ARTC Arthrocare Corp. (MM)

The medical devices industry, which was once acclaimed for its high-paying jobs and research and development opportunities, has been subject to the much controversial 2.3% medical device excise tax since its enactment in the beginning of 2013. Sequestration-related spending cuts to the U.S. federal budget have also undermined the medical devices industry’s prospects. In fact, this has significantly restricted the industry’s bottom-line improvement in the past year.

Partial Repeal: A Boon?

However, as a slight respite, in Jan 2014, the National Institutes of Health (NIH) got a $1 billion or 3.5% boost to its fiscal 2014 budget from the prior-year post-sequestration budget (according to fiscal 2014 Omnibus Appropriations bill, released on Jan 13, 2014). According to a statement by appropriators, this hike, although insignificant, is expected to result in 385 million new grant opportunities for researchers compared to 2013. We note that the sequestration, which resulted in a 5.5% cut in the NIH fiscal 2013 budget, resulted in 640 fewer grants in 2013.

Apart from NIH, the National Institutes of Standards and Technology, The National Science Foundation (NSF), health professions and nursing workforce development programs are some of the others to gain from this bill.

The U.S. Food and Drug Administration (FDA) has also managed to get $2.552 billion through this omnibus spending package, a $166 million (7%) increase over the fiscal 2013 post-sequestration funding level. The Centers for Disease Control and Prevention (CDC) received a $370 million or 6.8% increase over the year-ago post-sequestration funding level.

Situation Remains Bleak

Even more than three months after the Senate passed the Omnibus Appropriations bill, the research funding scenario continues to look bleak. Most economists are of the opinion that with cost of research rising astronomically, this nominal revision can hardly bring any reprieve. While the additional funding for NIH will help sustain current projects and begin funding for new research grants, this is still $714 million short of NIH’s pre-sequestration budget.

Further, things are not at all cheery for the Centers for Medicare and Medicaid Services (CMS). While the bill included $3.7 billion for the CMS, this was $195 million less than what was enacted in the previous fiscal.

Unless totally repealed or replaced, these spending cuts will last through 2021. NIH expects sequestration to turn graver in the coming years leading to serious consequences like delaying progress in medical breakthroughs, deterioration in job creation and tempering of economic growth. An NBC news article recently noted that many new researchers, who were trained with the U.S. taxpayers’ money, may have to move to Europe and Asia where government funding for medical research is on the rise.

Moreover, the medical device excise tax is taking a heavy toll on the MedTech sector, hurting pricing decisions of companies and subjecting them to tremendous margin pressure. The 2.3% excise tax (effective Jan 2013), which is imposed on the sales price instead of net profit, amounts to a sizable sum, wiping out almost a quarter of the profit at the med instrument owners.

The big players are trying out ways to change their business model and cost structure to accommodate the excise tax. These companies are undertaking various restructuring initiatives to counter costs incurred from the implementation of the new tax. Restructuring especially to offset the effect of the excise tax has already been adopted by several key players. The companies are also trying to focus on strategic mergers and acquisitions (M&A), emerging market expansion or are reducing operations in order to weather the tax burden.

M&A Activities

MedTech M&A continues unabated in 2014. Wary of an uncertain economy, MedTech giants have resorted to the acquisition route to harness their strengths and diversify offerings.

The first quarter earnings season in the medical device sector kicked off with such a mega acquisition announcement. Last week, on its earnings call, Zimmer Holdings (ZMH) disclosed that it has entered into a definitive agreement to acquire Biomet, Inc. -- a provider of surgical and non-surgical products -- for a transaction value of $13.35 billion. According to Zimmer, with the successful completion of this acquisition, it will be better able to capture the $45 billion musculoskeletal industry.

Another noteworthy move in recent times is the colossal $13.6 billion takeover of Life Technologies Corporation by its major peer Thermo Fisher Scientific (TMO) which closed in February. In the same month, artificial knee and hip maker Smith & Nephew plc (SNN), entered into an agreement to buy Arthrocare Corporation (ARTC) for $1.7 billion in order to expand its product line in sports medicines.

Global orthopedic device makers, Stryker Corporation (SYK) and Wright Medical Group, Inc. (WMGI) are also resorting to inorganic means to expand their businesses. In April, Stryker acquired German surgical tools firm, Berchtold Holding. In March, it acquired U.S.-based developer of hip arthroscopy products, Pivot Medical. In December last year, Stryker was in the headlines with its $1.65 billion acquisition of robotic assisted surgery developer, MAKO Surgical Corp.

Wright Medical to expand in the fast growing extremities market, announced a couple of acquisitions: Solana Surgical and OrthoPro. Earlier in November, Wright Medical completing the acquisition of French orthopedic extremities company Biotech International.

