STJ ST. Jude Medical, Inc.

A host of macro headwinds (including price and procedure volume pressure) which hit the MedTech industry last year continued to haunt the sector during the March quarter and encumber growth. Although a number of these issues are expected to linger through the remainder of 2011, the industry is expected to fare relatively better this year thanks to several tailwinds and growth opportunities.

Industry Dynamics

The global medical devices industry is fairly large, intensely competitive and highly innovative, with estimated worldwide sales of more than $300 billion in 2011. The U.S. is the largest market, with estimated sales of roughly $95 billion in 2010.

The medical devices industry is divided into different segments including Cardiology, Oncology, Neuro, Orthopedic and Aesthetic Devices. The U.S. medical devices industry continues to grow at a brisk pace, backed by 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.

Last year was challenging for medical device companies given the exigent economic conditions and a precarious healthcare environment. The MedTech industry faced several issues in 2010, including pricing concerns, hospital admission and procedural volume pressures, health care reform, reimbursement pressures and increasing regulatory involvements, which put investors in a dilemma about these stocks.

While several catalysts for growth in 2011 exist -- such as new product cycles, an aging population, geographic expansion, ongoing transition towards minimally-invasive techniques and emerging markets -- lingering issues from last year are expected to remain an overhang.

The aging population represents a major catalyst for demand of medical devices. The elderly population (persons 65 years and above) base in the U.S. was roughly 40 million in 2010, representing around 13% of the nation’s population and accounting for a third of health care consumption. Federal government estimates indicate that the elderly population will catapult to 72 million by 2030, ensuing a major boost for medical devices utilization.

Given the maturing legacy markets, medical device companies are looking to expand into lucrative incipient markets. Expansion in the emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2011 and beyond.

Pros and Cons of U.S. Healthcare Reform

The Government-mandated healthcare reform in the U.S. enacted last year -- the Patient Protection & Affordable Care Act -- has created a degree of uncertainty for medical devices companies. The reform has led to a less flexible pricing environment for these companies and may pressure pricing across the board.

Moreover, the proposed tax on device companies will be a drag. Nevertheless, the Act places considerable emphasis on patient safety and aims to reduce the number of uninsured people (from 19% of all residents in 2010 to 8% by 2016). The new law is expected to eventually extend health insurance coverage to an estimated 32 million Americans currently not insured.

Reimbursement Scenario

Medical device companies are susceptible to significant reimbursement risks as their products are reimbursed by the Center for Medicare and Medicaid (“CMS”) and commercial payers. Third-party reimbursement programs in the U.S. and abroad, both government-funded and commercially insured, continue to develop different means of controlling healthcare costs, including prospective reimbursement cuts with careful review of medical bills and stringent pre-approval requirements.

Increase in the publicly insured base (resulting from the healthcare reform) is expected to lead to lower reimbursement obtained by physicians, hospitals and other health care providers as public insurance generally offers lower reimbursement vis-à-vis private payors. Moreover, private insurance companies are increasing their scrutiny of certain surgeries, which may materially impact utilization in 2011. Changes in reimbursement policy significantly impact medical device companies as they hurt demand for their products and revenues.

The 510(k) Reform – More Stringent Regulation

The U.S. Food and Drug Administration (FDA) declared, in August 2010, a set of ambitious proposals for revamping the 510(k) device approval protocols. The 200-page report, consisting of 55 proposed changes, was designed to serve as a blueprint for the reform, representing FDA’s vision to streamline the device review process and make it more predictable and transparent.

As part of the listed proposals, the FDA intends to create the “Center Science Council,” which will oversee medical device science-based decision-making. Moreover, the regulator is seeking additional information regarding the safety and efficacy of devices in the 510(k) submissions. The FDA also aims to form a subset of moderately risky devices under the “Class IIb” moniker that would require submission of more clinical data and manufacturing information compared to the existing Class II devices.

In a major move, the FDA outlined a plan in January 2011, consisting of 25 proposals, which it intends to implement during 2011 to improve the regulatory approval pathway for medical devices. Most of these proposals, announced by the FDA’s Center for Devices and Radiological Health (“CDRH”), appear favorable for the medical devices industry.

