The COVID-19 pandemic has disrupted health care systems operations across the globe, with no precedent to look back on. While we normally think of medical devices as among the most stable of health care subsectors, there was a disproportionate negative impact to medical device companies from the March halt in elective procedures across the globe.

Some 17 of 47 (36%) of S&P Global Ratings' negative rating actions associated with the pandemic in the health care industry were related to medical technology and life-sciences (Table 1).

Table 1

Following the release of second-quarter results by publically traded issuers, we try to address the most frequently asked questions related to our views on credit ratings in these sectors.

Frequently Asked Questions

What are the distinguishing characteristics of the negative rating actions related to the COVID-19 pandemic?

Our actions in the medical technology and life sciences segments at the onset of the pandemic were mostly focused on credits with limited pre-COVID-19 capacity for underperformance (i.e., Becton Dickinson & Co., Stryker Corp.) and those in the areas we expected to have the most pronounced impact with limited offsetting factors.

• Dental manufacturers/equipment manufacturers: Dentsply Sirona Inc., Carestream Dental Parent Ltd., Zest Acquisition Corp., YI Group Holdings LLC
• Orthopedic implants manufacturers: Stryker, Zimmer Biomet Holdings Inc., Exactech Inc.
• Ophthalmic and eye care manufacturers: BVI Holdings Mayfair Ltd.

We also took a few negative actions among contract medical organizations (CMOs) that serve the medical devices industry, since the majority we rate have meaningful exposure to the orthopedic area (with the exception of Integer Holdings Corp., Spectrum Holdings III Corp., and Q Holdco Ltd.). We expected the impact to trickle down to the medical technology supply chain.

We downgraded several CMOs that already had limited capacity for underperformance before the pandemic disruption (Femur Buyer Inc., Viant Medical Holdings Inc.) and constrained liquidity (NN Inc.). We revised the outlooks to negative on those we expected to be affected over the course of 2020 (TecoStar Holdings Inc., Q Holdco).

How did the results for the quarter ended June 30, 2020, differ from your initial expectations?

By the end of the quarter, health care procedure volumes strongly rebounded and results indicated somewhat faster than expected recovery. And average revenue decline in June was about 10% compared to 22% for the entire quarter. This indicates meaningful improvement compared to March and April, when procedure volumes declined as much as 50%-70%.

However, we remain cautious about the second half, attributing some of the recovery to pent-up demand from rescheduled procedures. We believe in many therapeutic areas new patients are still reluctant to undergo medical procedures, especially in an inpatient setting, and the recovery may plateau below pre-COVID-19 levels.

Table 2

Given results in the last quarter, are you revising your timeline for industry recovery?

While second-quarter results for medical device companies mostly exceeded earlier expectations, our recovery timelines are largely unchanged.

Table 3

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We expect, after a rapid rebound in June and July, recovery will continue at a more gradual pace, reflecting concerns regarding the spike in COVID-19 cases in select regions and reluctance among some patients to visit medical facilities. We forecast operating performance expected before the pandemic to be achieved in mid- to late 2021.

We believe revenues from more emergent therapies (i.e., interventional cardiology, trauma-related procedures, spine and hip replacements, neuro-modulation, and other pain related therapies) will continue to recover faster than other subsegments. We also believe businesses tied to home-based or outpatient settings (i.e., procedures performed in ambulatory centers) may benefit from faster recovery.

We think elective procedures (i.e., diagnostic screenings, knee replacements, ophthalmic surgeries) face greater risk of near-term volatility if reported deaths and hospitalizations trends trigger a second wave of restrictive actions. However, that should not have the same impact as in April and May. This assumption reflects better preparedness, including testing availability, adequate supply of necessary medical equipment, and more effective treatment protocols. At the same time, we believe absent a vaccine some patients will be reluctant to visit medical facilities in the near term, somewhat limiting the recovery.

In addition, delayed product launches and more limited development and training activities may somewhat limit the industry's growth in the second half. But we believe will not materially change industry dynamics longer term. For example, Johnson & Johnson postponed the launch of its orthopedic robotics platform to the second half. The company also said it now expects to enter first-in-human clinical trials for its robotic platform for general surgery in the second half of 2022, a significant delay. Medtronic PLC said in May the COVID-19 pandemic was limiting its engineers' access to the hardware for its soft-tissue system, named Hugo, as they work remotely. At the same time, while the pandemic is clearly disruptive, we believe the adoption of robotic platforms will continue.

In your forecasts, which subsegments do you expect to have the longest recovery path?

We project the recovery in capital equipment sales will lag other segments, with full recovery expected only in late 2021-2022. We believe health care providers, from hospitals to dental offices, reacted to the pandemic by materially cutting their capital spending. Although somewhat faster than expected recovery of procedures in June and July sent a positive signal, and federal aid from the Coronavirus Aid, Relief, and Economic Security Act helped, we believe providers will continue to be cautious with capital allocation in the coming year. In the second quarter, Dentsply's equipment sales dropped 50%. Hologic Inc.'s breast imaging sales decreased 28% and its GYN surgical revenue declined 54%. In the robotic systems and imaging market, results were more favorable, ranging from a decrease of 22% in Intuitive Surgical Inc. revenues to growth in sales of Stryker's Mako system in the second quarter.

