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Medical Instruments Stock Outlook: Long-Term Prospects Bright

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The year 2018 has so far been remarkably rewarding for the global medical instruments space in terms of research and development (R&D). Starting from inventions like the artificial pancreas, human-brain pacemaker, electronic skin that displays vital signs of the body, needle-free injections and many more, the medical instruments fraternity has been in the limelight this year.

This year, the FDA made a major move by approving gene therapy for the treatment of inherited retinal disease. Meanwhile, Big Data has reached the next level of healthcare application and is used for patient monitoring in hospitals and for post-operative care. Not only that, with the occurrence of obstructive sleep apnea (OSA) on the rise, Neuromodulation has proved to be a a better way to treat apnea against popular treatments like a CPAP machine.

Going by KPMG data, medical instruments sector’s global annual sales are forecast to rise more than 5% a year to reach nearly $800 billion by 2030.

A CISION report says that the United States is the largest medical device market in the world at present, raking in more than $180 billion in revenues. Despite several socio-political hazards and economic dips, U.S. medical device companies have been riding high on R&D innovation, increasing consolidation, emerging market expansion and tax cuts.

While long-term growth prospects are quite encouraging, the ongoing trade tiff between the United States and China remains a major concern for most investors interested in the medical instrument space. Last week, the U.S. government announced a new round of tariffs (almost 10%) on about $200 billion on Chinese imports, effective from Sep 24. From Jan 1, 2019, the tariffs are likely to rise to 25%. Not to forget, a significant amount of these imports are medical instruments, devices and medical imaging components.

According to Ralph Ives, executive vice-president of medical device trade association AdvaMed, "We estimate that the imposition of additional 25 percent duties will impact approximately $836 million worth of medical technology entering the US from China, including related component parts and manufacturing materials." Not only that, going by Medical Imaging & Technology Alliance’s (MITA) recent survey report, the tariffs will cost the medical products companies more than $138 million this year.

The threat of huge trade losses is expected to force medical instrument makers to cut down their R&D expenses.

This apart, hurricanes are ballooning into a big concern for investors. The hurricane season, which typically starts in June and lasts through November, gathers strength in August and September. With Sep 10 marking the peak of the Atlantic hurricane season, the weeks till mid-October are expected to see a number of tropical storms and hurricanes (per an article on AccuWeather). The Medical instrument space has historically been majorly hit by hurricanes in the recent years.

Industry Lags on Shareholder Returns

While the Medical Instruments industry is showing signs of long-term prosperity, judging by shareholder returns over the past year, it seems that investors are not quite upbeat about the industry as a whole at the moment.

It seems that apart from growing geopolitical pressure, investors are worried about gradually mounting operating expenses within the core Medical Instruments business and tougher competition in a shifting health industry.

This reflects in the underperformance of the Zacks Medical - Instruments Industry, which is a 6-stock group within the broader Zacks Medical Sector, with respect to both the S&P 500 and its sector over the past year.

While stocks in this industry have collectively declined 10.8%, the Zacks S&P 500 Composite and Zacks Medical Sector have rallied a respective 13.3% and 7.1%.

One-Year Price Performance

Medical - Instruments Stocks Trading Expensive

Despite trade war related uncertainties, given the industry’s outperformance so far this year, its valuation looks expensive. Not to forget, of late, the companies are gaining in terms of gigantic consolidation, expansion and innovation. While spending is quite huge, new revenues sources are making the overall scenario profitable.

Valuation is a tricky business for the Medical - Instruments companies. However, one might gain a fair idea of the industry’s relative valuation from its Price/Book ratio.

The industry currently has a Price/Book TTM ratio of 11.31, at the highest point of the past year. When compared to the high of 11.31 and the median level of 3.55 over the past year, we believe investors should wait for a dip to enter the market.

Price-to-Book Trailing Twelve Months (TTM)

 

The space also looks stretched when compared to the broader Zacks S&P 500 Compositeat large, as the current Price/Book TTM ratio for the broader market is 4.11 and the median Price/Book TTM ratio is 3.85.

Price-to-Book Trailing Twelve Months (TTM)

 

Compared to the broader Medical sector, the space also trades at a significant premium now. The current ratio for the broader sector is 4.52 and the median level is 3.31. So, both the figures are below the Medical - Instruments industry’s respective ratios.

Earnings Outlook Does Not Evoke Much Optimism

Going by data provided in an article by Christian B. Jones in Mondaq, MedTech firms in the United States currently sell $4.7 billion annually to China, while the nation imports from China a total of $5 billion in medical devices. U.S. exports of medical devices last year totaled $52 billion, creating a $1 billion worldwide trade surplus.

