Medical Devices Stocks and SmartMoney's The Next Wave Of Moneymakers

This is from SmartMoney Magazine this month. It highlights the Medical Device Industry, which many investors tend to forget about, but there is a huge market for medical devices in the coming years. Although, with Obama's Healthcare Plan starting 2013 there will be an 2.3% increased tax on Medical Devices, I don't see it affecting these companies bottom lines as much as people think. You can read more about the tax at MassDevice.com's article, Device makers react to healthcare reform bill's excise tax. My main concern will be the FDA's tightening of 510K approvals in the near future.

There are a few others out there I would like to mention. Here is my list of Medical Device Companies on the rise. (In no particular order)

1. BSD Medical (BSDM)-- Huge gains as of late
2. Trinity Biotech (TRIB)--One of my favorites
3. MedQuist (MEDQ)--actually a Medical Coder
4. St Jude Medical (STJ)
5. NxState Medical (NXTM)
6. Derma Sciences (DSCI)
7. Varian Medical Systems (VAR)
8. iCAD, Inc. (ICAD)
9. Alcon (ACL)
10. STAAR Surgical (STAA)
11. Becton, Dickinson (BDX)

The Next Wave of Medical Moneymakers


For months Dr. Steven Pregulman has been hearing the same argument: Heath care reform is going to destroy his profession, the medical-device industry. Pregulman listens and then resumes his quest to develop the next great medical device.

The product that Pregulman is working on, a pump that can automatically adjust medication based on a patient’s real-time vital signs, is still years away from getting government approval, let alone being used in a hospital. But if it’s successful, the device will ensure that patients get the most appropriate dosages while freeing up doctors and nurses to spend time interacting with patients. Whatever the political climate that surrounds health care, a breakthrough would bring professional satisfaction to Pregulman and his team, and potentially millions of dollars in profit to his employer, Hospira, a Lake Forest, Ill.–based device maker and generic-drug manufacturer. No law that changes health care payments is stopping him, he says. “We want to make sure we’re the first, and certainly the best.”

This year the medical-device industry saw what seemed like a big obstacle thrown in its path: Obamacare. The health care reform plan will impose a 2.3 percent tax on thousands of medical devices, starting in 2013. Some investors fear it will kill innovation in the sector and turn device-maker stocks into dead money for years to come. But don’t tell that to the device companies themselves. Sales of everything from heart monitors to prosthetic limbs have steadily risen for more than a decade and are expected to continue increasing for the next several years. The companies are playing for the long term, as more than 70 million boomers hit retirement age in the next couple of decades. Indeed, by 2030 it’s estimated that 4 million knees will need to be replaced in the U.S. alone, not to mention the millions of other body parts that will need repairing or replacing. With an eye on that market, American companies spent $9 billion on research and development last year, a 6 percent increase from 2008, according to Ernst & Young.

Some forward-thinking investors have jumped into the sector this year, but many of the companies are trading well below their long-term price/earnings ratios. A slew of so-so earnings reports this summer pushed many medical stocks even lower. “Bad news was punished severely, and good news was punished a little,” says Mark Bussard, an analyst for the T. Rowe Price Health Sciences fund.

Regardless of health care reform and short-term profit outlooks, baby boomers are demanding relief from creaky knees and weakening hearts, and they want to get help without spending much time in a hospital. These forces will keep Pregulman and his colleagues busy for years to come, analysts say. Some subsectors generating particular excitement include obesity treatments and minimally invasive surgeries. “The less invasive they become, the greater the market opportunity is,” says Mark Leahey, CEO of the Medical Device Manufacturers Association. And these new innovations can bring a lot of money to their manufacturers very quickly. A few years back, Boston Scientific released its first drug-coated stent in the U.S., which allowed medicine to be delivered right into the walls of heart vessels. The company sold more than $200 million worth of the stents the following month.

To be sure, the most recent recession showed that people will delay or cancel expensive treatments during a bad economy. Analysts expect the same if another recession hits. But for some investors, there are just too many good potential breakthroughs and too much potential gain in a sector that generates more than $200 billion in sales annually. Here are five picks that some pros say have a healthy prognosis.

Medtronic

Medtronic (MDT: 33.65, +0.00, +0.00%) is the poster child for the maturing medical-device industry. The Minneapolis-based firm increased sales rapidly in the 1990s, and its stock rose 17-fold. While the company’s growth has slowed considerably, some analysts believe Medtronic now has advantages—namely, economies of scale and a diverse product line—that it never had as a fast-growing smaller company.

