Top Medtech Analyst Points to Post-Obamacare Opportunities

Source: George S. Mack of The Life Sciences Report  (9/6/12)

http://www.thelifesciencesreport.com/pub/na/14282

New product visibility is vital in medical device stories. Without something new to show physicians, there is no way to get through the door. Medical Devices and Outsourcing Services Analyst James Terwilliger of The Benchmark Company looks for investments that will pique the interests of cardiologists, orthopedists and long-term care facilities. In this exclusive interview with The Life Sciences Report, Terwilliger shares the names of companies poised to grow as the economy rebounds over the next two years.

The Life Sciences Report: You have worked in the big medical device industry at Johnson & Johnson (JNJ:NYSE), the grandfather of medical technology companies, as well as at a small medical device company. You know this industry inside and out. What are the headwinds facing medtech today?

James Terwilliger: The biggest headwind facing the healthcare industry as a whole, including medtech, is the economy. In the 2008-2009 downturn, we saw procedural volumes stop growing in the U.S. for the first time in years. As investors, we have always said that healthcare represents defensive growth-and it is defensive growth, but discretionary healthcare is also in the mix, and certain procedures can be delayed. Non-emergency orthopedic procedures, where people have pushed hip and knee replacements out 6, 9 or 12 months, are an example of discretionary care. Once people came under financial pressure and began losing their jobs and health insurance, they cut back across the board, including spending on discretionary healthcare. They are delaying surgical procedures as long as possible. We used to look at 4-8% growth in procedural volumes, but now we are looking at 0-3%. I would say that's the biggest headwind.

There are a couple of things I would add. The biggest driver of the industry is going to be new product visibility. We haven't seen significant new products, as we have historically. Looking backward, new products like heart stents came on the market, followed by drug-coated stents. In orthopedics, you had ceramic-on-ceramic hips. You had replacement extremities. But recently we have not seen breakthrough, blockbuster new products that can transform an industry.

Another headwind is the Patient Protection and Affordable Care Act (ACA/Obamacare), which has been in the headlines for quite some time. No one is 100% sure what the program will look like ultimately. Challenges to the law went all the way to the Supreme Court, which put a cloud over healthcare as a whole from an investing standpoint. The industry's macro headwind might be Obamacare, because of the lack of visibility looking into the future.

TLSR: I'm not trying to be Pollyannaish here, but everything you have said indicates we are still in a weak period in medtech. Could this make for strong comparisons (comps) in a year or two?

JT: Absolutely. That is why we should stay invested and continue to look at these stocks. You are 100% correct in recognizing that, if you take into account the easy comps that these companies have today, and then factor in the biggest driver for the investment thesis in this space, which is an aging population, we believe the turnaround could be very, very significant on the other side of this downturn. When these companies beat the easy comps, and when we see the return of the historical 4-6% growth rate in surgical procedures, that will represent significant increases in value.

TLSR: Does that portend earnings surprises?

JT: Yes, but I don't think there will be surprises on the upside in the near term. In fact, we have taken a very cautious stance in H2/12, and into 2013, because the European slowdown is just beginning to hit a lot of healthcare companies. It hasn't hit U.S. healthcare companies yet because we are a little bit defensive.

TLSR: What does a small medical device company have to do to succeed in this environment?

JT: That is a catalyst question. Our investment thesis focuses on a couple of catalysts. We look for companies launching new products. They don't have to be blockbusters, but new product visibility is key. What was driven into me at Johnson & Johnson was that a new product is something that medtech sales staff could talk about with clinicians. Face time with physicians is hugely important, because a new product doesn't drive new business itself. It also puts the medical device sales force in a position to do product pull-through with other products.

TLSR: What factors and features do you look for when you look for stories that can make money for investors?

JT: I look for a good balance sheet, a good cash and net-debt position. I look for dividends. I look for stock buybacks.

The balance sheet can truly represent the history of the company. When we had the downturn in 2008-2009, the only stocks that held value were those that had very, very strong balance sheets. When a company has cash and low net debt, it does not have to approach a bank for a loan. The company has the ability to buy back stocks, pay a dividend or acquire another company. With small companies, I also look for good management teams that can grow and execute.

In this current environment, I encourage investors to look at companies doing more business in the U.S., not less. Back in 2008-2009, companies going global were attractive. That's all anyone was talking about at the time. Now Europe is in trouble, and Asia is slowing down. Here in the U.S., we appear to be pulling out of the downturn. We are coming back faster than some of the emerging markets.

Investors also must look at the question of valuation. You can have a great company, but the stock may be too expensive. You can also have a good company with stock that is dirt cheap. Valuations are extremely important when you are selecting companies.

TLSR: You follow outsourcing services. What is your investment theory here? What are the global drivers feeding this industry?