The global medical devices industry is fairly large, intensely competitive and highly innovative. A regulated industry, medtech is spread across different segments including cardiology, cardiovascular, neuro, orthopedic and aesthetic devices. The U.S. medical devices industry relies largely on an aging baby boomer population, high unmet medical needs and increased incidence of lifestyle diseases (including cardiovascular diseases, diabetes, hypertension and obesity). Neuro, orthopedic and aesthetic represent the fastest growing categories.
However, the medtech industry is currently plagued by several issues, including pricing concerns, hospital admission and procedural volume pressures, Medicare reimbursement issues and regulatory overhang. Percutaneous intervention volumes continue to be relatively flat in the U.S., Japan and Europe with improvement not expected anytime soon. Nevertheless, several catalysts for growth exist such as new product cycles, an aging population, geographic expansion, ongoing transition toward minimally invasive techniques and emerging markets.
Given the maturing legacy markets, medical device companies are looking to expand into lucrative, incipient markets. Expansion in emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2012 and beyond. Also, the companies have been resorting to cost-cutting and share buybacks to drive bottom-line growth. Mergers & acquisitions (M&As), licensing deals, restructuring and share buybacks have become common in the medical device sector in recent quarters.
Another trend that we have been observing of late is the divestment of non-core business segments. For example, Smith & Nephew, through an agreement with Essex Woodlands, completed the disposal of its clinical therapies business in May 2012, to the newly formed Bioventus LLC, in which it will retain a 49% investment. Healthcare products maker Covidien is on track to spin off its pharmaceuticals business into a standalone public company by mid-2013.
Becton, Dickinson and Company is also in the process of divesting its Discovery Labware subsegment (excluding Advanced Bioprocessing capability) to Corning. The deal is expected to be completed by year end. Some other significant divestments include that of the neurovascular business by Boston Scientific (January 2011) to Stryker Corporation and the physio-control business to Bain Capital by Medtronic (January 2012).
Wary of an uncertain economy, medtech companies have resorted to the acquisition route to harness their strengths and diversify their offerings.
Major concluded deals include Johnson & Johnson's acquisition of Synthes, which should help strengthen its medical device portfolio. This is one of the biggest deals (approximately $21 billion) inked in recent times in the medtech space.
Boston Scientific has been looking to expand through acquisitions to counter the challenges of its core segments. After strengthening its cardiac rhythm management (CRM) portfolio with a subcutaneous implantable cardioverter defibrillator (ICD), the S-ICD system, with the acquisition of Cameron Health, the company is in the process of acquiring Minnesota-based BridgePoint Medical. This deal would bring in a catheter-based system to treat coronary chronic total occlusion, which has received both U.S. Food and Drug Administration (FDA) and CE Mark approvals.
Low global penetration and demand outstripping supply provide a positive long-term thesis for investing in the blood processing and supply chain management industry. With the acquisition of the transfusion medicine business of Pall Corporation, Haemonetics will be able enter the $1.2-billion whole blood collection market. Haemonetics is also in the process of acquiring Hemerus Medical, a Minnesota-based company that develops technologies for the collection of whole blood, and processing and storage of blood components.
Moreover, Mediware Information Systems has strengthened its position in the blood management solutions industry with the acquisition of Indianapolis-based Strategic Healthcare Group, a leading provider of blood management consulting, education and informatics solutions.
Masimo Corporation, spearheading noninvasive monitoring technologies, acquired Sweden-based PHASEIN AB, a developer and manufacturer of ultracompact mainstream and sidestream capnography, multigas analyzers and handheld capnometry solutions. Other acquisitions announced include that of Viking Systems by Conmed Corporation and GenturaDx, a molecular diagnostics company, by Luminex Corporation.
Cooper Companies, a global medical products player specializing in a wide range of contact lenses and also targeting the women's health market, acquired Denmark-based Origio to beef up its women's health franchise. Origio develops, manufactures and distributes highly specialized products targeting in-vitro fertilization treatment.
