A Mid-Year Assessment of Medtech Finances

Includes exclusive online content

Goldman, Sachs & Co. executives have never really been comfortable courting the public or the press. But two years ago, as the global investment bank contended with congressional hearings, federal fraud charges and an unflattering media portrayal as a “great vampire squid” (courtesy of Rolling Stone magazine), company bigwigs had little choice but to step outside their comfort zones to help repair the firm’s reputation.

Earlier this spring, Goldman stewards revisited that (dis)comfort zone, only this time, there were no government lawsuits or derogatory digs from pop culture journalists from which to seek redemption.
There was a similar literary lashing though, and it was almost as damaging as the Rolling Stone comment. Former executive director Greg Smith, disgusted with firm’s greedy values and its “toxic and destructive environment,” quit his job but submitted his scathing resignation letter to The New York Times. In his 1,252-word letter, Smith chided the firm for its lack of integrity and accused some managing directors of belittling clients as “muppets.”

While Smith’s public resignation was not as serious as the 2010 fraud charges or as demeaning as the Rolling Stone insult, it nonetheless prompted another round of image-building efforts by Goldman managers. Chief Executive Lloyd C. Blankfein spearheaded the most recent goodwill games, speaking publicly about the company’s focus on clients and its commitment to gay rights. (Goldman’s official response to Smith’s resignation—”we will only be successful if our clients are successful”—became the central theme of Blankfein’s message to a disconcerted society).

Yet Blankfein did not rely solely on speeches or lighthearted television interviews to restore public trust in the bank. He also enlisted the help of rank-and-file Goldman employees to restore integrity to the firm. Analyst David Roman, for instance, tried improving the company’s image with medical device manufacturers by predicting growth in the stagnant implantable cardioverter defibrillator (ICD) market. Though he is forecasting a paltry 1 percent expansion by year’s end, Roman’s conjecture gives hope to device makers that have been waiting patiently for a turnaround in the industry.

“We continue to see global pricing pressure in our IC [interventional cardiology] and CRM [cardiac rhythm management] businesses and lower defib procedure volumes in the U.S. compared to a year ago,” Boston Scientific Corp. CEO Hank Kucheman told analysts during an April 19 conference call to discuss the company’s first-quarter earnings. “However, the positive signs we saw in the U.S. last quarter suggesting possible stabilization in de novo implant volumes in the defib market and some easing of the pricing pressures in DES [drug-eluting stents] continued in the quarter…We remain optimistic about our future outlook.”

Kucheman has good reason to be optimistic about the remainder of 2012: First-quarter endoscopy sales jumped 5 percent and worldwide peripheral intervention device sales rose 8 percent. IC and CRM revenue fell 5 percent and 10 percent, respectively, but those products should be turning a profit by the fourth quarter if Roman’s forecast holds true.

St. Jude Medical Inc. and Medtronic Inc. might also benefit from the ICD market turnaround, though a slowing economy and worsening European debt crisis could doom Roman’s rosy outlook.

With such threats now looming large (the latest government data shows a scant 69,000 jobs added to the U.S. labor market in May) and no real consecutive pattern to first-quarter earnings, Medical Product
Outsourcing polled several analysts over the last few weeks to better gauge device companies’ potential for profit and losses over the next six months.

Analysts included:

• John Babitt, medtech leader for the Americas at global advisory services firm Ernst & Young;
• Glenn Novarro, managing director, Medical Supplies & Devices at RBC Capital Markets, a global investment bank with 70 offices worldwide; and
• Venkat Rajan, industry manager for the North American Medical Devices team at Frost & Sullivan, a Mountain View, Calif.-based market research and consulting firm.

Medical Product Outsourcing: With first-quarter earnings reports showing a mix of revenue/sales gains and losses, please discuss your expectations for medical device company earnings for the remainder of 2012.

John Babitt: 2012 looks to be an overall challenging year for growth in the device sector due to limited new product introductions, continued pricing headwinds from both providers and as well as payers in terms of coverage, and the lack of growth in overall hospital volumes and high unemployment. Despite their unique challenges, emerging markets and new therapeutic areas such as percutaneous heart valves offer some interesting avenues for growth.

Glenn Novarro: Most medical device companies have set the bar low for 2012. This is a change from 2011, when companies projected a pickup in surgical volumes in the second half of 2011. As we know now, the global economy slowed in the second half of 2011 and companies had to lower 2011 sales and earnings guidance in July/August 2011. As a result, several companies have provided conservative 2012 sales and earnings guidance, hoping to avoide the mistakes of 2011. On 1Q earnings conference calls, most of the companies I cover re-affirmed 2012 guidance despite delivering upside to 1Q guidance. Given macro concerns, i.e., Europe and F/X [foreign exchange], companies were hesitant to say volumes were improving and raise guidance for 2012. Thus, I would expect my coverage list to meet expectations for the remainder of the year.

