Interview by JIM STOMMEN

BB&T Contributing Editor

Phil Nalbone is a senior vice president and medical technology analyst at Wedbush Securities in San Francisco. During more than 18 years as a sell-side analyst, he has covered more than 80 companies at all levels of market capitalization. His main areas of focus currently are interventional cardiology, cardiac electrophysiology, spine devices, and aesthetic medicine.

Nalbone began his career as a medical products analyst at Hambrecht & Quist in New York and later served as a partner and senior medical technology analyst at Volpe Brown Whelan & Co. in San Francisco and as a director and senior medical devices analyst at Salomon Smith Barney.

Prior to joining Wedbush in September 2009, he spent nearly seven years at RBC Capital Markets as a managing director and senior medical devices analyst.

Nalbone discussed with BB&T Contributing Editor Jim Stommen the current state of the med-tech industry, regulatory overload and potential opportunities within the sector moving forward.

BB&T: The economists are saying that we've turned the corner in terms of the global downturn. How would you characterize the status of the med-tech sector today as compared to a year ago?

Nalbone: I would say that it's largely irrelevant what the economists are saying. The macroeconomic environment has definitely taken a toll on the med-tech sector. But that's the least of the sector's problems. Right now we're seeing a confluence of cyclical pressures and those have been driven by the economic environment: fewer people with insurance and fewer people with jobs, meaning fewer doctor visits, fewer diagnostic tests and a big slowdown in hospital admissions and interventional and surgical procedures of all sorts. There is a case to be made that some of those cyclical pressures will abate over time as the economy improves, but frankly, I think the economy is in for a rough patch for some time to come.

The real problems for the industry are structural. They relate to the fact that we have far too much competition in mature product categories, far too much pressure on pricing, far too little evidence-based medicine to support a lot of the common procedures and therefore a lot of pushback on the part of the insurers in terms of allowing those procedures. Those structural issues are not going to go back into positive territory; those are going to be with us in perpetuity.

BB&T: What's your slightly longer-term outlook for the sector? Are you optimistic at all in terms of the second half of 2011?

Nalbone: No, I remain quite pessimistic for pretty much the balance of 2011, and that's because we're not really going to see in that timeframe the appearance of significant new products that could change the growth or profitability profile for the industry. I really believe that for the next year or more, we're going to continue to deal with the kind of stagnation that we have seen for this industry over the past year. When you break it down, you're looking at the largest product categories that used to be growth drivers now essentially flat or trending down. For example, cardiac rhythm management – implantable defibrillators and pacemakers combined – are probably going to be down by a couple of percentage points on a year-over-year basis during the third quarter. Drug-eluting stents will essentially be flat on a year-over-year basis. Spine devices I think are perhaps one of the biggest wakeup calls for investors in this sector – this is a market that was growing 10% to 12% just one year ago; right now we see growth essentially flat on a year-over-year basis. I don't see pressures on those key product categories letting up anytime soon.

BB&T: In cardiovascular, percutaneous heart valve repair looks like a bright spot. Is that the way you see it?

Nalbone: I absolutely agree. That's one of the few promising areas for growth that unfortunately isn't an immediate-term opportunity. That's something that could affect the fortunes of this industry two to five years from now, but it's clearly one of the bright spots in terms of the pipeline. Certainly we believe that Edwards Lifesciences (Irvine, California) is in the lead here, and it will affect their fortunes significantly. Medtronic (Minneapolis) is a fast follower, but perhaps a couple of years further out. But nothing that really moves the needle for these big players in the immediate term.

BB&T: How does healthcare reform fit into your assessment of where med-tech is headed? I'm particularly wondering if you think that the whole “new insureds“ population will have any impact on moving the needle, or if because they're going to be mostly younger and healthier, that's not going to have much of an impact either.

Nalbone: I don't really think that we're going to see any salvation from more people entering the system. I think that the major factor will continue to be pressure on pricing and pushback from insurance carriers on allowing procedures that may not be necessary, and these factors will offset the increased number of participants in the system. So, from a financial perspective, I think there will still be very significant challenges for industry.

