MedTech Industry Stock Update - May 2013

by Zacks Equity Research

May 15, 2013 |

As expected, MedTech mergers and acquisitions (M&A) are heating up in 2013. Finally, the much-hyped takeover battle for Life Technologies Corporation (LIFE) came to an end last month with Thermo Fisher Scientific (TMO - Analyst Report) emerging as the clear winner.

For most of the last seven years, Thermo Fisher has supported its business momentum by acquiring several entities. Nevertheless, the proposed acquisition of Life Technologies is the biggest-ever deal for the company since its inception in 2006. The takeover will inevitably strengthen Thermo Fisher’s global foothold and commercial reach.

It's a Buyer’s Market

Medical device M&As are not stopping there. Wary of an uncertain economy, MedTech companies have resorted to the acquisition route to harness their strength and diversify offerings.

Last month, in a bid to strengthen its contraceptive portfolio, Bayer (BAYRY) inked a deal to buy contraceptive device-maker Conceptus Inc. (CPTS) for approximately $1.1 billion in cash. This impending acquisition will add the Essure permanent (non-surgical) birth control system to Bayer’s product portfolio. The transaction is expected to close by mid-2013.

In Mar 2013, Becton, Dickinson and Company (BDX) acquired AustriA-based Cato Software Solutions, the manufacturer of “catoA? and chemocatoA?” software, a suite of comprehensive medication safety solutions for pharmacy intravenous medication preparation, physician therapy planning and nurse bedside documentation.

Low global penetration and demand outstripping supply provide a positive long-term thesis for investing in the blood processing and supply chain management industry. With the acquisition of the transfusion medicine business of Pall Corporation (PLL), Haemonetics (HAE) entered the $1.2 billion whole blood collection market. Moreover, in May 2013, Haemonetics acquired Hemerus Medical that develops technologies for the collection of whole blood, and processing and storage of blood components.

Also, Quest Diagnostics’ (DGX) acquisition of UMass Medical Lab in Jan 2013 is in sync with its goal to create a planned 'lab of the future.' According to the company, this will help boost its long-term growth opportunities in the faster-growing esoteric markets.

Additionally, earlier this month the company announced the acquisition of the outreach testing operations of Dignity Health in California and Nevada. Quest Diagnostics expects to complete additional fold-in acquisitions, consistent with its goal of generating 1–2% revenue growth per year through accretive acquisitions.

Apart from the abovementioned takeovers and/or acquisitions, at the end of last year, Baxter International (BAX) entered into a $4 billion deal to take over Gambro AB, a Sweden-based privately-owned renal products company. The deal which is expected to close in the second quarter of 2013, is going to strengthen the company’s role in the hemodialysis market.

Moreover, after the three successive acquisitions of Cameron Health, Rhythmia Medical and BridgePoint Medical last year, Boston Scientific (BSX) recently acquired Vessix Vascular, which has developed the percutaneous radiofrequency balloon catheter technology for the treatment of hypertension. The company expects commercial launch of this platform in Europe and other international markets in 2013.

Other major deals inked in recent times in the MedTech space include six successive acquisitions by healthcare products maker Covidien (COV) exceeding $1.2 billion. In Jan 2013, the company completed the acquisition of Fremont, California-based medical device company, CV Ingenuity. In Mar 2013, leading vendor of cloud-based services for physician practices Athenahealth (ATHN) took over Epocrates, a pioneer of mobile health workflows and POC health apps.

The past year also witnessed significant M&A deals, including the acquisition of Switzerland-based Synthes Inc. by Johnson & Johnson (JNJ) for a whopping $19.7 billion, and Gen-Probe Inc. by Hologic (HOLX) for $3.8 billion.

Trends over the recent past reflect focus on the diagnostics space. A prime example is that of Agilent Technologies (A - Analyst Report) entering into the Diagnostics and Genomics space through the $2.2 billion acquisition of cancer diagnostic company Dako. The acquisition is intended to augment Agilent’s portfolio and build a global market share to better fight its major peers, especially Teradyne (TER), Thermo Fisher Scientific and Danaher Corp. (DHR - Analyst Report) in this space.

In order to expand into the large and lucrative market for drug-coated balloons, C.R. Bard (BCR) purchased Lutonix Inc. in Dec 2012. The worldwide peripheral vascular market for drug-coated balloons is forecast to hit roughly $1 billion annually over the next ten years. Further, the acquisition of Neomend will allow Bard to expand into another $1 billion market for surgical specialties offerings.

In Nov 2012, the neurovascular division of Stryker Corporation (SYK) acquired Surpass Medical (for $135 million) to expand its Complete Stroke Care portfolio. Surpass’ mainstay, the CE-Marked NeuroEndoGraft family of flow diverters is an attractive addition to the company’s product line.

In the light of the discussion above, 2013 is going to be another big year for M&As in the MedTech space. We expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Several MedTech majors struggling in their core businesses are looking to explore potential emerging therapies through collaborations and alliances.

Emerging Markets

The US still holds the leading position with almost one-third of the market share. However, emerging economies like Brazil, Russia, India and China -- collectively known as the BRICs -- are fast coming up in the medical devices space and are attracting a lot of attention.

