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© 2009 Morningstar, Inc. All rights reserved.

Healthcare Industry Dynamics

Damien Conover, CFA Equity Strategist and Healthcare Observer Editor Damien.Conover@Morningstar.com(312) 696-6052

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Background: Damien Conover, CFA

Morningstar Healthcare Analyst and Strategist× Covered the healthcare industry for over eight years× Primary focus on pharmaceutical and biotechnology industries

Editor of the Healthcare Observer× In-depth analysis of complex healthcare issues × Cross-industry investment ideas in healthcare

Recognized Authority in Healthcare Investing× Regular media appearances discussing healthcare stocks× Appearing on CNBC, CNN and Bloomberg TV

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Executive Summary

Healthcare Reform Overview× Several proposed healthcare plans are surfacing with broad

implications.× We expect new reform will only slightly impact Big Pharma’s

valuations.

Economic Environment/M&A Activity× Healthcare spending tends to hold up regardless of economic

cycle.× Several biotech companies look like acquisition targets for Big

Pharma.

Recommended Healthcare Stocks× Top Big Pharma picks include Novartis, Merck, Johnson &

Johnson and Abbott.× Medical devices are our top ranked industry. × Healthcare Focus List is outperforming our benchmark.

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Healthcare Reform: Will Major Change Happen?

U.S. Healthcare Spending Sustainable?

× U.S. healthcare spending is 72% higher than OECD average

× CMS projects healthcare spending will represent 18% of GDP in 2009, rising to 20% in 2018. (not including economic stimulus or healthcare expansion)

Better U.S. Healthcare?× Trails Modern World (Ranks

37th in WHO in quality and fairness)

U.S. record is more on par if we remove homicides, transportation accidents and adjust for obesity

Healthcare Spending (% of GDP)

OECD Countries

0% 5% 10% 15% 20% 25%

TurkeyPoland

KoreaMexico

Czech RepublicLuxembourg

Slovak RepublicIrelandJapan

FinlandHungary

UKSpain

NorwayAustralia

OECDItaly

IcelandGreece

SwedenNew ZealandNetherlands

DenmarkCanadaAustria

PortugalBelgium

GermanyFrance

SwitzerlandUSA

2006

2009

2018

U.S. uninsured*

Source: CRS Report for Congress, 2007/updated 2008 and Morningstar.

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Healthcare Reform: Will Major Change Happen?

× GAAP accounting (off-balance sheet) suggests stress on U.S. healthcare spending

Source: U.S. Treasury, CMS and Morningstar.

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Healthcare Reform: Will Major Change Happen?

History of Political Resistance× 1930s: despite the success of the New Deal, President

Roosevelt declines universal healthcare attempt, fearing its inclusion in Social Security Act would derail the entire project

× 1948: President Truman unveils single payer plan: American Medical Association succeeds in helping defeat it despite 75% public support

× 1960s: President Johnson attempts to further late President Kennedy’s healthcare goals, ultimately signs Medicare/Medicaid Bill in 1965

× 1970s: President Nixon explores universal healthcare with help from Senator E. Kennedy, efforts (and Watergate) ultimately produce no reform

× 1993: President Clinton's 1,300 page healthcare plan fails to come to a vote in House and Senate

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Healthcare Reform: The Five Committees

Senate Health, Education, Labor and Pensions (HELP) Committee – Late Sen. Ted Kennedy (D) (Mass.)– Sen. Chris Dodd (D) (Conn.) – Sen. Tom Harkin (D) (Iowa)

Affordable Health Choices Act: × Includes public plan× Reduces uninsured to 13% by 2019 from the current 19%

(Share of Non-elderly)× Community Rating and Guaranteed Issue× Mandates coverage (Forces most firms to provide insurance or

pay penalty)× Incentivizes coverage through subsidies (150%-400% of

poverty level) and penalties× Costs $600 billion over next ten years (Lacks new funding

source)× Odds of Passing: Low (in current form)

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Healthcare Reform: The Five Committees

House Ways and Means, Education and Labor and Energy & Commerce Committees

America’s Affordable Health Choices Act:× Includes public plan × Reduces uninsured to 6% by 2019 from the current 19%

(Share of Non-elderly)× Community Rating and Guaranteed Issue× Mandates coverage (Forces most firms to provide insurance or

pay penalty)× Expands Medicaid eligibility (11M new people: 10M not

covered, 1M from private)× Costs over $1 trillion over the next ten years

Funding: $800 billion raised by Medicare cuts ($220B) and taxes ($580B)

× Odds of Passing: Medium to Low (in current form)

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Healthcare Reform: The Five Committees

Senate Finance Committee– Max Baucus (D) (Montana)– Bipartisan Committee

America’s Healthy Future Act:× No public plan, Co-ops instead× Reduces uninsured to 9% by 2019 from the current 19%

(Share of Non-elderly)× Levies on insurers and other healthcare industry (Annual fees,

lower reimbursement)× Modified Community Rating and Guaranteed Issue× Modified mandated coverage (Forces most firms to pay fees

for employees tax credits)× Create an insurance exchange × Subsides for insurance up to 300% of the poverty level× Costs $774 billion over the next ten years

