Medical Device Link.

Originally Published MX January/February 2002

MARKET ANALYSIS

Medtech Forecast for 2002

When the winds of change are blowing, it’s best to have a whole crew of weathermen on board.

Steve Halasey and Flora Nguyen

In the waning days of 2001, the buzz among economists and market analysts was that the year's recession had bottomed out and that full economic recovery would follow soon.

According to many economists, the evidence in favor of a speedy recovery for the U.S. economy seemed to be all around us: rapidly rebounding public confidence, historically low interest rates and petroleum prices, and no signs of inflation. Analysts seemed just as eager for the start of a new bull market, declaring that small-cap growth stocks were likely to be the big winners in the early phases of the market recovery. Nearly all such economy watchers projected that recovery would be in full swing by the middle of 2002.

Inevitably, that's good news for medtech manufacturers-and especially for the many small, entrepreneurial companies whose survival depends upon access to investment funding of various types. But the forces that drive a general economic recovery are not always the ones of greatest importance for medtech companies, whose fate can also hinge on a variety of strategic issues such as the regulatory and reimbursement climate, competitive positioning, and the timing of technology-development cycles.

To find out what pressures medtech executives are most likely to face in 2002, MX polled a number of experts in the field (for biographies of the participants, see sidebar). The comments that follow provide an overview of the market by these industry watchers.

Market Drivers, Market Limiters

MX: What do you expect to be the major drivers and limiters for medtech markets in 2002? How can medtech companies use this information to plan effective business strategies?

Timothy A. Dugan: One market driver will be access to relatively attractive equity capital for leaders within the medical field. In times of economic uncertainty, the medical arena becomes a safe haven for investors. We have seen, and will continue to see, access for medical product companies that was not available a year ago.

Unlike previous market opportunities, however, the greatest access to capital will go to established companies with leading market positions. This will likely not be a market for emerging technologies, which will be a market limiter.

Eliot Lazar, MD: Market drivers will include the development of drug-delivery systems and a further push toward more-sophisticated means of using software to assist in patient diagnosis and management. Limiters will be older, standard technologies that have run their course.

Medtech companies should take the pulse of the needs of the medical community rather than attempting to drive the market themselves. Industry leaders typically listen to the end-users-the physicians.

Joseph G. Solari and Christopher L. Suscha: Over the past 10 years, major new-product cycles have enabled the medical device industry to grow faster than and outperform the S&P 500. That trend will continue as medtech companies target such large, rapidly growing product opportunity areas as coronary stents, implantable cardioverter-defibrillators, and recombinant and plasma proteins. Other drivers for 2002 include favorable demographic trends, a limited chance of healthcare reform, and an improving foreign-exchange environment.

Although medtech companies typically outperform the market during periods of recession and slowing economic growth, one significant limiter is the slowing private equity market. Between the second and third quarters of 2001, total private equity investment in medical devices and equipment declined by 21% from $390 million to $307 million. Compared with the third quarter of 2000, total private equity investment declined 30% from $432 million.

The general economic and political environment for medtech companies remains favorable. Medtech companies should continue to focus on both short- and long-term business strategies. Shareholder wealth can be created through product development, corporate alliances, and strategic consolidation.

Thomas J. Gunderson: Drivers in 2002 will obviously include favorable demographics and new-technology developments. But there will also be an increasing demand from a better-informed buyer, due in part to more Internet education and more direct-to-consumer advertising by industry. Private payers will start out 2002 in good financial shape; however, Medicare seems more crippled than usual.

In fact, the condition of the Medicare system could be a major limiter in 2002. The Medicare system is in transition-again. If things don't change, I would expect extra pressure on industry from hospitals that will be even more cash-strapped than ever as Medicare threatens to slow payments in the first quarter.

Other limiters include the fact that FDA processing isn't getting any faster and it already has a lot on its plate in the devices sector, especially, and ironically, drug issues-from drug-eluting stents, to bone morphogenetic proteins, to insulin pumps.

Finally, if unemployment rates continue to rise, the number of uninsured may increase by midyear. And a continuing slow economy or war fears could force some people to put off elective surgeries.

Christa Bähr: It is difficult to fix market drivers or limiters within the time horizon of a single year. The development of market conditions for medtech companies is closely connected to general conditions for the global healthcare market. In this larger context there are some obvious fundamental trends that likewise concern medtech companies, but it will take some years before they change basic market conditions.