These emerging economies are seeing an increasing uptake of medical devices due largely 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 2013 and beyond.

The focus on emerging markets is all the more significant given the saturation and uncertain growth in the developed markets of US, Europe and Japan. Companies like Medtronic Inc. (MDT - Analyst Report), Boston Scientific, Thermo Fisher Scientific, Stryker and Smith and Nephew (SNN) are all vying to expand their presence in the BRICs and other emerging markets. These companies are also looking to establish their manufacturing facilities abroad.

According to a McKinsey & Co. report (Jul 2012), health-care spending in China has more than doubled from $156 billion in 2006 to $357 billion in 2011. It is expected to grow to $1 trillion by 2020. China is also setting up proper health insurance coverage that should boost the healthcare sector. It is expected that within the next decade, China will be the biggest healthcare market in the world, even outpacing the US.

Among the other BRIC members, Brazil is currently the largest health-care market in Latin America, covering almost one-fourth of the population. Though India has one of the largest and fastest growing health-care markets in the world, it is considered to have the least developed health-care infrastructure and spends relatively little on health care. 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 healthcare and raise it to at least 3% by 2022.

Given the huge potential in these emerging regions, in Mar 2013, Stryker acquired China-based Trauson Holdings for $685 million. Trauson was a competitor in the Spine segment and a producer of Trauma products. The company sold as many as 120 offerings and maintained a decent pipeline.

Smith & Nephew, on the other hand, entered into two definitive agreements to expand in the BRIC regions. In Apr 2013, it contracted to purchase its Brazilian distributor, Pró Cirurgia Especializada (PCE). PCE has been associated with the company for the last 30 years and has distributed its sports medicine, orthopedic reconstruction and trauma offerings in Brazil.

In May 2013, the company announced another agreement, to take over Adler Mediequip Private Limited and with it the brands and assets of Sushrut Surgicals Private Limited, a leader in mid-tier, orthopedic trauma products for the Indian market.

Johnson & Johnson has already set up manufacturing and R&D centers in Brazil, China and India. While it has been doing business in China for more than 25 years, it established a new innovation center in the country in 2011. The Guangzhou Bioseal Biotech deal marked the company’s first MedTech acquisition in China. The company is expected to expand further in China on the back of the Synthes acquisition.

Medtronic is targeting 20% of its revenues from emerging markets by fiscal 2015−16. After setting up its Innovation Center in Shanghai, the first outside the US and Europe, last October the company acquired China Kanghui Holdings and formed a strategic alliance with China-based LifeTech Scientific Corporation (both in Oct 2012). The acquisition is expected to strengthen its orthopedic franchise in the country.

Boston Scientific is aiming to increase its below-average market share in the $700 million combined drug-eluting stent market in China and India, which is growing sharply at 20%. The company plans to invest $150 million in China over the next five years to build a local manufacturing operation.

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 and 10% in 2006.

Divestments

Another trend that we have been observing of late is the divestment of non-core business segments. For example, in an effort to focus on its high-margin surgical product portfolio, healthcare products maker Covidien is spinning off its pharmaceuticals business Mallinckrodt plc, which is expected to take place by Jun 2013.

In early January, Abbott Laboratories (ABT) separated its research-based pharmaceuticals business by creating a new company, AbbVie (ABBV), to allow the two separate entities to focus more on their operations.

Quest Diagnostics has also been focusing on areas with high potential such as gene-based esoteric testing for cancer, cardiovascular disease, infectious disease and neurological disorders. As a part of this strategy, in Apr 2013, the company completed the divestiture of the HemoCue diagnostics products business.

Last December, the company divested its OralDNA Labs salivary-diagnostics business in order to redirect its resources to core diagnostic information services. Johnson & Johnson, too, is currently looking for opportunities to sell or spin off its Ortho Clinical Diagnostics business.

In November last year, Becton, Dickinson and Company divested its Discovery Labware sub-segment (excluding Advanced Bioprocessing capability) to Corning (GLW) for $730 million. In May 2012, Smith & Nephew, through an agreement with Essex Woodlands, completed the disposal of its Clinical Therapies business, to the newly formed Bioventus LLC, in which it will retain a 49% investment.

Earnings Numbers

Challenging economic conditions, a competitive environment, pressure on core segments and a larger-than-expected currency headwind continue to remain as major causes of concern for medical device majors like Boston Scientific and St. Jude Medical (STJ). Both these companies barley managed to stay in line with the Zacks Consensus Estimate for earnings in the first quarter.

The still choppy U.S. defibrillator and global drug-eluting stents (“DES”) markets remain an overhang on these two stalwarts, and we expect the same to affect the performance of their peer Medtronic, which is slated to release its first quarter result on May 20, 2013.

While we are to some extent relieved with the signs of stability in Medtronic’s core spine markets, challenges remain in the Pacing and Spine business, which are expected to remain sluggish, in turn affecting the company’s overall performance. With the earnings Expected Surprise Prediction or ESP (Read: Zacks Earnings ESP: A Better Method http://www.zacks.com/stock/news/90676/Zacks-Earnings-ESP-A-Better-Method) of 0.0% and a Zacks Rank #3 (Hold) for the company, we are uncertain about a likely earnings beat in the first quarter.

