3 'Recession-Proof' Medical Device Companies Underperform

Since the market collapsed a few weeks ago, the general market has created a short term bottom. The medical device markers, however, have continued to fall. Over the past month, the S&P 500 is down about 9% while the medical device ETF (IHI) is down roughly 18%. Many investors are scratching their heads as these once recession-proof stocks have begun to significantly underperform the market. If you take a close look at the performance of the S&P 500 (SPY) and the IHI in the last six months you can see the divergence began during the first few weeks of November.

The IHI is made up of the biggest medical device players like Medtronic (MDT), Stryker (SYK) and Covidien (COV). In order to understand the current market environment, let’s quickly break down these companies’ last earnings releases.

Medtronic reported Q1 2009 earnings on November 18th which were down 14% from last year. Management blamed litigation-related charges and a loss of market share for the bulk of the earnings miss. The company received a subpoena earlier in the year from the Department of Justice regarding off label use of their bone graft product. Medtronic lowered both revenue and earnings guidance for the full year. Top line expectations were cut $300-$400 million to reflect the strengthening dollar. Management expects growth of 11-14% over the next 5 years and believes this “is an outlook that we feel very good about.”

• Full Year Revenue Guidance: Reduced to $14.6-$15B from $15-$15.5B
• Full Year EPS Guidance: Reduced to $2.90-$2.98 from $2.94-$3.02
• 2009 P/E: 10.89
• 5 Year Historic P/E Lows: 23,18,23,30,27
• Upside to 5 Year Average Low: 120%

Stryker reported Q3 2008 earnings on October 16th of $0.66 per share compared to $0.55 per share in the same period last year, missing analyst estimates of $0.67 per share for the quarter. Operating income for the quarter grew 18.5% to $364.1 million from $307.3 million in the comparable period previous year. Quarterly net sales rose 13.7% to $1.653 billion from $1.453 billion in the corresponding period previous year. Although Stryker missed analyst estimates, management reaffirmed earnings guidance of $2.88 a share for the full year 2008, which is a 20% increase over 2007’s EPS of $2.40.

• Full Year Revenue Guidance: Reaffirmed guidance of $6.8 billion
• Full Year EPS Guidance: Reaffirmed guidance of $2.88
• 2009 P/E: 12.13
• 5 Year Historic P/E Lows: 23,21,24,35,27
• Upside to 5 Year Average: 114%

Covidien reported Q4 2008 earnings on November 18th of $0.73 compared with $0.62 the year before. Sales rose 13.0% to $2.6 billion. Chairman Richard Meelia said that growth was well diversified, with “three of our four segments reporting double-digit increases.” Medical devices and pharmaceuticals led the way with sales growth of 10% and 37% respectively. Foreign exchange rates contributed 3.0% to sales in the quarter.

• Full Year Revenue Guidance: Reduced to $9.9-$10.2 billion
• Full Year EPS Guidance: $3.02
• 2009 P/E: 12.367
• 5 Year Historic P/E Lows: (Spun off Tyco less than 2 years ago)

Based on historical averages both Medtronic and Stryker have upsides of greater than 100%. This tells us something. The market obviously does not believe Medtronic and Stryker can continue to grow at the rapid pace they have for years. More likely than not these numbers will be cut, so those Price-to-Earnings ratios above are probably irrelevant. So who are selling these companies at such fire sale prices and why? I believe the sell-off of these types of companies may discount two potential threats to the industry.

1. The unemployment rate which is currently at 6.5% may go much higher.

A rising unemployment rate is bad for the economy in general, but it is very important for medical device companies who depend on employer sponsored health plans to cover procedures for hip, knee, spine and joint surgeries. Workers who have been laid off will push off surgery until they regain coverage. Also, those covered by insurers are still likely to push off surgery in a weak economic environment until they feel more financially secure.

2. Negative pricing pressure on devices and reimbursements from insurers.

Less employment leads to smaller profits for the managed care industry which leads to less growth in reimbursements from the insurers. Also, President Elect Barack Obama has vowed to reduce wasteful spending by Medicare and Medicaid.

The Bottom Line

Whether or not the medical device makers end up cutting guidance, the threat of a weaker economy has significantly reduced the multiples investors are willing to pay for their earnings. However, even if the next year proves to be very difficult, these companies are in a relatively safe consistent growth industry. My favorite long term play is Stryker Corporation because their management has an excellent track record of double digit growth and has returns on assets and equity that are best of breed. I do not think the medical device makers have bottomed, but even with a moderate guidance cut these companies are undervalued. Keep these titans on your radar because when the negative sentiment fades, you could see healthy returns.

-Allen Lutz

Disclosure: The mutual fund the author is associated with is long SYK.

Comments

[wz:]

The elephants in the room are the unknowns surrounding the move towards nationalization of health care, and simple demographics which are known. Aging baby boomers = lots of medical care, as well as knee and hip replacements over the coming years.

2008 Dec 14 02:57 PM

[dw57:]

its just another sign. there are no companies that won't be hit by this recession. there are no fields or markets that aren't going to get slashed a lot by the recession on this go around

2008 Dec 14 06:04 PM

[Walter1234:]

One thing I've been wondering about Covidien. Why do they blow so much money on 'name recognition' advertising? They have a huge sign in the middle of the Green Monster wall in Fenway Park and have a very high presence in other sports and consumer venues. They do not have any consumer products that I am aware of. This seems to me to be vanity advertising that is not targeting the actual user/customer of the product.

2008 Dec 14 10:28 PM

[jointsrme:]

Well if its going to slowdown I have yet to see it.One other way to look at it is possibly an unemployed or laid off individual that is still covered may look at it as an opportune time to have his or her joint replaced.Why not have the surgery now,recover and be ready when the next jobs cycle comes.

2008 Dec 15 09:05 AM