Covidien is also on the acquisition bandwagon. The company recently announced its decision to acquire privately held CNS Therapeutics, a specialty pharmaceutical company dealing with products for site-specific administration to the central nervous system to treat neurological disorders and intractable chronic pain. Other recent acquisitions by Covidien include Oridion Systems, expanding its portfolio in respiratory monitoring equipment; superDimension, which develops minimally invasive interventional pulmonology devices; and ventilator maker Newport Medical Instruments.
Meanwhile, trends over the recent past reflect focus on the diagnostics space. A prime example is women's health giant Hologic's acquisition of Gen-Probe for approximately $3.7 billion in August. In September, Danaher Corporation announced its decision to acquire IRIS International, a leading manufacturer of automated in-vitro diagnostics systems and consumables, and a provider of high-value personalized medicine solutions.
While Thermo Fisher Scientific strengthened its specialty diagnostics business with the acquisition of One Lambda, a leading player in the field of transplant diagnostics, Life Technologies, with two tuck-in acquisitions—Navigenics and Pinpoint Genomics—is building its diagnostics franchise. Moreover, Life Technologies has several agreements with pharmaceutical players such as Bristol-Myers Squibb and GlaxoSmithKline to shore up its companion diagnostics franchise.
Going forward, we do not expect this M&A trend to slacken. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Several medtech majors, struggling with their core businesses, are looking to explore potential emerging therapies.
Another avenue of growth for the medtechs is the huge untapped potential of emerging markets. An aging population, rise in wealth, government focus on healthcare infrastructure and expansion of medical insurance coverage make these markets a happy hunting ground for the global medical device players.
The Indian government plans to spend 2.5% of its GDP (from the previous level of 1.2%) on healthcare during the 12th Plan (2012-2017) and raise it to at least 3% by 2022. China is also increasing its expenditure to build hospitals and setting up proper health insurance coverage that should boost the healthcare sector. It is expected that within the next decade, China will be the biggest healthcare market in the world, outpacing the U.S.
The focus on emerging markets is all the more significant amid saturation in the developed markets of U.S., Europe and Japan in addition to economic uncertainties restricting growth. Companies like Medtronic, Boston Scientific, Thermo Fisher Scientific and Life Technologies are all vying to expand their presence in India, China, Brazil and other emerging markets. These companies are also looking at establishing their manufacturing facility to serve the local market.
While Johnson & Johnson has been doing business in China for more than 25 years, it established a new innovation center in the country in 2011 to design and develop medical devices and diagnostic products specifically for Asia's emerging markets. Other recent developments include the setting up of Medtronic's Innovation Center in Shanghai in August 2012, the company's first outside the U.S. and Europe; Boston Scientific's plan to invest $150 million in China over the next five years to build a local manufacturing operation; and ongoing expansion of Life Technologies' distribution centers in both Singapore and China.
In the light of the investments made in the emerging space, the medtech companies are setting their targets for these markets. While Medtronic is targeting 20% of its revenues from emerging markets by fiscal 2015−16, Boston Scientific is aiming to increase its below-average market share in the $700 million combined drug-eluting stent market in China and India, which is growing sharply at 20%. Recently, Medtronic announced its decision to acquire China Kanghui Holdings for $816 million in cash, which would strengthen its orthopedic franchise in the country.
Life Technologies expects this region to contribute $1.6 billion to revenues in 2015, up from just $188 million in 2007, representing a CAGR of 30%. Similarly, Thermo Fisher is leaving no stone unturned to garner 25% of total revenues from the high-growth Asia-Pacific region and emerging markets by 2016 from 19% in 2011 (10% in 2006).
Healthcare Reform: Tax Fear Grips Medtech
The government-mandated healthcare reform in the U.S.—the Patient Protection and Affordable Care Act (aka "Obamacare")—will impact the financial results of medical device companies. The reform has led to a less flexible pricing environment for these companies and may increase pricing pressure across the board.
Moreover, the highly controversial tax, representing a part of the act, will be a drag on device companies. When implemented, device makers will have to pay 2.3% excise tax on sales of certain products beginning 2013.