Funding: $825 billion by excise tax ($215B) and Medicare/Medicaid cuts ($409B)

× Odds of Passing: Medium to High

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Healthcare Reform: What Does Reform Mean for Healthcare?Increased Insurance Coverage × Reduce the number of uninsured through multiplayer

approach× Community Rating and Guaranteed Issue× Mandates coverage (Forces most firms to provide

insurance or pay penalty)× Expand coverage for children and Medicaid eligibility

Lower Drug Prices× Increased Medicare price negotiation× Increased Medicaid price negotiation× Comparative and cost effectiveness programs

Increased Investment in Healthcare Information Technology

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Potential Sector Reactions to Healthcare Reform

Managed Care× New government plan will increase insurance usage By 2016, 16 to 35 million more people covered

× Most likely stay with employer convergeHurdles to switching from employer sponsored plan:

• 30% tax subsidy for employer health insurance• Firms still likely to provide insurance as workers likely demand higher

wages without insurance• Firms’ penalty for not paying insurance is close to cost of paying

insurance (adjusted for taxes)• Larger firms tend to prefer in-house coverage, partly due to the low

administrative costs

Public vs. Private CoverageCBO: 6 million people go to public planLewin Group: 100 million people go to public plan

× Most likely outcome: Co-ops →minor switching away from private coverageNew Fees: $6 billion annually for the health insurance group

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Potential Sector Reactions to Healthcare Reform

Pharmaceuticals and Biotech× A lot of negative headline risk in 2009: Opportunity for

investing

× $80 Billion Deal over the next ten years $30 billion for offering a 50% discount for drugs in the Medicare Part D gap $50 billion for reforms (Dual eligibles: $47B, Medicaid rebate from 15.1% to 22%: $18.3B, Fees: $2.3B)

× Comparative Effectiveness Slow long term impact, CBO only .01% reduction in health-care

spending

× Proposals Largely off the table Allow drug re-importation: CBO only 1% reduction in drug spending Follow On Biologics: Several years away and less impactful than

traditional generic competition

× Bottom line: volume benefits outweigh lost pricing power in the near term

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Potential Sector Reactions to Healthcare Reform

Generics× Expanded insurance population should increase

utilization of the low cost drugs× Medicare Part D Analogy

Hospitals× Hospitals are required by law to treat patients and fewer

uninsured patients decreases bad debt expense× However, unlikely government lets hospital gain much

higher margins

Devices× Higher patient volumes largely offset by revenue mix

and pricing pressures

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Potential Sector Reactions to Healthcare Reform

Healthcare Information Technology× Strong Political Support

× Changes likely to be evolutionary, not revolutionary

Source: Morningstar.

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Reform Scenario: Drugs Industry Case Studies PFE, LLY, MRK

× Conservative approach – the entire uninsured population receives Medicaid pricing

× No reactionary cost cuts implemented

× Innovation does not suffer – i.e. R&D expenditures stay at close to current levels

× No scale savings are realized from increased volume

× Conclusion – only under the most severe scenario are our FVEs “crushed” 

% of Drug Spending

Current Discount

Price Cut Under National Plan

Medicaid 15% -30% 0%

Medicare 21% -15% -15%

Private 59% -10% -20%

Out of Pocket 5% -30% 0%

% ChangeU.S. Impact Volume Price Sales COGS SG&A R&D

0% -3% -3% 1% 0% 0%Total Firm Impact Volume Price Sales COGS SG&A R&D Fair Values

0% -2% -2% 1% 0% 0% -5%

% ChangeU.S. Impact Volume Price Sales COGS SG&A R&D

15% -7% 7% 2% 0% 0%Total Impact Volume Price Sales COGS SG&A R&D Fair Values

8% -4% 4% 1% 0% 0% 0%

% ChangeU.S. Impact Volume Price Sales COGS SG&A R&D

15% -15% -3% 4% 0% 0%Total Impact Volume Price Sales COGS SG&A R&D Fair Values

8% -8% -2% 2% 0% 0% -10%

% ChangeU.S. Impact Volume Price Sales COGS SG&A R&D

15% -30% -20% 9% 6% 3%Total Impact Volume Price Sales COGS SG&A R&D Fair Values

8% -15% -10% 4% 3% 2% -38%

Negotiated Medicare Prices

Increased Insurance and Negotiated Medicare Prices

National Plan (All U.S. Sectors get 30% discount)

National Plan (U.S. at Medicaid Prices)

% Change Basis Point Change in Margin

Basis Point Change in Margin% Change

% Change Basis Point Change in Margin

% Change Basis Point Change in Margin

Source: Morningstar.

Source: CMS, Congressional Reports and Morningstar.

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Implications of Credit Crisis

Credit Crisis leading world economies to recession

Where to Invest?

