SYK - The FDA Crash - Are Regulations Killing The Bull Case For Medical Devices And IHI?

2023-10-12 12:05:15 ET

Summary

• FDA announcement of the creation of a Digital Health Advisory Committee causes a 7.2% decline in the iShares U.S. Medical Devices ETF.
• Digital health industry shows immense potential, driven by consumer-driven healthcare, remote monitoring, and telehealth trends.
• Industry giants like Abbott Laboratories, DexCom, ResMed, and Intuitive Surgical show resilience and promising potential despite regulatory fears.

Introduction

One of my favorite industries to invest in was just disrupted by a major FDA headline. The U.S. Food and Drug Administration announced that it's creating a new Digital Health Advisory Committee to " help the agency explore the complex, scientific and technical issues related to digital health technologies ("DHTs") [...] ."

As one can imagine, the moment the government gets involved (even more than it already is), investors get nervous.

The iShares U.S. Medical Devices ETF ( IHI ) , the largest ETF in this industry, closed the day with a loss of 7.2%, one of the biggest daily losses of the past decade.

Incepted in 2006, this ETF has more than $4.8 billion in assets, making it one of the largest themed ETFs on the market.

With 54 holdings, this ETF tracks equities in the U.S. medical devices sector, one of the most advanced healthcare areas on earth.

The ETF, which has an expense ratio of 0.40%, is overweight in investments like Abbott Laboratories ( ABT ), Intuitive Surgical ( ISRG ), Medtronic ( MDT ), and Stryker Corporation ( SYK ).

Hence, in order to track this industry, there's no better ETF than IHI. This also goes for investors seeking industry exposure without having to pick specific winners in a very competitive landscape.

In this article, we'll dive into the details of digital health and why I believe that fears of additional FDA intervention are overblown.

I'll also show you my favorite players in the industry and explain what makes them potentially highly attractive long-term investments.

So, let's get to it!

Digital Health Is Where It's At

Digital health is fascinating - for a wide variety of reasons.

Especially the COVID-19 pandemic that emerged in 2020 triggered a significant digital health transformation, influencing various aspects of healthcare.

As reported by the Medical Device Network , MedTech leaders and healthcare providers embraced new technologies to enhance patient care and operational efficiency.

Please note that these two areas cover two very important aspects of healthcare.

• Enhancing patient care.
• Operational efficiency.

One can offer the best care in the world without being efficient. The problem is that we need to be increasingly efficient. Labor shortages and rising costs, among other issues, have put tremendous pressure on health to become not only better but also more efficient!

With that in mind, several trends are propelling the growth of the digital health market, including the rise of consumer-driven healthcare, demanding " anywhere, everywhere " access.

Consumers are becoming active participants in their healthcare decisions, necessitating the adoption of digital tools by healthcare professionals.

According to Accenture , more than 70% of companies want to include consumer-patient trends in their business strategies.

Smartwatches are just one example of this. People can continuously monitor some aspects of their health, including their heart rate, sleep quality, blood oxygen levels, and related.

Furthermore, according to Accenture's report, long-term trends include empowering patients to own their health data, thereby enabling the development of personalized medicine and advancements in drug discovery.

These trends also include the ability to provide care anywhere, at any time.

As we can see in the overview below, this includes:

• Remote devices and monitoring.
• Preventive care (wearables).
• Telehealth.

Based on this context, this is a great opportunity to show you some of my favorite players in the industry - before we move to regulatory risks and challenges.

Please note that I added links to relevant articles, as this article would get too long if I went into too much detail on each company. By clicking on the companies' names, you get re-directed to Seeking Alpha articles that explain my longer-term view of these companies.

• Abbott Laboratories.

Abbott is a dividend king with a 2.3% yield. The company is also one of the biggest players in the devices industry and the largest holding of the IHI ETF.

Abbott's Medical Devices segment specializes in managing heart disease, vascular conditions, diabetes, and neuromodulation.

Its Medical Devices segment is its crown jewel, growing by 14.2% in 2Q23 (without acquisitions!).

Especially the company's Diabetes Care products are doing well.

Within Diabetes Care, Freestyle Libre sales exceeded $1.3 billion in the quarter, growing by 25% on an organic basis. ABT also achieved a significant milestone as Libre became the first and only continuous glucose monitoring system to be nationally reimbursed in France for all people with diabetes who use insulin.

• DexCom ( DXCM ).

DexCom is one of the hardest-hit companies. In September, I wrote that the company was up to 40% undervalued. Now, it's 26% lower.