The proposals are aimed at overhauling the three-and-a-half-decade-old 510(k) device approval program by which roughly 4,000 devices have been cleared annually. The list includes streamlining the de novo review process for lower-risk devices, clarifying when devices companies should submit clinical data for a 510(k) application and establishing a new council of senior FDA experts.

However, interestingly, the regulator has shelved the most controversial issues of its previously-announced proposals including a definition of its authority to rescind approval of potentially unsafe or ineffective products and the creation of a new category of devices, which have drawn sneers from industry groups and devices companies.

President Obama emphasized that the planned changes represent the government’s efforts to keep patients safer and accelerate the approval process of innovative and life-saving products.

The CDRH forwarded seven of the controversial proposals to the Institute of Medicine, which provides national advice on medical issues, for independent review. These issues were met with significant concerns as indicated in the comments submitted to the public docket.

The FDA plans to implement its new set of plans through a process of regulatory actions such as draft guidance and proposed regulations, which will be open to public feedback. CDRH stated that it will wait for the pending review report of the Institute of Medicine before making a final decision.

While the 510(k) overhaul is still in process, it may eventually make device approval more complex, lengthy and burdensome. Moreover, with the expected rise in the regulatory bar for approvals, medical devices companies may be required to shell out more for R&D.

Our Thesis

We continue to recommend companies providing life-sustaining products and procedures, given their strong recurring stream of revenues as patients are unable to forego these products. Furthermore, investors should look at companies with strong earnings quality and liquidity profiles. These companies appear attractive considering their ability to leverage strong balance sheet and cash flows in maximizing shareholder value (via dividends/share repurchases).

Large companies with a wide product portfolio/healthy pipeline and strong infrastructure are also better poised for improved returns. Moreover, companies focusing on more judicious R&D investment, expansion into new markets and cost-saving through restructuring are better placed in 2011. These companies have greater capability of withstanding the sustained macro-level issues and increasing regulatory pressure.

Pressed by a still soft economy, top-tier devices makers are continuing their merger/acquisition binge in 2011, especially as a means to enter new markets and diversify their portfolio. Although this represents an important means for growth, we continue to advise investors to shun companies that have grown historically through extensive acquisitions only.

These companies may find it difficult to fund acquisitions considering the lingering impact of the recession. Also, they face increasing challenges in integrating acquisitions and delivering operational synergies from them, which are considered to be the prime reason for failures of mergers and acquisitions. Moreover, we still recommend investors to eschew companies making non-life-sustaining products and procedures (including elective procedures such as hip and knee replacement), as they are still engulfed by softened patient demand.

OPPORTUNITIES

In our universe, we see growth potential in companies dealing with cardiovascular devices, neuro, radiation oncology and blood-related products. Names include Medtronic Inc. (MDT), Boston Scientific Corporation (BSX), St. Jude Medical (STJ), Edwards Lifesciences (EW), ZOLL Medical (ZOLL), Abiomed Inc. (ABMD), Varian Medical (VAR) and Haemonetics Corporation (HAE).

The above-listed companies produce life-sustaining products and are less affected by economic turbulence. Some of these companies have been successful in weathering the storm (pricing, currency and volume headwinds) in the cardiovascular space in the wake of recovery.

In addition, low global penetration and robust demand provides a positive long-term thesis for investing in the blood processing industry. Also, the radiation oncology market is benefiting from improving trends and technology advancements, providing a compelling growth opportunity. These companies are all leading players in their respective fields and are potential winners in the long run.

MedTech Giants: Few Hiccups but Long-Term Winners

With a slew of new products, the Big Three players (Medtronic, Boston Scientific and St. Jude) in the $6.5 billion implantable cardioverter defibrillator (“ICD”) market are well positioned to gain market share, despite the challenging business environment and several other barriers to growth. These companies represent a good bet for long-term investors.

Among the names above, Medtronic, the undisputed leader in the MedTech space, has a diversified presence in cardiovascular, neuro, spinal, diabetes and ENT and boasts an attractive pipeline. Although the company witnessed slower market growth of ICD in the U.S. in the most recent quarter, new products should gradually contribute to growth and help it maintain/gain ICD share.

