TICKERS: ARTC, DXCM, EXAC, ISRG, MAKO, NUVA, SLTM
The dart board will not help in picking medical technology stocks.
Analyst and Managing Director William Plovanic of Canaccord Genuity
focuses on the musculoskeletal/orthopedic sector, which is sensitive to
factors beyond just the unmet needs of patients. Economic and regulatory
dynamics make it difficult to predict growth in medtech, but in this
exclusive interview with
The Life Sciences Report, veteran analyst Plovanic delivers both ideas and names that could generate excellent returns for investors.
The Life Sciences Report: What is the general feeling of institutional investors? Are they positive on medtech? Are they seeing
flows of funds come in from investors?
William Plovanic: I
don't think investors are necessarily positive on medical technology,
but they are definitely looking for opportunities. Medtech has been
difficult from a macro perspective, and therefore investors have not
been focused on putting money to work in this space. Over the last year
or two it's been challenging, to say the least.
TLSR: We
had a bit of a run-up in medtech between mid-December and end of
January. My assumption was that this was part of a general market
upswing.
WJP: Over the last 12 months, a lot of companies,
especially the growth names, have traded in a range after peaking at
the end of 2010—early 2011. The stocks that did move in the sectors that
I cover were due to company-specific drivers. But as a whole, 2011 was
probably more of a consolidation year.
TLSR: So you have to be selective when you're choosing medtech stocks, is that what you're saying?
WJP:
I think you do, but I've also seen the risk trade in high-growth,
high-multiple stocks make advances. As money flows back into medtech, it
typically goes into that high-growth group.
TLSR: On the outperformers, you think momentum has been the issue there?
WJP: On the growth names, definitely.
TLSR:
What has been holding medtech back? Is it macroeconomic, larger
co-pays/annual deductibles, regulatory? What is the single biggest
factor?
WJP: All of the above. Obviously, these have
resulted in a slowdown in procedure volumes, which have changed
drastically, and that has negatively impacted these companies. On top of
that, we're looking at negative pricing in orthopedics, which used to
be a sector that realized positive pricing power, and that's
macroeconomic driven as well. Two things have really impacted the
sector, volumes and pricing. All of these factors have impacted the
growth rates and the bottom line earnings of these companies for the
past couple of years and they will likely continue to do so going
forward as well.
TLSR: The earth has really shifted under the feet of this sector.
WJP:
Right. Also, new technologies are the lifeblood of any industry, and
one of the big issues, for med tech as a whole as well as orthopedics,
is the regulatory environment. It has become more challenging and more
stringent, resulting in fewer new technologies being approved, and that
has caused growth rates to slow. That has also been one of the causes of
lower pricing. Typically, a new product allows you to gain a premium
price. If you don't have innovation and new technologies coming to
market, you can't drive price mix.
TLSR: So, companies need to innovate, but the regulatory environment is in the way?
WJP:
Companies are trying to innovate, but with more stringent requirements,
it pushes out the timelines and increases the cost of innovation.
Companies have to become more selective on what technologies they move
forward with, based on what they believe the regulatory process may or
may not be for any given project.
TLSR: Has the slowdown
in regulatory approvals been a factor related to the increasing
complexity of the technology, or is there something else going on at the
U.S. Food and Drug Administration (FDA)?
WJP: That's a
difficult question to answer. Has the complexity of the devices changed
drastically in the last four years? No, but it has probably changed over
time. Maybe the regulatory process did not keep pace with technology
advances over the past few decades, and it's finally making the changes
necessary. But we've definitely seen a much more difficult regulatory
environment.
TLSR: Bill, do you expect to see consolidation in medtech during 2012?
WJP:
We have already seen some consolidation, and given the balance sheets
of the larger companies and the lack of innovation, I would expect to
continue to see that consolidation in order to drive the top line
revenues for those larger companies.
TLSR: I assume that
investors want to play the boomer market, and that would mean largely
musculoskeletal. Of course it could also be the cardiovascular realm as
people live longer.
WJP: It could be orthopedics, cardiovascular, diabetes, obesity or aesthetics. There are many different ways to play that market.
