Competition Is Fierce Inside the Medical Device Market
As bottom-up investors, we are always pleased when we can find companies with sustainable competitive advantages that are positioned for long-term growth. One area in which we’ve uncovered attractive growth opportunities is the medical device industry, which possesses several desirable attributes. First, the industry is broad and diverse, ranging from surgical robots to hospital beds to dental equipment. Second, assets in the industry tend to be sticky and brand loyalty high, particularly for surgical device manufacturers, as significant time and resources are spent training surgeons on tools and techniques. Additionally, demand is generally stable—with a notable recent exception during the COVID-19 pandemic when elective procedures were postponed.
The $400 billion industry has seen strong mid-single digit growth over the past five years and has an attractive margin structure. Established players enjoy around 70% gross margins, a historically stable rate, and over 25% operating margins. Medical device companies tend to experience 1% to 2% price declines across their product portfolios over time, but are usually able to offset those decreases through production efficiencies and new product innovations that command premium pricing.
High margins and profitability also foster tremendous industry competition. Companies are continuously innovating to maintain their competitive positioning, improving their products to make them easier to use, reduce surgery time and reduce invasiveness. Additionally, device companies are increasingly incorporating more technology and connectivity into their products. Industry acquisitions are common, with established companies strengthening their internal research and development (R&D) capabilities through strategic acquisitions or meaningful stakes in start-ups and early-stage companies.
Considering these attributes in aggregate—industry diversity, sticky assets, stable demand, ongoing innovation and strong growth—we have found multiple attractive investments in the space, including Medtronic and Boston Scientific.
Medtronic and Boston Scientific are diversified medical device manufacturers producing items such as endoscopes, heart implants, pacemakers, spinal cord stimulators and ventilators. Despite facing competitive end markets, we believe both companies are investing in their product portfolios and making decisions necessary to position themselves for the long term.
In 2020, Boston Scientific posted $9.9 billion in sales and spent $1.1 billion in R&D (approximately 11% of sales)—a higher spend than most peers. Additionally, the company maintains one of the largest venture portfolios in the medical device space, with over $500 million in investments in approximately 40 companies in mixed stages of opportunity. This allows Boston Scientific to source promising acquisition candidates from within its venture portfolio and also makes it a more educated buyer outside of its venture portfolio. The company has created a strong market position in several product categories and has been successfully executing on its strategy for several years now, with its portfolio mix and growth profile continually improving over the years.
BOSTON SCIENTIFIC PORTFOLIO REVENUE MIX: WIDE EXPOSURE TO FASTER GROWTH MARKETS DRIVES EX-COVID ORGANIC* GROWTH +6-8%
Source: Boston Scientific Company Presentation. *Non-GAAP measure. CAGR: Compound Annual Growth Rate. Excludes Specialty Pharmaceuticals. Growth goals ex-COVID represent comparisons between time periods in which results are not materially impacted by the COVID-19 pandemic.
With $28.9 billion in sales in its last fiscal year, Medtronic is one of the largest medical device manufacturers in the world, and similar to Boston Scientific, has established itself as a leader in several markets. Medtronic spent $2.3 billion, or approximately 8% of its revenues, on R&D in 2020, has a strong culture of innovation and has a robust R&D pipeline. Additionally, the company had a planned management change in 2020 and the new CEO, Geoff Martha, is making several positive changes, including more tuck-in acquisitions to supplement existing R&D and introducing a decentralized operating structure to provide more decision-making authority and profit and loss accountability to individual business units. We believe a decentralized operating model is the right move for an organization of Medtronic’s size and will result in better incentive alignment across the organization going forward.
In summary, favorable margins and stable demand make the medical device industry an appealing investment space, but competition is fierce. Industry players must innovate and invest adequately in their product portfolios or risk falling behind the competition. We continue to closely monitor companies in this space and look for promising investment opportunities as they arise.
As of April 30, 2021, Diamond Hill owned shares of Boston Scientific Co. and Medtronic PLC.
The views expressed are those of the research analyst as of May 2021, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
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