The Henry Fund Henry B. Tippie School of Management Krishnakumar Bakthisaran

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1 The Henry Fund Henry B. Tippie School of Management Krishnakumar Bakthisaran Health Care Equipment February 8, 2015 Healthcare Healthcare Equipment and Services Industry Group Investment Rating Overweight Investment Thesis Key Index Statistics 1 We are overweight on the healthcare equipment industry primarily because of: increasing demand for healthcare driven by demographics, increasing investments in R&D and the rising demand from the emerging markets. Drivers of Thesis Increasing investments by industry leaders in R&D to drive innovation and growth as a continuous pipeline of high margin, innovative products are developed. The number of adults aged over 65 as a proportion of total global population is expected to continuously increase at least till As this segment healthcare demands than any other, it is expected to drive a continuous demand for healthcare equipment and services Rising demand from the emerging markets like Russia, Brazil, China and India as their economies continue to grow and a growing number of their middle class gain access to healthcare facilities. Government and private spending on healthcare is expected to continuously increase with the developed markets growing at a 6% CAGR and developing markets growing at 10.3% CAGR Risks to Thesis Fluctuations in foreign exchange currency rates affects several medical devices companies as margins are thin in commoditized products and these fluctuations can wipe these profits Tightening Regulatory environment globally, could increase expenses and payback period for investors Price Data Current Price $ wk Range $ Price/Earnings (ttm) YTD Return(Mkt) Yield(ttm) % 0.32 Trailing Returns 3-Month Return 9.34% 1-Year Return 16.74% 3-Year Return 20.50% 5-Year Return N/A Key Players by Market Capitalization Johnson & Johnson $284.7B Stryker Corporation $35.5B Becton Dickinson $27.9B Baxter International $36.9B Boston Scientific $23.7B 50 Industry Sector Source: Yahoo Finance P/E Dividend Yield EV/EBITDA ROE 30% 25% 20% 15% 10% 5% 0% -5% -10% 12 Month Performance: Source: Yahoo Finance Industry Description XHE S&P 500 J F M A M J J A S O N D A medical equipment is an instrument designed to aid in the diagnosis, monitoring and treatment of a medical condition. The Health Care Equipment and Supplies Industry in the Health Care Sector includes manufacturers of medical equipment, devices, and medical products. The industry constituents primarily research, develop and produce non electronic medical, surgical, dental and veterinary instruments. 2 Important disclosures appear on the last page of this report.

2 EXECUTIVE SUMMARY We are bullish with regard to the Healthcare Equipment industry primarily because of several favorable long term trends including the increased R&D expenditure to drive innovation. Additionally, the demographics remain strongly in favor as the number of adults aged 65 years or above is expected to increase in 2015 and faster than the rate of population indicating an increasing share of the population for the elderly. Another important aspect is that the health care expenditures of developing countries is expected to surge as a growing middle class and increased access to better health care facilities is expected to drive a solid long term demand. Although the recent implementation of a 2.3% excise tax on medical devices does impact industry margins, the extent of the impact is minimal. Healthcare reform also that sees more than 32 million Americans get access to health insurance coverage. This will lead to an increase in physician visits, leading to increased demands for medical equipment and services. Overall, we believe that the presence of such solid long term trends bodes really well for the medical device industry and we expect continuous growth y/y in the long term. typically command price premiums if their clinical utility is established and face limited competition. Manufacturers can expect to profit from the high margins until competitors catch up, as they inevitably do due to the weakness of patents in the medical device industry 4. In the conventional supplies market, new entrants face low barriers to entry, intense competition and subsequently low margins. Successful firms typically have long term supply contracts with large institutional healthcare providers. For most firms in this industry the conventional product lines represent a stream of steady cash flow that can be used to fund research and development of the high technological products. As a result most firms have a mix of both commoditized products and high-tech products, and their profit margins typically point to the kind of product mix a firm has to offer. While the recession slowed medical device spending, the industry maintained sales growth through 2009 to Revenue is forecast to grow 3.6% per year on average to $114.9 billion over the five years to The major segments of medical supplies and products are cardiovascular, orthopedics, wound care, in vitro diagnostics, diagnostic imaging, and surgical instruments. The infographic below shows the various segments and their percentage share. INDUSTRY DESCRIPTION The Healthcare Equipment and Services industry consists of companies engaged in the manufacturing and distribution of basic medical equipment and supplies. The industry includes forceps, surgical knives and gloves, bandages and dressings, syringes, stethoscopes, medical laboratory equipment, x-ray films, dental drills, veterinarian instruments and other related supplies 2. It excludes retail sales of drugs and medical supplies, and manufacturing and distribution of high-tech medical equipment 2. The industry is extremely diversified and supplies hundreds of thousands of products. Medical products can be broadly classified into 2 categories 4 : conventional products, which have little or no technological variations and can be put to a lot of uses; and high-technology products, which use cutting edge technology to address highly specific therapeutic and diagnostic applications. In the former category, the margins are narrow and manufacturers depend on high sales volumes to generate profits. Some examples of products in this category include: surgical apparel, traditional wound dressings, kits, trays and a wide range of other products. Products belonging to the latter category Source: IBIS World We now look into detail the 3 biggest product segments of the medical devices industry to better understand future growth prospects. Orthopedic Instruments

