Medical Device Link.

Originally Published MX January/February 2003

MARKET ANALYSIS

The Medtech Outlook for 2003

Economic recovery and continued growth seem the likely outcomes for most medtech companies—but perhaps not for everyone. 

by Steve Halasey

Looking at the balance sheets of medtech’s largest companies, one would never imagine that company leaders might have concerns for the future of their firms. In a time when sales growth among the companies listed in the S&P 500 is puttering along at a mere 1.52%, growth rates such as those of medtech’s average of more than 15% look pretty good. 
But to find out what’s really going on in the medtech sector, one also has to look beyond the largest companies. Among the thousands of start-ups and small companies that populate the medtech landscape, company leaders are watching the future warily and hoping for the best.

This article offers a look at what industry watchers think is in store for the coming year, including the future prospects for some key sectors of the industry.

It’s the Stupid Economy

If there’s one factor that medtech executives will be watching more closely than any other during 2003, it has to be the performance of the global economy. Such concern about global economic conditions is unusual for medtech companies, which typically do well in economic cycles considered less-than-optimal for other industries.

“In times of economic uncertainty, the healthcare arena becomes a safe haven for investors,” says Christa Bähr, head of the life science team in the institutional equity research division of DZ Bank (Frankfurt, Germany). “Because of the relative resistance of the healthcare sector against economic cycles, the recent downturn of the medtech sector has not been as distinctive as in other industry sectors.”

“In general, medtech investment is higher when the economy goes sour,” agrees Patrick J. Driscoll, president of MedMarket Diligence (Foothill Ranch, CA). “Medtech is typically considered a safe fallback bet.”

Analysts’ expectations for such stability were generally fulfilled during 2002, as the largest medtech companies continued to post double-digit revenue gains and sufficient earnings to keep their investors happy and in the game. 

Even venture-backed medtech companies made a reasonable showing. “With regard to venture capital investment, private, U.S.-based medtech companies experienced an excellent year in 2002,” says Corey Lavinsky, CEO of Growthink Research (Venice, CA). “And that was particularly true in the first six months of the year.”

But if the healthcare sector offered a bright spot in an otherwise gloomy economy, it was still a dim bulb when compared with previous years. Consumer confidence was shaky throughout the year, offering no support to those who would be investors in medtech—or anything else. With such a weak market for initial public offerings (IPOs), only seven medtech companies dared to go public during 2002—and only one after the middle of the year (see Table I). The mixed results of those offerings provide no hint that the IPO market, or the general economy, might stage a comeback at any time in the near future. 

Nevertheless, some economists have suggested that global economic recovery is likely to begin sometime during 2003. When such a recovery might get under way and what effects it will have on the funding available to medtech companies are key questions on the minds of medtech executives.
According to Bähr, the beginning of the medtech turnaround could be difficult to detect. Just as the medtech downswing has been milder than in other industries, she says, “the potential upswing could also turn out less significant.” 

In any case, she adds, “we do not expect a global economic recovery before the end of the year, especially against the threatening background of a possible war in the Middle East. But if the recovery comes, the medtech sector should benefit just like the economy as a whole. The medtech funding situation could then be improved by capital market transactions (e.g., IPOs and capital increases). 

According to some industry watchers, however, the benefits of recovery may not reach out to medtech companies at every level. For some start-up companies, in fact, the arrival of global economic recovery could make matters worse. According to these analysts, a lot of investors are waiting for the high-technology sector to make a comeback. When it does, healthcare stocks—and therefore medtech stocks—may experience some downward price pressure, and start-up valuations could take another hit.

“On the upswing in the economy, investors won’t be excited by medtech’s 15% returns when 25 and 30% returns can be found elsewhere,” says Driscoll.

“Despite the projected economic recovery, the amount of venture capital invested in medical technology should be considerably less in 2003 than it was in 2002,” says Lavinsky.

Table I. Initial public  offerings in the medtech sector during 2002.  (Click to Enlarge)

“Too many VCs and analysts say that they are ‘cautiously optimistic’ instead of stating the obvious: funding will be down in 2003.”

