Originally Published MX March/April 2002
FINANCE
Roundtable: A Climate for Investment
Experts are predicting that investment in the medical technology industry will continue to be strong throughout 2002.
Moderated by
Steve Halasey
Speaking
before the House Financial Services Committee on the state of the U.S. economy
in late February, Federal Reserve Chairman Alan Greenspan announced that he
sees increasing signs that the economy is emerging from recession, but added
that he expects to see a subdued recovery. Economists have also slowed their
predictions, saying that they expect the general market to improve in the second
half of the year rather than after the first quarter.
According to analysts,
the outlook for the medical technology industry is just as bittersweet. The
medical technology research team at Merrill Lynch expects sector rotation out
of healthcare, "particularly after medical device stocks have had two spectacular
years of relative performance." Says investment analyst Daniel Lemaitre,
"Macro pundits are looking for an economic recovery to generate highly
leveraged earnings growth for the S&P 500 of 13% in 2002 and 26% in 2003,
which is a tough bogey to match for defensive stocks such as medical technology.
However, medtech fundamentals are accelerating, and we peg earnings growth in
2002–2003 at 18–19%."
To find out what these projections mean in terms of investment dollars available
to the medical technology industry for the coming year, MX talked with
several experts in the field (for biographies of the participants, see
sidebar). The complete
text of the interview is also available.
Current Investment Trends
MX: What are the latest trends in investment that are affecting
the medical technology area? How are they different from the general trends
in the marketplace?
Joseph G. Solari: Currently, there are four key trends driving investment
in the medtech industry. One is the continuance of strong unit demand for medical
devices. Medical devices are not necessarily sensitive to economic cycles, so
even though we're currently in a recession period, the demand for medical devices
is rather inelastic. The other driver is the compelling demographics. We've
got a population that continues to age. The baby boomers are getting older.
And as a result, we're seeing an increase in demand for medical devices.
The second key trend is a stable pricing environment. Medical devices make up
approximately 4% of U.S. healthcare expenditures, compared with approximately
8% for the pharmaceutical industry. What this means is that medical devices
really haven't hit the government reformers' radar screens yet, so there hasn't
been a lot of scrutiny over the cost of medical devices as of late. As a result,
we see stable pricing for those products.
Another key trend that we're beginning to see is potentially easing foreign-currency
exchange rates. Foreign-currency translation adjustments trimmed about 2% off
reported revenue growth for medical device companies in 2001, but we're starting
to see a little easing on that front, so there will be less of an impact from
foreign-currency translation adjustments in 2002.
The last trend has to do with emerging new technologies. Chief among these is
the drug-coated stent. And a close cousin of that would be radiation therapy,
which offers treatment for restenosis, or reclogging of the coronary arteries,
after a balloon angioplasty procedure. The other new technologies that are very
exciting are designed to treat congestive heart failure (CHF). These would be
devices that resynchronize the rhythm of the heart. We're seeing a lot of companies
coming out with devices in that area, such as St. Jude Medical (St. Paul, MN),
Medtronic (Minneapolis), and Guidant (Indianapolis).
Daniel C. Wood: In terms of emerging new technologies, a particular area
to watch is wireless technology. In Southern California, there is a large wireless
community, primarily due to the presence of companies such as Qualcomm (San
Diego) and its predecessor, Linkabit (also San Diego). There are about 600 wireless
companies in the Southern California area. We're starting to see more of a convergence
between wireless and healthcare. An example would be one of our portfolio companies,
Cardionet (San Diego), which manufactures a real-time ambulatory cardiac patient
monitor that is scheduled to be launched by mid-year.
We're also very excited about devices that treat CHF. We're currently looking
at a company that not only resynchronizes but reshapes the heart. CHF is a huge
market, and we'd like to be a part of it.
Richard S. Cohen: In terms of trends in investment banking, there's certainly
a continuation of the massive consolidation that characterizes the industry.
There are fewer blockbuster transactions now because there were so many in the
last two or three years, and the larger medtech companies are having digestion
issues. The sales forces of medtech companies are hungry for additional products.
They're looking for ways to expand their product lines, either by internal development
or by acquisition or licensing.
Lastly, I would mention that the medical device sector, much like other high-tech
areas, has seen too much money invested in companies and business models that
may not have long-term sustainability. Because of this, we now see companies
wanting for additional funding. Many are nearing the end of their cash availability,
and the investment community will have to contend with the fate of these marginal
technologies or business models.
Christopher Sweeney: The single most interesting trend we've seen since
fall 2001 has been the relative improvement in valuation among small- and microcap
companies in the device industry versus the relative stagnation in midcap companies.
