By Stephen D. Simpson
It hasn't been easy to make money in medical device stocks over the past year. Volume growth has been stymied by a job market where people have lost health insurance coverage or cannot afford to take time off to recuperate from major procedures. At the same time, Department of Justice audits have forced hospitals to reexamine their reimbursement and device usage policies. If that wasn't enough, those same hospitals are pushing back on the sort of annual price increases that medical device companies once considered automatic.
Against that sluggish backdrop all is not lost. Hospitals may have over-implanted cardiac rhythm devices like ICDs and orthopedic devices like artificial hips, but long-term demographics and quality of life expectations still favor these businesses. What's more, many companies have harvested the cash flow of their existing businesses to invest in long-range R&D projects that could open up large markets in the years to come.
With reasonable future growth prospects and undemanding present valuations, investors should check out the following names. Although none are likely to be quick wins, all should provide sound long-term value to patient investors.
C.R. Bard (NYSE:BCR)
The best and worst thing going for C.R. Bard is that it runs a well-balanced business that generally targets markets ignored by its large brethren. Bard has produced one of the few peripheral stents that actually seems to work, and markets like oncology and urology are solid cash cows where Bard can leverage its strong market position, but where the growth is too modest to attract full-scale assault from rivals.
At the same time, the company is boosting its own growth potential with strategic deals that move it into therapeutic hypothermia and drug-coated balloons. While the company does have to contend with a serious rival in Covidien, Bard benefits from the fact that many of its rivals are either small, distracted, or otherwise disinclined to reinvest consider funds in these markets - particularly true in the cases of Boston Scientific (NYSE:BSX) and Johnson & Johnson (NYSE:JNJ) as the former looks to fix its stent and CRM businesses and the latter looks to integrate its Synthes acquisition and support its drug business.
Bard does not offer an especially generous yield today, but market leadership in most of its product categories helps to fuel a very strong return on capital. A price in the mid-$80's makes it attractive on its two or three-year potential, while the chance to buy it below $80 would be a near slam-dunk.
Like Bard, Covidien largely succeeds with low-profile businesses that don't generate a lot of excitement on a line-by-line basis. Nevertheless, investors should note that this "boring" medical device company posted results during 2011 that most of its rivals simply couldn't match.
Covidien has some challenges today in its fixation business (where JNJ has gained on both it and Bard), but the peripheral vascular business is doing well, as is the endo business. There is also some risk that Intuitive Surgical (NASDAQ:ISRG) will penetrate Covidien's core markets, although the companies do collaborate on tools.
Against that backdrop, there are some real positives. With the company announcing a spin-off of its pharma business, Covidien can look forward to a more streamlined operating system and fewer headaches. At the same time, the company's opportunity in bariatric surgery looks sizable and Covidien is focusing more and more on higher-growth minimally invasive surgery markets and harvesting cash from more mature commodity businesses to support that.
Covidien's returns on capital are the lowest in the group, but the company pays a decent dividend and has been investing in R&D projects that should pay off in the next few years. At current prices, Covidien looks like the most attractively-priced stock of the lot and seems more than 35% undervalued today.
Medtronic has suffered from a common malady; for too long the stock carried a multiple that was just too ambitious relative to its growth prospects and now the sentiment has flipped to the other side. Although Medtronic is indeed heavily exposed to some mature markets, the company gets too little credit for innovations that could drive share gains and sales growth.
The company has recharged its pacemaker sales with an MRI-compatible device and the company is on its way with a similarly featured ICD. Although the drug-coated stent market is extremely competitive and Boston Scientific is hoping to regain momentum lost to Abbott Labs (NYSE:ABT), Medtronic is likewise looking to a platform refresh to drive better sales.
Medtronic also has several potential billion-dollar opportunities in the pipeline. Medtronic has made a sizable commitment to building a pipeline in atrial fibrillation and though it lags Edwards Lifesciences (NYSE:EW) in transcatheter valves, the data between the CoreValve and Sapien valves has been broadly similar and Medtronic's marketing muscle should be formidable in the U.S.
Beyond this is the potential of treating hypertension through renal ablation - a promising market that could move billions of dollars from chronic pharmaceutical therapy to device-based approaches. Last and not least, Medtronic has a strong diabetes franchise and continues to push towards a closed-loop insulin pump system that could be a major financial winner.
Medtronic offers the largest yield of this group and the smallest FCF growth prospects, but a similar double-digit ROIC. Consider buying the stock at prices below $40.
St. Jude Medical (NYSE:STJ)
Relative to its current sales base, St. Jude may have the most to gain from its R&D pipeline of anyone on this list. Like Medtronic, St. Jude is working on device-based approaches to atrial fibrillation and hypertension (renal ablation) that could be worth hundreds of millions, if not billions, in device sales. St. Jude also has a host of products under development in cardiac repair (four $1 billion opportunities in the pipeline) and neurostimulation that look to have relatively little direct competition.
One of the biggest questions for St. Jude is whether it can maintain, or gain, share in its pacemaker/ICD business. Recent recalls have dented the business and Medtronic has seen a lot of interest in its MRI-safe pacemakers. Still, BSX remains a feeble competitor and it is not as though St. Jude is not developing its own pipeline of next-generation devices.
St. Jude also has a host of smaller profitable businesses that could represent low-risk call options on future growth. St. Jude's wireless monitoring technology could emerge as a differentiating technology in the pacemaker/ICD space, while the electrophysiology business is an underappreciated growth opportunity as data continues to build on the benefits of functional measurement in cardiac care.
This company pays a respectable dividend today and arguably has the largest number of billion-dollar projects in its pipeline. Not all of these are likely to work out as planned, of course, but buying St. Jude shares in the mid-$30's looks like a great growth/value trade-off.
Stryker is best known by most investors for its orthopedics business, but the MedSurg surgical equipment, endoscope, and patient handling business is nearly as large, and the neurovascular/spine is likely to be the real growth leader in the near term. The neurovascular business in particular offers substantial long-range R&D potential and the company can benefit in the near term simply by correcting for the mistakes and underinvestment made by former owner Boston Scientific.
Stryker may soon be facing some interesting questions about whether to reinvest in its orthopedics business or diversify even further. Stryker has a solid hip and knee business, but may want to consider trying to increase its exposure in spine and trauma relative to JNJ and Medtronic or expand into extremities. In the meantime, Stryker's relatively lower exposure to Europe should be a help in 2012 and growth in neurovascular and MedSurg can offset ongoing sluggishness in orthopedics.
Stryker is another double-digit ROIC name, and one that pays a decent dividend and has solid growth prospects. Buying Stryker in the low $50's looks like a bargain.
The Bottom Line
Any or all of the five names listed here should reward patient investors in the years to come, though 2012 is apt to be another sluggish year. There is also a wide range of stories here to appeal to investors - from Bard's subtle market leadership to St. Jude's multiple flashy growth opportunities to Covidien's current sales execution. Clearly investors must do their own due diligence, but there certainly look to be multiple interesting opportunities like medical technology today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.