How Health-Care Reform Will Affect Device Makers

Erik Kobayashi-Solomon: Hi, I'm Erik Koboyashi-Solomon, co-editor of Morningstar's OptionInvestor. Just recently I did a video with Matt Coffina and Damien Conover discussing health care reform in the United States and how that would affect big pharma and also managed care. Today it's my great pleasure to welcome Julie Stralow to talk about how health-care reform will affect device companies. Julie, thanks for coming.

Julie Stralow: No problem, good to be here.

Kobayashi-Solomon: First, before we discuss health-care reform, I've just got to take a victory lap. Thanks to you we decided to buy Stryker calls. Call options on Stryker that were struck at $45 a share. Stryker is trading for $57 a share today. We are far in the money. Our investors have made a lot of money. Thank you very much. Great work.

Stralow: You're welcome, congratulations. It was your strategy, so...

Kobayashi-Solomon: Well, and it was your brains.

Stralow: All right. [laughter] Well, hope everybody invested.

Kobayashi-Solomon: Me too. So let's turn for a second to the health-care reform. We talked to Damian about big pharma. Damien thought that big pharma was kind of even-Steven. You know, there are some benefits, also some drawbacks. Matt was saying kind of the same thing for managed care. Maybe more on the downside.

What about devices? How do you see health care reform affecting the device market and Stryker in particular?

Stralow: Well, in general we have a relatively neutral stance on the reform package, with a negative glancing on it. That is because of the device tax that was introduced. And we think that that is going to induce some margin compression at some of these companies. Unless they can introduce some cost controls. So basically they're fighting to get the margins that they've had in the past in the future.

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Kobayashi-Solomon: I see. That's kind of a bit of a headwind. But I think the tax doesn't pick up immediately, right? Isn't there some lag time?

Stralow: Correct. So it will be introduced in 2013. So you have to think that they are going to plan accordingly and try to control their costs. If they're growing, which a lot of our device companies are, they should be able to become more efficient. There's a couple places we think, maybe in manufacturing and SG&A, they could try to control those costs a little bit better.

Kobayashi-Solomon: SG&A being sales, general and administrative expense?

Stralow: Correct. Marketing and general administration. So those are some areas, some places where they could pull some levers and possibly not take a hit off that device tax. We had been estimating that that could take about 5%-10% off of most of our established device firms long term earnings power, that device tax. But if they can control some of those costs, we think that that will largely be eliminated in the long run.

Kobayashi-Solomon: It seems likely that they will be able to kind of... OK, yes, the government's taking more, but then they're figuring out how to be more efficient at the same time.

Stralow: Absolutely. I mean, these companies, they have to adjust to a changing environment. So this is just another change that they're going to have to adjust to.

Kobayashi-Solomon: Yeah, that makes a lot of sense. Now one other thing that I want to ask you about. We're so far in the money now, we've made a lot of money on this. If you're seeing this kind of headwind, is now time to take profits on the Stryker position? Or are there any kind of timing factors that we should be thinking about right now?

Stralow: Well, I think that actually you should hold firm for a little bit. There could be some upside in the next several quarters. As you know, Stryker does have a major implant business. But it also has a capital equipment business as well.

Kobayashi-Solomon: This is the hospital equipment stuff? Beds...

Stralow: Correct. Operating room equipment, surgical tools. All sorts of things that take a big capital investment for hospitals to make. Stryker has really been getting hurt over the past year, and we think this quarter is actually going to have a really, really easy comparable, and momentum might return to that business again. And if momentum returns, investors might begin to appreciate the name a little bit more.

Kobayashi-Solomon: Start to realize what's happening.

Stralow: Exactly. So there could be some upside.

Kobayashi-Solomon: So you say they were being hurt. Basically just the hospitals are cutting back on spending and weren't spending as much for new hospital equipment and so forth?

Stralow: Yeah, definitely. Lots of delays and even some inventory reductions and things of that nature. Hospitals were really battering down the hatches last year.

Kobayashi-Solomon: Do you think we'll even see some bounceback a little bit? If they've delayed...

Stralow: Perhaps. But we don't have a huge bounceback. We're more looking from a sequential basis. We're more looking for things just to get better and bounce back from the lows of last year at this point. But you know, that momentum can build, and if people get back into the name just on that alone, there could be a little bit more upside in the Stryker shares.

Kobayashi-Solomon: Sounds great to me.

Stralow: Yeah.

Kobayashi-Solomon: Julie, thanks for coming.

Stralow: Thanks for having me, appreciate it.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more great option ideas based on Morningstar's fundamental research.