The performance of incumbent players in the MedTech industry
continued to be hamstrung by a spate of macro issues (including
sustained price and procedure volume pressures) in the September
quarter. The prevailing macroeconomic factors, pricing headwinds,
austerity measures, reimbursement pressure and the impact of health
care reform continues to weigh on the medical devices industry,
exacerbated by Europe's sovereign debt plight.
The beleaguered U.S. implantable defibrillator market continues to
bother cardiac devices makers, as reflected by sustained implant
volume pressure. On the other hand, companies in the orthopedic
domain remain affected by a still choppy reconstructive implant
market as they faced sustained pressure across hip, knee and spine
businesses in the third quarter (albeit to a lesser extent
vis-à-vis the sequentially prior quarter).
Although a number of these issues are expected to linger through
2011, the industry is expected to fare relatively better this year
thanks to several attractive growth opportunities and healthy
tailwinds.
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. Innovation is
the quintessential in MedTech industry leading to continuous
advancement in treatment and delivery of health care while driving
competitiveness through differentiated and improved product
offerings.
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 industry faced several issues in 2010, including
pricing concerns, hospital admission and procedural volume
pressures, health care reform, reimbursement issues and increasing
regulatory involvements, which put investors in a dilemma about
these stocks. Yet, the MedTech industry weathered the economic
vortex better than many others and is emerging as an important
contributor to economic recovery.
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 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 fillip 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 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 is materially impacting
utilization in 2011.
The 510(k) Reform – A Regulatory Overhang
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. 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.
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),
Thoratec Corporation (THOR) and
Varian Medical (VAR).
The above-listed companies make life-sustaining products and are
less affected by the economic turbulence. These companies are all
leading players in their respective fields and are potential
winners in the long run. Some of these players have been successful
in weathering the storm (pricing, currency and volume headwinds) in
the cardiovascular space.
MedTech Majors: 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 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 is experiencing weakness in its ICD business,
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 new REVO
MRI SureScan pacemaker and Arctic Front catheter should provide
support to Medtronic’s CRM business.
Boston Scientific has maintained its leadership in the drug eluting
stent (“DES”) market. Its pipeline DES product Promus Element
(expected U.S. launch in mid-2012) is shaping up to be a major
driver for its stent business. Although the CRM segment remains
challenging, we believe that the company’s continuous focus on
strategic initiatives to drive growth and profitability should
yield steady results moving ahead.
Boston Scientific is leaving no stone unturned to stay on course
for growth. It has undertaken a series of management changes and
restructuring initiatives that are expected to contribute to the
bottom line and margins. The company also plans to expand its
footprint in the emerging markets by reinvesting the savings from
restructuring efforts. It has recorded double-digit sales growth
across Brazil, India and China, the three largest emerging markets,
in the most recent quarter.
We remain intrigued by St. Jude’s ability to consistently produce
positive earnings surprises and revenue growth. The company is
gaining ICD market share despite a sluggish market condition. St.
Jude is poised for incremental opportunities in CRM on the back of
strong product momentum. A surfeit of new growth drivers are
expected to offer opportunities for accelerated sales growth over
the next few years.
St. Jude’s Fortify and Unify devices are gaining notable traction
and increased penetration of these products should enable it to
expand its position in CRM. The company recently commenced the
European roll out of its Unify quadripolar CRT-D system and is
currently awaiting approval of the product in the U.S. ,
representing a major growth prospect. St. Jude is currently the
only company to offer this technology globally. Moreover, the
company is well placed to leverage the solid growth momentum in
atrial fibrillation market.
Beyond the MedTech giants, Edwards Lifesciences represents another
value proposition. The company recorded strong revenue growth in
the third quarter, banking on robust performance of its heart valve
therapy products. Apart from heart valve therapy, healthy growth at
Critical Care and Cardiac Surgery Systems segments was
encouraging.
Edwards recently received the U.S. approval for the
highly-anticipated Sapien transcatheter aortic heart valve (for
inoperable patients). With this approval, it became the first
company in the U.S. to receive approval for a transcatheter device
which allows surgeons to replace a patient's ailing aortic valve
without resorting to open-heart surgery. 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 attractive 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. The company turned in a profit in the
most recent quarter riding on record sales. Higher Impella sales
fueled healthy double-digit revenue growth. We have upgraded the
stock to Outperform based on its strong results and upbeat
prospects for Impella.
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. Intuitive enjoys nearly a monopoly in robotic
surgery.
Another upbeat prospect is heart devices maker Thoratec. The
company enjoys a first mover advantage in the ventricular assist
devices (VAD) market and the growing number of centers for its
HeartMate II pumps indicates increasing acceptance. VAD represents
a substantial market opportunity for Thoratec with a significant
number of eligible heart failure patients globally.
With HeartMate II, Thoratec enjoys a monopoly in the U.S. market
because it is the only device of its kind for the destination
therapy indication (for heart failure patients who are not eligible
for heart transplant). Favorable adoption trend of the device is
expected to support revenue growth moving forward. We recently
upgraded the stock to Outperform.
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. 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 recently closed its acquisition of
Sweden-based blood test systems maker Phadia for $3.5 billion,
adding allergy and autoimmunity diagnostic tests to its portfolio
and strengthening its position in the high-growth specialty
diagnostics markets.
Emerging Markets: A Big Role to Play
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 fourth-quarter 2011 and
is optimistic about its entry in the European TAVI market by
end-2012. 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. Another emerging prospect is renal
denervation for treating resistant hypertension. We believe that
emerging markets represent a key catalyst for growth in 2011 and
beyond.
Favorable 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 three 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 will favorably impact results in the
December quarter.
WEAKNESSES
Japan - Weakest Link in the Chain
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.
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.
A Still-Clouded Orthopedic Space
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) remain
challenging with little or no clear visibility for a material
turnaround in near future. Reconstructive procedure volumes in the
September quarter have been lower than historical utilization
rates.
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: A Lingering Issue
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 three 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 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.
September quarter trends indicate sustained lumpiness in procedure
volume growth across hip and knee markets (although manifesting
signs of stabilization) and a substantial recovery 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. We continue to recommend investors to steer clear of the
above-mentioned orthopedic stocks until the pricing/volume pressure
unwinds.
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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