Issue 1

Medical technology companies that we rate investment grade largely turned in solid performances in the second quarter and first half of 2023, with the opportunity of improved margins in the second half.  For the quarter ended June 30, 2023, the group mostly outperformed our revenue forecasts amid stronger than expected procedure volumes, aided by the improving staffing situation as well as loosening of the supply chain conditions (especially with better availability of microchips and other components). The industry average core constant currency growth was about 9%, significantly higher than the historical mid-single-digit rate.

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We expect revenue growth to moderate to the mid-single-digit percentages.  We anticipate that the revenue growth rate will moderate in the second half of 2023 amid a tougher comparison to the second half of 2022. We also believe that the spike in procedure volumes starting in the second half of last year through the first half of 2023 includes some catch-up demand from drops during the COVID-19 pandemic. We forecast that this backlog will largely be absorbed by the second half of 2023 and lead to a more normalized revenue growth rate in 2024. Our base case also incorporates headwinds from the economic slowdown in China, as well as the expansion of value-based procurement by Chinese local and federal authorities that is affecting the pricing of medical devices and issuers' participation in this market.

But we expect margins to improve in the second half of 2023.  In contrast to the revenue growth trajectory, we project that the negative pressure from inflation, supply chain constraints, labor shortages, and currency effects will abate. Companies are reporting reduced freight costs and believe they will not need to resort to as much spot buying of components at elevated prices as supply chains loosen. This should lift cash flow given the improved working capital. The higher costs of components and inventory that elevated costs of goods and weighed on margins in the first half of 2023 should largely be utilized in the second half. However, for the full year, we project average adjusted EBITDA margins for the sector to decline slightly before gradually improving in 2024. We also expect free cash flow to improve in 2023 after a significant slowdown that stemmed from the need to increase inventories amid supply chain disruptions in 2022.

Mergers and acquisitions (M&A) will become a bigger theme, potentially pressuring ratings.   As the operating conditions improve, we assess that investment-grade companies focus could shift toward M&A. Although we believe that most investment-grade MedTech issuers have a significant pipeline of new products and that their appetite for large-scale acquisitions is relatively limited, most will continue to pursue their expansion targets through tuck-in deals. Some issuers that outlined their M&A priorities:

• Zimmer Biomet Holdings Inc. has indicated that it 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, relying on M&A.
• After spinning off from General Electric Co., we think GE Healthcare Technologies Inc. could also expand its M&A activity in the coming years to diversify its portfolio. Although leverage is closely aligned with the rating threshold of 3.75x, we expect it will have some capacity under the threshold by year-end. That said, we expect the company will likely prioritize debt repayment over the near term.
• Medtronic PLC indicated that it might seek to supplement organic growth with external growth opportunities in line with its strategy to increase its exposure to high growth areas. We believe its recently announced acquisition of EOFlow for about $738 million that adds to its M&A spending of approximately $1.9 billion in fiscal 2023 reflects a somewhat stronger appetite for tuck-in acquisitions. At the same time, Medtronic announced the separation of some slower-expanding businesses, which we believe will offset the impact of acquisitions on leverage.
• Boston Scientific Corp. will likely remain acquisitive. The company conducted roughly $3.8 billion in acquisitions across 2021-2022. We believe it will likely exceed this over the next two years to further expand its portfolio and product pipeline. In the last year, it has expanded its capacity for mergers and acquisitions at the rating.

Life sciences issuers pulled back on their second-half guidance.  Expectations coming into 2023 were for a strong second half for large life sciences companies. While most rated issuers have performed in line with or exceeded expectations, a broad pullback on annual guidance accompanied second-quarter earnings for Thermo Fisher Scientific Inc., Danaher Corp., Revvity Inc., and Agilent Technologies Inc., stemming from a slower-than-expected recovery in spending in China and more cautious spending behavior among biopharmaceutical customers.

We do not expect this to have a ratings impact because most large life sciences issuers have sizable leverage cushions at the current ratings and substantial free cash flow that can reduce net leverage if accompanied by slower share repurchasing or M&A activity. Additionally, much of the slowdown cited in China relates to reduced purchasing of consumables as customers utilized inventory. Accordingly, purchasing activity will need to pick up once inventory levels are further depleted.

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