DexCom wasn't just hit by regulatory issues, but also fears that GLP-1 (weight-loss drugs) could reduce diabetes cases.

DexCom is a leader in diabetes measuring instruments and devices that help customers control and regulate their own glucose levels.

In 2021, an estimated 537 million adults worldwide had diabetes, with this number expected to reach 783 million by 2045.

The market for glucose monitoring devices is intensely competitive , subject to rapid change and significantly affected by new product introductions and other market activities of industry participants. In selling our current CGM systems, we compete directly with the Diabetes Care division of Abbott Laboratories; Medtronic plc's Diabetes Group; Roche Diabetes Care, a division of Roche Diagnostics; privately-held LifeScan, Inc.; and Ascensia Diabetes Care , each of which manufactures and markets products for the single-point finger stick device market. Collectively, these companies currently account for the majority of the worldwide sales of self-monitored glucose testing systems . - DexCom 2022 10-K (emphasis added).

So far, DXCM is doing very well in this competitive industry and is even bullish that GLP-1 therapies require additional monitoring of glucose levels. Its products will substitute GLP-1 therapies instead of being driven out of business.

Hence, expectations are that DXCM is expected to grow its EBITDA by more than 20% per year on a prolonged basis.

The biggest problem is regulatory fears, as DXCM is one of the companies expected to benefit from AI adoption.

• ResMed ( RMD ).

ResMed is another favorite of mine that has been crushed by regulatory fears and (expected) GLP-1 headwinds.

ResMed produces and sells products that help customers with breathing issues and send data to their healthcare providers. This allows healthcare providers to monitor and treat customers remotely, increasing productivity and improving patient support.

On top of GLP-1 and regulatory fears, it also saw some pressure on margins as it shipped older models to customers instead of high-margin newer products. The company has done this to distribute available products and satisfy demand.

If it had waited to support margins, customers would have had to wait much longer for support.

Now, the company is quickly adapting to changing tech trends to expand its own offering. This includes AI.

Early testing of these AI-driven data products is very positive in both of these customer groups , and we will refine to the optimal digital design and then we will launch and then we will scale these products around the world . These AI-driven data products provide personalized suggestions to increase therapy adherence and to ultimately improve patient outcomes as well as patient, physician, and provider experience. - RMD 4Q23 Earnings Call

This brings me to the next stock.

• Intuitive Surgical .

Intuitive Surgical is the second-largest holding of IHI. It's also a company that may be best protected against regulatory issues.

The company manufactures robotic systems that minimize the impact of surgeries and hasten patient recovery.

According to the company (emphasis added):

The da Vinci surgical systems are designed to enable surgeons to perform a wide range of surgical procedures within our targeted general surgery, urologic, gynecologic, cardiothoracic, and head and neck specialties. To date, surgeons have used the da Vinci Surgical System to perform dozens of different types of surgical procedures . Da Vinci systems offer surgeons three-dimensional, high definition ("3DHD") vision, a magnified view, and robotic and computer assistance. They use specialized instrumentation, including a miniaturized surgical camera (endoscope) and wristed instruments (e.g., scissors, scalpels, and forceps) that are designed to help with precise dissection and reconstruction deep inside the body .

Thanks to a rapidly expanding installed base, the company is also increasingly benefitting from recurring revenue, which re-risks its business and paves the road for more consistent growth.

Also, risks related to weight loss drugs are limited, as the company offers complementary services.

This is what the company said during its 2Q23 earnings call:

Some customers have indicated that they are seeing increased patient interest in weight loss drugs . It is too early to conclude if the slowing growth is a temporary pause as patients evaluate these new drug therapies or if it is a trend that continues. We believe that during the quarter, da Vinci continued to gain market share in the bariatric surgical market .

Hence, of all my favorite stocks in the industry, ISRG has been the best performer.

Over the past 12 months, ISRG has returned 51.6%, outperforming the IHI ETF by a mile. Note that the other stocks in this article have underperformed the IHI ETF, which shows that the stars in the medical devices industry have now become laggards, at least for the time being.

I expect that to change, as regulatory risks may be overblown.

How Much Fear Makes Sense?

To go back to the FDA announcement I showed at the start of this article, the FDA isn't yet threatening anyone. It is just making sure that the massive trend in medical devices doesn't pose any risks to patients. After all, we're dealing with a megatrend that involves very critical patient data.

According to the FDA (emphasis added):

The Digital Health Advisory Committee will advise the FDA on issues related to DHTs, providing relevant expertise and perspective to help improve the agency's understanding of the benefits, risks, and clinical outcomes associated with use of DHTs . The committee should be fully operational in 2024.

