SYS-CON MEDIA Authors: Pat Romanski, Nikita Ivanov, Yeshim Deniz, Elizabeth White, Sean Houghton

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Zacks Industry Outlook Highlights: Zimmer Holdings, Medtronic, Covidien, Stryker and Smith & Nephew

CHICAGO, Aug. 27, 2014 /PRNewswire/ -- Today, Zacks Equity Research discusses the MedTech, including Zimmer Holdings (NYSE:ZMH-Free Report), Medtronic Inc (NYSE:MDT-Free Report), Covidien plc (NYSE:COV-Free Report), Stryker Corporation (NYSE:SYK-Free Report) and Smith & Nephew plc (NYSE:SNN-Free Report).

Zacks Investment Research, Inc., www.zacks.com

Industry: MedTech

Link: http://www.zacks.com/commentary/34109/

A confluence of several factors over the past few years has created ferment in the medical device market the world over. The investment climate for the medical device majors has become increasingly difficult due to the global economic downturn resulting in growing regulatory and budgetary pressures, cost escalation and resource constrictions.

The medical devices industry, which was once acclaimed for its high-paying jobs and research and development opportunities, has been subject to the much controversial 2.3% medical device excise tax since its enactment beginning 2013. Sequestration-related spending cuts have also undermined the medical devices industry's prospects. In fact, this has significantly hindered the industry's bottom-line improvement last year.

Does the 2015 HHS Budget Set a Positive Trend?

Healthcare spending has been projected to grow at a rate of 5.8% from 2012 to 2022. However, with the sluggish economic recovery, difficult capital spending environment and weak growth for Medicare and Medicaid, the growth rate in 2013 was pretty low.

However, the $1 billion or 3.5% boost to its fiscal 2014 budget, from the prior-year post-sequestration level, received by the National Institutes of Health (NIH) comes as a slight reprieve. Appropriators say that this hike, though insignificant, is expected to result in 385 million new grant opportunities for researchers compared to 2013. We note that the sequestration, which resulted in a 5.5% cut in the NIH fiscal 2013 budget, led to 640 fewer grants last year.

Apart from NIH, the National Institutes of Standards and Technology, The National Science Foundation (NSF), health professions and nursing workforce development programs are some of the others to gain from this bill in 2014. The U.S. Food and Drug Administration (FDA) has also managed to get $2.552 billion through this omnibus spending package, a $166 million (7%) increase over the fiscal 2013 post-sequestration funding level. The Centers for Disease Control and Prevention (CDC) received a $370 million or 6.8% increase over the year-ago post-sequestration funding level.

Nonetheless, the prospects for 2015 still remain bleak. Despite the expected improvement in economic conditions, the expansion of the Affordable Care Act (ACA) coverage and not to forget an aging population, the Budget for the Department of Health and Human Services (HHS) promises a total of $1 trillion in outlays and $77.1 billion in discretionary budget authority for fiscal 2015 – this is a reduction of $1.3 billion from the current fiscal. Going by this budget, estimated savings over the next 10 years will be as much as $355.6 billion.

However, the budget promises $4.6 billion for health centers, of which $3.6 billion has been financed by the Affordable Care Act's Community Health Center Fund, to serve approximately 31 million patients in 2015. This will lead to the establishment of 150 health centers in new areas of the country.

Besides, $14.6 billion of strategic investment will be made in three key areas: $4 billion in expanded funding for the National Health Service Corps (in addition to $100 million in discretionary funding and $310 million in current law funding for 2015), $5.2 billion for a new Targeted Support for Graduate Medical Education program and $5.4 billion for enhanced Medicaid reimbursements for primary care.

For the second time in a row, NIH managed to increase its budget funding. Although not so significant like it was in the earlier year, the fiscal 2015 budget includes $30.4 billion for the NIH, an increase of $211 million over 2014 reflecting that the government's focus on investment in advanced medical research has not been shaken even in its drive to stimulate economic growth.

For the FDA, the 2015 budget included $29 million for improving the protection of human and animal health through integrated monitoring of antimicrobial resistance. Besides, the budget added $1.5 billion, up $273 million over fiscal 2014, to boost the efforts of the FDA and CDC for implementing the Food Safety and Modernization Act. For the Centers for Medicare and Medicaid Services (CMS), the budget allocation is $897.3 billion in mandatory and discretionary outlays, a net increase of $54.3 billion above the previous fiscal.

Real Picture Remains Cloudy

Even more than six months after the Senate passed the Omnibus Appropriations bill, the research funding scenario does not look very encouraging. Most economists are of the opinion that with cost of research rising astronomically, the slender boost to the budget can hardly bring any respite. While the additional funding for NIH will help sustain current projects and begin funding for new research grants, this is still short of NIH's pre-sequestration budget.

NIH expects the sequestration (expected to last till 2021) to turn harsher in the coming years leading to serious consequences like delaying progress in medical breakthroughs, deterioration in job creation and tempering of economic growth. An NBC news article recently noted that many new researchers, who were trained with the U.S. taxpayers' money, may have to move to Europe and Asia where government funding for medical research is on the rise.

Moreover, the 2.3% medical devices excise tax, which is imposed on the sales price instead of net profit, amounts to a sizable sum, wiping out almost a quarter of the profit at the med instrument owners.

To weather the squall, medical device companies are coming up with efficient capital allocation and ingenuous business model innovation. In this regard, they are working on reducing fixed costs, conducting research and development prudently and extracting strategic value from intellectual property. The companies are also trying to focus on strategic mergers and acquisitions (M&A), emerging market expansion or are reducing operations in order to weather the tax burden.

M&A Activities

MedTech M&A continues unabated in 2014. Wary of an uncertain economy, MedTech giants have resorted to the acquisition route to harness their strengths and diversify offerings.

Following Zimmer Holdings' (NYSE:ZMH-Free Report) $13.35 billion mega acquisition plan of Biomet, Inc., the leading U.S. medical device major Medtronic Inc (NYSE:MDT-Free Report) came up with its plan to buy Irish rival Covidien plc (NYSE:COV-Free Report) for $42.9 billion in cash and stock. This has off late become a common ploy for medical stocks to dodge the steep U.S. corporate tax rate by shifting its tax base overseas. Zimmer, on the other hand, expects the successful completion of the Biomet acquisition to help capture the $45 billion musculoskeletal industry.

In addition to these major impending takeovers, Stryker Corporation (NYSE:SYK-Free Report) has once again made it to the headlines with rumors of its bid to acquire London-based orthopedic major Smith & Nephew plc (NYSE:SNN-Free Report) surfacing again. The investors are still hopeful and expect the acquisition of Smith & Nephew to further boost Stryker's competitive position in the hip and knee replacement market following the $1.65 billion MAKO acquisition.

Besides, Stryker closed the $375 million acquisition of Small Bone Innovations' North American assets in August and acquired the German surgical tools firm, Berchtold Holding in April. On the other hand, In May, Smith & Nephew acquired Arthrocare Corporation for $1.7 billion in order to expand its product line in sports medicines.

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