Summary
- Something about medical devices seems to encourage huge premiums on the multiples.
- Thermo Fisher and Abbott Labs are still dealing with the substantial come-down of their COVID-19 supported revenue.
- This revenue will not rebound from COVID-19 pickup, so the high 50x P/E seems unreasonable.
The iShares U.S. Medical Devices ETF ( IHI ) is a pretty fair representation of the listed medical devices field in the U.S., and the value-weighted nature for the most part keeps the expense ratios pretty low despite the relatively narrow scope. However, valuation continues to be a major problem, especially as the top holdings suffer from the comedown of COVID-19 earnings. This won't rebound, so we would not buy this exchange-traded fund ("ETF").
Quick IHI Breakdown
IHI has a pretty strong skew towards its top two holdings:
Thermo Fisher Scientific Inc. ( TMO ) and Abbott Laboratories ( ABT ) dominate the portfolio. Between the two , TMO definitely warrants less concern, but both have quite a bit of exposure to the surge in revenues that came from COVID-19 testing and lab engagement. The problem is that both sequentially and year-on-year, these revenues have been coming down as COVID-19 becomes less concerning both to the populace and politicians as issues around the economy arise. For TMO, the risk is more limited at around 10% of revenues, but for ABT, it's between 20-30% of the revenue that is at risk. We say "at risk," but in reality, COVID-19 revenue is almost certainly going to fall into possibly negligible amounts.
While the revenues are slated to fall, we are still looking at a monstrous P/E of 50x. Growth is really not good across these two main holdings, and the Seeking Alpha Factor Grades will tell you that.
For TMO, growth is bad, and cannot justify its multiple. Sales growth has stalled TTM, and the operating income is falling as inflation pressure and mix effects mount. ABT is at least seeing enough offsetting growth in other categories to keep positive growth in revenue and operating income, but it is still too limited for the multiple and trails the sector medians. Moreover, the growth only appears in TTM figures. In the quarter, earnings and sales growth are both falling, with the latter half of the year providing the weakness. At least ABT has the diabetes market with its blood sugar monitors, continuing to grow secularly.
Bottom Line
The 50x multiple doesn't seem reasonable, but it's not out of nowhere. The uses of medical devices are in secular growth, moreover, the value provided by the innovations in medical devices for the healthcare system is also valuable. Finally, there is also support from demographics, as older people require more care, and the population of dependents on the older side will grow a lot over the next 20-30 years, owing to great dependency ratios today.
The problem is that the market appears to be approaching medical devices with a modicum of blind faith. The ETF has traded down in line with the market, despite their valuations being more sensitive to growth. More than 30% of the portfolio is exposed to companies that are seeing their revenues impaired by a COVID-19 reversal, and they will have to generate and invest for growth in other areas to compensate.
The iShares U.S. Medical Devices ETF expense ratio is admittedly pretty low at 0.39%. This is not only below the mode for iShares ETFs, but it is also below average for ETFs that have relatively narrow scopes like this one. Nonetheless, there is no interest in iShares U.S. Medical Devices ETF on our part when there are so many more bargains on the market.
For further details see:
IHI Is Just So Expensive