New technologies surround us. New innovations are seemingly announced weekly, if not more often. The healthcare technology segment has the potential to touch us all, and for the better. A sub-sector of healthcare technology that is particularly interesting is medical device industry. The global medical devices industry is fairly large, intensely competitive and highly innovative, with estimated worldwide sales of more than $300 billion in 2011. The U.S. is the largest market, with estimated sales of roughly $95 billion in 2010.
This is the age of specialization and the medical device companies focus on several segments. The segmentation is roughly defined as Cardiology, Oncology, Neuro, Orthopedic and Aesthetic Devices. As we will see in more detail below, this industry is growing at a brisk pace; the industry average seven year sales growth rate is 18.7%. Looking ahead, growth in the U.S. will be fueled by the aging out of the Baby Boomers. Globally, the combination of population growth, aging and greater affluence, particularly in China, will drive growth.
Though the opportunities seem huge, each company operating in this space faces serious obstacles to bring new products to market. First of all, medical devices require extensive testing and trials for safety and efficacy. Each innovation requires regulatory approval from the Food and Drug Administration (FDA) in the U.S. and equivalent regulatory bodies in other countries. Another obstacle to overcome is the cost of these devices. These devices are very expensive and medical rationing, both in the U.S. and in Europe, will temper sales. Fast growing emerging markets offer other opportunities but in this market there are limitations on availability and the size of the market.
The big three players in this market are Medtronic Inc., (MDT), Boston Scientific (BSX), and St. Jude Medical (STJ). Medtronic is diversified into most of the segments described above. Boston Scientific is a big player in cardiovascular devices; stents in particular. St. Jude is expanding its presence in the cardiovascular market with new implantable cardioverter defibrillator products. There are more than 100 companies, large and small in this market making this an intensely competitive space.
We highlight four companies we think are best positioned to prosper and grow. These companies share the following attributes: they have strong recurring streams of revenue; they have strong earnings quality and liquidity profiles. With no or low-debt levels, they are able to leverage their strong balance sheets and cash flows to maximize shareholder value. Each company has reported positive earnings in each of the past seven years; each has positive free cash flow; each company shows positive sales, earnings, and net income growth over the trailing 12 months and the past seven years.
C. R. Bard, Inc. (BCR) is engaged in the design, manufacture, packaging, distribution and sale of medical, surgical, diagnostic and patient care devices. As of December 31, 2010, the company sold a range of products to hospitals, individual healthcare professionals, extended care facilities and alternate site facilities on a global basis. The company operates in four product group categories: vascular, urology, oncology and surgical specialties. The company also has a product group of other products. On July 6, 2010, the company completed the acquisition of SenoRx, Inc. On May 20, 2010, the company, through its wholly owned subsidiary, Bard Holdings Limited, acquired its Malaysian manufacturing operation. On April 12, 2010, the company completed the acquisition of the outstanding stock of FlowCardia, Inc., engaged in the design and manufacture of endovascular products used in the treatment of chronic total occlusions (CTOs).
Edwards Lifesciences Corporation (EW) is a global player in products and technologies designed to treat advanced cardiovascular disease. The company is focused specifically on technologies that treat structural heart disease and critically ill patients. The products and technologies provided by Edwards Lifesciences to treat advanced cardiovascular disease are categorized into four areas: Heart Valve Therapy, Critical Care, Cardiac Surgery Systems and Vascular. The company operates in United States, Europe, Japan and others. In March 2011, the company completed the acquisition of Embrella Cardiovascular, Inc. During the year ended December 31, 2010, the company discontinued its MONARC transcatheter mitral valve program.
Immucor, Inc. (BLUD) develops, manufactures and sells a line of reagents and automated systems that detect and identify certain properties of the cell and serum components of human blood for the purpose of blood transfusion. Its offerings are targeted at hospitals, donor centers and reference laboratories. Most of the company’s reagent products are used in tests to identify the blood group (A, B, AB, O) and type (Rh positive or negative); to detect and identify red cell antibodies or red cell antigens; to detect and identify platelet antibodies and to determine blood compatibility (cross match). Immucor’s serology instruments use both its solid phase technology, marketed under the name Capture, as well as certain manual reagents to perform tests. Immucor offers customers a selection of automated analyzers, marketed as Scalable Solutions, which address the various needs of low, medium and high-volume testing facilities. Immucor is in the process of being acquired by IVD Acquisition Corporation, an affiliate of TPG Capital, L.P.
