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As we've highlighted in Morningstar Healthcare Observer, the medical equipment sector is one of the areas within the health-care space that could see significant upside during the upcoming year, despite these firms not feeling so well from late 2008 through 2009. Over the past year, persistent uncertainty over health-care reform, accentuated by proposed reimbursement reductions to hospitals, exacerbated the capital spending cycle swing that was set in motion by the deteriorating macro-environment and credit constraints.

The economics of for-profit hospitals, which we don't consider overly attractive even in a bourgeoning economy, (Tenet Healthcare (NYSE:THC) --one of the largest for-profit hospital operators--has an operating margin has averaged a measly 0.5% over the past decade), become downright miserable when unemployment, and a corresponding level of uninsured individuals, rise in the down cycle. When combined with hospitals' existing high leverage and reliance on credit markets for both operating and capital needs, the perfect storm of a recession and a credit crunch pushed many hospital operators to the brink of bankruptcy early in 2009.

As a result, hospitals were forced to severely trim their budgets, and instrument and supply providers felt the brunt of these drastic reductions. Capital equipment makers were hit particularly hard, as customers extended life spans of expensive platforms in an effort to conserve cash. However, the impact was also felt by firms typically not susceptible to economic pressures. Surgical instrument maker Becton, Dickinson (NYSE:BDX), whose products include basics such as needles, syringes, and catheters, saw its quarterly revenue dip during the first quarter of fiscal 2009 after averaging high-single-digit growth over the past decade. As a whole, the medical supplies industry's revenue growth decelerated drastically.

Medical equipment stocks followed suit, with the entire sector down nearly 40% in late 2008. The shares' slide extended into first quarter of 2009, as hospitals continued to trim their inventory. The severe destocking during the first and second quarters of 2009 pushed averaged days' inventory to its lowest levels in years, forcing hospitals to become more efficient operators. Our conversations with hospital executives confirmed this phenomenon.

Hospital Spending Not Likely to See Dramatic Recovery
Before we discuss the reasons why we consider shares of hospital equipment makers to be a bargain, we need to provide a word of caution: We do not expect hospital spending to rebound drastically in the near future. In fact, hospital operators are likely to remain in a precarious financial situation, and only a reduction in the number of uninsured--whether through a swift health-care reform overhaul or an employment market recovery--could alleviate many of this beleaguered industry's woes. Don't let the steady bad debt as a percentage of revenue number (reported by a number of for-profit hospitals over the past few quarters) fool you into thinking that their businesses are stabilizing. More and more of the revenue previously reported as bad debt gets written off before it even makes it to the providers' income statements (in the form of a charity expense, which many of them don't publicly disclose).

There's also a legitimate concern that hospitals could be a "net loser" sector in an aftermath of the health-care reform. The historic inefficiency of hospitals has been well-documented: One data point is a New England Journal of Medicine study concluding that only 8% of hospitals surveyed use a basic Electronic Medical records system. As a result, any health-care system costs that could be directly attributed to hospital shortcomings could come directly out of their pockets. Hospital re-admissions, for one, could be penalized severely, and nearly 18% of all hospital visits result in re-admissions (reasons for which vary, but a notable number of them are due to hospital errors). Further reimbursement pressures could offset any potential boost stemming from the expanded insurance coverage.

Room for Optimism for Equipment Makers
There are, however, a number of factors that lead us to believe the environment for equipment manufacturers could turn more favorable in the upcoming year. First, a synthetic boost could come from lapping with depressed 2009 results. In our view, the environment simply isn't likely to weaken much further. Hospital supplies are severely depleted, and research facilities are utilizing equipment that is considerably dated due to rapid advancements in scientific and medical research. Comparisons are becoming easier, and, as a result, even a "normalized" level of instrument purchasing would manifest itself through noticeable improvements to equipment-makers' P&L statements.

