Medical Device Link.

Originally Published September 1999

COVER STORY

Sustaining Corporate Growth in a Rapidly Changing Industry

In an interview with Medical Device Executive Portfolio, Guidant president and CEO Ronald W. Dollens shares insights that have helped him lead his company through a period of success and expansion.

Greg Freiherr

Corporate growth is the highest priority for Ronald Dollens. Through in-house R&D, licensing, and acquisitions, Dollens has put together a technological juggernaut at Guidant Corp. (Indianapolis) that produces a variety of devices for cardiovascular therapy.

Last year, Guidant recorded nearly $1.9 billion in sales, an increase of 43% over the previous year. Its 1998 net income of $359.4 million was an 82% increase from 1997.

About half of Guidant's revenue comes from the sale of vascular products, such as coronary stents; the rest comes from electrical stimulators, such as implantable pacemakers and defibrillators. Both areas of the company's business are in strong and growing markets, says Dollens. These markets account for about $7 billion in worldwide annual sales. Guidant holds a share of about 40% in the stent-heavy global vascular market and about 30% in the U.S. pacemaker and defibrillator market.

To maintain market dominance, Guidant spends more on R&D as a percentage of sales than any of its competitors, Dollens says. But the firm, which was spun off from Eli Lilly & Co. (Indianapolis) in 1995 and is now publicly traded, also seeks out new technologies, licensing products from competitors or buying entire companies. Guidant purchased NeoCardia (Houston) and EndoVascular Technologies (Menlo Park, CA) in 1997, InControl (Redmond, WA) in 1998, and Sulzer Intermedics (New York City) in 1999.

Guidant has to invest to keep up with the rapid changes in the cardiovascular sector. Dollens says that although the implantable defibrillator market is strong, products for electrical stimulation to treat patients with congestive heart failure—the number one cause of death for people over age 65—could dwarf implantable defibrillator sales. According to Dollens, dual-chamber stimulators will eventually drive the market, and Guidant is positioned at the forefront of this technology. Stents are now the cornerstone of Guidant's vascular product line, but they may not be for long. "Although stents have caused business to grow astronomically, we think radiation is the next technology play," Dollens says.

To predict successful growth strategies, Dollens has relied on his broad understanding of the medical device industry. In this wide-ranging interview with Medical Device Executive Portfolio, Dollens explains his strategy of technology development and corporate acquisition. Among the subjects he discusses are the role of patents in corporate growth, the need to increase productivity, challenges to Guidant and the industry from price erosion and rising labor costs, and why the industry should play a larger role in regulatory affairs.

The Competition

MDEP: How do you assess competitors?

Dollens: There are really three things one should look at when sizing up the competition. The first is product development, the second is distribution, and the third is cost structure, or the profit margins the company is able to achieve. A company's success depends a lot on how well it can leverage these capabilities.

In leveraging your own internal capabilities, you try to reach across different market segments, namely cardiac rhythm management (CRM), cardiac and vascular surgery (C&VS) and vascular intervention (VI). How difficult is it to stretch across these three?

There is a lot of commonality. Many patients have both coronary artery disease and cardiac arrhythmias. The users of our products—the interventional cardiologist, cardiac surgeon, and electrophysiologist—are often in the same practices.

In terms of market strategy, how does Guidant's approach reflect market conditions?

The market in the United States is driven by managed care. In this environment, you need to leverage your assets. Last quarter, 41% of our sales were made in situations in which we were able to leverage across both the vascular intervention and the cardiac rhythm management segments.

Whether it's vascular intervention, which is mostly interventional cardiology, or cardiac rhythm management, which is electrophysiology, there are two or three players in each of those two markets. Guidant was the only one common across those markets until Medtronic (Minneapolis) bought Arterial Vascular (Santa Rosa, CA), which I think was an attempt on their part to assert some leverage.

So, ours is a novel situation where we have one to two competitors, and until recently we were the only company that had a presence in both areas.

But that can change, as demonstrated by what happened before Medtronic bought Arterial Vascular. Guidant had been doing well against heavyweights like Johnson & Johnson (New Brunswick, NJ) and Boston Scientific—and then, in less than a year, Arterial Vascular carved out a market share of close to 30%.

That's what makes this such an interesting business. Technology does play an important part. That's why margins on our products are as high as they are. If you look at Guidant, our gross margins are in excess of 75%. It's because the markets move very quickly. Technology ends up being very important to the user, so when a new company can bring a novel technology to the market, it can quickly attain a competitive position.

And in the process gain extraordinary valuation, as happened in Medtronic's purchase of Arterial.

