Smaller players who have higher costs of production and lower R&D budgets will increasingly struggle to compete with the big players. With that said, we typically steer clear of “mega” deals until they have had plenty of time to be digested by the acquirer. There are too many potential surprises that we simply cannot forecast but have shown to destroy shareholder value historically.
The Covidien deal aside, the medical devices market is extremely competitive and sensitive to government regulation.
Most medical device markets are fairly ruthless despite some of their high-tech innovations. Products generally have short life cycles, are notoriously price-sensitive, and require constant R&D to maintain their market share. In other words, investors wouldn’t want to be involved with companies that are dependent upon a small portfolio of products for their earnings!
Fortunately, MDT has meaningful scale ($28 billion in sales), strong market positions in its key segments, and a highly diversified product portfolio. Even still, the company had to reduce prices meaningfully during 2010-11 as the economy was slow to recover from the recession.
Government regulations such as the Affordable Care Act will continue to impact the U.S. medical device industry as well (MDT generates over half of its sales in the U.S.). Medical device manufactures have been assessed a 2.3% excise tax on revenue since 2013, reducing profit growth and limiting future returns. It also seems likely that the government will continue tightening standards for medical device reimbursements in an effort to contain healthcare costs.
The good news is that U.S. healthcare reform has significantly expanded coverage to a broad range of patients over the last two years. Around 17 million Americans have gained health insurance since September 2013, resulting in a meaningful increase in procedure volumes and strong domestic demand for many of MDT’s products.
However, as we have previously discussed, trees don’t grow to the sky. According to a report by Fitch, hospitals are seeing the tailwind from the Affordable Care Act start to dissipate. Even MDT’s management team acknowledges that growth is likely to level out over the coming quarters:
“With respect to the overall medtech market, look we have had a – the medtech industries has actually had a pretty good year and I think a lot of that is you look knowledge is driven by U.S. growth so U.S. has been stronger than I can remember for a long time and that is not only the medtech sort of companies but also hospitals. Now as we going to sort of calendar year ’16, there will be some anniversarying that is happening and also some of the hospitals have reported slightly sort of lower growth rates, so we are watching this carefully.
I do not know to what extent the procedure growth will continue at the same rate of growth. I do not think it will slowdown, per se, but the growth rate might well slowdown. So that is what we are watching very carefully and I think coming after the next couple of months it is pretty crucial to see how procedures go, but again really at the end of the day this is a U.S story and to a certain degree emerging markets Medtech has been resilient in the emerging markets compared to other industries simply because of the nature of the industry itself that governments continuing to invest there so that has been reach the bottom really has not fallen out that all and although I think we have our performed the overall market into the market in general it has been pretty resilient. So those things holding U.S. growth is what has driven the medtech industry. I think U.S. growth will anniversary probably steady a little bit.”
Source: Medtronic Quarterly Earnings Call
If volume growth does slow over coming quarters, it could surprise some investors and potentially raise questions about the Covidien deal impacting the combined company’s top line momentum. While there probably isn’t an impact on MDT’s long-term earnings potential, it might create some near-term stock price volatility.
Overall, it’s challenging to predict what other government regulations, favorable or unfavorable for MDT, could emerge over the next 5-10 years as our healthcare system continues evolving.