TLSR: Are there decent margins to be had now in orthopedics?
WJP:
In the orthopedic companies that I follow, the range of gross margins
is typically from 60–80%. There are always some outliers, but that's the
range. You don't start falling down to a 50% or below gross margin
until you get into truly commoditized product lines.
TLSR: What shifts are you seeing in the orthopedic/spine industry currently?
WJP:
For total joints, the discussion has shifted away from materials and
squarely onto fit and alignment. That could be achieved via robotic
surgery, custom implants or custom cutting guides, but we've definitely
moved away from materials as the solution.
There haven't been a
lot of new technologies in the spine area, but the one bright spot is
artificial discs. I think we'll see the approval of several cervical
discs coming over the next 12–24 months. I think that can help drive
that market.
With extremities/trauma, it's been the creation of
procedure-specific implants. Customization is really a very fast-growing
market, and that's driven an increased focus on this segment. Surgeons
and companies are coming up with new products that are specifically
kitted to solve a problem. If I need a plate for a procedure, it's
specifically made for that specific anatomy rather than bending and
cutting a standard plate to make it fit. I think we've seen a lot of
those types of technology advancements helping to drive that market.
TLSR: Bill, what companies are you talking to investors about today?
WJP: Growth names include
MAKO Surgical Corp. (MAKO:NAS) in robotics; I also follow
DexCom Inc. (DXCM:NASDAQ) in diabetes with its continuous glucose monitoring sensor;
Insulet Corp. (PODD:NASDAQ) with its disposable insulin pumps; and NxStage Medical Inc in the dialysis market. In terms of value names, there's
NuVasive, Inc. (NUVA:NASDAQ) in spine;
ArthroCare Corp. (ARTC:NASDAQ) in sports medicine. And then there is
Solta Medical, Inc. (SLTM:NASDAQ)
in the aesthetics space with its non-invasive fat ablation product that
it has just started commercializing in the beginning of this year. Of
the 21 stocks I cover, those seven names are probably the most discussed
on my coverage list today.
TLSR: You have DexCom rated Buy with an $11.50 price target. It's pretty close to that now. Do you expect to raise your target?
WJP:
I believe the company is well positioned this year in terms of the
guidance it provided and the potential for it to outperform those
expectations. As companies beat and raise estimates, the price targets
can typically move up. I think the big value driver for this company
will be its Gen 4 sensor, which is not due out until the end of this
year/early next year. Again, I repeat that stocks tend to perform well
in beat-and-raise years.
TLSR: You mentioned NxStage
Medical, a growth story. It's about portable home hemodialysis. You
raised your target price from $24 to $26. This is the kind of technology
that can reduce cost for an insurer, can it not?
WJP: I
think the key to NxStage's home hemodialysis is the fact that it's a
better therapy for the patient. The economic data showing that it
reduces costs to the system will be out the middle of this year. We've
seen data from frequent dialysis studies and it tends to point in that
direction, but I think what people need to really understand is that
when nephrologists and nurses are polled, almost all, like 98–99% of
them, would rather patients be on home hemo or peritoneal dialysis
rather than in-center. More frequent dialysis allows for lower drug use,
better quality of life and quicker recovery times post treatment. It is
the right treatment.
TLSR: You say economic data are
coming out mid-year. I'm just thinking here, FDA is considering
economics along with safety and efficacy in medtech. Why doesn't FDA
just defer this to Centers for Medicare & Medicaid Services (CMS)
and judge the product on its safety and efficacy?
WJP: Great question.
TLSR: So, do you have a comment on that?
WJP: No.
TLSR: Can NxStage improve predictability for reimbursement purposes?
WJP:
That will come over time. CMS will need to do that. One other thing
about this industry is that the service providers, the clinics such as
DaVita Inc. (DVA:NYSE ) and
Fresenius Medical Care (FMS:NYSE ),
are the gatekeepers. They're the ones that get reimbursed and they
basically control which therapy the patient goes on. So at the end of
the day, you get predictability when payers know exactly what the
economic model looks like for each type of therapy, and adoption will
likely increase. I would say at this point, NxStage, which has more than
5,000 patients on its therapy, has been mostly a word-of-mouth,
grassroots campaign.
