The medical device industry is ripe with opportunities from large to small. In general, the industry is safer than biopharmaceuticals by virtue of the products, which are generally less "hit or miss." However, even within the industry, risk/reward can vary considerably. Below, I review 2 large-cap device producers that offer plenty of safety and value. I then follow by offering a compelling small-cap device producer that I believe can provide stronger returns.
Large-Cap Device Stocks With Strong Returns
Over the last 12 months, Medtronic (NYSE:MDT) and Baxter (NYSE:BAX) have risen 15.5% and 20.8%, respectively. During the same time period, the Dow Jones only rose 11.1%. The S&P Healthcare Equipment (SPSIHE) was up 15%. In light of this outperformance, the natural question to ask is whether all of the upside has since been factored into the stock. I believe that, for both instances, the answer is a resounding "no." Here's why:
Multiples Still Compelling
Medtronic trades at a respective 14x and 11.9x past and forward earnings. Baxter trades at corresponding figures of 16.8x and 13.4x. At first glance, both multiples seem reasonable. Baxter is trading at a slight discount to its historical 5-year average PE multiple, but Medtronic is trading at a 15.7% discount. However, the industry average PE multiple is 19.9x. That of the S&P 500? 20.6x. So, both companies, come across fairly cheap.
This discounts can be somewhat, but not completely, be explained away by growth. Medtronic is forecasted for a 5.8% growth rate over the next 5 years, which is well below the 8.8% that is forecasted for the industry. Baxter, the pricier of the two, comes closer at an 8.5% growth rate forecast.
Either way, 5.8% growth on top of a 2.5% dividend yield provides a combined average return of 8.3%, which isn't bad for companies that have between 10% - 50% lower volatility than the broader market. Double-digit returns from closing the 20% - 40% discount to industry multiples are just, well, "bonus."
Free Cash Flow, Value Creation Trends Still Promising
Baxter has seen free cash flow rise from $1.4 billion in the twelve trailing months ending March 2009 to $1.9 billion today. This represents a CAGR of 7.9%. Medtronic, the larger of the two, has grown FCF from $3.4 billion in April 2009 to $4.3 billion today, which is a CAGR of 6%. For mature companies, this consistency is to be envied.
Baxter and Medtronic are also growing responsibly - the return on invested capital is 19.3% for the former and 14.4% for the latter, which compares very favorably against 12% for the industry average. Return on invested capital essentially refers to how well the company is creating value, and one way that you create value is through strong R&D. By way of example, Medtronic has grown R&D by 20.8% over the past 5 years. However, during the same time period, it has grown FCF by a rate of more than 2x faster at 44.3%. This just illustrates how these companies have been wisely - not, recklessly - growing.
Pipeline Looks Impressive
It's easy to point to a company's past trends and market position and argue that it will continue into the foreseeable future. However, it's better when you can make that point and back it up with a strong pipeline. Fortunately, that is the case for both Baxter and Medtronic.
In regard to the latter, there are several reasons to be optimistic. First, last moth, the FDA approved the company's 34 - 38mm-sized stents that elute drugs for patients with diabetes. These new sizes are specifically designed for treating long coronary lesions in diabetes patients. This followed the FDA approval for a bone screw system that would enable surgeons to treat obstructive sleep apnea. And, most excitingly, it followed the FDA approval of the company's MRI SureScan pacing system that works dually as a pacemaker and MRI scan, as the name suggests. As much as 75% of patients with heart device implants are expected to require an MRI scan while using those devices.
In regard to Baxter, similar optimism can be made. The acquisition of Gambro is the the company's largest ever, and integrates the 2nd and 3rd biggest dialysis equipment manufacturers. This will provide the company with annual synergies of $300 million by 2017 and help to improve pricing power. At the same time, the firm's Gammagard (Phase II) immune treatment for Alzheimer's resulted in stabilization over 3 years for 4 patients with the most effective dose.
Small-Cap Device Stock With Turnaround Potential
As attractive as Baxter and Medtronic are for their defensive nature and steady growth, larger returns can be found in smaller-sized companies. SanuWave Health (OTCQB:SNWV) is an emerging healthcare company poised for strong growth in the global wound market. With a lead product that is already miles ahead of the standard of care treatment, SanuWave is in a good position to turn around the business. Around 2 years ago from today, the stock was trading at an all-time high of around $5.72. It is now at a fraction of that price despite improving fundamentals.
