In the last three years, the health care industry in general and medical device manufacturers in particular faced unprecedented hurdles. They started with COVID-19 pandemic-related disruption in patient demand, then recently with persistent inflation, labor shortages, supply chain constraints, and unfavorable foreign exchange rates. Despite the challenging operating environment, investment-grade medical technology credit ratings remained resilient.

The primary driver behind negative rating actions in this group was debt-funded mergers and acquisitions (M&A), while positive rating changes stemmed from deleveraging on the heels of better than expected performance (in some cases augmented by COVID-19-related tailwinds). Our rating outlooks on these issuers are mostly stable, as the industry now benefits from increasing procedure volumes. Companies are better insulated from pricing pressures, and M&A remain mostly within ratings capacity. In the first half of 2023, we took one positive rating action on an investment-grade MedTech issuer (STERIS PLC). The rest were unchanged.

Chart 1

We Expect High-Single-Digit Percent Core Revenue Growth On Improved Patient Volumes

The quarter ended March 31, 2023, beat revenue growth expectations for most of the investment-grade issuers we rate in the industry, averaging 11% on a core constant currency basis.

Table 1

For 2023 (fiscal 2024 for some issuers), these manufacturers have guided to core constant currency revenue growth of approximately 7% on average, reflecting expectations for an increase in medical procedures post-pandemic, easing health care labor pressures, and stabilization of the supply chain preventing stock-outs of critical components. Near-term growth rates may also continue to benefit as the remaining procedure backlog is worked down over the next several quarters. We believe industry technological innovation elevating quality of outcomes (i.e., products enabling minimally invasive procedures, higher precision, better patient monitoring, or shorter hospital stays) also supports growth.

Health care labor shortages that constrained procedure capacity have also eased, with U.S. industry employment returning to and in many cases exceeding pre-pandemic levels. Also, usage rates and pay rates of temporary health care staffing declined in recent quarters (see "Health Services Outlook Negative With Elevated Risks For Lowest-Rated Companies", published March 21, 2023). Hospitals and other providers also indicated they have become more efficient in managing labor shortages. As remaining COVID-19-related restrictions have been lifted, we expect procedure volumes to continue increasing over the coming quarters.

On the other hand, we expect rapidly declining COVID-19 testing sales and foreign currency headwinds will offset the industry's reported revenue growth. The decline comes after extraordinary tailwinds in the past two years, bringing more normalized revenues for test makers (i.e., Abbott Laboratories, Hologic Inc., Becton Dickinson & Co.). Foreign currencies, although still a headwind in 2023, have mostly returned to historic levels, lowering the gap between reported and constant currency revenue expectations.

Table 2

EBITDA Margins Trend Is Mixed, With A Mostly Negative Bias

While we project procedure volumes and revenues to increase, our expectations for adjusted EBITDA margins for the group is mixed, mostly negative. We project that only four of the 12 investment-grade MedTech issuers will have operating margin expansion in 2023 and roughly 100-150 basis points of contraction on average for the industry. The contraction primarily stems from raw materials inflation, wage increases, and supply chain disruptions that created inefficiencies in manufacturing and distribution.

In 2022, medical device companies incurred higher costs to secure supplies of critical components and dealt with labor shortages along the entire manufacturing and distribution chains. These higher costs will continue to weigh on margins. We believe margin compression will be concentrated in the first half, as the high-cost inventory from 2022 is reflected in the cost of goods sold and year-over-year comparison is unfavorable. We assess that supply chain challenges will improve and, combined with price adjustments, margins will start expanding in the second half. However, we expect the detriment to be more pronounced and the average adjusted EBITDA margin profile for the sector to decline slightly. We expect gradual improvement to continue in 2024.

Table 3

M&A Could Increase, But Likely Within Rating Thresholds

M&A remains a major theme for the health care industry as players seek to gain efficiencies of scale and negotiating leverage (health care service providers), or to broaden their portfolios and pipelines (pharmaceutical companies).

However, for the medical device industry, we expect more muted activity. We do not believe the sector is under the same pricing pressure as other health care subsectors. Some players, such as Medtronic PLC and Baxter International Inc., are divesting portions of their businesses. While Medtronic is likely to also be active in M&A to augment its portfolio with higher-growth products, Baxter is focused on deleveraging after a recent large acquisition. Additional investment-grade medical device companies that we expect to be active are the recently spun-off GE Healthcare Technologies Inc., Boston Scientific Corp., and Zimmer Biomet Holdings Inc. All have capacity in the ratings for acquisitions. Unless they unexpectedly pursue leveraging transactions beyond those capacities, ratings should be unchanged.

Commentary On Selected Issuers

Boston Scientific Corp. (BBB+/Stable/A-2)

Analyst: Arthur Wong

• We project higher end growth since the company is off to a strong start to the year, generating organic growth of 14% for the first quarter and guiding to 8%-10% growth overall for 2023, in line with our projections of high-single-digit percent sales growth for 2023 and 2024. We believe Boston Scientific enjoys increasing sales momentum from its relatively young product portfolio.
• We project some improvements in EBITDA margins. This contrasts with our projections for most other rated medical device companies, as the company's efficiency initiatives from last year bear fruit while supply chain issues and inflation ease.
• Acquisitions are a wild card. We believe Boston Scientific will remain acquisitive over the near to medium term. We consider its track record over the past five plus years of steadily conducting moderate transactions to acquire technologies and new products to drive growth as largely successful. We reflect that in our higher end revenue growth projections. We expect it will maintain a relatively conservative financial policy that will keep sustained adjusted leverage below 3x, our downside trigger. Adjusted leverage was 2.6x at the end of 2022, so there is a significant debt cushion in the ratings.

