global gambits - 2006 medical devices & supplies · global equity research december 8, 2005...

Global Equity ResearchDecember 8, 2005

Global Gambits - 2006The Right Moves for Right Now

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The following is a chapter from Global Gambits � The Right Moves for Right Now, dated December 8, 2005. This chapter is presented for convenience, and should be read in conjunction with the full report and its analyst certifications and important disclosures. The full report is available on MorganMarkets.

Medical Devices & Supplieschapter

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December 8, 2005

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Medical Devices and Supplies Late in the Large-Cap Cycle; Look to Smaller-Cap New Product Stories for Outperformance Key Drivers Large-Cap Medical Devices • Following five years of outperformance, large-cap MedTech

stocks have been flat YTD, roughly in line with the broader market. This is in line with our outlook at the beginning of the year, when we stressed that we believe we are late in the investment cycle for large-cap MedTech stocks. We believe the major new product stories are for the most part behind the industry—primarily drug-eluting stents, ICDs and the uptick in the orthopedic implant market. Also, market growth rates should be generally slowing as the important new technologies introduced earlier in the decade climb further up their adoption curves, and currency tailwinds that have boosted the 40% of sector revenue derived overseas are beginning to reverse.

• 12-month forward P/E multiples for large-cap device stocks have contracted roughly three points in 2005, with compression being felt across the board but perhaps most acutely in the orthopedics sector. At present, the sector trades at 20-21x 2006E earnings, still a 30%+ premium to the S&P 500. We think there may be room for further multiple compression across the group, i.e., even as fundamentals and earnings growth remain strong, the sector may be on track for another six months of performance in line with the market.

Small/Mid-Cap Medical Devices and Diagnostics • We believe the small/mid-cap medical device and diagnostic

group remains poised for 17-18% top-line growth through 2007, driven by favorable demographics (aging population, increased incidence of disease, tendency for earlier screening), healthy reimbursement (particularly for molecular diagnostic and personalized medicine tests) and new product cycles.

• The convergence of life sciences with clinical medicine should fuel 7-8% growth within the US$25 billion in the vitro diagnostics market, led by: (1) novel tests in rapidly growing

markets, such as pulmonary hypertension, cancer and infectious diseases, (2) the growing need for productivity-enhancing systems at resource-constrained hospitals and reference labs, and (3) demographically driven growth in testing volumes.

• Although the broader group of small-mid-cap medical device and diagnostic stocks trade at a >100% premium to the S&P 500, EPS growth is expected to be more than double that of the S&P 500 (16% vs. 7% in 2006). We also note the likelihood for upside versus expectations for many in the group, based on healthy product flow, favorable demographics and M&A.

Life Science Tools • Our outlook on the life science tools universe remains

cautiously optimistic (6-7% growth), with demand from the need to fill anemic pharma pipelines, partially offset by concerns over the National Institutes of Health budget—which has seen growth slow to 0-2% from 15% (1995-2002) due to higher spending on defense—and the impact from pharma restructuring and cost rationalization programs (e.g., Pzifer, Wyeth, etc.).

• Biomanufacturing, including consumables to supply the scale up and launch of manufacturing campaigns for biologic compounds (>2,200 biologic drugs, antibodies and vaccines in clinical development, in addition to >400 on the market now), remains an area of rapid growth for many companies.

• Emerging market opportunities in diagnostics, industrial applications, environmental analysis, and homeland security represent significant near-term opportunities (particularly clinical diagnostics) for life tool companies over the coming six months, in our view.

• Life science tool companies currently trade at 18x forward earnings, a 19% premium to the S&P 500, but in line with the historical 17-22x range. Based on the sector’s earnings potential, however, we feel that the premium is reasonable and look for more consistent negative results as a catalyst for potential multiple contractions.

Global Sector Coordinator

Michael Weinstein (1-212) 622-6635 [email protected] J.P. Morgan Securities Inc. Full sector coverage details on page 108

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Our Non-Consensus Views • There are no readily apparent fundamental underweights in

our coverage universe currently. In general, our belief is that multiple compression will be offset by continued strong financial performance and the next six months hold little in the way of negative catalysts to precipitate more rapid revaluation.

