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MORGAN STANLEY RESEARCH EUROPE plc+an Stanley & Co. InteMichael K Jungling Michael.Jungling@morganstanley.com +44 (0)20 7425 5975 Karl Bradshaw, PhD Karl.Bradshaw@morganstanley.com +44 (0)20 7425 6573 Andrew E Olanow December 1, 2010 Andrew.Olanow@morganstanley.com +44 (0)20 7425 4107 MedTech & Services Valerie M Rinecker Valerie.M.Rinecker@morganstanley.com +44 (0)20 7677 0209 2011 Strategy & Model Book Industry View Recommendation Medical Technology Attractive to Cautious In our 2011 Strategy & Model Book we provide updated stock recommendations, earnings models and Medical Services In-Line an overview of the important investment themes. Stock Ratings MEDTECH UNDERPERFORM & SERVICES NEUTRAL Market Cap In 2011, we expect EU MedTech to underperform the Company Recommendation (EURm) Price Target EU Market as fundamentals deteriorate; as a result, its Fresenius SE Overweight 17,515 €72 10-YR average 1 YR FW P/E Relative of 1.6x may William Demant Overweight 3,174 DKK 490 struggle to hold. We expect EU Services to be neutral Life Healthcare Overweight 1,553 1,650 ZAc against the EU market; a relative valuation of 1.4x vs. its GN Store Nord Overweight 1,265 DKK 55 Synergy Overweight 539 940 GBp 10 YR average of 1.2x should be sustainable, supported Fresenius Medical Care Equal-Weight 10,600 €46 by acquisitive growth, government outsourcing and better reimbursement protection compared with Essilor Equal-Weight 10,409 €48 Smith & Nephew Equal-Weight 9,802 590 GBp MedTech. Short-term stock picking will be key to making money in 2011 – with greater volatility expected, Sonova Equal-Weight 1406,559 SFr. Elekta Equal-Weight 2212,491 SKK regular profit taking will be required, and investors Rhoen Klinikum Equal-Weight 2,215 €17 should be prepared to revise their holdings accordingly. Synthes Underweight CH1F1,020 111 INDUSTRY & INVESTMENT THEMES Coloplast Underweight 4,373 DKK 707 Celesio Underweight 3,270 €16 For 2011, key investments themes includeEU austerity Straumann Underweight 2,439 SFr. 160 measures affecting healthcare spend, US COBRA Nobel Biocare Underweight 1,125 SFr. 12.90 For valuation methodology and risks associated with any price targets above, please benefits rolling off and impacting elective procedure email email@example.com. growth in 1H 2011, volatileFX affecting growth rates and Source: Morgan Stanley Research margins, Emerging Markets growth opportunities and robust M&A activity from private equity or industry. OVERWEIGHT: FRE3, WDH, GN, LHC, SYR Our Overweights fall into four categories: 1] Value: Fresenius and Synergy; 2] Growth: William Demant and Life Healthcare; 3] High Risk / High Return: GN Store Nord; and 4] EU Austerity Benefits: Synergy. UNDERWEIGHT: NOBN, STMN, SYST, CLS1, COLOB Morgan Stanley does and seeks to do business with Our Underweights fall into three categories: 1] High companies covered in Morgan Stanley Research. As Valuations & Expectations: Nobel and Straumann; 2] a result, investors should be aware that the firm may EU Austerity Headwinds:Celesio and Coloplast; and 3] have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors Weakening Industry Fundamentals: SYNTHES. should consider Morgan Stanley Research as only a EQUAL-WEIGHT: LACK OF CATALYSTS single factor in making their investment decision. For analyst certification and other important We see Elekta, Essilor, FMC, Rhoen, Smith & disclosures, refer to the Disclosure Section, Nephew & Sonova as less actionable for time being. located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on research analyst account.ject company, public appearances and trading securities held by a MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services CONTENTS Outlook & Ratings 3 Review of 2010 Performance 12 Industry & Investment Themes 19 Medical Technology Industries 64 Medical Services Industries 90 Valuation Tables and Charts 107 MedTech Industry Statistics 125 Conferences & Meetings 130 2 MORGAN STANLEY RESEARCH MedTech & Services Outlook & Ratings Outlook for 2011 4 Relative Outlook 2011 6 Stock Ratings for 2011 9 Valuation Framework 11 3 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services Outlook & Ratings In this section, we provide our view on the 2011 Services sector has grown in market cap over the years and Outlook for the European MedTech & Services thus allows investors to pursue a more realistic and commercial sector and our revised stock recommendations. choice for allocating assets between devices and services. The aforementioned divergence in fundamentals is driven by: Outlook & Strategy for 2011 • Pricing – we see greater pricing pressure