Medtronic PLC (A/Stable/A-1)

Analyst: Ryan Gilmore

• Revenue growth guidance is slightly below average. The company reported April 28 quarter (fourth quarter of fiscal 2023) sales growth of 5.6%, both as reported and on an organic basis. It guided to 4%-4.5% organic growth for fiscal 2024 (starting April 29, 2023), somewhat below our industry average estimate.
• Medtronic has outlined a transformation target to simplify the organization and focus on higher growth areas. As part of this strategy, the company announced the separation of three businesses: its renal care business (by forming Mozarc Medical, a new kidney health company launched in April 2023 through a joint venture with DaVita Inc.), and its patient monitoring and respiratory interventions businesses (announced in October 2022, with an expected transaction close within 12-18 months).
• Medtronic will remain acquisitive. The company recently announced its acquisition of EOFlow, developer of a wearable disposable insulin pump that will supplement Medtronic's diabetes portfolio, for about $738 million. This adds to the company's M&A spending of approximately $1.9 billion in fiscal 2023.
• We believe Medtronic will continue to be active in M&A as it seeks to supplement organic growth with external growth opportunities. Its S&P Global Ratings-adjusted leverage fiscal year-end 2023 was 2.2x, and we believe the company has a significant debt capacity for acquisitions in fiscal 2024.

Baxter International Inc. (BBB/Negative/A-2)

Analyst: Alice Kedem

• Divestitures should help reduce leverage, but the core business performance remains under pressure. Baxter's S&P Global Ratings-adjusted leverage as of March 31 was about 5.3x, approximately 1.5x above our 3.75x threshold for the 'BBB' rating, after the acquisition of Hill-Rom Holdings Inc. and underperformance in 2022. Baxter's sales in 2022 were constrained by industrywide headwinds due to its dependence on microchips, a more dispersed manufacturing footprint, and somewhat limited ability to pass cost inflation under fixed price contracts. Its guidance for 2023 of 1% organic constant currency growth and EBITDA margin compression incorporates continuous headwinds, slowing the pace for deleveraging.
• Baxter's planned debt reduction from the proceeds of the announced divestiture of its BioPharma Solutions (BPS) business (estimated $3.4 billion) should help it to reduce leverage, but will not be sufficient to reach 3.75x. We project the company's leverage, pro forma for the BPS divestiture, will decline to about 4.4x-4.5x by the end of 2023.
• The company also plans to spin off its renal care and acute therapies segments into a stand-alone company. However, execution challenges remain. Absent improved operating margins and free cash flow in its core business, we see a risk to our base case that it will reach S&P Global Ratings-adjusted leverage below 3.75x by the end of 2024.

Becton Dickinson & Co. (BBB/Stable/A-2)

Analyst: Alice Kedem

• A new product pipeline supports increasing core growth prospects. We believe the 7% core constant currency revenue growth in the fiscal second quarter (ended March 31) reflects the company's increasing focus on high growth areas and solid new product launches execution. The guidance of 6.5%-7% core constant currency growth is in line with improving sales momentum, benefitting from the increasing contribution from new product launches. In addition, we project an improvement in Becton's EBITDA margins, reflecting inflation mitigation and operating leverage.
• Declining COVID-19 testing sales reduce reported growth. These sales fell in the fiscal second quarter (ended March 31) to $16 million from $214 million a year earlier. We now expect only about $40 million-$50 million in fiscal 2023, reflecting about a $460 million-$470 million sales headwind (about 2.5%).
• A large litigation burden somewhat limits M&A capacity. Our adjusted debt measure incorporates about a $1.5 billion litigation reserve (net of tax) as of March 31, the largest among the companies in this group. We forecast S&P Global Ratings-adjusted leverage by the end of fiscal 2023 will be about 3.5x, modestly lower than our downside threshold of 3.75x, somewhat limiting the company's capacity for M&A. At the same time, we believe Becton's product pipeline is strong and should support solid organic growth, lowering the need for large acquisitions.

Zimmer Biomet Holdings Inc. (BBB/Stable/A-2)

Analyst: Alice Kedem

• Zimmer benefits from a rebound in orthopedic procedures. The company reported 13.2% organic constant currency growth in the first quarter of 2023, reflecting stronger than expected growth in procedure volumes. As a result, we now expect organic constant currency growth in the 6%-7% range, higher than our previous 3%-5% estimate.
• We believe Zimmer could be more active in M&A in the coming years. Zimmer derives most of its revenue from mature segments (hip and knee implants accounted for 67% of 2022 revenue), characterized by relatively slow growth and significant pricing pressure. We expect the company's long-term strategy will focus on diversifying its portfolio into adjacent products in faster expanding categories such as trauma and sports medicine, and believe it will rely on M&A to achieve some of this. Zimmer reduced leverage to 2.7x as of Dec. 31, significantly below our 3.75x downgrade threshold. It has ample capacity for acquisitions. At the same time, we project the company will deploy free operating cash flow toward deleveraging following acquisitions. That will allow it to average in the 3x-3.75x range long term.

Chart 2