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Healthcare IT & Services. Lots of Value and Good Fundamentals Industry Rating: Overweight. Steven P. Halper Partner, Equity Research Phone: 212-271-3807 E-Mail: shalper@tweisel.com. 1. Healthcare IT and Services. Industry Overview Macro Orientation

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lots of value and good fundamentals industry rating overweight

Healthcare IT & Services

Lots of Value and Good Fundamentals

Industry Rating: Overweight

Steven P. Halper

Partner, Equity Research

Phone: 212-271-3807

E-Mail: shalper@tweisel.com


healthcare it and services
Healthcare IT and Services
  • Industry Overview
    • Macro Orientation
    • Healthcare (products and services) is a growth industry
  • Demand Trends by Sector
    • Pharmaceutical Services
    • Provider and Payer Software Services
  • Stock Selection
    • Peer Perform: ACDO, AHS, CAH, CVD, ESRX, HLTH, MEDQ, PRXL, PSTI, RX and TZIX

Industry Overview

  • Pharmaceutical Services
    • Utilization beginning to pick up again and net price increases remain solid
    • Forward buying opportunities still exist despite increasing use of inventory management agreements
    • Number of new product launches lowest in 19 years
    • Prefer drug distribution stocks over PBMs and CROs
  • Hospital industry enjoying solid performance.
    • IT expenditures still growing
    • Expect another good year for reimbursement trends
      • Medicare inpatient rates increase in line with expectations; Higher utilization of healthcare resources
    • Patient Safety and efforts to reduce medical errors represent additional long-term growth drivers
    • U.K. NHS upside for 2004 and beyond

Pharmaceutical Services

  • Current Environment:
    • Why are Big Pharma co’s cast as the villains?
    • Prescriptions filled growing in the 2-3% range Y/Y
    • Price increases averaging 5-6%, net of generics
  • Long Term Growth Drivers:
    • New product development is more important than ever
    • Use technology and outsourcing solutions to bring products to market faster and create efficiencies
    • Fewer buy side margin opportunities may lead to better sell side margins
  • Political Environment:
    • Medicare drug benefit limping along
    • Continue to expect headline risk on drug pricing, rebates and AWP

Pharmaceutical Services: Distribution

  • U.S. drug distribution industry now dominated by three large participants (ABC, CAH and MCK).
  • Industry characterized by large revenues, low margins and very high barriers to entry.
  • Retail prescription sales beginning to improve again. Independent drug stores showing a re-birth.
  • Generic margin opportunity over-rated as many large chains buy generics directly.
  • Fewer buyside margin opportunities available but impact varies by distributor
  • Specialty distribution still experiencing good growth
  • Stocks are very inexpensive. Investor perception is still negative. ABC is our favorite stock.

Pharmaceutical Services: Market Intelligence

  • IMS Health is the dominant provider of information and data services to the pharmaceutical industry. NDCHealth has about 10% market share in U.S.
  • Industry characterized by high margins for efficient providers. Securing access to data and ability to aggregate into meaningful information is not an easy task.
  • Virtually all U.S. drug manufacturers rely on IMS data to track sales effectiveness. Outside of U.S., there exists more local competitors.
  • Despite dominant participant, new competitors always try to enter the U.S. market.
  • An industry with good long-term fundamentals but the near term remains tough due to big pharma’s unwillingness to invest in new products and services.

Pharmaceutical Services: PBMs

  • As third-party payers look to reduce overall drug costs, pharmacy benefit managers are the primary vehicle.
  • Market participants include Caremark (merging with ADVP), Express Scripts and Merck-Medco.
  • While most commercially-insured individuals are already covered, the potential to gain/lose market share always exists. Medicare drug benefit represents new growth potential depending on vehicle to administer benefit.
  • Significant headline risk (subpoenas and DOJ investigations) remains but valuations over time, will ultimately reflect good growth prospects.
  • PBMs exploring other growth initiatives including specialty distribution, mail order and market intelligence.
  • Negative psychology toward Caremark

Pharmaceutical Services: CROs

  • Current CRO market is about $5 billion; expect revenue growth of about 10% near term
  • Fundamentals improving but no longer a 30% growth industry
  • “CROs” do more than just run clinical trials
  • Information technology to play an important role in the drug discovery and clinical development processes
  • Those CROs taking advantage of IT are likely to gain market share while maintaining or improving margins
  • Long-term growth drivers in place given bulge in new molecules; This scenario is several years away
  • New bookings growth and cancellation rates can be unpredictable, which limits valuation over the long term.

