June quarter results mostly mirror the preceding quarter as a host
of macro headwinds (including price and procedure volume pressures)
continued to haunt the MedTech industry and weighed on the
performance of the incumbent players. Although a number of these
issues are expected to linger over the second-half 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 highly-regulated 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 health care costs, including
prospective reimbursement cuts with careful review of medical bills
and stringent pre-approval requirements.
An increase in the publicly insured base (resulting from healthc
are 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.
Recently, in a bid to curb the nation’s bloated budget deficit, the
Obama administration has passed a bill which includes plans to cut
health care expenditure. Under the bill, a 12-person bipartisan
panel was created to recommend a sharp reduction in spending on
government programs including Medicare, Medicaid and Social
Security. Medicare and Medicaid, which account for about 20% of the
federal budget, represent a key target of the deficit-reduction
plan. The bill aims to cut $2.4 trillion in federal government
spending over the next decade.
Federal budgetary pressure (given a potential reduction in U.S.
government’s health care spending) has raised reimbursement risk as
payors may more actively pursue their cost reduction initiatives.
Changes in reimbursement policy significantly impact medical
devices companies as they hurt demand for their products and
revenues.
The 510(k) Reform – Changes on the Horizon?
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 (to include devices such as infusion
pumps) 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 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 (“IOM”), 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.
In a shocking move, in late July 2011, the IOM recommended the FDA
scrap the 510(k) process and replace it with a new regulatory
framework that integrates pre-market clearance and better
post-market surveillance. The IOM review concluded that the 510(k)
process fails to evaluate the safety and effectiveness of Class II
devices before they enter the market. The recommendation was met
with immediate industry-wide criticism.
However, the FDA noted that the IOM’s recommendation is not binding
and the 510(k) process should not be eliminated. The regulator is
currently seeking public feedback on the proposal (a meeting
scheduled in mid-September 2011) with plans in place to decide on
potential changes in late September/early October 2011.
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 and radiation oncology products.
Names include
Medtronic Inc. (MDT),
Boston
Scientific Corporation (BSX),
St. Jude
Medical (STJ),
Edwards Lifesciences (EW),
ZOLL Medical (ZOLL),
Abiomed Inc.
(ABMD) and
Varian Medical (VAR).
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.
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: A Few Hiccups but Long-Term
Winners
With a spate 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 have a number of
levers to pull and 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 weakness in its ICD business 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.
Boston Scientific has maintained its leadership in the drug eluting
stent (“DES”) market. The company saw all-round growth during the
second quarter, outstripping its own guidance, although the CRM
segment remains challenging. After several quarters, growth in the
Cardiovascular portfolio came as a pleasant surprise. Based on a
strong quarter, the company raised its guidance for 2011. We
recently upgraded the stock to Outperform.
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 devices are already
gaining notable traction.
Several new products (including the quadripolar CRT-D systems)
should boost the company’s CRM share in 2011, despite the weak
market conditions. However, we do account for the fact that
approval of the highly-anticipated quadripolar CRT-D, has been
pushed back to early fourth-quarter 2011 from mid-2011.
Beyond the MedTech giants, Edwards Lifesciences represents another
value proposition. The company recorded strong revenue growth in
the second quarter, banking on robust performance of its heart
valve therapy products. Apart from heart valve therapy, healthy
growth at the critical care segment (led by Flotrac systems and
pressure monitoring products) is also encouraging.
Moreover, Edwards’s robust balance sheet enables it to target
suitable acquisitions. Following the favorable recommendation of
the FDA Advisory Panel for Sapien THV (for inoperable patients),
the company is confident of receiving final approval by October
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.
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 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.
Another value proposition is robotic surgical systems maker
Intuitive Surgical (ISRG). Intuitive’s recurring
revenue stream continues to grow and provides a shield against
cyclicality of revenues, arising from the sale of discretionary
capital equipment to hospitals. We believe that its da Vinci
surgery system has the capacity to improve outcomes and cut down on
procedure time.
We expect a number of procedures that are currently completed
either in an open surgical manner or with laparoscopy to be
eventually replaced by da Vinci surgery, as robotic surgery becomes
the standard of care in many instances. The company enjoys a
virtual monopoly in robotic surgery with little competition.
Intuitive expects total procedure count to increase in the band of
27%-29% year over year in fiscal 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. Moreover, the company is also buying Sweden-based blood test
systems maker Phadia for $3.5 billion.
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 has
registered the first human implant of its next-generation TAVI
product dubbed Portico. The company expects to commence the
European clinical trial of Portico valve in late 2011 (launch
expected by first-half 2013). 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 companies 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
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, results from the first two quarters of 2011 indicate a
silver lining stemming from continued recovery in hospital spending
in the U.S. Spending levels are improving as hospitals appear to
have started replacing their worn-out equipment. A healthy
replacement/upgrade cycle may turn into a potential driver moving
forward.
WEAKNESSES
Impact of Japan Debacle
The impact of the horrific March 11 earthquake in Japan and its
aftermath 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.
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. U.S. medical devices firms account for roughly
60% of all imported medical devices products in Japan.
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.
Investors in devices companies, especially those with large export
businesses in Japan, have been concerned over the long-term effect
of the Japan crisis, which is hard to gauge at this moment.
A Still Clouded Orthopedic Outlook
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. The
reconstructive market fundamentals (pricing and volume) remains
challenging with little or no clear visibility for a material
turnaround in second-half 2011.
Companies that fit the bill include Stryker, Zimmer Holdings,
CONMED Corporation (CNMD),
Wright Medical
Group (WMGI) and
Symmetry Medical (SMA).
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 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 Continues to Hurt
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 results for
the first two quarters of 2011.
Pricing pressure and reimbursement uncertainties coupled with
austerity measures in Europe are expected continue to weigh on this
market through 2011. Moreover, private payors are delaying spine
surgeries by requiring more documentation before approving such
procedures, thereby contributing to the slowdown in this
market.
Volume: Stabilizing 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 and reimbursement-related pushback.
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. Volume headwind is likely
to sustain through the back half of 2011 as unemployment continues
to influence procedure deferrals.
Companies such as Stryker and Zimmer derive a chunk of their
revenues from replacement hips and knees. Most of the leading
players in the orthopedic space reported weak knee sales in the
most recent quarter, echoing a general softness in the market.
June quarter trends indicate that procedure volume growth across
hip and knee markets still remain sluggish (although stabilized
sequentially) 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
EDWARDS LIFESCI (EW): Free Stock Analysis Report
INTUITIVE SURG (ISRG): Free Stock Analysis Report
JOHNSON & JOHNS (JNJ): Free Stock Analysis Report
MEDTRONIC (MDT): Free Stock Analysis Report
ST JUDE MEDICAL (STJ): Free Stock Analysis Report
STRYKER CORP (SYK): Free Stock Analysis Report
THERMO FISHER (TMO): Free Stock Analysis Report
VARIAN MEDICAL (VAR): Free Stock Analysis Report
VOLCANO CORP (VOLC): Free Stock Analysis Report
ZIMMER HOLDINGS (ZMH): Free Stock Analysis Report
ZOLL MEDICAL CO (ZOLL): Free Stock Analysis Report
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