The Healthiest Play in Medical Devices


By Amy Tsao Investors are probably wondering whether the recent stock-price declines of some medical-device outfits signal a pullback for the sector. Delays in product development and lackluster trial results have sent some players tumbling in recent weeks. Could the fires fueling the medical-device sector be burning out?

Not likely, the experts maintain. Perhaps the temperature is due to cool a little, but thanks to strong demand for implantable cardiac defibrillators and drug-coated stents, a sectorwide downturn isn't in the cards, says Steve Paspal, senior research analyst at Sovereign Asset Management, a subsidiary of John Hancock Funds. "We won't see a secular slowdown, though the group won't be growing as strongly as before," he says.

THE LONG HAUL. For those investors who want a stake in health care, devices may well represent the best spot. While the outlook for drug companies remains clouded by various growth-stunting problems, Standard & Poor's predicts average annual earnings growth of 16% to 18% for device makers in 2004, vs. 10% for the pharmaceutical industry.

True, it's likely not the best time to load up heavily on the sector, says Eric Thorne, portfolio manager at Bryn Mawr Trust Wealth Management, who notes that investor enthusiasm has driven up many device stocks. "We've been through a period where investors have chased the growth rates," he says. "Our strategy has been to continue to be in the area, but pare back as positions get too large. We want to have a bet, but we don't want to be overly aggressive." (Thorne doesn't own stocks in the sector personally.)

Investors may benefit most by looking to long-term bets. Paspal's firm has a strategy of investing only in companies with five-year records of rising dividends. By those rules, it owns Medtronic (MDT), diversified health-care giant Johnson & Johnson (JNJ), and orthopedics specialist Stryker (SYK).

TEMPORARY ADVANTAGE? When it comes to predictable and stable growth, Medtronic is the outfit analysts most often mention. Despite a recent stumble, when the trial results it announced for an experimental drug-coated stent proved to be less impressive than those presented for similar products by Boston Scientific (BSX) and J&J, Medtronic's diverse business lines likely shield it from any steep declines if the stent doesn't fully meet expectations. "We think it can show annual earnings growth of 15% to 16% over the next five years," says Mark Davis, equity analyst of Tradition Capital Management. Over the next 12 months, he believes Medtronic can rise to $57 -- a tidy gain on the closing price of $49.22 on June 17.

That kind of growth is likely less certain with the other device makers, which Davis notes are all smaller and less diverse than Medtronic. Consider Boston Scientific, which is expected to enjoy spectacular gains in the next couple years, thanks to the recent U.S. approval of its Taxus drug-coated stent. However, when rival players catch up and begin competing in that market, Boston Scientific's advantage will be considerably diluted, Davis says.

Thorne agrees that Medtronic's growth may prove to be slower than that of other stocks in the field, at least in the short term, but he also notes that rivals can't match its diversified product line. As he puts it, Medtronic is "the IBM of the medical-device industry" -- a core holding that performs over time.

STRENGTH IN DIVERSITY. The latest stumbles at smaller companies are more worrisome, analysts say. In the case of Guidant (GDT), shares came under pressure at the end of May, when it disclosed that Future, its drug-coated stent, could be delayed by six months due to unspecified problems. The stock has since rebounded some, closing at around $57 on June 17. Despite the stock price being well below the 52-week high of $73 hit in March, analysts remain wary -- and, once again, the reason is familiar. "Guidant is not as diversified as we'd like to see," says Thorne, who adds: "We haven't come around to it yet."

For other names, valuation is probably the bigger problem. St. Jude Medical (STJ), which gets most of its revenues from implantable cardiac defibrillators, has been one of the sector's biggest climbers, as such products have become widely used. After it announced a short delay in the Food & Drug Administration's review of its next defibrillator, the stock dipped briefly but quickly regained its footing. As of June 17's close, it was $76.90, just shy of the 52-week high it achieved on June 9. At a forward price-earnings ratio of 28 times 2005 earnings, St. Jude may be due for a break, and UBS analyst Dave Lothson, whose target price is $65, recommends selling.

The medical-device sector still has plenty of heat, but investors would do well to be choosy. While you might find faster and greater gains from the one-product-wonder companies, that lack of diversification in their product lines also boosts the risks. Tsao covers the markets for BusinessWeek Online in New York


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