MedTech Industry Update: Restructuring, Mergers And Market Expansion

We are on the verge of the Q4 earnings season and it is once again time to review the players in the worldwide medical devices market. For the U.S. medical device industry, spending cuts and higher taxes have been a big issue lately. The industry faced sequestration related spending cuts to the U.S. federal budget and the 2.3% medical device excise tax.

Unfortunately, this is not the end of the story. This year, more spending cuts are scheduled to take place which will last through 2021. The sequestration which resulted in a 5.5% cut in the National Institutes of Health’s (NIH) fiscal 2013 budget resulted in 640 fewer grants in 2013.  

The NIH was not the sole victim of federal budget austerities. In 2013, under the sequester, there was a 5% cut in the Centers for Disease Control and Prevention's budget, another 5% cut to the U.S. Food and Drug Administration's fund and a 2% cut in Medicare funding that included cut in payments to hospitals, physicians, other medical providers, Medicare Advantage insurance companies and Part D prescription drug plans.

Unless repealed or replaced, NIH apprehends sequestration to take a worse shape in 2014 leading to serious consequences like delaying progress in medical breakthroughs, deterioration in job creation and tempering of economic growth. An NBC news article recently noted that many new researchers, who were trained with the U.S. taxpayer’s money, may have to move to Europe and Asia where government funding for medical research is on the rise.

On top of these, the Obamacare’s medical device excise tax is taking a heavy toll on the MedTech sector, hurting pricing decisions of companies and subjecting them to tremendous margin pressure. The small and the medium-sized players in the sector (comprising about 80% of the industry) are the worst hit by this public policy. The devastating 2.3% excise tax (effective Jan 2013), which is imposed on the sale price instead of net profit, amounts to a stupendous sum, wiping out almost a quarter of the profit at the med instrument owners.

Conversely, the big players are trying every means to change their business model and cost structure to accommodate the excise tax. They are undertaking various restructuring initiatives to counter costs incurred from the implementation of the new tax. Restructuring especially to offset the effect of the excise tax has already been adopted by key players, such as, Boston Scientific Corporation (BSX), Medtronic Inc. (MDT), St. Jude Medical, Inc. (STJ), Stryker Corporation (SYK), Zimmer Holdings (ZMH) and Quest Diagnostics (DGX). The companies are also trying to focus on strategic mergers and acquisitions (M&A), emerging market expansion or are reducing operations in order to weather the tax burden.
 
M&A Activities

As mentioned above, MedTech M&A is expected to continue unabated in 2014. Wary of an uncertain economy, MedTech giants have resorted to the acquisition route to harness their strength and diversify offerings.

The most noteworthy move in recent times was the Irish medical device maker Covidien plc.’s (COV) $860 million deal in December to acquire Israel-based diagnostic products maker Given Imaging (GIVN) in order to get a share of the $3 billion gastrointestinal (GI) market. The acquisition is expected to be completed by Mar 31, 2014.

Stryker Corporation was also in the headlines last month with its $1.65 billion acquisition of robotic assisted surgery developer MAKO Surgical Corp. Stryker is excited about inheriting MAKO’s robotic technology as the company believes it has long-term potential for human joint reconstruction.
Last month, HeartWare International (HTWR) acquired CircuLite, Inc. -- developer of the SYNERGY Circulatory Support System for a cash-and-stock deal amounting to $350 million. This accentuates the company’s focus on advanced heart failure treatment.
 
In November, Wright Medical Group, Inc. (WMGI) succeeded in its efforts to expand its direct sales and international distribution network in France by completing the acquisition of French orthopedic extremities company Biotech International. The acquisition has added Biotech’s extremity product portfolio that will boost WMGI’s global Extremities business growth.

In continuity of its strategic investment plans, Henry Schein, Inc. (HSIC) acquired a 60% stake in BioHorizons, a U.S.-based manufacturer of advanced dental implants with sales of $115 million. The acquisition of BioHorizons marks Henry Schein’s foray into the global implant market, which is estimated to touch $4.2 billion by 2016. Combined together, the U.S and Canadian markets alone have a potential of $1.5 billion in 2016, up from $1 billion in 2012.

