MedTech Defies Sequestration, M&As Steal the Show - Industry Outlook

By Zacks | Updated August 26, 2014 AAA

A confluence of several factors over the past few years has created ferment in the medical device market the world over. The investment climate for the medical device majors has become increasingly difficult due to the global economic downturn resulting in growing regulatory and budgetary pressures, cost escalation and resource constrictions.

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 beginning 2013. Sequestration-related spending cuts have also undermined the medical devices industry’s prospects. In fact, this has significantly hindered the industry’s bottom-line improvement last year.

Does the 2015 HHS Budget Set a Positive Trend?

Healthcare spending has been projected to grow at a rate of 5.8% from 2012 to 2022. However, with the sluggish economic recovery, difficult capital spending environment and weak growth for Medicare and Medicaid, the growth rate in 2013 was pretty low.

However, the $1 billion or 3.5% boost to its fiscal 2014 budget, from the prior-year post-sequestration level, received by the National Institutes of Health (NIH) comes as a slight reprieve. Appropriators say that this hike, though 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, led to 640 fewer grants last year.

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 in 2014. 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.

Nonetheless, the prospects for 2015 still remain bleak. Despite the expected improvement in economic conditions, the expansion of the Affordable Care Act (ACA) coverage and not to forget an aging population, the Budget for the Department of Health and Human Services (HHS) promises a total of $1 trillion in outlays and $77.1 billion in discretionary budget authority for fiscal 2015 – this is a reduction of $1.3 billion from the current fiscal. Going by this budget, estimated savings over the next 10 years will be as much as $355.6 billion.

However, the budget promises $4.6 billion for health centers, of which $3.6 billion has been financed by the Affordable Care Act’s Community Health Center Fund, to serve approximately 31 million patients in 2015. This will lead to the establishment of 150 health centers in new areas of the country.

Besides, $14.6 billion of strategic investment will be made in three key areas: $4 billion in expanded funding for the National Health Service Corps (in addition to $100 million in discretionary funding and $310 million in current law funding for 2015), $5.2 billion for a new Targeted Support for Graduate Medical Education program and $5.4 billion for enhanced Medicaid reimbursements for primary care.

For the second time in a row, NIH managed to increase its budget funding. Although not so significant like it was in the earlier year, the fiscal 2015 budget includes $30.4 billion for the NIH, an increase of $211 million over 2014 reflecting that the government’s focus on investment in advanced medical research has not been shaken even in its drive to stimulate economic growth.

For the FDA, the 2015 budget included $29 million for improving the protection of human and animal health through integrated monitoring of antimicrobial resistance. Besides, the budget added $1.5 billion, up $273 million over fiscal 2014, to boost the efforts of the FDA and CDC for implementing the Food Safety and Modernization Act. For the Centers for Medicare and Medicaid Services (CMS), the budget allocation is $897.3 billion in mandatory and discretionary outlays, a net increase of $54.3 billion above the previous fiscal.

Real Picture Remains Cloudy

Even more than six months after the Senate passed the Omnibus Appropriations bill, the research funding scenario does not look very encouraging. Most economists are of the opinion that with cost of research rising astronomically, the slender boost to the budget can hardly bring any respite. While the additional funding for NIH will help sustain current projects and begin funding for new research grants, this is still short of NIH’s pre-sequestration budget.

NIH expects the sequestration (expected to last till 2021) to turn harsher 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 2.3% medical devices excise tax, 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.

To weather the squall, medical device companies are coming up with efficient capital allocation and ingenuous business model innovation. In this regard, they are working on reducing fixed costs, conducting research and development prudently and extracting strategic value from intellectual property. 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.