for the medical Before providing our Outlook & Strategy for 2011, we believe it device companies under our coverage (e.g. orthopaedics, is important to set the backdrop, by highlighting what happened dental, wound care, ostomy, incontinence) compared to in 2010. In 2010, EU MedTech underperformed the EU MSCI service providers (e.g. dialysis). Moreover, it is service by -7% (+5% vs. +11% for the market). The underperformance providers that are growing in size and should over time, as was driven by a strong cyclical recovery in the EU market, a result of greater purchasing power, put incremental which could not be matched by the generally more defensive pressure on medical device manufacturers. nature of the medical devices sector, which over the past 6-9 • Acquisitions – a core part of many service business months has been under further pressure from concerns about pending EU austerity measures on government healthcare models is to grow through acquisitions (e.g. hospital spend. Moreover, some cyclical constituents such as dental groups adding other hospitals, dialysis operators adding implants have so far shown nomaterial recovery, disappointing clinics, hearing aid retailers buying other dispensers, or investors. In 2010, EU Services faired better, outperforming decon/sterilization companies consolidating the market), the EU MSCI by +3% (+15% vs. +11% for the market), driven which are typically earnings enhancing within 2 years of by positive investor sentiment on dialysis, which represents a purchase, due to synergies. As a result, we feel there are large portion of the sector, and by other sub-sectors with more opportunities for growth than in MedTech. positive exposure to potential European austerity measures, such as outsourced healthcare services. • European Austerity – we see greater pressure on MedTech companies from EU austerity measures, Our 2011 investment strategy consists of three core themes:1] compared to the Services sector, which either has limited Stock Picking and Less Macro; 2] Services to outperform exposure (e.g. dialysis), is more immune (e.g. hospitals), Devices; and 3] Regular Profit Taking Required. or benefits from restricted budgets (e.g. governments outsource additional services). We estimate that >70% of 1] Stock Picking and Less Macro EU hospitals are government owned, many of which are loss-making. As such, we see it as unlikely that With the macro-economic picture showing a relatively stable governments will cut reimbursement, as it only increases backdrop (i.e. an ongoing tepid recovery in the developed the losses of their hospitals; this in our view should give markets and a strong recovery in the emerging markets), we private hospitals protection from material reimbursement feel making money in EU MedTech and Services, as in 2010, cuts. Moreover, history shows that periods of austerity will be driven by focusing on company specific events and have led to increased chances of additional privatisations, developments. However this would be an inappropriate view which can provide additional growth opportunities. for investors who are approaching 2011 with double dip concerns, in which case more of a macro call would be Exhibit 1 appropriate – this would mean being overweight reimbursed European MedTech – Performance and Average P/E (e.g. dialysis, orthopaedics) and underweight the non- Sector Performance CY08 CY09 CY10 YTD reimbursed sub-sectors (e.g. corrective lenses, hearing aids EU MedTech -28% 36% 5% and dental implants). We stress, that our 2011 strategy does EU Medical Services -31% 13% 15% not incorporate a double dip recession, in line with Morgan Reimbursed -21% 23% 11% Non-reimbursed -32% 44% 6% Stanley’s European strategists’ 2011 outlook. Sector 1-YR Forward P/E CY08 CY09 CY10 YTD EU MedTech 16x 14x 17x 2] Services to Outperform Medical Devices EU Medical Services 16x 12x 15x For 2011, we are taking a more distinctive approach between Reimbursed 17x 14x 16x the Medical Device and Medical Service sectors, based on our Non-reimbursed 15x 14x 18x Source: Datastream, Morgan Stanley Research view of diverging 2011 fundamentals. Furthermore, the EU 4 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services • Valuation – based on consensus valuations, the EU 3] Regular Profit Taking Required MedTech sector is currently trading on a 1YR forward P/E Unlike previous years, when investors could place 12-month of 17x vs. EU Services at 15x. In our view, the MedTech theme bets, such as reimbursed vs. non-reimbursed or a premium is vulnerable and as such, we feel investors may high-end hearing aid product cycle, we feel 2011 share price find greater upside in EU