Medical Devices Industry Outlook – April 2011 - Industry Outlook

Last year was challenging for medical device companies given the exigent economic conditions and an uncertain healthcare environment. The MedTech industry was hit by several macro headwinds in 2010 including price/volume and utilization pressure and a more restrictive regulatory environment. Although a number of these issues remain, the industry is expected to fare better this year due to several tailwinds and growth opportunities.

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 medical devices market, with estimated sales of roughly $95 billion in 2010.

The medical devices industry is divided into different segments such as Cardiology, Oncology, Neuro, Orthopedic, Aesthetic Devices and Healthcare IT (“HCIT”). The U.S. medical devices industry continues to grow at a brisk pace, thanks to 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 faced a host of issues in 2010, including pricing concerns, hospital admission and procedural volume pressures, health care reform, reimbursement pressures and increasing regulatory involvements, which put investors in a dilemma about these stocks. While several catalysts for growth in 2011 exist — such as new product launches, an aging population, geographic expansion and emerging markets — lingering issues from last year remain an overhang.

The aging population represents a major catalyst for demand of medical devices. The elderly population (persons 65 years and above) base in the U.S. was roughly 40 million in 2010, 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, ensuing a major boost for medical devices utilization.

With several growth constraints in the legacy markets, medical device companies are aiming to expand into lucrative new markets. Expansion in the emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2011 and beyond.

U.S. Healthcare Reform

The Government-mandated healthcare reform in the U.S. enacted last year — the Patient Protection & Affordable Care Act — has created 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 proposed tax on device companies may hit their bottom lines. 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

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 healthcare costs, including prospective reimbursement cuts with careful review of medical bills and stringent pre-approval requirements.

Increase in the publicly insured base (resulting from the healthcare 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 may materially impact utilization in 2011. Changes in reimbursement policy significantly impact medical device companies as they hurt demand for their products and revenues.

Regulatory Landscape – The 510(k) Reform

The U.S. Food and Drug Administration (FDA) declared, on August 3, 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 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 on January 19, 2011, consisting of 25 proposals, which it intends to implement during 2011 to improve the regulatory approval pathway for medical devices. Most of these proposals, announced by the FDA’s Center for Devices and Radiological Health (“CDRH”), appear favorable for the medical devices industry.

The proposals 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.

However, interestingly, the regulator has shelved the most controversial issues of its previously-announced proposals including a definition of its authority to rescind approval of potentially unsafe or ineffective products and the creation of a new category of devices, which have drawn sneers from industry groups and devices companies. 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, which provides national advice on medical issues, for independent review with feedback expected in mid-2011. These issues were met with significant concerns as indicated in the comments submitted to the public docket.

The FDA plans to implement its new set of plans through a process of regulatory actions such as draft guidance and proposed regulations, which will be open to public feedback. CDRH stated that it will wait for the pending review report of the Institute of Medicine before making a final decision. Moreover, the regulator is planning for a public meeting in April 2011 to seek feedback on two other issues.

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

We continue to recommend companies providing life-sustaining products, given their strong recurring stream of revenues as patients are unable to forego these products. Furthermore, investors should look at companies with strong earnings quality and liquidity profiles. These companies appear attractive considering their ability to leverage strong balance sheet and cash flows in maximizing shareholder value (via dividends/share repurchases).

Large companies with a wide product portfolio/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 in 2011. These companies have greater capability of withstanding the sustained macro-level issues and increasing regulatory pressure.

Pressed by a still struggling economy, top-tier devices makers are expected to continue their merger/acquisition binge in 2011, especially as a means to enter new markets and diversify their portfolio. Although this represents an important means for growth, we continue to advise investors to shun companies that have grown historically through extensive acquisitions only.

These companies may find it difficult to fund acquisitions considering the lingering impact of the recession. Also, they face increasing challenges in delivering operational synergies from these acquisitions, which are considered to be the prime reason for failures of mergers and acquisitions.

