If you listen to its critics, the controversial 2.3% Obamacare medical device tax has been a kick in the pants to the entire U.S. medical device industry.
In its most recent 10K, med-tech behemoth Medtronic (NYSE:MDT) said it shelled out $135 million on the tax in its 2015 fiscal year. Medtronic has been vocal that the tax is onerous, eroding its ability to create jobs and expand research. The company also leads the pack in cranking up its lobbying on Capitol Hill, with over $5 million in lobbying expenses last year.
But healthcare -- and healthcare reform -- is extremely complicated. Those who are paying the most for the tax aren't necessarily suffering the most. In fact, overall net profits reported by the 102 largest U.S.-based med-tech companies increased a comfortable 7% from 2013 to 2014, and a downright off-the-hook 19% the year before that, according to a survey of company data by the Government Accountability Office.
Drilling down a little further
If you look deeper, however, you'll find another story. And this one isn't nearly so rosy.
Unlike the pharmaceutical industry, a large number of smaller device companies with one or two products characterize the device industry. These companies don't have the pricing edge of a Medtronic or Johnson & Johnson, which are the go-to sellers of a wide range of medical supplies. Smaller companies are much more sensitive to the impact of the device tax, since they are less able to simply pass on the tax to their customers.
In addition, since the tax is on sales, not profit, the tariff eats up most of the profits of many of these small players, if they have any. We're not talking only pie-in-the-sky start-ups here. Because of the lengthy and somewhat unpredictable regulatory process that must be negotiated before a medical device can be sold, it can take from $70 million to $100 million in total sales before a med-tech becomes profitable.
Statistics bear this out. While leading U.S. med-techs are logging record profits, smaller device companies are feeling tremendous margin pressure. In a survey done by the U.S. Government Accountability Office, nearly all of the reported increase in net profit for the 102 companies surveyed came from the 30 big caps with sales of over $1 billion per year. By contrast, the 72 smaller companies surveyed reported an overall net loss over the same years.
What's the real risk of this tax?
Probably the key argument against the medical device tax is that it throttles small-company innovation. Medical device firms that are entering the market have a harder time becoming profitable with the additional cost of this excise tax. In turn, this would give an advantage to larger, more established firms, reducing the competitiveness of the industry.
As Boston-based AbioMed's CEO Michael Minogue told NPR: "I don't think taxing the innovators and taxing the group of companies that provide innovation for healthcare is a smart idea, but the biggest concern I have, and what's unprecedented, is to tax companies that are not yet profitable, and in our industry where 70% of the companies are not yet profitable, this is going to have detrimental effects in their job growth, in their survival."
Whether it's in the realm of point-of-care technology or personalized medicine, it's these under-the-radar companies that are likely to solve some of the major issues healthcare faces today. Unfortunately, when the profits of an early stage medical device company are wiped out, it can also snuff out their ability to fund research and development activities that could ultimately greatly benefit those who need their devices.
Mark Throdahl is the CEO of privately held OrthoPediatrics, the world's only company specializing in making orthopedic equipment for children. Throdahl said on the matter: "This is a very burdensome tax because it is based on sales, not profits. In terms of magnitude, the tax is about the size of our entire product development budget."
Other companies are in worse straits. "We're actually borrowing money to pay the excise tax," said Tom Allen, CEO of another privately held device maker, Iconacy Orthopedic Patients. Like most of their peers, both these CEOs believe a tax on profit would be more fair -- and certainly more manageable for smaller medical device makers.
Rather than seeing the glass as half empty, however, let's look at the other side. Here's who could win big if a repeal passes the finish line.
Two fast-growing small caps that could hugely benefit
In other words, while the big caps would net the highest dollar volume gain, it's the fast-growing smaller medical device stocks that should feel the greatest impact from a repeal. One such company is Dexcom (NASDAQ:DXCM), which recently nabbed FDA approval of a continuous glucose monitoring device to compete with Medtronic's similar device.
Dexcom saw revenue growth of 58.5% last quarter and earnings growth of 38.33%, on a year-over-year basis. But its profit margins were a negative 3.97% in the quarter. While that's an improvement compared to 10.20% loss for the same quarter last year, a repeal could help nudge Dexcom into the black.
Another example of a small medical device company that would benefit hugely from a repeal of the tax is Inogen (NASDAQ:INGN), an innovator in oxygen therapy. Inogen's shares managed to float even higher in the recent sell-off and are up 61% since the beginning of the year. Inogen also saw its revenue grow 45% last quarter, over the same quarter last year.
Inogen sells a portable oxygen concentrator that uses a chemical process to separate oxygen from nitrogen in the surrounding air. That means users don't have to drag along a heavy tank that only provides air for two to three hours. Inogen's device lasts nine hours and is rechargeable by plugging into a typical outlet.
Like many small med-techs, however, Inogen relies heavily on domestic sales, so the medical device tax cuts deep. Inogen sells overseas, but the company experiences its strongest sales growth in the U.S., with domestic sales growing 80.5% last quarter.
1%-5% projected lift for industry leader Medtronic
Of course, the larger companies in the industry would also gain from a repeal. When discussing the tax, Medtronic's CFO Gary Ellis said Medtronic would make "trade-offs" and that "we won't have as much to invest going forward." Thus far, the trade-offs appear to have succeeded. Last fiscal year, Medtronic saw its net profit margins exceed 20%, putting it on par with many pharmaceutical giants. In the face of that, a 2.3% tax doesn't seem onerous.
Still, while the company seems to have successfully passed on the cost of the tax to the hospitals that purchase its devices, hospitals are becoming more cost-conscious. While it's hard to put a dollar amount to how much of an impact a repeal could have, Bernstein Research has noted that a repeal of the tax could boost the medical device companies' profits by 1% to 5%. He also named Medtronic as a key beneficiary.
Can a Senate repeal override the expected veto?
The House has already voted to repeal the device tax. The next hurdle is a Senate vote before it reaches President Obama's desk.
A Senate repeal seems highly likely, since last year in a non-binding Senate vote, 34 Democrats and 45 Republicans voted against it, saying it's a tax on innovation. Very much up in the air, however, is whether backers in the Senate can gain enough votes to override the expected presidential veto.
President Obama has made it clear he believes the tax is necessary to pay for Obamacare. And even those most eager for repeal realize it's going to be hard to come up with a $30 billion offset to replace what the tax is projected to generate over 10 years.
Despite bipartisan protests, the medical device tax survived last year. While repeal looks more likely this year, Capitol Hill is always unpredictable. Investors should also note that a possible repeal could already be priced into the major med-tech stocks. The market typically prices in political events before reality confirms them.
Still, there are stocks in this group that are worth watching. In particular, while EPS estimates for 2015 are mostly mediocre for med-tech, there are a handful of smaller stocks that expect spectacular growth. If you see the repeal gaining steam and grabbing headlines, you might want to look closer at the two small caps already mentioned, or RTI Surgical (NASDAQ:RTIX) a small cap medtech which has a bold plan to grow its revenue by 92%.
While these stocks are more volatile than large, established healthcare companies, they are also where an actual repeal could have the greatest impact.
Cheryl Swanson owns shares of Johnson & Johnson. The Motley Fool owns shares of Medtronic. The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.