Dow Climbs As Pharma Stocks Jump, but Will Drug M&A Hurt UnitedHealth?

The Dow kept rising steadily today, but big news in the health-care industry could have an impact on the Dow in the longer term.

Apr 21, 2014 at 9:04PM

The Dow Jones Industrials (DJINDICES:^DJI) rose more than 40 points Monday as investors continued to ride the wave of enthusiasm that has accompanied the beginning of earnings season. Leading the way higher for the Dow were Pfizer (NYSE:PFE) and Merck (NYSE:MRK), which gained 2% and 1.4% respectively. But among the biggest decliners in the Dow Jones Industrials was UnitedHealth Group (NYSE:UNH), whose 1.1% drop raised obvious questions about whether strength in pharma stocks automatically means greater pressure on health-insurance companies.

The big move up for Pfizer came on news that Pfizer had had merger talks with a major British drugmaker that would have created an even larger drug colossus to lead the industry. Even though some analysts question whether a Pfizer merger would even make sense, it does highlight the pressure that Pfizer, Merck, and other drug companies are under to make sure that they can keep their pipelines full and replace lost revenue from treatments that lose their patent protection. Moreover, with companies scrambling to find every possible way to cut costs so as to allow as much revenue as possible to flow down to bottom-line profits, the idea of Pfizer or Merck finding large partners for business combinations makes plenty of sense.

By contrast, UnitedHealth last week reported earnings that were already hurt by health-care reform, and signs of strength from pharmaceutical companies could make things even more difficult for health insurers. UnitedHealth Group in particular has relationships with drugmakers through its Optum pharmacy-benefit management division, and indirectly, UnitedHealth will also bear the added cost of drugs that might result if major combinations of pharmaceutical companies lead to greater pricing power against health insurers.

In theory, UnitedHealth Group has the ability to pass through higher drug costs to its members in the form of higher premiums. Yet with Obamacare's restrictions on medical loss ratios and with competitive pressures to keep insurance premiums down, UnitedHealth might find it more difficult than expected to sustain its profit margins if drug costs rise. Already, many ultra-high-priced medications have forced UnitedHealth Group and its peers to make tough decisions about whether to cover them under conventional insurance, and that controversy is likely to go on for a long time.

In the long run, a stronger pharmaceutical sector could lead to higher drug costs, and that in turn could hurt health insurance companies in their efforts to offer low-cost insurance alternatives while remaining profitable. Investors in drug companies need to understand the political issues that are involved and not take sales gains for granted as discussions of possible future mergers continue.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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