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Marketing Analyst Speculates about Future of Medical Devices

DANA POINT, Calif. (MarketWatch) -- Jim Hawkins likes to think of himself as a “good acquirer” but he knows it may be not be long before the tables are turned on him.

The chief executive of Natus Medical Inc. (BABY) , a maker of specialized medical devices used to treat infants as well as neurological patients, isn't shy about his company's strategy.

He is growing his company organically as well as through buyouts of compatible firms, but says he likes to keep the identity in the small properties he acquires. Natus has made 13 acquisitions of sizable firms in the last nine years -- picking up as many as three a year during that time.

“We like to think of ourselves as a good acquirer in that we continue to keep the brand names,” Hawkins said.

Natus, however, is a small-cap San Francisco Bay-area company worth roughly $327 million with $233 million in annual sales. And it could one day become the target of a much bigger fish, Hawkins acknowledges.

“That's something we've always said, that at some point every good medical device company will get bought. So I'm sure it will happen,” he said.

That time may come sooner rather than later. Hundreds of small medical device makers are out there for the taking, and they're starting to get picked up, says Matt Dolan, senior research analyst at Roth Capital Partners in Newport Beach, Calif.

“There's a wave coming in the next three to five years,” he said. “I think it's one of the more obvious trends that we've seen in a long time.”

The trend was evidenced this week by two purchases involving prominent, publicly held device makers. Boston Scientific Corp. (BSX) , hobbled in recent years by financial troubles, announced plans earlier this week to buy closely-held defibrillator maker Cameron Health Inc. for roughly $1.35 billion.

It was just two years ago that Boston Scientific's own defibrillator business was under the microscope for design flaws, and that rival device makers were hiring away many of its sales staffers, causing the company's shares to plunge. Shares remain in the $5 to $6 range.

But the company is now in better shape, Dolan said.

“They're in a better position than they were two years ago,” he said. “They're on record saying they're going to buy more going forward.”

The other major purchase involved ZOLLMedical Corp. (ZOLL) , a maker of cardiac devices used in emergency rooms and by paramedics. ZOLL is to be acquired by Asahi Kasei Corp. (AHKSY) of Japan for $2.2 billion, roughly a 25% premium above its previous trading range.

Expect more merger activity, Dolan says. There are several factors at play, not the least of which is increasing pressure on device-maker profits. The industry has seen a doubling in its operating margins in the last decade, lifting them to nearly 20%, but the party is ending.

For one, hospitals and doctors are beginning to push back on the industry. Several years ago, private-practice doctors would request devices and supplies be placed at their disposal in hospitals with little regard to cost. Now, most doctors are aligning themselves with medical centers and jointly the two groups are trying to push costs down.

Another reason is a key provision in the Affordable Care Act is about to take effect. A medical device tariff of 2.3% will kick in on Jan. 1, which means larger companies will end up handing over sums in the millions to the government.

Margin pressures are forcing even such big names as Johnson & Johnson (JNJ) and other major medical makers to cut back on their own research and development. Instead, they'll be innovating by acquisition, Dolan says.

In addition to Boston Scientific and J&J, look for other major players to jump in, including Medtronic Inc. (MDT) , Abbott Laboratories (ABT) , St. Jude Medical Inc. (STJ) , Stryker Corp. (SYK) and Zimmer Holdings Inc. (ZMH)

“Their [projected] cash flow over the next several years exceeds the market value of all the small cap companies combined,” Dolan said. “They certainly can afford to do it. The question becomes can they afford not to do it, given the environment?”

A number of small-cap makers of medical devices were on display this week at Roth's annual conference at the Ritz-Carlton Hotel in Dana Point, Calif., an upscale community about 90 miles north of San Diego.

Dolan said a number of them are possible buyout candidates, including Edwards Lifesciences Corp. (EW) , a prominent maker of artificial heart valves installed through non-invasive surgical means, along with vascular imaging specialist Volcano Corp. (VOLC) and Hawkins's Natus.

It's just a matter of time before they get eyed by companies who have to consider a purchase if they hope to keep growing, he believes.

“The question is who's more desperate because all of these companies are facing pressures,” he said. “It is certainly tougher to be a small company and face all these regulations that are either in existence or coming.”

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