Medical Device Makers' Sad Tale

By Tony Daltorio - May 21, 2012 | Tickers: BSX, MDT, SNN, ZMH | 0 Comments

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Medical cost inflation is an everyday fact of life for most Americans. So you would think most companies in the medical field are raking in the money. But not so for the sprawling $300 billion medical device industry...an industry that is becoming ever more important in improving the quality of life and prolonging it for people around the globe. 

Profit margins for medical device manufacturers continue to shrink under increasing pressure from economic austerity in developed nations and tougher regulatory scrutiny from both US and European regulators. Hospitals and health insurers are also carefully scrutinizing the value of medical devices as they seek to control costs. 

In addition, there is another reason for the industry's falling profit margins (price erosion of 3%-4% a year), at least according to the CEO of Smith & Nephew PLC ADR (NYSE: SNN), Olivier Bohoun. He says the industry has failed to innovate. That is, to come up with new products that will command higher prices. He firmly believes that healthcare providers would be more than willing to pay higher prices for devices that will save them money in the long term. 

His comments should certainly resonate among other companies in the industry including Medtronic (NYSE: MDT), Boston Scientific (NYSE: BSX) and Zimmer Holdings (NYSE: ZMH). All of these firms are becoming more and more dependent on government reimbursements for much of their revenues and are being hurt by cutbacks. For example, Medicare spending now accounts for more two-thirds of US revenue for many device makers. 

Stocks in the sector, including Zimmer and Boston Scientific, tumbled sharply last winter when fears of audits by state Medicare officials of medical procedures in several large states surfaced. Both companies are heavily dependent on the procedures named at the time to be investigated and on government reimbursement in general. And for Medtronic, fully half of its US revenues come from government reimbursements. 

These companies' profit margins may become even more constrained next year when there will be some mandatory changes in their practices brought about by President Obama's healthcare plan. Some of the changes include disclosure of any “consulting” fees made to surgeons and the end of royalty payments to surgeons on medical device inventions they made and sold to medical device makers. 

But rather than innovate, many in the industry would rather complain about government policies. Take Medtronic, the world's largest medical device maker by sales. Its CEO Omar Ishrak said last fall that the problem lies in the US government's approval process for medical devices and the length of time it takes to get approval from the Food and Drug Administration (FDA). 

Mr. Ishrak recommends the European approach to approvals which allow new medical devices to reach the market 18 to 24 months sooner than in the United States. He does have a point. The slowness in FDA approvals has pushed most clinical trials of new devices to Europe. More than half of the clinical trials now occur in Europe and between 2004 and 2010 more than half of devices were first approved in Europe, before being later approved in the United States. It is also important to mention that there has not been seen a greater number of safety issues with devices approved in Europe. 

A speedup of the approval process by the FDA will certainly help these companies. But Mr.Bohoun of Smith & Nephew is right, there has been a failure to innovate over the past several years. Many of the companies have grown lazy, feeding off of government largess. 

So what should investors likely expect from these companies? Probably more of the same underperformance. However, orthopedic specialists such as Zimmer and Smith & Nephew should continue to outpace the companies in the pacemaker/defibrillator and stents segment like Medtronic and Boston Scientific. 

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