OPPORTUNITIES

In our universe, we see growth potential in companies dealing with cardiovascular devices, Neuro, radiation oncology and blood-related products. Names include Medtronic Inc. (MDT), Boston Scientific Corporation (BSX), St. Jude Medical (STJ), ZOLL Medical (ZOLL), Abiomed Inc. (AMBD), Cyberonics Inc. (CYBX), Varian Medical (VAR), Accuray Incorporated (ARAY), Haemonetics Corporation (HAE).

The above-listed companies produce life-sustaining products and are less affected by economic turbulence. Some of these companies have been successful in weathering the storm (pricing, currency and procedure growth headwinds) in the cardiovascular space in the wake of recovery. In addition, low global penetration and robust demand provides a positive long-term thesis for investing in the blood processing industry. These companies are all leading players in their respective fields and are potential winners in the long run.

MedTech Giants: Long-Term Winners

With a slew of new products, the Big Three players (Medtronic, Boston Scientific and St. Jude) in the $6.5 billion implantable cardioverter defibrillator (“ICD”) market are well positioned to gain market share, despite the challenging business environment. However, we do acknowledge the fact that a soft CRM market may be a drag on these stocks. The prevailing macroeconomic factors, pricing pressure, austerity measures and the impact of health care reform are expected to continue to weigh on the CRM market through 2011.

Among the names above, Medtronic, the undisputed leader in the MedTech space, has a diversified presence in Cardiovascular, Neuro, Spinal, Diabetes and ENT and boasts an attractive pipeline. Although the company lost some U.S. ICD market share in the most recent quarter due to competition, new products should gradually contribute to growth and help it maintain/gain ICD share.

The long-awaited issue of the FDA warning letters, relating to Medtronic’s Mounds View facility and manufacturing unit in Puerto Rico, was finally resolved in March 2011, paving the way for the U.S. approval and launch of new products including the much-anticipated Protecta ICD device. While Protecta ICD has yet to be cleared in the U.S., it continues to perform very well in Europe.

We believe that the recent approval of the REVO MRI SureScan pacemaker and Arctic Front catheter should provide some support to Medtronic’s CRM business. Its spinal segment should also benefit gradually from the recent product launches.

Moreover, Medtronic plans to adopt restructuring initiatives (including workforce reduction) to sustain long-term growth. The company is also blessed with strong cash flows which it prudently uses for maximizing shareholder value. Medtronic is active on the acquisition front and is investing in emerging markets, which it considers an increasingly important growth driver.

Boston Scientific has maintained its leadership position in the global drug eluting stent (“DES”) market with 35% share (46% in the US market). Importantly, its pipeline DES product Promus Element is shaping up to be a major driver of its stent business. Moreover, we are also encouraged by Boston Scientic’s acquisition of asthma-treatment company Asthmatx, which will enable it to target the pulmonary devices area.

Boston Scientific has undertaken a series of management changes and restructuring initiatives that are expected to contribute to the bottom line moving forward. The company plans to expand its footprint in the emerging markets by reinvesting the savings from restructuring efforts. In this context, we reckon the company’s divestiture of its Neurovascular business as a smart move, enabling it to prepay a portion of the debt and invest in high growth markets.

St. Jude is poised to grow its market share in the CRM segment (especially in ICDs), driven by its new Fortify and Unify lines of devices. Launch of several products (including the quadripolar CRT systems) in the U.S. and Europe should boost the company’s CRM market share in 2011. Moreover, we are optimistic about the emerging opportunity in the intravascular imaging market, enabled by the company’s LightLab acquisition in July 2010.

St. Jude’s EnSite mapping system for diagnosis and treatment of arrhythmia continues to be the key driving force in atrial fibrillation. Also, its $1.3 billion acquisition of heart devices maker AGA Medical Holdings will eventually make St. Jude a clear leader in the structural heart market. The company expects the acquisition to help its sales grow at a low double-digit rate in 2011.