3 The orthopedic instruments are the largest segment representing 23% of total industry sales. Orthopedic instruments are used in surgeries concerned with conditions involving the musculoskeletal system 2. The basic drivers in this sector is an increasing aging population, an increasing percentage of obese people in the population and an increase in road accidents, combined with a growing incidence of musculoskeletal which will fuel steady demand for orthopedic procedures and instruments, and also drive research into the musculoskeletal afflictions 2. The following graph 5 shows the steady increase of the orthopedics products since 2007 at a CAGR of 4.5% and a projected growth rate of 3.5%. in this segment is again a large ageing population, a rise in number of surgeries especially elective ones and the growing demand for minimally invasive surgeries. The global surgical equipment market is expected to grow at a significant CAGR of 11.1% till 2020 as show in the graph below, with Asia-Pacific growing at a 16.1% CAGR 7. Source: Allied Market Research The major firms in this segment are show in the pie chart below 15. Surgical Instrument Sales 2014 Source: Harris Williams Investment Bank The major firms in this segment are show in the pie chart below 14. Orthopedic Instrument Sales Surgical Instruments Source: Becker Spine J & J Stryker Zimmer Biomet Medtronic Others Surgical instruments are specially designed tools or devices used for performing specific actions of carrying out desired effects during a surgery or operation, such as modifying biological tissue, or to provide access for viewing it 6. The Surgical Instruments and supplies account for 19.0% of industry revenue. The primary growth drivers Covidien Stryker J & J Others Diagnostic Apparatus Diagnostic apparatus are tools used to detect diseases or illnesses 2. These include devices like endoscopes and blood test kits. A rapidly aging global demographic is the primary driver of this segment. The demand is also expected to increase with a rise in healthcare standards in developing regions primarily because diagnostic apparatus improve the quality of healthcare while decreasing long term treatment costs. The primary players in this sector include Roche, Siemens, Danaher and Abbot Laboratories. In conclusion, we think that firms that have diversified portfolio offering of conventional products and high technological products represent ideal long term investment opportunities. For the conventional products, the larger the size of the firm the faster economies of scale are achieved and higher the margins on these products. Also, given that the most overarching trends such as a Page 3