Provider and Payer Software Services

  • Current Environment:
    • Hospital utilization of IT continues to expand
    • Consolidation among vendors has subsided
    • Physician and Internet opportunities are more limited
  • Long Term Growth Drivers:
    • Continuous focus on cost control
    • Patient Safety
    • Eventually hospital capacity will increase
    • U.K. NHS contract awards likely in Q4/Q1
  • Political Environment:
    • Hospital profitability determined by Medicare reimbursement, which changes every year
    • Federal and state mandates to use information technology to reduce medical errors and increase patient safety

HIMSS Survey Data Results(2003 and prior Survey Data available at www.himss.org)

Source for all survey results include previous years Annual HIMSS Leadership Survey Sponsored by IBM and Dell Computer Corporation and the 13th Annual HIMSS Leadership Survey Sponsored by Superior Consultant Company, Inc.


Top 5 IT Priorities 2003 vs. 2002

Survey Finding

  • Reduce Medical Errors/ Promote Patient Safety (52% vs. 46%)
  • Upgrade security on IT Systems to meet HIPAA regulations (47% vs. 60%)
  • Implement privacy modifications for HIPAA (46% vs. NM)
  • Upgrade Inpatient Clinical Systems (38% vs. 42%)
  • Upgrade network infrastructure (34% vs. 37%)

TWP Opinion

  • Continued recognition that CPOE has potential to improve patient safety
  • Much HIPAA work has already been completed on security issues but numerous privacy issues still remain
  • Hospitals may be focused on other issues rather than clinical systems improvements
  • Infrastructure getting better

Significant Barriers for IT (2003 vs 2002)

Survey Finding

  • Lack of adequate financial support (23% vs. 27%)
  • Vendors’ inability to effectively deliver (19% vs. 18%)
  • Difficulty in proving IT quantifiable benefits/ ROI (13% vs. 13%)
  • Lack of staffing resources (12% vs. 4%)
  • Difficulty achieving end-user acceptance (10% vs. 15%)

TWP Opinion

  • Hospital execs are finally figuring it out
  • A common complaint for large complex software installations
  • Hospitals are more sophisticated about under-standing workflows
  • Surprising result especially given the overall tech meltdown
  • A very positive trend

Growth Driver: Use of a Computer-based Patient RecordWe have a fully operational CPR system in place:

1998 : 2%of respondents

1999 : 11%

2000 : 12%

2001 : 13%

2002 : 13%

2003: 19%

-- installations in progress increased in 2003 (37% vs. 32% in 2002)

TWP Opinion:

After all these years, CPR is making progress, yet still very under penetrated


Anticipated Changes in IT Budgets

1998 & 1999: 71-73% of respondents indicated budgets were definitely or probably increasing

2000:weighted average was 67% - representing a tough trend

2001:68% of respondents indicated budgets were definitely or probably increasing

2002:67% of respondents indicated budgets were definitely or probably increasing

2003:68% of respondents indicated budgets were definitely or probably increasing

TWP Opinion: Steady budgets confirm our belief that this is still a growth industry


Medicaid Managed Care

  • Current Environment:

Medicaid HMOs are still not considered mainstream by investors. Too many investors associate Medicaid with Medicare; Growth predicated on membership growth, not rate increases.

  • Long Term Growth Drivers:

More states will look to managed care as a solution to expanding Medicaid population and expenditures; Studies indicate that managed care plans help states save money.

  • Political Environment:

Must be monitored on a state by state basis; Recent Federal tax package includes $20 billion for the states over the next 2 years, with $10 billion targeted directly at Medicaid programs.

which stocks should we own outperform rated stocks
Which Stocks Should We Own?(Outperform rated stocks)

Pharmaceutical Services:

AmerisourceBergen (ABC)

AdvancePCS (ADVP)

McKesson Corp. (MCK) Pharmaceutical Product and Development (PPDI)

Omnicare (OCR)

Priority Healthcare (PHCC)

Provider and Payer Software and Services:

Cerner Corp. (CERN)

IDX Systems (IDXC)

IMPAC Medical (IMPC)

NDCHealth (NDC)

ProxyMed (PILL)

Other: Amerigroup (AGP)

Centene Corporation (CNTE)


Pharmaceutical Services:AmerisourceBergen (ABC)