Services. performance will be more volatile. Due to the strong quarterly sales growth variability in 2010, most of the MedTech and As a reminder, the EU MedTech’s 1 YR forward P/E has been as high as 41x during the internet bubble, with a low of 10x Medical Services sub-sectors should see lumpy sales growth in 2011, with regular acceleration and deceleration. With during the recent financial crisis, while the 10 year average is MedTech still regarded as a growth sector, swings in sales 20-21x. The de-rating since 2007 is driven by a general slow growth performance can have a material impact on short-term down in sales growth for the sector. share price performance. As a result, it is possible that in one quarter, a sub-sector such as dental implants or reconstructive Exhibit 2 EU MedTech – 1 YR Forward P/E growth accelerates, driving share price performance, to only then see a reversal in subsequent quarters, as market growth again decelerates. 4x 41.4x Exhibit 4 3x Quarterly CC* Industry Growth Comps for 2011 21.6x Segment Q1 CY10A Q2 CY10A Q3 CY10E Q4 CY10E Dental Implants 3% 4% 4% 4% 2x 16.9x ` Radiation Oncology 5% 14% 13% NA Reconstructive 7% 4% 1% -1% 1x Spine 3% 0% 2% 4% 10.1x Trauma 8% 7% 5% 6% Source: Company data, Morgan Stanley Research, * = Constant Currency, ** = Order Book Growth, NA = not available Q4 2010 not yet forecast, e = Morgan Stanley Research estimates. 0x While some investors may expect the market to price this in, 5/31/2001 5/31/2002 5/30/2003 5/31/2004 5/31/2005 5/31/2006 5/31/2007 5/30/2008 5/29/2009 5/31/2010 11/30/200011/30/200111/29/200211/28/200311/30/200411/30/200511/30/200611/our observations over the past 12 months suggest that this is Source: FactSet, Morgan Stanley Research not always the case. To provide colour to our thesis, we have provided in the Exhibit above an overview of the quarterly As a reminder, the EU Medical Services’ valuation range has growth comparisons for a number of sub-segments. The most been as high as 26x in 2000 and subsequently fell to a low of 9x at risk are: in 2002, due to company specific issues with FMC and Fresenius. The 10 year average is 16x. • Reconstructive – Q1 & Q2 2011 face tougher comps and as a result may show weak sales growth in 1H. Q3 & Q4 Exhibit 3 comps are easier and could fuel an acceleration in growth EU Medical Services – 1 YR Forward P/E and thus be a share price catalyst for Smith & Nephew. 30 26.2x • Trauma – 1H 2011 shows tougher comparisons, while the 2x 2H becomes easier. As such, SYST’s shares may struggle into 1H but get some tailwind into 2H 2011. 2x 16.0x • Radiation Oncology – Q1 2011 will benefit from easy order bookings comparisons, while Q2 and Q3 will 15 ` 15.2x become significantly tougher. Hence, post Q1 2011, companies such as Elekta may have a tougher time. 1x 9.3x Areas with less volatility include Corrective Lenses (i.e. Essilor) and Dental Implants (i.e. Nobel Biocare and Straumann), 5x where most of the comps are relatively evenly distributed. 11/30/200011/30/200111/29/200211/28/200311/30/200411/30/200511/30/200611/30/200711/28/200811/30/200911/26/2010 Source: FactSet, Morgan Stanley Research 5 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services may struggle to hold. This may especially be the case with the Relative Outlook – 2011 sub-segments of: 1] Dental Implants, where punchy valuations Exhibit 5 below provides our relative outlook for EU MedTech. could easily overstate the future industry growth potential; 2] Corrective Lenses, where demanding valuations may Exhibit 5 overestimate a 2011 recovery; and 3] Orthopaedics, where EU MedTech - Performance Expectations ongoing deterioration in growth rates may cause the vs. European Market Underperform sub-segment to approach Pharma-like P/E multiples. Vs. European Medical Services Underperform Furthermore, our strategy team is overweight equities vs. vs. European Pharmaceuticals Underperform bonds as they represent a better hedge for rising inflation risk vs. US MedTech Underperform Source: Morgan Stanley Research from monetary policies in the US, UK and European Central Bank. With this backdrop, our strategy team recommends Exhibit 6 below provides our relative outlook for EU Services. sectors that can comfortably pass on higher input costs, such as Mining, Chemicals and CPI linked businesses such as Exhibit 6 Regulated Utilities, Transport, Bus & Rail and Airports. It is our EU Services - Performance Expectations view, that the MedTech sub-sector is not a great hedge for vs. European Market Neutral inflation, especially at timeswhen key payers are governments, Vs. European MedTech Outperform who are focused on implementing austerity plans to