3 Medical Appliance Stocks to Buy, 2 to Sell

by Will Ashworth | July 12, 2013 11:56 am

Intuitive Surgical (ISRG[1]) sure took it on the chin Tuesday.

The company’s stock plunged 16% on news that its second-quarter numbers[2] on both the top and bottom lines would miss analyst estimates.

ISRG’s precipitous drop had me harkening back to an article I wrote in March about the medical appliance industry in which I picked two buys, two sells[3] and a bonus recommendation. Four months later, it’s time to revisit my picks. I’ll tell you how they’ve fared and what, if anything, to do differently in the future.

How Have They Fared?

Sell #1: Opko Health (OPK[4]) — down 3.3%
Sell #2: Hologic (HOLX[5]) — down 12.5%
Buy #1: Sirona Dental Systems (SIRO[6]) — down 3.8%
Buy #2: ResMed (RMD[7]) — down 0.34%
Bonus Buy Pick: Intuitive Surgical – down 13.3%

You can’t say I’m not consistent. All five picks experienced negative total returns between March 20 and July 11. In the same period, the SPDR S&P 500 (SPY[8]) achieved a positive total return of 8.1%.

All is not lost, however, because my two sells have averaged a negative total return of 7.9% compared to a negative total return of 5.8% for my three buys. Clearly, Intuitive’s surprise miss has made all the difference.

Where to From Here?

Opko Health: One of its biggest supporters is CEO and Founder Dr. Phillip Frost (worth $3 billion, according to Forbes), who has bought approximately 2.7 million shares over the last four months, bringing his total shares to 159.9 million, or 48% of its stock. In addition, while its 20% equity interest in RXI Pharmaceuticals (RXII[9]) and 10% interest in Tesaro (TSRO[10]) should pay off, I’m going to stick with my original call: OPK will continue to tread water for the remainder of the year, and will likely fall back 10%-20% on any bad news.

Hologic: Zacks Equity Research released a short note June 19 reiterating its “hold” rating on the company, which is best known for its 3D mammography imaging products. Since I wrote about Hologic in March, it has delivered mixed second-quarter results and cut its guidance for all of 2013. It now expects to generate at least $2.53 billion in revenue and $1.54 in earnings per share. While neither number is horrible, the fact that it cut earnings and revenue by 2.5% and 3% respectively while trying to digest $5 billion in debt isn’t a very good omen. With approximately $321 million in levered free cash flow, any slowdown in earnings will impair its ability to reduce its debt. With total debt at 6.6 times EBITDA, it can’t afford any more lackluster reports. Until it demonstrates it can make money from its acquisitions, I’d permanently avoid this stock.

Sirona Dental Systems: At first read, Sirona’s Q2 earnings would appear mediocre. However, upon closer inspection, I think it’s safe to say its business continues to grow quite nicely. Revenues gained 14.7% year-over-year, while its non-GAAP adjusted EPS grew 11.3% to 75 cents. For the entire fiscal 2013, Sirona expects constant currency revenue growth of at least 10% and non-GAAP adjusted EPS growth of 11%. Once again, the big winner in its business in Q2 was its CAD/CAM division, which saw revenues grow 20.6% year-over-year to $103.6 million while its gross profit increased 16.7% to $69.9 million. The only negative was a 260-basis-point decrease in its gross margin to 67.4%, which the company attributes to a lower gross profit margin of its Omnicam imaging system. In its Q2 conference call, CFO Simone Black indicated that it’s looking for ways to lower the cost of manufacturing. I’m confident that it will be successful — the 4% decline since March has only made the stock cheaper to own.

ResMed: Sleep apnea is ResMed’s bread and butter. Revenues in its third quarter gained a respectable 10%, and net income grew by 31% — a testament to the company’s operating efficiency. During the past five years, earnings have grown by 19% per year, suggesting ResMed’s business is actually strengthening. And with $1 billion in cash, this company could repay all of its debt ($340 million) and still have $660 million left to repurchase shares, increase its dividend and make bolt-on acquisitions. CEO Jeff Slovin recently indicated that investing in its operations is its No. 1 priority; you don’t hear that refrain from public companies too often these days. This is my kind of business — of my three buy picks, RMD is definitely my favorite.

Intuitive Surgical: Any time a stock drops by 15% to 20% in the span of two trading days, you have to consider whether the stock has become cheap or not. According to Morningstar, its P/E, P/B, P/S and P/CF are all lower today than their average over the past five years. But for those looking for growth at a reasonable price, this latest correction brings it clearly into view. Several analysts downgraded ISRG. Hospitals are cutting back on their capital investments in the wake of Obamacare and renewed fears about the safety of ISRG’s da Vinci surgical systems, putting serious headwinds in front of its stock. Frankly, I hope it gets more downgrades so investors can buy it for even less. ISRG continues to make good money. Perhaps business won’t come as easily in the future, but with no debt and $1.3 billion in cash, it can buy back shares until some of the systemic issues are successfully dealt with. Until then, I’d take advantage of every double-digit drop in its stock price if you’re patient enough to stomach it for the long-term rewards.

Bottom Line

Nothing I recommended investors to do back in March has changed. My buys are still buys and my sells are still sells. Whatever the future holds, the medical device industry will continue to be very competitive. Some will win and some will lose. Where that leaves all five of these stocks in six more months remains to be seen.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. ISRG: http://studio-5.financialcontent.com/investplace/quote?Symbol=ISRG
  2. second-quarter numbers: http://www.bloomberg.com/news/2013-07-09/intuitive-surgical-declines-on-falling-da-vinci-sales.html?cmpid=yhoo
  3. two buys, two sells: http://investorplace.com/2013/03/2-stocks-to-buy-2-to-sell-in-medical-appliances/view-all/
  4. OPK: http://studio-5.financialcontent.com/investplace/quote?Symbol=OPK
  5. HOLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=HOLX
  6. SIRO: http://studio-5.financialcontent.com/investplace/quote?Symbol=SIRO
  7. RMD: http://studio-5.financialcontent.com/investplace/quote?Symbol=RMD
  8. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  9. RXII: http://studio-5.financialcontent.com/investplace/quote?Symbol=RXII
  10. TSRO: http://studio-5.financialcontent.com/investplace/quote?Symbol=TSRO

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