CareFusion Corp. (CFN) announced in November that it has signed a $500 million agreement to acquire Vital Signs, a division of GE Healthcare, for $500 million. The acquisition will not only expand its Specialty Disposables business under the Procedural Solutions segment internationally but establish it as a leader in the $3 billion market for respiratory and anesthesia consumables.

There have been many more M&As in the MedTech space. Boston Scientific Corporation recently closed the acquisition of Bard EP, the electrophysiology business of C.R. Bard, Inc. (BCR). The deal, valued at $275 million, is a step forward to strengthening the company’s foothold in the $2.5 billion global electrophysiology market.

In October, St. Jude Medical acquired world’s first and only leadless pacemaker manufacturer Nanostim, Inc. for $123.5 million. St. Jude utilized an exclusive option, obtained on May 3, 2011, when it had entered into a partnership agreement with the then privately-held company.

In September, Kinetic Concepts formed a trinity with LifeCell Corp. and Systagenix to develop a diversified wound care, biologics and regenerative medicine company with more than $2 billion in sales.

At the end of September, Baxter International (BAX) closed its $3.9 billion deal to acquire Gambro AB, a Sweden-based privately-owned renal products company. The deal is expected to strengthen the company’s role in the hemodialysis market.

A notable move made in recent times was the MedTech giant Medtronic Inc.’s strategic shift from being a device manufacturer to a provider of broader healthcare services and solutions with meaningful clinical and economic value for hospitals, physicians, patients and payers. As an opening move, in August, the company acquired privately-held Cardiocom, a provider of integrated telehealth and patient services for chronic disease management, for $200 million.

Also worth mentioning is the mega $13.6 billion takeover agreement by Thermo Fisher Scientific (TMO) to acquire its major peer Life Technologies Corporation (LIFE). This is the biggest ever deal for Thermo Fisher which will inevitably strengthen the company’s global foothold and commercial reach. With the approval of LIFE’s stockholders and the European Commission in favor of the deal, the acquisition is expected to close in early 2014.
 
In August, C. R. Bard entered into a $200 million definitive acquisition deal to purchase a leading developer and supplier of plant based hemostatic agents, Medafor, Inc. The acquisition will help Bard gain access to a proprietary technology platform and expand its global footprint. It will boost the company’s surgical specialties portfolio (particularly surgical hemostats) in its Davol subsidiary.

Also, Quest Diagnostics’ acquisition of ConVerge Diagnostic Services, LLC from Water Street Healthcare Partners in October was part of the five-point strategy announced by the company in 2012. ConVerge Diagnostic was the fourth laboratory acquisition of Quest Diagnostics in 2013 following the acquisitions of UMass Memorial Medical Center's clinical and anatomic pathology outreach laboratory businesses (Jan 2013), the toxicology and clinical laboratory business from Concentra, a subsidiary of Humana, Inc (HUM) (May 2013) and the acquisition of lab-related clinical outreach service operations of California-based Dignity Health (Jun 2013).

In June, to strengthen its contraceptive portfolio, drug and pesticide maker Bayer (BAYRY) acquired the contraceptive device maker Conceptus Inc. for approximately $1.1 billion in cash. This acquisition has added the Essure permanent (non-surgical) birth control system to Bayer’s product portfolio.

In the light of the discussion above, we see no slowing down of M&A deals in the MedTech space in the first half of 2014.
 
We also expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Several MedTech majors struggling in their core businesses are looking to explore potential emerging therapies through collaborations and alliances.
Divestments
With the medical device excise tax in force, leading to further contraction in profit margins, we have been observing a lot of divestments of late, particularly of non-core business segments. Divestment, specifically to offset the tax, has already been announced by key players like Johnson & Johnson (JNJ), Medtronic and Quest Diagnostics. We expect this trend to continue into 2014.