reign in vs. European Pharmaceuticals Neutral costs and reduce deficits. As a result, we are confident that for Source: Morgan Stanley Research 2011 EU MedTech will achieve lower returns compared to the European MedTech vs. European Market. For 2011, we EU Market. expect EU MedTech will underperform the EU market. European Services vs. EU Market. For 2011, we predict that Between mid-2008 and mid-2009, EU MedTech experienced a EU Services will be neutral compared to the EU market. strong de-rating from its relative long-term valuation of 1.6x, Between 2004 and 2008 EU Services experienced a strong driven by worries regarding the impending US healthcare positive re-rating from < 1x to ~1.4x, driven by a combination of reform after the Democrats won the election. Beginning in the strong organic and earnings enhancing acquisitive growth, latter half of 2009, EU MedTech recovered and reverted to its 10-year average of 1.6x by mid 2010. The latter half of 2010 especially in dialysis; furthermore the defensive nature of healthcare services in a recessionary environment provided an saw a slight de-rating, driven by concerns surrounding softer additional boost during this period. However, the election of a procedure volumes in the United States and pending European healthcare austerity measures. Democratic President in the United States and his push for healthcare reform concerned investors, resulting in a sharp Exhibit 7 de-rating to ~1x. With dialysis being exempt from any negative EU MedTech vs. EU Market – 1YR Fwd P/E reform, we started to see a sharp relative valuation recovery to 2.5 1.4x in 2010. In addition, several smaller cap services segments showed a valuation recovery, including hospitals 2.1x (Rhoen Klinikum) and hearing aid retail (Amplifon). 2.x 1.6x 1.6x Exhibit 8 EU Services vs. EU Market – 1YR Fwd P/E 1.5 20 1.8x 1. 1.x 1.1x 16 1.4x 1. 1.2x 0.5 12 5/31/2001 5/31/2002 5/30/2003 5/31/2004 5/31/2005 5/31/2006 5/31/2007 5/30/2008 5/29/2009 5/31/2010 11/30/2000 11/30/2001 11/29/2002 11/28/2003 11/30/2004 11/30/2005 11/30/2006 11/30/2001.11/28/2008 11/30/2009 11/26/2010 Source: FactSet, Morgan Stanley Research 08 0.8x Our 2011 expectation of underperformance for EU MedTech is 0. driven by our view that industry fundamentals are unlikely to 04 show a meaningful recovery with respect to innovation, price or volumes, and as such we believe that the current relative 5/31/2001 5/31/2002 5/30/2003 5/31/2004 5/31/2005 5/31/2006 5/31/2007 5/30/2008 5/29/2009 5/31/2010 11/30/2000 11/30/2001 11/29/2002 11/28/2003 11/30/2004 11/30/2005 11/30/2006 11/30/2007 11/28/2008 11/30/2009 11/26/2010 valuation of 1.6x, although in line with the 10 year average, Source: FactSet, Morgan Stanley Research 6 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services Our 2011 expectation of neutral performance for EU Services European MedTech vs. European Pharma. In our view, is based on our view that the above average relative valuation while EU MedTech may offer better near-term fundamentals of 1.4x can hold, driven by the following key points: because of the absence of patent cliffs, the mid-term earnings outlook is converging, with upside to ROIC and earnings for EU • Acquisitive Growth – unlike Medical Devices, we see Pharma as it withdraws from most internal small molecule greater opportunities from acquisitive growth. For services research and reallocates capital to in-licensing and other companies, buying up individual hospitals, hearing aid non-pharma assets. Furthermore, while EU MedTech does not dispensers or dialysis clinics is a key element of their have any material patent cliffs, several of its key sub-sectors business models. Due to the benefits of scale, the are seeing an ongoing deceleration in growth rates (e.g. acquisition is typically earnings enhancing within the first 2 orthopaedics) due to lack of innovation and pricing pressure, years, although with hospitals it can take a bit longer. which may suggest that the end-result in earnings growth is not materially different to that of Pharma. With this backdrop, we • High Government Ownership – unlike Medical Devices, wonder whether MedTech’s valuation of 1.4x, above its 10 YR we see less pressure on Services from European austerity average of 1.2x, is sustainable in 2011. measures, either because our companies have less exposure to Europe (e.g. FMC has high exposure to the Exhibit 9 US) or have some protection due to high government EU MedTech vs. EU Pharma – 1YR Forward P/E ownership; the last point relates primarily to the hospital 1.8x segment, where an estimated +70% of European hospitals 1.7x 1.6x are owned by the government. And with an estimated 