GE's Dismal Earnings a Warning for Other Medical Device Companies

General Electric (GE) shocked Wall Street with its first disappointing earnings report in years, mostly due to problems in its financial business, but GE Healthcare's 17% drop in first quarter profits on a slight revenue decline should be giving investors in medical device companies pause. What does GE's explanation that "Healthcare earnings were impacted by a difficult U.S. environment and continued regulatory shipping restrictions on the surgical supplies business" mean for Johnson & Johnson (JNJ),Covidien (COV) and Intuitive Surgical (ISRG)?

In my March 3rd comment on Intuitive Surgical, I wondered whether problems in the municipal bonds markets would cause hospitals to cut back on their capital expenditures. While ISRG has rallied impressively since my bearish review, GE says that community hospitals have cut capital expenditures significantly due to the credit markets crisis. This is bad news for all medical devices companies. For an idea of the broad range of products offered by GE Healthcare, click here. In its presentation prepared for its call with securities analysts, GE said that in the first quarter, its healthcare business saw a 1% decline in major equipment orders, following a 7% decline in the fourth quarter of last year, and an 8% increase in services orders following an 11% increase in the fourth quarter of 2007. In the medical equipment business, it said "MR and life sciences strength [was] offset by CT." GE said it that in healthcare services it saw "broad strength across core services and in" health care information technology services. Healthcare earned $528 million on revenues of $3.9 billion.

Drilling down, GE’s presentation offered more hints at what’s happening in the health care major equipment and services markets. It reported:

Healthcare
Global growth in Diagnostic Imaging, Services & Life
Sciences
U.S. market pressure … OEC, DRA & customer access
to capital markets

Deep in the presentation, on page 9, GE reveals the problems with its health care business:

Segment highlights – Healthcare
1Q commercial trends
• Orders up 2% … service +8%,
equipment down 1%
• Service backlog $2.1B, +7%
• CSA backlog +17% driven by HCA
~$1B contract win
Revenues $3,887 -%
Segment profit $528 (17)%
($ in millions)
1Q dynamics
Challenging U.S. environment … strong global growth
• OEC expected to ship in April
• U.S. equipment market remains soft
– Americas DI orders -13%
– Community hospital orders -18% in
March ’08 … funding & CAPEX
• Global equipment revenues as expected
– DI International +8%, Clinical Systems
International +13%
– Life Sciences Europe +24%
• Service revenues strong +9%
– DI service +9%, Clinical Systems +25%

GE’s OEC problems are explained here. The January 2007 Food and Drug Administration press release announced:

The U.S. Food and Drug Administration [FDA] today announced that GE OEC Medical Systems, Inc., its parent company, the General Electric Company doing business as GE Healthcare, and two of their top executives have signed a consent decree of permanent injunction related to X-ray surgical imaging systems manufactured by GE OEC Medical Systems. The consent decree prohibits the manufacturing and distribution of specified GE OEC Medical Systems X-ray surgical imaging systems at facilities in Salt Lake City, Utah, and Lawrence, Massachusetts, until the devices and facilities have been shown to be in compliance with FDA’s current good manufacturing practice [CGMP] requirements as set forth in the Quality System [QS] regulation for devices.

The decree was filed today in the U.S. District Court for the District of Utah and is subject to court approval.

The X-ray surgical imaging systems subject to the decree are manufactured and designed at GE OEC Medical Systems’ facilities in Salt Lake City, Utah, and Lawrence, Massachusetts, and include the 9900 Elite C-Arm System, 9900 Elite NAV C-Arm System, 9800 C-Arm System, 2800 UroView System, 6800 MiniView System, Insta-Trak 3500 NAV System, and ENTrak 2500 NAV System, as well as their components and accessories. These are radiological image processing and image-intensified fluoroscopic X-ray systems that are used during diagnostic, surgical, and interventional procedures, such as orthopedic, cardiac, critical-care, emergency room procedures, and other imaging applications.

“These devices are used on thousands of patients, and their dependability and accuracy are critical for the successful outcomes of important medical procedures,” said Daniel Schultz, M.D., director of FDA’s Center for Devices and Radiological Health. “When FDA’s August 2006 inspection found ongoing CGMP deficiencies at the Utah facility, GE voluntarily stopped distributing devices from that facility and is working with FDA to ensure that necessary corrective actions are fully implemented.”

Disclosure: I don’t own GE, COV, JNJ or ISRG, but my investment club owns GE, ISRG and JNJ.

Comments

[Donald E.L. Johnson]

After I submitted this post, Seeking Alpha posted GE's earnings call transcript, and I wrote the following brief update:

<i>Update: In their conference call, GE's executives said they think funding will continue to be a problem for clinics and hospitals. They also noted that the unit's first quarter wasn't as bad as the figures suggest, because accounting changes made last year look a bit stronger than it was.</i>

Also, I've since posted a comment about health care stocks' vulnerability to a recession on my blog, which I'll submit to SA later today.