Some other significant newest buyouts include Covidien plc’s (COV) $860 million acquisition of Israel-based diagnostic products maker Given Imaging (in February) and Quest Diagnostics’ (DGX) takeover of Solstas Lab Partners Group and its subsidiaries for approximately $570 million (Mar 2014). Besides, to expand its dental business in Europe, in February, Henry Schein, Inc. (HSIC) acquired five companies from a Dutch company, Arseus NV.  

There have been many more M&As in the MedTech space. Boston Scientific Corporation (BSX) closed the acquisition of Bard EP, the electrophysiology business of C.R. Bard, Inc. (BCR). Earlier in September, Baxter International (BAX) closed its $3.9 billion deal to acquire Gambro AB, a Sweden-based renal products company.  

In the light of the discussion above, we see no slowing down of M&A deals in the MedTech space in rest of 2014. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates.

Divestments

With the medical device excise tax in force, leading to further contraction in profit margins, we have been observing a lot of divestments of late, particularly of non-core business segments. Divestments, specifically to offset the tax, have been announced by many key players. We expect this trend to continue in the rest of 2014.

MedTech giant Johnson & Johnson (JNJ), after its $1 billion acquisition of privately-held, pharmaceutical discovery and development company, Aragon Pharmaceuticals, Inc, in Apr 2014 announced its decision to sell off its Ortho-Clinical Diagnostics business to The Carlyle Group (CG) for about $4 billion. The divestment, which is expected to go through in mid-2014, will help the company increase its focus on the core pharma business.

Taking a cue from Abbott Laboratories (ABT), which separated its research-based pharmaceuticals business by creating a new company AbbVie (ABBV) last year, Baxter International revealed in Mar 2014 that it will split its biopharmaceuticals and medical device segments into two independent companies in order to put greater management focus on these two businesses.

In January, Wright Medical exited the hip and knee implant market with the $290 million divestment of its OrthoRecon business to MicroPort Scientific Corporation and its affiliates. In January again, Covidien sold off its Confluent Surgical product line for approximately $235 million.

Novartis (NVS) has also entered into a definitive agreement to divest its blood transfusion diagnostics unit to Spain-based Grifols for $1.675 billion. Kimberly-Clark Corporation (KMB) on the other hand is working on a potential tax-free spin-off of the company's health care business. In November last year, Quest Diagnostics divested its Enterix colorectal cancer screening test business.

Emerging Markets

Although the U.S. still holds the leading position with almost one-third of global market share, a gradual slowdown in established markets due to a number of lingering headwinds are forcing MedTech companies to look for opportunities in the developing world. Currently, with the growth rate remaining in low single digits in developed markets like the U.S., Europe and Japan, large-cap medical device makers are looking to invest more in the high-growth emerging regions.

Accordingly, emerging economies like Brazil, Russia, India and China (BRICs) as well as Turkey, Mexico, Malaysia, South Africa, South Korea and the Czech Republic are fast coming up in the medical devices space. These emerging economies are seeing an increasing uptake in medical devices largely due to growing medical awareness and economic prosperity.

An aging population, increasing wealth, government focus on healthcare infrastructure and expansion of medical insurance coverage make these markets a happy hunting ground for global medical device players. Expansion in emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2014 and beyond.

Among the BRIC members, Brazil is currently the largest healthcare market in Latin America, covering almost one-fourth of the population. Though India has one of the largest and fastest growing healthcare markets in the world, it is considered to have the least developed healthcare infrastructure and spends relatively little in this area. In order to reverse the trend, during the 12th Plan (2012-2017), the Indian government planned to spend 2.5% of its GDP (up from 1.2% earlier) on health care and raise it to at least 3% by 2022.

Accordingly, big players in the MedTech sector are vying to expand their presence in BRIC and other emerging markets. These companies are also looking to establish their manufacturing facilities abroad.

Abbott continues to lead the trend with about 40% of sales coming in from the emerging markets. The company expects this contribution to increase to 50% by 2015. Johnson & Johnson showed 13% growth in the BRIC nations during the first quarter of 2014 and is currently working to increase its presence in these regions.

The company has already set up manufacturing and R&D centers in Brazil, China and India and expects to expand further in China on the back of the Synthes acquisition.

Becton, Dickinson and Company (BDX), with about 58% of revenues from international markets, witnessed double-digit sales growth in emerging geographies during the first quarter with China growing over 25% at constant exchange rate (CER). For Medtronic, emerging market grew a robust 12% (at CER) in its third quarter fiscal 2014, representing more than 13% of the company’s total sales mix. Management is targeting 20% of its revenues from emerging markets, adding incremental revenues of $2.5 billion over the long term with mid-teens growth for the current fiscal.