Varian Medical Systems, Inc. (VAR) is engaged in the design, manufacture, sale and service of equipment and software products for treating cancer with radiotherapy, stereotactic radiosurgery and brachytherapy. It also design, manufacture, sell and service x-ray tubes for original equipment manufacturers; replacement x-ray tubes, and flat panel digital image detectors for filmless x-ray imaging in medical, dental, veterinary, scientific and industrial applications. It designs, manufactures, sells and services linear accelerators, digital image detectors, image processing software and image detection products for security and inspection purposes. It also develops, designs, manufactures, sells and services proton therapy products and systems for cancer treatment. The company’s products include Oncology Systems and X-ray Products. The company has two other businesses and its Ginzton Technology Center that it reports together under the Other category.
By starting with sales growth rates, we get a sense of how the recession in the U.S. and the drama in Europe have impacted each company. Sales for the most recent period (ttm) have generally been robust for each of the companies as compared to their respective seven year sales growth rates. BLUD has seen the greatest deviation from its long term sales growth rate and BCR the least. A similar pattern emerges when comparing growth rates for gross income, net income and EPS. In fact, BLUD’s divergence from its long term average growth rates may be the catalyst for the acquisition. BCR shows consistency in growth rates over the long and short term. I think this reflects management’s focus on sales and adaptability to the changing environment. EW is showing accelerating growth rates. Free cash flow growth rates are healthy for the trailing twelve moths though VAR saw a negative growth rate for this period. Dividends are a factor only for BCR. Again, BCR shows great consistency in its dividend growth rates.
Here, we take a look at EPS estimates for the current year and the next two fiscal years. Each company is expected to grow EPS. Long term growth rates are in the 10%-14% range for three of the companies. Analysts are aggressively estimating EW’s EPS to grow at the rate of 26% over the next 3-5 years.
If sales grow as the analysts project, will the companies convert these sales into earnings? As we can see, these companies sport gross margins and operating margins above their industry peers for both the trailing twelve months and their respective comparative five year averages. VAR is the weak sister in this comparison as its gross margins fall below its peers. However, VAR earns points for maintain consistent gross margins over the years.
On the basis of ROA, ROE, ROIC and CFROI, all four companies blow the competition away. We see high levels of ROE foe each company. More importantly, each company generates a high level of ROIC. When these companies make an investment, they create value for the shareholder.
This graphic is giving us a quick picture of the company’s liquidity. No company should have any difficulty in meeting short term obligations. We note, however, that VAR’s current ratio of 1.8 is less than we would want to see in a company like this.
BCR is the only company that carries long term debt. The debt levels are definitely manageable as exemplified by the low ratio of LT debt to free cash flow.
We turn our attention to how well these companies manage their assets. Our four target companies perform in line with their industry peers.
We are reminded of the adage, “Value is what you get; Price is what you pay.” Do these companies make good investments today? We maintain that value is in the eye of the beholder. Obviously, TPG Capital thinks they are making a good investment by buying BLUD. In this case, we see that BLUD’s current PE is well below that of its seven year average and comparable to that of BCR and VAR. In comparison, BCR’s current PE shows no deviation from its seven year average. EW has a current PE twice as great as its competitors. The forward PE for next year may be more revealing. EW will still be selling at a marked premium to both the S&P 500 and the industry median whereas the other companies will be in line with their peers.
On a Price/Book basis, BLUD is selling at a deep discount to its historic average whereas the others are selling either in line (VAR) or at a premium (BCR, EW) to their averages. All of these companies sell at a Price/Book level greater than the industry median. This pattern repeats itself for Price/Sales and Price/FCFPS ratios.
The Enterprise Value ratios may offer more insight as these ratios reflect net debt. The EV/EBITDA ratios for all our subject companies, with the exception of EW, are less than the industry median. The EV/FCF ratio is roughly in line with the industry, excepting EW. The EV/Invested Capital and EV/sales ratios tell a different story. These metrics indicate the subject companies may be selling at a premium to their peers.
These companies offer an exciting opportunity to participate in life-sustaining technology. However, we think that these companies are unjustifiably priced at a premium to the market. Estimated growth rates for sales and EPS do not justify these lofty multiples. On the other hand, these companies have solid balance sheets.