The shift in power in Washington may have big implications for medical device companies if legislation is rekindled to ditch the 2.3% medical device tax.
That tax, enacted as part of Obamacare to help fund the cost of boosting insurance enrollment nationwide, reduces medical device company profitability by $29 billion dollars over the coming decade, according to the Congressional Budget Office.
If Congress repeals the tax and the president doesn't veto it, medtech companies, including Medtronic (NYSE:MDT) and Stryker (NYSE:SYK), should see earnings grow, so let's learn more about the tax and its impact.
First, a bit of background
The medical device tax was included in the ACA as a way to help pay for the cost of boosting insurance enrollment.
It has been a divisive issue among politicians, particularly those from states that are home to large medical device companies. Those companies maintain that the tax stifles innovation by reducing funding available to R&D and that it may force companies to reduce their workforce to offset it.
The argument holds some water considering that medical device companies tend to be lower margin businesses than pharmaceuticals, which also pay a tax under the ACA. That may suggest that ACA taxation poses a bigger drag medtech companies than it does on drugmakers. For example, Medtronic's operating margin of 21.3% and Stryker's operating margin of 12.68% over the past 12 months is significantly below the ratios for major biotech companies Biogen (NASDAQ:BIIB) and Amgen (NASDAQ:AMGN)
In a bid to offset the impact of the ACA tax, both Medtronic, which estimates it will pay $125 million in medical devices taxes this year, and Stryker have made moves to restructure their operations. In 2012, Medtronic announced it was cutting 1,000 jobs and in May 2013, Medtronic laid-off another 2,000 people. In 2012, Stryker specifically cited the ACA's 2.3% tax as the reason behind eliminating 1,100 lay-offs.
Senators across both sides have said that they would support a repeal of the medical device tax. In a nonbinding vote last year, 79 senators agreed that the tax should be repealed. However, efforts to bring a formal vote to the floor have been blocked by the democratic leadership, led by Senate Majority Leader Harry Reid.
That could change now that democrats have lost the majority in the Senate. Kentucky's republican senator Mitch McConnell, the incoming majority leader, has listed the repeal of the medical device tax as one of his top priorities. That has Washington watchers thinking that a bill to repeal the tax could be one of the first actions on republican's agenda.
Impact of a change
The medical device tax isn't overly popular and is arguably less popular than ACA taxes on pharmaceutical drugmakers and insurance companies. So a bill repealing it could make its way through the White House if republican leaders are willing to give up something in return.
If so, the impact on the bottom line for major medical device makers like Medtronic and Stryker could prove to be significant. Both of these companies are paying a larger share of their revenue to government since the tax went into effect in 2013.
At Medtronic, the company set aside $212 million for income taxes on $1.08 billion in earnings during the most recent quarter ending July. For comparison, Medtronic had set aside $200 million on $1.15 billion in earnings the year before. Over at Stryker, the company's income taxes through the first nine months total $444 million, up from $161 million in 2013.
Granted, the medical device tax isn't responsible for all of this increase. Both of these companies have a lot of other moving pieces that are affecting their tax provisions, including Medtronic's planned acquisitions and the creation of a European regional headquarters at Stryker. Regardless, the bump up in tax liability from the medical device tax has created a profit headwind that investors would benefit from seeing eliminated.
And if it doesn't happen?
Neither of these two companies needs the repeal to survive. In Medtronic's fiscal first quarter, which ended in July, sales grew 4% year over year to $4.27 billion and adjusted earnings per share (after adjusting out those pesky one-time accounting items) climbed 6% to $0.93 year over year. Stryker posted similar growth in its recently completed third quarter. Stryker's sales were up 11.1% to $2.4 billion and its EPS grew 10.6% to $1.15.
That suggests that a potential repeal of the medical device tax would be more incremental than game-changing. Nonetheless, it would remove a profit headwind and add clarity, both of which would likely help boost both company's share prices in 2015.