Medical Device Link.

Ironically, the heady price performance of the group comes at a time when reported sales growth is subpar. While unit dynamics appear to be tracking secular growth of 10%, reported sales growth has slowed from 1999's 14% gain (which was abetted by several large cash acquisitions) to just 6% in 2000, as weak foreign currency rates have trimmed immediate top-line momentum by 2 to 3 percentage points. However, earnings are still expanding at a midteens rate due to hedging activity and a hefty dose of one-time expenses (costs related to a company selling or buying assets, expenses tied to layoffs, etc.).

As evidenced by lackluster third- and fourth-quarter earnings, the U.S. economy appears to be slowing. Indeed, Merrill Lynch's economic team expects earnings growth for the S&P 500 to slow from 11% in 2000 to just about flat in 2001. Historically, the demand for medical devices has held up well in times of economic slowdown. In the early part of a slowdown, healthcare utilization has typically increased as folks scurry to get elective procedures done while they still have insurance coverage.

But with a lingering currency hit, medical technology sales growth is likely to remain in the single digits in 2001, which will mitigate upside earnings per share (EPS) surprises. Nevertheless, given the slowing economic backdrop, 13–15% EPS growth in 2001 for the medtech universe could be nearly three times the anticipated S&P 500 earnings growth of 5%—the best relative showing since 1998.

In the face of the slowing economy, the Federal Reserve may elect to ease interest rates, which may arrest, or even reverse, the recent strength of the dollar. The euro's average value of 86 cents from October through December 2000 is roughly 16% below exchange parities of a year ago. But with the euro currently trading at around 90 cents, the currency impact dissipates dramatically and comparisons could turn positive by the fourth quarter of this year (see Table II).

Euro exposure for Merrill Lynch's medtech universe varies dramatically, as illustrated in Table III. Big-cap companies Becton Dickinson (BD; Franklin Lakes, NJ) and Baxter (Deerfield, IL) top the list with 50 to 55% of international sales denominated in euros. But BD has hedged with options, which will limit potential upside if the euro strengthens, while Baxter has not hedged (although the temptation to do so now must be enormous). Thus, Baxter may have more EPS upside if the euro strengthens.

Major Themes

Some stocks in Merrill Lynch's medtech universe have exposure to major technology developments that could have significant investment implications in coming years. These technologies include recombinant Factor VIII (rFVIII), a blood protein that helps restore the clotting cascade in hemophiliacs, and pathogen inactivation systems to improve the safety of blood transfusions, biventricular pacing, and implantable defibrillators for the treatment of heart failure, coated stents, spinal implants, and orthobiologicals.

Transfusion Therapy Safety. Merrill Lynch continues to forecast 15% growth for the $1.5–$2 billion Factor VIII market, driven by 5–6% annual patient growth, a shift to safer and higher-priced recombinant products, and increased prophylactic dosing. Indeed, the recombinant portion of the market could compound at an estimated 20% through 2003 (to $2.4 billion). Baxter is the best way for investors to participate in this market growth, given recent approvals of its second and third rFVIII manufacturing facility.

And just about the time when growth from the bolus of new rFVIII capacity will start to wane, Baxter and its development partner, Cerus (Concord, CA), should launch a pioneering new technology for pathogen inactivation of blood components. Baxter has exclusive worldwide marketing rights to Cerus's Intercept pathogen inactivation systems that target platelets, plasma, and red blood cells. Cerus was recently upgraded to buy/buy status as a result of experts' increased conviction in favor of pathogen inactivation after hearing a presentation on solid Phase III European platelet data at the American Society of Hematology (Washington, DC) meeting last November.

All told, pathogen inactivation systems represent a $1.5–$2 billion market opportunity. The first platelet pathogen inactivation system from Baxter and Cerus could be on the market in Europe by late 2001. Longer term, the approval of a red-blood-cell system (which represents the lion's share of the transfusion market) in late 2003 or early 2004 could dramatically impact the revenue and earnings profile for Cerus and could be a key long-term driver for Baxter's bioscience business.

Biventricular Pacing. Premarket approval (PMA) applications for the first biventricular pacing devices for congestive heart failure patients will be filed in early 2001 and could garner FDA market clearance by the end of the year. While initially there will be a healthy debate about the long-term effects of this new therapy, the immediate physiological benefits (increased ejection fraction and exercise tolerance) are profound. Investor enthusiasm should mount as clinical data are presented at meetings of the American College of Cardiology (Bethesda, MD) in March and the North American Society of Pacing and Electrophysiology (Natick, MA) in May. Merrill Lynch pegs the market potential for biventricular pacing devices at nearly $500 million by 2003. Guidant (Indianapolis) and Medtronic (Minneapolis) should both file PMA applications in early 2001.

Nearly 5 million Americans suffer from heart failure. If just an additional 8000 people underwent an ICD implant each year, market growth could accelerate from the 20% vicinity to nearly 30% annually, which could add another $500 million or more to industry sales by 2003. And if ICDs are shown to provide a significant mortality benefit in congestive heart failure patients, the emerging market for biventricular pacing devices is likely to migrate to devices with an ICD backup, such as Guidant's Contak CD and Medtronic's InSync ICD. This overspill could push biventricular pacing prices to the upper end of a $10,000–$30,000 range.

Given the profound impact that heart failure patients could have on the ICD market, investors should have some exposure to this market with stocks such as Medtronic, Guidant, and St. Jude Medical (St. Paul, MN). Wilson Greatbatch Technologies (Clarence, NY), which provides batteries and capacitors for ICDs, is another way for investors to gain exposure to this market.

Johnson & Johnson (New Brunswick, NJ) has categorically emerged as the front-runner in the coated stent sweepstakes. The company started an 1100-patient, 55-center U.S. study in January. In Europe, enrollment is about 50% complete in a 220-patient study. In addition, Boston Scientific, Cook (Indianapolis), and Quanam Medical Corp. (Santa Rosa, CA) are also in clinicals in Europe with paclitaxel or a Taxol derivative.

Guidant and Medtronic appear to be lagging in the coated-stent race. But one of these companies may be able to jump-start its internal program by acquiring Cook, a private company with sales approaching $500 million, whose owner is apparently exploring the possibility of selling the company. In our view, the favorite to acquire Cook would have to be Medtronic for two reasons. First, Medtronic's own coated-stent program seems to be fairly far behind. Secondly, Medtronic's hefty multiple and cash hoard provide ample firepower to outbid other players. But a possible Guidant win cannot be ruled out, since Cook is an Indiana-based company. And with 30% of sales and 40% of profits coming from stents, Guidant stands to benefit the most from a secular change in industry prospects if it can get in the game.

Investors looking for exposure to this market should buy Stryker Medical (Kalamazoo, MI), which is the leader in developing next-generation orthobiologicals. Its OP-1 is a bone-growth factor that appears to work by recruiting and activating cells that would normally form cartilage or bone. The product passed a second European regulatory review in December. And while the U.S. regulatory path is less clear, FDA marketing clearance is still possible in 2001.

Medtronic is also in the hunt and could be the first company to file for a spinal indication with its bone growth factor, rhBMP-2. A PMA filing is possible by midyear. Next-generation recombinant products could boost the market for bone grafts and orthobiologicals from less than $200 million in 1999 to approximately $500–$700 million by 2003.

Annual sales growth for the companies in Merrill Lynch's medtech universe have averaged 8%, and revenues now approach $95 billion, nearly two-thirds of the estimated $160 billion worldwide medtech market. These companies should continue to do well in the months to come, representing significant opportunities for investors in an otherwise volatile marketplace.