MX: How to Build Fundamental Business Value

Analyzing a device company in the role of an outside buyer enables managers to see their own companies’ strengths and weaknesses.

9 Min Read
MX: How to Build Fundamental Business Value

The task of all senior managers is to ensure that their medical device companies are profitable by building fundamental business value. However, there is no simple guide for accomplishing this task.

A sluggish economy, higher co-pays, and higher deductibles are depressing healthcare use, causing a slump in demand for healthcare products. Added to this scenario are stricter FDA procedures, lower government spending, tighter hospital budgets, reduced reimbursements, and a cloudy healthcare reform picture. For these reasons device company executives face major challenges in building their companies’ fundamental value.

Managers of publicly traded firms are keenly aware of their stock prices and market caps as measures of shareholder value. Yet, even public companies can focus too rigidly on their product lines and lose sight of both the wider market and the bigger picture. For their part, principals of privately run device companies may be in a more difficult position than their public counterparts because they don’t have market valuation tools as feedback. Managers of all companies, though, may confuse meeting short-term goals such as quarterly targets with building fundamental value.

‘Buy’ Your Business
For this reason managers can achieve a deeper understanding of their businesses by analyzing their companies as if they were outside buyers. This exercise provides a unique insight on how outsiders would value the company and can serve as a guide to building fundamental value. It also applies to divisions and product lines of public companies. Done dispassionately, this exercise will provide a wider perspective on the company and offer answers to hard questions about essential assets, stagnant product lines, and investment plans.

It is common to see private equity and venture capital firms acquire businesses or product lines that are languishing and then redirect the strategy to successfully build fundamental value.  Often, the underperforming assets are privately owned and the principals lack the wherewithal to unlock the value. In contrast, managers of large public companies find their focus drawn to achieving quarterly results and meeting analysts’ expectations, causing managers to take their eyes off building their businesses. Financial sponsors with fresh eyes are not tied to past business practices or the distractions of meeting short-term expectations.

A prime example is Smith & Nephew's 2006 sale of the Dermagraft and TransCyte regenerative medicine product lines to Canaan Partners after failing to win FDA approval for the treatment of venous leg ulcers. The new company, Advanced Bio Healing, redirected the skin substitute technology to address diabetic foot ulcers, obtaining positive clinical results, FDA approval, and favorable reimbursement rates. The product repositioning subsequently increased sales from $9million in 2007 to $147million in 2010, and the company was recently sold for $750 million to Ireland-based Shire plc.

A Simple Exercise
The key is for top executives to develop the same outsider viewpoint and the ability to look at their companies with “fresh eyes.” They can accomplish this by taking on the role of executives at a company looking to acquire their firm and conducting some core “due diligence.” That effort involves answering questions about their own businesses such as:

What is the value proposition the business offers to the market?
How well does the product offering meet current and future customer needs?
Are these needs sustainable and what are the possible risks involved both near and long term?
What are your strategies for driving success 1, 3, and 5 years out?
What is the ultimate objective and how will the business achieve it?
What will be required to profitably grow the business?
Does the company have the wherewithal, resources, talent, and staying power to realize its goals?
How durable are the company’s competitive advantages in areas such as intellectual property, core competencies, exclusive sales channels, and long-term regulatory burden?
To what extent is the company driving innovation in the industry?
What growth initiatives are in place in R&D or in new markets?
What is the company’s long-term growth outlook?
How intense is the competitive environment?
Is the company in a good competitive position, or is it vulnerable to competitors?
What outside trends impact the company? Trends could be economic, demographic, regulatory, governmental, and technological.
Is the company vulnerable to such trends or in a position to take advantage of opportunities that may come from them?
Is the company nimble enough to adapt to changing circumstances?
What operational risks does the company face? These risks include supply chain interruption, product safety, pricing changes, and pressure from low-cost suppliers.

Assessing Business Value
The answers to these fundamental questions will determine the company’s business value. Business value is based on both absolute and relative measures in both the near and long term. It is absolute because it is a function of the operating cash flow; it is relative because business value is set by the marketplace and the device company’s performance in comparison with its competitors. Value is derived both from the results that are achieved today and the potential that can be predictably realized in the future.

