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  • Important disclosures appear on the last page of this report.

    The Henry Fund

    Henry B. Tippie School of Management

    Luv Bhagria [Luv-Bhagria@uiowa.edu]

    Medical Equipment and Devices February 8, 2017 Healthcare Sector Industry Rating Market Weight

    Investment Thesis Key Industry Statistics We recommend a market weight for the Medical Equipment and Devices industry. A favorable regulation environment, coupled with an increase in healthcare spending will have an immediate positive impact on the industry. Moreover, the increasing focus on innovation and R&D, as well as potential growth opportunities in emerging markets, will serve as driving forces over a longer term. Drivers of Thesis Innovation: The healthcare sector is just entering a new innovation cycle.

    Leading firms continue to invest in R&D to drive innovation and growth, in order to garner pricing power.

    Favorable demographics: An increasingly aging population worldwide will further boost the demand for pacemakers, diagnostic equipment, monitoring devices and other medical equipment, which will drive revenues and earnings over a longer term.

    Favorable regulations and policies: With the republican-led Congress and new President in power, speculation for favorable legislation and regulations, including repeal of medical device tax suspension, will be a huge driving force for Medical device firms.

    Increasing healthcare spending: US Government healthcare spending per capita is expected to continuously increase over the next 5 years, at an

    annualized rate of 3.34% to reach $4.1 trillion by 2022.1

    Growth opportunity in developing markets: Increasing demand for healthcare equipment and services in emerging markets, including Asia, Middle-east and Latin America to provide overseas opportunities.

    Risks to Thesis

    Stringent guidelines by FDA and potential new regulatory constraints globally with respect to sales of medical equipment could hurt the margins.

    Delay and uncertainty in implementing the new federal regulations might keep the investors away from investing in the industry.

    Cybersecurity issues in digital medical devices pose a huge threat of security breaches and malware infections to customers and providers

    Market Cap (top 6) (in $billions) Medtronic Plc. $104.32 Abbott Laboratories Danaher Corporation Stryker Corporation Becton, Dickinson & Co. Boston Scientific Corp. Intuitive Surgical Inc. Baxter International

    $73.25 $57.38 $45.81 $37.96 $34.23 $28.59 $28.13

    Peer Company Statistics (avg.) (>$10 B MKT CAP)

    Beta 0.875 ROA 6.88% ROE Operating Margin (mrq) Net Profit Margin (mrq) P/E (ttm) P/E (forward) PEG Ratio (5 yr. exp.) Price/Sales (ttm) Price/Book (mrq) EV/Sales EV/EBITDA

    16.62% 20.47% 15.32%

    37.43 20.19

    2.02 4.54 4.40 4.84

    17.40

    12 Month Performance Industry Description

    The Medical Equipment and Devices industry in the Healthcare sector includes companies that develop, manufacture and provide medical devices and products including diagnostic equipment, cardiovascular and orthopedic devices, surgical equipment, and other conventional as well as specialized medical products. Innovation, demographic, legislation and regulations are some of the industrys major driving forces.

    37.4

    16.6 15.3

    47.7

    19.416.5

    0

    50

    P/E ROE (%) Net Profit Margin(%)Source: Factset, Yahoo Finance

    Peer Companies Sector

    -10%

    0%

    10%

    20%

    30%

    40%

    F M A M J J A S O N D J

    Source: Yahoo Finance

    XHE S&P 500

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    EXECUTIVE SUMMARY

    The recommendation to market weight the Medical Equipment and Devices industry within the Healthcare sector is driven by number of factors, such as increasing innovation, favorable demographics, increasing healthcare spending and implementation of new healthcare regulations.

    Innovation drives the topline growth and creates a solid foundation for sustainable long-term growth in the healthcare sector. Acceleration in scientific advancements, greater understanding of human body and introduction of new innovations, such as robotic surgeries, telemedicine and IoT (Internet of Things) devices can be translated as a start of new innovation cycle for the industry. We expect this industry to produce new technologies and products over the next few years, that will change the face of healthcare sector.