TLSR: You mentioned the robotics
company MAKO Surgical, another of your growth names. This stock is up
35% in the past three months and has almost doubled in the past 12
months. What makes it so interesting?
WJP: I believe it's
also the most expensive stock in med tech from an enterprise value:sales
multiple. Robotics has been a big value driver.
Intuitive Surgical Inc. (ISRG:NASDAQ)
was a great success, and I think people point to that company a lot.
MAKO has done a phenomenal job in the unicompartmental knee replacement
market. Historically, the challenge was surgeons being able to implant
the replacements correctly. It was very technique-sensitive. What MAKO
did was to make this procedure extremely reproducible in any surgeon's
hands. Why replace the whole joint when you can intervene earlier and
replace only the diseased part?
However, the value and the driver
of this stock over the last 12 months have been the expectations for
the hip market, which it has been slowly launching. MAKO showed the
product at the American Academy of Orthopaedic Surgeons' big conference
in the spring of 2011, and it started commercializing it at the end of
2011. I think that's what really drove the stock over the last 12
months. I think the jury is still out on how quickly the adoption and
penetration rate will be for the hip application and implants.
TLSR: You also mentioned ArthroCare, which has had its issues with the Department of Justice (DOJ). What do you have it rated?
WJP: We have a Buy rating on ArthroCare, and our target is $29.
TLSR: What do you like about it?
WJP:
The thesis on ArthroCare is it is a market leader in the two markets
where it competes. It started as a platform technology company and
created the market-leading position in sports medicine for the use of
energy for the cutting/ablating of soft tissue rather than using
mechanical tools. It now has 50% of that energy market in sports
medicine. It then utilized that beachhead to backfill with other
products that would be used in arthroscopic procedures. It also took the
technology and moved it into the ear, nose and throat (ENT) market for
tonsillectomies where it now has 40% market share. It has also done some
backfilling with some other ENT products. It's a company that has great
market leadership in the subsegments where it competes. It also has a
very high free cash flow yield, floating around 10% right now.
TLSR: But it's had the legal issues.
WJP:
The ongoing legal issues have been its biggest challenges over the last
three or four years. But it's been going through its checklist
one-by-one and ticking them off. It had almost completed that, and then a
new one popped up. We'll see how long that one takes to get resolved.
This is a company that has great market position and great potential. In
terms of acquisition, it would fit well into somebody else's portfolio.
TLSR: So it's a takeout candidate, but now it has the new issue with the DOJ which could put more pressure on the stock.
WJP:
It would delay the timing of anything, which therefore puts pressure on
the stock. That's why the stock moved from $30 down to where it is.
TLSR: Are the shareholder lawsuits nuisances, or are they material as well?
WJP:
Actually it took a charge for the shareholder lawsuits and put the
money aside for that. So, that's one of the legal issues that has been
resolved.
TLSR: I'm noting that you follow and have a Buy on
Exactech Inc. (EXAC:NASDAQ) with a target of $27. Could you speak to that one?
WJP: Exactech is actually the company I've had coverage on the longest, since March 1998.
TLSR: Your target price implies about 80% upside.
WJP:
The company trades at a significant discount to the rest of small cap
medtech. When it gets some of its new product cycle moving and growing
its top line, it will be lifting to a valuation that's closer in line
with all of small cap.
TLSR: The company appears diversified in its product lines, and I thought that was interesting considering its small market cap.
WJP:
The challenge with these smaller companies is that orthopedics is a
capital-intensive business, and they tend to have very low free cash
flows. All their money needs to be reinvested into instruments to help
grow the business. So orthopedics is definitely a business of scale, and
scale could be $1 billion (B) in revenue, but it's difficult to get to
that $1B because share shifts very slowly.
TLSR: You mentioned one of your value names, NuVasive, and you have it Buy-rated with a $21 target.
