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Industry Outlook

Last year proved to be challenging for medical technology (“MedTech”) stocks given the exigent economic conditions and the precarious healthcare environment. The performance of incumbent players was hamstrung by several macro issues, including sustained price and procedure volume pressures.

The difficult macroeconomic backdrop, pricing headwinds, austerity measures, reimbursement pressure, a still unstable job market and the impact of health care reform continue to weigh on the medical devices industry, exacerbated by Europe's sovereign debt plight.

With fewer patients going under the knife accompanied by concerns of overuse of devices, companies in the cardiovascular and orthopedic domain continue to grapple with tepid utilization. After having a buoyant first half, the MedTech sector went through a rough patch in the back half of 2011 given the weakened sector fundamentals, sluggish key end-markets and macro pressures. Many of the MedTech stocks lost a third of their values last year.

Although the industry is still saddled with the unfavorable macro environment, it is expected to fare relatively better in 2012 thanks to several attractive growth opportunities and healthy tailwinds including improving hospital spending, emerging markets and pent-up demand.

Industry Dynamics

The global medical devices industry is fairly large, intensely competitive and highly innovative, with estimated worldwide sales of more than $300 billion in 2011. The U.S. is the largest market, with estimated annual revenues in excess of $100 billion.

Innovation is the quintessence in the MedTech industry, leading to continuous advancement in treatment and delivery of health care while driving competitiveness through differentiated and improved product offerings.

The highly regulated medical devices industry is divided into different segments including Cardiology, Oncology, Neuro, Orthopedic and Aesthetic Devices. The U.S. medical devices industry continues to grow at a brisk pace, backed by an aging Baby Boomer population, high unmet medical needs and increased incidence of lifestyle diseases (including cardiovascular diseases, diabetes, hypertension and obesity). Neuro, orthopedic and aesthetic represent the fastest growing categories.

The MedTech industry is plagued by several issues, including pricing concerns, hospital admission and procedural volume pressures, uncertainty surrounding health care reform, Medicare reimbursement issues and regulatory overhang, which have left many investors scratching their heads.

The beleaguered U.S. implantable defibrillator market continues to bother cardiac devices makers, as reflected by sustained implant volume pressures. On the other hand, companies in the orthopedic domain remain affected by a still choppy reconstructive implant market as they face sustained pressure across hip, knee and spine businesses.

While several catalysts for growth in 2012 exist -- such as new product cycles, an aging population, geographic expansion, ongoing transition towards minimally-invasive techniques and emerging markets -- lingering issues from last year remain an overhang.

Adding to the pain is the foreign exchange headwind (stemming from the recent strengthening of the U.S. dollar) as medical devices companies derive a chunk of revenues from overseas markets. Factoring in the negative currency impact, several companies have already dialed back their forecasts for 2012. Medical devices makers are also expected to contend with margin pressure in 2012 given the sustained pricing headwind.   

The aging population nevertheless represents a major demand catalyst for medical devices. The elderly population (65 years and above) base in the U.S. is roughly 40 million, representing around 13% of the nation’s population and accounting for a third of health care consumption. Federal government estimates indicate that the elderly population will catapult to 72 million by 2030, ensuring a major boost for medical devices utilization.

Given the maturing legacy markets, medical device companies are looking 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 growth in 2012 and beyond.

Healthcare Reform: Tax Fear Grips MedTech

The Government-mandated health care reform in the U.S. -- the Patient Protection & Affordable Care Act (labeled as "ObamaCare") -- has raised 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 highly controversial proposed tax, representing a part of the Act, will be a drag on devices companies. When implemented, devices makers will have to pay 2.3% excise tax on sales of certain products beginning 2013.

The outlay is expected to throttle innovation as it will impact investment in R&D. Moreover, it will lead to job cuts and higher prices for customers. The federal government expects to raise $20 billion from the tax over a ten-year period. In response, devices makers have started to take up several initiatives including headcount haircut and other restructuring activities to counter costs associated with the implementation of the new tax.

