The Key To Healthy Growth

• Victor Reklaitis
• On 5:53 pm EDT, Friday September 4, 2009

Many medical equipment companies have taken a hit during the recession as hospitals cut capital spending.

"If you look at capital equipment budgets, there's been a huge decrease in overall capital outlays for the laboratory by the hospital," Stephens analyst Scott Gleason said. "That's been a big challenge."

About 77% of U.S. hospitals have slashed their capital spending on clinical technology, facility upgrades or information technology since early 2008, according to a survey by the American Hospital Association.

The mix of companies in the medical systems and equipment group is diverse. It ranges from medical robotics to heart instruments to radiation therapy products to patient monitoring systems.

The strongest performers are device and gear makers with business models tied to cheaper disposable products, rather than big-ticket items, or to critical procedures rather than elective surgeries.

Case in point: Abaxis (NasdaqGS:ABAX - News), which makes portable machines that can rapidly test blood. Other top performers include wound-care firm Kinetic Concepts (NYSE:KCI - News), Sirona Dental Systems (NasdaqGS:SIRO - News) and Idexx Laboratories (NasdaqGS:IDXX - News), which competes with Abaxis.

As of Friday, the group of 80 companies ranked No. 70 among IBD's 197 industry groups.

1. Business

Susquehanna analyst David Turkaly has a straightforward explanation for how many medical equipment companies are staying alive and even thriving.

"Drugs work for a lot of things, but they haven't figured it all out. There's not a pill for everything yet," he said. Medical gear and systems firms are often "targeting an area that a drug by itself, at least in this day, can't handle," Turkaly said.

It's a competitive field, with leading companies putting a big emphasis on research and development spending and new products. Big companies are also constantly on the prowl for innovative small firms.

"The 'buy 'em up and consolidate' theme is always an important one in the space," Turkaly told IBD. "You're seeing deals even in a tough economy."

Kinetic Concepts bought tissue grafts provider LifeCell for $1.7 billion last year. And in 2007, mammography products firm Hologic (NasdaqGS:HOLX - News) merged with Pap smear test maker Cytyc in a deal worth $6 billion.

During the recession, firms whose main offerings are tied to critical care have fared better than those linked to procedures that can be put off.

Companies that make inexpensive disposable products also have posted gains, since they're less exposed to the slump in capital spending. U.S. demand for medical disposables will grow steadily at a 4.6% annual rate through 2013, becoming a $59 billion market, according the Freedonia Group, a research firm.

Name Of The Game: Leading companies stay hungry for new products, which come from research and development efforts or strategic acquisitions. Firms focused on critical procedures or disposables can weather tough times.

2. Market

An aging population that requires high-quality tests and more and more care has created a big market for manufacturers of medical systems and equipment.

The portion of the U.S. population that's 65 or older is on track to climb from 11.3% in 1980 to 19.3% by 2030, according to the Department of Health and Human Services.

Another factor boosting medical equipment firms: a growing dearth of lab technicians, the trained personnel who run tests or operate sophisticated gear. The vacancy rate is an estimated 10.4% for nonsupervisory medical technologist jobs and 8.8% for laboratory assistants.

That shortage is broadening the market for devices that are faster and simpler to use, says Stephens' Gleason.

"I think what you're going to see over time is more consolidation into single, easy-to-use, fully automated platforms," he said.

Cepheid (NasdaqGS:CPHD - News) is already on top of this issue, Gleason says. The molecular diagnostics firm sells automated tests for detecting diseases or harmful agents such as anthrax.

When it comes to the specific markets that make up the broad medical equipment sector, bigger is better, says Abaxis CEO Clint Severson.

"Market size is critical," he said. "We are (in) point-of-care blood chemistry, and the market is about $4.9 billion. So we have a very large target. That way, you don't have to have huge market shares to have a reasonable-sized business."

3. Climate

The industry is greatly affected by the three R's: recession, regulation and reimbursement.

The recession has led to less spending on big-ticket medical equipment, less traffic to doctors' offices and fewer elective procedures.

On the regulation front, companies have to win approval for many of their products from the FDA and state and local agencies.

Then they work on getting their offerings covered by Medicare and Medicaid, hoping for a high reimbursement rate.

"I think those ebb and flow, the regulatory and reimbursement challenges," though they are always present, said Turkaly, the Susquehanna analyst.

One way to tackle regulation is avoid heavily regulated segments or push to get rules relaxed, says Abaxis' Severson. The company's blood analysis products for humans are eligible for waivers, and Abaxis has worked to secure them.

"If you are in an environment where it's highly regulated, including the user, you've got a problem," Severson said. "So you have to have a process where you can get your products deregulated, or your market's going to be limited."

4. Technology

Amid growing concerns about the cost of health care, technological innovations that provide savings are attracting more attention.

One way to lower costs is to speed up tests and treatments.

"If you can reduce cycle times for procedures, you can increase your efficiency," Abaxis' Severson said.

His company's contribution: dramatically faster blood tests.

"Add the sample, push the button and get the result," he said. "Reduce the cycle time (for blood tests) from hours or days to 12-and-a-half minutes."

The medical systems and equipment group is also full of innovative companies that aren't focused on cutting costs. Gee-whiz technologies include the minimally-invasive robotic surgery equipment produced by Intuitive Surgical .

Kinetic Concepts' LifeCell also draws praise for its innovative skin graft products processed from cadaver skin.

5. Outlook

The aging population and its health care needs should give medical equipment firms a tail wind for many years, analysts say.

The Obama administration's much-discussed health care overhaul efforts also might boost the industry. If millions of uninsured Americans get some sort of coverage, that could boost demand for medical gear.

While the benefits to device and gear makers will hinge on reimbursement rates, a push toward cost cuts should benefit device makers and help health care providers save money or work more efficiently.

Companies linked to critical procedures likely will continue to weather the recession, says Susquehanna's Turkaly.

"Even when the economy's good, you still need to get these procedures done," Turkaly said.

Upside: An aging population creates a big market in the long run. Health care changes might lead to more customers for the industry.

Risks: Robust capital spending by hospitals may not resume quickly. Health care overhaul could lead to lower reimbursement rates, pressuring prices and cutting into margins.

As the economy recovers, investors may switch their focus away from this relatively recession-resistant industry, hurting share prices.

Buzz up!