Needless to say, despite the booming outlook with respect to new innovations, the medical device lobby is extremely apprehensive about the ongoing tariff battle on Chinese products as it could significantly affect international trade.

This apart, in the recent past, the industry has witnessed some side effects of a complex regulatory environment and growing external competition.

We note that the highly regulated U.S. medical device industry is plagued by stringent and complex procedures, which delay approval. This sometimes deters companies from investing in product development. In fact, according to a report by Josh Makower based on a survey of over 200 medical technology companies,the FDA takes significantly more time to review compared to its European counterpart.

Adding to the woes, the medical-device tax repeal amendment is a temporary relief for manufacturers. It will be back again in 2020.

One reliable metric that can give investors an idea of the industry’s future price performance is its earnings outlook. Empirical research shows that earnings outlook for the industry, showing the earnings revision trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

Looking at the aggregate earnings estimate revisions, it appears that over the last three months, there has a marginal improvement in this group’s earnings outlook for 2018.

Price and Consensus: Zacks Medical - Instruments

One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number. This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Current Fiscal Year EPS Estimate Revisions

As you can see here, the $1.93 EPS estimate as of September 2018 is a marginal improvement from $1.45 at the end of August. However, earnings estimates have plummeted sharply since last year’s $2.22.

Please note that the $1.93 EPS estimate for the industry for 2018 is not the actual bottom-up estimate for every company within the Zacks Medical -  Instruments industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for 2018 but how this estimate has evolved recently.

Zacks Industry Rank Indicates Prospects for Improvement

The group’s Zacks Industry Rank is basically the average of the Zacks Rank of all the member stocks.

The Zacks Medical - Instruments industry currently carries a Zacks Industry Rank #99, which places it at the top 39% of more than 250 Zacks industries. Our research shows that the top 18% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that although the industry’s rank was in the top 50% since the beginning of August, last week it deteriorated to the bottom 38%, probably due to Trump’s tariff-related update. However, the latest rank indicates that the industry is better poised than before.

Medical - Instruments Promises Long-Term Growth

The long-term prospects for the industry indicate steady growth. When compared with the broader Zacks S&P 500 composite, the long-term (3-5 years) EPS growth estimate for the Zacks Medical - Instruments industry of 13.61% appears promising. The corresponding figure for the Zacks S&P 500 composite is 9.8%.

Mean Estimate of Long-Term EPS Growth Rate

 

In fact, the basis of this long-terms EPS growth could be a sharp improvement in the top line that these Medical - Instruments stocks have been showing since the beginning of 2010.

Revenues: Zacks Medical - Instruments industry

 

Bottom Line

The U.S.-China trade war is gradually becoming more intense with tensions unlikely to ease anytime soon.

However, as stated earlier, investors should not lose hope as the encouraging research and development scenario is expected help the industry maintain its competitive niche down the line. Also, inorganic consolidations, strategic divestments and emerging market prospects are expected to play a crucial role in advancing the medical instruments space.

Despite stretched valuations, investors can build positions in the Medical - Instruments industry based on the abovementioned factors as well as strong earnings outlook.

Stock to Buy

Here we pick three stocks from the Medical - Instruments industry with a Zacks Rank #1 (Strong Buy) or 2 (Buy), out of which one has seen positive earnings estimate revision. You can see the complete list of today’s Zacks #1 Rank stocks here.

Penumbra, Inc. (PEN - Free Report) : Headquartered in Alameda, CA, Penumbra is a global healthcare company. The company sells its products to hospitals and clinics primarily through its direct sales organization in the United States, most of Europe, Canada and Australia, and through distributors in select international markets. The stock has a Zacks Rank #1.

The Zacks Consensus Estimate for current-year earnings moved up 70% in the last 60 days. The stock has returned 71% in a year’s time.

 

Masimo Corporation (MASI - Free Report) : Irvine, CA-based Masimo develops, manufactures and markets a family of non-invasive monitoring systems. The company has two segments: Product Revenues, Royalty & Other revenues. The Zacks Consensus Estimate for current-year earnings moved up 0.4% in the last 60 days. Masimo, a Zacks Rank #2 stock, has returned 44.5% year to date.

 

CryoLife, Inc. (CRY - Free Report) : Headquartered in suburban Atlanta, GA, CryoLife is a leader in the manufacturing, processing and distribution of medical devices and implantable tissues used in cardiac and vascular surgical procedures focused on aortic repair.

The Zacks Consensus Estimate for current-year earnings moved up 6.9% in the last 60 days. CryoLife, a Zacks Rank #2 stock, has returned 59.8% over the past year.

 

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