50% 1.6x 1.5x of public hospitals loss-making, we see it unlikely that 1.4x governments will reduce hospital reimbursement, as it 1.4x 1.3x 1.2x would only increase the losses of their own hospitals. As a 1.2x result, we see hospital reimbursement as stable in 2011, 1.1x 1.0x which provides a level of security for the private operators (e.g. Rhoen Klinikum and Fresenius), who get reimbursed 0.9x 0.8x 0.8x under the same system. Potentially, stronger austerity 0.7x measures in 2011 could mean that governments may be 0.6x interested in divesting some of their loss making hospital facilities, which could enhance the acquisition 5/31/2001 5/31/2002 5/30/2003 5/31/2004 5/31/2005 5/31/2006 5/31/2007 5/30/2008 5/29/2009 5/31/2010 opportunities; it should be noted that, for the acute care 11/30/200011/30/200111/29/200211/28/200311/30/200411/30/200511/30/200611/30/200711/28/200811/30/200911/17/2010 Source: FactSet, Morgan Stanley Research hospital operators such as Rhoen Klinikum and Fresenius, making acquisitions of loss making government hospitals With Morgan Stanley’s Pharma team suggesting that much of is a core part of their business models. patent cliff risk now reflected in the 1 YR forward consensus P/E of ~12.5x and the underlying fundamentals for the EU • Outsourcing – with EU austerity measures likely to MedTech sector at risk of deteriorating (i.e. ongoing increase in 2011 (we have seen little so far in Germany, deceleration in sales growth) over the next 12 months, we are France and Italy), we see opportunities for governments to confident that medical devices should underperform in 2011. outsource services to the private sector, if savings can be achieved. Potential areas include decontamination and European Services vs. European Pharma. For 2011, we linen services, which could benefit UK-listed Synergy. think EU Services will be neutral compared to EU Pharma. Between 2002 and 2007, EU Services experienced a strong • Inflation Adjustor or Non-government Pay – for service positive re-rating from 0.5x to 1.3x, driven by a combination of companies who have governments as major payers, there is typically an annual inflation adjustor (e.g. hospitals and the Pharma sector showing an absolute valuation decline as well as Services showing a combination of strong organic and dialysis), while out-of-pocket orientated businesses, such as hearing aid or corrective lens retailers, should be able earnings enhancing acquisitive growth. Since 2007, we have seen a sideways movement in relative valuations. to pass inflationary pressures onto the consumer, making price less of a concern than for medical device companies. 7 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services Exhibit 10 Moving into the recession in 2008, EU MedTech saw a sharp EU Services vs. EU Pharma – 1YR Forward P/E de-rating to ~0.8x, driven by its large exposure to 1.5x non-reimbursed areas (e.g. corrective lenses, dental implants and hearing aids), which were sharply sold off by investors. 1.3x 1.2x With the onset of a macro economic recovery more visible in 1.2x 2009, we have seen a sharp recovery in the valuations of the 1.0x non-reimbursed stocks, resulting in a relative upward re-rating 0.9x to 1.3x and close to the 10 year high of 1.4x. With a continued macro economic recovery for 2011 already 0.6x largely priced into our cyclical sub-sectors (i.e. already high 0.5x valuations for Dental Implants, trading on CY11E P/E of 21x, Hearing Aids on 20x and Corrective Lenses at 20x), we believe 0.3x the EU MedTech risk/reward is less attractive than for US 5/31/2001 5/31/2002 5/30/2003 5/31/2004 5/31/2005 5/31/2006 5/31/2007 5/30/2008 5/29/2009 5/31/2010imate ~30-40% of EU 11/30/200011/30/200111/29/200211/28/200311/30/200411/30/200511/30/200611MedTech by market capitalization is not reimbursed, compared Source: Factset, Morgan Stanley Research to an estimated <5% for US MedTech. Furthermore, we believe several EU MedTech sub-sectors may show deteriorating As previously mentioned, with Morgan Stanley’s Pharma team suggesting that much of the patent cliff risk now reflected in the industry fundamentals, especially Dental Implants. Hence, 1 YR forward consensus P/E of ~12.5x and the underlying from an overall valuation perspective, we feel on the balance of probabilities there is a greater likelihood that EU MedTech’s fundamentals for the European Services sector unlikely to change over the next 12 months, we are confident that the premium of 1.3x will contract rather than increase over the coming 12 months. relative performance will be neutral in 2011. Earnings Growth. In addition to our 1 YR forward P/E analysis, European MedTech vs. US