• We believe uncertainties over pharma restructuring (Pzifer, Merck, Wyeth), the increasingly challenging M&A environment, and declining currency tailwinds (potentially turning to headwinds), could add volatility to the life science group over the coming six months. We believe our longer-term thesis remains intact.

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Medical Devices and Supplies: Top Picks Company Key Financials Rationale and Catalysts Stryker Corp. Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: SYK US / SYK 2004 2005E 2006E 1.43 1.75 2.10 Exchange: NYSE P/E (Calendar) Price (Local): US$43.75 2005E 2006EMkt Cap (US$): 17.7 bn 25.0 20.8 Analyst: Michael Weinstein EV/EBITDA (Calendar) Phone: (1-212) 622-6635 2005E 2006EEmail: [email protected] 13.7 12.0

• Stryker is one of the world’s leading medical technology companies with strong market shares in its core orthopedic and MedSurg businesses, organic revenue growth averaging 14% over the past five years, and an impressive consistency in delivering 20% EPS growth year-in and year-out. It is this track record of success that has made Stryker and its management among the most admired in healthcare.

• Yet during 2003 and 2004, Stryker’s shares trailed its MedTech and orthopedic brethren in performance, with 400bps of P/E compression in 2004 alone. And YTD 2005, Stryker’s shares have performed better than peers—Zimmer and Biomet—but have fallen 10%, on over 600bps of multiple compression, as concerns have been raised over orthopedic implant pricing and slowing industry growth in general.

• For Stryker in particular, though, we think fears of US pricing pressure in hips and knees are overblown. US recon represents just 20% of Stryker’s business mix, and while pure pricing may dip into negative territory, mix benefits should continue to some extent, and we believe Stryker is poised (with its Triathlon knee and Restoration Modular revision hip, among others) to offset market weakness through improved, above-market performance. Meanwhile, Stryker’s MedSurg business continues to grow at rates well above market averages, and, perhaps most importantly, the company is funding R&D programs in several key growth areas of orthopedics, such as orthobiologics and artificial discs.

• For these pipeline programs, the next catalyst should be the anticipated 1Q06 PMA submission for OP-1 in spinal fusion, which should lead to FDA approval during 2007, followed by approval of the Flexicore lumbar disc in 2008 and the Cervicore cervical disc in 2009. These pipeline programs, in our view, should enable Stryker to continue to deliver on high-teens EPS growth target for many years to come. Given this growth profile, we believe Stryker deserves to trade at a premium to the MedTech universe.

St. Jude Medical Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: STJ US / STJ 2004 2005E 2006E 1.16 1.53 1.80 Exchange: NYSE P/E (Calendar) Price (Local): US$49.02 2005E 2006EMkt Cap (US$): 18.0 bn 32.0 27.3 Analyst: Michael Weinstein EV/EBITDA (Calendar) Phone: (1-212) 622-6635 2005E 2006EEmail: [email protected] 20.4 17.4

• St. Jude continues to be one of the most attractive stories in the cardiovascular subsector, in our view. Its strong performance since 2003 has largely been the result of rapid growth in the cardiac rhythm management (CRM) market, which accounts for nearly two-thirds of St. Jude’s revenues. Although we expect the high voltage segment of CRM to decelerate into the high teens over the next few years from its current +20% run rate, this still represents one of the fastest-growing markets in MedTech, and we believe St. Jude remains most leveraged to this growth opportunity.

• In 2006, St. Jude should benefit not just from strong underlying growth in CRM, but also from continued market share gains over its competitors. 2005 has been a year of turmoil in CRM, with both Medtronic and Guidant announcing major product recalls. Guidant’s struggles, in particular, have opened the door for St. Jude to gain substantial high voltage share (up 640bps Y/Y). Our checks indicate that much of this shift is likely to be permanent, even as Guidant makes strides to rebuild its image, and St. Jude will continue to expand its presence in CRM.

• St. Jude has also taken steps this year to diversify its business by building a pipeline that goes beyond CRM. In April, the company acquired privately held Velocimed and its emerging suite of cardiology products for embolic protection and PFO closure. In October, St. Jude announced its biggest acquisition to date when it agreed to buy Advanced Neuromodulation Systems (ANSI). ANSI gives St. Jude a foothold in the developing field of neurostimulation, an area which we believe has the potential to be one of the fastest-growing fields in MedTech over the next decade. These acquisitions provide St. Jude with a broad pipeline to complement its CRM business, and should support continued growth above its peers over the next few years.

