Device Sector Defies Economic Downturn

Johnson & Johnson's solid second-quarter results reported in mid July 2008 suggested the weak economy hasn't slowed demand for procedures such as knee and hip replacements – a good sign for the medical device industry.

Investors who were braced for confirmation that weak economic conditions were prompting consumers to postpone the elective surgeries breathed a sigh of relief at the J&J numbers.

Shares of Zimmer Holdings Inc, the largest maker of orthopaedic devices, and Stryker Corp each climbed about 2% following the J&J results.

ECONOMIC CONCERNS

"The big worry on the ortho side has been industry volume growth rates; and when you get the number two player reporting good volume growth, it really helps. That is why all the stocks are up today in the ortho space," says Tim Nelson, analyst with FAF Advisors, investment adviser to First American Funds, which owns J&J shares.

The medical device sector has traditionally served as a safe haven for investors in tough economic times, and the current economic downturn has proved no exception.

The Standard & Poor's Health Care Equipment Index <.GSPMED> which includes 11 healthcare companies, is up about 2.3% for the year to date, while the broad Standard & Poor's 500 Index .SPX> has fallen about 21%.

However, some have worried that parts of the industry may be more vulnerable to an economic slowdown this time around as more Americans go without medical insurance, and as those who have it are forced to shell out larger co-payments for procedures.

In the first quarter, sales of hip and knee replacements slowed across the industry, including for J&J.

Rising raw materials costs have also fanned concerns about the sector's resiliency.

DEVICE SECTOR STAYS STRONG

But in July, J&J's DePuy orthopaedic unit posted worldwide quarterly sales growth of 13.6%, or 8.5% excluding the impact of the weak dollar, which boosts the value of overseas sales when converted back into US currency.

Sales of surgical products in the company's Ethicon and Ethicon Endo-Surgery divisions were also strong. Strength in the medical businesses helped offset soft growth in pharmaceutical sales.

J&J chief financial officer Dominic Caruso said the company saw no slowdown in orthopaedic procedures in the latest period, and the first quarter's weakness was not the start of a trend. J&J also said higher materials prices so far were not having an impact on its businesses.

J&J's total US medical device and diagnostics sales rose 4% from a year earlier, tempered by declining sales of J&J's Cypher drug-eluting stent to treat clogged heart arteries, which is under pressure from new competition from Medtronic Inc and Abbott Laboratories Inc.

Still, the growth in overall US device sales represents a rebound from flat first-quarter levels and should allay fears about slowing US surgical procedure volumes, particularly for Zimmer and Stryker, said JP Morgan analyst Michael Weinstein.

"What's clear is that J&J's results bode well for the device group, in our view," Weinstein said in a note to clients.

J&J's medical devices as well as its consumer brands should continue to fare well in a slowing economy, says Morningstar analyst Damien Conover, who expects sales growth in the high single digits for the DePuy orthopaedic business going forward, excluding any currency benefit.

"The resilience of these more staple-like products is really showing up in this quarter," he adds.