MedTech. For 2011, we expect we take into consideration the earnings growth potential of EU EU MedTech to underperform compared to US MedTech. Until MedTech and Services against other sectors. Based on our 2002, EU MedTech showed a sharp relative valuation de-rating to a low of 0.7x, driven by a strong product cycle in bottom up forecasts, we expect EU MedTech to deliver +10% EPS growth and EU Services +11% EPS growth over the cardiovascular (e.g. drug eluting stents and cardiac rhythm next two years compared to our strategists expectations of management), an area where EU MedTech did not have many +10% for the EU Market and our Pharma analysts listed companies. Since then we have seen a major re-rating to expectations of +5% for EU Pharma. a high of 1.4x driven by cardiovascular seeing a major slow down in growth, while at the same time several cyclical Exhibit 12 sub-sectors (i.e. dental implants and hearing aids) showed an MedTech & Services - Growth Comparison improvement in growth. Sales CAGR EPS CAGR P/E 2 YR CYS1eCYr10-1EY10-12E Exhibit 11 EU MedTech 6% 10% 17.1x 1.7 EU MedTech vs. US MedTech – 1YR FWD P/E EU Services 5% 11% 15.2x 1.3 1.6x 1.5x EU Pharma 2% 5% 12.4x 2.5 EU Market* 5% 10% 10.9x 1.1 1.4x 1.3x US MedTech 6% 11% 14.9x 1.4 Source: Datatstream, Morgan Stanley Research estimates, * = EU MSCI 1.2x 1.1x 1.0x This equates to a PEG of 1.7x for MedTech and 1.3x for Services, which is below Pharma on 2.5x; despite this, we 0.8x reiterate our expectation of underperformance from EU 0.6x 0.7x MedTech, as we see earnings risk and multiple compression. Relative to the EU Market, neither MedTech, Services nor 0.4x Pharma looks particularly cheap. This in our view is driven by expectations of a meaningful improvement in margins for the 11/30/200011/30/200111/29/200211/28/200311/30/200411/30/200511/30/200611/30/200711/28/200811/30/200911/26/2010 broader market. Source: FactSet, Morgan Stanley Research 8 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services Stock Ratings for 2011 estimates of +6-7% and material scope over the short term for the company to show better margin recovery back to pre Below is a summary ofour 2011 recommendations. We have recession levels. Not in our forecast is the potential launch of its rolled forward our price targets where appropriate and base first invisible hearing aid (a miniaturized CIC) in 2011. While the them on CY11 earnings, also accounting for the 2010 equity company was initially dismissive of such a device, we feel the rally by reducing our market risk premiums. We see absolute strong interest in one of its competitor’s offerings could have share price upside for our Overweight recommendations. changed their mind. Life Healthcare delivers an EPS growth Exhibit 13 profile of +18% over the next 3 years, driven primarily by top Stock Ratings line sale growth in fast-growing emerging markets, but also Rating Mkt cap (€mn) Price target with margin improvement. On a CY11E EV/EBITDA of 6.5x, it is undervalued compared to consensus for its SA peers at 8.8x. Fresenius SE Overweight 17,515 €72 William Demant Overweight 3,174 DKK 490 Life Healthcare Overweight 1,553 1,650 ZAc HIGH RISK – for investors who are looking for more of a high-risk high-return investment case, we prefer GN Store GN Store Nord Overweight 1,265 DKK 55 Synergy Overweight 539 940 GBp Nord, where a recently appointed management team has set out intermediate financial targets, which for 2013 is ~25% Fresenius Medical Care Equal-Weight 10,600 €46 Essilor Equal-Weight 10,409 €48 below our EBITA and in our view not reflected in the company’s share price; our more conservative forecast compared to Smith & Nephew Equal-Weight 9,802 590 GBp Sonova Equal-Weight 6,559 SFr. 140 management guidance for 2011, 2012 and 2013 is based on previous management teams finding it difficult to achieve their Elekta Equal-W,ig9h1t SKK 221 Rhoen Klinikum Equal-Weight 2,215 €17 own targets. Furthermore, thereis additional upside should the company be able to win its pending €1bn claim for incurred Synthes Underw1e,02t0 111 CHF Coloplast Underweight 4,373 DKK 707 losses against the German Cartel Office, which blocked the sale of ReSound in 2007; the decision by the German Federal Celesio Underwe,i7h0t Straumann Underweight 2,439 SFr. 160 Supreme Court in May 2010, which stated that the decision by Nobel Biocare Underweight 1,125 SFr. 12.90 the Cartel Office was unlawful, suggests that GN should be firstname.lastname@example.org with a request for valuation methodology and damages. Finally, with the positive German Federal risks on a particular stock. Source: Morgan Stanley Research Court decision, GN ReSound may again