The long-awaited issue of the FDA warning letters, relating to Medtronic’s Mounds View facility and manufacturing unit in Puerto Rico, was finally resolved in March 2011, paving the way for the U.S. approval and launch of new products including the much-anticipated Protecta ICD device.

We believe that the recently approved REVO MRI SureScan pacemaker and Arctic Front catheter should provide some support to Medtronic’s CRM business. REVO is already gaining positive initial market acceptance and is expected to be key growth drivers going ahead. The company’s struggling spinal franchise should also benefit gradually from the recent product launches.

Moreover, Medtronic plans to adopt restructuring initiatives (including workforce reduction) to sustain long-term growth. The company is also blessed with strong cash flows which it prudently uses for maximizing shareholder value. Medtronic is active on the acquisition front and is investing in emerging markets, which it considers an increasingly important growth driver.

Boston Scientific has maintained its leadership position in the drug eluting stent (“DES”) market with 46% share in the U.S. market. The launch of Taxus Element stent (commercialized as Ion) in the U.S. in April 2011 strongly places the company to gain DES share. Moreover, its pipeline DES product Promus Element (expected launch in the U.S. in mid-2012) is shaping up to be a major driver of its stent business. Besides, the acquisition of asthma-treatment company Asthmatx has enabled Boston Scientic to target the pulmonary devices area.

Boston Scientific has undertaken a series of management changes and restructuring initiatives that are expected to contribute to the bottom line moving forward. The company plans to expand its footprint in the emerging markets by reinvesting the savings from restructuring efforts. In this context, we reckon the company’s divestiture of its Neurovascular business as a smart move, enabling it to prepay a portion of the debt and invest in high growth markets.

We remain intrigued by St. Jude’s ability to consistently produce positive earnings surprises and revenue growth. The company is poised for incremental opportunities in CRM on the back of strong product momentum. St. Jude’s Fortify and Unify lines of ICDs are already gaining notable traction. Moreover, launch of several products (including the quadripolar CRT systems) should boost the company’s CRM market share in 2011.

The recent European clearance of the Accent MRI pacemaker and the approval ShockGuard technology, designed for use with the Fortify and Unify systems, represents an incremental positive for the company. Another encouraging prospect is St. Jude’s April 2011 pact with health care supply contracting company Novation. Under the deal, Novation will make the company’s CRM products available to some of the leading academic centers in the U.S. This should broaden the use of St. Jude’s products and technologies and boost its market share.

Moreover, the recent U.S. approval of two new irrigated ablation catheters (Safire BLU and Therapy Cool Path) for treating cardiac arrhythmias should help St. Jude sustain the healthy growth in Atrial Fibrillation through 2011.

Trifecta, which was launched in Europe in fourth-quarter 2010 and was recently approved in the U.S., represents a major new driver for the company’s Cardiovascular franchise. St. Jude’s tissue valve business in Europe is growing more than 30% rate and the company expects similar growth in the U.S.

We are also optimistic about the emerging opportunity in the intravascular imaging market, enabled by the company’s LightLab acquisition in July 2010. Moreover, its $1.3 billion acquisition of heart devices maker AGA Medical Holdings will eventually make St. Jude a clear leader in the structural heart market. The company expects the acquisition to help its sales grow at a low double-digit rate in 2011.

However, we do acknowledge the fact that a soft CRM market may be a drag on these stocks. The prevailing macroeconomic factors, pricing pressure, austerity measures and the impact of health care reform are expected to continue to weigh on the CRM market through 2011. Data for the U.S. defibrillators market, published in the first-quarter 2011, indicate deterioration in the defibrillator market growth rate, including the pricing impact.

The CRM market also faces a number of challenges including physician reaction to recent study results published by the Journal of the American Medical Association (“JAMA”) regarding evidence-based guidelines for ICD implants and the U.S. Department of Justice’s investigation into hospitals' ICD implants.

Beyond the MedTech giants, Edwards Lifesciences represents another value proposition. The company recorded strong revenue growth in the first quarter, banking on robust performance of its heart valve therapy products. Moreover, Edwards’s strong balance sheet enables it to target suitable acquisitions. Importantly, its Sapien transcatheter heart valve is slated for review by the FDA Advisory Panel on July 20, 2011. The U.S. approval of the device should offer a major boost to the company’s sales in the long term.

