TWST: Where are you focusing your attention in the medical device space these days?

Mr. Denhoy: We continue to follow the space fairly broadly. We follow about 30 stocks, most concentrated in cardiovascular and orthopedics, but also in areas like neurology and radiation oncology. We have some names in dialysis, in diabetes and some other areas, but we pretty much cover the waterfront in medical devices.

TWST: And are there particular areas you like better than others right now?

Mr. Denhoy: I'm not sure you could define it by clinical areas. The broad theme that we continue to focus on is that there is a fundamental shift taking place right now in the way medical devices are being sold and brought to market. The way that this industry has done business over the last 25 or so years is fundamentally changing. The model for a long time has been that the surgeon or the clinician who uses the technology was the ultimate customer. That is now changing.

The customer is being more broadly defined. The customer is still the clinician but it now includes the hospital, the insurance company and the governments who are paying for the technology, and their focus tends to be a little bit different. And the industry is still trying to adapt to this change.

Some of the larger device categories — things like hips, knees, spine, defibrillators, pacemakers and stents — are starting to be show the effect of this changing dynamic. A lot of what's sold in those markets could be considered commodities. There is very little clinical differentiation amongst the various products and the various companies. And as the purchasers tend to focus on this more, it's starting to drag down pricing. I think this trend is going to continue for a long time as a major secular headwind for this industry.

There have also been some short-term challenges in those markets. The economy continues to sap some of the growth out of procedures as patients are electing to delay. We've seen Europe become quite challenging for these companies, and it looks like that's going to continue for some time. There has been some increased scrutiny on the use of medical technology, whether the right patients are getting the right technologies, which continues. But I think the longer-term secular changes — the way the health care is delivered and who purchases it — are perhaps more damning challenges for the industry over time.

As a result, we try to look for innovative technologies, new markets, companies that have some technology they can use to still grow, in a sense. Those are becoming more difficult to find, but there are still some of them out there. We’re focused on things like transcatheter heart valves, and Edwards Lifesciences (EW), which is really pioneering the use of these valves, is replacing surgical aortic valves. These do everything you want them to do — lower costs, improve outcomes. This is the stuff people should be focusing on. For example, Volcano (VOLC) has technologies for improving PCI procedures. Cyberonics (CYBX) has technology for improving epilepsy, and we think, over time, depression as well.

TWST: We’ve talked in the past about the litany of headwinds facing the medical device sector. With the Supreme Court decision and the medtech tax settled, is there a little more certainty?

Mr. Denhoy: I think the only thing that's gotten more certain is the challenges. I think even before the Affordable Care Act was allowed to stand by the court, the ship had already sailed in terms of the changing purchasing landscape out there. Purchasers had already started to get more aggressive in their view of devices. The incentive structure of the purchasers had already started to shift, clinicians becoming more aligned with the hospital purchasers. That change in incentive structure had already started to take hold. This was driven in a large part by the economic downturn over the past several years and the increased focus broadly on where we are spending our money, and in terms of health care, whether that spending is sustainable. That is continuing, and I think the Supreme Court decision maybe solidified that direction, but I don’t think it really is going to change much.

As for the device tax, I think most of us assumed that would survive the Supreme Court decision, and it has. We're adjusting our models for what this 2.3% tax is going to mean, and starting to adjust earnings numbers down. It’s just another headwind that this industry is going to have to confront.

TWST: There are plenty of them out there.

Mr. Denhoy: It's true. In some respects, a lot of industries are changing and I don't think medical device companies are immune to that. The way that we've done business in this industry for a long time has had a lot of unintended negative consequences. Focusing on the clinician as the ultimate customer engendered a level of product incrementalism in a sense. True innovation wasn't really happening. If a surgeon was implanting a particular type of device or doing a particular type of procedure to treat a certain condition, there wasn't a lot of incentive to really upset the apple cart. That was your customer: you kept him happy and sales were good.

Pricing wasn't the question, and every year you sold something that was modestly tweaked, you could charge a little bit more, and everybody was happy. Now, all of a sudden, the lack of innovation in a lot of these big markets has come home to roost. The fact that there's no real clinical differentiation among most of the products in these major categories now is something that these companies are going to have to contend with. If a number of companies are selling a commoditized product, the price will continue to come down until you reach some sort of stable price again. And I don't think we are anywhere near that.

TWST: Is the pricing pressure a significant part of the evaluating companies?

Mr. Denhoy: When you think about a lot of the challenges that are taking place in this industry — as I mentioned, it's the realignment of incentives on the purchaser side, what's happening in Europe — that all manifests ultimately in what the purchasers are willing to pay for this technology. A lot of things feed into price, but it's really, I think, the manifestation of all of that. There are still short-term issues, too.

One of the major themes everybody focuses on, quarter in and quarter out, is when are we going to see a resumption in procedure volume growth. As I mentioned, it's been a long time since we've seen real strong growth from the procedure side. It continues to be somewhat anemic. We've seen some signs that maybe orthopedics is stabilizing a little bit, but I think nobody is willing to call a bottom on any of this yet.

TWST: What is the latest you are hearing about utilization and personal health expenditures? Do you have a broad outlook?