MedTech giant Johnson & Johnson, after its $1 billion acquisition of privately-held, pharmaceutical discovery and development company, Aragon Pharmaceuticals, Inc, is currently looking for opportunities to sell or spin off its Ortho Clinical Diagnostics business. Last August, Medtronic handed over its interventional device Pioneer Plus re-entry catheter product line to Volcano Corporation (VOLC).

Quest Diagnostics has also been focusing on areas with high potential, such as, gene-based esoteric testing for cancer, cardiovascular disease, infectious disease and neurological disorders. As a part of this strategy, in November, it divested the Enterix colorectal cancer screening test business to Clinical Genomics Technologies Pty Ltd.
 
In July, the company sold its rights to royalties from the commercialization of the Imbruvica to Royalty Pharma, the industry leader in acquiring royalty interests in marketed and late stage biopharmaceutical products, for $485 million in cash. Earlier, in April, the company completed the divestiture of the HemoCue diagnostics products business.

Kimberly-Clark Corporation (KMB) on the other hand is working on a potential tax-free spin-off of the company's health care business.  This spin-off would create a stand-alone, publicly traded health care company with $1.6 billion in annual net sales with a significant presence in both surgical and infection prevention products and in the medical devices market.

Wright Medical expects to close the sale of its OrthoRecon unit to MicroPort Medical B.V., a subsidiary of MicroPort Scientific Corporation, by the end of January this year. Novartis (NVS) has also entered into a definitive agreement to divest its blood transfusion diagnostics unit to Spain-based Grifols for $1.675 billion. The divestment is expected to be completed by the first half of 2014. Last October, GE Healthcare sold off its Centricity Laboratory Division to Cirdan Ultra, a subsidiary of Ireland-based Cirdan Imaging Limited.

In 2013, to focus on its high-margin Medical Devices and Medical Supplies businesses, healthcare products maker Covidien (COV) divested its pharmaceuticals business Mallinckrodt plc (MNK). Last January, Abbott Laboratories separated its research-based pharmaceuticals business by creating a new company, AbbVie (ABBV), to allow the two separate entities to focus on their core areas of expertise.

Emerging Markets

Although the U.S. still holds the leading position with almost one-third of the global market share, a gradual slowing down of the established markets due to several prevailing headwinds are forcing MedTech companies to move beyond their comfort zone. Currently with the growth rate remaining at low-single digits in developed markets like the U.S., Europe and Japan, large-cap medical device makers are looking to invest more in the high-growth emerging markets.

Accordingly, emerging economies like Brazil, Russia, India and China – collectively known as BRICs – as well as Turkey, Mexico, Malaysia, South Africa, South Korea and the Czech Republic are fast coming up in the medical devices space. These emerging economies are seeing an increasing uptake in medical devices due largely to growing medical awareness and economic prosperity. Urbanization is taking place at a massive rate in most of these regions with people entering the middle class and demanding better health care.

An aging population, increasing wealth, government focus on healthcare infrastructure and expansion of medical insurance coverage make these markets a happy hunting ground for global medical device players. Expansion in emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2014 and beyond.

Companies like Abbott, Medtronic, Boston Scientific, Edwards Lifescience (EW), Thermo Fisher Scientific, Life Technologies, Smith and Nephew (SNN) and many more are all vying to expand their presence in BRIC and other emerging markets. These companies are also looking to establish their manufacturing facilities abroad.

Abbott continues to lead the trend with about 40% of sales coming from emerging markets. The company expects this contribution to increase to 50% by 2015. Johnson & Johnson with almost 25% of sales derived from the emerging markets is currently working to increase its presence in this region.
 
The company has already set up manufacturing and R&D centers in Brazil, China and India. The Guangzhou Bioseal Biotech deal marked the company’s first MedTech acquisition in China. The company is expected to expand further in China on the back of the Synthes acquisition.