Nevertheless, the Act places considerable emphasis on patient safety and aims to reduce the number of uninsured people (from 19% of all residents in 2010 to 8% by 2016). The new law is expected to eventually extend health insurance coverage to an estimated 32 million Americans currently not insured.

Reimbursement Scenario: Bumps Ahead

Medical device companies are susceptible to significant reimbursement risks 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 health care costs, including prospective reimbursement cuts with careful review of medical bills and stringent pre-approval requirements.

An increase in the publicly insured base (resulting from health care reform) is expected to lead to lower reimbursement obtained by physicians, hospitals and other health care providers as public insurance generally offers lower reimbursement vis-à-vis private payors. Moreover, private insurance companies are increasing their scrutiny of certain surgeries, which will continue to materially impact utilization in 2012.

Federal budgetary pressure (given a potential reduction in U.S. government’s health care spending) has also raised reimbursement risk as payors may more actively pursue their cost reduction initiatives.

In an effort to curtail costs, the CMS, in November 2011, announced a pilot program which directs Medicare recovery audit contractors to perform a pre-payment audit (by means of reviewing patient records, claims and other documents) for certain “big ticket” cardiology and orthopedic procedures in key states, including Florida, starting January 2012.

The goal of this move, which represents a shift from the conventional “pay-and-chase” method, is to avoid unnecessary/inappropriate payments and reduce Medicare payment error rate. The procedures include pacemaker and defibrillator implantations, joint replacements and spinal fusions which will go under the CMS scanner before payment. The measure, which will eventually delay payments, has goaded strong reactions from the medical community.

The 510(k) Reform – A Paradigm Shift

The U.S. Food and Drug Administration (FDA) declared, in August 2010, a set of ambitious proposals for revamping the 510(k) device approval protocols. The 200-page report, consisting of 55 proposed changes, was designed to serve as a blueprint for the reform, representing 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 the “Center Science Council,” which will oversee medical device science-based decision-making. Moreover, the regulator is seeking additional information regarding the safety and efficacy of devices in the 510(k) submissions. The FDA also aims to form a subset of moderately risky devices (to include devices such as infusion pumps) under the “Class IIb” moniker that would require submission of more clinical data and manufacturing information compared to the existing Class II devices.

In a major move, the FDA outlined a plan in January 2011, consisting of 25 proposals, designed to improve the regulatory approval pathway for medical devices. The proposals, announced by the FDA’s Center for Devices and Radiological Health (“CDRH”), are aimed at overhauling the three-and-a-half-decade-old 510(k) device approval program by which roughly 4,000 devices have been cleared annually.

The list includes streamlining the de novo review process for lower-risk devices, clarifying when devices companies should submit clinical data for a 510(k) application and establishing a new council of senior FDA experts. President Obama emphasized that the planned changes represent the government’s efforts to keep patients safer and accelerate the approval process of innovative and life-saving products.

The CDRH forwarded seven of the controversial proposals to the Institute of Medicine (“IOM”), which provides national advice on medical issues, for independent review. In a shocking move, in late July 2011, the IOM recommended the FDA scrap the 510(k) process and replace it with a new regulatory framework that integrates pre-market clearance and better post-market surveillance. The IOM review concluded that the 510(k) process fails to evaluate the safety and effectiveness of Class II devices before they enter the market. The recommendation was met with immediate industry-wide criticism.

However, the FDA noted that the IOM’s recommendation is not binding and the 510(k) process should not be eliminated. As such, the agency continues to move ahead with its reform plans.

Among the latest developments, the FDA, on December 27, 2011, issued a draft guidance which aims to provide detailed information about the current review practices for 510(k) submissions. The guidance offers greater clarity and transparency on the regulatory framework, policies and practices underlying the agency’s 510(k) review process.

The primary aim of the guidance is to elucidate certain key points (outlined in a decision-making flowchart) in the decision-making process for determining substantial equivalence of devices reviewed under the 510(k) program. Devices makers must prove that their devices are substantially equivalent to a predicate device already marketed to secure the FDA green signal. The FDA is currently seeking public comments on the draft guidance and, if finalized, it will replace the old documents which have long defined the approval pathway.

