A Company to Watch in the Medical Device Space

Despite the 2.3% excise tax going into effect at the start of this year, the Dow Jones U.S. Select Medical Equipment Total Return Index has risen nearly 32.60% in 2013 so far and has outperformed the broader market. One of the major gainers in the medical device space this year has been Exactech (NASDAQ: EXAC  ) . The company is a developer, manufacturer, and seller of orthopedic implant devices, related surgical instruments, and biological material and services intended to make patients more mobile.

Exactech's shares have gained more than 35.50% so far this year, and are currently hovering around their 52-week high. The gains have been driven by strong financial performance this year. Given the outlook for the orthopedic device market, Exactech's shares are poised for further gains.

The orthopedic device market is poised for growth
The orthopedic devices market is expected to see significant growth in the coming years, which will be driven by an aging population, especially in the developed world.

In a report on the orthopedic industry released last year, Orthoworld noted that global orthopedic product sales reached $43.1 billion in 2011. This represented an increase of just under 5% over the previous year. According to Julie Vetalice, information products editor for Orthoworld, sales in the U.S. accounted for 60% of total 2011 orthopedic revenues.

The report also noted that the population over the age of 45, which accounted for 97% of all replacement procedures in 2011, is growing by 3% annually. This is three times faster than the 1% growth for the overall population. The Orthoworld report highlights the fact that growth in the orthopedic marketplace will be driven by an aging population. A report from marketsandmarkets.com notes that the orthopedic industry has maintained a steady growth rate of 7% to 10% over the last decade, which is expected to continue in the years to come.

In terms of region, China is seen as a key growth driver for orthopedic device market in the future. According to consulting firm Frost & Sullivan, China's orthopedic implant market is forecast to grow at a CAGR of 18.1% through 2015.

Given the outlook for the orthopedic device market, Exactech is set for robust growth. This was evident in the company's recently released third-quarter results.

Strong third-quarter results
Exactech recently announced its financial results for the third quarter. For the quarter ended Sept. 30, Exactech's sales were $55.7 million, which represented an increase of 9% over the same period last year. This is in line with the growth for the orthopedic industry.

Exactech's net income for the quarter was $3.2 million, or $0.23 per share, compared to $2.6 million, or $0.19 per share, reported for the same period in the previous year. Extremity sales for the quarter rose an impressive 24% to $15.1 million. According to Millennium Research Group, the orthopedic extremity device market in the U.S. alone is expected to reach more than $4.2 billion by 2016.

Another impressive thing to come out of Exactech's results for the third quarter was an improvement in the company's margin. The company's gross margin for the quarter improved 100 basis points to 71%. This was despite the impact of 2.3% medical device excise tax. The improvement in gross margin highlights the company's operating efficiency.

CFO Jody Phillips noted that the improvement in the gross margin was a function of a higher-than-expected U.S. sales mix as well as lower costs due to the company's internal manufacturing operations. However, Phillips noted in a conference call that going forward expecting a 70%-71% gross margin is probably unrealistic. After all, the company will face the continued impact of the medical device tax going forward and expects its outside-the-U.S. mix to be higher than what it experienced in the third quarter. U.S. sales accounted for 70% of the company's total sales in the third quarter.

Looking ahead, Exactech expects 2013 sales to be between $237 million and $239 million. The company expects full-year earnings to be between $1.09 per share and $1.11 per share.

Conclusion
As I said before, Exactech shares have had an excellent run so far in 2013 and are currently trading at around their 52-week high of $23.70. Despite the substantial gains, Exactech is undervalued at its current level. The company's shares are currently trading at a P/E ratio of 21.32, which is below Stryker's (NYSE: SYK  ) 31.85 and Zimmer Holdings' (NYSE: ZMH  )  22.63. Exactech trades on a P/S ratio of 1.32, which is less than half the P/S ratio for Stryker (3.15) and Zimmer Holdings (3.31). One must note that Stryker and Zimmer Holdings are more diversified than Exactech.

Stryker offers a range of medical technologies, which include reconstructive, medical and surgical, and neurotechnology products. The company is also significantly bigger than Exactech, with net sales of $2.2 billion in its most recently reported quarter.

Zimmer Holdings, meanwhile, offers orthopedic reconstructive, spinal and trauma devices, biologics, dental implants and related surgical products. In its most recently reported quarterly results, Zimmer had reported net sales of $1.07 billion.

However, even after considering the fact that Stryker and Zimmer are more diversified and bigger than Exactech, I think Exactech's shares are trading at a significant discount. 

Also keep in mind that the orthopedic industry is poised for substantial growth in the years to come. Exactech currently generates a significant portion of its revenue in the U.S., which is the largest market for orthopedic products. It is also focusing on boosting its presence internationally, however, which will help in diversifying its revenue in terms of geography.

The improvement in gross margin highlights Exactech's operating efficiencies. The fact that the company has been able to control costs helped to reduce the impact of 2.3% excise tax on its devices. While the company may see a contraction in its margin going forward, it is still expected to remain at healthy levels.

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