by Julie Stralow, CFA
For the past couple years, the Food and Drug Administration has been reviewing the regulatory process that most medical devices use to reach the U.S. marketplace, the 510(k) pathway. After delaying decisions last year on its own hot-button recommendations until the Institute of Medicine released its (very controversial) report this summer, the FDA recently made plans to decide on potential 510(k) changes by early October.
If the FDA makes relatively modest changes to the 510(k) process, the regulatory uncertainty weighing on medical device stocks may dissipate, giving medical device shares an upward catalyst. However, if the FDA decides to create a new moderate risk category with different qualifications for approval, Congress may need to get involved, which could significantly lengthen the timeline and reinforce the uncertainty surrounding potential changes. Of note, the FDA currently is seeking comments in public meetings where medical device makers, among others, are weighing in on the potential changes. Also, we plan to attend the AdvaMed Conference in late September, where we expect to gain more insight on this regulatory topic and many other issues facing medical device firms today.
So what is the 510(k) pathway, and why is it so controversial? Medical devices can reach the market through two regulatory processes. The most rigorous is the premarket approval (PMA) process, which requires scientific evidence through clinical trials of safety and effectiveness for a device's intended use. Class III devices, which support or sustain human life, including many novel cardiac devices, already are subject to the PMA process. In contrast, a device maker going through the 510(k) process just seeks to prove an investigational device is substantially equivalent, or at least as safe and effective, as another device (a predicate device) that has already been cleared by the FDA. The 510(k)'s standard of substantial equivalence to a predicate device is much quicker and cheaper for device makers to pursue than the PMA process, and the 510(k) process enables evolutionary changes that are the hallmark of many device niches, including orthopedic implants.
Patient advocacy groups argue that some moderate risk devices should be subject to more rigorous pre- and post-market requirements than the current 510(k) process enforces. In fact, in late July one organization that the FDA commissioned to study the device approval process, the Institute of Medicine (IOM), recommended scrapping the 510(k) approval process altogether to enable significantly higher scrutiny of moderate risk devices. That recommendation appeared shocking to both us and the FDA, which doesn't have to follow the IOM's advice. The agency indicated after receiving the IOM's report that, while it was still open to new ideas, scrapping the 510(k) system wouldn't be necessary.
The FDA remains open to fine-tuning, rather than scrapping, the process. In a recent public meeting, FDA officials stressed that increasing transparency and predictability of device approval requirements were its main goals. At last year's AdvaMed conference, panelists from the device industry and the FDA cited lengthened timelines for approval in recent years because review standards were not clear. In many cases, it appears that regulators aim to codify existing standards, making them clear to all users, rather than significantly overhauling the system. Also, at last year's AdvaMed conference, FDA officials appeared sympathetic to industry concerns that potential changes would dramatically increase the time and investment cost of next-generation (evolutionary) devices that likely don't need extra scrutiny. Again, it appeared that most devices shouldn't face big changes to the existing approval process. However, moderate risk devices in the FDA's cross-hairs include orthopedic devices (especially in light of the metal-on-metal hip controversy highlighted by Johnson & Johnson's (NYSE:JNJ) recall) and infusion pumps (with multiyear recalls and remediation projects at both Baxter (NYSE:BAX) and Hospira (NYSE:HSP)). When considering changes to the approval process for these or any other devices, the FDA will need to balance safety concerns with the benefits of the 510(k) process, which has kept innovation flowing with limited device failures in comparison with the wide variety and large number of devices approved in the system's 35-year history. For reference, about 3,000 devices are approved in the 510(k) system annually, and the average number of Class I (most serious) recalls according to FDA postings during the past five years was less than 30 annually.
Recently, we cut the fair value estimates of Stryker (NYSE:SYK) and Zimmer (ZMH) by about 5% each due to the increased scrutiny we expect from regulators in light of IOM recommendations. In general, we assume the costs associated with developing orthopedic devices will rise moderately in future years but still remain manageable. Timelines to market may also lengthen, causing some pressure on average selling prices, as existing technology remains on the market for longer periods of time before new, premium-priced technology can be introduced. We also think post-market registries, currently in the process of starting up in the U.S., may be required for approval, as well. We'd actually welcome that development, especially since they would go a long way to identifying safety concerns quickly after new devices are introduced.
However, if the FDA uses the recent IOM report as justification for significant structural changes to the approval process for some moderate-risk devices, our recently lowered fair value estimates may still prove too optimistic. In these worst-case scenarios, we'd consider further cuts to our orthopedic valuations (in the midteens as a percentage of our current fair value estimates). The good news is our worst-case valuation scenarios for the orthopedic device makers currently remain above recent share prices, leaving investors with a significant margin of safety when considering shares in this niche.
In other device niches, we don't anticipate significant valuation changes. For cardiac-focused firms, their dependence on the PMA process to introduce novel new technology insulates them somewhat from changes in the 510(k) process. For infusion pump makers such as Baxter, CareFusion (NYSE:CFN), and Hospira, we could see some negative implications. While we wouldn't expect them to affect a highly diversified firm like Baxter, we may make slight changes to our fair value estimates for the other two infusion pump firms. Also, we don't think surgical tool providers will be significantly affected either. For example, since hardware typically doesn't remain in the body after surgery, endoscopic tools that enable minimally invasive procedures often aren't directly associated with major health consequences. Rather, the surgeon's skill with those tools typically determines the safety risks for patients, and we don't expect endoscopic tools to face significantly higher regulatory requirements from the FDA going forward.