4 rapidly increasing aged population and improving healthcare standards, are global, it would be vital for companies in this industry to have a global presence. Firms that fall in this category include Johnson & Johnson, Stryker and Baxter International. Affordable Care Act RECENT DEVELOPMENTS As part of the Affordable Care Act passed in 2010, an estimated 32.0 million Americans will gain health insurance coverage by The government will subsidize the health insurance coverage for those individuals with low incomes thereby increasing the number of individual visiting doctors and purchasing medical products and undergoing surgery. As shown by the graph below, the number of uninsured dropped to 13.4% in Q2 of 2014, the lowest in 5 years 8. This increase in people with health insurance is expected to have a directly positive effect on the number of physician visits which is a key demand driver in the medical equipment sector. The number of physician visits is expected to grow y/y at least till a recent survey 9 found that a majority of US companies did not make any major changes in response to the imposition of the excise tax. Weak Global Economy The global economy still remains weak from the 2009 economic crisis. The high level of unemployment caused by the recession lead to a significant drop in the hospital inpatient and outpatient utilization rates. The resultant drop in Hospital Capital Expenditures lead to slowing demand for medical devices worldwide 4. Demand remains sluggish especially in the EU and Japan, affecting US companies exporting to these regions as shown below. MEDICAL DEVICE EXPORTS & IMPORTS Source: IBIS World Source: Gallup Source: IBIS World The US economy strengthening has partially offset the weak global demand. The US accounts for 38% of the global device market demand 4. Also, a strong US Dollar is making American devices more expensive to overseas buyers. However, the focus is still increasingly on international markets especially emerging countries to generate a sustained demand. Industry products sold in the world s four largest emerging markets (Brazil, Russia, India and China) account for 8.7% of industry exports in 2014, growing from 5.7% in According to recent med tech earnings calls the rising dollar is expected to undercut medical device company earnings by 6% this year 17. St. Jude Medical Inc. is expected to have the most exposure to these fluctuations followed by Abbot Laboratories which leaves their earnings vulnerable 17. Tightening Regulatory Environment However, the cost of the government subsidy is partially offset by a 2.3% excise tax on sale of medical devices which will might impact profit margins of the manufacturers and possibly stifle innovation and decrease budgets for research and development (R&D) of medical devices. Still, The Medical Instrument and Supply Manufacturing industry is highly regulated by the Food and Drug Administration (FDA) in the US and by the European Medicines Agency (EMA) and other various country specific bodies in Europe. Recently, the EU has proposed Page 4

5 setting higher standards for device manufacturers while the US is considering bringing laboratory developed tests under its purview 4. These proposed changes in the regulatory standards of the EU and US would entail that the medical device manufacturers will have a more cumbersome product review and certification process, thereby potentially requiring a greater investment of time and resources. This might drive away potential investors especially in small ventures as they have to wait longer for payback due to a lengthy approval process. However the FDA released a guidance document in October 2012, where it plans to bring down the average waiting period for clearance applications from the current 150 days to 124 days by So it remains to be seen on how the FDA and other regulatory bodies change their regulations. INDUSTRY TRENDS Increasing M&A Activity The medical devices industry has seen a lot of M&A activity in the recent years driven by soft product sales globally and also due to the presence of a lot of cash on the balance sheets of some of these companies. In the first half of 2014, the total worth of M&A ($27.2 billion) had already exceeded full year 2013 M&A value of $19 billion 4. The table below shows the major acquisitions in the sector in Source: Capital IQ The device industry will continue to consolidate to achieve cost savings and diversify product portfolios, arising from the need to combat the impact of the federal excise taxes, continued pricing pressures, and declining volumes in certain high-cost treatment areas. According to IBISWorld 2, over the five years to 2019, the number of industry firms is expected to decline at an annualized 2.1% to 13,908. Moreover the depreciation of currencies worldwide against the USD make acquisitions in those countries attractive to U.S. companies 17. Increasing R&D spending Historically, the adoption of new technologies and expanding applications of existing ones are the key sales drivers in the medical products industry. Given the industry s competitive nature and strong dependence on product innovation, firms must invest in R&D to stay competitive. The continued industry consolidation driven primarily by the excise taxes, will give many smaller manufacturers access to substantial R&D budgets, driving innovation and product development. Chart below shows the R&D expenditure change in the industry till Page 5