The midcaps—for example, Boston Scientific (Natick, MA), Becton Dickinson
(Franklin Lakes, NJ), and Arrow International (Reading, PA)—have not seen
a tremendous improvement in valuation or stock-price movement versus smaller
companies such as Medical Action Industries (Hauppauge, NY), Encore Medical
(Austin, TX), or Merit Medical (South Jordan, UT). This is opening up the possibility
for a lot of smaller transactions. If this trend continues, there will be consolidation
at the smaller end, whereas a lot of the midcap companies will continue to stagnate
and perhaps become open to purchase by large-cap companies.
Where the Money Is
Which areas in medical technology are the most likely to gain strong investment
this year? How do you evaluate which areas are the strongest?
Solari: Access to capital will still be available for larger, more-established
companies that have a track record of earnings growth. On the flip side, the
access to capital markets for smaller, earlier-stage emerging technology companies
may not be as great.
In terms of how to differentiate the good from the bad, we look for companies
that are technological leaders in their space and that have a broad product
platform, a strong management team, and superior marketing and distribution
capabilities. Obviously, if a company doesn't have those attributes, it's going
to be less desirable to investors.
Cohen: I've been impressed by advances in medical technology. One area
ripe for greater exposure is pictorial archive communication systems (PACS),
which are computerized inventories of digital images, replacing film and paper.
This segment has attracted a large number of start-ups. Some companies are software
oriented; others have a hardware perspective. This sector is still fragmented,
but consolidation will occur, as in the case of the domination by the imaging
giants Siemens (Malvern, PA), Philips (Bothell, WA), and GE (Waukesha, WI),
each of which has made multiple acquisitions, not only in terms of PACS but
also in diagnostic modalities such as magnetic resonance imaging, computed tomography,
fluoroscopy, and nuclear imaging.
With the coming concentration, I suspect hospitals will feel more comfortable
making large investments in those types of systems, knowing that there are substantial
companies behind them. The independent companies still in existence will therefore
be under great pressure, and many will not survive.
Sweeney: From what we have seen over the last six to nine months, medical
device companies now have improved access to capital. The reason behind such
a shift is because there has been a turn away from more-cyclical industries.
We have found that private-equity groups and banks are consistently on the sidelines
in terms of the general market, but that they retain a strong interest in medical
device investment. We've also found that our access to capital for transactions
that we're working on has been very good, which stands in sharp contrast to
the broader corporate finance market.
In a declining
economy, some investors merely "rent" space in healthcare. But this
time, have some investors adopted a new approach to healthcare, where they believe
that a certain amount of their dollars need to be there no matter what?
Solari: I think it's intuitive and obvious that investors recognize healthcare
as a defensive industry. There are empirical data proving that healthcare stocks
generally outperform the broader market during economic downturns and then underperform
the general market as the economy begins to rebound and investors rotate out
of healthcare stocks into more-cyclical plays to look for the upside. I don't
see that changing much in the future.
On the other hand, given that healthcare services and products will always be
needed regardless of the economic situation, there may be some investors who
always keep some percentage of their investable assets in healthcare stocks.
This would be especially true today, given the compelling demographic trends
I spoke about earlier.
Valuation
Criteria
What criteria do you use to evaluate medical technology companies seeking
corporate financing? Are those criteria different for each sector of the medtech
industry?
Solari: Some of the differentiating factors that we look at, again, are
broad product platforms, technological leadership, high-growth markets, strong
management teams, and demonstrable earnings growth. Given that a lot of medical
device companies are manufacturing companies at heart, I would say that there's
not a whole lot of differentiation based on the space that they play in, such
as cardiovascular or orthopedics.
That said, there still are some sectors within the medical device industry that
are projected to grow faster than others. Cardiology is one that comes to mind,
given the incidence of heart disease in this country, the aging of the population,
and the increasing obesity of our population.
Wood: As early-stage investors, the most important thing to us is management,
and that would be, first and foremost, the CEO. Early-stage companies need to
raise a lot of money and recruit a lot of good people. These companies need
a CEO who has been there and done that before—somebody who can adhere to
a schedule and make accurate projections.
Another thing that's important to us is the quality of the syndicate we invest
with. That lowers our risk. We are always looking for two to three larger experienced
funds in the space.
Cohen: Entry
barriers, particularly for early-stage companies, are critical. When we're evaluating
companies, we really have to pierce through and drill down into their intellectual
property to see how bulletproof it is. I'm not sure design patents, for instance,
are enough.
And as I mentioned before, the subject company could present a growing market
opportunity, along with a terrific product and great projections, but if its
sector is characterized by dominant companies, then we have to be concerned
with whether the concept will attract large competitors once it is proven in
the market, and whether the subject company will have a long-term future.