Rated: Outperform

  • Our favorite drug distribution stock
  • Fears of guidance reduction are overblown; ABC still has synergy capture from Bergen consolidation; not as dependent on buyside margins as CAH
  • ABC focuses primarily on independent drug stores and regional chains; largest provider to mail order segment; We are not overly concerned with the potential loss of ADVP business with Caremark merger. Dominant provider in hospital pharmacy segment as well.
  • Similar to other distributors, ABC focused on building ancillary businesses. Focus includes: Automation, specialty pharmacy and packaging

> Expectations are low enough which creates an interesting investment opportunity; Our favorite stock among the big three distributors


Pharmaceutical Services:McKesson (MCK)

Rated: Outperform

  • Distribution operating margins still posting positive trends; Revenue growth surprisingly strong;
  • Expectations are still achievable even with slowing pharmacy retail trends. Top customers include RiteAid, WalMart and Omnicare.
  • Recent channel checks indicate good acceptance of Horizon Expert Orders within existing customer base. MCK is uniquely positioned within hospital business given its automation, IT and outsourcing focus.
  • Specialty pharmacy operations under appreciated by investors.

> Much like ABC, expectations are low enough which creates an interesting investment opportunity;


Pharmaceutical Services:Priority Healthcare (PHCC)Rated: Outperform

  • Broad-based, all product specialty distributor; Organic growth slowing to about 20% given weakness in Hep C and Fertility markets. New product flow has been strong. Under appreciated alternate-site healthcare distribution operations.
  • All product strategy may encounter increased competition from PBMs and main-line distributors.
  • Potentially a great acquisition target.
  • Wal-Mart outsourcing contract represents new growth opportunity which cannot be duplicated by another industry participant.

> As growth continues and Wal-Mart begins to contribute, multiple expansion is likely


Provider Software:

Cerner Corp. (CERN)

Rated: Outperform

  • Premier provider of clinical apps to hospital industry; diversifying revenue stream
  • Q1 bookings disappointment represents first glitch in almost four years; Strong recovery in Q2
  • Recovery like to be quicker this time around as around as the company does not require major investments in sales force, client service and R&D areas
  • Industry trends remain positive. Big potential from UK NHS project.

> Shares are no longer that in expensive based on 2004 EPS estimate; Still worth owning as next EPS revision is upward.


Provider Software:

IDX Systems (IDXC)

Rated: Outperform

  • Premier provider of practice management systems to large physician groups and inpatient clinical applications.
  • Much more diversified by customer focus and product offering than most investors believe.
  • Has added new products (radiology and PACS) and more realistic about growth in CareCast.
  • Recently divested struggling medical transcription operations;
  • Participating in UK NHS procurement project

> Shares trade at 21X 2004 EPS estimates, but next EPS revision is probably upward.


Medicaid Managed Care:

Centene Corp. (CNTE)rated Outperform

  • Operates Medicaid managed care plans in WI, IN and TX; Acquired NJ plan; Wisconsin characterized as stable growth and Indiana viewed as strong growth; Texas beginning to live up to expectations
  • Beginning rate negotiations in WI and IN.
  • Should continue to grow by acquisitions; uses decentralized branding strategy while back office operations are centralized.

> Shares are now more reasonably valued relative to other managed care stocks. Strong chance of upside surprise to estimates; Overtime, Medicaid should be viewed as a growth industry and shares should trade at premium to managed care group


Stocks Not That Compelling

  • Covance (CVD; rated PP): Well balanced development company. Repositioning itself as a lab-focused organization. Must jump start central lab bookings or 2004 estimates are in jeopardy.
  • WebMD (HLTH; rated PP): Envoy has yet to post meaningful revenue growth. Shares are very expensive on an Enterprise value to EBITDA basis. We need to see better top line growth. Recent search warrants do not help the cause.
  • Parexel (PRXL; rated PP): Very dependent on clinical development business but valuation remains too high. Suspect use of non-recurring charges.
  • Per Se Technologies (PSTI; rated PP): Core physician services business still growing in low single digit range. Using cash to pursue Lloyd’s litigation. Balance sheet is leveraged.
  • TriZetto (TZIX; rated PP): New sales are lumpy; shares appear expensive on PE basis.
lots of value and good fundamentals industry rating overweight1

Healthcare IT & Services

Lots of Value and Good Fundamentals

Industry Rating: Overweight

Steven P. Halper

Partner, Equity Research

Phone: 212-271-3807

E-Mail: shalper@tweisel.com