Executives can nevertheless identify tendencies that can enable them to plan business strategies in order to steer their companies toward a top market position. One of these tendencies is the trend toward shorter product cycles and corresponding pressure to increase innovation, which forces companies to expand their R&D activities and expenses. Another tendency is the general pressure to reduce healthcare costs in all countries. In light of such pressures, there are outstanding growth prospects for companies that offer products and technologies that can help realize cost savings.

Joseph Kozikowski, MD: There are several distinct healthcare equity markets, and each is likely to behave in its own way in 2002.

The healthcare private-equity market will have two drivers: the strong flow of capital into private healthcare funds and the valuations achieved at liquidity, particularly in initial public offerings (IPOs). In 2001, more than $4 billion flowed into private healthcare funds, surpassing even the record inflows of the previous year. This will make the markets for late-stage private-equity healthcare companies flush with follow-on capital, as funds look to deploy larger amounts of capital quickly. It will also finally open up the early-stage markets, since Domain Associates (Princeton, NJ), Frazier & Co. (Seattle), De Novo Ventures (Saratoga, CA), and others are targeting more than $1 billion at early-stage healthcare ventures.

On the other hand, valuations appear likely to drive the healthcare private-equity market in an interesting biphasic way. During the first phase, which will last through much of the early part of 2002, valuations for both early- and late-stage deals will continue to be unspectacular. Nevertheless, they will continue to attract bargain-hunting capital to the sector, and will enable funds to refill their depleted healthcare portfolios. During the second phase, valuations will rise nicely, in part because follow-on financings at decent step-ups will be executed in a capital-flush environment, and in part because the healthcare public-equity markets-which benchmark both IPO and acquisition exits-will to some extent benefit from continued rotation of institutional money into that sector.

Limiters of medtech private-equity valuations will include the uncertainty of high-value IPO exits. Accordingly, base-case valuation models will continue to discount lower-value acquisition exits, and stock deals will likely be modeled using lower price-to-earnings-to-growth (PEG) multiples that reflect the moderate earnings growth of many potential medtech acquirers. Another potential valuation limiter is a newly adopted Financial Accounting Standards Board (FASB) statement (no. 142) that limits the write-down of intangible assets that often constitute a large part of a medtech target's value, and may serve to reduce what medtech companies can pay for their acquisitions. The Securities and Exchange Commission (SEC) now expects that all registrants will perform extensive valuations of acquired intangible assets on all prospective business combinations.

Medtech executives in late-stage private companies should integrate these market conditions into their financial strategies in several ways. First, they should limit follow-on offerings until later-stage valuations pick up during the second half of 2002. Second, they should use the staying power afforded by the capital-flush follow-on markets to avoid selling marketing rights to corporate partners on unfavorable terms. And finally, they should avoid investing in intangibles that may not drive value at acquisition.

In the healthcare public-equity market, investor demand will be a primary driver, as institutions, in particular, continue to reallocate their portfolios more heavily into healthcare. This demand for quality healthcare equities is probably sustainable through 2002, especially in light of the relative attractiveness of healthcare's solid demographic fundamentals. Other tech sectors may have strong potential for secular growth, but they will continue to lack credible earnings forecasts and, hence, valuations, and will continue to have exposure on their cyclical natures.

Limiters will nevertheless be in play in the healthcare IPO markets, where underwriters are having their wings clipped somewhat by regulators and by the more than 1000 shareholder suits under way seeking upwards of $50 billion. And in the consolidation market, there is uncertainty regarding the ability of acquiring companies to simultaneously deploy capital quickly, avoid free-cash-flow volatility, strip out infrastructure cost, and operate quality-driven business units. Such concerns suggest that the market for consolidation may peak soon and then begin to unwind, something they always do at some point anyway.

Medtech executives in public companies can benefit from these market conditions by articulating their technology's value propositions to the street. This means describing the target patient populations and their competitive advantage, supporting cost-utility claims with tangible examples, and supporting product-adoption forecasts with documented visibility into end-users, channels, and contract purchasing.

Incidentally, because public-equity markets consistently overvalue earnings growth, a medtech company that can deliver strong earnings growth during this recession and as capital rotates into its sector has a chance to achieve extreme overvaluation, use its stock to acquire in a weak market, and come out huge when the entire sector has its day.