A proper value assessment requires the following steps:

Balancing short- and long-term perspectives. All managers have an idea of their companies’ near-term earnings outlook. Most managers tightly control costs in order to improve near-term results. Potential buyers, however, take a hard look at the underlying dynamics influencing demand and driving growth and earnings. Managers build value by putting themselves in position to take advantage of those underlying drivers, risk-adjusted for uncertainty.

Often, the challenge of long-term positioning involves investing in new sales and marketing resources, new machinery and equipment, or more engineering talent. Making these investments may provide a platform for future growth, but it also entails a short-term earnings hit before the investments bear fruit. Obviously, there is the uncertainty that the objectives will be realized. There is a temptation to focus on near-term earnings and delay these investments. However, if a manager analyzes the company as a buyer would, the resulting analysis will lead to more rigorous decisions based on measurable outcomes and adapting to changing circumstances.

Escaping the bubble. Often, an insular insider view may distort the true value of a company’s technology or product line. As the technology or product matures, huge commitments of dollars, time, and resources may result in diminishing returns that do not justify the same levels of backing. Frequently, R&D is overvalued because of the riveted attention and costs involved in developing a technology. Taking the view of a buyer may allow the freedom of looking at one’s own business, product, or technology more objectively. It could encourage openness to acquiring other technologies or aligning with other companies in order to strengthen the business. Even Fortune 500 companies are guilty of over-investing in a maturing, company-owned technology rather than seeking more promising technology that is "not invented here."

Examining innovation and growth potential. Profitable growth is fundamental to creating business value. However, it is easy for managers to be caught in the trap of “doing more, better” as their primary source of growth. Eventually, product line extensions fail to achieve significant growth, and there are no more new major geographic markets available for a company’s current product offering. Innovation, both within the product line and in other areas, is the key to long-term growth. Despite the day-to-day demands of managing a business, it is critical for managers to step back and ask themselves how they can skillfully innovate and what investments they need to make today that will drive productive growth tomorrow.

Surveying the competitive environment. Savvy buyers of companies know that the competitive environment has a major impact on value. This is because even an outstanding management team will be limited in what it can achieve in hotly contested markets. If the company is in such a situation, look for ways to expand its technology or unique competencies into different markets. Alternatively, find niche markets that, when combined, can add significant business value. In fact, several profitable niche markets where the majors are less dominant can often provide the additional capital needed to stay competitive in more highly contested markets.

Identify environmental forces and trends. The medtech industry in the U.S. is undergoing tremendous change. The future winners will be the ones that take advantage of this change. This does not mean looking into a crystal ball; there is too much uncertainty to accurately predict these changes. The winners will be those companies that recognize the uncertainty and shifting dynamics and create adaptive strategies to better position themselves to take advantage of whatever the future may bring. It may also require strategies that are designed around “learning and experimenting” approaches rather than “forecasting and control” approaches. Times of great change involve great risk but also involve great potential for building business value.

Examining operational risk. Anyone wanting to acquire the company will be examining all of its associated intrinsic and extrinsic risks. These risks include technological obsolescence, decreasing reimbursements, marketing of unapproved indications, and unintentional patent infringements that could reduce the value of the business. Management teams conducting due diligence of their own companies need to look at those same risks upfront because they have the potential to cause a future problem. While there is some debate as to whether one can predict “black swans,” there is an increasingly clear understanding that risk management is becoming an important management discipline that is necessary for preserving business value.

Profitable Pathways
While this exercise sounds straightforward, it is always a challenge to step out of the current paradigm. It may help to bring in a skilled expert to help develop an informed outside viewpoint and package the business as if it were being presented for sale, even if there are no plans to do so.

Taking an outsider’s viewpoint will begin to reveal whether the company is investing too much in current assets and not enough in building new assets. There is always another perspective to consider. Device company executives may find that they need to focus more effort on finding new areas of opportunity. The exercise may also determine that it would be prudent to divest some assets or reposition the business for long-term advantage.

The quest for building fundamental business value is at the heart of this exercise. At the very least, going through this exercise will help senior managers to focus on this important commercial measure and make it a primary strategic objective. When properly utilized, it will provide clear insights into profitable pathways to future success.

Merle Symes is managing director of The Walden Group Inc. (Tarrytown, NY), a strategic healthcare investment banking and consulting firm.

Richard S. Cohen is president of The Walden Group Inc.

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