6 remain profitable. By 2019, average industry profit is expected to moderately decrease to 10.1% of revenue, down from 10.5% in MARKETS AND COMPETITION Shown below is the R&D expense as a percentage of sales for the top players in this industry. Companies that spend a higher than average portion on R&D expenses typically are well positioned and develop a diverse product portfolio and pipeline of products. Johnson & Johnson in that respect stands out with an industry high R&D spend. Company Name R&D Expenses Baxter 6.98% Johnson & Johnson 11.43% Boston Scientific 11.18% Stryker 6.35% Becton Dickinson 6.21% Medtronic Plc 8.60% Average 8.46% Continued Pricing Pressure Source: IBIS World Source: Factset Ever since the recession overall demand for medical devices has softened in response to both macroeconomic and industry factors. As a result the medical device sector has faced increasing pricing pressure. AdvaMed s June 2014 report 10 highlighted that medical technology prices lag behind the Consumer Price Index (CPI). It also points out that the Medical device and diagnostic prices increased from 1989 to 2011 at an average annual rate of 1.0%, compared with the CPI increase of 2.7%, the Medical Care CPI increase of 4.6%, and the Medical Care Services CPI increase of 1.0% 4. Also, downstream customers like hospitals are also consolidating by acquiring doctor s practices to better control costs of medical supplies and instruments 2. This works to the advantage of the large industry operators who have sufficient negotiating leverage as compared to smaller operators. These smaller operators will face a pricing pressure and struggle to While the Medical Equipment and Supplies industry has a number of large operators, small and medium businesses (SMBs) have historically dominated the market. Based on data from the US Census Bureau 11, close to 85.0% of industry establishments employ fewer than 20 employees. Smaller businesses usually have quick adaptability, ability to identify unmet market needs and substantial innovative potential, and thus form an important component of the healthcare industry globally. According to Net Resources 1 International, 56.0% of new industry products are developed by small businesses. Small companies however, join larger companies in order to gain access to global distribution networks, substantial research and development budgets as well as the knowledge of working with the FDA to successfully bring the product into the market. Shown below is a graphic of the market share in the industry 2 : Market Share 2014 Others 81% Source: IBIS World J & J 8% Stryker 5% However most firms in this industry do not operate entirely in the medical devices space and prefer to diversify their earnings from a variety of segments. In fact for the largest medical device companies, medical device sales represent only a portion of their sales. The table shown below are the largest medical device companies and the proportion of their revenues from medical device sales. Industry leader like Johnson & Johnson, GE, Siemens and Philips have thoroughly diversified across segments BD 4% Baxter 2% Page 6

7 and medical device revenues represent only a portion of their total sales 4 : Source: Factset Source: Capital IQ Competition within the industry is limited by government regulatory requirements. Medical devices are regulated by the FDA, and legislation regarding the production and specification of medical equipment and supplies poses a significant barrier to entry. This has limited the competition from new entrants. Sales are primarily driven by new products which are in turn a result of investments in Research and Development. Companies are increasingly focusing on one particular segment which in some cases can be highly specialized and niche. This can allow them to generate rapid product improvements and forms the basis of competition for most small companies. Larger firms are horizontally and vertically integrated, have economies of scale, large multinational footprint and recognizable brands. All this gives them the pricing power in the industry. As noted earlier, firms with the highest proportion of R&D spending typically have a well-diversified product pipeline that helps them to drive continuous and sustainable long term growth. Johnson and Johnson with an R&D spend of 11.43% of its sales represents such a company. With Price Earnings ratios less than the market average of 33.27, Johnson and Johnson along with Baxter are undervalued. Another attractive aspect of these 2 company stocks is the near industry high dividend yields offered. Overall both these companies are the most attractive primarily due to their current undervalued prices and also their high dividend yields. ECONOMIC OUTLOOK Growing global population The world population is expected to increase by 1 billion in the next 12 years at a CAGR of 1% 12. As show in the graphic below, most of that growth will occur in the developing regions. This increase in population especially in the developing regions, where healthcare services are still largely primitive, and a growing middle class, are expected to drive a continuous demand for healthcare supplies. While medical device companies will face some pressure from local players as well as local treatments for medical conditions, crucial partnerships and outsourcing could help them compete. Peer Comparison The table below shows the peer comparisons for some of the major players in the industry: Source: Wikipedia Page 7

8 Aging population and Life Expectancy Worldwide, one of the fastest growing segments of human population is the demographic of people aged above 65 years. They are expected to continue to increase in the percentage share of the total population. Graph below shows the increase in percentage share of the elderly. to be a long term driver of this sector with solid demand in orthopedic and surgical instruments. Foreign Currency movements The United States leads the world in terms of recovery from the Financial Crisis of 2008, while many of the foreign markets for the US Medical device manufacturers remain in an economic rut. These US device manufacturers have 40% 50% of their revenues coming in from foreign markets (with close to 30% coming from EU region). As a result, the operating environment outside the US and the movement of foreign currencies versus the US dollar, are both critical to the performance of US medical companies. Table below shows the share of foreign revenues for some of the major players 4. Source: Wikipedia Also, better healthcare facilities and technological advancements have seen an increase in life expectancy rates worldwide. Graph below shows the increase in various parts of the world. Source: Capital IQ Source: Wikipedia An increasing proportion of the elderly population combined with an increase in life expectancy rates means that an ever increasing number of people of would require access to healthcare. We believe this aging demographic As a majority of currencies weaken against the US dollar, it creates an unfavorable environment for US exports as they are more expensive outside the US. We believe, that some of the major currencies including the Euro and the Yen will considerably weaken relative to the US dollar, especially in light of the recent Quantitative Easing programs in both these regions. The currency fluctuations however represent a more near term impact to earnings and any underlying sales growth based on a long term trend will eventually prove profitable ex-currency as firms hedge against such volatility. CATALYSTS FOR GROWTH As mentioned previously in the report, one of the primary catalysts for growth is innovation and development of new Page 8

