Medical Device Link.

Originally Published January/February 2001

Street Smart

Medical device firms are following a Wall Street formula for success: consolidate, integrate, leverage—repeat.

Thomas J. Gunderson

Today's smart dollar is chasing medical technology companies. Medical technology companies are showing greater economic returns than the average company in Standard & Poor's 500. The average cash return on capital invested in one of the 18 companies included in the U.S. Bancorp Piper Jaffray medical technology group, for instance, has been far above and beyond the cost of that capital. How are medtech companies achieving these superior results?

One way is by investing wisely in internal operations. Internal investment is always a challenging task for companies. Company executives face an array of appealing possibilities, any of which could be equally capable of producing either substantial benefits or disastrous consequences. Should a company buy back shares? Build new manufacturing facilities in the United States or overseas? Add to its sales and marketing force? Increase the number of projects in development?

Just as the companies themselves have difficulty determining appropriate internal investments, Wall Street analysts are challenged to determine how companies will invest and what returns will result. However, that task is becoming easier and more predictable for both medical companies and analysts alike.

Medtech companies are starting to show signs of entering into an interesting internal investment cycle. The character of this cycle can be best understood by examining the individual segments of the cycle within its political and investor contexts.

Politics and Economics Drive a New Cycle

Because of their pervasive nature and impact on the national economy, healthcare companies are never far from the political limelight. From the social, economic, and political storms that blew in (and then out again) with the ill-fated Clinton healthcare reform plan to the current debate about pharmaceutical pricing, Americans—or at least their elected leaders—love to flog the current system. Almost no one seems willing to defend the system on the basis of its wide geographic availability or the access it provides to high-quality medical technologies. The bane of the best healthcare system in the world is that it costs too much.

Political pressures over the past decade have prodded medical device companies to take a number of actions, thereby refocusing their internal investment strategies while also, inadvertently, positioning them for greater growth. During the past few years, companies have lowered their costs of manufacturing and worked to increase productivity; they have consolidated their businesses while achieving growth, breadth, global marketing mass, and political clout; and they have tightened their financial management.

Cut Costs, Pump Up Productivity

As a result of the healthcare reform movement at the beginning of the 1990s, automatic annual price increases have become little more than a nostalgic memory. Instead, medtech companies have focused on lowering their costs so as to keep gross margins improving even in the face of declining prices. From 1993 to the present, gross margins for the 18 largest medical device companies in the United States have improved on average from 52 to 67%. In the face of relatively stable pricing, such an improvement is a tremendous achievement.

Although most medtech stock prices underperformed during the years 1992–1993, during that period companies made a number of changes that set the stage for better performance. And when investors returned to purchasing healthcare stocks, medical device companies were rewarded with magnified earnings growth and skyrocketing stock performance.

Consolidate to Earn Clout

This spurt of internal growth began to slow at the end of 1997, partly because group purchasing organizations (GPOs) began to demand volume discounts from their suppliers. But with stock prices still sky-high (providing many large companies with ready currency), and a plethora of young, high-growth companies just opening their doors, the larger medtech companies went on a buying spree. In 1998, there were 28 medtech mergers or acquisitions totaling $25.4 billion. Six of these deals alone totaled $19 billion.

Although this consolidation activity continued through 1999, the 26 deals conducted that year had a total dollar value of just $7 billion, and none of the acquired companies were valued at more than $1 billion. Through early November 2000, just seven deals at a total of $3.1 billion had been brokered for that year; no deal had been valued at more than a billion dollars.

This consolidation in the medtech industry has provided a second means for medical device companies to deal with the uncertainties of the political environment. Like the pharmaceutical companies before them, bigger medical device companies now have the combined assets necessary to lobby more successfully, market worldwide, and support greater R&D. By increasing the breadth of their product and service offerings, they have removed some of the risk and uncertainty that previously existed in the minds of investors (see insert below). Although the merger mania resulted in some assimilation indigestion, for the most part the new, larger companies are now fully integrated.

Tighter Ledgers

As a result of the acquisitions of 1998–1999, many medical device companies are now undergoing changes in their financial management. Obviously, a number of medical device companies are now much larger than they were in the past. Assets for 18 of the largest medtech companies (companies that earn more than half their revenues from devices) have ballooned from $30 billion in 1997 to almost $45 billion today. As medical device companies grow bigger and bigger, several overall trends can be discerned that may illuminate the future course of the industry.

