Discount Stores
3.00
1.01
10
Food Wholesale
3.00
0.94
4
Online Retail
3.00
1.00
10
Education
2.89
0.93
9
Specialty Retail
2.86
0.94
14
Groceries
2.69
1.02
13
Furniture Retail
2.67
1.06
6
Gambling/Hotel Casinos
2.63
1.06
16
Clothing Stores
2.43
1.11
21
Personal Services
2.29
1.10
7
Hotels
2.20
1.21
10
Department Stores
1.83
1.41
7

 

For homebuilders, we're anticipating a moderately hard landing. On average, we expect a 10%-30% drop in unit volume for these companies over the next year and a half. For total housing starts, we're forecasting a 14% decline in 2007, and then flat in 2008. Beyond that, we expect moderate 5% annual growth. Given the hardship many homebuilders are facing, we expect to see the industry consolidate further.

The knock-off effect to other industries will be pervasive. The big-box retailers will be affected directly, while other retailers will feel it indirectly. There will be much less need for construction labor throughout the country, as builders are already mentioning they've laid off 10%-15% of employees, not even counting the direct labor (which is all farmed out). Real estate agents and mortgage brokers will also feel the pinch.

Moving to retailers, retail results from November and December 2006 suggest that we'll see a recurrence of the themes we saw over the past year: strong spending from affluent consumers, shakeout among mid-range department stores, increasing competition for home electronics spending, and solid performance from strong merchandisers.

Demand for luxury goods remains strong, and we expect this trend to continue into 2007. With the stock market finishing 2006 on a high note and investment banks doling out healthy bonuses, we believe the affluent consumer will continue to spend on discretionary items. Retailers like  Coach ,  Nordstrom , and  Tiffany  that provide unique, high-quality products in addition to superior customer service are well positioned to benefit from this trend. While these stocks are not currently undervalued in our opinion, we like the companies and would buy shares at the right price.

Armed with a national chain under the Macy's name, we think  Federated  will make a comeback in 2007. Consolidation among mid-tier department store chains has been rampant in the past couple of years, and Federated has emerged as the dominant player. We believe advertising under a single name will benefit Federated's bottom line in 2007; however, the pressure is on this retailer to provide differentiated merchandise to compel consumers to shop in its stores.

We have seen a surge in spending in the consumer-electronics category and anticipate this will continue in 2007. We expect additional margin compression in the upcoming year on home electronics, particularly flat-screen TVs, given the increased rivalry in this category. With the competition heating up, we expect players like  Best Buy  will try to differentiate themselves by enhancing their service offering.

The retail space is becoming increasingly crowded, placing a greater emphasis on product differentiation. We think retailers, like  Target  and  Chico's , that know their customers well and have solid merchandising teams in place will outperform their peers in 2007. For retailers that are poor merchandisers, we anticipate near-term struggles.  Gap  is one retailer that has lost its way, and we don't see a clear strategy in place that will help it right its course in the upcoming year.

The restaurant industry--specifically casual-dining specialists--has some attractive valuations. Casual dining has hit its roughest patch in more than 15 years, but we don't believe this difficult environment will persist indefinitely. Spending at casual-dining restaurants should get a boost from maturing baby boomers entering their peak earning years, a rise in dual-income families, and a growing desire for convenience in a time-pressed society. Among our high-rated stocks:  Applebee's International  Cheesecake Factory ,  P.F. Chang's China Bistro , and  Brinker International .

Among casinos, we see a trend toward high-end, mega-resort casinos on the Las Vegas Strip. We think this will lead to lower ROIs in the industry because of higher-cost properties and more competition. We also wouldn't be surprised to see more consolidation and private-equity interest, with potential targets including  Boyd's Gaming ,  Penn National Gaming , and  Pinnacle Entertainment . Finally, we see Macau as well on its way to becoming the next Las Vegas, with revenue far exceeding the Las Vegas strip over the next five years. We expect further investment by the incumbent players:  Las Vegas Sands ,  Wynn , and  MGM Mirage .

Finally, we like several firms in the education industry. Demand for all types of education is more likely to grow in the long run than shrink, as more advanced skills become necessary in the workplace. This is especially true for displaced manufacturing and low-skill workers who must cope with increasing international competition for jobs. We like the prospects of  Apollo ,  Strayer , and  Lincoln Educational .

Also see:
Information Super Sector
Manufacturing Super Sector

Securities mentioned in this article

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Haywood Kelly, CFA has a position in the following securities mentioned above: TIF JNJ APOL FTEK WU Find out about Morningstar's editorial policies.
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