Manoj Kenkare: The healthcare industry has many more challenges and limitations than it does drivers or positive forces (see sidebar). Nevertheless, if all the medical technology companies and regulatory organizations were to work toward resolving the limitations and challenges, 2002 could offer healthy competition and excellent service opportunities for end-users and consumers.

Trends and Opportunities

What would you identify as the key trends and emerging opportunities for the different sectors of the medtech industry for 2002?

Solari and Suscha: Drug-coated stents offer a significant growth opportunity. The U.S. coronary stent market is expected to grow to over $5 billion by 2005 from $1.5 billion today. Congestive heart failure represents a $1.2 billion new U.S. growth opportunity. Other emerging opportunities include breast cancer detection, diagnostic imaging, and drug screening.

Gunderson: Key trends and emerging opportunities are especially strong in the field of products designed to treat congestive heart failure, such as biventricular pacing devices, left-ventricular assist devices, artificial hearts, and more. The development of devices using more chip memory will permit greater sophistication of the diagnostics embedded in cardiac rhythm management devices.

Other opportunities include the areas of stroke prevention and therapy, human-genome-related diagnostics that change the therapeutic pathway, and drug delivery to parts of the body other than the heart (peripheral vascular, brain, uterine lining).

Lazar: Key trends are miniaturization and minimally invasive technologies, or anything that adds value to those technologies. Drug-delivery devices and biosensors are certainly forward-looking technologies that will have a future impact.

Bähr: Key trends are increasingly characterized by highly developed, innovative technologies. The growth potentials of various segments are dependent on the prevalence and incidence of the individual diseases treated by technologies in that sector. In addition, the increasing numbers of older patients will bring a shift to chronic and degenerative diseases.

One of the winning segments should be the orthopedic market, especially solutions involving endoprosthetic and osteosynthetic treatments. There are also good growth opportunities in the fields of minimally invasive technologies (made possible by the extreme miniaturization of individual components), laser medicine (strong growth of refractive surgery and aesthetic treatments), telemedicine and data management (because of the increasing flood of data in the healthcare sector), and in the development of diagnostic imaging (allowing diagnosis at early stages and making it possible to treat diseases in a less-invasive manner).

Ash Vahman: In the global orthopedic market, growth is being driven by recent developments in biomaterials and changing demographics. Traditional orthopedic surgery uses invasive techniques and metallic implants that can lead to integration problems. By contrast, orthobiologic products and approaches use naturally occurring materials and growth factors that prompt the body to regenerate damaged tissue and bone. In addition, market growth is driven by an increasing proportion of people over age 65 who suffer from bone and joint diseases such as osteoporosis and arthritis.

In the dental arena, new products continue to expand the market. These include implants that are noncoated, tapered, and threaded in design, and which are immediate-load in nature to allow for delivery in a single procedure.

In the interventional cardiology market, emerging technologies that treat in-stent restenosis-such as radiation therapy and drug-coated stents-will be catalysts for growth in the global interventional cardiology market.

Given the prevalence of peripheral vascular disease, the global market for peripheral vascular stents will experience tremendous growth over the next few years, driven by advances in endovascular technologies such as drug-coated stents, improvements in intervention techniques, and positive clinical results.

Endoscopy, which allows surgeons to operate through small openings in the body, uses miniaturized instruments in order to reduce operating time, trauma, and postoperative discomfort. The continued miniaturization of instruments coupled with the emergence of surgical robotics and image-guided surgery are helping to drive growth in this market.

Coupled with increasing knowledge of and interest regarding the treatment of neurological diseases, the current trend toward minimally invasive surgical practices is fueling exciting growth in the field of interventional neuroradiology. Interventional neuroradiologists are now using endovascular methods to treat common neurological disorders including stroke, aneurysms, vascular abnormalities, and intracranial tumors. While the field of neuroradiology is small, it is rapidly growing.

The market for the treatment of urologic conditions remains one that is largely underserved. Growth in the urological device market is being driven by an aging U.S. population with an increasing incidence of urological disorders. New pharmaceutical and surgical technologies and techniques are expanding the patient population.

Consolidation Continues

What effects will industry consolidation have on medical technology companies-both large and small?

Solari and Suscha: Consolidation will continue to play a major role in shaping the medtech industry. In 2001 alone, the industry experienced several billion-dollar acquisitions, including Medtronic's $3.3 billion acquisition of MiniMed and Tyco's pending $3.1 billion acquisition of C. R. Bard.

