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A Look at Two Undervalued Small-Cap Health Care Stocks
Posted by: Benjamin Shepherd (IP Logged)
Date: August 9, 2012 01:07PM

When investors think of the health care sector, it’s hardly surprising that pharmaceutical companies usually come to mind. With a combined mar­ket capitalization of more than $1 tril­lion, drug makers comprise about half of the sector’s total market capitalization (see “Swelling Markets”). The bulk of this market cap rests in just a handful of large companies.



However, if you dig deeper you’ll find an amazingly diverse group of promising businesses, the majority of which are off the radar. Here, I look at two undervalued stocks that are tied into secular trends in health care. None have attracted a great deal of investor attention but they offer sub­stantial upside potential.

Working Smart

A major trend in the pharmaceuti­cal business has been towards tailor­ing treatment to fit an individual pa­tient’s biology and disease. As a result, advanced biotechnology has come to play an increasingly critical role in the health care sector.

PDL BioPharma (PDLI) owns a portfolio of patents covering the production of “humanized anti­bodies,” which are a mixture of mouse and human components.

Antibodies are the gendarmerie of our immune systems; each antibody fights a particular sort of pathogenic invader by binding with specific pro­teins. Using antibodies to fight specif­ic diseases has become a cornerstone of personalized medicine and the basis of several next-generation drugs for the treatment of cancer, multiple sclerosis and other diseases.

However, the antibodies used in those drugs are derived from mice, which means our immune systems of­ten recognize them as foreign invad­ers and destroy them. That biologi­cal response can be overcome by using PDL’s process of humanization, which essentially reorganizes the antibod­ies’ proteins into a more human form, thereby tricking an immune system into believing the mice antibodies be­long within the host.

Several drug companies, including major outfits such as Roche (OTC: RHHBY) and Genetech, Wyeth and Novartis (NVS), have licensed PDL’s technology to produce block­buster drugs such as the cancer treat­ment Herceptin, the macular degenera­tive disease treatment Lucentis and the asthma drug Xolair. The technology is also used to produce Perjeta, a breast cancer treatment that was approved in early June and is widely predicted to become a new blockbuster drug with annual sales in excess of $1 billion.

Under licensing agreements, PDL collects a sliding percentage of drug sales based on total revenues gener­ated. PDL’s revenues have grown an average of 22.4 percent over the past five years. Annual revenue growth is expected to slow to about 13 percent, as the current slate of drugs that in­corporate PDL’s technology mature. However, it’s unlikely that PDL won’t strike new licensing deals, because a growing number of new drugs incorporate antibodies.

PDL is trading at its lowest valua­tion in several years, with a price-to-earnings (P/E) ratio of 5.6. It’s also trading at only 1.7 times its forecasted earnings growth. PDL is an attractive high-yield stock, offering a $0.15 quar­terly dividend, which amounts to a yield of about 9 percent.

Going HITECH

While the Patient Protection and Affordable Care Act (PPACA) was the capstone in President Obama’s ef­forts to reform American health care, he and congressional Democrats were already making headway in that arena well before PPACA was signed into law in 2010.

As part of the American Recovery and Reinvestment Act of 2009, other­wise known as the economic stimulus bill, the Health Information Technol­ogy for Economic and Clinical Health (HITECH) Act created financial incen­tives for physicians and hospitals in the form of higher Medicare reimburse­ments to encourage the adoption of electronic health records (EHR). The incentives total $19.2 billion and run through 2014.

EHRs are an important policy priority because they help health care organizations standardize and lower the cost of care for chron­ic — and consequently expensive — conditions such as diabetes. They also improve the quality and effi­ciency of care by integrating doc­tor offices with hospitals and labs.

Despite those financial car­rots, adoption of EHR systems has been relatively tepid over the last few years because of the gener­ally weak economic environment and uncertainty over the ultimate fate of health care reform.

But no law is complete without some sticks. Beginning in 2015, phy­sicians who aren’t using EHRs face financial penalties that begin with a 1 percent reduction in Medicare pay­ments during that year and may rise as high as 5 percent by 2018.

Although 2015 seems a long way off, the deadline is looming disturb­ingly large because it can take be­tween one to three years to implement an EHR system, depending on its size and complexity.

As a result, orders for EHR systems should pick up over the course of the next several quarters, particularly as small- and mid-sized health care pro­viders that have delayed action be­cause of budgetary concerns begin buying systems.

Computer Programs & Systems (CPSI) serves that small- and mid-sized market, focusing primar­ily on hospitals with fewer than 300 beds. The company experienced a spike in new clients in the first quar­ter of this year. While most of that growth is largely attributable to secu­lar regulatory trends, the depth and breadth of the firm’s offerings also played a role.

In addition to offering EHRs, Computer Programs & Systems also provides business functions including payroll and personnel management, inventory control systems and IT ad­ministration. The company has begun offering its productions on a Software as a Service basis, allowing clients re­mote data access and storage capabili­ties and potentially reducing their li­ability in the event of a data breach.

These important business functions set the company apart from its com­petitors and they’re crucial for compliance with HITECH. To ensure that every dollar is used for the intended purpose of promulgating EHR, the federal government has attached a proviso: physicians and hospitals that want to qualify for incentive payments must demonstrate that they’re actually using the technology.

In other words, purchasing and even installing an EHR system is not sufficient. The health provider must demonstrate that it is beneficially and efficiently using the system in the real world. This prevents providers from buying a new EHR system, getting paid by the government, and then mismanaging or underutilizing the system. Computer Programs & Sys­tems helps clients with this mandate.

Over the past five years, the compa­ny has generated average revenue and earnings growth of about 11 percent. For the rest of 2012 and into 2013, this growth rate should rise into the mid-teens. With a surge in EHR demand on the horizon and an attractive $0.46 quarterly dividend, Computer Programs & Systems is a solid dividend investing play.


Stocks Discussed: NVS, PDLI, CPSI,
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