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Thinking Small in Medical Devices

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Jesup & Lamont

THE LAST TWO YEARS (2006 and 2007) have been challenging times for the medical-device industry. Reimbursement concerns impacting large orthopedic and cardiology companies, combined with a dearth of new products, and stagnant growth in the formerly high-flying DES (drug eluting stent) and ICD (implantable cardioverter defibrillator) markets have weighed on valuations.

Additionally, when viewing the competitive landscape among the large players, innovations capable of changing these market dynamics are lacking. These factors have led investors to shy away from the sector in a significant way. In contrast, exciting and innovative technologies are emerging from the small- and micro-cap device players, which is where we suggest investors focus their efforts.

Positives for the industry include demographics, the global demand for health-care innovation, significant increases in research and development, and historic levels of cash among large-caps, all of which have industry revenue projections increasing between 10% and 15% in 2008. (At the midway of 2008 point we are around 12%)

The market for medical devices is increasing along with the aging population. In 2000 14%, or 46 million people in the U.S., were 60 years of age or older, which was a 12% increase from 1990. By 2020, there will be 75 million people older than 60, representing more than 20% of the population.

Venture funding, always significant in the health-care space, has witnessed a mix shift the last two years, with device funding levels approaching biopharma levels in 2007.

Driving this has been a lack of drug approvals (only 17 approved in 2007) and a stiffer regulatory environment (more so than devices). Devices are also easier for investors to understand than drugs and tend to be effective in almost everyone, in contrast to drugs, which often work only in a small percentage of patients.

Note that the government, as payer for approximately 50% of all health-care spending, has an outsized impact on profitability for the medical-device and overall health-care industry. Investors need to keep an eye on government reimbursement (Centers for Medicare and Medicaid Services) as well as regulation (Food and Drug Administration).

So while there is great potential for profits in the device space, Washington has an outsized impact on profitability. For example, in 2007 spending by hospitals on medical scanners declined as hospitals' administrators began to worry about the potential for lower reimbursement.

Medical devices are a U.S. industry (made in the USA) as most companies are located in the U.S., which is also by far the largest consumer of medical devices. There is thus a potential for international expansion, for example, ICDs are hardly utilized outside of North America.

The orthopedic and cardiovascular sectors each tend to trade as a group. Major ortho players include: Stryker (ticker: SYK), Zimmer Holdings (ZMH), [closely held] Biomet and Smith & Nephew (SNN). These companies see minimal share shifts with relative growth driven by mix cycles. Product cycles tend to be long and currently there are multiple Department of Justice investigations (regarding marketing practices) hindering valuation.

On the cardiovascular side, Medtronic (MDT), St. Jude Medical (STJ) and Boston Scientific (BSX) are the major players. Cardio sees more rapid share shifts than ortho and shorter production cycles. Additionally, growth in major products, DES and ICD, has become stagnant. In the last two quarters we have seen a slight rebound in DES.

-- Kenneth J. Siri, CFA



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