Acquisition activity in the midsized market continues to be extremely active as companies search out leading-edge technologies to either expand existing product lines or penetrate markets quickly.

Bähr: As it is in the medtech sector, consolidation is a general trend in highly developed industries. Smaller companies are typically only able to survive if they are focused on specialized niches. Larger companies usually are more diversified and have broader product portfolios.

The planned merger between the activities of the ophthalmology unit of the Carl Zeiss Group and Asclepion-Meditec is a recent example where the intent is to generate synergies by merging compatible business units. As in that case, the greater effects of synergy usually arise for the smaller companies. They usually gain from the opportunity to use the better-known brand name and from access to broader distribution channels. The larger companies gain advantage by rounding out their product portfolios.

Kenkare: Consolidation is part and parcel of the healthcare industry, and is also taking place on both the supplier and end-user sides. In the midst of the general economic slowdown, companies are trying hard to deal with the challenges of providing quality healthcare in a highly competitive environment characterized by lowering reimbursement rates and increasing regulation. Marked decline in transaction activity, mass layoffs among various healthcare start-ups, and a substantial increase in bankruptcy filings in 2001 reflect the severe pressures under which healthcare-sector companies are currently operating. In addition, all segments of the healthcare industry face some degree of uncertainty due to the events of September 11. Because of such uncertainties, merger and acquisition activities will continue to be slightly sluggish, albeit stable, in 2002.

Consolidations will occur in 2002, so long as they make strategic sense for the companies involved. Companies are looking to build out their pipelines and ensure that they have enough products on the shelf to meet the changing demands of the consolidating base of end-users. It is always more efficient to buy out products than to use precious R&D dollars to develop them internally.

It is difficult to tell what impact consolidation will have on medtech companies, because every instance is unique. However, it is certain that there is demand for superior products that meet the needs of end-users. It is therefore of prime importance that companies seek to enhance product quality and time to market as goals of any planned consolidation activity.

On the end-user side, hospital merger activity declined for the third straight year in 2000. As measured by the number of deals announced, hospital consolidation activity dropped 22%, from 110 deals in 1999 to 86 deals in 2000. This trend was even stronger when viewed across all healthcare segments. Overall, healthcare consolidation activity fell 34%, from 728 deals in 1999 to 481 deals in 2000. The equivalent numbers for 2001 will be available shortly, and will help us to determine the impact that the recession or the events of September 11 had on M&A activity in healthcare.

Dugan: The large medical technology companies are in a position where incremental growth is their leading objective and challenge. Small companies can represent the solution they seek, so it is reasonable to expect continued and increased activity of large companies working with or acquiring small companies that can provide new technology and new market opportunities.

Gunderson: The impact of consolidation on large companies includes the ability to "buy" growth, balanced by the uncertainties and challenges of financial and cultural integration.

Smaller companies consequently tend to focus more on "disruptive" technologies ignored by the bigger companies. The result for those smaller companies is more risk, balanced by the potential for greater reward if they are successful.

Lazar: It is hoped that consolidation will lead to a leaner industry that can expend the energy and resources for large R&D programs that will develop better and more-efficient technologies. The removal of me-too companies from the sector could create a more dynamic industry.

At the Vanguard of Recovery?

Many equity analysts are predicting that healthcare will be the sector to bolster an economic recovery. Do you agree with this prediction?

Lazar: Yes, I believe that the stability of healthcare will lead to a fair amount of financial-sector attraction in the upcoming year.

Bähr: This prediction seems generally correct. In comparison with other sectors, the healthcare sector remains a growth market that is largely immune to economic cycles and driven by demand.

Rapid technology developments and increasing life expectancy, coupled with an explosion of costs, can lead to enormous market potentials. But the keys to a company's success are its abilities to create solid business models and to offer economically and technologically superior solutions for future problems in a constantly growing market. In this way, the healthcare sector can bolster an economic recovery.

Vahman: In general, healthcare is a good counter-cyclical bet that will grow with an aging population. However, some downward pressure is expected due to budgetary and third-party-payer constraints.

Furthermore, anecdotal evidence suggests that many investors are merely "renting" defensive stocks such as those in the healthcare sector. At some point, such investors are likely to move their capital out of these sectors into cyclical segments of the economy that are currently undervalued and could grow profits faster in a recovery.