The outlay is expected to throttle innovation as it will impact investment in research and development (R&D). Moreover, it will lead to job cuts and higher prices for customers. The federal government expects to raise $20 billion in taxes over a ten-year period. In response, device makers are employing several initiatives, including headcount reduction and other restructuring activities, to counter costs associated with the implementation of the new tax.
We continue to have a neutral outlook on large-cap medical device stocks. While the companies will keep facing challenges like pricing pressures, declines in procedural volume from economic uncertainties and sluggish growth in the CRM business, increased focus on emerging markets and product approvals in latent areas could help reduce the impact. Better pipeline visibility and appropriate utilization of cash should increase confidence in the medical device sector.
With a slew of new products, the Big Three players (Medtronic, Boston Scientific and St. Jude Medical) in the ICD market are striving to gain market share, despite the challenging business environment and several other barriers to growth. These players are also exploring new avenues of growth beyond the mature pacemaker and ICD markets. With gradual stability in the ICD market, these players should be able to revive their top line.
In our universe, we see growth potential in companies dealing with promising technologies. In this respect, Edwards Lifesciences represents a value proposition. Following the U.S. approval of Sapien (for the treatment of certain inoperable patients with severe symptomatic aortic stenosis) in November 2011, sales of the device have been quite encouraging so far.
The company is also progressing well with respect to imparting training centers. Given a strong second-quarter performance, Edwards raised its 2012 outlook for Sapien sales in the U.S. Moreover, with a favorable recommendation from the FDA's advisory panel for Sapien in high-risk patients, the probability of final approval is high.
Robotic surgery is another fledgling area and Intuitive Surgical clearly leads the pack with its state-of-the-art technology. Intuitive enjoys a virtual monopoly in robotic surgery and continues to deliver forecast-topping earnings. Its sales are growing at a torrid pace, buoyed by the da Vinci surgical system. With higher average selling price per system, which stood at $1.53 million in Q2/12 (up from $1.44 million in the year-ago period and $1.47 million in the first quarter) and upgraded revenue outlook for 2012 (growth now expected at 20−23% versus earlier projection of 19−21%), this company is well placed to traverse a higher trajectory.
We also believe that cardiac assist devices maker Abiomed represents another attractive opportunity for investors. The company reported the best quarter in its history, with 42% growth in revenues and 56% growth in its Impella device, which is increasingly penetrating the percutaneous circulatory support segment in the U.S.. This is amply proved by the more than 30% growth recorded by Impella for the eleventh straight quarter. Given the strong growth potential for both Intuitive Surgical and Abiomed, estimates for these companies have been on the rise since the last reported quarter.
We are positive on Cooper Companies, which reported a strong third quarter of fiscal 2012, leading it to raise guidance for the fiscal year. Additional factors such as margin expansion, acquisitions expanding the product line and geographical reach as well as share buybacks and an attractive valuation are driving the stock. Moreover, this contact lens and women's health focused company has delivered positive earnings surprises in six of the last seven quarters with an average beat of 10.9%.
On the back of rising earnings estimates owing to strong fourth quarter and fiscal 2012 results, and several strategic initiatives to re-align its portfolio, we are bullish on CareFusion. Moreover, this global medical technology company has delivered positive earnings surprises in six of the last seven quarters with an average beat of 5.1%. While the company is dogged by product recalls, it is continuously working on investing in quality systems.
Banking on its core product, Invisalign Clear Aligner, Align Technology has established itself as a strong player in the malocclusion market. Based on the strength of this product, the company was able to exceed consensus estimates for both revenues and earnings over the past six quarters in a row.
Contribution from the acquisition of Cadent has helped Align to entrench its presence in the malocclusion market. We are positive on the company, which has immense growth potential in the malocclusion market. Moreover, estimates of the company for both 2012 and 2013 have been on the rise over the last 90 days.
Cooper, CareFusion and Align Technology all carry Zacks #1 Ranks (short-term Strong Buy rating).