Following Zimmer Holdings’ (ZMH) $13.35 billion mega acquisition plan of Biomet, Inc., the leading U.S. medical device major Medtronic Inc (MDT) came up with its plan to buy Irish rival Covidien plc (COV) for $42.9 billion in cash and stock. This has off late become a common ploy for medical stocks to dodge the steep U.S. corporate tax rate by shifting its tax base overseas. Zimmer, on the other hand, expects the successful completion of the Biomet acquisition to help capture the $45 billion musculoskeletal industry.

In addition to these major impending takeovers, Stryker Corporation (SYK) has once again made it to the headlines with rumors of its bid to acquire London-based orthopedic major Smith & Nephew plc (SNN) surfacing again. The investors are still hopeful and expect the acquisition of Smith & Nephew to further boost Stryker’s competitive position in the hip and knee replacement market following the $1.65 billion MAKO acquisition.

Besides, Stryker closed the $375 million acquisition of Small Bone Innovations' North American assets in August and acquired the German surgical tools firm, Berchtold Holding in April. On the other hand, In May, Smith & Nephew acquired Arthrocare Corporation for $1.7 billion in order to expand its product line in sports medicines.

In July, Danaher Corporation (DHR) announced that its indirect wholly-owned subsidiary Beckman Coulter will be acquiring the clinical microbiology business of Siemens Healthcare Diagnostics for an undisclosed amount.

Global orthopedic device maker Wright Medical Group, Inc. (WMGI) has also taken the inorganic route to expand its business in the fast growing extremities market. After completing the acquisition of French orthopedic extremities company Biotech International, the company announced a couple of other acquisitions: Solana Surgical and OrthoPro. Johnson & Johnson (JNJ) is also pursuing growth through suitable acquisitions, especially to boost its cardiovascular business.

Some other significant recent buyouts include the colossal $13.6 billion takeover of Life Technologies Corporation by Thermo Fisher Scientific (TMO); the acquisition of Nordion, a provider of products and services to the global health science market by Sterigenics International for $805 million; Covidien’s $860 million acquisition of Israel-based diagnostic products maker Given Imaging and Quest Diagnostics’ (DGX) takeover of Solstas Lab Partners Group and its subsidiaries for approximately $570 million.

The list of M&As in the MedTech space goes on. After closing the acquisition of Bard EP, the electrophysiology business of C.R. Bard, Inc. (BCR), Boston Scientific Corporation (BSX) announced its plans to acquire the Interventional Division of German healthcare major Bayer AG (BAYRY). The deal, valued at $415 million, is a step toward strengthening the company’s foothold in the global peripheral interventions market.

Divestments

With the medical device excise tax in force, leading to further contraction in profit margins, we have also been observing a lot of divestments lately, 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 going forward.

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 Inc. (BAX) 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. On the verge of splitting its business in July Baxter decided to offload its commercial vaccines division to its pharmaceutical rival Pfizer Inc. (PFE).

In the same month, MedTech major Abbott Laboratories inked an all-stock deal with Mylan (MYL) to divest a portion of its generics pharmaceuticals business for a deal value of $5.3 billion. While Abbott expects to gain strategic flexibility with more focus on emerging market, Mylan is looking to save taxes besides expanding its portfolio.

Johnson & Johnson, after its $1 billion acquisition of privately held, pharmaceutical discovery and development company, Aragon Pharmaceuticals, Inc, in Apr 2014 sold off its Ortho-Clinical Diagnostics business to The Carlyle Group (CG) for about $4 billion. The divestment will help the company step up its focus on the core pharma business. Stryker on similar lines decided to divest its Bone Morphogenetic Protein-7 (BMP-7) assets to Mariel Therapeutics, Inc., a clinical stage biopharmaceutical company.

In May, Symmetry Medical, Inc. (SMA) announced the sale of its U.K. based subsidiary Clamonta Ltd. to The HLD Corporation Ltd. for approximately $1.3 million (or £0.8 million) to focus on core markets and shed manufacturing footprint.

Emerging Markets

Although the U.S. still holds the leading position with almost one-third of global market share, a gradual slowdown in matured 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 increasingly looking to invest 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.

