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A Haven in Downturns, Medical Device Makers Face Shifting Tides

Some analysts say an economic recovery is the last thing these stocks need.
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No sooner did analysts predict an economic recovery than some have begun to wonder who may suffer from one.

With the economy in critical condition in 2001, defensive stocks such as medical device makers -- manufacturers of cardiac stents and pacemakers -- outperformed the

S&P 500

for the second-straight year. But with an economic recovery forecast for 2002, some think the group's run could be over.

"While 2002 fundamentals for the group appear healthy, with 9% to 10% sales growth and 17% earnings per-share growth on tap for the year, external variables may scotch the group's chances of a three-peat vs. the S&P," said Matt Dodds, an analyst at SG Cowen, in a research note yesterday.

Up and Down

In the past, there's been a negative correlation between the performance of medical device makers and the S&P 500. From 1998 through 2000, the S&P Healthcare Equipment Index tacked on a 35.9% gain, which isn't bad, except that during those years, the S&P 500 surged 56.9%.

As the economy swooned, the S&P 500 fell 21.3% from 2000 through 2002, while the Healthcare Equipment Index rose 36.1%. Now, some economists are saying GDP growth could turn positive as early as this quarter. And with that change, they're forecasting sector rotation into cyclical names.

That could mean an end to heady gains for medical technology stocks. "With the group trading at 27 times '02 expected earnings, a 15% premium to the S&P, and the sentiment on an economic recovery becoming more bullish, multiple expansion for medical technology stocks seems unlikely," said Dodds.

Adding to the risks for the group in the year ahead is currency translation. While expectations for a U.S. recovery have increased, they haven't for Europe or Japan, according to Dodds. "This could lead to a strengthening of the U.S. dollar vs. the euro and yen, which in turn will put pressure on sales and earnings per share growth for many of the companies in the sector," Dodds said.

Diversity

Medical device makers derive a significant portion of their sales from Europe and Asia.

Medtronic

(MDT) - Get Report

, a manufacturer of cardiovascular equipment, got 33% of its total sales from outside the U.S. in fiscal 2001, while

Biomet

TST Recommends

(BMET)

, a maker of orthopedic medical supplies, drew 28% of its total sales from overseas markets in its latest quarter.

Not everyone is overly concerned about currency translation problems. "It's been a problem for the group," said John Putnam, an analyst at Gruntal. "But it will be no more of a problem in 2002 than it has been in the past." According to him, a lot of these companies are hedged against currency risk.

Putnam has outperform ratings on three stocks in the group: Medtronic,

Guidant

(GDT)

, and

St. Jude Medical

(STJ)

. And in the months ahead, he doesn't think the stocks are going to see depressed multiples, mostly because of their ability to generate 15% earnings growth each year.

"What you see in earnings growth, you'll see in stock price appreciation," Putnam said.

Predictable Growth

Others echo his optimism: "The nice thing about these companies is that they have predictable earnings," said Bruce Nudell, an analyst at Sanford Bernstein. But he added: "The companies really need to be close to 15% in their top-line growth for investors to be happy with them."

Sales for medical device makers are driven by technology. In December, Medtronic was able to reiterate its 2002 guidance because of strong demand for new products to treat heart failure and diabetes.

As the baby boomers head into retirement, the number of patients will keep growing. According to a report issued last month by the Census Bureau and National Institute on Aging, the world's population age 65 and older is growing by an unprecedented 800,000 people a month.

With an improvement in the economy, cyclical stocks may outperform medical device makers. "But if you want a balanced portfolio," says Putnam, "15% earnings growth is nothing to sneeze at."