ZOLL Zoll Medical Corp. (MM)

Over the recent past, medical technology (MedTech) players have faced the brunt of exigent economic conditions and a precarious healthcare environment. The performance of the players was thereby hamstrung by several macro issues, including sustained price erosion 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. The situation is exacerbated by Europe's sovereign debt plight. With fewer patients going under the knife, accompanied by concerns regarding the overuse of devices, companies in the cardiovascular and orthopedic domain continue to grapple with tepid utilization.

Industry Dynamics

The global medical devices industry is fairly large, intensely competitive and highly innovative. This highly regulated industry is spread across different segments including cardiology, oncology, neuro, orthopedic and aesthetic devices. The US medical devices industry relies largely on an aging baby boomer population, high unmet medical needs and increased incidence of lifestyle diseases (including cardiovascular diseases, diabetes, hypertension and obesity).

The MedTech industry is challenged by several issues: pricing concerns, hospital admission and procedural volume pressures, uncertainty surrounding health care reform, Medicare reimbursement issues and regulatory overhang. Percutaneous intervention (PCI) volumes continue to be relatively flat in the US, Japan and Europe with improvement not expected before the second half of the year on a year-over-year basis. Nevertheless, several catalysts for growth exist such as new product cycles, an aging population, geographic expansion, ongoing transition towards minimally invasive techniques and emerging markets.

In December 2011, the FDA released numerous draft proposals on the 510(k) process. Devices makers must prove that their devices are substantially equivalent to a predicate device already marketed to secure the FDA green signal. 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 device companies may be required to shell out more for R&D.

Given the maturing legacy markets, medical device companies are looking to expand into lucrative incipient markets. Expansion in emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2012 and beyond.

M&A Activities

The MedTech companies have resorted to the acquisition route to harness their strengths and diversify their offerings. Major deals on the anvil include Johnson & Johnson's (JNJ) acquisition of Synthes (scheduled to be completed on June 14th), which should help strengthen its medical device portfolio. This is one of the biggest deals (approximately $21 billion) broached in recent times in the MedTech space. The FTC nod regarding the deal comes with the rider that J&J will have to divest its system for surgically treating serious wrist fractures.

The company intends to sell this system (known as DVR) along with the rest of its product line for treating traumatic injuries, to Biomet Inc. This deal, on the other hand, would enable Biomet to expand its Sports, Extremities and Trauma businesses.

Another MedTech major, Boston Scientific Corporation (BSX), has been looking to expand through acquisitions to counter the challenges of its core segments. The company's Cardiac Rhythm Management (CRM) portfolio now includes a subcutaneous implantable cardioverter defibrillator (ICD), the S-ICD system, subsequent to the acquisition of Cameron Health.

Hologic Inc. (HOLX), catering to the healthcare needs of women, recently announced its decision to acquire Gen-Probe (GPRO) for approximately $3.7 billion. This would enable Hologic to strengthen its foothold in the molecular diagnostics space and gain access to Gen-Probe's molecular diagnostic platforms of Tigris and Panther systems. With 61% of revenues from molecular diagnostics and 35% from blood testing, Gen-Probe is a prominent player in molecular diagnostics products and services that are used primarily to diagnose human diseases, screen donated human blood and help ensure transplant compatibility.

With the proposed acquisition of transfusion medicine business of Pall Corporation (PLL) for $551 million, Haemonetics (HAE) will be able enter the $1.2 billion whole blood collection market. Manual whole blood collection accounts for the vast majority of the nearly 60 million red blood cells collection procedures performed annually worldwide.

Healthcare products maker, Covidien (COV) seems to be on an acquisition spree. The company plans to acquire Israel-based Oridion Systems for approximately $300 million expanding its portfolio in respiratory monitoring equipment. Other recent acquisitions by Covidien include superDimension, which develops minimally invasive interventional pulmonology devices for $300 million and ventilator maker Newport Medical Instruments for $108 million.

Going forward, we expect this M&A trend to continue. We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Several MedTech majors, struggling with their core businesses, are looking to explore emerging therapies with potential.

Healthcare Reform: Tax Fear Grips MedTech

The Government-mandated health care reform in the US -- the Patient Protection & Affordable Care Act (labeled as "ObamaCare") -- has raised 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 device companies. When implemented, device makers will have to pay a 2.3% excise tax on sales of certain products beginning 2013.

The outlay is expected to choke 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 in taxes over a ten-year period. In response, device makers have started to take up several initiatives including headcount reduction and other restructuring activities to counter costs associated with the implementation of the new tax.

OPPORTUNITIES

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

With a slew of new products, the Big Three players in the ICD market (Medtronic, Boston Scientific and St. Jude) are striving to gain market share, despite the challenging business environment and several other barriers to growth. These players are also exploring new avenues of growth beyond the mature pacemaker and ICD markets.

The US implantable defibrillator market continues to bother cardiac device makers, as reflected by sustained implant volume pressures. As per estimates, the global CRM market is expected to shrink at low single digits (at constant currency) in 2012. However, the silver lining is that the US market is showing signs of stabilization.

Among the above-mentioned names, Medtronic, the undisputed leader in the MedTech space, has a diversified presence in cardiovascular, neuro, spinal, diabetes and ENT and boasts an attractive pipeline. Despite sustained weakness 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 target to return 50% of free cash flow to shareholders through dividends and buybacks.

We are optimistic that over the long term, stability in the US ICD market along with a deep pipeline/portfolio -- which includes CoreValve, Resolute Integrity, Atrial Fibrillation, renal denervation and peripheral businesses -- will be the driving factors for the company going ahead.