While the 510(k) overhaul is still in process, it may eventually make device approval more complex, lengthy and burdensome. Moreover, with the expected rise in the regulatory bar for approvals, medical devices companies may be required to shell out more for R&D.

Our Thesis

For 2012, we advocate companies providing life-sustaining products and procedures, given their healthy recurring revenue streams. Further, investors should look for stocks with strong earnings quality, healthy growth trajectory, and liquidity profiles as they appear attractive considering their ability to leverage strong balance sheet and cash flows in maximizing shareholder value in the form of dividends and share repurchases or use them for value acquisitions. Stocks with healthy dividend yields offer a cushion against market volatility.

MedTech companies with vast product range/healthy pipeline and strong infrastructure are also better poised for improved returns. Moreover, companies focusing on more judicious R&D investment, expansion into new markets and cost-saving through restructuring are better placed for 2012. These companies have greater capability of withstanding the sustained macro-level issues and increasing regulatory pressure.

Pressed by a still-soft economy, top-tier devices makers are expected to continue their merger/acquisition binge in 2012, especially as a means to enter new markets and diversify their portfolio. Although this represents an important avenue for growth, we continue to advise investors to shun companies that have grown historically through extensive acquisitions only. These companies face increasing challenges in integrating acquired businesses and delivering operational synergies from them, which are considered to be the prime reason for failures of mergers and acquisitions. We are also cautious of dilution associated with these transactions.

At the end, we still recommend investors to eschew companies making non-life-sustaining products and procedures (including elective procedures such as hip and knee replacement), as they are still engulfed by softened patient demand.

OPPORTUNITIES

In our universe, we see growth potential in companies dealing with cardiovascular devices, neuro and radiation oncology products. Names include Medtronic Inc. (MDT - Analyst Report), Boston Scientific Corporation (BSX), St. Jude Medical (STJ - Analyst Report), Edwards Lifesciences (EW - Analyst Report), ZOLL Medical (ZOLL), Abiomed Inc. (ABMD) and Varian Medical (VAR - Analyst Report).

The above-listed companies make life-sustaining products and are less affected by economic instability. These companies are all leading players in their respective fields and are potential winners in the long run. Some of these players have been successful in weathering the storm (pricing, currency and volume headwinds) in the cardiovascular space.

With a slew of new products, the Big Three players (Medtronic, Boston Scientific and St. Jude) in the $6.5 billion implantable cardioverter defibrillator (“ICD”) market are well-positioned to gain market share, despite the challenging business environment and several other barriers to growth. These companies have a number of levers to pull and represent a good bet for long-term investors.

Among the names above, Medtronic, the undisputed leader in the MedTech space, has a diversified presence in cardiovascular, neuro, spinal, diabetes and ENT and boasts of an attractive pipeline. Despite sustained weaknesses in its key ICD and spinal implants businesses, we like the company’s efforts to augment/diversify its product range, expand into emerging markets for growth, and generate strong cash and healthy dividend yield. Besides, the new MRI SureScan pacemaker and Protects ICDs should offer support to its core CRM business.

Boston Scientific has maintained its leadership in the drug eluting stent (“DES”) market. The earlier-than-expected approval of the next-generation DES product Promus Element coupled with a new line of ICDs better places the company for 2012. Although Boston Scientific’s December quarter results were disappointing and its CRM segment remains challenging, we believe that the company’s continuous focus on strategic initiatives (including new products and cost cutting measures) to drive growth and profitability should yield steady results moving ahead.

Boston Scientific is leaving no stone unturned to stay on course for growth. It has undertaken a series of management changes and restructuring initiatives that are expected to contribute to the bottom line and margins. The company is also expanding its footprint in the emerging markets by reinvesting the savings from restructuring efforts.

We remain intrigued by St. Jude’s ability to consistently produce positive earnings surprises and revenue growth. The company is gaining ICD market share despite a sluggish market condition. St. Jude is poised for incremental opportunities in CRM on the back of strong product momentum. A surfeit of new growth drivers are expected to offer opportunities for accelerated sales growth over the next few years.