To begin with, device companies are displaying greater sensitivity to the need for close asset management than they ever did in the past. Managers and investors are paying more attention to overall return on invested capital. In part, this shift is reflective of the growing maturity of the industry. In the old days, companies kept their high-margin top lines growing and figured everything else would work out. Start-up companies in medtech still operate in this mode. But to maintain growth on an ever-increasing base of revenues, larger companies must use their capital more efficiently. This move toward optimizing returns by means of tighter management of all company assets constitutes a third means for companies to deal with uncertain politics.

Tighter financial management has generated a new asset base among medtech companies that is too big to ignore—and Wall Street is paying attention. Larger institutional investors are increasingly demanding to know "What's going on with the balance sheet?" Some clues about how the industry balance sheet is changing can be gained by looking at Piper Jaffray's 18-medtech-company index (see Figure 1). Between 1997 and 2000, the "average" large-cap medical company's balance sheet showed the following changes.

• Current assets inched down as a percentage of total assets, from 47.6 to 45.7%.
• Net property plant and equipment decreased from 24.1 to 20.9%.
• Net intangibles (e.g., goodwill) increased from 19.7 to 23.1%.
• Long-term debt increased from 21.8 to 22.9%.

Figure 1. Cash returns on invested capital (economic margins) for the 18 companies in the U.S. Bancorp Piper Jaffray medical technology group, compared with returns for companies listed in Standard & Poor's 500. The greater economic returns of medtech companies are helping the sector to win favor with Wall Street analysts and investors alike.

What do these trends mean? Over the past four years, companies have tied up proportionately less of their capital in receivables and inventories and, by the same token, have reduced the relative size of their holdings in hard assets. Companies have also increased their long-term debt in order to finance cash acquisitions, resulting in higher goodwill expense along with higher interest expense. Note, however, that the increasing number and larger size of acquisitions made in 1998–1999, by themselves, caused a shift in the arithmetic. Between 1997 and 1999, net intangibles increased from $5.9 billion to $10.1 billion in real dollars and, therefore, other asset classes took up a smaller proportion of the total asset base. Nevertheless, the relative increase in other categories was slower—indicating a rebalancing of the balance sheet.

Investors are paying more attention to these balance sheet changes and, for the most part, they are pleased with what they are seeing. Cash is being squeezed out of accounts receivables and inventories; days sales outstanding has declined from 91 to 85; and inventory turns have remained relatively stable, declining by nearly one day to 172 days. Net property plant and equipment is up overall for the four-year span, but its value represents a lower percentage of overall assets.

Taken together, these trends suggest that the total quality management consultant fees of the late 1990s are finally delivering results, enabling medtech companies to get greater production out of their existing assets. In addition, more and more companies are engaged in outsourcing major portions of their operations, providing more contract business for full-service firms such as Colorado MedTech, Horizon, and Plexus, as well as for specialists such as sterilizers IBA and Steris. All in all, medical technology companies are employing more capital more effectively than ever before.

What the Future Holds

Higher productivity, higher growth, higher expectations, and higher stock prices are all leading to an intense round of consolidation, integration, and financial focus. Where do we go from here? Would you believe another round?

The most probable scenario is that the large medtech companies will continue to squeeze superior returns from their capital. These returns will be invested in even more capital. But high-return assets are not easy to build in a medtech world burdened with both FDA regulation and Health Care Financing Administration reimbursement controls. Growth will eventually slow, and the superior returns will be invested in acquisitions. Companies will engage in consolidation, integration, and financial leverage—and then repeat.

Within a political context, this medical technology scenario is likely to oscillate with varying amplitude and frequency for an indefinite period of time. But the underlying drivers continue to be important: the world's population is getting older, and health and healthcare are becoming even bigger issues. With high demand for their products and supplies, well-run medtech companies should deliver superior returns. For the short- and medium-term, investors should share in these superior returns. For the long term, medical device firms and analysts alike will have to watch for political disruption.

Thomas J. Gunderson is a managing director and senior analyst for U.S. Bancorp Piper Jaffray (Minneapolis) and a member of the MX editorial advisory board.

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