To support the development of safe and effective digital health technologies while also encouraging innovation , the FDA will solicit views from the committee, which will consist of individuals with technical and scientific expertise from diverse disciplines and backgrounds. This will help ensure digital health medical devices are designed and targeted to meet the needs of diverse populations .

Moreover:

"Technology moves at an incredible pace, and we're excited to have a committee of experts throughout the field who can help ensure our regulation of these exciting tools maintains an appropriate pace while working within parameters of safety and effectiveness standards," said Troy Tazbaz, director of the FDA's Digital Health Center of Excellence.

As I do not yet have a significant position in this industry, I can say without bias that none of this worries me. The initial reaction was expected. The moment the government gets involved, investors fear price caps, slower innovation, and related risks.

While the FDA's increasing involvement won't strengthen the bull case, I see no reason why companies should suddenly run into issues - especially the companies mentioned in this article.

Similar findings came from an October 9 Wall Street Journal article .

The article discussed the challenges faced by the FDA and other US agencies in establishing policies amidst the growing AI revolution.

Between 2020 and late 2022, the FDA approved over 300 devices incorporating AI features, surpassing the approvals of the entire previous decade, as AI is still in its early phase.

Striving to navigate this evolving landscape, the FDA is evolving its traditional oversight methods to accommodate the dynamic nature of AI-enabled devices.

Unlike static compounds, AI algorithms in devices can rapidly evolve, (potentially) posing a challenge for maintaining safety while allowing improvements.

Furthermore, the FDA's evolving policies are influencing the development trajectory of AI-powered healthcare products, which is what investors are fearful of.

Startups, wary of regulatory complexities, might limit the scope of their innovations, focusing on smaller problems than their algorithms can potentially tackle.

The FDA's influence in defining regulatory boundaries thus inadvertently shapes the direction and scale of product development in the healthcare sector.

In other words, I believe these developments confirm what I just said. While smaller startups could see innovation risks, the main focus here seems to be on AI and not knowing how AI could handle our data and health in the future.

What if something goes wrong? What if a future AI tool misreads data and kills a patient? We don't know what could happen.

In light of these developments, I cannot make the case that the FDA's increasing involvement is bearish for IHI or any of the stocks I mentioned.

AI is still somewhat limited in these company's product and service portfolios, and all of these mega-corporations know they need to be careful with AI.

Major risks to the medical devices bull case are elevated rates, pressuring funding, and demand. Also, competition is an ever-present risk.

In the case of the IHI ETF, competition is somewhat eliminated.

The Verdict

Medical Devices were the place to be (I believe they still are).

Over the past ten years, IHI has returned 238%, which beats the healthcare sector and the S&P 500, even after the recent decline.

As the chart above shows, IHI started to decline in late 2021.

A lot of medical stocks were overvalued due to the pandemic. This resulted in selling. Also, accelerating inflation caused funding fears, pressuring demand expectations.

This year, GLP-1 and regulatory fears have been added to the list of worries.

However, I do not believe that either GLP-1s or regulatory involvement can derail the long-term bull case.

IHI and the stocks discussed in this article remain my favorites for long-term healthcare investors.

I have little doubt that if I were to write a follow-up in ten years, we could see that IHI is still outperforming.

Hence, despite the new FDA involvement, my strategy remains unchanged. I'm still looking to incorporate some of these stocks into my portfolio.

For now, my favorite is ABT, as it comes with long-term dividend growth and a 2.2% yield. As I'm a dividend growth investor, it makes a lot of sense for me to add ABT soon.

Takeaway

The recent FDA announcement regarding the creation of a Digital Health Advisory Committee stirred the medical devices industry, causing a notable market dip.

The iShares U.S. Medical Devices ETF saw a 7.2% decline, reflecting investor nervousness as government involvement in this sector raised concerns.

However, a deeper exploration into the digital health landscape reveals immense potential, especially with support from the shift during the COVID-19 pandemic.

Consumer-driven healthcare, remote monitoring, and telehealth are pivotal trends driving growth.

Despite regulatory fears, certain industry giants like Abbott Laboratories, DexCom, ResMed, and Intuitive Surgical show resilience and promising potential in navigating these challenges.

Long-term healthcare investors may find value in these players, as the FDA's increasing involvement is perceived to primarily focus on AI-related issues rather than significantly impacting the established medical devices landscape.

Thus, opportunities for long-term growth in the medical devices industry remain very compelling.

For further details see:

The FDA Crash - Are Regulations Killing The Bull Case For Medical Devices And IHI?