My med-tech coverage straddles both the pharmaceutical and the medical device segments and it's pretty clear that we're already seeing downward pressure on the financial performance of the pharmaceutical companies due to some of the healthcare reform initiatives. Financial performance has already been hurt this year from the increase in the Medicaid rebate rates. Beginning next year, we're going to see incremental pressure on the pharma companies in the form of the elimination of the federal income tax deduction related to filling the Medicare Part B donut hole.

And then, of course, for the medical device industry beginning in 2013, we have the specter of the 2.3% excise tax on sales of most medical devices. So the financial impact for most of the companies will be negative, even with more users coming into the system. Theoretically, we're supposed to see a lot more people show up for treatment, but industry has to fund these reform initiatives and I think treatments are going to be at pricing that offset the increased demand.

BB&T: It certainly is clear across the spectrum that pricing as a commodity is definitely going to be the thing.

Nalbone: Hospitals have become extremely sophisticated in how they think about pricing, and they are playing hardball with the manufacturers. They are demanding big pricing concessions, and because the manufacturers want to hold onto share in an intensely competitive environment, they are capitulating, and I don't see any change in that pattern. I don't think that industry will regain any pricing flexibility in existing product categories. It's going to be all about new product flow and new therapeutic categories, but unfortunately I think we have a bit of an innovation gap within the industry and we're just not going to see significant new product categories enter the equation for perhaps another couple of years. In the meantime, we're likely to see increased pricing pressures for the device industry in Europe next year as the austerity plans in that region take root.

BB&T: Your point about covering both sides of the medical universe leads me to wonder if you see some modest salvation down the road in terms of combination products.

Nalbone: We've been hearing about this theme of drug-device combinations or biologic-device combinations for many, many years now – and the best example to date has been drug-eluting stents. Of course there will be important new therapies that are combination products down the road, but as a theme, as something that an investor should try to focus on, I don't see too many near-term opportunities there. There will be one-off opportunities over the years, but as a broad investment theme, I think most investors would be disappointed attempting to find things that would be meaningful opportunities.

BB&T: Your coverage universe focuses on some of the bigger players in the sector, but part of what you watch for is how those companies stock their product pipelines via acquisitions of smaller firms with innovative products that are nearing or have just begun commercialization. Who do you see continuing to be major participants in M&A, and are there newcomers to the process looking to make some significant plays?

Nalbone: There certainly have been newcomers over the past year or so. It has been interesting to see some of the smaller companies trying to gobble up competitors and do filler, tuck-in acquisitions, but for the most part I think we're going to see a continuation of what we've seen for the past several years. Consolidation will be a very big factor in this industry, and it will be all the usual suspects. It will be the J&Js and Medtronics and St. Judes and Covidiens of the world, looking at anything that makes sense. Boston Scientific would like to do deals, and needs new growth drivers, but for the foreseeable future will lack the wherewithal to pursue significant deals.

One of the reasons that I continue to like Abbott Laboratories (Abbott Park, Illinois) is that the company has been targeting acquisitions in a very broad range of therapeutic categories and technology categories. Biologics, diagnostics, pharmaceuticals, medical devices, diabetes care, vision care – really covering the whole spectrum in drugs and devices. They have tended to acquire very shrewdly and to integrate very well and to get the desired synergies.

Right now, it's pretty clear that these are very challenging times for the medical products industry broadly speaking, including both devices and drugs, particularly in the developed world, where growth has slowed dramatically. One of the major points of differentiation for companies in this industry over the next several years will be the extent to which they can grab a meaningful share of the much faster-growing emerging markets. Abbott stands out here. They have been very aggressive in targeting the emerging markets: they already are the No. 1 pharmaceutical company in India, one of the fastest-growing markets in the world. At a time when the pharmaceutical industry in the developed world will be growing in the very low single digits, the pharmaceutical market, particularly for branded generics, in the emerging markets will be growing in the range of 15% to 20%. So we see that sort of geographic expansion as being more important in the near term than product-based expansion or diversification. Abbott already derives about 20% of its revenues from the emerging markets, and that will increase a lot during the next few years.

BB&T: One of the interesting things about Abbott has been their fearlessness in identifying an area they haven't been in at all and going out and making a big acquisition.