Dugan: Healthcare companies generally remain steady performers in an economic downturn. In fact, from a value standpoint, healthcare tends to be counter-cyclical and investors move to this safe haven.

In 2002, however, there is not likely to be a material increase in revenue or operating income from the sector beyond the increases witnessed in recent years. So it shouldn't be expected that the sector will lead any kind of fundamental recovery. Rather, the sector is one of the components of the economy that tends to dampen swings in the economic cycle.

Kenkare: The healthcare sector is one of the factors that would help bolster an economic recovery-but not the sole factor. Healthcare has always been a primary focus of decision makers within industry, on Wall Street, and in Washington, DC.

According to the U.S. Department of Labor, in October 2001 the number of unemployed increased by more than 730,000. During the same month, the healthcare industry increased the number of workers it employs by about 24,000, having already added 250,000 total jobs from January to October. Simply read, this means that layoffs elsewhere in the economy make it possible to hire hospital personnel for technical and clerical positions.

The growing number of layoffs and related stresses may still have had something of a positive effect on the healthcare industry. A recent report released by the American Hospital Association (Chicago) states that hospitals continue to get busier in a declining economy. According to the report, inpatient admissions rose 2.5% in 2000 to 32.6 million. Outpatient and emergency-room visits also increased in 2000.

Another significant event that might fuel the economic recovery is the expiration of patents on pharmaceutical goods. The expiration of patents on prescribed goods could lead to tremendous growth opportunities in the generic and new drug-delivery markets. Over the next five years, the global market for generic drugs is expected to increase to $30 billion from its current market of $20 billion. In the same period, the new drug-delivery market, currently worth $24 billion, is expected to increase to $70 billion. Brand-name pharmaceuticals that will come off patent in that period include Epogen/Procrit (Amgen), Neupogen (Amgen), Intron A (Biogen), Avonex (Biogen), and Energix-B (SmithKlineBeecham), among others.

Other highlights of the U.S. healthcare industry include the mapping of the human genome and the development of groundbreaking technologies that are helping healthcare make the transition into the digital age. For example, some medtech companies have developed wireless infrastructure technologies that integrate patient information from various manufacturers' monitoring and bedside devices into a single network. With seamless roaming between radio-frequency access points, such monitoring devices allow doctors to wirelessly monitor patients throughout a healthcare facility.

Kozikowski: During the third quarter of 2001, the healthcare products and services industry provided the greatest number of IPOs and was one of the few industries able to avoid valuation erosion in that quarter's anemic $4 billion of mergers. In fact, healthcare has been a bright spot in the otherwise-weak liquidity markets. The medtech industry, in particular, was actually quite robust, with Given Imaging, TheraSense, and Fisher & Paykel all trading up from their offering prices and raising more than $250 million total. Amazingly, medtech seemed to be leading the IPO underwriters out from the pall of shareholder suits and federal investigations-that is, until DJ Orthopedics's remarkable $153 million offering went sour.

In any event, the $80 billion medtech industry accounts for just under 1% of the U.S. gross domestic product (GDP). Furthermore, we know that healthcare equity market swings don't pull economies out of recession, and that bolstering economic recovery means bolstering real per-capita GDP growth.

To what extent might healthcare bolster real GDP growth? Consumer healthcare spending, steadily growing at 4% annually, helps a little. Medtech exports would help, were it not that the U.S. $7 billion medtech trade surplus is currently exposed to a strong dollar, a global recession, and a healthcare funding crisis in Japan, which is the nation's largest medtech export market.

But more importantly, healthcare's dramatic per capita cost increases of 10-24% among 2001's HMO, POS, PPO, and pharmacy claims appear poised to put a heavy drag on corporate earnings, accelerate deficit spending, spawn "crowding in" financial market effects, and potentially contract GDP in the intermediate term.

So perhaps the predictions may have a bit too much analytical exuberance.

Solari and Suscha: The healthcare sector comprises approximately 15% of the U.S. GDP. As the population continues to age and companies strive to bring cost-effective treatments to the market, healthcare spending will continue to contribute to an economic recovery. Private investment in the healthcare sector will continue as companies and investors charge ahead in the pursuit of leading-edge, lifesaving technology, and ultimately increased shareholder value.

Steve Halasey is editor in chief and Flora Nguyen is associate editor of MX.

Illustration by Chuan Khoo/Artville.

Copyright ©2002 MX