St. Jude recently won the U.S. approval for its Unify quadripolar CRT-D system. The device is expected to help the company win ground in the highly competitive U.S. defibrillator space in 2012. St. Jude is currently the only company to offer this technology globally. Moreover, St. Jude is well placed to leverage the solid growth momentum in the atrial fibrillation market.

Beyond the MedTech majors, we are also optimistic about scientific instrument maker Thermo Fisher Scientific (TMO - Analyst Report). The leading, diversified scientific instrument maker has been successful in expanding operating margins over the past few quarters on the back of operational efficiency and cost discipline. It has strong international exposure and is focusing on acquisitions and the emerging markets for growth.

Robotic surgery is another area which appears to be better placed for growth in 2012 and Intuitive Surgical (ISRG - Analyst Report) clearly leads the pack with its state-of-the-art technology. Intuitive enjoys a virtual monopoly in robotic surgery and continues to deliver forecast-topping earnings. Its sales are growing at a torrid pace buoyed by the da Vinci surgical system.

Another good pick is Varian, the world’s leading manufacturer of integrated radiotherapy systems for treating cancer. The company is poised to increase its market share in the radiation oncology market. Varian is currently enjoying a healthy demand for its RapidArc radiotherapy technology, which is meaningfully contributing to its oncology net order growth.

Edwards Lifesciences represents another value proposition. The company received, in November 2011, the U.S. approval for the highly-anticipated Sapien transcatheter aortic heart valve (for inoperable patients). With this approval, it became the first company in the U.S. to receive approval for a transcatheter device which allows surgeons to replace a patient's ailing aortic valve without resorting to open-heart surgery. Banking on the launch of the Sapien valve in U.S. and other product developments, Edwards expects to record robust sales growth in 2012.

We also believe that cardiac assist devices maker Abiomed represents another attractive opportunity for investors. The company possesses a broad portfolio of products that are life-sustaining in nature and has been able to deliver sustainable growth in a challenging economy. Abiomed enjoys strong demand for its Impella cardiac pumps.

We are also upbeat about the prospects of resuscitation devices-maker ZOLL Medical. ZOLL is a leading player in the global market for external defibrillators, which is worth more than $1 billion. The company’s LifeVest wearable defibrillator business continues to grow at a healthy quarterly run rate, benefiting from increased awareness of the product and associated sales force enhancements. Moreover, its significant international presence should also push growth.

Emerging Markets: A Big Role to Play

The leading U.S. cardiovascular devices companies such as Medtronic, Boston Scientific and St. Jude are exploring new avenues of growth beyond the mature pacemaker and ICD markets. These companies are increasingly seeking opportunities to expand into fast-growing new therapy areas within or outside the cardiology space, including markets such as atrial fibrillation and neuromodulation.

Among the emerging cardiology markets, an encouraging prospect represents the structural heart market with its major categories including Patent Foramen Ovale (PFO) and Left Atrial Appendage (LAA) occlusion. The AGA acquisition has provided St. Jude with devices targeted at PFO and LAA markets.

Moreover, the Transcatheter Aortic Valves (TAVI) market, an opportunity estimated in the ballpark of $2 billion, is emerging as a substantial new growth prospect for the top-tier MedTech companies. St. Jude has registered the first human implant of its next-generation TAVI product dubbed Portico. The company is optimistic to enter the European TAVI market with its Portico valve before end-2012.

Medtronic’s TAVI offering, CoreValve, is already approved in Europe and is currently undergoing evaluation in a pivotal trial in the U.S. Boston Scientific is planning to launch its Lotus valve in EMEA in the second half of 2013. Edwards has the first-mover advantage in the U.S. in TAVI with its Sapien valve.

Intravascular ultrasound imaging (IVUS), Optical Coherence Tomography (OCT) and other next-generation imaging technologies are expected to offer incremental opportunity for companies such as Volcano Corp. (VOLC - Analyst Report), Boston Scientific and St. Jude. The OCT market has been projected to grow at a double-digit clip over the next five years.

Another emerging prospect is renal denervation for treating resistant hypertension. We believe that emerging markets represent a key catalyst for growth in 2012 and beyond.

