Need Defense? Think Medical Supplies

Conventional wisdom says investing in health care is a smart way to defend against tough economic times.

These days, however, purchasers of many defensive stocks, from major pharmaceuticals to large biotechs to big-name device makers, are suffering from offensive returns.

Still, there's an island of cheer amid this medical malaise. When it comes to a good defense, you can't beat catheters, syringes, needles, instruments and hospital supplies. In other words, you can't beat companies like C.R. Bard ( BCR) and Becton Dickinson ( BDX).

Many analysts forecast a continuing, comparatively strong showing for these firms and some of their peers. "Historically, falling interest rates and decelerating corporate profits bode well for defensive med-tech stocks, as does a weaker dollar," says a recent analysis by JPMorgan.

There's a tortoise-and-hare quality to Bard and Becton Dickinson vs. major drugmakers such as Merck ( MRK) or large biotechs like Amgen ( AMGN).

The latter companies have enjoyed jackrabbit stock gains when they produce blockbusters, but all have slumped when something went wrong in clinical testing, in the marketplace or with regulators.

With Bard and Becton Dickinson, slow and steady wins the race. Because they make many products, they can better absorb disappointments, setbacks and even recalls.

For the 12 months ended April 2, Bard was up 22%, and Becton Dickinson gained 15%. The S&P 500 was down 8%, while the Amex indices for both large drugmakers and major biotechs lost 12%.

During this period, Bard and Becton Dickinson easily outscored device-makers such as Medtronic ( MDT) and Boston Scientific ( BSX). Although they also sell many products, the device makers have soared and sagged with their respective signature devices -- implantable cardioverter defibrillators and drug-coated cardiac stents.

For the five years ended April 2, the slow-but-steady crowd produced even better stock results. Becton Dickinson gained 170%. On a split-adjusted basis, Bard was up about 200%, or four times the growth rate of the S&P 500 and nearly double the gain of the Amex Biotech Index. The Amex big-drug index barely broke even. Medtronic was narrowly in the black, while Boston Scientific was in the red.

Tough Competition

Bard, Becton Dickinson and their peers battle on many treatment fronts, including urology, diabetes, hernia repair, circulatory system problems and cancer care, as well as drug-delivery products and general surgical supplies. Competitors can be small companies focusing on few treatment areas, or health care conglomerates such as Johnson & Johnson ( JNJ) and Baxter International ( BAX).

Because of the commodity-like nature of many products and the maturing of U.S. markets in certain treatment areas, Bard and Becton Dickinson have succeeded by improving old products, finding new markets and diversifying.

"In the rapidly evolving medical-device field, continuing innovation is the key to prolonged success, as differentiation advantages erode quickly and rivalries intensify," says Alex Morozov of the independent research firm Morningstar, in a recent report.

Diversification has obvious benefits, but it also holds risks, because efforts to develop more complex, higher-margin products could backfire, analysts say. Becton Dickinson, for example, entered the blood-glucose monitor field in 2003 and quit three years later.

Wall Street also wonders whether the hospital-supply companies can sustain or improve their growth rates or whether their current share prices have outpaced their fundamentals. Bard, which has a market capitalization of $9.9 billion, has a buy-hold ratings ratio of 3-to-7, according a Thomson First Call poll of analysts. Becton Dickinson, whose market cap is $21 billion, has a buy-hold ratio of 6-to-5.

Becton Dickinson's path to continued growth depends partly on its ability to sell traditional surgical products in "rapidly growing European and Asian markets," says Morozov, in a research report. But the biggest source of growth will be its roster of products used in pharmaceutical and biotech R&D and its diagnostics business. In recent years, Becton Dickinson acquired two small companies to improve the diagnosis of cancer and drug-resistant bacterial infections.

Diversification won't be easy, because competitors in diagnostics and biosciences such as Abbott ( ABT) and Roche have "greater marketing reach and larger R&D budgets," Morozov warns.

However, Becton Dickinson's "reputation for searching out pockets of growth, along with its sizable manufacturing and distribution infrastructure, convinces us that it will be able to fend off competition," Morozov says. He gives the stock a three-star rating on a scale of one (sell) to five (buy).

Buy and Build

Bard also will need some bolt-on deals to help propel sales and profits, says Kristen Stewart of Credit Suisse. In the last two years, Bard has bought businesses that make non-heart stents, a device that prevents catheters and intravenous tubes from falling out of a patient's body, and safety needles and syringes.

Stewart told clients in a March 10 report that Bard will probably make more small acquisitions. "Given the current conditions in the credit and equity markets, as well as the regulatory and reimbursement environment, we believe larger med-tech companies may be able to acquire smaller companies at reasonable valuations."

Stewart, who has a neutral rating, says the current stock price more than reflects Bard's growth rate prospects. She doesn't own shares, but her firm is a market maker. She and other analysts say Bard has become a star thanks to a big deal that didn't happen. The voracious conglomerate Tyco International ( TYC) bid for Bard in May 2001, but the deal fell through in February 2002.

After the deal unraveled, Bard restructured, developed new products and accelerated sales and profit growth. "The company initially fell into its standard pattern" of 6% to 8% sales growth, says Matthew Dodds of Citigroup Global Markets, in a March report to clients. The emergence of new products pushed the sales growth rate past 10% and the earnings-per-share rate over 15% for several years, says Dodds, who has a buy rating.

Another surge of new products, starting two years ago, should keep Bard in "double-digit sales and mid-teens EPS growth through 2010," says Dodds, who doesn't own shares. His firm has had a non-investment-banking relationship. Bard is "one of the safest, most diversified companies in med-tech," says Dodds.

Analysts say Bard must beware of Covidien ( COV), which was spun off in mid-2007 from Tyco. Covidien represents Tyco's spending spree for medical-device, drug, radiation and surgical-products companies.

With a market cap of about $23 billion, Covidien is a major force in medical devices, which account for nearly 70% of sales from continuing operations. However, it may take two years for Covidien to really get rolling, because it must undo the damage caused by Tyco.

Tyco, analysts say, paid inadequate attention to its health care properties, starving them for financial support and treating them merely as cash generators. "Covidien's near-term profitability will be negatively impacted by growing marketing and R&D costs," Morozov told subscribers in February.

Covidien also was saddled with $144 million in unresolved tax liabilities "and a long list of outstanding legal proceedings," he says. Morozov gives Covidien a four-star rating, because "we view these as temporary hurdles."

Since its spinoff, Covidien has sold, or announced plans to sell, three businesses and has bought two small device-makers. Analysts expect more wheeling and dealing.

"Covidien is on the right track pruning noncore businesses and building on its core medical technology franchises," says Joanne Wuensch of BMO Capital Markets, in a March 12 note to clients. Wuensch, who doesn't own shares, has a market perform rating.

Between July 2, 2007, the first formal trading day on the NYSE, and April 2, 2008, Covidien's stock was up 5%.