Nalbone: It's true, and generally the strategy has worked very well for Abbott. The biggest deal, the most transformative, was back in the 2000 timeframe, the acquisition of Knoll Pharmaceuticals, which brought in their now-flagship product, Humira, one of the most successful drugs or biologics ever and a main engine of growth for Abbott, now representing about 18% of revenues. You're absolutely right, they have targeted many new areas for expansion and then typically made them work. They acquired Guidant Vascular and are now the No. 1 player in the drug-eluting stent market. They acquired Kos Pharmaceuticals and significantly expanded their blood-lipid drug franchise. They made a big push into the vision care market. So yes, I would say they have been fairly intrepid and also quite successful in their acquisition strategy. Lately it has mostly been about the opportunity to expand globally and to lock in a big presence in the emerging markets. The Solvay deal earlier this year was a major first step, and then more recently some deals in India, both a acquisition and a distribution agreement for branded generics, have gotten them critical mass in that key market.

BB&T: Many of those involved in the start-up end of the equation – especially the entrepreneurs who start such companies and the angel or venture investors who back them – are outspoken these days about how growing uncertainty in the regulatory process is impacting innovation in the U.S. med-tech sector. Are the big guys worried as well about whether their start-up “farm system“ is threatened?

Nalbone: Yes. I think we've seen the VC community take a big step back in its level of interest and its investment in the medical device sector, in part because they're not seeing meaningful innovation and in part because the pathway to product approval has become so uncertain. This is a common theme in discussions that I have with executives of medical device companies both large and small. The FDA approval process is now very uncertain, and the large, acquiring companies are very averse to taking on clinical and regulatory risk. It really means that they are going to wait out regulatory approvals and then pay up to make acquisitions once something has been approved and validated commercially. So while we're going to see a lot of M&A in the sector, a lot of it is going to be among later-stage companies. There will be exceptions, of course, but the most common targets will be companies that have already commercialized their products.

BB&T: The days of buying companies that are still in Phase II clinicals may be a thing of the past.

Nalbone: We're reminded almost daily of the pitfalls of unblinding Phase III data, and we're reminded repeatedly that there is no certainty about the timing or logistics of FDA approval of new products. Again, there will always be exceptions. But, generally, the big companies are shying away from taking on clinical and regulatory risks.

BB&T: There seem to be signs that the new leadership at the FDA may be “getting it“ in terms of regulatory uncertainty and may be ready to take steps that might bring greater clarity to clinical issues, even though that appears likely to bring more stringent requirements for companies in achieving approvals. Would the existence of greater clarity represent a reasonable tradeoff vs. having to meet more difficult requirements?

Nalbone: Well, I absolutely believe that greater clarity and consistency would help the sector. I think that one of the worst things that business people and investors are asked to deal with is uncertainty. But I don't agree that the FDA “gets it“ in terms of trying to provide clarity or consistency. I think that they “get it“ in terms of trying to appear tough and to cater to the desire of Congress and the news media to appear to be acting with an abundance of vigilance in terms of protecting public safety. But I would say that since Dr. Margaret Hamburg became FDA commissioner in May 2009, we have had nothing but a lack of clarity. The agency has outlined a very aggressive effort to step up its oversight of drugs and devices to prevent harm to the American people. In a now-infamous speech that Dr. Hamburg gave in August 2009 to the Food and Drug Law Institute in Washington, she said, “The FDA must be vigilant, the FDA must be strategic, the FDA must be quick, and the FDA must be visible.“ And it is clear that the FDA is trying to be all of those things, and especially they're trying to be visible, they're trying to send a clear message to the American public that the cop is on the beat.

The agency has become not only more vigilant, but much more punitive, and in many ways more uncertain of itself. And all this has resulted in many more enforcement actions, and a much slower pace of product reviews and approvals. We've seen products that have been on the market for a while being withdrawn from the market. We're seeing more companies getting FDA warning letters and having to hold up the launch of important new products. I would say that the level of FDA scrutiny is truly unprecedented, and we're a long way away from having true clarity on what any of this means. Right now, it means a muddle and very uncertain times for the industry and a much higher level of risk for investors.