[HarMegiddo]

luckily GE and ISRG are nothing alike. a supermega cap conglomerate and a mid cap surgical robotics maker???,Hmmmmm?
hospitals all over the world are buying da Vinci robotics. if they don't buy them now, they are behind the curve. which hospital wants to say "we don't have the best equipment'??
da vincis are selling and the razor/razorblade model will carry them for a long time.

[tj115]

I agree with HarMegiddo... the stock is a great value price now

[Donald E.L. Johnson]

I'm not trying to puncture ISRG's bubble, but I think that you'll find that when hospitals see their cash flow threatened by new Medicare and Medicaid reimbursement rules or by increases in their uninsured and collectible patient numbers, you'll see that they cut back on buying new technology. You might want to take a look at the cap expenditures numbers for the last 10 or 15 years at THC, HMA, LPNT and UHS, which are fairly good proxies for the hospital industry.

Morningstar's discounted cash flow Fair Value estimate for ISRG is still only $175. It says its FV estimate uncertainty is high and consider buying the stock at $113.80 and consider selling around $262. The PE is 90 and the price/cash flow is a very expensive 63.

So beware the cheerleaders. If ISRG misses by a penney, look out below. I'm not saying it will, just that it's a very volatile, and I think, risky stock at the current price.

[Donald E.L. Johnson]

That should be that if hospitals seen the number of patients who don't and won't pay their bills going up or about too, they have to manage their cash flow, and one way they do that is cut capital spending. This could and is likely to happen during a recession.

[jdspain]

we heard the same thing prior to the last quarter and isrg blew away the estimates.. these hospitals if to compete for clients must have the robot or people will go to another hospital. there are several in philly and because of it. several more have been installed in the suburbs at local hospitals to keep business from moving into center city. All these machines can be leased vs purchased outright by isrg which has plenty of cash on hand to finance these robots. ge problems are not isrg problems.

[David Lentz]

Looking back at the last quarter's presentations by ISRG and ARAY, I was struck by the fact that the actual numeric trends presented, were not all that much different (or so it seems to me, YMMV).

But the great gulf between the two as received in the marketplace was entirely in the skill of their presenters.

It seems unavoidable that hospitals will face (or are facing) strong pressures to contain capital spending in the face of a recession, and that a company whose PE of 90 (!!!) would be extremely unlikely to be able to avoid the same multiple compression that the rest of the market is working through, regardless of whether their earnings decline or not.

Only the most fervent true believers would think that the earnings of ISRG will continue to grow through this economic calamity in a manner sufficient to sustain a PE of 90 while the credit markets are imploding and unemployment is rising.

A hint: unemployment says something about corporate finances, and in the end, corporate finances are almost entirely what supports hospitals, as Medicare is a money-losing proposition, and individual insurance money flows are trivial in comparison to employer sponsored health insurance. Unemployed people are much more likely to postpone surgery until they have insurance coverage -- even if it kills them.

All this says absolutely nothing about the quality of ISRG, or whether they are likely to see competition for their (very) expensive devices, either from other medical equipment companies or from the pharmaceutical/biotech industry (e.g., if there were an better nonsurgical treatment for cancer, esp. prostate cancer, ISRG would be impacted severely) -- all that is being said is that ISRG (and all other medical equipment companies) faces some serious headwinds that have more to do with the investing public's valuations than any part of their business. GE's medical equipment business is just another barometer of how strong those headwinds are likely to be.

Full disclosure: I hold some ISRG puts (that I am losing my shirt on, as to date, the market disagrees with me about the near-term course of ISRG's valuation).

[PhilipMichaelThomas]

Don Johnson, ISRG is a risky stock? Really? Thanks for the tip, captain obvious. Hey, if you continue to predict bad quarters for ISRG, I suppose you are bound to right someday, so keep trying.

[GPHMoney]

You guys realy think you know about medical spending? Fools... ISRG has no competition, high barrier to entry and owns the market. GE sells equipment that is "me too" only from a different company. GE missed it's earning because of other reasons besides what hospitals spend. I worked for medical device companies and the market never dictated our growth... only competitive pressures and in patient admittals. That doesn't change because of the market.

[TimThigpen,EditorEchoChief.com]

Tis the best and worst of times.

If you are seeking alpha and blue water, I'd suggest you begin to view markets from the perspective of saving time and money.

Historically, devices/procedures and many new imaging techniques within a particular modality rely upon reimbursement codes.

We see companies growing in our segment, cardiovascular ultrasound. The growth however is not based not on payments but rather what the deployment of the technology can do for lowering costs and reducing headcount/saving physcian time.