Some executives are striking a cautiously optimistic note that the worst is behind them. Stryker's (NYSE:SYK) CEO mentioned in his company's third-quarter earnings call that "...the capital spending cycle is unlikely to deteriorate meaningfully from the current level". While the cautious tone of the commentary shouldn't instill exuberant optimism in equipment makers dependent on hospital budgets, it definitely offers some evidence of stability.

A more tangible boost could come from pent-up demand. An unprecedented level of hospital spending contraction during the past year sets the backdrop for a rebound. Hospitals' destocking activities left them with unsustainably-low levels of basic consumables (see chart below), and frozen capital budgets have resulted in aging equipment. Even the slightest restocking of basic consumables could provide equipment makers with revenue momentum. We believe the bounce back in spending could come as soon as the first or second quarter of 2010.

Another boost could come from an improving macro-environment. A reduction in the number of uninsured individuals is an oft-overlooked by-product of improving unemployment numbers, but it represents a material growth catalyst in the health-care world. Decisions to consume health care are considerably less burdensome for insured (and employed) people. Even COBRA coverage tends to result in greater utilization of health-care services. Thus, a recovering job market would directly benefit hospital operators, and afford them some spending flexibility.

Other Positive Catalysts for the Industry
We think the NIH economic stimulus bill will contribute to an uptick in sales in the academic and government customers segments. Signed into law in February 2009, the American Recovery and Reinvestment Act has specifically allocated $10.4 billion to the National Institute for Health (NIH) to support scientific research over a two-year time horizon. This amount complements the $30 billion in funding that the NIH usually receives and doles out to researchers annually.

We would not be surprised to see a pickup in merger and acquisition activity in this space. While the environment for consolidation was particularly ripe in 2009 due to depressed market prices, purse strings should loosen up with a recovery on the horizon. We've seen several takeouts in the equipment space already, highlighted by Agilent's (NYSE:A) pending acquisition of Varian (VARI), and Danaher's (NYSE:DHR) entry into this space through acquisition of AB Sciex unit of Life Technologies (NASDAQ:LIFE) and MDS (MDZ). The life sciences and equipment sectors still remain highly fragmented, offering further opportunities for consolidation. In particular, we think large conglomerates such as General Electric (NYSE:GE) and Siemans (SI), and Danaher, that have already expressed keen interest in expanding their life science operations, will increasingly look at external sources to enhance their presence.

Our Top Picks in the Space

  • Becton, Dickinson: BD's direct sales into hospital channels left the company vulnerable to destocking trends, but the vital nature of the firm's products (syringes, scalpels) should allow it to recover fairly quickly once spending bounces back. BD's lean operations and growing presence in attractive emerging markets should also have a favorable impact on its earnings in the upcoming year.
  • Covidien (COV) : This Tyco spin-off has great opportunities ahead, stemming in part from its strong competitive positioning in bariatric instruments and minimally-invasive surgery (MIS). MIS, in particular, should enjoy strong growth in the years ahead, as these procedures provide a great value for even cash-strapped hospitals, due to reductions in patient re-admissions, post-surgical complications, and hospital stays.
  • Thermo Fisher Scientific (TMO): Thermo Fisher's business is well-diversified, yet the company still fell victim to the drought in hospital and academic spending, and saw its stock plunge considerably since its highs in mid-2008. While shares have somewhat recovered recently, we believe Thermo Fisher still trades at a sizable discount to its intrinsic value, and would benefit significantly from loosening capital spending and inventory replenishment. The firm took the opportunity to streamline its operations in 2009 and should see a sizable earnings momentum if its revenue growth returns to a normalized level.
  • Stryker : While more of an orthopedic device maker rather than a hospital supplier, Stryker is directly impacted by hospital spending fluctuations in its MedSurge business. Recovering hospital budgets should boost this segment. In its orthopedic business, Stryker should benefit from favorable demographics trends (aging population, obesity) and a recovering economy would give its potential patients the means to afford these procedures.
Source: Hospital Spending Recovery Should Boost Equipment Stocks