Another interesting pick in our portfolio is resuscitation devices-maker ZOLL Medical. ZOLL is a leading player in the global market for external defibrillators, which is worth more than $1 billion. The company’s LifeVest wearable defibrillator business continues to grow at a healthy quarterly run rate, benefiting from increased awareness of the product and associated sales force enhancements. Moreover, its significant international presence should also push growth.

We also believe that cardiac assist devices maker Abiomed represents another favorable opportunity for investors. The company possesses a broad portfolio of products that are life-sustaining in nature and has been able to deliver sustainable growth in a challenging economy. Abiomed enjoys strong demand for its Impella cardiac pumps. Higher Impella sales continue to fuel double-digit revenue growth. Based on an upbeat Impella outlook, Abiomed recently issued a solid revenue guidance.

Varian is the world’s leading manufacturer of integrated radiotherapy systems for treating cancer. The company is poised to increase its market share in the radiation oncology market. Varian is currently enjoying a healthy demand for its coveted RapidArc radiotherapy technology, which is meaningfully contributing to its oncology net order growth. Strong order activity in oncology coupled with healthy momentum in the X-ray products business will set the stage for better performance in 2011.

We are also optimistic about scientific instrument maker Thermo Fisher Scientific (TMO). The company has been successful in expanding operating margins over the past few quarters on the back of operational efficiency and cost control. Thermo Fisher has strong international exposure and is focusing on emerging market for growth.

The company’s strong cash position enables it to make suitable acquisitions. Moreover, the acquisition of leading chromatography systems maker Dionex Corporation has provided Thermo Fisher ample scope to further strengthen its position in mass spectrometry, representing one of the fastest growing categories in life sciences tools.

Emerging Markets: A Lucrative Prospect

The leading U.S. cardiovascular devices companies such as Medtronic, Boston Scientific and St. Jude are exploring new avenues of growth beyond the mature pacemaker and ICD markets. These companies are increasingly seeking opportunities to expand into fast-growing new therapy areas within or outside the cardiology space, including markets such as atrial fibrillation and neuromodulation.

Among the emerging cardiology markets, an encouraging prospect represents the structural heart market with its major categories including Patent Foramen Ovale (PFO) and Left Atrial Appendage (LAA) occlusion. The AGA acquisition has provided St. Jude with devices targeted at PFO and LAA markets.

Moreover, the Transcatheter Aortic Valves (TAVI) market, a potential blockbuster prospect, is emerging as a substantial new growth opportunity for the top-tier MedTech companies. St. Jude recently registered the first human implant of its next-generation TAVI product dubbed Portico. Medtronic’s TAVI offering, CoreValve, is currently undergoing evaluation in a pivotal trial in the U.S.

Intravascular ultrasound imaging (IVUS), Optical Coherence Tomography (OCT) and other next-generation imaging technologies are expected to offer incremental opportunity for the incumbent players such as Volcano Corp. (VOLC), Boston Scientific and St. Jude. The OCT market has been projected to grow at a double-digit clip over the next five years. We believe that emerging markets represent a key catalyst for growth in 2011 and beyond.

Improving Hospital Spending Cycle

A soft hospital capital spending backdrop was challenging for the MedTech stocks in 2010. The North American and European markets were affected by shrinking budgets for equipment purchases at the height of the recession. However, first quarter results indicate continued recovery in hospital spending in the U.S. Spending levels are improving as hospitals appear to have started replacing their worn-out equipment. This may turn into a potential driver moving forward.

WEAKNESSES

Japan Debacle: Greater Impact Looms?

The impact of the March 11 earthquake (and Tsunami) in Japan and its aftermath on the medical devices industry appears to be substantial. Japan is the second-largest medical devices market (after the U.S.) and accounts for roughly 45% of the medical devices industry in the Asia-Pacific region.

The roughly $25 billion Japanese medical devices sector has been an extremely successful market for American medical devices firms. U.S. firms account for roughly 60% of all imported medical devices products in Japan.

