Medical Devices Face Onslaught Of Pricing Pressure

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Makers of medical devices are coming under increasing pressure, owing to a fundamental power shift in American medicine favoring insurance companies, hospitals and their patients.

The change, according to Moty Avisar, president of medical systems maker Surgical Theater, is based on patients being forced by soaring medical costs to take control of their health care.

"Let's say a patient is told by his family doctor he needs heart surgery," said Avisar, whose company makes a surgery simulator that lets surgeons practice in a no-risk setting.

"The patient's doctor recommends a surgeon. The patient goes in and interviews the surgeon and then goes down the street to interview the next surgeon on his list so he can compare prices and services," Avisar told IBD.

As a result, medical technology device makers' "customer base is shifting as (insurance) payers, health systems and patients become more influential than they have been in the past," according to Ernst & Young's Medical Technology Report 2013, released on June 30 of that year.

The shift undermines what has been the fundamental business model for many medtech operators, the report says.

The companies are forced to find new ways to create, deliver and capture value.

The industry's challenges are encroaching on three fronts.

First, skyrocketing health costs have led to the rise of value-based health care.

Hospitals are not buying new equipment unless it's absolutely necessary and proven, ISI Group analyst Vijay Kumar said.

"Most health care costs have been unmanageable," Kumar said. And much as the Great Depression changed spending habits, the Great Recession of 2008-09 has made consumers savvier about negotiating medical costs.

A second line of fire is the rising regulatory pressure that medical device makers feel from tighter federal guidelines.

These costs are at least partly related to the Affordable Care Act, commonly called ObamaCare.

This fact was underscored by an April 17 advisory from the Food and Drug Administration. The release warned surgeons that a technique called power morcellation was likely to increase the risk of spreading cancerous cells.

The laproscopic procedure is reportedly used on tens of thousands of women each year. It involves using specialized equipment for cutting tissue -- often uterine fibroid tumors -- into small pieces for removal.

On April 30, diversified medical companyJohnson & Johnson ( JNJ ) said that it was, for the time being, discontinuing the worldwide sales, distribution and promotion of its market-leading morcellator devices.

The third factor: funding. Younger medtech companies, a powerful source of innovation, find themselves resource-constrained as venture capital migrates to what investors see as hotter territories, such as biotech drugs.

Meet The Medtechs

Pressure from the shift was evident inIntuitive Surgical 's ( ISRG ) first-quarter report after the market's close on April 22.

In the following session, investors sent shares of Intuitive down 11%. By far the largest company in the 63-company Medical-Systems/Equipment Group, Intuitive has a market capitalization of $15.8 billion, nearly twice the size of No. 2Varian Medical Systems ( VAR ).

Intuitive makes the da Vinci robotic surgery system. Surgeons control the da Vinci tool while sitting at a remote console, viewing the the operation on a screen while conducting surgery through the use of mechanical hands. The hands reach into the patient, generally through small incisions.

On April 1, Intuitive announced its fourth-generation product, da Vinci Xi.

The new system operates via an overhead boom. Its arms rotate to let a surgeon operate on more than one area of the body at a time, opening the door to more complex procedures.

Doctors use Da Vinci systems for gynecological, cardiac and other surgeries. They are also used in the type of morcellator procedures named in the FDA's advisory, ratcheting up investor uncertainty regarding the stock.

Still, CEO Gary Guthart hopes the da Vinci Xi will shore up flagging sales of the high-tech systems, which cost upward of $1 million each. A three-quarter slump in sales accelerated during the first quarter, driven by weak procedure growth in America.

"The first quarter was a difficult one," Guthart said on the Q1 conference call, echoing his earlier comments that 2013 was challenging.

"Trends that emerged in the second quarter of 2013 continued through the balance of the year, including revenue uncertainties for United States customers due to pressure on gynecology surgery broadly; the implementation of the Affordable Care Act," which ratcheted up costs; and other factors, he had said in the January earnings call.

