Seeking Alpha
Deep value, biotech, long-term horizon, tech
Profile| Send Message|
( followers)  

The medical device sector is one of the most inappropriately grouped sectors on Wall Street. Quite simply, the fact that two companies both sell medical devices gives them only negligibly more common ground than two companies that both have the letter X in their ticker symbols. And yet, these companies are often grouped together in investment strategies, mutual funds, and even ETFs like IHI.

Medical device companies are not like mining companies where the market is more uniform and the objective is straightforward: Just dig it out of the ground for cheaper than its market price. Each medical device market is different from the next, and companies focus on radically different subsectors that are often independent of one another, and sometimes a company even successfully creates a new market that previously didn't even exist. In my opinion, treating medical device companies as a collective and investing accordingly is a mistake. Investors must research each individual company and come to disparate conclusions. Here are four big names and my outlook for each.

Varian Medical Systems (VAR)

There's nothing about Varian that is especially attractive as an investment. There are pluses and minuses, arguments on both sides, and that being the case, it is not one of my top picks, given that it is brushing all-time highs as is the rest of the stock market. In this type of environment, I look at least for investor protection in the form of dividends in the event of capital loss. Varian does not pay any.

It does however, have a policy of stock repurchases which it has been conducting since 2011, retiring the shares it purchases, which has the effect of concentrating investor holdings. The company's Board of Directors authorized 8 million (page 55) more shares to be purchased through 2013, though there is no guarantee that the repurchase will actually take place. The last time the company authorized a repurchase, only 75% of the authorized 12M shares were actually reabsorbed and retired. Cynics can interpret a stock repurchase authorization as a company's way of trying to inflate speculative hype and support its stock price without following through on its word 100%.

Varian's biggest weakness is its non-diversified business structure, which is almost entirely dependent on oncology and x-ray systems. Any systemic change in either of these markets, say in treatment or technology, has the potential to seriously affect Varian's business.

The company does have its strengths though. Its most impressive feat was that its revenues and earnings did nothing but rise throughout the '08 cyclical bear market. From '07 through '09, revenues rose 26%, and net income at an even more impressive 33% growth that has continued through 2012. The fact that VAR declined almost 60% from top to bottom during the same period was a signal as clear as day that the decline was totally irrational and one should buy into it. If such a scenario ever plays out again, Varian investors won't be so weak handed this time around, which will protect the stock from excessive downside in the event of another cyclical bear market.

The other big plus is that Varian has a debt to market cap ratio of only 2% and falling, and the debt that it does have is tethered to fixed interest rates (page 80), shielding it from any rises that are sure to come.

Given the above, Varian is far from a steal at $74, and its non-diversified business model leaves it vulnerable, but given that it has been quite formidable as a company in hard times with tight finances, it should be protected from any serious downside that any impending market correction could bring.

Idex Corporation (IEX)

Just looking at Idex Corporation's recent cash flow would make you think the stock should have sold off at the last earnings report. The company's earnings dropped off a precipitous 80% in 2012. So why is IEX at its all-time high? Usually such glaring dissonance would be an obvious sign of an overbought stock, but not in this case. Idex's sudden drop in income is not due to any material effect on its business. After all, revenues of nearly $2B have never been better (page 13) for the company. Rather, it had $231M in non-recurring expenses in Q4 due to goodwill and other intangible asset impairment charges on its balance sheet. If such accounting measures were going to affect the stock, it would have happened already. Apparently, shareholders are not fazed by the reshuffling of a balance sheet as long as Idex is still making money.

Its business is very diversified in three major subsectors: fluid and metering technologies, health and science technologies (everything from drying systems used in food and drinks to medical implants and coatings used in a wide range of industries) and fire and safety supplies.

Idex was only minorly affected during the last bear market (earnings were down only 11% during the great recession), and the fact that the stock has not been affected by its impairment issues shows that further upside is still very possible. At the very least, Idex is a safer company to hold because it pays a consistent annual dividend that is currently at $.80 a share, and it is not heavily dependent on any single aspect of its business.

If I were looking for a place to park money, IEX is safer than VAR for these reasons.

