Why Medical Device Stocks Are Outperforming and May Continue

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Although the Affordable Care Act will implement a much underreported 2.3% tax on medical device manufacturers, industry stock returns have outperformed broader indices in the recent year. From strong innovation to growing markets, reward still tends to outweigh risk. In deciding which medical device company is the right investment for you, I recommend looking at how the company is responding to competition and whether it is building a coherent product portfolio around a target market. Below, I review three stocks engaged in the business.

Why You Should Buy Baxter International (NYSE: BAX)

Over the last six months, Baxter's stock has risen 28.8%, an outperformance of 2,160 bps over Covidien (NYSE: COV), off of strong data. In general, the company has held up well by virtue of going after lethal conditions that are less vulnerable to lower healthcare spending compared to the target market of peers. Baxter has continued this path through securing a partnership with Onconova Therapeutics, wherein Baxter would gain European commercialization rights to rigosertib in return for an upfront $50 million payment. Rigosertib is a late-stage candidate that treats rare blood malignancies and pancreatic cancer. It is a product that reflects the medical device maker's core high-risk and blood markets.

Baxter's main catalyst comes from data relating to BAX 326, a treatment for hemophilia B. Hemophilia B effects 25,000 individuals worldwide, and it is currently addressed by only one recombinant protein. BAX 326 is a prophylactic treatment that widens consumer options with reliable results: In a Phase I/III trial, 43% of patients taking the orphan-status drug did not bleed afterwords. Further, Biogen's late-stage hemophilia drug candidate won't overthrow Baxter's Advate, the market leader, any time soon, since consumers are unlikely to switch drugs for such a debilitating disease. In any event, data for Biogen's product is most favorable for addressing spontaneous bleeding episodes, which represent just a fourth of Advate's domestic sales. So, dissipating fears over this supposed headwind have lifted shareholder value for Baxter.

When you add in the company's $4 billion takeover of Gambro (announced on Dec. 7), Baxter is clearly building upon its core business and not dabbling in irrelevant activity. This deal, the largest yet, provides the medical device company with an estimated $300 million in annual synergies a year until 2014 and accretion after around 2014. Baxter trades reasonably at 16.2x past earnings and is near an all-time high. While I think the stock has limited upside (the Dec. 18 report by RBC Capital Markets has a $70 price target), downside is limited in light of the above-mentioned catalysts. For stronger upside, I encourage buying Covidien, which trades at only 14.7x past earnings despite a more bullish outlook on the Street.

A Symple Buy for Medtronic (NYSE: MDT)

If you are looking for more exposure in medical devices, Medtronic may be an ideal candidate. It trades at only 13.7x past earnings and is forecasted for 6.5% annual EPS growth over the next five years. While the immediate growth and 2.5% dividend yield are not enough to provide outperformance, the catalysts' long-term prospects are…

One main catalyst comes in the form of a renal denervation system called "Symplicity." Renal denervation involves a minimally invasive catheter that is inserted into a renal artery and produces radiofrequency pulses to mitigate sympathetic responses. The nerves are effectively ablated to reduce hypertension, a condition that affects north of 42 million individuals. On Dec. 17, Medtronic released 1-year data for its Symplicity, and consumers who used the product showed a drastic blood pressure drop (-28/-10 mm Hg [p<0.001]) compared to the baseline at 12 months. No serious adverse events were reported. An earlier feasibility study showed that all nine patients treated with the system had a 100% cure success rate in administering therapy. 

Symplicity may be the main catalyst, but there are several other growth drivers. For example data concerning the company's CoreValve heart implant product showed an improvement in 1-year survival rates and quality of life. The purchase of China Kanghui Holdings for $816 million represents yet another opportunity. This target produces orthopedic implants and effectively gives Medtronic access to thousands of hospitals in an emerging market.

Medtronic is also a solid investment for its ability to create value. The company has a 14.4% return on invested capital, which is roughly 290 bps greater than the industry average. Stronger margins and a much lower P/B ratio (2.5x versus 3.6x) compared to peer averages only add to the upside.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Medtronic and has the following options: short MAY 2013 $44.00 calls on Medtronic. Motley Fool newsletter services recommend Covidien Ltd.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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