I think because Medtronic had not had much success with the vascular intervention market, they paid $3.7 billion to get into the business. But, just as you can have exceptional growth, there is also a potential downside. As we came out with our next-generation stent in the fourth quarter, we obtained a share in excess of 50%, and that made it difficult for the other players.

Cardiovascular Technologies

What about the market for cardiac rhythm management? This is a highly technical area.

It is very sophisticated technology, based on one's understandings of chips and hybrids and software and how to integrate them in a miniaturized form. And it demands rapid product development. We launched six new implantable defibrillators in six quarters. The velocity of product development makes it very difficult for companies to stay up to date.

How does this market for cardiac rhythm management break out? There are segments within this segment, right?

There are two markets in CRM. One is the implantable defibrillator market, which we and Medtronic keep switching back and forth between 45 and 50% share, with probably 10% share for the St. Jude group (St. Paul, MN). The other is the pacemaker side, of which, with the acquisition of Intermedics, we have approximately a 25% share in the United States, and Medtronic has probably about a 50% share.

When you put the two segments together, we're a 30 or 32% player. So we may be number one in implantable cardiac defibrillators and, for sure, number two in terms of pacemakers. Those are the market dynamics.

Regarding cardiac and vascular surgery, how does C&VS differ from vascular intervention?

It's primarily in the customer base. Much of the technology is the same, so we can leverage the technology directly from our vascular intervention to our C&VS group.

Why make this distinction?

When we first started the C&VS business, it was really directed toward less-invasive, minimally invasive approaches to be used in general surgery, but we soon made the strategic decision to focus on the vascular surgeon. We came to that conclusion by looking at what's important in terms of being competitive. A big piece of the general surgery market is the distribution organization.

We had two competitors—Johnson & Johnson and U.S. Surgical (Norwalk, CT)—with distribution organizations that were 10 times our size. So, we decided to refocus our effort on just one participant—the vascular surgeon. We acquired a company called EndoVascular Technologies, which had come up with a minimally invasive approach to treat abdominal aortic aneurysms using a catheter graft, and whose organization was directed toward the vascular surgeon rather than the interventional cardiologist or the electrophysiologist.

R&D

What does the intensity in product development in the cardiovascular area do to your R&D budget?

As a percentage of sales, Guidant spends more than twice the industry average on R&D: approximately 15%, compared to an industry average of about 6 to 7%. As a result, in the fourth quarter, 64% of our sales were from products that were less than 12 months old. Since we became a freestanding, publicly traded company, that number has never been below 30%. So the velocity of product development is huge. It is the critical success factor in this business.

What is the most R&D-intensive segment of your business?

Right now, it is CRM, but there's not much more than a 2% difference between CRM and our vascular intervention side. So, on both sides of our business, the customers are demanding that we bring forward new products.

Global Economic Factors

How do your customers break out in terms of global markets? What is the relative opportunity in the United States versus the rest of the world?

In the last year, our international business has shrunk from 40 to 28% of our total business. That reduction is not because the international business has slowed down; it's because there's been such huge growth in the United States, which is primarily because of the use of coronary stents. For Guidant, the United States produces about 72%, Europe 20%, and Japan and Asia about 7 to 8% of total revenues.

But traditionally you start selling new products overseas rather than in the United States. Is this part of a global strategy?

Really it's just practical. The reason for going to Europe is the shorter regulatory approval cycles. At least until about 1994 or 1995, novel technologies could be made available in Europe about two and a half to three years before they would be available here. That's been changing now that FDA has really focused on becoming more efficient. We have seen the differences shortened substantially. In some cases, there has been only a 30-day difference between when a product became available in Europe and in the United States.

You use partnering mostly for international distribution, as you did with Thoratec (Berkeley, CA) to distribute their Vectra Vascular Access Graft and with EMBOL-X (Mountain View, CA) to distribute some cardiac surgery products in Europe and Canada. Would these be examples of filling your product line and using your distribution channels?

We are doing that, but we are also learning more about those markets. In some of those situations where we have acquired European distribution, it wasn't that we were so interested in making money on that distribution, especially if it was an early-stage technology, as it was that we wanted to learn how patient flow happens within the clinical community, what the treatment patterns look like, and what the reimbursement looks like. This information allows us to decide whether we want to make a longer term and more substantial statement in that treatment modality. These partnerships are more about learning than they are about financial gain.

With the regulatory shift, the boom in the U.S. market, and the economic uncertainties in other parts of the world, particularly Asia, will you be emphasizing the U.S. market more in the future?