Favorable Hospital Spending Cycle

A soft hospital capital spending backdrop was challenging for MedTech stocks in 2010. The North American and European markets were affected by shrinking budgets for equipment purchases at the height of the recession.

However, results in 2011 indicate a silver lining stemming from continued recovery in hospital spending in the U.S. Spending levels are improving as hospitals appear to have started replacing their worn-out equipment. A healthy replacement/upgrade cycle is expected to favorably impact results in 2012.

WEAKNESSES

A Still-Clouded Orthopedic Space


We continue to advise investors to spurn companies in the orthopedic domain. Companies in this roughly $37 billion market continue to struggle as patients defer their elective procedures given the lingering economic softness, exacerbated by sustained pricing pressure.

The reconstructive market fundamentals (pricing and volume) remain challenging with little or no clear visibility for a material turnaround in the near future. The joint replacement market has been hit by patient deferral of elective procedures, leading to weak demand for hip and knee implants.

Companies that fit the bill include Stryker (SYK - Analyst Report), Zimmer Holdings (ZMH - Analyst Report), CONMED Corporation (CNMD - Analyst Report), Wright Medical Group (WMGI - Analyst Report) and Symmetry Medical (SMA - Analyst Report). We remain cynical about these stocks given the sustained price/volume pressure.

However, we acknowledge that companies such as Stryker and Zimmer, with less exposure to metal-on-metal (MoM) hip products, are better placed to gain share than their highly-exposed counterparts such as Johnson & Johnson’s (JNJ) Depuy and Wright Medical. The ongoing transition from MoM implants to next-generation hip systems represents a tailwind for these players.

Pricing: A Lingering Issue

Pricing compressions on hips, knees and spine products, which impaired the performances of most of the orthopedic companies in 2011, remain a key concern, at the macro-level. 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 pricing. This is expected to continue hurt selling prices on a global basis.

Moreover, the advent of group purchasing organizations (GPOs), which act as agents that negotiate vendor contracts on behalf of their members, has also put pressure on pricing. The prevailing economic climate has bolstered the bargaining power of GPOs. The scenario in 2012 is expected remain challenging as hospitals continue to push back pricing.

Spine Still Hurts

The spinal market has been worst hit by pricing/volume headwinds and payor push back as manifested by a moribund quarterly growth trend. Leading companies in the orthopedic space such as Stryker and Zimmer continue to experience price and volume pressure, evident in 2011 results.

Pricing pressure and reimbursement uncertainties coupled with austerity measures in Europe are expected continue to weigh on this market in 2012. Moreover, private payors are delaying spine surgeries by requiring more documentation before approving such procedures, thereby contributing to the slowdown in this market.

Volume: Still a Headwind

The $12 billion replacement hips and knees markets have been affected by lingering economic softness, as reflected in procedure volume pressure. Cash-strapped patients continue to defer surgeries given the weak economy and reimbursement-related pushback.

Procedural volumes in the U.S. have been negatively impacted as a result of a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans.

As per the demographic analysis, these trends had a significant impact on the potential patient base for joint replacement procedures, those between 45 and 65 years of age and without any Medicare coverage. On the other hand, austerity measures are contributing to the reduction in procedure volumes in Europe. Governments across several European countries have taken up measures to curb spending on drug and devices, which is expected to thwart utilization this year.

The hip/knee market in Europe is expected to remain challenged in 2012. Volume headwind is likely to sustain this year as unemployment continues to influence procedure deferrals.

Companies such as Stryker and Zimmer derive a chunk of their revenues from replacement hips and knees. Most of the leading players in the orthopedic space reported weak knee sales in the most recent quarter, echoing a general softness in the market.

December quarter trends indicate sustained lumpiness in procedure volume growth across hip and knee markets (although manifesting signs of stabilization) and a substantial recovery is not likely, at least in the near term. In fact, it is still hard to pin down the timing of the rebound in procedure volume to pre-recession level. As such, we continue to recommend investors to steer clear of the above-mentioned orthopedic stocks until the pricing/volume pressure unwinds.

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