Originally Published MX January/February
2003
Finance
When Earnings
Can Wait
Early-stage medtech companies may maximize shareholder value
in the long run by forgoing profits in the short run.
by
Mark Speers,
Nathan Harrington, Brian Chan
An old belief holds that small, growing companies should earn profits as soon as possible. Corporate boards, supported by some Wall Street analysts, often push CEOs to steer their companies quickly into the black under the mistaken notion that positive earnings always drive valuations higher and higher. However, the most expeditious course to profits frequently entails a lean expense base or opportunistic selling—circumstances that may inadvertently and unfortunately limit a company’s innate potential and its long-term shareholders’ gains.
There are times when deferring positive earnings makes long-term strategic sense and ultimately maximizes shareholder value. Once a publicly traded company reports positive earnings, analysts and investors will expect it to continue growing profits. This can shackle a firm that still has only limited resources. Company executives must explicitly weigh the trade-offs in determining whether to begin delivering earnings sooner or later. While the early strategic decision may affect the bottom line immediately, its influence on the company’s long-term performance is more important. Thus, it is worth the investment of management time and resources to collect data and perform analyses that will make evident the best course of action.
Formulas for Market Valuation
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Table I. The small- and |
Twenty-one public small- and microcap cardiovascular device companies with market capitalizations under $750 million were examined. Nine reported positive earnings and 12 reported negative or no earnings
(see Table I). A multiple regression analysis of the revenue, earnings before interest and taxes (EBIT), and anticipated two-year revenue growth of companies in each group was conducted to predict market capitalization. Multiple regression is a predictive method of statistical analysis used to approximate a linear relationship between several independent variables and a dependent variable
(see sidebar, page 47 for explanations of statistical terms appearing in this section).
The equations for both groups that resulted from the analysis demonstrate impressive statistical significance, or degree of probability of reflecting reality. R-squares for positive and negative earners are notably high values of .69 and .78, respectively. In addition, the driving coefficients appearing in front of the independent variables in the equations exhibit high T statistics, a measure of warranted confidence in their validity.
For positive earners, the regression formula for determining ultimate market capitalization is
(–1.8 ¥ revenue) + (25 ¥ EBIT) + (1.0 ¥ forecast CAGR), where CAGR represents the compound annual growth rate of a company’s revenues. Based on the T statistics of the three independent input variables, EBIT is the most statistically significant of the three inputs. Comparing the coefficients, EBIT can also be seen to have the greatest impact on market capitalization. The formula indicates that each additional $1 million in EBIT results in another $25 million in valuation. Not surprisingly, the analysis suggests that this set of profitable companies is valued primarily on the basis of EBIT.
For negative earners, the regression formula for market valuation is (5.9 ¥ revenue) + (–3.6 ¥ EBIT) + (0.9 ¥ forecast CAGR).
Here, revenue is most significant statistically, and the T statistics and coefficients show it to be the largest driver of valuation. Revenue growth is of minor significance, while EBIT is
of no significance. Every $1-million increase in revenue results in an extra $5.9 million in valuation. Thus, negative earners are valued primarily on their revenue.
When a negative-earnings company that has been valued largely on the basis of its revenue becomes EBIT-positive, it is then suddenly judged on earnings. The company could conceivably suffer a decline in valuation unless it attains a high EBIT margin and has strong growth prospects.
Corporate managers conducting this exercise should take care to benchmark their company to the most appropriate set of firms. Relevant benchmarking criteria include having roughly proportional revenues, sharing a targeted disease state or patient population, exhibiting
similar technological sophistication, and using similar business models. Likewise, the analysis must take into account valuations over a sufficiently long period of time to mitigate market variability.
The valuation models presented above were applied in considering the strategic options of a hypothetical cardiovascular device company.
Modeling Two Strategies
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Table II. The modeled |
The imagined early-stage device company was posited to have $10 million in cash, an expected Year 1 revenue of $15 million, and a current gross profit margin of 20% of revenue. This starting profile would not be unusual for an early-stage company in the cardiovascular device sector. Two typical business strategy choices for this hypothetical company were then modeled. One, Strategy A, pushes for early profitability
(see Table II). Strategy B, by contrast, allows profits to wait (see Table
III).
In Strategy A, management has the option to minimize expenditures in order to achieve profits sooner and to limit the number of dilutive fund-raisings. Cash is conserved at the expense of R&D and manufacturing improvements.
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| Table III. The modeled earnings trajectory of the hypothetical device company following a strategy of heavier early investment in R&D and in production processes to minimize the cost of goods sold. Financial figures are millions of dollars. CAGR = compound annual growth rate. Taxes, depreciation expense, and capital expenditures do not have a net material effect on the bottom-line numbers shown, and so are not explicitly listed (depreciation and capital expenditures can be assumed to roughly cancel each other out). (Click to Enlarge) |
In Strategy B, profitability comes later. The company can invest more in the short term in order to ensure rapid growth later. Management can decide to invest in researching and developing a second-generation product that better meets the needs of its customers; consequently, product sales can be expected to penetrate the market to a greater degree in Year 4. At the same time, with this strategy, investments are made in engineering and manufacturing. These expenditures are intended to reduce the cost of goods sold (COGS) and thus increase gross margins. This period of additional investment involves a requirement that extra cash be raised; company executives pursuing this strategy are diluting shareholders’ positions for the time being.
