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Zacks Analyst Interviews

Prelude

The global medical devices industry is fairly large, intensely competitive and highly innovative with annual worldwide sales in 2009 in excess of $220 billion. The U.S. accounts for approximately 41% of this market.

The industry is divided into different segments such as Cardiology, Oncology, Neuro, Orthopedic, Aesthetic Devices and Healthcare IT (HCIT). The U.S. medical devices industry continues to grow at a brisk rate, thanks to an aging Baby Boomer population, with Neuro, Orthopedic and Aesthetic representing the fastest growing categories.

With several growth constraints in the legacy markets, medical devices companies are aiming to expand into lucrative incipient markets. Expansion in the emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for future growth. Our focus in this write up, however, is primarily the U.S. market.

The Regulatory Eco-system

Medical device companies are susceptible to significant reimbursement risk as their products are reimbursed by the Center for Medicare and Medicaid (CMS) and commercial payers. Third-party reimbursement programs in the U.S. and abroad, both government-funded and commercially insured, continue to develop different means of controlling healthcare costs, including prospective reimbursement cuts with careful review of medical bills.

The Government-mandated healthcare reform in the U.S. in March 2010, dubbed as the “Patient Protection & Affordable Care Act,” has created a degree of uncertainty for medical devices companies. The reform has led to a less flexible pricing environment for these companies and may pressure pricing across the board. Moreover, the proposed tax on device companies may hit their bottom-lines. Nevertheless, the Act places considerable emphasis on patient safety and aims to reduce the number of uninsured people, representing some of the positive outcomes. 

“The 510 (k) Reform”

The U.S. Food and Drug Administration (FDA) declared a set of proposals on August 3, 2010, aimed at the overhaul of its 510 (k) device approval protocols. Although the proposed changes are subject to public feedback and independent study (to be completed in mid-2011), some of these are expected to be implemented over the next few months.

The 200-page report, consisting of more than 70 proposed changes which will serve as a blueprint for the reform, represents FDA’s vision to streamline the device review process and make it more predictable and transparent. As part of the listed proposals, the FDA intends to create a new “Center Science Council,” which will oversee medical device science-based decision-making. Moreover, the regulator aims to seek additional information regarding the safety and efficacy of devices in the 510 (k) submissions.

Our Vision

We recommend companies providing life-sustaining products, given their strong recurring stream of revenues as patients are unable to forego these products. Furthermore, investors should look at companies with strong-earnings quality profiles.

Moreover, large companies with a wide portfolio of products are also better poised for improved returns. These companies have greater capability of withstanding the economic doldrums.

We advise investors to spurn companies that have grown historically through extensive acquisitions only. These companies may find it difficult to fund acquisitions considering the lingering impact of recession. Also, they face increasing challenges in delivering operational synergies from these acquisitions, which are considered to be the prime reason for failures of mergers and acquisitions.

OPPORTUNITIES

In our portfolio, we see growth potential in companies dealing with cardiovascular devices, Neuro and blood-related products. Names in this list include Medtronic Inc. , Boston Scientific Corporation , St. Jude Medical Inc. , Haemonetics Corporation and Cyberonics Inc. . Although these companies have Neutral ratings, they remain well placed in the current environment. We will closely monitor their performances in the current quarter for possible upgrades.

Big-Three MedTechs Lead the Way

The above-listed companies are producers of life-sustaining products and are less affected by economic turbulence. As evident from the most recent quarter results, some of these companies have been successful in weathering the storm (pricing, currency and procedure growth headwinds) in the cardiovascular space in the wake of recovery.

These companies are all leading players in their respective fields and are potential winners in the long run. In particular, with a slew of new products, the big three players (MDT, BSX and STJ) in the implantable cardioverter defibrillator (ICD) market are well positioned to gain market share, despite the sluggish business environment.

Among these names, Medtronic has a diversified presence in Cardiovascular, Neuro, Spinal, Diabetes and ENT. Boston Scientific is the leader in the drug eluting stent (DES) market and is better placed with the recent resolution of all issues cited in its 2006 FDA corporate warning letter regarding serious regulatory problems and corrective actions at three of its facilities. The company’s return to the ICD market (after one month absence due to product recall) represents another boost. Moreover, Boston Scientic’s restructuring initiatives are expected to contribute to the bottom-line moving forward.

St. Jude is poised to grow its market share in the CRM segment (especially in ICDs) driven by its new Fortify and Unify lines of devices. Moreover, we are optimistic about the emerging opportunity in intravascular imaging market, enabled by the company’s LightLab acquisition in July 2010.

The Federal “Stimulus” Boost

Another area which is interestingly poised for growth these days is Healthcare IT. The landscape has changed since the Obama Administration has taken initiatives to encourage hospitals and physicians to modernize their health record keeping as part of the “Stimulus Package.” The Stimulus is aimed at increasing the use of electronic health record (EHR) systems by medical practitioners.

Optimism about the growth prospects of HCIT service providers has improved since the Stimulus package. Moreover, the recently released “meaningful use” rule that enables hospitals to qualify for federal incentive program will boost business opportunities for the incumbents in the long-run.

Beneficiaries of the Stimulus include Allscripts-Misys Healthcare Solutions and Quality Systems . Allscripts-Misys Healthcare Solutions presently holds a Neutral rating, but is a potential candidate for an upgrade.

WEAKNESSES

The Dark Side of 510 (k) Reform


As part of the 510 (k) reform, the FDA aims to create a subset of moderately risky devices under the “Class IIb” moniker that would require submission of more clinical data and manufacturing information vis-à-vis the existing Class II devices. However, it remains to be seen which devices or group of devices should fall under this domain.

If implemented, this is expected to make the device approval process more complex, lengthy and burdensome. Moreover, with the expected rise in regulatory bar for approvals, medical devices companies may require to shell out more on R&D expenses. As such, critics and certain industry groups have started lobbying against such proposal.

Orthopedic Remains a Concern

We advise investors to shun companies in the orthopedic domain until we see a complete economic recovery. Companies in this space have suffered from the economic downturn as patients deferred their elective procedures. Names on this list include CONMED Corporation , Stryker Corporation , Zimmer Holdings and Symmetry Medical .

Pricing Woes Linger

Recent operating results manifest weak performances across the hip- and knee-replacement businesses, which underscore the macro-level concerns related to product pricing pressure. Pricing concerns on hips, knees and spine products have impaired the performances of most of these companies.

Despite the gradual recovery in procedure volumes and stabilization of market share, the pricing issue remains a concern. The effect of government health care cost containment efforts and continuing pressure from local hospitals and health systems as potential Medicare reimbursement cuts create additional reasons for hospitals to push back on pricing. This is expected to hurt selling prices on a global basis for the remainder of 2010.

Soft Hospital Spending Backdrop

A soft hospital capital spending backdrop has been challenging for orthopedic companies in the first-half of 2010. The North American and European markets continue to be affected by shrinking budgets for equipment purchases, in part, due to the sustained effects of the recession.

Besides competition-driven pricing pressure on implant products, a still weak capital spending environment and sluggish European markets could potentially dent earnings of these companies in the second-half 2010. Despite these concerns, we note the favorable impact of the resurgent replacement hip and knee markets, which have rebounded from a slowdown in the height of recession.

With the economic recovery underway, some of the names listed above have already been upgraded to Neutral over the past few months. However, the economic indicators are pointing that the economy is not out of the woods yet, resulting in a still sluggish spending environment. Hence, we remain leery about the prospects of these companies in the second-half and recommend investors to steer clear of these stocks at least for now until we see a material recovery.

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