Baxter International ( BAX ), a diversified medical products maker, reported on April 17 that its first-quarter earnings rose 13% to $1.19 per share on a 15% hike in revenue to $3.95 billion. Both figures topped analyst expectations.

CEO Robert Parkinson in a conference call that day commented on the shift to value-based health care: "Pressure to control costs is enormous -- as is the need to expand access to quality care, which requires further investment of limited resources."

He added, "It is little wonder then that governments and insurers around the world are pursuing multiple levers to control expenses."

Baxter hopes to unlock value for its shareholders by splitting the company in two. One company will retain the Baxter International name and sell medical devices. It had revenue of $9.3 billion last year.

The other, as-yet-unnamed company, which had about $6 billion revenue in 2013, will start out with a portfolio of drugs to treat hemophilia and other bleeding disorders and develop treatments.

The split is expected to be completed by mid-2015.

Baxter shares climbed nearly 4% on March 27 after it announced the split-up, which follows in the footsteps of several other large medtech companies.

In January 2013,Abbott Laboratories ( ABT ) broke into two companies. One, a medical-device maker, retained the Abbott name. The other, a research-based drugmaker, is nowAbbVie (ABBV).

In March,Boston Scientific (BSX) announced it was considering a spinoff of businesses grouped under its Endosurgery division.

A number of analysts and investors have pushed for a similar carve-out atPfizer (PFE). Other divide and conquer candidates include Johnson & Johnson and the U.K.'sSmith & Nephew (SNN).

One thing that device makers aren't likely to spin off: their lawyers. Patent protection and litigation remain central concerns for medtech companies.

Align Technology (ALGN), the largest maker of transparent aligners for teeth, announced a major court victory April 3.

The International Trade Commission affirmed an earlier court decision that found rival ClearCorrect infringed on five of Align's key patents.

The ITC issued an order to ClearCorrect to cease using the technology. Shares of Align, which is on the IBD 50 list of top-rated stocks, climbed 2.3% the next day.

Challenges

Anemic industry revenue growth has narrowed venture capital interest in the market. Total sales among U.S. medical technology makers rose just 2% in 2012 to $210.1 billion.

U.S. venture capital investment in medtech has responded by sliding to its lowest level in at least seven years.

After a slight rebound in 2011-12 from recession lows, "the total amount of U.S. medtech venture funding slid 19% to $3 billion in the 12-month period ended June 2013," the E&Y report said.

The number of new medical-system companies scrambling for a piece of that shrinking pie is growing. Initial public offerings doubled from three to six in the year ended June 2013. Total value was up 20% to $155 million.

Meanwhile, the medtech industry is consolidating elsewhere.

"All signs point to deals," Ernst & Young said in its report.

Johnson & Johnson in June 2012 bought Swiss medical device maker Synthes Holding in a $20 billion cash and stock deal.

As the number of medtech acquisition targets in the U.S. and Europe dwindles, many Western companies are turning to China.

In the 12-month period ended June 2013, Western companies acquired nine Chinese firms for a bargain-basement total of $1.7 billion, E&Y said.

The seven years prior to 2012-13 saw a total of 25 deals. Combined value: $346 million.

For many, the big question is what will be the long-term impact of ObamaCare.

Until the effects of the medical overhaul are fully known, "hospitals today are being very selective with what they are buying," Surgical Theater head Avisar said.

The former Israeli air force pilot, who helped design the flight simulator for the U.S. Air Force's F-16 jet fighter, forecasts that "it will be a conservative year.

"We don't see a lot of growth of medical equipment sales. I think a lot of (medical) centers are sitting on the fence waiting to see in the first year of ObamaCare how revenue will play out."

Still, Ernst & Young said in its report, the industry is weathering the storm well, and "companies are adapting to a new health care ecosystem that values better health outcomes and cost-effectiveness."

Follow James DeTar on Twitter: @IBD_JDeTar .



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: JNJ , ISRG , VAR , BAX , ABT

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