Beyond the medtech majors, we are optimistic about scientific instrument maker Thermo Fisher Scientific. This leading, diversified scientific instrument maker has been successfully expanding operating margins over the past few quarters on the back of operational efficiency. Its focus on keeping the cost structure lean has helped the company to achieve this end. It has strong international exposure and is focusing on acquisitions and emerging markets for growth though the academic/government market is still fettered by constraints.
Coming to the weakest link in the medtech sector, we recommend avoiding names that offer little growth/opportunity over the near term. These include companies that reported disappointing earnings in the last reported quarter.
Conmed Corporation carries a Zacks #5 Rank (short-term Strong Sell rating). The company reported a disappointing second quarter, with both revenues and earnings missing the Zacks Consensus Estimates.
Moreover, revenue guidance for 2012 was lowered by $10 million to $765−775 million due to lower-than-expected capital product sales on the back of economic headwinds in the first half, though earnings guidance was maintained. With earnings estimates for 2013 declining significantly and limited visibility for the near future, it is better to avoid this stock.
Quality Systems began fiscal 2013 on a disappointing note, with both sales and earnings lagging the respective Zacks Consensus Estimates. Despite 18% year-over-year growth in sales, the company was adversely affected by lower-than-expected revenue from large, higher-margin software system sales. In addition, declining margins remain another challenge for the company.
Accuray Incorporated also exited fiscal 2012 on a disappointing note, with revenues and loss per share lagging the Zacks Consensus Estimates. The worst part was the double-digit decline in Cyberknife revenues in fiscal 2012, primarily due to shipment delays in Europe and lower demand in America.
The company is also facing challenges in combining the direct sales teams following the TomoTherapy acquisition in the U.S. A challenging outlook and slashed estimates for the upcoming two fiscals make this stock unappealing for investors.
Another company we remain concerned about is Thoratec Corporation, a world leader in mechanical circulatory support with a product portfolio to treat heart failure patients. However, its dominance in the bridge-to-transplant (BTT) indication will be challenged, following the prospective approval of HeartWare International's Ventricular Assist System later this year. Apprehending increased competition in the BTT indication for Thoratec, 2013 estimates have been on a downtrend over the last 90 days.
Several pressing issues currently at play in the medtech sector are discussed below.
One of the biggest challenges of the medtech industry is the current economic uncertainty. While the debt crisis in Europe remains unabated, economies throughout the world are trying to come to terms with myriad challenges. Consequently, procedural volumes in the U.S. have been hit by a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans. Governments across several European countries have taken up measures to curb spending on devices, which is taking a toll on utilization. Volume headwind is likely to linger as unemployment continues to influence procedure deferrals.
Players in the medical device space are experiencing pricing pressure of varying degrees. Companies are witnessing global pricing pressure in the CRM business and, in some cases, in stents. Although data from the recently reported quarter signal some relief in the rate of pricing erosion, we believe pricing will continue to bother given global budget constraints amidst deteriorating economic conditions.
Adding to the risk is the foreign exchange headwind (stemming from the strengthening of the U.S. dollar) as medical device companies derive a chunk of revenues from overseas markets. Factoring in the negative currency impact and economic uncertainty, several companies have already lowered their forecasts for 2012. Medical device makers are also expected to contend with margin pressure given the sustained pricing headwind.
Still Clouded Orthopedic Space
Orthopedics is one of the largest medical device market segments worldwide. However, this market, valued at approximately $30 billion in 2011, is still struggling as patients defer elective procedures given the lingering economic softness. Lukewarm demand is exacerbated by sustained pricing pressure. In particular, the reconstructive market fundamentals (pricing and volume) have languished over the recent past with little signs of stability. The joint replacement market has been hit by patient deferral of elective procedures, leading to weak demand for hip and knee implants.
Pricing compressions on hips, knees and spine products, which impaired the performances of several orthopedic companies, remain a key concern, at the macro level. We remain skeptical about companies including Stryker, Wright Medical Group and Smith & Nephew, given the sustained price/volume pressure. Moreover, these players have been subject to downward estimate revisions for 2013 over the last 90 days.