A Difference of Perspective

No wonder so many medtech executives are eyeing the performance of the global economy so carefully. While large companies may have difficulty discerning the early stages of recovery, for start-up companies the prospects of economic recovery could be problematic, at best. 
According to analysts, the device companies likely to do best in 2003 are large corporations in established sectors of the industry. “In cardiology and orthopedics, the global players have generally been established in the market for a long time,” notes Jochen Badouin, a financial analyst for healthcare/clinics in the institutional equity research division of DZ Bank. “And even though the performance of their share prices and operating business was not a positive highlight during the past year, their balance sheet relations are mainly in good order. Such large conglomerates as Johnson & Johnson or General Electric can readily afford to finance their development efforts through a satisfactory liquidity situation or by cross-financing from other profitable business fields. Moreover, a promising sector outlook for the coming years should strengthen their economic situation.”
“Most of the large and small public companies in cardiology seem to be okay and could readily survive a drought in public financing,” agrees Thomas J. Gunderson, senior research analyst for cardiovascular/diversified medical technology at U.S. Bancorp Piper Jaffray (Minneapolis). “However, small private companies are struggling moreso than a few years ago. The lack of an IPO market has closed one potential exit for investors. The flip side of the lack of a public market is that the larger consolidators are making more investments in start-up and middevelopment medtech companies.” 
Consolidation, in fact, could turn out to be a major trend for 2003. “A consolidating process is under way to create companies with enough critical mass—R&D spending, marketing power, etc.—that they can compete with the big players,” says Badouin. “In the cardiology and orthopedics markets, being a system provider for a broad range of indications is a key skill. And gaining adequate size and diversification can help a company to survive even bigger economic crises.” 

Not all such consolidation may be so friendly, however, and whether it is considered a good thing or not may be a matter of perspective. Taking advantage of decreased valuations and the desperation of cash-starved smaller companies, large companies with deep pockets seem poised to snap up intellectual properties, product lines, physical plants, and anything else that isn’t nailed down—and all at bargain-basement prices. Never mind the niceties of mergers and acquisitions; acquiring the whole company that owns a desired property is strictly optional. 
Ownership and control are especially negotiable items among venture-capital-backed companies. “Medical technology in general has not been well funded, and the VC market has become increasingly more critical and hands-on,” says Driscoll. “Financing therefore means giving up more equity and control than ever before.” 

“Many venture-backed medtech companies are struggling because they are prerevenue and are too dependent on continued VC investment,” says Lavinsky. “The current economic downturn is clearly hurting these companies, as VCs are more likely to write off investments in their portfolios that are hemorrhaging cash than ones that are generating revenues. 

“Funding is also insufficient for early-stage companies looking for initial investments. Roughly 80% of the capital invested by venture capitalists in 2002 went to follow-on financing for companies already in their portfolios,” Lavinsky adds. “If this percentage continues to grow, companies looking for their first round of funding will hardly have a chance to develop new technologies.”

How will such companies weather 2003—especially if a recovery brings a potential drop in the availability of funding? “Companies that are unable to raise venture capital should consider state or federal grants or small business innovation research (SBIR) awards,” says Lavinsky. “Over $10 billion has been awarded by the SBIR program to various small businesses. Often a grant or an SBIR award will enable a company to build itself to a stage that will attract a venture capitalist or other strategic investor once the economy picks up again.” 

Opportunities for 2003

“Predicting breakthrough technologies is a risky, almost foolhardy, practice,” observes Driscoll. “Many, many companies have very exciting technologies and are likely to have breakthroughs soon—but soon could mean anything from one to three years from now, at the earliest. Chances are, the best-run innovators—companies such as Medtronic—will have one or more major achievements in 2003.”
Despite such inherent difficulties in picking favorites, among the analysts contacted for this article the fields of orthopedics and cardiology were clear leaders for having good near-term growth potential. During 2002, both sectors produced important clinical data that should translate into substantial sales within the next couple of years. 

Orthopedics. According to Badouin, one of the most important segments of the orthopedics market is that involved in developing implants, such as plates and cages, for use in spinal surgery. “Driven by a high rate of innovation, the annual growth rate of this segment—roughly 20–25%—is significantly higher than the overall orthopedic market growth of 8%. As the newer therapies are becoming more and more accepted by surgeons, leading providers Medtronic (Minneapolis) and Synthes-Stratec (Oberdorf, Switzerland) are discovering new opportunities in an area that was once merely a side business.”

At the same time, says Badouin, orthopedics manufacturers will be challenged to demonstrate the benefits of the paradigm changes they have brought about. “Recent innovations in biomaterials have led to the development of orthobiologic products that provide a basis for new treatment alternatives, especially in the traumatology sector,” he says. “But to gain higher market penetration, manufacturers will have to develop convincing evidence of the cost-effectiveness of such devices.” 