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 market which is expected to increase to 50% by 2015. The company’s growth strategy includes building leadership positions in key emerging geographies across its wide portfolio. In the most recent quarter, while sales from developed and other markets declined 4.7% on an operational basis, sales in key emerging markets climbed 9.7% driven by growth in Brazil, India and China.

Johnson & Johnson is also looking to increase its presence in emerging markets. The company is looking forward to the opening of its Shanghai Innovation Center in Oct 2014. J&J 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.

For Becton, Dickinson and Company (BDX), with about 60% of revenues from international markets, emerging geographies during the second quarter witnessed 9% sales growth with China growing at an impressive 21% at constant exchange rate (CER).  

For Medtronic, emerging market grew a robust 11% (at CER) in its first quarter fiscal 2015, representing more than 13% of the company’s total sales mix. Although, growth in India and China fell below expectations, the Middle East and Africa region demonstrated strong 30% growth. Management is targeting 20% of its revenues from emerging markets, which is expected to add incremental revenues of $2.5 billion over the long term.

In the face of flattening or declining sales growth in developed markets, Boston Scientific achieved 14% international growth in the second quarter of 2014 on the back of 19% growth in emerging markets.

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

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 #85, medical info systems is #90, med products is #164 while the med/dental-supp is #209. Analyzing the Zacks Industry Rank for different MedTech segments, it is obvious that while the outlook for med instruments stocks is positive, that for med products and medical info systems is neutral. The outlook for med/dental-supp remains bearish.

Earnings Trend of the Sector

So far, 98% of the Medical sector participants have reported second quarter results which have been fairly good with respect to beat ratios (percentage of companies coming out with positive surprises). The results were also pretty impressive in terms of year-over-year growth.

The earnings "beat ratio" was 77.6%, while the revenue "beat ratio" was 83.7% in the second quarter. Total earnings for the companies in this sector increased a strong 15.7% year over year on revenue growth of 12.3%. In fact, earnings and revenues showed a decent improvement from the first quarter 2014 performance.

The earnings is expected to increase by 6.8% in the third quarter 2014. The sector is expected to register an impressive growth of 12.9% for the full-year 2014 and 12.4% in the full-year 2015. In terms of revenue expectation, the sector is expected to register 10.0% year-over-year growth in the third quarter of the year, resulting in an annual growth rate of 10.9%.

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 a gradual stability in the ICD market, these players should be able to revive their top line.

In the second quarter of 2014, while St. Jude Medical’s ICD revenues increased 1%, Boston Scientific’s defibrillator revenues were up 3% year over year at CER. Although Medtronic posted a quarter of weak ICD sales, the company is looking to enter into a new launch cycle with the CRT-D that is expected to boost ICD sales growth.

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. McKesson Corporation (MCK) holding a similar Zacks rank has posted a fiscal first quarter beat and subsequent increase in earnings guidance for 2015.

We are also optimistic about medical device major Edwards Lifesciences Corp. (EW), another Zacks Rank #2 holder based on the company’s strong strategic growth plan and financial goals.

Beyond the MedTech majors, we are optimistic about the Zacks Ranked #3 orthopedic device player 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 giant stands 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.

Among other MedTech stocks, Opko Health, Inc. (OPK), Abaxis, Inc. (ABAX), Symmetry Medical, Inc. (SMA), ICU Medical, Inc. (ICUI) and NuVasive, Inc. (NUVA) carrying a Zacks Rank #2 (Buy) also look attractive.

CHALLENGES

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 Accuray Inc. (ARAY) bearing a Zacks Rank #5 (Strong Sell), Hanger, Inc. (HGR), Zimmer Holdings, Inc., Cyberonics Inc. (CYBX), Thoratec Corp. (THOR), ResMed Inc. (RMD) and ABIOMED, Inc. (ABMD), all carrying the Zacks Rank #4 (Sell).

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