Venkat Rajan: Overall, the sector is improving, especially coming out of last year. In 2011 we saw companies recover from some of the hits that were taken in 2009 due to the recession. We’re seeing hospitals bending up, so a lot of purchases that had been delayed during that time period due to access to capital and other resources are now picking up. I’m expecting potentially strong growth in certain areas. I think a lot of the established markets are going to continue to be mature. Areas like pacemakers, stents, ICDs, I see fairly flat growth and there should be some opportunities in the robotics space. Treatment areas that are currently underserved like peripheral vascular disease, including the lower limbs and the carotid space, should have some growth. The neurostimulation space is another one we see that would have some strong opportunities for long-term growth.

MPO: Are there any sectors within the industry (orthopedics, diagnostics, cardiovascular, for example) that are expected to perform better than others or stagnate in the second half of the year?

Novarro: If the economy weakens in in the secong half of this year, spine and orthopedic companies are more likely to disappoint versus cardiovascular device companies. Ortho and spine procedures are elective. If an individual loses their job and therefore their insurance coverage, a knee/hip procedure can be delayed. Cardiovascular procedures, (i.e., pacemakers, heart valves, etc.) are not elective. Thus, while all surgical procedures will slow if the economy slows in the second half of 2012, cardio procedures will slow less.

Rajan: There is definitely a lot of growth opportunity in the neurology space. There’s a lot of different new technologies that are available there. There are certain product sectors with specific fields that should have strong growth opportunities. A lot of the established markets will see fairly flat single-digit growth rates at best, so technologies like hip and knee, pacemakers, ICDs, minimally invasive spine procedures—they are large established markets, but in terms of growth opportunities, they’re going to be fairly stagnant. Growth is going to come from new technologies, underserved spaces like peripheral vascular disease—it’s a strong market and we’ve seen some increased focus there. There’s been a lot of M&A in that space in the last two years with companies like Stryker, Johnson & Johnson and Covidien being fairly aggressive and beefing up their product portfolios. A lot of that is in neurovascular treatments—embolic coils used for aneurysm treatment and similar technologies—we are fairly bullish about the treatment opportunities there. There’s also the transcatheter valve opportunitis with Edwards [Lifesciences LLC], the first to get approval here in the U.S. late last year. They are going through a fairly structured rollout of the products. They had fairly minimum sales in Q1 but I think it was by intent in terms of feeling out the market and rolling out their product. I expect their transcatheter sales to be fairly strong by the end of the year. There’s been a lot of interest around renal denervation technologies.

Babitt: We continue to see the most interest and best growth prospects in diagnostics and life science research tools. New areas such as companion diagnostics that can be used in personalizing medicine and tools that aid new targeted research should provide interesting growth avenues. Companies
specializing in these areas have also been very active on the M&A front.

MPO: How will the European debt crisis potentially affect U.S. device sales and volume?

Rajan: Most companies are aware of it. Obviously austerity measures have limited growth opportunities there, but overall, since the recession hit, most companies have seen fairly flat growth in the major markets from the U.S., Japan and Western Europe. There’s not likely something that will significantly alter that, especially given the austerity measures that are fairly ingrained in government protocol.

Babitt: Companies are rethinking how they do business and, in particular, if they want to do business in markets that have extented payment terms and experiencing incremental financial uncertainty. In other markets we have observed some fairly draconian pricing terms and tenders that have caused companies to reassess their European business. It is now not uncommon for EU [European Union] sales reps to be debt collectors first and sales reps second.

Novarro: Europe represents about 25 percent of sales for the group. Europe will impact the group in two ways. First, as the euro currency weakens, the translation of European sales into the U.S. dollar will yield less sales and profitability. Most companies hedge currency exposure and try to limit the impact on EPS [earnings per share], but there will be a modest negative impact on EPS. Companies updated 2012 guidance in late April assuming a euro of $1.31. The euro is now down 5 percent since then. While my coverage list should be able to offset such an impact through cost control, a weaker euro will limit any upside to EPS come July/August, when companies start reporting 2Q results. Second, European sales will slow as the euro-zone economy slows. However, as European governments fund all surgical procedures and this funding has already taken place at the beginning of the year, the impact from a weaker euro zone will be felt more in 2013 when governments replenish hospital budgets. A weaker second half will lead to governments offering less funding in 2013.