BB&T: Sounds like my question should have been, “Does the FDA get it in terms of posturing?“

Nalbone: They definitely get it in terms of posturing. Some might say pandering – to Congress and to consumer advocacy groups and to the news media.

BB&T: The new economic realities mean that investors of all kinds – from venture to individual to institutional – are having to adjust to the reality of smaller returns. Might that bode well for at least part of the medical-products industry, where they're comfortable with a smaller return? Diagnostics, for instance, is an area where there may be opportunities for start-up firms because VCs are comfortable with smaller returns in exchange for greater promise that it's actually going to happen.

Nalbone: I think we are in a situation where we're trading the hopes and dreams and aspirations for huge returns from outsized growth opportunities for opportunities that are a little bit more grounded in reality. In a world where you have low single-digit growth, upper single-digit growth starts to look pretty good. So yes, I would say that investors at all levels, in the venture stage and within the public markets, are definitely moderating their expectations in terms of growth and returns.

BB&T: You've talked about how cardiology is flat. What other areas are poised for growth?

Nalbone: There definitely are new technologies in the vascular space, new technologies in the neuro space, so I do think we'll see growth opportunities there. There will be one-off growth opportunities in all of these product categories, but in many cases it could be very short-lived and just related to new product cycles. There's clearly innovation in all of these fields, and one would hope that eventually we'll find something meaningful in the treatment of obesity. So far, that has been a very, very disappointing arena, but I sense that VCs continue to look at anything that is in the pipeline in the obesity space. For the most part, investors are not playing themes, they're not playing therapeutic categories – they're looking at the unusual, one-off opportunities that exist throughout the sector.

As we have looked at the world recently, within our coverage universe three stand out: one jumbo-cap, one small-cap and one micro-cap. Abbott is the biggest, and again, it's largely about the geographic differentiation that it is bringing to the story.

In the small-cap space, we like a company called Zoll Medical (Chelmsford, Massachusetts), which is finding new opportunities for growth in cardiac resuscitation, previously thought to be a pretty mature, sleepy market. But Zoll has been both innovative and acquisitive and they have found ways to take an entirely innovative approach to their markets. Zoll now has a completely new product cycle that will give the company an outsized growth opportunity for several years to come. In fact, I think Zoll represents one of the best new-product stories in the entire medical device industry right now.

Then in the vascular space there's a company we like very much, Vascular Solutions (Minneapolis), which makes a variety of clinical niche catheters for interventional cardiology and interventional radiology. We think that Vascular Solutions has a very, very nice growth opportunity over the next several years as it cranks out a bunch of products to leverage its large sales force. The company has done very well pursuing that multi-product strategy, with big improvements in the operating margin and overall profitability as a result. Now, with the recent launch of a new catheter-based device called GuideLiner for treating some of the most challenging cases of blocked arteries, Vascular Solutions has entered the mainstream of interventional cardiology practice and is gaining the respect and attention of some of the luminary doctors in the field. This marks a turning point for this small company, and I think will lead to upside in the company's financial performance during the next year. GuideLiner itself could become a pretty big product, and I think it will pull through sales of Vascular Solutions' many other products for the cath lab as the new device opens doors to new accounts.

We're very much in a mode where you as an investor need to be very selective in the med tech field. More than ever, we need to do the work to identify companies, not therapeutic categories, not big broad themes, but companies that have somehow managed to create new product cycles or differentiated growth opportunities through geographic expansion, that provide the potential higher growth and for operating leverage improvement. Right now, we see very few companies, large or small, that meet those criteria.

BB&T: Is there a question I haven't asked that you wish I had?

Nalbone: Not a question, really, just a further observation on the matter of investors in the sector. It's fair to say that most investors are now pretty well-versed in the challenges affecting this industry. Most are a little burnt-out on the med-tech industry, but I think we're in the very early stages of investors asking the right questions about where the promising, one-off opportunities might reside. Over the next year or so, it will be a matter of individual stock-picking rather than these broad themes of yesteryear that people could latch onto. I don't think buying the basket is going to get you there – I think it's going to be all about selectivity, and that's the main theme that I'm trying to focus investors on.