Medical technology stocks of all stripes have been enjoying a pretty exceptional run in the market, as healthcare has actually been 1 of the leading sectors in the recent rally. Unfortunately for investors, however, revenue, profits, and free cash flow have not been improving at the same rate, and the number of real bargains in the market has shrunk noticeably. While there are still a few opportunities that look undervalued, investors are increasingly finding themselves faced with a limited menu of attractive options.
Want growth? Bring your wallet
Growth is always in demand in the stock market, but the relatively small number of great growth stories in the med-tech sector has created even more scarcity value. Top-end revenue growth names like Dexcom Inc. (NSDQ:DXCM), HeartWare International (NSDQ:HTWR), Endologix (NSDQ:ELGX) and Intuitive Surgical (NSDQ:ISRG) all still sport hefty valuations, and it’s likewise not easy to call stocks like Insulet (NSDQ:PODD) or Edwards Lifesciences (NYSE:EW) cheap at today’s prices.
So where has all the growth gone? For starters, the underlying economic environment is still not very hospitable. While doctor visit and patient procedure volumes have recovered, hospitals have pushed back hard on pricing and higher deductibles and co-pays have led many patients to put off or refuse procedures on financial grounds. That has created a tough environment for new products and procedures, particularly those with a price tag and/or uncertain reimbursement.
I also think that the market environment created by the recession and credit crunch a few years back could have something to do with the lack of good growth stories today. As the financial markets struggled, it became extremely difficult for unproven companies to raise funds in the IPO market, and likewise many venture capital funds found it difficult to raise money. I believe this choked off the funding to many developmental companies, leading them to either sell out to larger med-tech companies or implement much more conservative clinical and product development plans.
Quality stories no longer trading at big discounts
Even a year ago investors could shop among a pretty respectable collection of quality mid-cap and large-cap med-tech stocks trading at attractive long-term valuations. Since then, stocks like Covidien (NYSE:COV), Stryker (NYSE:SYK), Medtronic (NYSE:MDT), Johnson & Johnson (NYSE:JNJ), and Becton Dickinson & Co. (NYSE:BDX) have meaningfully outperformed the market – in many cases doubling the performance of the S&P 500 over the past year.
While there are still opportunities for these companies to improve their performance – whether from ongoing sales/market share growth (Covidien, J&J) or operational/margin improvement (Stryker, Becton Dickinson) – Wall Street has shifted from "show me" attitude to one where these companies are now largely getting the benefit of the doubt. With that performance, few bargains remain. Most of these stocks now trade within 10% of their fair values and are basically in line with long-term averages for metrics like enterprise value to sales and enterprise value to EBITDA.
It’s also worth noting that there’s a segment of the med-tech space populated by bruised growth stories that are neither cheap enough to look like values today, nor strong enough to get the attention and full confidence of growth investors. Cepheid (NSDQ:CPHD) has long been a great growth story in diagnostics space and still sports robust valuation, but sales and manufacturing missteps have led to a 20% fall from its 52-week high. Similar arguments could be made for companies and stocks like Hologic (NSDQ:HOLX) and Illumina (NSDQ:ILMN). While these companies have hardly been failures from an operational standpoint, expectations got too far ahead of reality and the stocks have languished with less-than-perfect quarterly results.
Cheap stocks seem to largely be "cheap for a reason"
Making matters worse in the sector, most of the stocks that look like bargains are trading at discounts for a reason. Many of these companies have recently reported disappointed earnings and/or revised their guidance lower. As a result, they may not even be cheap at all – should revenue and margin assumptions have to be revised even lower, the apparent value all but disappears.
Companies like Accuray (NSDQ:ARAY), Masimo (NSDQ:MASI), Mako Surgical (NSDQ:Mako) and Volcano (NSDQ:VOLC) serve as a representative sample for this market group. While Accuray has long struggled to gain share against the leaders in the radiation therapy market (Varian Medical (NYSE:VAR) and Elekta), recent manufacturing problems and a shift in the company’s sales strategy have led to significant cuts in sell-side estimates and equally significant underperformance in the stock.
Similarly, Mako’s recent performance in terms of system placements and system utilization have forced investors to reconsider this story. Once sold by bullish analysts as a "robot growth story like Intuitive Surgical", investors have had to recalibrate their expectations to a slower growth trajectory and accept that this company is unlikely to command market share in its addressable markets to the same extent that Intuitive has in robot-assisted prostatectomy and hysterectomy.
For Masimo, the primary challenges have been living up to past valuations/expectations and driving adoption of the new "rainbow SET" monitoring platform. Along similar lines, Volcano has long enjoyed a pretty robust valuation, but investors have increasingly begun to worry about the company’s ability to execute, as highlighted by a pretty significant revision to management’s earnings expectations earlier this year.
While these are just four particular names, their stories are familiar in the context of those med-tech stocks that appear undervalued today. While there are a few stocks that look like legitimate opportunities (including Medtronic and Mindray), most of the apparent bargains have a lot to prove. Companies like Accuray, AngioDynamics (NSDQ:ANGO) and AtriCure (NSDQ:ATRC) have to reestablish investor confidence that they can actually grow their revenue at a worthwhile clip, while companies like Boston Scientific (NYSE:BSX) and Volcano have to rebuild confidence that their management teams can execute on the opportunities in front of them.
The bottom line
Successful investors roll with the punches and adapt to situations as they evolve. Insofar as that applies to the medical technology space, investors likely need to accept that today’s environment means that they either need to accept lower probable returns or work much harder to uncover and analyze the relatively few remaining bargains. History teaches us that there’s almost always an under-appreciated up-and-comer to be found in any and every sector, but the sector-wide valuations tell me that the Street is pretty much up to speed with med-tech stocks.
Large cap names like J&J and Covidien probably won’t hurt investors at this level, and stocks like Medtronic and Stryker may actually still be more than 10% undervalued. Down the list a bit in market cap, stocks like Mindray, Intuitive, Volcano, and Masimo could all still deliver good performance from these levels, but investors have to acknowledge and accept the greater risk that they are taking on – each of these companies still has something to prove in terms of execution and faces its own particular set of risks with competition, regulation, and market acceptance.
In summary, investors should be cautious given the valuations in the med-tech sector and the market as a whole. That’s particularly relevant given that we are heading into the first quarter reporting season. As many of these stocks have a history of trading flat or down after earnings, investors considering taking new positions in med-tech may just want to sit tight and see how the earnings season plays out, while being ready and willing to take advantage of any overreactions that follow those earnings reports.
Disclosure: Simpson owns shares of Accuray.
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at tuonela.fool@gmail.com.