MPO: If/when a solid, sustainable economic recovery takes hold, will larger-cap companies or smaller firms be better positioned to take advantage of the growth?Why?

Babitt: Larger companies have spend considerable efforts over the past few years on operational efficiencies and enhancing product offerings with tuck-in acquisitions. Any general lift in overal economic activity, which should include an expansion in the number of individuals covered by health insurance, should really benefit the larger companies. All of this needs to be balanced against an earnings drag from the device tax, which is scheduled to be implemented in 2013.

Novarro: If there is a sustainable recovery in the global economy, all the companies I cover would benefit, but orthopedic and spine companies would benefit the most. Yes, smaller companies may benefit more, but any sustainable economic recovery would be a positive for the entire group. Small companies that would benefit in orthopedic/spine, just to name a few, would include NuVasive Inc. and Tornier.

Rajan: Good question. The established markets have slowed down but the bigger companies have taken advantage of the economic climate to acquire companies with strong growth potential. I think we’ve seen that a lot with deals from companies that have pursued others. J&J has a new CEO who is fairly focused on building up their medical device business. There were some articles in The WallStreet Journal and other places talking about how they [J&J] will be aggressive now like they were with the Synthes acquisition last year. If they see something that’s attractive and fits a need, they’ll be going after it. Due to the nature of the economic climate, companies can be aggressive in M&A deals. The device tax coming into effect next year – which will put a 2.3 percent tax on all device sales – obviously will further hurt margins but in order to address that, big companies have better positioned themselves to take advantage of emerging treatment areas and emerging markets. The medical technology spend in China and India is growing at 20 percent or in the high teens and so they [big companies] are trying to establish themselves further in those markets.
Bigger companies are positioned better because as a small device firm, your product is pretty much all you have, and you might not have the same resources to go after a new treatment area unless you take significant risk either because it’s fairly early stage or you have the resources to deploy the amount of field individuals and resources in some of these emerging markets. Due to cost containment issues here in the UnitedStates, regardless of whether the healthcare reform bill stays or not, healthcare spending is constrained due to the nature of the market. Reimbursement is going to be fairly flat long term and if the device tax goes into effect it will affect margins here in the United States. If you want to grow your top line it’s going to have to come from these emerging markets where there’s a significant need to upgrade and invest in new technology and the middle class is growing. With that said, it’s not easy. There’s significant demand there and a significant need for these technologies but each country, whether it be Brazil, China, India or even some other up and coming area like Turkey, have significant need. However, due to the differences in each country’s healthcare systems, the governments that are in place and the mix of government pay vs. out of pocket pay, it’s not as easy as it is entering Europe or the United States. There are no national distribution structures for medical devices in Europe or the United States – there’s not one source where you can go and say ‘Here’s our device. Can you sell it across the country?’ You have to target specific groups. In China, you have to work through the government; even so, there’s competition that’s coming up in those markets. Local manufacturers inChina, India and some of the other regions will sell lower-priced products to compete against yours. An effective strategy in these emerging regions is going to be fairly critical.

MPO: What recommendation would you give to capitalists looking to invest in medical device stocks?Are there any that are more worthy investing in than others?

Novarro: My advice would be as follows: 1.) Invest in unmet medical needs; 2.) Invest in differentiated technologies; 3.) Invest in technologies with strong patent positions, and 4.) Invest in areas that are being ignored by the larger companies as this could potentially increase the likelihood of being acquired.

Rajan: You have to look at the underserved patient populations where currently available treatment options are not adequate enough – where drugs don’t necessarily offer a definite cure. Some of the hot growth areas are peripheral vascular disease, neurostimulation, renal denervation, where there is significant interest in addressing hypertension. Hospitals that have implemented advanced stereotactic radiosurgery programs have found them to be fairly profitable relative to other treatments, so there is a need and utilization for those kinds of programs. If you look at stock performance, Intuitive Surgical Inc. has been one of the strongest stocks over the last couple of years, which seems counterintuitive given the economy and capital spending limits. You’d think the economy would have hurt companies like Intuitive Surgical or some of the stereotactic radiosurgery firms, but there’s a need for the technology.

Babitt: No crystal balls, but a few trends from M&A activity to note. Overall, the macro factors for diagnostics and life science research tools continue to be favorable as reflected by high PE ratios and high M&A take-out premiums. Also, the number of mid-market medtech companies (market cap $100 million to $500 million) should continue to be an attractive sector as larger medtechs are reliant on growth from M&A and the universe of available targets continues to shrink.

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