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 Scientific 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.
ABIOMED INC (ABMD): Free Stock Analysis Report
ABBOTT LABS (ABT): Free Stock Analysis Report
BECTON DICKINSO (BDX): Free Stock Analysis Report
BOSTON SCIENTIF (BSX): Free Stock Analysis Report
CONMED CORP (CNMD): Free Stock Analysis Report
EDWARDS LIFESCI (EW): Free Stock Analysis Report
HAEMONETICS CP (HAE): Free Stock Analysis Report
JOHNSON & JOHNS (JNJ): Free Stock Analysis Report
MEDTRONIC (MDT): Free Stock Analysis Report
SPRINT NEXTEL (S): Free Stock Analysis Report
ST JUDE MEDICAL (STJ): Free Stock Analysis Report
STRYKER CORP (SYK): Free Stock Analysis Report
VARIAN MEDICAL (VAR): Free Stock Analysis Report
WRIGHT MEDICAL (WMGI): Free Stock Analysis Report
ZIMMER HOLDINGS (ZMH): Free Stock Analysis Report
ZOLL MEDICAL CO (ZOLL): Free Stock Analysis Report
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