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Since the beginning of the global economic crisis, medical device stocks have fared no better than the overall market with both down just over 40% since September 1 2008 on a market weighted basis. We continue to recommend that investors focus on companies providing life-sustaining products.

These should remain insulated from the current economic crisis as target patients are unable to forego procedures. The recent slide in the market has left many strong companies looking very attractive.

In the coming year, investors should allocate funds to companies with high earnings quality profiles. We recommend companies with the following characteristics:

  • Size - Larger companies will find it easier to survive any future liquidity issues and acquire new technologies at cents on the dollar
  • Scope - Companies providing life-sustaining products should remain insulated from the current economic crisis, as target patients are unable to forgo procedures. Also, companies that provide a broad assortment of products related to their primary market served will be better positioned to compete when large purchasing organizations consolidate suppliers
  • Strategy - Focus on companies that have historically grown organically. Avoid companies that have a long track record of 'growth by acquisition'. These companies may find it difficult to fund growth (acquisitions), diminishing underlying growth. Additionally, the financial statements for these companies are often clouded by one-time charges, lowering their quality of earnings

For comparison purposes, companies possessing the above characteristics have fared better since the crisis started. Of the stocks in our coverage that we recommended at the time of our last Industry Overview, all have outperformed the market and industry: STJ (-24%), BAX (-29%), BDX (-25%), BSX (-34%), and BCR (-17%).

Valuation

Historically, the medical products industry has traded at a trailing and one-year forward P/E multiple of 30 and 25, respectively. Current P/E multiples hover between 12 and 13 for these measures, a discount of more than 50% each.

The landscape has changed dramatically. Companies will experience slowing sales growth and pricing pressure as unemployment rises and the governments focus on cost cutting initiatives (competitive bidding in U.S.). Curtailed hospital capital spending will hurt device makers offering larger capital equipment. A stronger dollar will weigh heavily on companies with significant international exposure. And, companies producing products used in elective procedures will feel the effect of delayed procedures.

OPPORTUNITIES

The items above that changed the landscape over the past few years vary greatly in their effect on individual companies. The medical products industry is very diverse and some boats sit much higher in low tide than others. Even during recent economic turbulence, many of these names will continue performing well on a financial basis. Areas within our coverage that should perform well include cardiovascular devices and surgical equipment, blood related products, and associated consumables.

The names currently on our BUY list that we believe provide safe vehicles over the coming 12 months include St. Jude Medical (NYSE:STJ), Baxter (NYSE:BAX), Becton Dickinson (NYSE:BDX), Boston Scientific (NYSE:BSX), CR Bard (NYSE:BCR) and Haemonetics (NYSE:HAE).

WEAKNESSES

As noted in our prior overview, companies we believed would not fare well at the beginning of this crisis focused on the orthopedic markets and included ArthroCare (ARTC, -81%), Conmed (CNMD, -57%), Symmetry Medical (SMA, -65%), Stryker (SYK, -51%) and Zimmer (ZMH, -49%). This provides evidence of the great diversity within the medical products industry and potential returns an investor can expect.

We are changing our opinion on medication dispensing, delivery, and software to something more positive. Since the Obama administration passed a health care stimulus package to incent hospitals and practices to modernize their health record keeping, we believe there are many smaller names that will benefit. Names in this area include Omnicell (NASDAQ:OMCL), AllScripts (NASDAQ:MDRX) and MRGE Healthcare (NASDAQ:MRGE). However, none match the criteria laid out above for companies we favor during this crisis.

Lastly, orthotic and prosthetic services are an area where we believe consumers will cut spending during difficult economic times. As a result, we lowered our rating on Hanger (NYSE:HGR) to HOLD.

--Christopher Titus, CFA

Source: Medical Device Industry Outlook