We can't depend just on the U.S. market to support the huge R&D investments that we make. We've got to look at world markets and work with public policy makers to get reasonable reimbursement and support for the development of innovative kinds of technology.

You mentioned the United States, Europe, and Asia in terms of revenue share. Where does Latin America fit into your overall strategy?

Latin America has obviously been a bit more volatile than other markets in terms of commercial enterprises and exchange rates, but we see that it also has a higher growth rate, especially in Brazil. We've just set up direct operations in Latin America.

Are you worried about price erosion in your products, especially because reimbursement is a concern in an environment dominated by managed care?

It's always a concern. We need to work with healthcare systems around the world to make sure they understand that if there's not sufficient incentive or if they don't allow the users to dictate the value of the technology, there is not going to be this kind of evolution of technology.

But when technology moves as quickly as it is moving in cardiovascular therapy, for example, clinical outcomes end up being the determining factor in price. So there are very few examples, especially around cardiovascular therapy, where we've seen substantial price erosion.

Let's talk about reimbursement for a moment. There's concern that Medicare is cutting back, third-party payers are looking at cutting back, and HMOs are tightening their grip. How big of a concern is this for you?

I haven't seen much cutting back in the United States. The pressure has come more from competitors, and that's the way the marketplace should work. That's not true in Japan or in France, where we do see almost an arbitrariness.

It seems whenever Alan Greenspan appears before Congress, he talks about two countervailing forces. One is the effect of a shrinking labor market and how it might affect inflation. The other is the ability of American businesses to increase productivity as a means for reducing this effect. What effect do these forces have on Guidant?

They are very substantial. Let me give you a case in point. The one area that has substantial pricing pressures for us is angioplasty catheters, with price reductions of as much as 20% in some years. Reductions are continuing at about 10% per year. We've absorbed those reductions by having a higher level of productivity and by lowering our manufacturing costs so that we've been able to retain our margins in this business, which is exceptional. So increasing productivity has a huge impact because we are not getting the advantage of price increases that we have in the past, but we're still able to grow profit levels.

How about global economics as a challenge, especially Asia? Just a few years ago, this was a bright spot for the medical device industry.

Everyone is still confident that the global future will bring growth. It is just that the growth is going to start later. For us, we've actually had a phenomenal growth rate of more than 30% in Japan, which is where we have most of our business in that part of the world. That's because we were in the process of switching from a distributor organization to a direct sales organization, which allowed us to participate with substantially higher selling prices. So that ended up masking any adverse effects.

Acquisitions and Consolidation

It seems clear that corporate acquisitions are a major part of your strategy. Why is that?

Because there are hundreds, if not thousands, of early-stage companies directed toward medical applications. Those that are focused on cardiovascular care will end up being owned by one of only a few companies.

None of these early-stage companies really have business plans to become freestanding entities 15 years from now. The company leaders think that they will not have the critical mass to succeed in a managed-care setting in which there are fewer and fewer vendors. They won't be able to support the long-term product development investment that's required. So they're trying to bring forward their novel technology to create some value, which is a fabulous situation for them and for us in that it allows us to be able to look at those entities after they've been somewhat proven and then decide whether they fit our strategic direction. Having this group of very interesting novel technologies looking for partners is a great situation for us to be in. But with all the consolidations that have happened in the industry, there are fewer and fewer partners.

In making these acquisitions, what does Guidant bring to the deals?

We will not acquire any company if we can't leverage our technology or our distribution channels for it. If you're going to make an acquisition, you're probably going to pay a premium for it, and if so, you must know what makes it have value for your shareholders. You have got to make it more successful than it would have been on its own. So we will bring something to every acquisition.

Typically, there are two reasons for consolidation. One is to gain size; the other is to cover product gaps. Are those the two major forces that have spurred Guidant's acquisitions?

That's exactly right. If there is a product gap, then that's one way to fill it. But joining together also sometimes creates opportunities for reaching new customers.

For instance, an implantable electrical stimulation device (other than a pacemaker or defibrillator) might apply to a new customer or a narrower customer segment of the market. Or it might be a catheter-based system, as in the case of neurovascular treatment of strokes, aneurysms, or arteriovascular malformations. If this treatment requires novel guidewires to get up through the neurovasculature, we would bring a lot to that. And because the customer base would be small, it would not require substantial investment in a field organization to reach those customers. So, the critical success factors end up being the technology and the product design, and those are areas where we would bring a lot to an acquisition.

Is there a downside to making acquisitions, in that you are incurring debt when you buy these companies?