Of these driving factors, renal denervation, serving a very significant unmet clinical need in uncontrolled hypertension, deserves special mention given its immense market potential. According to the company, this indication alone holds a $2-$2.5 billion market opportunity by 2020, excluding the other potential applications of renal denervation. During fiscal 2013, revenues from Medtronic's renal denervation business is expected to almost double to $60-$70 million.

Medtronic's peer, Boston Scientific is leaving no stone unturned to stay on the growth curve. The company is looking at improved share in the global DES market subsequent to the earlier-than-expected approval of Promus Element Plus in the US (in November 2011), and the launch of the product in Japan and Canada, both in March 2012. We are also encouraged with the launch of Ingenio and Advantio pacemakers and Invive cardiac resynchronization therapy pacemakers (CRT-P) in Europe in April 2012, followed by FDA approval in May 2012.

Although Boston Scientific continues to experience challenges in its CRM and stents businesses, 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. Some of the other significant products in its pipeline include the fourth-generation Synergy DES (CE Mark expected in late 2012 with full launch in 2013 and commencement of US trial scheduled for mid-2012) and Vercise deep brain stimulation program for the treatment of Parkinson's disease. Both these technologies are expected to begin contributing to revenues in 2013 and substantially in 2014.

For St. Jude, we are intrigued by the company's ability to gain ICD market share despite the sluggish market conditions. St. Jude is poised for incremental opportunities in CRM on the back of strong product momentum. Specifically, the company benefited from the recent launch of its Unify quadripolar CRT-D system. On the back of its success with Unify, the company is looking at benefiting from the Ellipse line of ICDs (the world's smallest high-energy ICD). The company is also eyeing percutaneous mitral valve repair technology -- representing almost $1 billion in market potential -- with a launch scheduled in Europe by 2013.

Edwards Lifesciences represents another value proposition. The company recorded strong Sapien sales in the US in its first full quarter of launch after receiving FDA approval in November 2011. The mid-point of the guidance for Sapien sales in the US was lowered by only $10 million despite the one-quarter delay in approval for high risk patients primarily due to better-than-expected ramp up in Sapien sales in US. Approval of Sapien for high risk surgery patients in US, however, remains a concern. Edwards has the first mover advantage in the US in the field of transcatheter aortic valve replacement (TAVR) with Sapien, though Medtronic with its CoreValve offers tough competition in Europe.

Robotic surgery is another fledgling area which is expected to gain ground in 2012. Intuitive Surgical (ISRG) 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.

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.

Beyond the MedTech majors, we are also optimistic about scientific instrument maker Thermo Fisher Scientific (TMO). 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 emerging markets for growth. Although the academic/government market is still fettered by constraints, it improved on a sequential basis during the most recent quarter.

We also expect fractional flow reserve (FFR) guided therapy and optical coherence tomography (OCT) technology within the intravascular imaging market (valued at approximately $500 million) to offer incremental opportunity for companies such as Volcano Corp. (VOLC) and St. Jude. We expect penetration of the FFR technology to improve on the back of growing awareness about appropriateness of stents and for validating stent outcomes amidst a tight economic and reimbursement scenario.

WEAKNESSES

Still-Cloudy Orthopedic Space

Orthopedics is one of the largest medical device market segments worldwide. However, this market, valued at approximately $30 billion in 2011, is still struggling as patients defer their elective procedures given the lingering economic softness. Lukewarm demand is exacerbated by sustained pricing pressure.

In particular, 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.

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.

We remain skeptical about companies including Stryker (SYK), Zimmer Holdings (ZMH), Wright Medical Group (WMGI) and Symmetry Medical (SMA) given the sustained price/volume pressure.

EHR Incentive Payments on a Downturn

CMS incentive payments for electronic health records (EHR) to hospitals (including both Medicare and Medicaid) declined more than 35% in the month of April 2012. The $116 million in disbursements made by Medicare to hospitals in April 2012 is the lowest since the September 2011 payout of $64 million. It was at its highest in December at $375 million.

Huge fluctuations in Medicare payments ($188 million in January, $134 million in February, $184 million in March and $116 million in April) force us to take a cautious stand. As such, we are a little wary of players catering to the HIT (healthcare information technology market). Names in this domain include Merge Healthcare (MRGE), Quality Systems (QSII) and Allscripts Healthcare Solutions (MDRX).

Additional concerns for Quality Systems emanate from a drop in the number of signed contracts along with a decline in the proportion of green field projects. The most recent quarter marked the fourth straight quarter of declining year-over-year growth rate of the pipeline. (The company defines the pipeline metric as aggregate worth of contracts with a 50% or greater possibility of closure during the upcoming four months). Moreover, as the government-sponsored EHR program winds down over the next few years, it is expected to create significant headwinds for these players.

Economic Challenges

While the debt crisis in Europe remains unabated, economies throughout the world are trying to come to terms with myriad challenges. The May jobs report for the US economy has raised doubts again about any possible recovery with the unemployment level climbing to 8.2%. The emerging economies of Brazil, India and China are also slowing down. Unemployment in the 17 countries of the Euro-zone stood at 11% in April.

This situation adds to the woes of the MedTech sector as many companies look for sales from the international arena. So, many companies are looking at emerging markets for future growth.

Depressed Volumes

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 expected to thwart utilization this year. Volume headwind is likely to linger this year as unemployment continues to influence procedure deferrals.

Pricing Pressure

Players in the medical device space are experiencing pricing pressure of varying degrees. Cardiovascular devices companies are witnessing global pricing pressure in the ICD and CRM businesses. Although data from the recently reported quarter signal some relief in the rate of pricing erosion, we believe pricing will continue to bother given global budget constraints amidst deteriorating economic conditions.
 
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