Cardiology. Analysts contacted for this article left no doubt about the most important development in the field of cardiology: the availability of drug-eluting stents. The first mover in this segment is Johnson & Johnson/Cordis, which received CE marking for its Cypher sirolimus-coated stent in April 2002. After a unanimous recommendation for approval by an FDA circulatory system device advisory panel last October, FDA approval for the Cypher stent is expected sometime in the first quarter of 2003.

Although drug-eluting stents are expected to be priced much higher than conventional stents, demand for the new devices is projected to be very strong. According to Badouin, estimates indicate that the global market for stents will more than double—to around $5 billion—within the next few years. “I gauge the near-term growth to be 30–35% per annum,” he says. 

With such a large market in play, investors might be forgiven if they momentarily forget that any other products exist. “The advent of drug-eluting stents is a supernova that will blind the market to any other innovations in 2003–2004,” says Piper Jaffray’s Gunderson. 

“These devices are on the fast track to becoming the preferred therapy for a huge population of patients,” says Badouin. “But the most interesting markets—the United States, Northern Europe, and Japan—are still to be divided among the dominant companies, which include Johnson & Johnson, Cook, Guidant, Boston Scientific, and Jomed.

“The success of any individual manufacturer’s product will basically depend on the efficacy of the active agent used with the stent and the time remaining before market launch of the products,” he adds. “Johnson & Johnson’s main competitors are at least six months behind in the regulatory processes.”

Intense investor interest in cardiac stents seems to be creating some beneficial fallout for other companies in the sector. “In the third quarter of 2002, the top three medical device companies that raised funding were focused on treating heart problems,” notes Lavinsky. “IntraLuminal Therapeutics (Carlsbad, CA) develops products for interventional cardiologists and radiologists to cross and recanalize totally occluded arteries. CHF Solutions (Brooklyn Park, MN) designs and manufactures mechanical pump and filter systems to remove excess fluid in congestive heart failure patients. MicroMed Technology (Houston) develops products to help patients suffering from congestive heart failure. Collectively, these three companies raised $79.2 million. 

“And although the final fourth-quarter numbers aren’t in yet, Acorn Cardiovascular (St. Paul, MN), which develops devices to extend the life of heart failure patients, announced a $20 million round of funding in November. 

“I suspect that this segment (i.e., medical devices for heart problems) had a fairly good fourth quarter and will continue to generate investor interest in 2003,” says Lavinsky.

Badouin agrees that products now under development to treat congestive heart failure, including artificial hearts, make the cardiology sector one of the most interesting and worthwhile of all the medtech fields. “For instance, we currently see great progress in the field of cardiac rhythm management,” he observes. “And the results of trials such as the MADIT II study should boost the demand for implantable cardioverter-defibrillators by showing the significant benefits that can accrue from preventive applications. The market leaders—St. Jude Medical, Guidant, and Medtronic—should benefit the most from these trends.”

Other Opportunities. Although advances in cardiology may temporarily overshadow developments in other medtech areas, companies in those fields continue to make progress that will be worth noting in the coming year. One such firm is Proxima Therapeutics (Alpharetta, GA), a privately held medical device company that develops site-specific cancer treatment systems for breast and brain tumors.
“Over the past eight years, the company has raised five rounds of funding from top investors (including New Enterprise Associates, Domain Associates, and Boston Scientific) and has received FDA clearance for its proprietary radiation-delivery systems,” notes Lavinsky. “Although Proxima probably won’t ‘break through’ in 2003, it is a solid, revenue-producing company that has a bright future.” 

Conclusion

It won’t be news to medtech executives that the coming year will offer technological and marketplace challenges that they have never faced before. Because this year’s challenges may include serious restrictions on the availability of funding, however, company executives could find themselves severely tested just to keep their companies afloat.

“The biggest challenge for a medtech company looking for capital is finding an investor who has enough confidence in the company’s future to invest in it during a time when the economy is lackluster and the IPO market is anemic,” says Lavinsky. 

“Despite this gloomy outlook, however, there are still many investors (with billions of dollars under management) looking for quality deal flow,” he adds. “Although valuations are much lower than they were a few years ago, ample opportunities still exist for companies with promising new technologies, attainable revenue goals, and strong management teams.” 

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