A comparison of modeled outcomes reveals that Strategy B’s revenues should eventually overtake those of Strategy A as Strategy B’s larger up-front investments pay off. The corresponding assumption is that Strategy B sustains a high forward annual revenue growth of 65% in years 3 and 4 while Strategy A’s revenue growth declines to 15% in those years. Revenue achieved by following Strategy B is thus higher than
that modeled for Strategy A by Year 4. The growth numbers for this hypothetical case were based on observations of device companies offering innovative products that have ad-dressed areas of significant unmet needs. Of course in the real world, market research has to support the viability of such growth in this time frame, and management needs to be confident it can execute to achieve this level of performance.
As for gross margins, Strategy A’s should improve modestly as manufacturing investments are kept to a minimum. The gross margin of Strategy B, on the other hand, should improve substantially. The model has Strategy A’s margins growing slowly to 35% in Year 4, while Strategy B’s grows to 50% in that year owing to higher investment in manufacturing. These gross margins are in line with industry observations. The model accounts for the divergence by assuming a significantly greater SG&A expense (cost of doing business) for Strategy B than for Strategy A every year.
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Table IV. Predicted |
The results of modeling the two strategies can be summarized as follows (see Tables IV and V). Although Strategy A required only $5 million in financing while Strategy B involved twice as much fund-raising, Strategy B is nevertheless only slightly more dilutive. Its share price exceeds that of Strategy A throughout the planning period. In fact, Strategy B’s stock price in Year 4 is almost double that of Strategy A. This can be traced to the significantly higher predicted market capitalization with Strategy B. The larger market cap more than offsets the greater dilution of shares caused by the higher level of financing, so that returns for current investors are much higher under Strategy B than under Strategy A.
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| Table V. Predicted share prices for the early-stage device company pursuing a delayed-earnings strategy. (Click to Enlarge) |
Thus, even though earnings are delayed, Strategy B results in greater shareholder value in this hypothetical case. Furthermore, the vast difference in modeled stock performance leaves sufficient margin for error. The inputs for revenue growth and gross margin that were used for Strategy B could be toned down considerably and the corresponding valuation and share price would still exceed those of
Strategy A.
Implications for Medtech Executives
Sometimes circumstances suggest that management should defer company earnings. To have substantive and effective discussions to determine what realistic performance can be attained and at what cost, company executives will first have to perform some analyses
(see Table VI). Simply stated, the two main areas of consideration that will determine bottom-line performance are those of revenues and expenses, each of which raises its own set of issues.
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Table VI. Strategic |
Companies can lose some revenue potential by targeting the wrong customer segments, by pricing their product lower than necessary, or by introducing it to a particular market segment at the wrong time. In segmenting its customers, a firm should understand the value each target group accrues from use of its product and should price the product accordingly. A price-demand curve generated through analysis often suggests a way to maintain a high, yet reasonable, price for one subset of customers. Over time, the product can be offered at lower prices to more-price-sensitive segments. This gradual penetration into the remaining market buys the company time to achieve manufacturing economies and manage its gross margins.
On the expense side of the equation, a company needs to determine the relative importance of future R&D, manufacturing cost advantage, and marketing in its business strategy to be able to invest effectively in product positioning. A company that invests more in R&D and clinical trials may benefit by delivering just the right product to the market. There is no point in mass-producing a product for a wide market if it requires further improvement and refinement before it can win market acceptance. Yet, some niche placements may be valuable in terms
of both testing the market and refining requirements for the next iteration in order to command value and price
as well as competitive advantage.
Likewise, it may be prudent to invest in engineering and manufacturing processes so as to ensure a competitive cost position with an attractive COGS. There is little value in bringing to market a product that, while it is reasonably successful, fails to earn sufficient gross profits or cannot be supplied to meet demand. Additionally, marketing efforts should be planned and timed so that, when profits do begin to accrue, their trajectory is steep and the product’s fortified positioning is sustainable.
Conclusion
Myopic pursuit of near-term positive earnings may mean sacrificing the potential for a higher level of future performance. That would not be in the long-term interest of the company or its shareholders. Management should consider a wide variety of operating plans and their cash flow implications before setting direction. Developing customized valuation models to compare outcomes of different strategies can provide an early-stage company with insights to augment the results of standard
discounted cash flow analyses. Earnings cannot be delayed indefinitely, of course, and the rationale behind a deferral decision must be apt.
Naturally, company executives need to manage the reactions of key stakeholders to the direction they choose to pursue. If they have opted to delay earnings, they will have to have reviewed alternative cash flow analyses in order to address the board’s anticipated and warranted skepticism. Such information will have to clearly demonstrate the potential value to shareholders arising from delaying earnings, by showing that the steps taken will result in greater growth and profitability than could have been expected had early profitability been the objective. Similar communications need to be shared with the investment community in order to instill confidence in investors that the company managers are on top of the situation and have a compelling business strategy.
Mark Speers is cofounder and managing director, Nathan Harrington is manager, and Brian Chan is senior analyst at Health Advances LLC (Weston, MA), a strategic medtech consulting firm.
Copyright ©2003 MX
