By Amy Tsao In many ways, health-care equipment -- hip and knee replacements, devices to prevent snoring, and pacemakers to keep the ticker ticking -- is as boring as it gets, not a sector to dazzle with fast growth or high returns. Yet in recent months, it has been sizzling. Aging baby boomers and rising demand for innovative products are lifting companies that have typically puttered along in the shadows of the sexier health-care players in the pharmaceutical and biotechnology sectors.
Led by gains in shares of large-cap, diversified device makers like Medtronic (MDT), St. Jude Medical (STJ), and Guidant (GDT), Standard & Poor's health-care-equipment index is up about 20% since the start of 2003.
The question: Can the trend continue? Analysts say more gains could lie ahead for companies whose products are in strong demand. "Sustainable long-term fundamentals are driving this group," says Deutsche Bank analyst Bruce Jacobs. "I'm not convinced we've see the last of good-performing stocks." He sees revenues in the sector growing in the low double digits, and earnings increasing by a few points above that.
STENTED GROWTH. New products to treat cardiovascular ailments have been a major boon to Medtronic, Boston Scientific (BSX), St. Jude, and Guidant. These large outfits, while clearly the sector's blue-chip names, are trading at high price-earning ratios in the mid-30s, based on expected 2004 earnings. "If they have a strong conviction in their business momentum, then I would take the risk of higher valuation," says Steve Paspal, senior research analyst at Sovereign Asset Management. Still, he urges caution on the large-cap names when they hit forward p-e ratios in the upper 30s.
Demand appears strong for drug-coated stents, considered a significant advancement over uncoated stents used to prop open arteries. Johnson & Johnson (JNJ) recently became the first company to receive U.S. approval for a coated stent. But Boston Scientific, which is expected to have its own version on the market early in 2004, may be the better stock play. Shares of Boston Scientific, at $60, have already gained 37% year-to-date, but Jacobs has a price target of $68.
JNJ and Boston Scientific have filed patent-infringement lawsuits against each other, but analysts say sales should soar regardless of the legal disputes (see BW Online, 10/11/03, "Stents Make Investors' Hearts Beat Faster"). Boston Scientific, which is awaiting final regulatory approval, says it will release safety data in September.
RICHES IN NICHES? Orthopedics, which includes replacement hips, knees, and other joints, is another growing subsector of health-care equipment, since such products will be in heavy demand as baby boomers near retirement age (see BW Online, "Biomet and Stryker: Stocks with Legs?"). All three major companies in this area -- Zimmer (ZMH), Biomet (BMET), and Stryker (SYK) -- have histories of consistent earnings growth. Biomet, however, appears the best value when looking at forward p-e's: Biomet's ratio is 23. Stryker's 28, and Zimmer's 24.
Another way to play this sector is to veer away from the large-caps stocks and look for sizable niche players. One is Varian Medical (VAR), maker of machines that irradiate tumors. It has been a strong long-term performer, growing at a steady clip and beating analysts' expectations for many consecutive quarters straight, says Jacobs. Varian has recently launched a radiation system that attacks tumors more accurately.
At $61 and with a forward p-e of 29, shares are already pricey -- but Jacobs figures it could gain a further 15% to hit his target price of $71. (Jacobs doesn't personally own shares in any of the stocks discussed. Deutsche Bank is seeking fees from Medtronic, Boston Scientific, and Zimmer.)
SAFEST BETS. Dentsply (XRAY), the largest maker of dental equipment and products, is another outfit that dominates its niche. Joseph Zock, president and portfolio manager of Capital Management Associates, sees organic growth of 6% to 8%, but with more acquisitions, earnings could grow at around 15% a year for some time.
"It's a combination of a defensive play as well as looking for long-term growth," says Zock, noting that demographics work in Dentsply's favor, offsetting any bumps caused by sluggish economic conditions. He sees the stock rising 25% over the next 12 months to 18 months. (Zock doesn't personally own Dentsply, but his fund does.)
Larger, diversified companies are probably the safest way to go in this sector. Paspal says he looks for management teams able to anticipate high-growth therapeutic areas and then make acquisitions and earmark resources in anticipation. Says Paspal: "I go into these stocks if they have a history of anticipating, are diverse, and have balance." (He doesn't own any health-equipment stocks personally. His fund owns Medtronic, JNJ, and Stryker.)
"I LOSE MY INTEREST." Paspal cautions that not all well-known names are low-risk bets. For example, at various times he has bought C.R. Bard (BCR) and Becton-Dickinson (BDX) for the fund. Lately, both companies have seen earnings growth slow down, he says, noting that each has disappointed him in the past. "They fail to get long-term commitment from investors," he says. "I look at them, get excited here and there. Every time, something slows down, and I lose my interest."
Allen Klee, small-cap portfolio manager at First Investor, also warns investors to be mindful of the typical risks associated with smaller health-care companies. By nature, they're more narrow in focus, often with just one product on the market. "It's a dicey area," he says, noting that such companies are especially sensitive to the reimbursement decisions of Medicare and other insurers, and the buying habits of hospitals and medical-equipment purchaser.
Klee's fund has shares in several health-care-equipment stocks, but his favorite for the long term is Wilson Greatbatch (GB), which makes batteries and capacitors for implantable cardiac devices. Sales of ICDs, growing at around 20% anually, are driving the strong stock performances of larger-cap device makers Medtronic, Guidant, and St. Jude (see BW, "Medtronic and St. Jude: Pumping Profits"). Wilson Greatbatch has benefited too. At close to $39 and a forward p-e ratio of 28, shares are probably fairly valued, but Klee says it should grow along with the ICD market.
Health-care-equipment stocks typically carry less risk than, say, biotechs. However, as the overall economy and corporate profits continue to show improvement, investors are likely to increasingly favor riskier, higher-growth prospects. If that happens, health-care equipment could lose some of its glow. Still, you can find some long-term winners in both the big- and small-cap universe -- despite their already respectable gains this year. Tsao covers financial markets for BusinessWeek Online in New York