The company is known primarily for its cardiovascular products, such as pacemakers and stents, but those account for just half of Medtronic’s $15.8 billion in annual revenue. The firm gets billions of dollars in sales from products that treat spinal and neurological conditions; diabetes; ear, nose and throat ailments; and heart problems. The company plans to launch 60 major new products in its fiscal 2011, which began in May, roughly double the number it launched last year, CFO Gary Ellis tells SmartMoney. Ellis has high hopes in particular for a new pacemaker that can withstand an MRI scan. The company also aims to continue its sales growth in emerging markets such as China and India, Ellis says. Sales in emerging markets were 7 percent of total sales five years ago; now they are closing in on 20 percent, and Ellis says he expects that sales growth to continue.

This overseas growth can counter many domestic obstacles, some investors say. The company expects that the Obamacare-enacted excise tax will carve $150 million to $200 million from its profits beginning in 2013—about 4 percent of the roughly $4.8 billion that analysts predict for that year. Nevertheless, some pros believe the stock is a bargain at 10 times next year’s expected earnings, even if the blockbuster sales growth is a thing of the past. “We’ve shifted from being a highflying growth company of the 1990s to a strong, consistent player,” Ellis says.

Hospira

Hospira (HSP) already has a major share of the hospital pump business, even without a breakthrough from Pregulman and the other company engineers. But the pumps also offer an important entry point for other sales within the hospital; once a pump contract is signed, device companies can “bundle up the wazoo” with other products, says Junaid Husain, senior medical-technology analyst at Soleil Securities.

Unlike many of its competitors, Hospira had a reason to cheer the new health-reform plan. Obamacare cleared the way for the specialized drugs known as generic biologics, which Hospira already sells in Europe, to gain approval in this country. Previously, only branded versions of biologics—drugs made from living organisms—could be sold in the U.S. Analysts estimate the company will increase earnings by 22 percent this year. Hospira CEO Christopher Begley isn’t sweating the impact of the 2.3 percent excise tax on medical devices either. The tax will go into effect in 2013 but will affect the company’s earnings per share by “a dime or less,” Begley says. At 13 times earnings, Hospira is trading ahead of its peers, but Husain says the firm’s above-average growth prospects should command a premium.

Stryker

A couple of decades ago, only the elderly got knee replacements. “The goal was letting Grandma ambulate around the apartment pain-free,” says Patrick Treacy, vice president for knee reconstruction at Stryker Orthopaedics, a division of Kalamazoo, Mich.–based Stryker (SYK: 50.45, -0.12, -0.23%). These days baby boomers in their 50s get new knees so they can resume mountain climbing.

Demographics are clearly in Stryker’s favor. Analysts expect that about 4 million knees will need to be replaced in the U.S. by 2030, up from 550,000 replaced through 2009. It’s not just aging that’s fueling the trend either; obesity takes a toll on the knees as well, Treacy says. About 60 percent of Stryker’s $6.7 billion in annual sales come from its knee-making orthopedics unit. The rest comes from a variety of other medical equipment, with products ranging from stretchers that accommodate 700-pound patients to high-speed surgical drills.

Both sides of Stryker’s business took a hit in 2009, a year that executives have called one of the toughest in the company’s 69-year history. Stryker’s trauma-orthopedics segment suffered because, thanks to the recession, fewer construction workers were working and thus fewer got injured and needed orthopedic repairs. Company executives have said that 2010 will be a transition year. Stryker did get a boost earlier this year, however, after the Food and Drug Administration said the firm had cleared up some quality-control issues at a few company facilities.

To be sure, the pros don’t expect a quick return to the explosive growth that has characterized much of Stryker’s history. But the company has a very strong balance sheet, and Stryker’s valuation of 14 times expected 2010 profits is “a good long-term entry point,” says Russell Croft, comanager of the $296 million Croft Value fund, who has added to the fund’s Stryker position recently.

C.R. Bard

Some medical companies strive to design awe-inspiring devices that restore full movement to the hips or repair the walls of the heart. By contrast, C.R. Bard (BCR: 82.95, -0.25, -0.30%) makes low-cost, decidedly unsexy stuff. A little more than a quarter of the company’s $2.5 billion in annual sales came from urology products—most notably, catheters. “They really don’t go after the proverbial home run,” says Bob Goldman, senior vice president at C.L. King, an investment bank that follows the company.

But the lower-tech strategy has served the Murray Hill, N.J.–based firm well for its 103-year existence, and some pros see Bard’s approach as an advantage in an era when health care providers are being pushed to cut costs. The recession, along with pressure from insurers, has dissuaded some hospitals from spending on big-ticket health care machines. But many of Bard’s products, while very useful, cost only a few dollars each, and analysts say hospitals are loath to have a shortage of disposable products. Bard even recently pushed across a price increase on some of its catheters.

