Originally Published MDDI February 2004
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Big Leap for Small-Cap Medtech Stocks
Small-cap medtech stocks showed 60% growth over the course of 2003, says Steven F. Hamill, CFA, senior
research analyst with Piper Jaffray (Minneapolis). Large-cap medtech stocks traded fairly in line with historical premiums. The discounts for small-cap stocks clearly shrank because of their growth. Discounts were down from 35% to 25% for price-to-sales ratio. That change reflects strong movement in the small-cap group. Hamill cautions, however, that the small caps rose en masse. He questions whether some companies that were taken along for the ride—but did not perform—might pull back. He also notes that although the mergers and acquisitions window did open up somewhat, the average deal stayed relatively small at $300 million, and the premiums for takeovers were not enormous. Half of the deals were in orthopedics, including the only two that were more than $1 billion. Also of note: there were no IPOs, and secondary offerings did not change. The 2003 deals did perform better than the previous year, but they ran the gauntlet in terms of quality.
Sorting out the Highs and the Lows
It was a good year for healthcare and medical devices, small-cap stocks in particular, says Thomas J. Gunderson, senior research analyst with Piper Jaffray. “As growth continues, we question whether P/E, earnings, and revenue growth are enough to value the bigger caps,” says Gunderson. He points out that 12 years ago, large-cap medical device stocks did not exist. “Only Medtronic could have counted as one. Now, as we have many
larger-cap device stocks, we need more sophisticated tools [with which to evaluate them],” he says. Many factors, including goodwill, can inflate earnings growth, he says. Foreign currency added 4–6% on top of the growth.
“We are working harder to tease out the actual earnings and crunch them. One indicator is a company's cash flow rate divided by total assets. That gives us a better correlation to market value [than many of the traditional measures],” he explains.
He says the double-digit growth by this measure appears not to be sustainable over a 2–3 year period, citing Zimmer, Boston Scientific, Cytec, and STERIS as strong performers by this measure. “The highs are lower and the lows are higher. We need more-sophisticated tools that don't replace fundamental analysis or due diligence, but rather increase our sense of the sell side,” he says. “There will be winners and losers.”
Key Themes for 2004
Devices are moving into traditional drug markets such as congestive heart failure, depression, cancer, and Alzheimer's disease, says Scott R. Davidson, senior research analyst with Piper Jaffray. He also highlights the drug-device convergence, noting that devices are getting into areas that have historically only seen pharmaceutical solutions. “We are quite optimistic. It's good to see.”
One issue, he says, is what he calls cliff risk. Issues such as going off patent are becoming relevant to more and more device industry subsectors. “We saw this happen in the first round of the stent wars,” he says. “This issue can determine which stocks should be sold. It will also help predict the breakouts of successful companies.”
The device industry will also face consolidation. He says 2004 will see an above-average amount of mergers and acquisitions in the medtech space, especially as it pertains to companies on the upswing of a new-product cycle. “We will see offensive M&A, in which companies look to the next leg of growth, but also defensive M&A, to protect market leadership and existing franchises,” Davidson says. He says spinal disc deals have been
particularly prominent, with three in the last 18 months.
Davidson says analysts are hopeful about FDA actions restricting growth. He notes that the agency is increasingly willing to work with foreign-
country clinical trial data as a larger part of a PMA. He also believes that device user fees will bring more reviewers to help get products to market faster. He is optimistic about new reimbursement rules in Japan and a new leadership at CMS in the United States.
Cardiology is the most dynamic of the big sectors, Davidson says, but cautions that 2004 will be “a bit of a gap year.” Large cardiology companies could be active acquirers. “The orthopedics sector will also continue its positive trends, and consolidation will be big.” Another major sector, neurology, has is the potential approval of the first device to treat depression, he adds.
Buyers are scarce, he says, particularly because of small-cap valuations in 2003. However, he concludes that the field is likely to stay very strong. “There will be strong plays in the traditional fields like cardio and orthopedics. People will also be encouraged to look at subgroups like hearing aids, women's health, and diagnostics,” he says. Certain companies in these areas could outperform predictions. He also forecasts selected opportunities in a small number of stocks that did not perform well in 2003.
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