News Analysis date published New: 
Tuesday, August 24, 2010 - 15:41
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Thursday, August 15, 2013 - 04:24
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Tuesday, August 24, 2010 - 15:41

Medtronic's Drop Signals Trouble, but Buyout Candidates Could Deliver Gains

Tuesday, August 24, 2010 - 3:41pm

Lost in all of this spring's hand-wringing about the potentially negative impacts from President Obama's health care overhaul, investors seemed to overlook two more powerful forces that could severely impact the health care industry. Consumers' financial distress is leading to a sharp slowdown in elective medical procedures (as my colleague Andy Obermueller recently noted), while hospitals and insurers are pressing medical device makers to cut prices if they are to see continued use of their products.

[Read: As Fewer Go to the Doctor, This Winning Health-Care Company Bucks the Trend]

Those factors led Medtronic (NYSE: MDT), a leading supplier of spinal products and defibrillators, to post weak fiscal first quarter results, pushing shares down -10% in Tuesday trading. Shares are now at their lowest level in more than 10 years (with the exception of the market swoon in early 2009), and prospects are very dim for a rebound. As Chairman and CEO Bill Hawkins noted in a call with investors, industry conditions are unlikely to improve any time soon.

These industry pressures appear inevitable. Health care costs had been rising faster than inflation for quite some time: U.S. spending on health care surpassed $2.3 trillion in 2008, more than three times the $714 billion spent in 1990 and more than eight times the $253 billion spent in 1980, according to the Kaiser Family Foundation. Most agree that this burdensome trend must come to an end.

It's easy to blame our aging and increasingly obese population for ever-rising health care spending. Yet as the Congressional Budget Office notes, "about half of all growth in health care spending in the past several decades was associated with changes in medical care made possible by advances in technology." And that's where companies like Medtronic and Boston Scientific (NYSE: BSX) come in. These companies have consistently sought out acquisitions of smaller medical device players that offered novel but pricey applications to cure what ails us. Growth is slowing for these big companies precisely in the areas in which they made a lot of acquisitions. In a nutshell, it's been a great era to invest in smaller medical device companies that have ultimately been bought out. Just this year, Medtronic agreed to acquire ATS Medical and Osteotech (Nasdaq: OSTE). In both cases, Medtronic paid greater than a +50% premium to acquire these firms. Yet these firms are seeing increasingly restrictive reimbursement environments themselves.

In a box
At this point, large players like Medtronic and Boston Scientific are in a box. They have to assume that consumer spending on elective healthcare will stay downbeat for some time to come. It's easier to deal with a bad back on your own than come up with major out-of-pocket funds if you need an un-reimbursable elective procedure. And changes at the federal level won't be of much help. As parts of the health care overhaul, tests are underway to identify the cost-effectiveness of a wide range of medical procedures. Any procedures that fail to materially improve patient outcomes are likely to see reimbursement levels slashed in the next few years.

In a best case scenario, these firms will be able to boost sales at a small pace, largely thanks to acquisitions. More than likely, organic growth is likely to be flat to negative. So to boost profits, these firms can cut costs (Medtronic has already cut a lot of fat and likely has little left to cut) or buy back stock (Medtronic recently completed a $500 million buyback).

In light of all of these pressures, there is simply no way to justify purchase of Medtronic shares, even as they languish at lows. Management has already conceded that business will remain lousy for at least several more quarters, although sales are unlikely to rebound in the next few years either.

Action to Take --> Shares of Medtronic and Boston Scientific are too cheap to short. Instead, investors should stick to smaller medical device makers that either have robust growth prospects or might eventually find an acquirer. For further research, you can investigate names such as Given Imaging (Nasdaq: GIVN), Nuvasive (Nasdaq: NUVA) or Varian Medical (NYSE: VAR).

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.