Sweeney: The single most important thing that we look for in today's
healthcare environment is the ability to demonstrate significant cost savings
for the healthcare providers that use medical technologies. A good example of
that is a company we have invested in called InSite One (Wallingford, CT), which
provides archiving solutions for digital images. The company can walk into a
hospital and say, ‘We can save you 30 to 40% off your existing storage
solution and eliminate capital expenditures immediately.' I think that's true
across the board for medical technology products. In today's environment, where
providers are looking at ever-greater reductions in funding from both private
and public payers, the most important thing is for a company to be able to go
in and show that it can save providers money, no matter what the product is.
What kind of
evidence do you expect companies to present in order to demonstrate those kinds
of cost-saving potentials?
Sweeney: Typically, what we want to see from companies is a study validated
by a credible third party that demonstrates the holistic cost savings associated
with their products. To take an example, a company called Derma Sciences (Princeton,
NJ), which manufactures a sponge designed to clean and wash patients in long-term-care
homes, was able to demonstrate strong labor and product cost savings versus
the traditional method of bathing patients. There are many components of cost
in a typical healthcare setting, and the company put together a reasonably good
analysis across those different cost components of how it can save dollars in
each area.
None of you
specifically mentioned either a regulatory plan or a reimbursement plan as a
basis for your evaluation. Are those two areas not issues for you? Where do
they fit into the overall valuation process?
Solari: These are definitely factors that we look at. Obviously, reimbursement
is a big one. If a company doesn't have reimbursement from Medicaid or Medicare
for its products, then that will definitely affect the way that we view it.
In terms of the regulatory front, I think that's obvious, too. If a company
doesn't have the requisite approvals to market its products, then that's a major
milestone it has to get past in order to become successful. We also consider
the different types of approvals, whether it's the easier 510(k) or the much
more difficult PMA. A company that has to get a PMA is going to be a riskier
venture than one that needs to get 510(k) clearance.
Bolstering the Economy
How do you think the general market dynamic will change over the coming
12 months? Are we going to see a recovery? If so, what type of recovery will
that be for medical device companies?
Wood: There's a lot of talk about an economic recovery. My sense is
that a lot of it is going to be consumer driven, but with continued layoffs,
I don't see where the recovery is going to come from.
Fortunately, it does look like healthcare is maintaining its resilience in terms
of liquidity and number of IPOs. It has been the leader recently, and I'm hoping
that this trend will continue because it's allowing quality companies to get
out. And with any sort of enthusiasm, they'll trade to premiums, which will
breed even more IPOs.
Cohen: Based on what I've heard from the experts, the general market
is expected to improve in the latter half of this year. In regard to medical
devices, the outlook is rather bright, as there are exciting new technologies
in the pipeline that will improve the quality of care and reduce healthcare
costs. But there is still too much inefficiency in hospital workflow across
all provider segments. It's up to medtech companies and software companies to
devise new systems to alleviate the problem.
Another matter that should be mentioned is the system of group purchasing organizations
(GPOs). It particularly affects smaller device companies, which have a hard
time getting through GPO gateways into the hospitals they represent. It's a
difficult situation because the only way to get into the buying segments of
large hospitals is through the GPOs, and they seek to contract with large, established
device companies that have broad product portfolios. It's important for smaller
device companies to be able to find a marketing outlet, because the smaller
companies are major engines of innovation.
Sweeney: In terms of medical technology, I think we're at a little bit
of a turning point. We will probably see another two to four years of really
good performance and really good results. The market has flushed out a lot of
the effects of overinvestment and elements that weren't necessarily true cost-saving
and labor-saving development. As a result, the pace of innovation for products
that save time and expense has improved. We're going to continue to see improved
results in the medical device area because there are a lot of new cost-saving
technologies being developed. Another trend worth noting is the increased use
of contract manufacturing, which is going to improve profit margins across the
board for a lot of medical device companies.
Solari: Based on the literature I've read, the latest estimates in terms
of an economic recovery are late in the first quarter or early in the second
quarter. That projection has moved up a bit from what economists were saying
perhaps 60 days ago, when there was a widespread consensus that the recovery
wouldn't begin until the second half of 2002.
As medical device companies go, especially the large-cap and midcap public companies,
they're all projecting top-line sales growth in the 9–10% range. In addition,
industry analysts are expecting about 15–17% earnings growth. So medical
device companies are going to continue to do well, despite what's happening
around them from a general economic sense.
That's a pretty
rosy picture.
Solari: It is. These are very good companies that have performed year
in and year out for their investors.
Photo by the Stock Market
Copyright ©2002 MX