Becton, Dickinson and Company (BDX) with about 23% of revenues coming from the emerging markets is currently promoting its product lines in HIV monitoring, Diabetes Care and TB Diagnostics. Baxter on the other hand, given the possibilities rife in these regions, is working hard at expansion. 20% of the company’s worldwide sales came from this segment in the third quarter of 2013.

Medtronic (with emerging market exposure of 12%) continues to record double-digit growth in emerging markets, accounting for half of its overall growth. The adoption of its implantable cardioverter-defibrillators (ICDs) and pacers in the emerging markets continues to improve. Moreover, commercialization of new products should accelerate sales growth in these regions.
Management is targeting 20% of its revenues from emerging markets over the long term with mid-teens growth for the current fiscal. According to the company, the premium segments in China and India alone include a population of more than 380 million, leading to $5 billion of annual sales opportunity.

Boston Scientific is also aiming to increase its below-average market share in the $700 million combined drug-eluting stent market in China and India, which is growing sharply at 20%. The company plans to invest $150 million in China over the next five years to build a local manufacturing operation. Stryker, with its acquisition of China-based Trauson Medical, is expected to grow market share in the value-oriented orthopedic segment in the developing nations.

In November, orthopedic major, Smith & Nephew acquired the assets of its Brazilian distributor, Pró Cirurgia Especializada (PCE). PCE has been associated with the company for the last 30 years and has distributed its sports medicine, orthopedic reconstruction and trauma offerings in Brazil.
 
The company is also venturing into India and Turkey. In May 2013, the company announced an agreement to take over Adler Mediequip Private Limited and with it, the brands and assets of Sushrut Surgicals Private Limited, a leader in mid-tier, orthopedic trauma products for the Indian market. Last July, the company decided to acquire certain assets of its Turkish distributor Plato Grup. The acquisition will promote distribution of Smith & Nephew’s orthopedic reconstruction, trauma and sports medicine products in Turkey.

Thermo Fisher is also expanding its presence in the emerging markets. It expects to garner 25% of total revenues from the high-growth Asia-Pacific region and emerging markets by 2016, up from 19% in 2011. According to the company, China with its rapid industrialization, increasing focus on healthcare, new BioPharma R&D centers and government sponsored research has robust growth potential.

Brazil is also gaining momentum with growth rate of more than 20%. On the other hand, key growth drivers in India include outsourcing of clinical packaging and logistics by Pharma and Biotech companies, growing Biotech and food & beverage industries, and introduction of environmental regulations to address air quality issues in the wake of rapid industrialization.

Among the BRIC members, Brazil is currently the largest healthcare market in Latin America, covering almost one-fourth of the population. Though India has one of the largest and fastest growing healthcare markets in the world, it is considered to have the least developed healthcare infrastructure and spends relatively little in this area. In order to reverse the trend, during the 12th Plan (2012-2017), the Indian government planned to spend 2.5% of its GDP (up from 1.2% earlier) on health care and raise it to at least 3% by 2022.
 
Other Issues at Work

Apart from the medical device excise tax and sequestration, other issues faced by the MedTech industry include pricing concerns, hospital admission and procedural volume pressure, Medicare reimbursement issues and regulatory overhang. While the debt crisis in Europe remains unresolved, economies throughout the world are trying to come to terms with myriad challenges. Consequently, procedural volumes in the U.S. 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 taking a toll on utilization. Volume headwind is likely to linger as unemployment continues to influence procedure deferrals.

Last but not least, the highly regulated U.S. medical device industry is constrained by stringent and complex procedures, leading to approval delays. This sometimes demotivates companies, deterring them from investing in product development. According to a report based on a survey of over 200 medical technology companies (FDA Impact on U.S. Medical Technology Innovation), the FDA takes a significantly longer time to review compared to its European counterpart.