Against the backdrop of flattening or declining sales growth in developed markets, Boston Scientific achieved 8% international growth in the first quarter of 2014 on the back of 22% growth in emerging markets, which represented 9% of total company sales.

Stryker, with 7% sales coming from emerging markets in the first quarter of 2014, is expected to grow market share further in key geographies like China and India. Orthopedic major, Smith & Nephew, continued to gain double-digit sales growth in emerging markets.

Thermo Fisher is also expanding its presence in emerging markets. It expects to garner 25% of total revenues from the high-growth Asia-Pacific region and emerging markets by 2016, up from 19% in 2011. According to the company, China with its rapid industrialization, increasing focus on healthcare, new BioPharma R&D centers and government sponsored research has robust growth potential.

Zacks Industry Rank

Within the Zacks Industry classification, MedTech is broadly grouped into the Medical sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: med instruments, med products, med/dental-supp and medical info systems.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for med instruments is #101, med products is #161, med/dental-supp is #164, while the medical info systems is #216. Analyzing the Zacks Industry Rank for different MedTech segments, it is obvious that while the outlook for medical info systems stocks is negative, that for med instruments, med products and med/dental-supp is neutral.

Earnings Trend of the Sector

So far, 41.2% of the Medical sector participants have reported first quarter results which have been fairly good with respect to beat ratios (percentage of companies coming out with positive surprises). We note that the results were not impressive in terms of year-over-year growth.

The earnings "beat ratio" was 76.2%, while the revenue "beat ratio" was 38.1% in the first quarter. Total earnings for the companies in this sector increased a strong 15.2% year over year on revenue growth of 16.2%. In fact, earnings and revenues showed a massive improvement from the fourth quarter 2013 performance.

The earnings is expected to increase by 3.1% in the second quarter 2014. The sector is expected to register an impressive growth of 8.1% for the full-year 2014 and 16.2% in the full-year 2015. In terms of revenue expectation, the sector is expected to register 7.3% year-over-year growth in the second quarter of the year, resulting in an annual growth rate of 7.4%.

For more information about earnings for this sector and others, please read our ‘Earnings Trends’ report.

OPPORTUNITIES

In spite of several core market challenges, the big three medical device players -- Medtronic, Boston Scientific and St. Jude Medical, Inc. (STJ) -- are striving to gain share in the ICD market through new product launches. With gradual stability in the ICD market, these players should be able to revive their top line. In the first quarter of 2014, St. Jude Medical’s ICD revenues increased 2.1% (3% in constant-currency).

Although Boston Scientific posted another quarter of weak ICD sales with 3.1% year-over-year decline, it is taking several initiatives to revive its top line. We also wait for a better-than-expected ICD performance from Medtronic which is slated to report its fourth quarter and fiscal 2014 results on May 20.

The Cooper Companies Inc. (COO) holding a Zacks Rank #2 (Buy) represents a value proposition based on factors such as margin expansion, acquisitions, product line expansion and geographical reach as well as share buybacks. Johnson & Johnson holding a Zacks Rank #2 has been trying to offset the declining sales of some of its important products by bringing in new products through in-licensing deals and acquisitions.

Beyond the MedTech majors, we are also optimistic about the Zacks Ranked #3 orthopedic device players, Zimmer Holdings and Stryker Corporation. The percentage of population over 65 in the U.S., Europe, Japan and other regions is expected to nearly double by the year 2030. We believe the orthopedic giants stand to benefit from this aging demography.

Among scientific instrument makers, Thermo Fisher Scientific has been successfully expanding operating margins over the past few quarters on the back of operational efficiency. Apart from the newest incorporated segment Life Sciences Solution segment with the buyout of Life Technologies, Thermo Fisher’s market leading portfolio of analytical technologies demonstrated strong performance with growth in the Life Sciences Mass Spec and Chromatography businesses.

Among other MedTech stocks, Mead Johnson Nutrition Company (MJN), Covance Inc. (CVD), Cardinal Health, Inc. (CAH), Illumina Inc. (ILMN) and Hologic Inc. (HOLX) carrying a Zacks Rank #2 (Buy) also look attractive.

CHALLENGES AND WEAKNESSES

Coming to the weakest link in the MedTech sector, we advise investors against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends for 2014 reflect a bearish sentiment.

Stocks which do not look inspiring are Intuitive Surgical (ISRG) sporting a Zacks Rank #5 (Strong Sell), Wright Medical, Volcano Corporation (VOLC), CareFusion Corporation (CFN), Haemonetics Corporation (HAE), Patterson Companies, Inc. (PDCO) and DENTSPLY International Inc. (XRAY), all carrying the Zacks Rank #4 (Sell).
 
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