Beyond the MedTech giants, an interesting pick in our portfolio is resuscitation devices-maker ZOLL Medical. ZOLL is a leading player in the global market for external defibrillators, which is worth more than $1 billion. The company’s LifeVest wearable defibrillator business continues to grow at a healthy quarterly run rate, benefiting from increased awareness of the product and associated sales force enhancements.

We also believe that cardiac assist devices-maker Abiomed represents another favorable 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. Higher Impella sales continue to fuel double-digit revenue growth. Based on healthy Impella demand trend, Abiomed has raised its revenue guidance for fiscal 2011.

We are also optimistic about companies in the radiation oncology market such as Varian and Accuray. The radiation oncology market is benefiting from improving trends and technology advancements which are expected to boost the performance of these companies in 2011.

Accuray is a global leader in the field of radiosurgery and continues to enjoy healthy demand for its CyberKnife robotic radiosurgery systems as evidenced by sustained growth in the number of patients receiving treatment with the device. Notably, the company’s acquisition of its rival TomoTherapy (TOMO) will reinforce its foothold in the radiation oncology space.

Varian is the world’s leading manufacturer of integrated radiotherapy systems for treating cancer. The company is poised to increase its market share in the radiation oncology market. Varian is currently enjoying a healthy demand for its coveted RapidArc radiotherapy technology, which is meaningfully contributing to its oncology net order growth. Strong order activity in oncology coupled with healthy momentum in the X-ray products business will set the stage for better performance in 2011.

Emerging Markets: An Opportunity to Diversify

The leading U.S. cardiovascular devices companies such as Medtronic, Boston Scientific and St. Jude are exploring new avenues of growth beyond the mature pacemaker and ICD markets. These companies are increasingly seeking opportunities to expand into fast-growing new therapy areas within or outside the cardiology space, including markets such as atrial fibrillation and neuromodulation.

Among the emerging cardiology markets, an encouraging prospect represents the structural heart market with its major categories including Patent Foramen Ovale (PFO) and Left Atrial Appendage (LAA) occlusion. The AGA acquisition has provided St. Jude with devices targeted at PFO and LAA markets. Moreover, the Transcatheter Aortic Valves (TAVI) market, a potential blockbuster prospect, is emerging as a substantial new growth opportunity for the top-tier MedTech companies.

Intravascular ultrasound imaging (IVUS), Optical Coherence Tomography (OCT) and other next-generation imaging technologies are expected to offer incremental opportunity for the incumbent players such as Volcano Corp. (VOLC), Boston Scientific and St. Jude. The OCT market has been projected to grow at a double-digit rate over the next five years. We believe that emerging markets represent a key catalyst for growth in 2011 and beyond.

Hospital Spending: A Potential Tailwind?

A soft hospital capital spending backdrop was challenging for the MedTech stocks in 2010. The North American and European markets were affected by shrinking budgets for equipment purchases at the height of the recession. However, recent quarterly results indicate signs of recovery in hospital spending in the U.S. Spending levels are improving as hospitals appear to have started replacing their worn-out equipment. This may turn into a potential driver moving forward.

Federal “Stimulus”: A Boon for HCITs

Another area which is interestingly poised for growth these days is Healthcare IT. The landscape has changed since the Obama Administration took initiatives to encourage hospitals and physicians to modernize their health record-keeping as part of the “Stimulus Package.” The Stimulus is aimed at increasing the use of electronic health record (EHR) systems by medical practitioners.

Optimism about the growth prospects of HCIT service providers has improved since the Stimulus package. Moreover, the “meaningful use” rule that enables hospitals to qualify for federal incentive program will boost business opportunities for the incumbents in the long-run. Beneficiaries of the Stimulus include Allscripts-Misys Healthcare Solutions (MDRX) and Quality Systems (QSII).

