One sector that has kept a promising longer-term outlook is medical devices and supplies. We recently met with Zacks senior analyst Christopher Titus, CFA regarding his outlook on the group, and which companies he would recommend.
How has earnings season gone so far? Any major surprises?
Medical device companies continue turning in good results in the aggregate. In Q208, companies under my coverage that have reported earnings have increased sales 12% year-over-year [y/y], with a median growth rate of 14%. Specific areas that continue showing solid growth include minimally invasive products and their disposable parts, orthopedic implants and the firms that support their growth, companies providing interventional cardiovascular surgical products, and companies that help reduce hospital acquired infections and medical errors.
In the aggregate, pre-tax profit margins before depreciation contracted slightly (48 bps). This was primarily driven by a contraction in gross margins (85 bps). The major contributors to the decline cited foreign exchange fluctuations, obsolete inventory related to product recalls, changes in sales mix, and idle plant capacity as a result of the recalls and sales mix (hips and drug-eluting stent).
The decline in gross margin was offset by lower SG&A expenses as a percentage of sales. The improvements were related to numerous restructuring and expense management programs instituted by device companies over the past year. In addition, divestitures and layoffs at Boston Scientific (BSX) positively impacted results. R&D expenses as a percentage of revenue was flat y/y.
Was there one sub-sector or group that outperformed better than others in your coverage?
The segments that did well share a few characteristics. They provide a cure with the least amount of trauma and risk of infection to the patient. As a result, the total cost per procedure is lower when factoring in shorter hospital stays and risk/error making Medicare reimbursement less of a hurdle.
Over the long-term, we will continue to see gains in the Orthopedic companies. Many have diversified into neuromodulation, a non-invasive and non-chemical way to alleviate pain and possibly depression.
Are you expecting further consolidation to take place among the industry's bigger players?
I would not rule it out. However, I believe large acquisitions increasingly pose anti-trust complications, as these companies have built out substantial portfolios. For now, it appears most are pursuing smaller tuck-in acquisitions that add a complimentary technology.
Which are your top Buy recommendations at this time?
We currently rate two companies as BUYs: Hanger (HGR) and ArthroCare (ARTC). However, there are a few HOLDs that could move into the BUY category should their next two quarters provide greater certainty and visibility into their business. These include Angiodynamics (ANGO), CR Bard (BCR), and Becton Dickinson (BDX).
In what way would you advise investors looking toward overweighting medical devices stocks in their portfolios?
As a group, I believe these are sound long-term investments that have delivered consistent growth supported by sound demographic trends. I would look for more of the same moving forward. On an individual stock basis, I would look for companies that have a focus in these areas: minimally invasive products, offer disposable parts that provide for recurring revenue streams (razor/razor blade models), serve orthopedic, interventional cardiovascular surgery and acquired infections/medical errors segments.
These are also favorable characteristics that the Centers for Medicare & Medicaid Services support in their decisions to reimburse for specific procedures.
Christopher Titus, CFA is a senior analyst covering the medical supplies and devices industry for Zacks Equity Research.
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