It’s Always Sunny in Orthopedics

Older patients. Mega suppliers. More insured patients. A growing economy. More jobs. Some give on prices.

In the words of top gun orthopedic industry analyst Bill Plovanic of Cannacord Genuity, the signs are in place for better growth rates and, for investors, “long term opportunities within orthopedics…and [we] believe the industry will continue to evolve and offer investors ample opportunities for capital gains…”

On January 24, Plovanic issued an important new report where, among other conclusions, he revised his expected sales growth rates in two of the largest orthopedic sectors upward and suggested that the industry will grow at rates unseen since before the Great Recession of 2008.

But he isn’t so sure that last year’s torrid M&A activity can stay hot. “Given the mega mergers and small cap valuations trading near record highs, we believe M&A activity may cool off a bit in the near term.”

The Outlook for Large Joints

For large joints, Plovanic is raising his growth expectations to levels not seen since, well, before 2008.

In many respects, this uptick in growth expectations reflects the experience of the 2008-2010 recession. U.S. unemployment peaked at 10% in October 2009 and the very next year hip and knee replacement shipments fell approximately 4% and 5%, respectively, industry wide.

The extent to which employment rates and large joint procedures are linked was driven home between 2008 and 2010. And why not? No job. No insurance. No surgery.

This year every economic analyst of note is predicting a strong job market for the U.S. According to David Payne in this month’s Kiplinger Report, the job market will continue to be strong in 2015 and beyond. Payne is expecting that monthly job gains in 2015 will average 250, 000—about 3.0 million for the year, slightly above 2014’s addition of 2.95 million jobs and that those gains will keep incomes and consumption fueling a healthy economy. And trips to the doctor.

Payne wrote earlier this year that unemployment will likely finish 2015 at about 5.3%—or roughly half the rate of October 2009.

Plovanic is now “modeling for a continued ‘rebound’ for large joint procedure volumes through year end 2014and into 2015…”

Here is how Plovanic modeled recent history:

Will Consolidation in Large Joints Continue?

It’s been a very busy couple of years with six high profile corporate deals in 2013 and two more earlier in 2014. Large, integrated orthopedic companies have been sitting on billions of dollars of cash which, if not deployed in ways that generate a return better than, say, money market rates, can actually drag down overall assert and equity returns.

Instead of buying new technologies these buyers went for companies that had already been through the regulatory gauntlet, had distribution—preferably in China—scale and in one instance, a proven new market with robots.

Here’s a chart which summarizes all the major transactions since 2011.

In Plovanic’s view, the urge to merge will likely slow down in 2015. As he stated in his report:”Given the mega mergers and small cap valuations trading near record highs, we believe M&A activity may cool off a bit in the near term.”

Spine, Growing Again?

No sector was hit as hard by a multiple of factors nor fell from such lofty heights as spine did in the period of 2009 to 2012. As Plovanic illustrates so well in his report, spinal implant companies were rolling along at solid double-digit growth rates from 2000-2009 and innovation was the name of the game. Then the four horsemen in the form of FDA, CMS, GDP (gross domestic product) and IPO (as in no capital market) hit.

From a consolidated public spine company growth rate of 17% year-over-year growth rate in 2009 to a negative 1% in 2011, it was a rocky road for many companies.

In Plovanic’s view, “The worst of the storm has passed with several headwinds having dissipated and starting to become tailwinds. Specifically we believe Physician Owned Distributorships (POD) market share growth has stalled, if not started to shift back to the vertically integrated manufacturer/distributors, providing some growth over 2013 and 2014. We would expect this trend to continue as hospitals put rules in place to block POD business.”

The Key Takeaways

Wall Street analysts, who are some of our favorite straw men largely because they are forced to be so public and so specific about their opinions and forecasts (and I used to be one), operate in a kind of no-man’s land between industry and the capital markets. All parties, managements, institutional investors and hacks like those of us at OTW, lob criticisms into this no-man’s land—particularly when they blow a forecast.

But enduring the grueling quarterly round of spreadsheet calibrations and conference calls creates in most surviving analysts an especially sensitive trend antennae. Plovanic belongs to that small tribe of such analysts (there are roughly a dozen members) who can read trends and can spot inflection points very well.

His report of January 26 was, we think, a great example of this. His antennae are telling him that something fundamental has shifted and new, more favorable factors are driving company results. It is time to raise growth rate assumption. How much have conditions improved? Plovanic isn’t putting a number on it. But he sure is pointing at the direction.

To close, Plovanic took his macro insights and applied them to specific companies—always an act of courage, but one for which he earns the big bucks.

Here are his summary comments by selected company (not an all-inclusive list):