Other major earnings reports by industry players include the first quarter earnings beat of Stryker Corporation. The austerity measures in Europe notwithstanding, which dampened sales growth at some of its segments, the recent stability in the company’s domestic recon market is encouraging.

However, there was a negative earnings surprise from Quest Diagnostics and its arch rival Laboratory Corporation of America (LH). We believe that the overall soft industry trends leading to challenging volume environment for testing laboratories and utilization weaknesses are looming headwinds. Moreover, their poor fiscal 2013 revenue guidance reflected the fact that the industry trend will not improve in the near future.

Notable in this regard, the implementation of the Medical Device Excise Tax (implemented in Jan 2013) will have an incrementally  negative impact on earnings per share of most of the medical device majors. This is also reflected in the conservative guidance posted by these companies.

OPPORTUNITIES

We continue to have a Neutral outlook on large-cap medical device stocks. While the companies will keep facing challenges like pricing pressures, declines in procedural volume from economic uncertainties and sluggish growth in the Cardiac Rhythm Management (CRM) business, increased M&A activities, focus on emerging markets and product approvals in latent areas could help reduce the impact. Better pipeline visibility and appropriate utilization of cash should increase confidence in the medical device sector.

With the announcement of its proposed acquisition by Bayer, shares of Conceptus reached a new high, leading to a Zacks Rank #1 (Strong Buy) for the stock. The Zacks Rank #2 (Buy) stocks in the MedTech sector include Becton, Dickinson and Company and The Cooper Companies Inc. (COO) among others.

In our universe, we see growth potential in companies dealing with promising technologies. In this respect, both these companies represent a value proposition. We are positive on Cooper based on factors such as margin expansion, acquisitions, product line expansion and geographical reach as well as share buybacks.

In spite of several core market challenges, the big three medical device players -- Medtronic, Boston Scientific and St. Jude Medical -- are striving to gain share in the implantable cardioverter-defibrillator (ICD) market through several new product launches. The big three are also exploring new avenues of growth beyond the mature pacemaker and ICD markets. With gradual stability in the ICD market, they should be able to revive their top line.

Beyond the MedTech majors, we are optimistic about the Zacks #3 Ranked orthopedic devices player Zimmer Holdings Inc. (ZMH). The percentage of population over age 65 in the US, Europe, Japan and other regions is expected to nearly double by the year 2030. In the US, the oldest baby boomers are now approaching retirement age. We believe the orthopedic giants will stand to benefit from this aging demography.

Among the scientific instrument makers, Thermo Fisher Scientific has been successfully expanding operating margins over the past few quarters on the back of operational efficiency. Given Life Technologies’ expansive line of consumables for genomic, and molecular and cell biology, the proposed buyout will complement Thermo Fisher’s market-leading portfolio of analytical technologies and specialty diagnostic.

CHALLENGES AND WEAKNESSES

On the flip side, the MedTech industry is currently hampered by several issues including the 2.3% medical device excise tax. Many of the nation’s medical devices players are currently bracing themselves for the impact of this tax.

The companies are either trying to relocate outside the US or reduce operations in order to weather the 2.3% tax burden. They are undertaking various restructuring initiatives to counter costs associated with the implementation of the new tax.

Other issues include pricing concerns, hospital admission and procedural volume pressures, Medicare reimbursement issues and regulatory overhang. While the debt crisis in Europe remains unresolved, economies throughout the world are trying to come to terms with myriad challenges. Consequently, procedural volumes in the US have been hit by a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans.

Governments across several European countries have taken up measures to curb spending on devices, which is taking a toll on utilization. Volume headwind is likely to linger as unemployment continues to influence procedure deferrals.

Last but not least, the highly regulated US medical device industry is encumbered by stringent and complex procedures leading to approval delays. This sometimes demotivates companies, deterring them from investing in product development.

According to a report based on a survey of over 200 medical technology companies (FDA Impact on U.S. Medical Technology Innovation), the US FDA takes a significantly high time to review compared to its European counterpart.

Coming to the weakest link in the MedTech sector, we advise against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends for 2013 and 2014 reflect a bearish sentiment. Covidien currently retains a Zacks Rank #5 as doubts linger around its proposed divestiture of its pharmaceuticals business Mallinckrodt plc.

Another Zacks Rank #5 (Strong Sell) stock is Health Management Associates Inc. (HMA). Also, Edwards Lifescience Corp (EW), Orthofix International N.V. (OFIX), Vascular Solutions Inc. (VASC) and Symmetry Medical, Inc. (SMA) do not look inspiring and carry a Zacks Rank #4 (Sell).

Further, pricing compressions on hips, knees and spine products, which impaired the performances of several orthopedic companies, remain a key concern, at the macro level. We remain skeptical about companies including Wright Medical Group (WMGI) although the stock currently carries a Zacks Rank #3 (Hold).

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