Medical Device Firms on Sale

With solid long-term growth prospects and return-generating capabilities, medical device firms sport some of the most attractive profiles in the health-care industry. In the past, the market rewarded these topnotch firms with similarly topnotch valuation multiples, and our favorite picks right now (see bottom) averaged more than 30 times earnings over the past five years. However, recent worries about Medicare cuts, an antitrust investigation, and product recalls have tainted the market's view of these firms, pushing the group's average down to 18 times forward earnings. We think these factors might wind up being short-term blips on the radar screen, and we don't think investors should mirror the market's myopia by ignoring medical device firms in the discount aisle.

Current concerns do not erase the underlying attractiveness of the medical device industry, which we think is conducive to the development of economic moats. Barriers to entry remain high, as firms must jump through regulatory and reimbursement hoops to even get their products on the market. They also must provide compelling clinical evidence to convince physicians to use them, which can be costly and time-consuming. Switching costs, especially in orthopedic devices, can be high as well, because procedure outcomes vary based on physician comfort with devices. The time and effort needed to train on new devices can hinder switching between competitive product sets. These favorable industry dynamics help established players consistently generate excess returns on their costs of capital, and we expect that to continue.

Demographic and lifestyle trends also favor medical device firms. As the developed world's population ages, demand for cardiac devices and orthopedic implants should grow robustly. Active lifestyles also are putting more pressure on joints, which should lead to more initial orthopedic procedures in younger patients and revision surgeries as they age. Underlying volume growth in traditional device strongholds should remain quite healthy given these demographic trends. Also, our favorite medical device firms continue to expand their reach into different health-care treatment niches. Medtronic (MDT) exemplifies successful expansion into other areas, such as diabetes, obesity, and pain management. Top device firms continue to possess innovative abilities that should help the overall device market grow.

Three major factors are casting shadows on the industry's positive attributes, though. First, the Center for Medicare and Medicaid Services has proposed reimbursement changes that could cut rates on many profitable procedures like cardiac and orthopedic surgeries. Of course, medical device associations have decried these proposals, but even some groups these cuts were intended to help--like patients and traditional hospitals--have voiced concerns about the proposals. One particularly compelling belief is that because the center used dated information, patients could miss out on beneficial new technologies, like drug-eluting stents, because the proposed reimbursement schedule doesn't support those costs. We think arguments for more implementation time and less dramatic cuts than the center's original proposal make sense, and we don't think that the potential rate changes will end up being as severe as initially proposed.

Second, the U.S. Department of Justice recently issued antitrust subpoenas to top orthopedic device firms. The specifics of the investigation remain fuzzy, but given the dynamics of this niche, we think it would be very difficult for the government to prove participants are collectively using anticompetitive tactics. Switching costs are particularly high in the orthopedic device niche, in which procedure outcomes vary based on a surgeon's comfort with device features, which can differ greatly from one product set to another. With slow-moving market share changes based primarily on technology differences, orthopedic firms have little incentive to compete on price. Therefore, we think this niche's dynamics, rather than any colluding forces, make pricing wars improbable. So while any investigation is negative, we question whether the government will actually find evidence that device firms are competing inappropriately or inflict damages that destroy this business's positive economics. See Debbie S. Wang's recent Analyst Note for more on our take of this situation.

Third, implantable cardioverter defibrillator recalls, mostly from Boston Scientific (BSX), have slowed implantable defibrillator growth as physicians reconsider the risks of current products. While particularly negative for Boston, the recalls have actually opened doors for top competitors Medtronic and St. Jude Medical , with physicians worried about Boston's offerings. Also, we must note that ICD penetration remains in its infancy with reports suggesting only one out of every 10 patients qualifying for therapy actually receives an implantable defibrillator. We think device makers will devote significant resources to improve the safety profile of next-generation products, which, if successful, should lessen existing concerns and grow long-term demand.

Despite those three risks, we think this niche's attractive qualities and growth opportunities remain intact and investors should consider reaching into the bargain bin for the following medical device firms with moats.

Biomet  
Economic Moat: Wide
Business Risk: Below Average
While smaller than its orthopedic device rivals, Biomet continues to impress with its innovative skills and lean operating infrastructure.
From the  Analyst Report: "Biomet enjoys a wide economic moat that comes from the firm's focus on developing new products that offer a substantial benefit to the surgeons who install the devices as well as the patients who use the devices...This approach has resulted in robust gross margins of more than 70%--superior to those of competitor Stryker  (SYK), in the mid-60s. Moreover, Biomet manages to hold down its sales and administrative costs better than its rivals, leading to superior operating margins in the low 30s."

Johnson & Johnson (JNJ)
Economic Moat: Wide
Business Risk: Below Average
This health-care industry bellwether will generate about 30% of sales from medical devices.
From the  Analyst Report: "J&J is a model of consistency and stability. The firm has delivered 20 consecutive years of double-digit earnings increases and 43 consecutive years of dividend increases. Cash flow from operations covers the dividend nearly 3 times. J&J has an excellent record of capital allocation and generation. Returns on invested capital averaged 33% during the past five years."

Medtronic (MDT)
Economic Moat: Wide
Business Risk: Below Average
Medtronic's diversified revenue streams set it apart from stand-alone, medical device firms.
From the Analyst Report: "This wide-moat company's vision is to establish a significant presence in chronic diseases, in addition to its historical stronghold in heart disease. Investments in neurological, diabetes, and spinal products from the middle to late 1990s have started to pay off, offering new revenue streams and taking some pressure off heart products...Compared with its peers, Medtronic relies less on any single type of product and is better able to weather glitches in the development or approval process for any particular new device."

Zimmer Holdings (ZMH)
Economic Moat: Wide
Business Risk: Below Average
As the leading provider of hip and knee implants, Zimmer looks poised to benefit from demographic and lifestyle trends driving demand for orthopedic devices.
From the Analyst Report: "Reputed to have a superior salesforce, Zimmer has been a key competitor in the orthopedic arena. With the addition of Centerpulse, Zimmer has greatly strengthened its position. It now holds nearly 30% of the hip- and knee-implant market, having leapfrogged large rivals Stryker and Johnson & Johnson's DePuy orthopedic unit. Considering the stability of market share among the top players, we anticipate Zimmer will be able to maintain its hold as the leader."