Mr. Denhoy: It's been three-plus years now that everyone has been trying to call a bottom here, but as much as everyone keeps expecting a resumption of growth, we may be in the new normal. And to expect any of these large categories to really grow faster than the low single digits on a unit basis is probably incorrect. Most of these markets are demographic driven, and the aging of the population really only supports low single-digit growth. You are going to have to contend with some consistent pricing pressure. And the ability to sort of offset that pricing pressure with new, innovative products is becoming more challenging.

So if you're buying to the idea that maybe your negative pricing can be offset by some sort of mix or technology innovation, then you're just left with unit growth, and demographics, again, support something in the very low single digits. So if you look at some of these larger companies, your mainline medical technology companies — the Medtronics (MDT), the Bostons (BSX), the St. Judes (STJ), the Strykers (SYK), the Zimmers (ZMH) — these companies are anywhere from 40% to 80% exposed to what we would call commoditized-type markets. The best you could probably hope for from those sectors is growth in that range. They continue to try to bolt-on or develop faster-growth products, but it's really difficult to escape the pull from those slow growth markets. That's the rut that we are stuck in here.

TWST: And we've seen some notable acquisitions in the space, including Johnson & Johnson buying Synthes. Are you expecting to see a lot more deals soon or is that all?

Mr. Denhoy: That's a pervasive theme here. Despite the pretty weak topline growth of late, these companies have managed to maintain a fair level of profitability as they've gone through this. I think they are looking for growth and that involves acquisition. Quite a few innovative, small, interesting companies get acquired, and I think that theme is going to continue.

TWST: Is M&A a big part of your thought process when you look at some of the smaller companies?

Mr. Denhoy: I think it provides a nice level of support for a lot of the smaller names. For example, in areas such as diabetes, where we track companies like Insulet (PODD) and DexCom (DXCM) who have differentiated technologies for treating type I diabetes. Their technologies, at some point, will most likely find a way into the hands of a larger company. That's just the way these things go.

TWST: We've entered earnings season. What have you seen so far?

Mr. Denhoy: There has been some cautious optimism that are seeing some stabilization in the U.S., but nobody is willing to suggest that growth is going to accelerate. On the orthopedic side thus far, we've maybe seen a little bit more stabilization than has been projected on the cardiovascular side, but again, no one is willing to step out and say that we’re through the worst of it.

And while there are some encouraging signs domestically, it is being offset by what's happening in Europe. Europe has taken a step back for a lot of these companies. The demand out of southern Europe and some of the pricing pressures that are coming out of Europe are really starting to impact results. The euro is also weak, and a lot of these companies have a pretty big exposure to Europe, so that is now starting to weigh on results. Overall, it's been mixed so far in terms of earnings.

TWST: And do you see some opportunities? Where are you pointing investors now? What are some of your favorite names at the moment?

Mr. Denhoy: Again, we try and focus on innovation, broadly defined. Edwards Lifesciences is doing pioneering work in transcatheter valves. They are very early in the launch of the technology in the United States, and all indications are that the adoption and growth is going to remain strong for years to come. Edwards continues to innovate and have a technologic advantage over the companies that are coming behind them. They're in a very nice position to continue to grow quite nicely.

I mentioned Volcano. They have some very interesting technologies that have been shown to improve interventional cardiology procedures. Their technology ensures that when the stent is put in, it's done properly. But also, very importantly, they have a technology called FFR, or fractional flow reserve, which has been demonstrated in several important studies to define which patients should be stented. The data shows that, one, you end up not stenting as many patients as you thought you are going to, and two, you get much better outcomes in the ones you do stent. I think it's a technology that’s very likely to be adopted in a widespread fashion over time.

Outside of cardiovascular, as I mentioned, we like the diabetes space. I think that's an industry where you are going to see continued growth. You are starting to see a new product cycle coming out of Insulet and DexCom, which should help their growth over the next couple of years. They continue to move toward integrated products, pumps and sensors working together to really make the treatment of type I diabetics better. It's a multiyear play here, but I think the innovation continues to happen and growth here is going to remain quite good.

I also mentioned the company Cyberonics. They have an implantable device, which right now has been used for epilepsy. They are going to be approaching Medicare over the next several months about expanding the reimbursement coverage for that device into treatment-resistant depression. That could represent a fairly substantial opportunity for this company, and it's going to become very real here over the next six to 12 months. That's a company we're trying to get people to focus on.

TWST: Any areas of the space or individual companies you are concerned about or down on?

Mr. Denhoy: I used the word commoditized earlier, and companies oftentimes don't like to hear that word because they really do believe they have innovative products, and there is some differentiation. But we continue to discourage people from focusing on commoditized products, because the outlook for them is not great. As I said, the pressure on pricing is going to continue to be quite strong. And if there is very little differentiation or ability to support the price for your product because there are other companies willing to sell the same thing for less, that’s a difficult thing to overcome. And as clinician incentives align more with the purchasers — more with the hospitals — the ability for these companies to influence clinician behavior becomes less.

These products, I think, will behave more like commodities, frankly, which implies the pricing will come down. Beyond that, I think the medical device tax is something that we are going to have start to contend with in a very real way over the next few months. Particularly for some of the smaller-cap, more growthy companies that are not as profitable, the device tax is going to have a pretty outsized impact on earnings over the next couple of years.

TWST: Anything else we should cover?

Mr. Denhoy: No, this is good.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 07/24/12.

Raj Denhoy

Managing Director

Jefferies & Company, Inc.

520 Madison Ave.

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