WEAKNESSES

Japan Debacle: Hurting MedTech

The impact of the recent massive earthquake (and subsequent Tsunami) in Japan and its aftermath on the medical devices industry appears to be substantial. Japan is the second-largest medical devices market after the U.S. It accounts for roughly 45% of the medical devices industry in the Asia-Pacific region.

The roughly $25 billion Japanese medical devices sector has been an extremely successful market for American medical devices firms. U.S. firms account for roughly 60% of all imported medical devices products in Japan.

MedTech majors such as Medtronic, Boston Scientific and Johnson & Johnson’s (JNJ) Depuy has a major exposure to the Japanese medical devices sector. Other key players such as Abbott Laboratories (ABT), St. Jude, Stryker Corporation (SYK), Becton, Dickinson (BDX) and Zimmer Holdings (ZMH) also have strong foothold in this lucrative market. Many of these players derive sizable revenues from Japan.

The impact of the horrific disaster has been already felt as it has led to a major disruption in the global supply chain with Japan being a critical link. It will inevitably result in delays in shipments, elective surgical procedures and regulatory clearance for new products. Investors in devices companies, especially those with large export businesses in Japan, have been concerned over the long-term effect of the Japan crisis (as reflected in falling share prices), which is hard to gauge at this moment.

Orthopedic Still a Concern

We continue to advise investors to spurn companies in the orthopedic domain until we see a complete economic recovery. Companies in this space continue to struggle as patients defer their elective procedures given the lingering economic softness. Companies that fit the bill include Stryker, Zimmer Holdings, CONMED Corporation (CNMD), Wright Medical Group (WMGI) and Symmetry Medical (SMA).

However, we do admit that companies such as Stryker and Zimmer, with less exposure to metal-on-metal (MoM) hip products, are better placed to gain share in 2011 than their highly-exposed counterparts such as JNJ/Depuy and Wright Medical. The ongoing transition from MoM implants to next-generation hip systems represents a tailwind for players such as Stryker and Zimmer.

Pricing Woes Linger

Pricing concerns on hips, knees and spine products have impaired the performances of most of the orthopedic companies in 2010. The pricing issue, at a macro-level, remains a key concern. The effect of government health care cost containment efforts and continuing pressure from local hospitals and health systems as potential Medicare reimbursement cuts create additional reasons for hospitals to push back pricing. This is expected to continue hurt selling prices on a global basis.

Moreover, the advent of group purchasing organizations (GPOs), which act as agents that negotiate vendor contracts on behalf of their members, has also put pressure on pricing. The prevailing economic climate has bolstered the bargaining power of GPOs. The pricing scenario in 2011 is expected to stay the same as last year as hospitals continue to push back pricing.

A Broken Back

The U.S. spine market, which grew at a double-digit rate in 2009, took a tumble in 2010. The spinal market was worst hit by the pricing/volume headwinds as manifested by a moribund quarterly growth trend. Leading companies in the orthopedic space such as Stryker and Zimmer continue to experience weak spine sales, which have somewhat shaken our confidence in these stocks.

Pricing pressure and reimbursement uncertainties coupled with austerity measures in Europe are expected continue to weigh on this market over the next few quarters. Moreover, private payors are delaying spine surgeries by requiring more documentation before approving such procedures, thereby contributing to the slowdown in this market.

Procedure Volume: Stabilizing but Still a Headwind

The $12 billion replacement hips and knees markets have been affected by lingering economic softness, as reflected in procedure volume pressure. Cash-strapped patients continue to defer surgeries given the weak economy.

Procedural volumes in the U.S. have been negatively impacted as a result of a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans.

As per the demographic analysis, these trends had a significant impact on the potential patient base for joint replacement procedures, those between 45 and 65 years of age and without any Medicare coverage. On the other hand, austerity measures are contributing to the reduction in procedure volumes in Europe. The hip/knee market in Europe is expected to remain challenged in 2011, but to a lesser extent than 2010.

Medical Devices Industry Outlook – April 2011 – Industry Outlook

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