Indeed, since Bard’s products often require little medical infrastructure, they have been adopted quickly in developing economies, analysts say. Bard’s sales were $651 million in the first quarter of 2010, a 9 percent jump from a year earlier, thanks mostly to an increase in sales overseas. The catheter business is changing domestically now that some U.S. hospitals are clamping down on catheter use because it is a leading cause of urinary-tract infections. However, “the catheterization business isn’t going to go away,” says Mark Travis, comanager of the $165 million Intrepid Capital fund and a shareholder. Other analysts like Bard because it appears to be cheap. Its stock is trading at 13 times next year’s expected earnings, well under its 10-year average of 21.

Covidien

Covidien (COV) sees a growing opportunity in shrinking waistlines. The Dublin-based firm makes thousands of products, from thermometers to ventilators, but it also makes the staples that are used in bariatric surgery, also known as stomach shrinking. The staples are now only a fraction of the firm’s annual sales of nearly $11 billion, but they could become a much larger business, analysts say, if more of the roughly 15 million morbidly obese Americans opt for the surgery.

Since its spin-off from Tyco International three years ago, Covidien has pared back its other medical businesses to focus on medical devices, which represent about 60 percent of sales. The firm has doubled its research-and-development spending since 2004 and intends to increase it even more in the coming years, CFO Chuck Dockendorff tells SmartMoney. The company is directing a growing chunk of its R&D spending abroad and has established a manufacturing and training center in China for medical devices, Dockendorff says. Forty-two percent of Covidien’s sales come from outside the U.S.

Bonus Medical-Device Stock: Alere

As Washington tries to rein in spiraling health care costs, Alere (ALR: 30.57, +0.24, +0.79%) sees a profitable future in helping Americans better monitor their weak hearts and ailing kidneys from home. And with researchers estimating that three-quarters of all health care spending in the U.S goes toward treatment of chronic conditions, Alere could be well positioned.

The Waltham, Mass.–based company—which in July changed its name to Alere, from Inverness Medical Innovations—today gets the bulk of its revenue from devices that help doctors and nurses diagnose conditions ranging from high cholesterol to blood clots. In 2008 the company acquired Matria Healthcare, a health- and disease-management company that aims to lower costs for employer health plans, hospitals and patients through more effective patient monitoring and care. Some pros say Wall Street remains a bit uneasy with the acquisition, which investors viewed as a departure from the company’s core strength of disease diagnosis. “This is a company that’s misunderstood in many ways by Wall Street,” says Zarak Khurshid, an analyst with Wedbush Securities. While the new health-management business remains a work in progress, Alere has done a better job of integrating it than many investors realize, Khurshid says.

Trading at 10.1 times 2011’s expected earnings, Alere looks “much too cheap,” says Ben Kirby, an equity research analyst at Thornburg Investment Management and a shareholder. The stock plunged more than 20 percent in June after the company reduced its earnings guidance for 2010 to $2.60 from $2.90 on a weaker euro, a weaker-than-expected flu season, lower European sales and increased research-and-development spending. (Europe accounted for nearly 17 percent of the company’s $1.9 billion in 2009 net product sales and services revenue.) The market reaction was “too severe,” Kirby says, considering that the reduction was based largely on factors beyond the company’s control. “The company has a unique vision for helping to reduce chronic illness in the U.S.,” he says.

Covidien’s second-quarter sales fell short of some analysts’ expectations, and the stock has lagged the overall market in recent months. The company, which also makes flu vaccines, attributes the disappointing numbers in part to a weaker-than-expected late flu season. Some investors see the stock’s struggles, however, as a good opportunity to buy. “The company’s very healthy,” says Chris Armbruster, vice president of research for Al Frank Asset Management, which has added more Covidien shares to its holdings recently.

Devices Develop a Following
Several mutual funds also are making big bets on medical-device stocks. Two of the most prominent.

T. Rowe Price Health Sciences (PRHSX)
One-Year Return: 10.4%
Five-Year Return: 5.7%*
Expenses: $87 for $10,000 invested
Investors worrying about whether medical-device companies can grow has created bargains in the sector, says Mark Bussard, an analyst at the firm. “These stocks are priced for no growth,” he says. Holdings include Stryker and Covidien.

The Jensen Portfolio (JENSX)
One-Year Return: 13.2%
Five-Year Return: 1.8%*
Expenses: $92 for $10,000 invested
The fund’s top holding is device maker Abbott Laboratories, and other positions include C.R. Bard, Stryker and Medtronic. “These companies are very cognizant of the headwinds and are trying to manage around them,” says Allen Bond, an analyst for the fund.

*Annualized.
Source: Morningstar