become a strategic asset for a larger hearing aid company. Unlike 2010, where we did recommend a sub-segment approach between reimbursed vs. non-reimbursed names for EUROPEAN AUSTERITY – with European governments likely 1H 2010, followed by stock picking in 2H, our stance for 2011 is to target further cost efficiency measures, we see it as likely very much focused purely on stock picking. that some services could be outsourced to the more efficient private sector. This may amongst other areas include OVERWEIGHTS – FRE, GN, Life, Synergy, William Demant decontamination and linen services, in which Synergy is a For 2011 our Overweights fall into one of four categories of major operator. In addition, the company may benefit from further acquisitions in existing or new markets, as well as Value, Growth, High Risk High Return and European Austerity. success through its growing presence in the Chinese market. VALUE – for value-oriented investors, our preferred choice is Fresenius (CY11E P/E of ~15x), driven by attractive valuation UNDERWEIGHTS – Dental, Celesio, SYNTHES, Coloplast and several potential trigger pointsthat would result in earnings For 2011, our Underweights fall into one of three categories of upgrades including upside in APP from US drug shortages and potential hospital acquisitions in Germany, while a disposal of High Valuations & Expectations, European Austerity Measures, and Deteriorating Industry Fundamentals. its Biotech operation would make sense to us (though the company has made no specific comment on this). Synergy HIGH VALUATIONS & EXPECTATIONS – we view Dental should also be considered part of Value, as we see it as Implants, namely Nobel Biocare and Straumann, as an mispriced on a CY11E P/E of ~15x for EPS growth of +15%; unattractive combination of demanding valuations (CY11E P/E more details on this stock are in the European Austerity of 21x) and expectations of a strong recovery in top line growth category. over the next 12-18 months. While the premium industry should eventually witness a more material recovery in industry growth GROWTH – for growth-oriented investors, a good choice is William Demant offering a 3 YR EPS CAGR of +16%, based rates (despite growing generic competition) following a major slowdown from +15% in 2008 to -6% in 2009 and an estimated on conservative organic constant currency sales growth 9 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services +1% in 2010, we question whether a +10% growth rate is reimbursement system that starts 1 January 2011. Our sense realistic over the intermediate term and retain our Underweight. is that we must see a changeto the CMS transition payment of M&A speculation may continue to resurface in 2011, but we -3.1% to something more like -1% for the shares to have an see it as unlikely given the current valuations. opportunity to perform. We also have concerns about its ability European Austerity Measures – we remain cautious on the to raise commercial payer rates in 2011 by the typical +4-5%. EU Pharma Distribution and Ostomy and Incontinence Smith & Nephew – despite deteriorating industry growth rates sub-sectors and as such have an Underweight rating on in its most important division of orthopaedics, we stick with our Celesio and Coloplast. With many EU countries facing large budget deficits driven by the 2009 recession, we feel the Equal-weight. This is based on our view that the company has the potential to offset some top line weakness with further current valuations do not reflect the uncertainty of further margin improvement by outsourcing more of its production to healthcare reform that could put pressure on reimbursement levels for generic and branded pharmaceuticals, as well as China. The potential of moving more of its Wound Care production from the UK to Chn i a should not be underestimated, pharmacy-specific reimbursement; for Coloplast we are and its new Chinese orthopaedic manufacturing facility, which concerned about an estimated ~60-70% of its sales being directly price regulated by EUgovernments. With the 2 YR EPS should go live in 1H 2011, could yield upside. CAGR for Celesio of +8% likely to be below that of the EU Sonova – in this report we have lowered our recommendation market consensus of +10%, we see downside risk as investors from Overweight to Equal-weight, despite standing in front of a assign a discount to the current market relative P/E of ~1x to new high-end product cycle through the launch of Ambra in more like 0.8x. With Coloplast trading on a CY11E P/E of ~17x, October 2010. While we continuewith our theme that Ambra is we believe there is more scope on the downside than upside. likely to