Medical Device Link.

Originally Published MX January/February 2002

COVER STORY

Building a (Bigger) Niche

American Medical Systems CEO Douglas W. Kohrs says that his company's public-market success comes down to two things: sales growth and profitability.

Interview by Steve Halasey

American Medical Systems (AMS; Minneapolis), a manufacturer and marketer of medical devices used in the areas of incontinence, erectile dysfunction, and prostate disease, has had a banner year. The company announced record-breaking results for the third quarter of 2001, reporting a 22% increase in sales and a 52% increase in earnings as compared with the same period in 2000. Such figures are staggering, especially with the recent downturn that the U.S. economy has taken, but Douglas W. Kohrs, president and CEO of AMS, doesn't consider the results surprising. After all, the company that AMS is today was built by a group of savvy investors and dedicated employees.

MX: Although AMS has caught the attention of investors since going public in 2000, the company is not a new one. How did the company originate?

Kohrs: This summer AMS will celebrate its 30-year anniversary. The company was started here in Minneapolis by an engineer and a surgeon, Brantley Scott, MD, who invented the technologies for both the artificial urinary sphincter and the penile prosthesis, both of which we still sell today.

Many people think that the company was started to develop penile prostheses, but it actually started by treating male urinary incontinence, primarily following prostate cancer treatment. The artificial urinary sphincter was designed for that purpose, and has been improved significantly over the years.

In 1983, AMS was purchased by Pfizer, which went on to own the company for 15 years. Then, in September 1998, Pfizer decided to sell its four medical device companies and exit the business.

The other three companies are all familiar names, and they were all sold to existing companies. Howmedica (Rutherford, NJ), a large orthopedics company, was sold to Stryker Corp. (Kalamazoo, MI). Schneider (Minneapolis), a cardiovascular stent manufacturer, was sold to Boston Scientific (Natick, MA). And Valley Labs was also sold into a company with quite a large portfolio. AMS was the odd one out. Instead of being sold to another device company, it was sold to an investment group led by Warburg Pincus Equity Partners.

After Warburg Pincus took over, how was the new management team brought on board?

Warburg Pincus bought the company in September 1998, and initially they didn't make a lot of changes. They brought me on board in April 1999, about six months after the purchase was completed.

What attracted me most was my own due diligence, during which I figured out that the marketplace was very underserved. In other words, the number of procedures being done each year to cure people represented only a very, very small percentage of all those who could potentially benefit. I was confident that if the right things were done, I would have a good opportunity to change those penetration rates.

An Appetite for IPOs

It was only a year after you joined AMS that you decided to take the company public. How did that develop?

When I started in April of 1999, we were not running the company with the intention of taking it public. We were growing the company to improve its top line and try and make the company profitable. Those were our main goals.

But in January and February of 2000, after about a two- to three-year hiatus from medical device companies going public, Aspect Medical and Oratec both issued IPOs and were very successful initially. So there seemed to be a renewed interest in medical device IPOs, which may have been a result of the early waning of the high-technology and dot-com markets. Over the next few months we kept our eye on the market as some other device companies went public, and finally in June we decided to test the public market's waters.

In the past, investor confidence and interest in medtech companies has sometimes been soured by start-ups that have failed to deliver. What can start-up executives do to inspire investors in the public market?

A lot of start-up people have asked me that question. From what they observe, the public markets are good for established medical device companies, but they're not necessarily good for start-ups.

What I stress, and what we were able to do, is that companies should lay out a number of milestones for product development, growth, and profitability, and then create a compelling story that shows how the company's technologies and innovations will help it to meet those milestones. That's what it's really all about. Companies should set realistic but slightly aggressive goals, and then ensure that they meet those goals. By doing so, they can build investor confidence—and that works for a small company as well.

Your IPO raised $53 million, so that improved AMS's financial structure significantly by getting rid of about half of the company's debt. And then in July 2001, you went for a secondary offering. What was the purpose of that funding?

We raised the money, in part, to pay down our debt. As of the end of the third quarter of 2001, the company has a little over $50 million in cash and a little under $30 million in debt.

A lot of people have asked why we don't just pay the debt all the way down. We want to keep a significant cash balance because we have a number of acquisition opportunities that we are evaluating. We don't want to have to keep raising money and paying banking fees all the time. So our cash on hand exceeds our debt, but it gives us the flexibility that we need to move quickly.

Since July we have looked at and evaluated a number of opportunities, but we haven't yet acted on any of them.

Acquisition Strategies

In evaluating those companies, are you primarily looking to extend your product lines or do you have other strategic goals in mind?

What we're looking for is complementary products. We're not necessarily looking to acquire another penile implant or benign prostatic hyperplasia (BPH) company, so we place greater value on technology or on a company that doesn't compete with what we currently have.

We are very interested in the whole field of prostate cancer. Our products treat all the fallout from prostate cancer treatment—in other words, impotence and incontinence—but we don't actually have a prostate cancer treatment. So from an investment standpoint, that's an area that's very attractive to us. Obtaining such a product would provide us with something we don't yet have, so it would not be cannibalistic. Yet the product would be in a familiar market, where sales could be made to customers that we are already calling on. There are a number of market areas that meet similar criteria and would be a good fit for AMS.

Another concern for our acquisition and licensing activities is whether the effects will be immediately accretive or dilutive. We have gone to great lengths to turn the company profitable and make progress every quarter, and we don't want that progress to be stalled. So we ideally desire our acquisitions to be accretive in the year that we actually purchase them. Fortunately, there are a number of opportunities for us to do that.

How does AMS handle the integration of acquired companies? Do you physically move the acquired company, or do you leave it in place? And what do you do with the company's existing workforce?