    Moreover, the demographics forecast strongly favor the healthcare sector. Growing middle-class in emerging markets are demanding more state-of-the-art therapies. In the developed world, an aging population will drive growth, as older people are more prone to chronic diseases, and spend way more on orthopedic and surgical devices. According to US Census Bureau, the number of adults aged 65 or more is estimated to increase at an average annual rate of 3.3% from 45.8 million in 2016 to 55.62 million by 2022.2 Moreover, they estimate people aged 65 and more to represent around 12% of the total

    population in 2030, up from 8.5% in 2015.3

    Another important aspect to consider is the increasing healthcare spending worldwide, which is anticipated to

    increase to $18.28 trillion by 2040, at a CAGR of 2.6%.4 According to Congressional Budget Office (CBO), the total health expenditure is estimated to increase from $3.36 trillion in 2016 to $3.41 trillion in 2017.1 Rising wealth and improving economic conditions of the middle-class in developing markets, especially Asia and Middle-East are the primary drivers. (See: Appendix 1,2 and 3)

    The most significant factor that will determine the fate of the industry in the coming 12 months is the federal regulation changes for the healthcare sector. During the campaign for Presidential elections last year (2016), the ACA (Obamacare) and some major issues related to the healthcare sector, specially pricing, was a hot topic. Although, the medical devices industry received a huge

    sigh of relief when the medical device excise tax was temporarily suspended for two years through 2017.5 The firms are hoping that the new administration will permanently repeal the tax regulation. While this is highly probable, uncertainty regarding the implementation of Health law replacement (replacement of The Patient Protection and Affordable Care Act) are keeping the firms and investors on the edge.6 Nonetheless, we believe that the overall tax regulation environment will favor this industry in the coming few years.

    However, being a highly regulated industry, there are always operational and regulatory risks, such as longer product approval process and pricing pressures. Additionally, with new technological advancements, there is an increasing threat of malfunctioning of the devices, and cybersecurity risks for networked devices.

    INDUSTRY DESCRIPTION

    The Medical Equipment and devices industry consists of companies primarily engaged in manufacturing, development and distribution of medical, surgical, diagnostic and dental equipment. These medical devices include instruments, apparatus, machines, implant, in vitro reagent or other equipment used for diagnosis, cure, mitigation, treatment of prevention of disease.

    Although, this industry is extremely diversified regarding the range of products, it can be classified into two broad categories: conventional products and high-technology products. Development and sales of any pharmaceutical drugs are not considered part of this industry.

    Conventional products can range from basic equipment such as trays, surgical apparel, syringes, scalpels, catheters, anesthesia apparatus, imaging machines and blood transfusion equipment. These products are low-margin and high-volume devices generally sold on a

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    contract basis to hospitals and physicians through bulk purchases.

    High-tech products are more advanced devices with high margins, as they require premium pricing. These products require huge capital expenditure in terms of R&D funding. Companies in the medical equipment industry rely less on the patents and more on innovation, primarily due to the continuous development of next-generation devices and partially due to weakness of the equipment patents. As a result, most firms rely on sales of both the conventional, as well as high-tech products. Consequently, their profit margins are typically derived from the product mix they offer.

    Hospitals, medical and dental services, also known as group purchasing organizations (GPOs), account for nearly two-thirds of purchases of the medical devices. This gives them a lot of bargaining power. Hospitals revenues are expected to increase at a CAGR of 3.3% to $1.2 trillion over the next 5 years.19 However, the industry is facing recruitment of skilled labor, which might result into increase in wages and incentives. Moreover, to mitigate the risks associated with medical devices, hospitals are looking to invest in IT security and risk management teams. Therefore, to offset the increase in costs, hospitals might want to bargain the costs of medical devices.

    Over the last 12 months, the S&P Healthcare Equipment Select Industry Index outperformed both the S&P 500 and S&P composite 1500 Healthcare index by a huge margin, with an annual return of 25.36%.7

    The medical equipment industry is majorly categorized into 7 segments, as indicated by the chart below. Nearly 3/4th of the industry revenues are from two major categories: Surgical instruments and Surgical Appliances.8

    Surgical Instruments and Supplies

    Surgical instruments include several basic surgical devices, tools and supplies used for specific actions while performing surgery or operation, such as syringes, catheters, sca