Medical Technology
No Quick Fix: Orthopaedics
Has Secular Challenges;
SYK at UW, ZMH at EW
The fundamental drivers of orthopaedics are in
secular decline, preventing a return to historical
growth rates and valuation as cyclical factors ebb.
Economic headwinds have exacerbated these declines
but growth may not rebound to prior levels even as these
headwinds recede. We see industry growth returning to
4-6%, below historical and consensus growth of 8-10%.
Our ratings and below-consensus forecasts reflect our
cautious view on the orthopaedic industry.
Factors driving our cautious long-term view:
(i) Our analysis indicates volume growth peaked in
2004 and has since returned to long-term average. As
the industry reaches maturity, price and mix will become
more challenging while the battle for market share will
intensify. Spending on R&D, surgeon training, and
marketing will need to increase to drive share and
volume albeit at lower margins. (ii) We see recent
declines in R&D having ripple effects on product mix
that are magnified by cyclical factors clouding R&D
returns. (iii) Economic weakness and the prospect of
hospital payment reductions are likely to continue to
erode price but we see near-term declines as
manageable. Reform risk remains underappreciated
and recon is less insulated from reimbursement cuts,
bundling, and price transparency than other devices.
Extremely negative sentiment may provide
short-term tactical upside. Consensus turned
negative in 4Q08 but data indicate volume, price and
mix deterioration began in 2004 suggesting the group is
a consensus negative trade. ZMH boasts the lowest
valuation in our coverage (9.5x 2010) such that any
signs of stabilization can drive greater near-term
outperformance. SYK, while clearly better positioned
long term, is exposed to both headwinds in recon and
hospital capital spending, implying greater short-term
pressure.