MedTech majors such as Medtronic, Boston Scientific and Johnson & Johnson’s (JNJ) Depuy has a major exposure to the Japanese medical devices sector. Other key players such as Abbott Laboratories (ABT), St. Jude, Stryker Corporation (SYK), Becton, Dickinson (BDX) and Zimmer Holdings (ZMH) also have a strong foothold in this lucrative market. Many of these players derive sizable revenues from Japan and envision lower sales from this region to weigh on their top line in 2011.

The impact of the horrific disaster is being already felt as it has led to a major disruption in the global supply chain with Japan being a critical link. It has resulted in some delays in shipments, elective surgical procedures and regulatory clearance for new products. The negative impact of the Japan crisis on MedTech companies with high exposure is expected to become more pronounced in the June quarter.

Investors in devices companies, especially those with large export businesses in Japan, have been concerned over the long-term effect of the Japan crisis (as reflected in falling share prices), which is hard to gauge at this moment.

Softness in Orthopedic Lingers

We continue to advise investors to spurn companies in the orthopedic domain. Companies in this space continue to struggle as patients defer their elective procedures given the lingering economic softness, exacerbated by sustained pricing pressure. Companies that fit the bill include Stryker, Zimmer Holdings, CONMED Corporation (CNMD), Wright Medical Group (WMGI) and Symmetry Medical (SMA). While most of these names beat expectations in the first quarter we remain cynical about these stocks given the sustained price/volume pressure.

However, we acknowledge that companies such as Stryker and Zimmer, with less exposure to metal-on-metal (MoM) hip products, are better placed to gain share in 2011 than their highly-exposed counterparts such as JNJ/Depuy and Wright Medical. The ongoing transition from MoM implants to next-generation hip systems represents a tailwind for these players.

Pricing Woes Here to Stay

Pricing compressions on hips, knees and spine products, which impaired the performances of most of the orthopedic companies in 2010, remain a key concern, at the macro-level. The effect of government health care cost containment efforts and continuing pressure from local hospitals and health systems as potential Medicare reimbursement cuts create additional reasons for hospitals to push back pricing. This is expected to continue hurt selling prices on a global basis.

Moreover, the advent of group purchasing organizations (GPOs), which act as agents that negotiate vendor contracts on behalf of their members, has also put pressure on pricing. The prevailing economic climate has bolstered the bargaining power of GPOs. The pricing scenario in 2011 is expected to stay the same as last year as hospitals continue to push back pricing.

Spine: Still Hurts

The U.S. spine market, which grew at a double-digit rate in 2009, took a tumble in 2010. The spinal market was worst hit by the pricing/volume headwinds and payor push back as manifested by a moribund quarterly growth trend. Leading companies in the orthopedic space such as Stryker and Zimmer continue to experience price and volume pressure, which was evident in their March quarter results.

Pricing pressure and reimbursement uncertainties coupled with austerity measures in Europe are expected continue to weigh on this market over the next few quarters. Moreover, private payors are delaying spine surgeries by requiring more documentation before approving such procedures, thereby contributing to the slowdown in this market.

Volume: Stabilized but Still a Headwind

The $12 billion replacement hips and knees markets have been affected by lingering economic softness, as reflected in procedure volume pressure. Cash-strapped patients continue to defer surgeries given the weak economy.

Procedural volumes in the U.S. have been negatively impacted as a result of a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans.

As per the demographic analysis, these trends had a significant impact on the potential patient base for joint replacement procedures, those between 45 and 65 years of age and without any Medicare coverage. On the other hand, austerity measures are contributing to the reduction in procedure volumes in Europe . The hip/knee market in Europe is expected to remain challenged in 2011, but to a lesser extent than 2010.

Companies such as Stryker and Zimmer derive a chunk of their revenues from replacement hips and knees. Both these companies reported weak knee sales in the most recent quarter. A general sluggishness in procedure volume continues to impinge on the results of the leading players in the orthopedic market.

March quarter trends indicate that procedure volume growth across hip and knee markets still remain sluggish (although manifesting some signs of sequential stabilization) and a material turnaround is not likely at least in the near term. In fact, the timing of the rebound in procedure volume to pre-recession level remains unclear, at this stage. As such, we continue to recommend investors to steer clear of the above-mentioned orthopedic stocks until a substantial recovery in the pricing/volume environment materializes.
 
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