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Tickers in this Article: ISRG, XHE, IHI, MDT, TMO
Health care has been a pretty solid sector so far in 2013, with the space rising above the overall market in the year-to-date time frame. While many investors have been focused in on the outperforming biotech segment, there has also been some strength in the often-overlooked medical device sector too.

This corner of the market has been a good performer as well to start the year, as the sector has fought through Obamacare tax worries to post strong long term gains. In fact, top ETFs in the space have beaten out the S&P 500 over the past five years by a decent margin, suggesting a pretty good track record for the industry (see Medical Device ETFs: A Better Way to Play Health Care?).

However, the recent run may be coming to an end thanks to some weakness in one of the sector’s key components. Surgical device maker Intuitive Surgical (ISRG) gave a bad warning for its Q2 results, pushing its shares sharply lower by about 18% on the day (ISRG currently has a Zacks Rank #4- Sell).

What Happened to ISRG?

The firm released preliminary second quarter 2013 results of $575 million in revenue, compared to $537 in revenues for the year ago period. Meanwhile, net income looks to come in at just $160 million, compared to $155 million for the same time frame a year ago.

The instruments and accessories revenue division also saw decent growth, of roughly 18%, though this offset a reduction in stocking orders related to a decline in system sales, according to the company’s press release. While this was disappointing, the real pain was probably due to the lackluster revenues on the firm’s key da Vinci Surgical System.

The company released preliminary results on sales for this important segment that showed a decrease in terms of year-over-year revenues of roughly 6%. Intuitive Surgical sold 143 da Vinci Surgical Systems during the quarter—compared to 150 last year—but saw a huge decline in the U.S. market, citing hospital spending pressures as the main culprit for the decline (instead see 2 Great Healthcare ETFs in Focus).

The firm’s President and CEO, Gary Guthart, also chimed in on the report, revealing his displeasure with the results. "While we are disappointed in our performance this quarter, particularly with respect to our capital sales in the U.S., overall procedure performance was solid in a difficult environment. We remain confident in the value that our products and services bring to patients, hospitals and the healthcare system."

As you might imagine, the stock sold off significantly on this release, while analysts also downgraded the stock. At time of writing, the losses were approaching $90/share for the day, while volume was already ten times normal, only half way through the session.



Medical Device ETF Impact

This horrendous report also had a negative impact on medical device ETFs. The space was down on an up day thanks to this ISRG release, and we have highlighted some of the funds that were the hardest hit by this news below:

iShares Dow Jones US Medical Devices ETF (IHI)

This is easily the most popular medical device ETF on the market, tracking the Dow Jones US Select Medical Equipment Index. This benchmark produces a fund that holds roughly 40 companies in its basket, charging investors 45 basis points a year in fees for this exposure.

The ETF is a bit concentrated, as firms like Medtronic (MDT) and Thermo Fisher Scientific (TMO) combine to account for roughly 20% of the assets. ISRG makes an appearance in the top five though, accounting for roughly 6.4% of the fund.

IHI was up about 16% in 2013 before the ISRG release, but the ETF saw modest losses after the report, falling by about 1.6% on heavy volume (read 3 Top Ranked Sector ETFs for Earnings Season).

SPDR S&P Health Care Equipment ETF (XHE)

The newest entrant in the medical device space, this ETF follows the S&P Health Care Equipment Select Industry Index. This benchmark results in an ETF that has about 60 companies in its basket, though fees come in at just 35 basis points a year.

Investors should also note that this product is a bit more spread out than its counterpart, allocating less than 3% to each stock in the fund. Due to this, ISRG only makes up about 2.3% in this product, in line with a number of other stocks in the ETF.

XHE was up 14.1% to start 2013 before ISRG revealed its bearish report, and the fund only fell 0.9% immediately following the release. Obviously the lack of concentration certainly helped XHE on the day, though it has led to some underperformance in the longer term when compared to IHI (see 5 Most Popular ETFs of the Second Quarter).

Bottom Line

The news from ISRG isn’t good for the medical device sector. While the company saw decent sales in markets outside of the U.S., the real trouble was clearly in the important domestic market.

Here, the company cited cost pressures being pushed down onto hospital spending, an item that is causing many to defer new expenditures at this time. While this is obviously just one company, if others in the sector share similar concerns, it could signal a rough stretch for the segment, suggesting that investors need to keep an eye on earnings reports this season if they are thinking about the medical device ETF space at this time.

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