WJP:
NuVasive is a stock that we've covered for probably three or four
years. We went negative on it with a Hold rating about a year and a half
ago. We foresaw a lot of the challenges coming in the spine market,
including price and procedure-volume impact. At current valuations, we
recently upgraded it. Given the acquisition of the neuromonitoring
business, we felt that this stock was finally positioned where it could
meet or exceed expectations. We felt that if approval of its cervical
disc and the cross-selling efforts with neuromonitoring could come to
fruition that it would be all upside to the numbers. Upside tends to
drive stock higher. Given the current valuation, which is anywhere
between 1–1.5x enterprise value:revenue, that tends to be a bottom for
these names. On top of that, NuVasive is the category leader. It created
the lateral procedure where it leads the market. It is considered the
best player with that technology, and that is a great asset in my
opinion.
TLSR: Insulet is one of your growth names. Would you comment on that?
WJP:
Insulet is an interesting technology. It is the first player to market
with a three-day, disposable insulin pump. It's another company like
DexCom that has had challenges with new products coming through the FDA.
Its next-generation disposable pump is a very promising technology, and
should help more from a profit and loss standpoint than anything else.
It's a little smaller, and it might be a little more applicable to a
broader patient population as a smaller patient can wear it. But I think
this is more of a gross margin story, allowing it to increase from a
50% level to, say a 65–70% gross margin. We have Insulet rated Buy, and
the target is $27.
TLSR: You mentioned Solta Medical in the aesthetics space.
WJP:
Solta really pioneered fractional laser technology, Fraxel, for skin
resurfacing and also the use of radiofrequency energy for skin
tightening under the Thermage brand. Solta is different from the rest of
the aesthetics pack in that a large component, more than 50% of its
business model, is disposables, which is significantly higher than any
of its energy device competitors. Those disposables carry ~90% gross
margins. The reason we like it that it is literally in the first inning
of a new product cycle in a new market with a different technology to be
sold to its current customer base. It acquired Liposonix, a noninvasive
fat ablation product. It is second to market in this category, and it
just began commercializing the product at the end of 2011. We'll see the
first significant revenues from this product in Q112. Non-invasive fat
ablation is a very fast-growing segment of the market.
TLSR: These procedures are largely non-reimbursable.
WJP: They're all cash out of pocket.
TLSR: Bill, I enjoyed speaking with you.
WJP: Thank you very much.
William Plovanic
joined Canaccord in 2007 as managing director, medical technology
equity research analyst. He has been a publishing sell-side analyst with
coverage of medical devices for over 15 years. Mr. Plovanic's areas of
coverage include orthopedics, diabetes, obesity, neuro-technologies,
dialysis, aesthetics and general surgery. In 2009, Plovanic was ranked
as the #2 Earnings Estimator for Health Care Equipment & Supplies by
Starmine. Furthermore, in 2003 and 2004, Mr. Plovanic was selected as a
Wall Street Journal
"All Star" Analyst in the medical device
sector and in 2002 was named the #1 ranked analyst by Starmine for stock
picking and performance in the medical technology sector. Mr. Plovanic
is a frequent presenter at medical and industry meetings. Prior to
Canaccord, Plovanic was a managing director and senior research analyst
at First Albany (now Gleacher & Company). Previously, he worked at
PMG Capital covering medical devices and products. He also worked as
director of research for the capital markets division of LaSalle St.
Securities Inc., where he focused on the small-cap healthcare,
technology and biotechnology industries. He graduated from Bradley
University with a Bachelor of Science in finance and is a chartered
financial analyst.
DISCLOSURE:
1) George S. Mack of
The Life Sciences Report conducted
this interview. He personally and/or his family own shares of the
following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of
The Life Sciences Report: None.
3)
Bill Plovanic: I personally and/or my family own shares of the
following companies mentioned in this interview: None. I personally
and/or my family am paid by the following companies mentioned in this
interview: DexCom, Insulet Corp. and TranS1 are investment banking
clients of Canaccord Genuity Inc. Additional information, including
disclosures regarding all securities under research coverage, is
available at Additional information, including disclosures regarding all
securities under research coverage, is available at
http://www.canaccordgenuity.com/en/ODD/pages/disclosures.aspx. I was not paid by Streetwise for participating in this story.
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