9 product lines. This has become particularly important as healthcare customers increasingly seek better value for their money 13 and firms vie for customers in an increasingly fierce competitive environment. Growing global population and the increasing of the elderly as a proportion of the population means that the demand for healthcare equipment will continue to rise over the long term. We also believe, the rising standards of living in the developing regions along with the rise in the middle class will also drive demand for healthcare facilities. Overall we also believe that the increase in both private and public health expenditures as shown below will also be a long term driver of demand for healthcare equipment 4. Source: Capital IQ INVESTMENT POSITIVES The favorable long term trends as discussed above that ensure a sustained demand for healthcare equipment. The defensive nature of the sector overall as it is largely unaffected by economic environment, due to the indispensable nature of healthcare as a service to people. Strong Balance Sheet of the companies in the sector along with an increasing amount of cash returned to shareholders. The Affordable Care Act which will ensure previously uninsured people get access to healthcare thereby ensuring steady domestic demand as well. INVESTMENT NEGATIVES The medical devices excise tax will negatively impact profit margins and also lead to spending cuts on R&D. The tax also makes it difficult for small companies to pursue a product or innovation idea. Firms in this sector have sizeable operations outside the US. In the global economic uncertainty relatively low margins on conventional medical products could be entirely decimated by unfavorable currency movements. VALUATION When evaluating specific companies within the industry, we will be particularly interested in and pay a close attention to those with a rich and diversified portfolio of products. Examining the R&D expenses as a percentage of sales and benchmarked against the industry average is a good indicator. Also firms that are market leaders in niche and underserved markets with high margin products are of particular interest as they have the pricing power and can also focus on rapid innovation because of their focus. It will also be important to look at the scale of their operations globally and understand if with their economies of scale would give them an edge. While geographical diversity is also important, in the near term we are wary of firms that generate sizeable revenues areas of volatile currency movements. Overall attractive investments in this sector include Baxter and Johnson & Johnson primarily because of their low price earnings ratio, geographical and product diversity and high dividend yield. KEYS TO MONITOR 1. FDA s changes to the 510(k) review or filing process for medical devices and also EU s. 2. Any additional regulations/taxes levied on the Medical products. 3. R&D expenditures and productivity at an industry level. 4. Managements proven track record to make strategic and sustainable revenue decisions. 5. Analysis of any major producers new strategic alliances with smaller start-ups for R&D and distribution REFERENCES 1. All index price data from 2. Sector definition from IBISWorld Industry Report 33911a Medical Instrument & Supply Manufacturing in the US 3. The New York Times: Page 9

10 onditionsandhealthtopics/health_insurance_and_man aged_care/health_care_reform/index.html 4. S&P Capital IQ: Industry Surveys Healthcare: Products & Supplies 5. Harris Williams Investment Bank report: ustry_reports/orthopedic_industry_overview_ pdf 6. Wikipedia: Gallup: 9. Global Medical Device Industry Outlook for 2015 by Emergo: AdvaMed s June 2014 report: US Census Bureau: United Nations Population Division, World Population Prospects. 13. Ernst and Young: Pulse of the industry report 2014: statistics on top 10 worldwide orthopedics companies: IBIS World Industry report on Surgical Equipment Manufacturing. ports/us/industry/default.aspx?entid= Fierce Medical Devices website: Bloomberg Medical Device Earnings Intelligence Report summary: 15/siemens-cheers-euro-slump-as-emerson-seeks-toease-dollar-sting Henry Fund reports are created by student enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa s Tippie School of Management. These reports are intended to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report. IMPORTANT DISCLAIMER Page 10