Our history offers the best example. When we acquired our way into the female incontinence business in December 1999, we acquired a very nice product, but we also acquired a direct sales force. We retained all of the people from the acquired company—including the engineering and manufacturing staff—but the real jewel was the sales force.

Most of the salespeople from that acquisition are still with the company, and they are doing a fantastic job for AMS. They've been able to learn and grow with AMS, and they've merged very well into our existing sales force. In this case, the company had resources that were attractive beyond its technology, and we ended up keeping everything we wanted.

As we look forward, we recognize that talent is one of the keys to growth. So if we can add talent in the form of engineers or salespeople who are very experienced at their business, that's an additional attraction for us.

Growing Technology

In addition to looking for potential acquisitions, AMS is also building its internal R&D facilities. Is product-line extension also the goal in that area?

Yes. Since I've been here, at any given time we have had about 15 very focused internal ongoing R&D projects. In 2001, we launched a number of products that were all internally generated.

We're not really a technology-driven company; we're still very much a marketing-driven company. The ideas that we work on internally have primarily come from our physician clients. In other words, we've become very good at listening to our customers, and when they come up with ideas, we try to act on them as quickly as possible. We screen the ideas, as most companies do, but once we decide to move on an idea we try to get it to the marketplace quickly.

In 2001 we launched some very interesting technologies, and all of them were driven by the marketplace. The best example is the Sparc system, a new minimally invasive female incontinence procedure that we launched last August. That system originated with a doctor's idea, which we worked through concept, regulatory approval, and market launch in only 12 months.

What percentage of revenues do you put into R&D?

It averages about 10% a year. That's a pretty high percentage, but we expect to continue investing at that level for at least the next several years.

When you are sorting out your product-development priorities, what are the primary criteria that enable you to put one product ahead of another?

It starts with how many patients the product will be able to help. The more patients the product can help, the higher its priority.

Another thing that we watch out for is time to market. The importance of whether a product is a 510(k) or a PMA changes depending on how our product-development cycle is flowing. Since the PMA process takes longer, some years we will release several PMA products and other years we'll release none. To keep the product pipeline flowing on a consistent basis, those PMA products have to be supplemented with 510(k) products.

We also have to consider the probability of a product's commercial success, that is, will it work better than something else that's on the market. We always strive to produce devices that work better rather than those that are merely equivalent.

Where does cost of development fit in? Is that a lower-ranked consideration?

Yes, because in urology the cost of development is usually relatively small, especially for 510(k) products. The real cost is not the money spent in a research lab or on engineering, it's the money spent over a two- to three-year period studying the product in clinical trials. Where significant clinical research is required, those costs have to be factored in near the top of the list.

Sales and Marketing Options

Aside from direct sales, are there other selling options that are worthy of consideration or have you looked at those and discarded them?

We have looked at other options, and we're very happy with the direct sales force model. Because we are selling high-end, usually high-cost surgical products, a certain high level of service is required both in the doctor's office and in the operating room. We feel that we have the premier sales force in the field of urology, so we want to make maximum use of that advantage.

Some of the treatment areas that AMS deals with are very personal. Does direct-to-consumer marketing for the products used in those areas make sense now or in the future?

We're experimenting with a direct-to-consumer approach now, but not on a national basis. Our tests are being done on a regional basis, where the intent is to direct patients to a particular doctor's office. Used in this way, direct-to-consumer marketing does increase the number of patients coming to the doctor's office to ask about a specific health condition. In the future, as AMS gains even greater mass, this approach to marketing could play a bigger role.

The problem with direct-to-consumer marketing on a national basis is that it's very expensive. And at this point, the company is not in a position to take a chance on a major multimillion-dollar direct-to-consumer campaign and have it not work. So we're being fiscally responsible in our approach.

Our best direct-to-consumer piece is our Web site, where we have a lot of links to other medical Web sites. Patients sometimes find their doctors through our site, and they go in with a printout from the site asking the doctor to tell them about a particular product. That doesn't happen as often as we would like, but I think it'll become an important part of the business.


Eyeing the Future

Is AMS now getting a boost from the investment community and from the way it's spending its R&D dollars that it didn't get when it was part of a larger conglomerate?

Yes. When I arrived and started looking at what was in the R&D pipeline, I found an organization that was relying on old product lines and had not produced a significant new product for eight years. A lot of money was being spent on R&D, but it really just funded a lot of research churning. Products would get almost to the end, but they would never make it to market.

So one of the first things our team did was to halt work on several projects. That was a difficult task, because we had to overcome the emotional attachment of people who had been working on certain projects for years. It was hard to tell them, 'I know this is your baby, but you have to stop because the project doesn't make sense for the current marketplace.'

Under Pfizer, AMS had been a technology-driven company, so it had a lot of technologies that were looking for markets. We changed that by adopting our current market-driven approach, allowing our customers to tell us what they wanted. Once we did that, products made the journey all the way through development and onto the market.

How would you rate AMS's performance since becoming a public company?

We didn't go public during great economic times, but we're proud of our performance since we've been public. Compared with all the troubles and economic uncertainties that other companies are having, things have turned out very well for AMS.

We've exceeded expectations for five quarters in a row, and that has attracted significant attention. We've also leveraged that success internally with our own employees, proving to them that when they perform they will be rewarded.

What's your best guess about 2002?

This year we expect to grow even more than we did last year. Moreover, we think we can continue to grow organically and potentially add complementary products through licensing and acquisition. An additional challenge will be to improve on earnings—but that's also something we think we'll be able to achieve.

Photos courtesy of American Medical Systems.

Copyright ©2002 MX