Medical Device Companies Still Have Upside, New Tax or Not

by Dan Burrows | September 30, 2013 12:42 pm

The Affordable Care Act is a once-in-a-lifetime policy change, but it might be too late to make it a once-in-a-lifetime investing opportunity.

Healthcare — a $2.7 trillion industry representing 18% of the economy — will never be the same, as the Affordable Care Act extends coverage to another 47 million citizens. Naturally, the market is bidding up healthcare stocks in anticipation of all those new customers lining up for insurance, hospital care, pharmaceuticals and medical devices.

The healthcare sector has generated a total return of 29% for the year-to-date, second only to consumer discretionary, which has gained almost 30%.

Consumer discretionary is, of course, cyclical — it’s supposed to be among the market leaders when the economy and stocks are picking up.

Healthcare is nothing of the sort. It’s a defensive, plodding sector, best suited for sideways or declining markets. And yet, here it is, a market leader as stocks notch all-time nominal highs.

Ordinarily, you’d say, that ain’t right.

But these are not ordinary times. It’s a cliche, but it’s true: The market is forward-looking. Healthcare stocks were outperforming even before the Supreme Court gave Obamacare the green light in the summer of 2012. The market has been betting on this outcome for a long time.

That has valuations for much of the sector starting to look a bit stretched — and bargains hard to find. As Morningstar analyst Alex Morozov wrote in a note to clients:

“With two years of stellar returns behind us, there aren’t many exciting investment opportunities in the sector.”

Except, maybe, for medical device companies.

The medical device manufacturers are among the stocks lagging the big sector rally, largely because of fears that the Affordable Healthcare Act will cripple them with a new sales tax. Indeed, a repeal of the 2.3% excise tax on their revenues was put forth by Republican lawmakers as part of a package to avoid a government shutdown.

But, as is often the case with the market’s anxiety, the fears are overblown, leaving some appealing opportunities in an otherwise pricey sector.

A 2.3% sales tax is indeed tough to swallow. Even an unprofitable medical device company like Mako Surgical (MAKO[1]) — which recently was bought by Stryker (SYK[2]) — would have to pay the tax. Eesh.

However, it’s not such a big deal for behemoths like Medtronic (MDT[3]) and, yes, Stryker. With MDT and SYK doing about $17 billion and $9 billion in annual sales, respectively, the tax represents a large bill in dollar terms … but it’s hardly a crippling blow to revenue (or margins or profits) on a percentage basis.

Heck, when the dollar is strong, it’s not unusual for either company to report a hit to revenue from unfavorable foreign exchange of 2% to 3%. So this tax is nowhere close to being make-or-break for MDT or SYK.

At the same time, shares in both companies trade essentially in line with their own five-year averages on a forward earnings basis. No, MDT and SYK are not cheap, but they’re not expensive, either. And both look to have some double-digit percent upside ahead.

Wall Street’s average price target on Medtronic stands at $58. Add in the 2.1% yield on the dividend, and you get an implied total return of 11.5% in the next 12 months or so. Meanwhile, analysts’ price target on Stryker is $75. Including the 1.6% dividend yield, the implied total return stands at 12.6%.

Medical device companies will take longer to benefit from the ACA than insurers or hospitals. Those industries have to get their cuts before they approve and sell more medical procedures and devices.

But the sales are coming, and both MDT and SYK have more than ample bulk to withstand the new tax.

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

Our InvestorPlace experts have you covered – click here[4] for more analysis on how to invest under Obamacare.

  1. MAKO:
  2. SYK:
  3. MDT:
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