MedTech Industry Stock 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. -Zacks Equity Research