The three largest imaging equipment manufacturers (Siemens Healthineers AG, GE Healthcare, Koninklijke Philips N.V.) reported declines in the mid- to high-single-digit percents. This reflected a mitigating effect of large installed bases, stable recurring service and maintenance income streams, and benefits from an uptick in demand for COVID-19-related equipment (i.e., intensive care monitoring) compensating for a decline in traditional magnetic resonance imaging, scanners, etc. It's also worth noting that in Asia and Europe, hospitals are mostly backed by government-sponsored health care systems so the challenges are mitigated by external support. In the U.S., some hospitals weakened by the COVID-19 pandemic do not have an immediate backstop from insurers or government. We expect higher uncertainty and volatility in earnings of equipment manufacturers that have higher than average exposure to the U.S. market (i.e., Hologic, Hill-Rom Holdings Inc.).

Table 4

In some cases, companies with diversified business models can partially or fully offset the impact of the capital sales decline with the revenues from other product categories. For example, Hologic posted growth in the June quarter driven by its COVID-19 molecular testing volumes, as did Hill-Rom driven by hospital bed sales. However, we believe the upside from hospital beds and ventilators sales will subside in the coming quarters, while surgical equipment sales may continue to be suppressed longer, creating a delayed trough in Hill-Rom's sales compared to those of other medical device manufacturers.

We also note EBITDA margin pressure did not necessarily translate into material reductions in cash flow generation for some companies, stemming mainly from significant inflows of working capital in the second quarter, as the companies increased their receivables collection while their payables decreased. For example, Dentsply Sirona's adjusted EBITDA dropped close to zero from $225 million in the second quarter of 2019, while reported free cash flow increased to $162 million compared to $118 million in the same period last year. Although less pronounced, we noticed a similar trend in the results of Zimmer Biomet, Stryker, and Teleflex Inc.

We expect this to reverse in the coming quarters, with a trough of cash flow generation potentially delayed to the third or fourth quarters. At the same time, the good liquidity positions of the overwhelming majority of medical device companies we rate, especially after proactive debt issuances or revolver draws early in the pandemic, will enable them to pursue their long-term strategies.

Do you expect further negative pressure on the ratings on medical device manufacturers in 2020?

A full recovery will not likely happen until after the arrival of a COVID-19 vaccine, which we do not expect until mid-2021. Still, given the capacity most issuers have in the ratings, the continued gradual recovery, and assuming no significant backsliding due to regional outbreaks, we do not expect further ratings deterioration in the medical devices, diagnostic, and life sciences subsectors.

Do you continue to view merger and acquisition (M&A) activity as a significant downward risk for medical technology ratings?

Before the pandemic, companies were consolidating and M&A activity was a significant driver of downside rating actions. Indeed, a number of recent outlook revisions were driven not solely by COVID-19-related drop in demand but also by a potential deviation from a deleveraging path related to acquisitions. Our outlook revisions on Becton Dickinson, Stryker, and Boston Scientific Corp. were partially driven by such considerations.

After a short period when the M&A activity was put on hold due to the pandemic, we believe medical device companies are likely to resume expansion strategies as soon as their core businesses start to recover, especially considering some--Boston Scientific and Becton Dickinson--recently issued equity that at least partially will be spent on acquisitions. In early August, Siemens Healthineers signed an agreement to acquire Varian Medical Systems Inc. for $16.4 billion to expand its presence within the oncology solutions market, the first large acquisition in the industry since the pandemic.

Do you foresee positive rating actions in the segments that benefit from COVID-19?

Revenues for life sciences and diagnostics, in contrast to other health care subsectors, actually were a net increase due to the pandemic, as COVID-19-related tailwinds (increased demand for testing, vaccine research and manufacture) offset related headwinds (disruption to research laboratory activity, procedure volume declines). However, that will be uneven, depending on each company's products, and the sustained increased demand is uncertain. Thus, such increased demand is unlikely to drive a positive rating action, especially for larger, higher-rated investment-grade players.

The disruption in research lab activity at government and academic labs decreased demand for life science products. The disruption in medical procedures not only affected demand for medical products and devices, but also collaterally demand for pre-procedure related diagnostic tests. However, diverse companies such as Thermo Fisher Scientific Inc. and PerkinElmer Inc. have more than offset the loss with increased demand for their products that support COVID-19 diagnostic tests. The disruption in research lab activity is also abating, as large markets such as China and western Europe begin to return to normal activity.

In the meantime, we believe diagnostic testing demand should remain strong for the balance of the year. Demand for life science products also benefits from increased COVID-19 vaccine research. Demand at companies such as Danaher Corp. will further increase once a developed vaccine goes into production.

Considering the better than foreseen recovery in the second quarter, when do you expect to review negative outlooks on medical technology credits?

We have some evidence that many procedure volumes have recovered to as high as 90% of pre-COVID-19 levels. However, as mentioned above, despite acknowledging faster recovery in the second quarter, we continue to see risks that can slow the recovery in coming quarters (e.g., persistent reluctance among some patients to visit medical facilities, spikes in cases after schools reopening, and cash preservation in health care facilities). Given continued macroeconomic uncertainty and that a portion of the recovery was likely due to working down a backlog of delayed procedures, we would like to see pandemic-related risks at least partially abate and procedure volumes stabilize for a sustained period, if not further improve, before reviewing the ratings with negative outlooks.

Greater comfort around the companies' financial policies regarding share repurchases and resumption of acquisitions would also aid a return to stable outlooks. Given our base-case projections reflecting potential continued challenges for many rated companies, we will not revise our negative outlooks just yet. We expect to do so after at least one or two quarters of sustained recovery trajectory.