The Lurking Danger in the Affordable Care Act

The Patient Protection and Affordable Care Act, or PPACA, has undoubtedly changed the way America treats health care. In expanding health care coverage to more than 30 million Americans currently without insurance, the act will guarantee that many who need medical care won't be left hanging. But for all the happy rhetoric from the health care industry around an influx of new customers, one tax provision poised to launch in 2013 looms dangerously over medical device corporations.

Taxing troubles
The PPACA requires a lot of money to implement its grandiose vision for expanded national insurance coverage. One way that Congress decided to pay for the legislation came in a 2.3% excise tax on sales of taxable medical devices -- ranging from basic products such as surgical apparel to complex devices like pacemakers and artificial joint replacements. There are some exemptions in this  -- equipment for retail sales, such as bandages, wouldn't feel the hit, nor would products for further manufacturing or export.

The tax has come under fire in Congress, where the House of Representatives voted to repeal the tax. Surprisingly, the measure received bipartisan support in the House, with members from both parties voting for the repeal. Unfortunately for many affected companies, the bill stalled in the Senate -- and the tax, set to begin in January, continues to survive.

For a domestic medical device industry with total sales estimated to exceed $100 billion annually, 2.3% might not seem like a significant amount at first glance. For instance, health care giant Johnson & Johnson  (NYSE: JNJ ) recorded $26 billion in global medical device and diagnostics revenues in 2011. 2.3% in excise tax would only tap this health care giant for a maximum of $598 million -- a startling amount, but not a crippling blow to the company's $9.7 billion in 2011 net profit.

Things aren't so harmless for the smaller players in the medical device industry, however -- and it's those companies that stand to lose big should the excise tax come to fruition.

Underdogs under fire
Companies in the medical device industry spend a lot of cash on research and development, particularly the smaller players with weak revenues that are still trying to establish a foothold. Some players developing cutting-edge technologies, such as promising robotic surgery and orthopedic implant developer MAKO Surgical (Nasdaq: MAKO ) , operate at a net loss as they forge their foundations of the future.

But the PPACA's excise tax inadvertently will smash these small, research-heavy corporations financially. Continuing with MAKO as an example, the company invested nearly 25% of its 2011 revenues into research and development, while burning through $13 million in cash. An excise tax would have cost the company nearly $2 million  more on top of that number in 2011. While $2 million might seem inconsequential, for a small, research-heavy corporation like MAKO that doesn't yet record a profit, that's money it can't afford to lose in this crucial stage of growth.

This tax comes on top of standard corporate taxes, so small players in the industry will have little recourse. Slashing research and development budgets could compensate for the excise tax, but such moves would threaten the future of small, research-heavy medical device companies like MAKO that live and die by innovation.

Simply counting on increasing revenues from the newly insured 30-million-plus  Americans under the PPACA to compensate for the tax might work for the entrenched, major corporations, such as Johnson and Johnson and Medtronic (NYSE: MDT ) , that have the ability to produce on a massive scale. Smaller companies such as MAKO, however, often lack the production power needed to expand sales quantity on the fly -- an action that can take significant investment over time.

The last resort for companies is cutting jobs to save money. And if early action by several companies is a harbinger of the future, this trend has already begun.

Trends already under way
Job cuts at some smaller medical-device companies have already started. Earlier in September, private medical device maker Welch Allyn slashed 160 jobs over a three-year period of restructuring necessitated by the Affordable Care Act.

Welch Allyn is hardly the only case of companies in this industry cutting costs domestically because of the tax. Medical-device maker Stryker (NYSE: SYK ) made plans last November  to lay off 5% of its workforce, due in part to the excise tax. Overall, Steve Ubl, CEO  of industry trade organization Advamed, claimed that the tax could cost the medical-device industry potentially 43,000 jobs and $30 billion over the next 10 years.

It's hard to point fingers at proactive companies like Stryker and Welch Allyn. With the excise tax based on revenues, major corporations such as Johnson and Johnson and Intuitive Surgical (Nasdaq: ISRG ) that record massive net profits will have the flexibility to absorb the tax's blow. Small companies, such as MAKO -- a rival of Intuitive's in the robotic surgery industry that hopes to follow in its profitable footsteps -- won't have that room to maneuver. Ultimately, this regressive tax will hammer the smaller businesses in the medical device industry the hardest, giving their larger competitors an even greater advantage.

The diagnosis is bleak
Undoubtedly, the PPACA will send ripples throughout the health care industry. Those without insurance won't have to live on a razor-thin edge, where a medical scare takes down their life savings. However, there are a lot of less-damaging ways for the government to make up the tax revenue that this excise tax would bring in. Investors beware: This regressive measure will only hurt the medical-device industry and shareholders alike.

Investors in the medical-device space can hope this tax is repealed, but you'll need to stay ahead of this and other industry trends. To know what's in store for MAKO Surgical in the future, check out the Fool's premium special report on MAKO Surgical. It's packed with in-depth analysis, and you get a full year of updates to keep up with industry trends. Click here now to get an investing edge.


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