Med-Tech Due For More M&A

by: Stephen Simpson, CFA

Buyouts have long been a staple feature of the med-tech landscape. While giants like Johnson & Johnson (NYSE:JNJ), Medtronic (NYSE:MDT), and Abbott Labs (NYSE:ABT) are often knocked (and often unfairly) for their inability to innovate, they do excel at marketing. That creates a pretty steady conveyor belt where smaller, innovative companies create new devices that move the state of the art forward and large companies gobble them up to goose their own growth and leverage their existing production and sales infrastructures.

Now, though, it looks like the old system may be getting a few new kicks in the pants. A new tax on medical device companies will go into effect in 2013, threatening the profits and cash flow growth of smaller players. At the same time, large companies in Korea and Japan are increasingly looking to healthcare as a new source of growth and cash flow. All in all, that should make for a more interesting M&A picture in 2013.

Will A New Tax Bite Push More Deals?

With a new 2.3% excise tax on the way as part of the Affordable Care Act of 2010 (aka "Obamacare"), the operating environment for smaller medical device companies is about to get more difficult. Unlike regular federal income taxes, which are assessed after expenses and interest, this tax is based on revenue.

That means that it will potentially take a much larger bite out of the profits of a smaller companies, and some of them are already responding preemptively. Welch-Allyn, a small privately-owned company focused around patient monitoring, has announced that it's cutting 10% of its workforce, while Cook Medical (also private) has dramatically cut back its plant-building plans (having built two of a planned seven plants and shelving plans for the other five).

Given that many smaller companies depend more on U.S. sales as a percentage of total revenue and often have lower operating margins than the larger players (less efficiencies of scale), this pressure could lead many companies into deals. While not a complete list by any means, companies like Nuvasive (NASDAQ:NUVA), Integra LifeSciences (NASDAQ:IART), Masimo (NASDAQ:MASI), Volcano (NASDAQ:VOLC), Thoratec (NASDAQ:THOR), and Wright Medical (NASDAQ:WMGI) could all become appealing candidates due to the combination of their solid technology/products and vulnerability to this tax.

Go East, Young Man

Also possibly helping matters in 2013 is more activity from the Far East. Both Sony (NYSE:SNE) and Samsung have announced their intentions to significantly expand their medical technology businesses, and acquisitions will almost certainly be a key part of the building process. Given past announcements from the likes of Fujifilm, Terumo, and Asahi Kasei, this is not a surprising development, but it does throw two more well-heeled and motivated buyers into the mix.

Sony has been relatively vague about their intentions so far, other than to indicate that they are interested in taking a stake in Olympus, one of the world's largest makers of endoscopes in the world. If they're looking seriously at surgical tools, though, names as big as Intuitive Surgical (NASDAQ:ISRG) or Stryker (NYSE:SYK) could conceivably be on the list.

For Samsung, the strategy seems more clear. Samsung has already acquired Medison (a maker of diagnostic ultrasound products), and has expressed interest in expanding its MRI and tomography businesses. Whether they intend to go further, say into image-guided therapy, I don't know, but for now it seems that they are focused on the sort of "Big Iron" products that companies like General Electric (NYSE:GE) currently sell. At the same time, though, Samsung has announced its intention to enter into generics and biosimiliars, so expansion into the device industry shouldn't be dismissed outright.

The Intersection Of When And If

I am always reticent to recommend any stock on the basis of its likelihood of acquisition, if for no other reason than you may not get entirely what you were hoping for or expecting. For instance, I bought both ISTA Pharmaceuticals and TomoTherapy in part on the expectation of a buyout - ISTA did indeed get a nice all-cash bid, while Accuray's (NASDAQ:ARAY) cash-and-stock deal for TomoTherapy hasn't yet delivered nearly the same returns to TomoTherapy shareholders.

All of that said, it looks like there are a lot of market factors pushing towards more deal activity. Large device companies are finding it harder and harder to grow organically (as hospitals and payors push back hard on prices) and many companies have sizable cash hoards to deploy. At the same time, the new device excise tax is going to weigh heavily on the earnings of small-cap companies and large Asian companies want to get into the industry.

I always emphasize that investors need to prioritize the stand-alone quality of med-tech stocks, but the added boost from M&A activity could help spur a sector-wide revaluation in 2013 and lead to better multiples (and higher prices) for a host of quality small- and mid-cap names even despite the earnings pressure from the excise tax.

Disclosure: I am long ARAY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.