× Traditional Defensive Areas: Healthcare and Consumer Staples

× Traditional Growth Areas: Technology, Financials, Healthcare

Defense + Growth = Healthcare

Healthcare Recession Resistant

× Limited Correlation between GDP and Healthcare

× Healthcare Spending Never Turned Negative

(even in prolonged recessions of 1970s & 80s)

× Major Gaps in GDP and Healthcare Spending

in Past Three Recessions

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Why Does Healthcare Hold Up?

× Basic Need

× Government and Employer Health Insurance

× Supplier-Induced Demand

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Credit Crisis: 2009 to be the Year of Mergers and AcquisitionsAcquisitions: Large Cap Firms Step Up

× Venture Capital is shut and public financing is too dilutive

× Big Pharma needs growth and has cash

× Expect many small cap plays

× Mid Cap Targets: Amylin (FV: $15), OSI Pharma (FV: $45), Onyx (FV: $32), BioMarin (FV: $30), Regeneron (FV: $22), Vertex (FV: $35), Elan (FV: $13), Crucell (FV: $23)

Mergers: Cost Cutting

× Big firms are cutting costs to grow bottom line

× Cuts can be deeper through consolidation ($3.5B for MRK, $4B for PFE)

× Problem: Exacerbates patent cliff in most cases× Large Cap Targets: Schering-Plough* (FV: $37), Biogen Idec (FV:

$65), Celgene (FV: $54), Genzyme (FV: $82), Wyeth** (FV: $59) *Merck announced the acquisition of Schering on Mar. 9th **Pfizer announced the acquisition of Wyeth on Jan. 26th

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Credit Crisis: Top Biotech Takeout Targets

Source: Morningstar M&A Report

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Stock Outlook: Top Pharmaceutical Recommendations

Stock Moat Price/FV Star RatingUncertainty Mkt Cap

Novartis (NVS) Wide .62 Low $109B

Rationale: Diversified drug platform (branded, generic, consumer, vaccine) Generics should improve in ‘10

Blockbuster launches in drugs and vaccines: FTY720, ACZ885, Menveo/Men B

Strong inline product group focused on oncology (Tekturna becoming a blockbuster)

Merck (MRK) Wide .71 Medium $68B

Rationale: Good price on Schering acquisition (we expect JNJ to modestly renegotiate RA deal)

Get Schering’s pipeline (TRA, Golimumab, Asenapine, Boceprevir)/ cost synergies ($3.5B ‘12)

Johnson & Johnson (JNJ) Wide .76 Low $167B

Rationale: Diversification protects the company from patent losesLeading pipeline: Rivaroxaban, Telaprevir, Golimumab, CNTO 1275Most negatives behind the company: Epo, DES, Risperdal (Watch

out for Concerta in ‘10)

Abbott Laboratories (ABT) Wide .67 Low $72B

Rationale: Strong inline products: Humira, Trilipix, Xience and modest patent exposure

Strong acquisition track record (Kos, Knoll, and likely AMO)

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Sector Outlook: Top Sectors by Star Rating

Source: Morningstar

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Stock Outlook: Healthcare Focus List

Source: Morningstar

Source: Morningstar

Health-care Focus List Performance Since Inception

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

Focus List Health-care Index (IYH) S&P 500

Company Ticker Moat Risk Price to Fair Value Star Rating AnalystWellPoint WLP Narrow Medium 0.58 CoffinaZimmer ZMH Wide Medium 0.60 StralowCovidien COV Narrow Medium 0.62 MorozovThermo Fisher Scientific TMO Narrow Medium 0.62 MorozovNovartis NVS Wide Low 0.62 ConoverBoston Scientific BSX Wide Medium 0.63 WangGenzyme GENZ Wide Medium 0.65 AndersenAbbott Laboratories ABT Wide Low 0.67 ConoverVCA Antech WOOF Narrow Medium 0.74 WangAmerisourceBergen ABC Narrow Medium 0.81 Coffina

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Morningstar Healthcare Team

Alex Morozov, CFA Medical Instruments312-696-6159

Karen Andersen Biotechnology 312-384-4826Julie Stralow, CFA Devices/Orthopedics 312-696-

6278Debbie Wang Devices/CRM 312-384-

3937Bill Buhr Healthcare Services 312-696-

6042Matthew Coffina Managed Care/Distributors 312-696-

6864Patrick Dunn Healthcare IT 312-384-

3767Brian Laegeler, CPA Generic Drugs 312-384-

4825Lauren Migliore Biotech/Specialty Pharma 312-244-

7048

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Questions?Where to find more information?

Healthcare Observer: http://healthcare.morningstar.com/

Additional Information: www.morningstar.com/goto/health11

Upcoming Issues:

Outlook for Obesity Treatments

New Devices and Drugs for Atrial Fibrillation

Past Issues:

Upcoming Breakthroughs in Cancer Drugs

The Impact of Healthcare Reform on Stocks

Dynamics of Drug Eluting Stents

Strong Trends in Contract Research Organizations

2009 Outlook for M&A

Profits in New Advancements in Ophthalmology

Next Wave of Healthcare Information Technology