Zacks Industry Rank

Within the Zacks Industry classification, MedTech is broadly grouped into the Medical sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: med instruments, med products, med/dental-supp and medical info systems.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for med instruments is #141, med products is #93, med/dental-supp is #161, while the medical info systems is #246. Analyzing the Zacks Industry Rank for different MedTech segments, it is obvious that while the outlook for medical info systems stocks is negative, that for med instruments, med products and med/dental-supp is neutral.

Earnings Trend of the Sector

Overall fourth quarter earnings guidance for the medical majors looks not so impressive. However, third quarter results have been fairly good with respect to beat ratios (percentage of companies coming out with positive surprises). We note that, the results were not impressive in terms of year-over-year growth.

The earnings "beat ratio" was 74.5%, while the revenue "beat ratio" was 51.0% in the third quarter. Total earnings for the companies in this sector increased marginally 0.2% year over year despite revenue growth of 5.8%. In fact, earnings and revenues showed a slight increase from the second quarter 2013 performance.

The earnings is expected to decline by 3.5% in the fourth quarter 2013. However, the sector is expected to register a nominal growth of 0.6% for the full-year 2013 and an impressive 8.3% in the full-year 2014. In terms of revenue expectation, the sector is expected to register 3.1% year-over-year growth in the fourth quarter of the year, resulting in an annual growth rate of 5.1%.

For more information about earnings for this sector and others, please read our ‘Earnings Trends’ report.

OPPORTUNITIES

In spite of several core market challenges, the big three medical device players – Medtronic, Boston Scientific and St. Jude – are striving to gain share in the ICD market through new product launches. The companies are also exploring fresh avenues of growth beyond the mature pacemaker and ICD markets.
 
With gradual stability in the ICD market, these players should be able to revive their top line. Also, better pipeline visibility and appropriate utilization of cash should increase confidence in the medical device sector. The better-than-expected ICD performance from the trio indicates a revival in the worldwide ICD market.

The Cooper Companies Inc. (COO) represents a value proposition based on factors such as margin expansion, acquisitions, product line expansion and geographical reach as well as share buybacks. On the other hand, we are positive about multiple initiatives taken by Boston Scientific to expand electrophysiology (EP) division. St. Jude is also doing well with its growing Atrial Fibrillation products portfolio that witnessed a major boost with the acquisition of Endosense and the regulatory approval of its Mediguide catheters.

Beyond the MedTech majors, we are also optimistic about the Zacks Ranked #3 orthopedic device players, Zimmer Holdings and Stryker Corporation. The percentage of population over 65 in the U.S., Europe, Japan and other regions is expected to nearly double by the year 2030. In the U.S., the oldest baby boomers are now approaching retirement age. We believe the orthopedic giants stand to benefit from this aging demography.

Among scientific instrument makers, Thermo Fisher Scientific has been successfully expanding operating margins over the past few quarters on the back of operational efficiency. Thermo Fisher’s market leading portfolio of analytical technologies and specialty diagnostic will be complemented by the upcoming buyout of Life Technologies. The latter has an expansive line of consumables for genomic, molecular and cell biology.

Among mid-cap MedTech stocks, Align Technology (ALGN) and Symmetry Medical, Inc. (SMA) carrying a Zacks Rank #2 (Buy) also look attractive.
 
CHALLENGES AND WEAKNESSES

Coming to the weakest link in the MedTech sector, we advise investors against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends for 2014 reflect a bearish sentiment.

After posting dismal third quarter results and lowering its fiscal guidance, Intuitive Surgical (ISRG) currently retains a Zacks Rank #4 (Sell). Other stocks which do not look inspiring are Allscripts Healthcare Solutions, Inc. (MDRX), Laboratory Corporation of America Holdings (LH) and Edward Lifesciences. While MDRX holds a Zacks Rank #4 (Sell), EW and LabCorp fall under the Zacks Rank #5 (Strong Sell) category.

Pricing compression on hips, knees and spine products, which impaired the performances of several orthopedic companies, remains a key concern, at the macro level. We remain skeptical about the prospects of Zimmer and Wright Medical Group (WMGI), each with a current Zacks Rank #4 (Sell).

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