Health care reform is going to be unimaginably expensive, costing roughly $1 trillion in the next decade. One of the many ways Uncle Sam plans to raise the necessary cash is with a 2.3% tax on the sale of all medical devices, starting in 2013.

That’s obviously unwelcome news for the medical device industry, which makes all sorts of gadgets — from blood sugar meters and thermometers to x-ray machines and artificial hearts — for use by patients, doctors, nurses and other health care professionals. Global medical device sales surpassed $220 billion in 2009, with U.S. medical device firms accounting for more than 40% of that business.

While medical devices are big money, it would be a mistake to underestimate the burden of the new sales  tax , which is expected to cost the industry an extra $20 billion throughout the next 10 years after its inception. The tax could seriously hurt the bottom line of many medical device companies, or even push some into the red, especially smaller firms without deep pockets.

Take Wright Medical Group (Nasdaq: WMGI), a small-cap firm that makes artificial joints and synthetic bone grafts. If the 2.3% tax was in place now, it would cost Wright an extra $11.7 million based on current annual sales of $511 million. That would more than erase the company’s after-tax net income of $11 million. Who’s to say that won’t be exactly what happens to Wright or any number of other smaller medical device companies when 2013 rolls around?

A large-cap alternative
I still think medical device stocks are excellent investments, though, as long as they’re the right ones. In fact, there’s a company I’m confident can weather the new tax and deliver enviable stock returns averaging +13% to +23% annually during the next three or four years — a level of performance I certainly don’t expect from the overall market.

The company, a large-cap maker of heart-regulating devices such as pacemakers, artificial heart valves and implantable cardioverter-defibrillators (ICDs), currently has annual sales of $4.9 billion. Thus, a 2.3% levy would lop another $113 million off its post-tax net income of $849 million, deflating that figure by -13% to $736 million.

That’s a nasty hit, but the bottom line would still be comparable to last year, when the company booked net income of $777 million. It would still far outstrip 2005 through 2008’s net income of $393, $548, $559 and $384 million, respectively.

There are several other reasons I believe this company — St. Jude Medical (NYSE: STJ) — can handily beat the market going forward. First, the consensus on Wall Street, which knows full well about the new sales tax, is for earnings growth averaging +12.8% annually for the next five years, compared with +9.9% and +9.0%, respectively, for main rivals Medtronic (NYSE: MDT) and Boston Scientific (NYSE: BSX).

Much of those earnings are expected to come from newer heart-regulating devices, which will account for nearly 60% of sales compared with the 7% of sales St. Jude’s heart valves currently bring in. In fact, the company recently surpassed Boston Scientific in market share for ICDs, which should continue to be highly profitable because a serious heart problem, known as atrial fibrillation, often doesn’t respond to any other treatment. Once implanted, an ICD uses electrical charges to keep the heart beating normally.

St. Jude has also been expanding into promising new territories, a major one being the fast-growing, billion-dollar market for “neuromodulation” devices that stimulate the spinal cord to reduce chronic pain. Such devices have also shown the potential to treat other conditions such as depression, epilepsy, incontinence and Parkinson’s, and St. Jude should receive FDA approval to use these devices for treatment of at least a couple of these conditions in a few years or so. When it does, the company will be well-positioned to take advantage of the new revenue opportunities.

St. Jude’s purchase of LightLab Imaging for $90 million in July should prove to be a key acquisition. It enables the company to quickly become a leading player in the $500 million vascular imaging market by owning a technology known as optical coherence tomography (OTC). This technology helps doctors manage cardiovascular disease by providing extremely high-resolution, three-dimensional images of problems with the heart and blood vessels.

Action to Take –> Despite the large outlay for LightLab and costs for entering the neuromodulation market, St. Jude remains financially fit. For example, its debt-to-equity and leverage ratios of 0.47 and 1.8, respectively, are in line with industry averages. At $692 million, free cash flow is as strong as ever. Plus, the stock is -40% less volatile than the overall market, as indicated by a beta of 0.60.

These characteristics and market-beating growth potential make St. Jude a top-notch medical device play. I’d select it over any of the smaller medical device stocks, since they’re much more vulnerable under health care reform. I’d also pick it over Boston Scientific and even industry big boy Medtronic because it’s set to grow significantly faster in terms of sales, earnings and total return.