Source: Company data, Datastream, JPMorgan estimates, JPMorgan SaVanT. Prices as of November 22, 2005.

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Medical Devices and Supplies: Top Picks (cont’d) Company Key Financials Rationale and Catalysts Thermo Electron Recommendation: Overweight Fiscal EPS (Local): Year-end December Ticker: TMO US / TMO 2004 2005E 2006E 1.25 1.53 1.77 Exchange: NYSE P/E (Calendar) Price (Local): US$30.29 2005E 2006EMkt Cap (US$): 4.9 bn 19.6 16.9 Analyst: Tycho W. Peterson EV/EBITDA (Calendar) Phone: (1-212) 622-6568 2005E 2006EEmail: [email protected] 10.4 9.9

• Leading provider in the life science tool and analytical instrument markets: With nearly US$3 billion in projected revenues next year, Thermo Electron is one of the world’s largest life science tools and analytical instrument companies, with product lines (both instruments and consumables) that enjoy leading or near-leading positions among core academic and biopharmaceutical laboratories, across a wide range of areas, including sample preparation and storage, spectroscopy, tissue analysis, laboratory informatics, mass spectrometry and robotics.

• Strong new product flow should drive 2006 growth: Innovation remains key to the Thermo franchise, and we believe a continuous stream of new products (goal 25% of sales company-wide, up from 15% previously), should drive continued performance. In August, Thermo began shipping its new mass spectrometer, the LTQ Orbitrap, which we view as a significant driver for both revenues and market share gains, given its improved speed and accuracy versus competitive systems.

• Execution by an operationally focused management team has been impressive: We believe Thermo’s management, led by CEO Marijn Dekkers and CFO Peter Wilver, deserve high marks for deft and timely execution of ongoing restructuring initiatives over the last several years, including the sale of non-strategic assets, M&A and headcount reductions. The transition to a more focused operating structure, which also includes an increased presence in Asia (e.g., China), has translated to significant gains in the bottom line.

Varian Medical Systems, Inc. Recommendation: Overweight Fiscal EPS (Local): Year-end September Ticker: VAR US / VAR 2004 2005 2006E 1.18 1.50 1.54 Exchange: NYSE P/E (Calendar) Price (Local): US$50.31 2005E 2006EMkt Cap (US$): 6.6 bn 28.6 28.6 Analyst: Tycho W. Peterson EV/EBITDA (Calendar) Phone: (1-212) 622-6568 2005E 2006EEmail: [email protected] 20.7 17

• Varian remains the dominant leader (>70% market share) in the US$1.4 billion worldwide market for external beam radiation oncology systems, where demand remains strong owing to growing incidences of cancer, increased consumer awareness for less-invasive treatments, favorable reimbursement, new technology development, and more broadly speaking, the growing opportunity for radiation therapy, driven by improved clinical outcomes and adoption in new areas of treatment (metastasis, brain tumors, etc.).

• Uptake of legacy IMRT platforms abroad, and IGRT within the US, remain key near-term drivers. IGRT, which debuted two years ago, is now rapidly emerging as the standard of care for treating major cancers (prostrate, head and neck, metastases, etc.). Importantly, it provides VAR with the opportunity to sell both hardware (e.g., onboard imagers with silicon flat panel imagers) and higher-margin software (treatment planning to coordinate) to its installed base of over 4,000 customers. Internationally, the demand for IMRT also remains healthy, driven largely by growth in Europe and Asia. In addition, within the US market, we expect that implementation of a new IGRT reimbursement code this January could act as an additional catalyst for uptake going forward.

• Trilogy paves the way for expansion into the US$350 million stereotactic radiosurgery market. Leveraging core capabilities in external beam radiotherapy, Varian has recently begun to move aggressively into stereotactic radiosurgery (SRS), a market dominated mainly by a sole competitive offering, the GammaKnife (US$3 million ASP) from Elekta. By offering IMRT, IGRT and stereotactic treatments, however, we expect that Trilogy should appeal to a broader customer base, something that has been supported by the strong early demand. Varian also continued to develop its pipeline, with early stage development of next generation platforms, including biologically-guided radiation therapy systems.