Intuitive Surgical (ISRG)

Intuitive Surgical has anything but a diversified business model, but in this case, it doesn't matter. Intuitive's claim to fame and entire business centers around the da Vinci Surgical System and its accessories. This device has been a game changer for surgical procedures worldwide, and its applications have not yet begun to scratch the surface of its potential.

Think of da Vinci as a video game console for surgeons. Microsurgical devices are implanted via minimally invasive methods into a patient's body, which are then manipulated via a console by the surgeon controlling by remote. Intuitive has been successfully selling these machines since the FDA approved them in 2000, but the implications are even more vast than improving surgery and making it less life-threatening.

There is nothing theoretically preventing a surgeon in the US using a da Vinci system from operating on a patient across the world in Australia, except that the company has not focused its efforts on promoting the idea or building the software to enable it. Despite criticism against the da Vinci System that it's too expensive ($1.3M per machine plus maintenance) and that it doesn't materially improve surgical procedures, the free market says otherwise. Intuitive Surgical has been growing year-in year-out at an alarming rate, even through the great recession when net income rose an amazing 61% from '07-'09. Since then, income has risen another 182%. Its amazing success has likely been a significant contributing factor in the company's shying away from developing truly remote surgery capability. ("If it ain't broke, don't fix it.") But if and when growth begins to slow, look for expansion in that direction.

ISRG has dipped 12% since its recent February top; the company has zero debt, and no signs of any let-up in da Vinci sales. The real opportunity, though, will come when the da Vinci surgery market begins to saturate and Intuitive looks into truly remote surgery to expand, essentially globalizing, in a real sense, the entire surgical market for anyone on the planet. Despite ISRG's high price and lack of a dividend, buying this dip would be prudent.

Hologic (HOLX)

Hologic is a diagnostic equipment supplier including medical imaging systems and surgical instruments. I keep looking at this company's income statements and balance sheet and am left wondering who is managing this company and why the stock is within a mere 8% of its all-time high. I don't generally short stocks, but this one looks like a good candidate for doing just that.

Let's put it this way: Hologic's finances look a lot like the Federal government's, and both of their "growth" strategies are very similar. The Fed goes deeper and deeper into debt and loses more and more money in an unhealthy attempt to increase GDP through borrowing and quell America's stockholders, i.e. dollar holders. In much the same way, Hologic goes deeper and deeper into debt and loses more and more money in an unhealthy attempt to increase revenues through borrowing and quell Hologic's stockholders.

Hologic has an accumulated deficit of $2.44B, 41% of its market cap, total debt of over $5B or 85% of its market cap, which increased 222% last year when it acquired Gen Probe for $3.7B in cash it did not have. To show for it, the company has a 25% increase in revenues since 2008 and is operating at a loss mainly due to interest payments on its debt. These payments, I might add, are subject to floating interest rates, which are bound to rise as the Federal government simply cannot stop spending. So the two debts are, in a way, more intertwined than I even at first suggested. From Hologic's annual report:

A significant portion of our indebtedness is subject to floating interest rates, which makes us more vulnerable in the event of adverse economic conditions, increases in prevailing interest rates, or a downturn in our business. As of September 29, 2012, approximately $2.5 billion aggregate principal of our indebtedness, which represents the outstanding principal under our tranche A term loan facility and our tranche B term loan facility, was subject to floating interest rates. We currently have no hedging arrangements in place to mitigate the impact of higher interest rates.

Even more than that, Hologic's SG&A expenses have increased 45% in a year, evidence that managing its new acquisition is proving more expensive than previously thought.

Hologic will either have to grow at breakneck speed to pay off its debt before interest rates start to rise, or else totally restructure. Given that, the fact that HOLX is just off all-time highs is beyond me.

Conclusion

With the market skirting its all-time highs, it is a dangerous time to buy looking for capital gains in any company that isn't either paying respectable dividends or showing tremendous growth. To that effect, IEX is a relatively safe stock to hold given its broad based business model and quarterly dividend payments. Varian, though growing and showing signs of earnings stability through economic turbulence, is too dependent on specific markets to buy before a correction takes place, and it pays nothing. Intuitive Surgical is expensive, but growing at breakneck speed with the potential for revolutionary implications in its successful da Vinci Surgical System. Hologic, on the other hand, looks like a perfect setup for a short sell.

Source: 4 Medical Device Companies, 4 Completely Different Stories