result in top line growth acceleration from +8% now to Deteriorating Fundamentals – despite SYNTHES being a +10% over the next 12-months, we feel the earnings upside is being eroded by the cochlear implant recall in November 2010 well-run organization, we remain concerned that it may not be and a strong FX headwind, which has caused a transactional able to sufficiently compensate for the deteriorating industry fundamentals in which it operates. In orthopaedic trauma, EBIT margin headwind. Longer ter,m we remain positive on Sonova, driven by a powerful R&D engine enabling product which makes up an estimated 75% of group sales, growth rates differentiation, a management team with a strong track record have fallen over the years and are starting to converge to the lower-valued orthopaedic reconstructive segment, driven by and the rollout of its first generation invisible hearing aid Lyric, which has the potential to become an interesting product line. pricing pressure. In orthopaedic spine, which makes up an estimated 25% of group sales, industry growth rates have Essilor – we view Essilor as a very high-quality company, but fallen from +8% in 2009 to +0-2% Q2/Q3 2010, due to price with its high P/E valuation of ~19x CY11E, a lot of good news is pressure and softer volumes as insurance companies are more priced in, including upside potential from a full corrective lens conservative in giving approval for spine procedures. While we market recovery as well as solid execution with FGX, Shamir recognise that SYNTHES is currently in the process of and Signet acquisitions. Our Equal-weight recommendation launching an updated lumbar fusion product line called Matrix also reflects our concerns that afull recovery in the lens market in Q4 2010, we are not convinced it can offset the potential may take longer, especially in Europe and the United States, incremental weakness in its larger trauma franchise. With despite very strong growth coming from emerging markets. SYNTHES trading on a CY11E P/E of ~14.5x or a +23% Elekta – while we were bullish on Elekta for a good portion of premium to the global orthopaedic peer group (EV/EBITDA premium of +10%), we feel there is downside to the price. 2010 based on a recovery of the US capital equipment market, we are less positive for 2011. With a demanding valuation of ~21x CY11E P/E and prospects of capital budget cuts from EU EQUAL-WEIGHTS – FMC, SNN, Sonova, ESSI, Elekta, RHK For 2011, our Equal-weight recommendations relate to governments in 2011, we feel order booking growth could companies where valuations may be reasonable or where we decelerate, despite strong growth in emerging markets. As a result, we are reiterating our Equal-weight recommendation. see few catalysts for the time being for material upward or downward movement in the share price. Rhoen Klinikum – despite the financial crisis having put Fresenius Medical Care – while we regard FMC as a high further pressure on public finances, which may prompt the states to sell loss-making hospitals that could be run more quality company, we feel that its valuation is currently too effectively by the private sector, there is a lack of activity to demanding to warrant a more positive recommendation. Furthermore, we are concerned that consensus expectations suggest a hospital privatisation wave is around the corner. With this in mind, we see no rush to own Rhoen Klinikum today, remain high with respect to the earnings impact of the new US despite finding the longer-term opportunity to be attractive. 10 MORGAN STANLEY RESEARCH December 1, 2010 MedTech & Services Valuation Framework resulting implied P/E valuations vary significantly, with the faster growing businesses historically attracting 1YR forward Our valuation framework typically consists of relative market multiples of 20-25x, while slower growers can trade at multiples P/Es in a bear or recovering market, while DCFs are our as low as 10-13x. Over the longer term, we value preferred methodology in a more stable environment. The non-reimbursed assets more highly, and these include Hearing underlying MedTech & Services value driver is constant Aids and Corrective Lenses, while the reimbursed areas, which currency sales growth and margin outlook for the various are likely increasingly to be subject to reimbursement cuts, sub-sectors, as well as acquisitions. Given that the underlyincarry a lower valuation. These include Orthopaedics and fundamentals of each sub-sector are very different, the Pharmaceutical Distribution. Exhibit 14 EU MedTech & Services – Comparative Risk-Reward 100% BULL 80% 60% 40% 19% 15% 20%
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