• Other opportunities—X-ray, bracchytherapy and homeland security—continue to evolve. Within Varian’s other lines of business, the X-ray segment has seen growth accelerate substantially (>20% in recent years) due to the emergence of flat-panel imaging technology for applications in dentistry, ventrinary, military and general medicine. Furthermore, we believe that Varian’s homeland security business, still in its naissance, could see significant upside should dollars ever materialize for cargo screening (Varian is one of the only two companies—the other based in China—with technology to accurately screen cargo from container ships).


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Medical Devices and Supplies: Top Picks (cont’d) Company Key Financials Rationale and Catalysts Hologic Recommendation: Overweight Fiscal EPS (Local): Year-end September Ticker: HOLX US / HOLX 2004 2005 2006E 0.57 1.25 1.29 Exchange: NASDAQ P/E (Calendar) Price (Local): US$69.87 2005E 2006EMkt Cap (US$): 1.5 bn 47.8 51.7 Analyst: Tycho W. Peterson EV/EBITDA (Calendar) Phone: (1-212) 622-6568 2005E 2006EEmail: [email protected] 28.0 25.9

• As one of the two leading companies in the rapidly growing, US$350 million digital mammography market, Hologic has enjoyed strong growth due to a combination of favorable market expansion (digital mammography market is growing at a 38% CAGR WW, led by 15-20% growth in procedures) and competitive share gains (versus GE Medical). Moreover, the digital market opportunity remains large, with digital systems representing only 5% of the worldwide installed base (1,500 systems out of 35,000 worldwide), and 8% within the US, although we expect this could ultimately grow to >80%.

• Accelerating procedure rate, favorable reimbursement, and improved clinical outcomes are key near-term drivers for digital adoption. With breast cancer the second leading cause of cancer-related death for US women (220K new cases and 40-45K deaths per year, 1 in 7 women develop the disease), demand for early and accurate methods of detection is high. Compared to film-based (e.g. analog) systems, digital offers improved speed (35 patients per day versus 25 with analog), higher quality, lower radiation exposure, eliminates recurring costs (film processing and storage), improved reimbursement (US$135 per test vs. US$85 for analog), and favorable clinical results (i.e., more sensitive tumor detection across key subgroups).

• The superior technology platform translates into market share gains. Aided by a larger detection plate and direct-capture method (versus GE Medical’s indirect approach), as well as exclusive distribution agreements with software (e.g., CAD) providers, we estimate that HOLX’s digital mammography system (Selenia) could capture >60% market share in the next 2-3 years (from 50% today), taking share from competitors GE Medical and Siemens (which is a distant #3 in the market).

• Launch of the 3D tomosynthesis platform in 2007 could drive further upside. Hologic is currently developing a highly-sensitive 3D screening system, which should begin FDA trials next year. Using technology similar to the current Selenia system, the platform takes a series of 11 images within the breast, thus providing a more in-depth means of screening. Importantly, given that the 3D system will be sold as a turn-key (e.g. software) upgrade, with margins in the 95-99% range, we believe it could drive significant upside to our current estimates.


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JPMorgan Global Medical Devices and Supplies Team – Research Equity Research Credit Research Medical Devices and Equipment Life Sciences Tools and Equipment Michael Weinstein Americas Americas Americas Global Sector Coordinator

United States

Michael Weinstein Taylor Harris Kimberly Weeks Christopher Pasqual

United States

Tycho Peterson Melissa Kim

United States

Arun N. Kumar, CPA (HG – Healthcare) Shivangi Shah (HG – Healthcare) David Common, CFA (HY – Healthcare) Yilma Abebe (HY – Healthcare)

EMEA Justin Smith Asia Pacific

Australia Alex Smith

Kylie Reynolds

See page 193 for team member contact details.

December 8, 2005


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JPMorgan Equity Research Ratings Distribution, as of September 30, 2005 Overweight

(buy) Neutral (hold)

Underweight(sell)

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