Not necessarily. You will incur debt as long as you think that is the best financial mechanism. We have an excellent currency in our stock with a price/earnings ratio higher than 40. As long as the SEC allows pooling of interests, then we can use our stock to buy companies. This is a very efficient mechanism.

In one recent case, Sulzer Intermedics, you used cash.

We did because you can't do a pooling of interest if you're buying a division. You can only do that if you're buying a completely freestanding company, and Sulzer was a division. Because of Guidant's credit rating, we could borrow money at a very low interest rate of less than 6%. We viewed the stock as having a greater return than that, so we went ahead and used debt. We will have that debt paid down to very reasonable levels over the next two to two and a half years.

How would you rate your three different market segments in terms of the importance of consolidation? Is VI more important than CRM, for example, or CRM more important than C&VS?

The VI and CRM consolidation has already happened. You are already down to two or three major players. That really hasn't happend yet on the C&VS side.

And C&VS is really a very small market for you?

It is. And that's probably where a large part of our acquisition effort will happen—to build it to be a much more substantial area.

Patents and Intellectual Property Disputes

What role do patents play in your strategy?

We have a very high emphasis on intellectual property as the way to build proprietary positions for Guidant. When we started down this medical device road, around 1984 or 1985, we became very aggressive. We brought a pharmaceutical mentality to intellectual property. We were the first company to really value intellectual property, and we kept competitors from getting into the market. If they had an implantable defibrillator, they had to have a license from us. If they wanted to have rapid-exchange angioplasty, they had to get a license from us.

We have got more than 1200 patents now issued or pending—that's double what we had before we became a public company. The key from a company standpoint is to make sure that you have a sufficient portfolio and that you never put the business at risk. Whether you have to buy licenses from others or buy a company, the goal is to make your portfolio strong enough that others need licenses from you. Doing so gives you appropriate trading bait. It's a very high-profile issue for us.

It seems Guidant has been on the receiving end of bad news lately regarding patent litigation and settlements—St. Jude Medical, $9.6 million; General Surgical Innovations (Cupertino, CA), $12.9 million; CR Bard (Murray Hill, NJ), $60 million. What's going on?

When you talk about the suits we've lost, they are really very trivial. You're talking about $9 million and $12 million against a corporation with a $16 billion market capitalization.

And interestingly, if you look at the St. Jude litigation, there were a number of patents in dispute, and it was only one patent on an ancillary product on which they obtained this $9 million. If you noticed, that day our stock went up 6 points. So, I think that was probably viewed as a win.

With CR Bard, we decided we would buy a number of patents from them—that was not a loss situation. We decided it would be better if we acquired those patents to give us more flexibility with our product designs, especially with materials.

Why don't we hear about this positive side?

Maybe we put ourselves at a disadvantage, but one thing you'll never see from Guidant is a press release about the wins, because we just don't think that's an appropriate way to do business. It's usually the small firms or the firms that have their backs to the wall that feel compelled to talk about those situations.

Have you been successful in pressing litigation against competitors?

We have been very successful.

Can you give me some examples?

In regard to the rapid-exchange technology, SciMed (Maple Grove, MN) had to withdraw its product from the marketplace and pay a huge royalty to that point of time. Boston Scientific had to do the same thing. That's one of the major reasons Boston Scientific paid $2.1 billion for Schneider (Plymouth, MN)—to get access to that rapid-exchange intellectual property.

Have you ever used patent litigation as others have—as a tactical weapon to slow down competitors?

I don't think it slows them down unless you can get an injunction to force them to withdraw from the market. Other than that, there's no slowing the process until you win litigation.

But putting a company through litigation can exert extraordinary financial pressure, especially on middle- or small-sized companies.

You're right. And they have to defend against it, especially the small guys, because intellectual property is their number one asset. Venture capitalists and investors understand that. If they never expect to grow into a major company anyway—they only expect to be acquired—a substantial portion of their assets is their intellectual property.

So any kind of litigation is an attack at the core of their business and has to be defended at all costs?

That's right, because it's probably the most valuable thing that business has.

The Future for Guidant

What must Guidant do to keep winning in the marketplace?

We've got to do two things well. One is what's been important in the medical device business for the last 20 years: new product flow. For us, that means aggressive investments in R&D, which includes enhancing our regulatory approval cycle. We were the first company in the medical device industry to do electronic filings with the FDA. We have worked hard to shorten the time frames.

The second thing, because we are under financial pressure around the world, is that we have to be able to form economic partnerships with our customers. To do this, we need a broad product line, as customers try to deal with fewer and fewer vendors. It also means we have to focus on less resource-intensive technology so
as to replace therapies that are more resource intensive.

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