Dr. Nudell: I cover the cardio companies, Medtronic (MDT), St. Jude Medical (STJ), Boston Scientific (BSX) and Edwards (EW). I also cover the orthopedic stocks, inclusive of Stryker (SYK) and Zimmer. (ZMH) Amongst the diversified medtech companies, I cover Abbott (ABT), JNJ (JNJ) and Baxter (BAX).
TWST: What key trends do you see on the macro and micro levels of the sectors
you cover?
Dr. Nudell: On a macro level, in the cardio space the two identifiable big
markets, ICDs and drug eluting stents, have sluggish trajectories. The
defibrillator market in the United States has basically been flat since 2005,
and the ex-U.S. market has decelerated to around 10% or 11% operational growth,
with a continued slow deceleration ex-U.S. likely. The big controversy in the
ICD space is whether or not the U.S. market resumes growth, or whether it
shrinks at a modest rate over the next five years. In our model the worldwide
ICD market grows at about 2% through 2013, with the U.S. shrinking and the ex-
U.S. market growing in the high single digits. The ICD market impacts all three
cardiac rhythm management companies. The stent market has rebounded somewhat
this year based on new data suggesting limited risk associated with late stent
thrombosis. Beyond this adjustment, however, and looking forward, we expect
drug-eluting stent volumes to increase at around 2-3%, driven by procedure
growth rather than mix shift to drug-eluting stents from less expensive bare
metal stents. Pricing pressure has been in the high single digits, so our models
reflect a gently shrinking drug-eluting stent market on a worldwide basis.
Summarizing, we have the ICD market at around 2% and the drug-eluting stent
market shrinking. This somewhat constrains our top-line estimates for the stent
and CRM cardio companies, BSX, MDT and STJ. In orthopedics, we've characterized
unit growth in the United States at around 7% from 1999 through 2008. This year
is a sluggish year around the world in terms of units. This year due to the
downturn, I think the U.S. is enjoying perhaps 3-4% unit growth and the ex-U.S.
markets - and this has been surprising - has moved down to very low single-digit
unit growth. The big controversy in the ortho space is whether the companies
will be able to inject mix in the key U.S. market in the face of slightly
negative price pressure on established products. In our view, the companies
should be able to do this because of good orthopedic department profitability
which in turn is driven by the large spread between commercial and Medicare
reimbursement rates. For all of medtech procedures, commercial insurance pays at
around 1.5 times the Medicare rate. And commercial insurance really supplies the
bulk of the profit enjoyed by the surgical departments. So it remains to be seen
whether or not our hypothesis is correct, but unless the commercial-to-Medicare
reimbursement spread narrows, I suspect that the orthopedic industry will be
able to retain modest momentum in ASPs driven by mix. We are conservatively
modeling about 5% orthopedic unit growth longer term in the U.S. and a couple of
points of ASP momentum. It might turn out to be six points in units and one of
ASP, but we suspect that U.S. orthopedic revenue growth will be in that
ballpark. On a worldwide basis, for the next five years, we're presuming a 5% to
6% worldwide orthopedic market. But like I said, the trajectory of U.S. ASPs,
net of pricing mix, is the key controversy in the space. We've been reasonably
optimistic that ortho ASPs won't go into deflationary cycle, but as is true for
everyone, we're waiting to see the real outcome of the health care reform
initiative.
Turning to the diversifieds, JNJ has a wide set of businesses, which should show
buoyancy when the economy turns around. Medtech should enjoy a step-up in
elective procedures and consumer should rebound from increased consumer
optimism. On the pharma side, JNJ is increasingly relying on alliances to bring
in lower-risk, late-stage drugs. And on the purchase of early-stage companies
with interesting specialty drugs, they are not interested in me-too line
extensions, focusing rather on assets which meet unmet medical needs and which
fit into their commercial footprint. Net-net, we remain comfortable that JNJ can
maintain their formula of about 5% top-line growth with high single-digit
bottom-line growth. Also JNJ will remain a core holding because it's diverse and
they have the resources to buy assets that will help them weather health care
reform. On a broader level, I think one way to play the uncertainty associated
with health care reform is to invest in a company like JNJ that's diverse and
has the resources and track record of buying good, value-added assets. The other
way to win in this very uncertain period is to focus on small, emerging
companies that have novel products that fulfill unmet medical needs and which
therefore provide a lot of volume upside. Edwards is a case in point. While we
launched with a neutral because of valuation, we're pretty certain that Edwards'
pivotal Partner trial for percutaneous valves will be positive and drive U.S.
regulatory approval. A successful U.S. launch will transform the company and
really create value. There is sufficient volume associated with this product so
that it won't really matter whether percutaneous valves are priced at $23,000 or
$19,000. Relative to Edwards' size, percutaneous valves are a really big market
opportunity. If you can afford to be patient and look out two or three years,
the company is going to be in a much better position than it is today simply
because of percutaneous valves. So to sum up, you can probably best weather
health care reform by looking to the large and well-funded companies or to the
small and innovative.
Continuing on with the diversifieds, I think Abbott has a similar top line and
earnings profile to that of JNJ. But at this moment, the stock is somewhat
handcuffed simply because the majority of future profits are attributable to
HUMIRA, which has slowed somewhat in the U.S. Ex-U.S., the drug is growing
remarkably well, and we ultimately think that HUMIRA will reach $8 billion in
sales. We suspect that U.S. HUMIRA growth has been adversely impacted by the
economy, but we need to confirm that there is still a fair amount of volume
growth in the inflammatory bowel disease and psoriasis categories. If U.S.
trends stabilize and improve slightly, Abbott should hit our target of $52. But
movement beyond that point will probably by gated by clarity as to how the cash
flow and operating margin headroom provided by HUMIRA is deployed. Rounding out
the diversified companies that we cover, Baxter has been a great story. To date,
it's been all about the bioscience division, which in turn is driven principally
by plasma-derived products. Increasingly, attention is being focused on their
emerging vaccine business, which is employing cell culture production
techniques. Net-net, Baxter is a high single-digit top line and low double-digit
bottom line company. I think that the plasma market is in better shape than some
people fear, hence I believe that the bioscience division will be able to grow
at a sustainable rate of around 10% with operating margins that meet or beat
40%. The other half of Baxter is growing at 5% to 6%, with much more modest 12-
13% operating margins. While the fortunes of Baxter appear to be driven
principally by bioscience, my suspicion is that if Baxter can do anything with
regards to beating expectations for medication delivery and/or renal, that this
will really round out the story and ensure the long-term success of the
investment. Net-net, we're very comfortable with our low $60s price target.
Tickers included in this excerpt: ABT, ARAY, BAX, BSX, EW, HTWR, JNJ, MDT, STJ, SYK, THOR, ZMH
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