It's long been a generally accepted belief that the medtech industry—while not recession-proof—is at least recession-resistant. Regardless of prevailing economic conditions, after all, people continue to grow older, get sick, or have accidents that typically result in the need for medical care.

So what about the current downturn? Is medtech holding on to its position as the proverbial port in the storm, or is the sector experiencing the same financial woes that are undercutting both the general economy and equity values overall?

Determining the health of the medtech industry at mid-year greatly depends upon the particular measurement used. While medtech revenues and earnings continue to show significant growth—particularly for large-cap companies—those gains seem to be occurring in a universe directly opposed to that of industry stock prices, which have lagged since the beginning of the year.

With just a few days left in the month of July, 16 of the world's top public medtech companies have filed their financial reports for the first six months of 2008, posting an average revenue gain of 11.73% over the year-ago period. Revenue increases ranged from 3.49 to 21.49%, with 11 of the 16 companies reporting double-digit gains, while only one reported a decline (see Table I).

During the same period, however, stock prices for 15 of the top 25 companies declined. Stock value loss during the first six months of 2008 ranged from 0.59 to 30%. Among the 16 reporting companies, 10 stocks posted double-digit percentage losses, while only two posted double-digit percentage gains.

Since equity values are influenced by many variables in addition to revenues and earnings, it's not all that surprising to see stocks flexing their independence. But the extent of the disparity suggests that the current investment climate is challenging even for the medical technology industry, which continues to boast strong demand, significant revenue growth, pricing power, enviable margins, and positive fundamentals.

“This year, there really are no ports against storms,” says Jan Wald, managing director and senior medtech analyst in the Boston office of the Stanford Group Co. (Houston). “Some medtech stocks have held up better than others, but the economic woes are seeming to put a drag even on those that have been relatively stable. To date, larger cap stocks seemed to have fared better than smaller cap stocks, at least among the cardio, neuro, and ortho names I follow.”

“In general, healthcare has not fared well so far this year,” agrees Thomas J. Gunderson, managing director and senior healthcare analyst with Piper Jaffray & Co. (Minneapolis). “Medtech has been somewhat of a safe haven in the storm, but only in the large-cap space. And even there, it's an issue of not so much performing better, but performing ‘less badly' than other sectors.”

Gunderson says that the out-performance of large-cap medtech firms is largely a function of their “stronger balance sheets, stronger cash flow, and, for the most part, stronger earnings.” He also notes that the weak dollar has boosted the exports of larger companies, most of which have significant overseas operations. “Smaller medtech companies generally have weaker balance sheets, fewer overseas operations, and a mix of revenue and earnings results that offer more risk to investors,” he says.

Medtech tends to hold up in down times, says Gunderson, because the costs of most medical procedures and products are paid through third-party insurance—thereby offering investors some protection against the downward pressure of decreased consumer spending. “Yet we are starting to see the beginnings of elective procedures being postponed as higher co-pays for these insured surgical operations are being affected by consumer budget constraints,” says Gunderson. Manufacturers of lasers and other devices used in Lasik eye surgery and elective cosmetic procedures are likely to be hardest hit by this emerging market trend, he says.

Since the beginning of 2008, the value of the S&P 500 has decreased by 14.34%, with all 10 of its component sectors showing declines. The healthcare sector, which includes pharmaceuticals, medical devices, and healthcare services, is off by 9.18% during the period. Yet, the market value of healthcare stocks has now exceeded the capitalization of the financial sector, which has lost 51.8% of its value since its all-time high of last October.

Making the case that the financial performance of the medtech industry is not cyclical, most industry analysts see sustained growth going forward. Raj Denhoy, research director for medical devices in the New York office of Thomas Weisel Partners LLC (San Francisco), sees the strength of the industry as a matter of underlying fundamentals. For the orthopedics sector that is his focus, Denhoy says, “demographics continue to support this sector.

“For aging baby boomers who want to maintain active lifestyles, most orthopedic procedures are seen as essential rather then elective,” says Denhoy. “We're not likely to see the near-20% growth levels that we had in orthopedics a few years back, but even in this difficult climate, mid to high single-digit growth is likely for the rest of the year. There were some concerns about revenue growth slowing in the 4Q07 to 1Q08 transition. But that is not much of an issue now, with generally favorable earnings coming in and investors gaining back confidence in the orthopedics sector.”

Michael Matson, senior medical device analyst with Wachovia Capital Markets LLC (New York City), sees the ortho sector approaching 10% growth for the rest of the year. “We may see some slowing in hip and knee replacements, but spine, trauma, and sports medicine will pick up the slack,” he says. “Going forward, there is no indication that sector growth is unsustainable. We're not immune to the broader market malaise, but risk aversion is more likely to affect early-stage companies with innovative, but unproven technologies.”

However, Matson notes that orthopedic manufacturers are getting hit with steadily increasing material and shipping costs. “While not as significant as in the consumer space, these increases could have a small but material impact on earnings,” he says. “We expect most orthopedic manufacturers to offset and absorb these costs; if not, margin expansion could suffer.”

So, in the face of generally positive financials—particularly when compared with other industries—why are medtech stocks in the doldrums?

“It's not as if medtech companies are likely to report downside surprises,” observes Wald. “But they're being treated as if they were radioactive, with no investor wanting to touch them for fear of being punished for some undetermined reason.

“There currently seems to be a malaise where the markets—especially in cardio—do not seem as attractive as they once were,” says Wald. “Similarly, the neuro market is perceived as being riskier than anticipated as a result of clinical trial failures and the length of time required to bring good products to market. And the ortho market is looking to new growth opportunities, such as spine, to drive revenues and renew investor interest.”

Industry watchers continue to view the medtech industry as a relatively safe haven in turbulent economic times. But many analysts believe that current conditions have produced a cautious and tentative investor community that has fallen victim to a kind reverse Greenspanism—an irrational reluctance of sorts.

But if medtech companies continue to post positive financial reports, as anticipated, sector stocks could see a decided upturn in the months ahead.

© 2008 Canon Communications LLC

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