Growing Market To Penetrate
According to AdvaMed, chronic and complex wounds are a $20 billion market in just the United States alone. 23.6 million Americans suffer from diabetes, and 15% of these individuals are expected to develop a non-healing ulcer. This results in north of 1.5 million diabetic foot ulcers (DFUs) occurring annually. GlobalData estimates the DFU market was $1.2B in 2010 and will grow by a CAGR of 10.2% to $2.3B by 2017.
Superior Product, Positioned For FDA Approval
SanuWave's Pulsed Acoustic Cellular Expression technology is a shockwave therapy that produces a biological response to treating chronic wounds. It is ultimately based on lithotripsy, which is form of therapy that is most well known for physically breaking down kidney stones. Over time, it was observed that the therapy had the ancillary benefit of healing wounds. One Seeking Alpha contributor likened its science to muscle recuperation following workout and exercise: if damaged cells are stimulated, the expectation is that they can then be healed.
In any event, dermaPACE - the company's lead product that is already marketed for skin and subcutaneous soft tissue defects - is now specifically being tested for diabetic foot ulcer (DFU) treatment. It is important to note that while dermaPACE failed to gain original FDA approval following its Phase III trial, the product still demonstrated superior efficacy in treating DFUs compared to the standard of care. A second Phase III trial will be conducted under slight modifications, and there are several reasons why approval is likely.
First, the FDA has agreed to let some of the data from the first Phase III trial flow into the second. Only 90 patients will be enrolled in the streamlined "follow-up" study. For investors, this means less uncertainty and volatility. In addition, the original trial eventually met its overall goal but simply did not complete it within the planned time. Accordingly, expectations have been modified to allow for easier approval.
In this second Phase III trial, more aggressive dermaPACE treatment will be used to help further showcase the product's efficacy. There is good reason to believe that this strategy will be successful, since the results the first time around speak for themselves:
In its earlier 206-patient Phase III trial conducted in 2011, superior efficacy was demonstrated across multiple time periods. Within 6 weeks, dermaPACE patients saw significantly smaller ulcers compared to the control, which received the standard of care. By week 12, 21% of the experimental patients achieved complete wound closure versus 15% for the control. By week 20, those numbers widened to 38% and 21%, respectively. By week 24, there was only a 4.5% negative recurrence rate for dermaPACE patients that saw complete wound closure at week 12 versus 20% for the control. The more opportunity that dermaPACE has to prove itself, it does.
And this second Phase III study provides that opportunity. dermaPACE's trial is just about ready to begin and will provide a more rigorous real-time assessment of patients. In the double-blind study, 4 dermaPACE procedures will be conducted for the first 2 weeks. As much as 4 additional dermaPACE procedures will be conducted bi-weekly between the 4th and 10th week. An independent Data Monitoring Committee will carefully monitor to determine progress. If the progress is so strong by the week 12, premarket approval will be sought immediately. Premarket approval ultimately is expected in as soon as 20 months from the start of the study.
Apparently, I am not the only one who believes that corporate healthcare woes have been overblown. Baxter and Medtronic are near their 52-week highs, and SanuWave is positioned for a turnaround. The new CEO, who comes equipped with financial experience in healthcare, understands a good company when he sees it. His entrance coincided with $2 million worth of bridge financing, which was 60% more than expected. He will not be paid until the lead product receives FDA approval and is introduced into the market, among other conditions. In many ways, these three companies - large and small - provide a strong context from which one can gauge the healthcare sector at large.
For years, the bears have warned us about the deleterious patent cliffs and slow product development. The fears failed to materialize as expected and, in the process, healthcare investors saw substantial returns. Fortunately for value investors, the fundamentals are still impressive. Medtronic and Baxter are still trading at a discount to historical levels, and growth stories, such as SanuWave, are destined to keep the momentum going.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We seek business from all of the firms in our coverage, but research covered in this note is for subscribers and prospective clients, repeat or new, who may now or in the future have a position. The distributor of this research report, Gould Partners, manages TakeoverAnalyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.