BUSINESS BRIEFINGS - ONLINE EXPANDED VERSION
It didn't feel like news when the National Bureau of Economic Research (NBER) announced last December that the U.S. economy had officially entered into a recession a full year earlier. Through personal adversity and company hardship, people all over the world had already recognized that the world's economies were tanking, and they didn't need the NBER to tell them so.
But somehow, an official declaration changes things. By the beginning of January, economists and industry analysts were turning their attention to the design of policies intended to restore growth and bring the world's economies out of recession. And for medtech analysts, all the New Year's buzz was about whether the medical device industry would be able to maintain its long-standing and well-deserved reputation as an industry resistant to recession.
That question was seen as all the more serious because the newly recognized recession is widely believed to be much broader and deeper than any other downturn that has occurred since the device industry was first regulated, in 1976. Demonstrating continued strength in the face of an economic falloff of historic proportions can go a long way toward boosting investor confidence in medical technology companies, big and small.
Even so, figuring out how to measure the recession-resistance of the diverse and varied medical device industry, for which broad market intelligence isn't readily available, can be a challenge. And market analysts--like economists--don't necessarily have a consensus position on how to go about it.
One reason that it's so difficult to decide on a methodology for measuring the economic health of the medical device industry is that different kinds of companies have very different ideas about what's important. "Measures of how effectively companies are dealing with recession are dependent upon where each company stands in the development cycle," says Patrick Driscoll, founder and president of MedMarket Diligence LLC (Foothill Ranch, CA). "The Boston Scientifics and Medtronics of the world will have measures that differ from those of seed- or development-stage companies."
The same is true for the varied constituencies that medtech companies serve. From the perspective of an investor, for instance, company earnings might be taken as the best indicator. "Top-line revenues can be increased by lowering prices, but earnings are dependent on a company's bottom line," says James X. Laskaris, senior emerging technology analyst with MD Buyline (Dallas). "Companies with great, unique products that are in demand and backed by adequate reimbursement have great earning potential."
Table I . (click to enlarge) Earnings of medical product businesses and earnings per share for the top 15 public medical device companies, as selected by reported revenue for the four trailing quarters ending September 30, 2008. Except as noted, all company fiscal years end 31 December. All figures subject to rounding. Source: Company reports.
By the measure of earnings, most of the largest medical device companies have done pretty well over the period since the official beginning of the current recession in December 2007 (see Table I). Among the industry's largest 15 public companies, only two--Covidien and Boston Scientific--have posted earnings losses for their 2006 or 2007 fiscal years. In a time when significant losses are being posted by many companies in other major industries--including those in the housing, finance, and automotive sectors--medtech's continuing profitability is a good sign.
But earnings are only part of the story, and maybe not always the best part. Because earnings typically include calculated charges and write-offs that can be altered by a company's fiscal management decisions, relying on that single line can be misleading. "A strong balance sheet is probably the best indication of a well-prepared management," says Manfred Scholz, PhD, president of Scholz Consulting Partners LLC (Medford, MA) . "While earnings, revenue, and share price are all good indicators for overall management in normal situations, the speed and size of cost-control measures--inventory control, personnel adjustment, and so on--are probably the best indicators of an attentive management."
" I don't think there is necessarily one specific metric that would be a good indicator of which companies are equipped to handle recessionary pressures," agrees Venkat Rajan, industry manager for medical devices at Frost & Sullivan (San Antonio, TX). "Over time we will see which companies had the resources and reserves allocated to weather a recessionary period--or even take advantage of it. A company's aggressiveness in terms of licensing new technologies or conducting mergers and acquisitions (M&A) might be indicative of a firm working from a position of strength."
The challenge of creating an industry-specific measuring tool wasn't helped much by the December announcement of the NBER's business cycle dating committee. The committee explained a number of elements that it considered important for defining the current downturn as a recession, as well as factors that had contributed to its declaration. But it didn't offer guidance about how to measure the status of an individual industry within the broader economic trend.
Trending the Bucks
A better and simpler measuring tool is provided by economic tradition and popular lore, in which two consecutive quarters of economic contraction is frequently taken to indicate the beginning of a recession. Although that definition is meant to apply across entire economies, it's also a useful test for measuring the expansion or contraction of individual industries. And it has the advantage of using readily available figures reported by all public companies--sales revenues.
Table II. (click to enlarge) Quarterly and fiscal year revenues for the 15 largest public medical device companies, from FY06 through Q308, ranked according to revenues for the four trailing quarters ending September 30, 2008. Fields in green indicate increased revenues over the preceding quarter; fields in purple indicate decreased revenues compared with the previous quarter; fields in red indicate consecutive quarters of decreasing revenue. Company-reported figures have been placed in the standard calendar quarters to which they correspond, without regard to the company's numbering of fiscal quarters. Currency conversions have been made for each quarter according to the exchange rate on the final bank-open day of its calendar year (not fiscal year), as provided at www.x-rates.com. Except as noted, company fiscal years end on December 31.
Looking back at 2007, for instance, the top 15 public medtech companies mostly participated in the economic expansion then under way (see Table II). Many of those companies experienced revenue ups and downs on a quarterly basis, but usually not in a fashion that would suggest a tendency toward declining revenues. Of the 60 quarters reported by those companies, only 20 (33%) indicated that companies had brought in less revenue than the preceding quarter. And of those, the classic two-quarter definition of a recessionary trend was satisfied by only four pairs of quarters, one of which toppled over into 2008.
Notably, three of the four offending pairs (reported by Medtronic, Boston Scientific, and Olympus) involved the second and third quarters of the year--periods preceding the onset of the recession identified by the NBER. In fact, 10 of the 15 top medtech companies reported a drop in revenue growth during the third quarter of 2007.
The record of medtech's top companies wasn't quite so good in 2008. Of the 45 quarters so far reported for the year, 22 (49%) have indicated a decline in company growth when compared with the preceding quarter. But even with such a concentration of lowered revenues, only three companies endured consecutive quarters suggesting diminishing economic activity. Siemens added a third down quarter to the two that turned the corner into the new year, but the company's sales rebounded significantly in the third quarter of the year. Medtronic reported another pair of down quarters in Q208 and Q308. And, after having an upward quarter at the end of 2007, Boston Scientific was unable to capture the momentum, suffering three consecutive quarters of decline in 2008. And once again, 10 of the top 15 companies reported a drop in revenue growth during the third quarter of the year.
Taking the reports of all 15 of the industry's top companies together tells a slightly different version of the same story. By that view, every quarter in 2007 represented an advance over the revenues reported in the previous period. When calculated according to company fiscal years, in FY07 the top 15 companies posted an increase of 12% over the previous year. Of the top 15 companies, only 3M Healthcare posted negative growth from FY06 to FY07 (-1%), reflecting the company's sale of its global branded pharmaceuticals business in Europe.
Once again, however, the group faltered in 2008. In the first quarter of the year, the group dropped $1.3 billion off the previous period's results. And in the third quarter, the group experienced another drop, albeit a much smaller one of less than $400 million.
Looking at the quarterly results of industry's top companies certainly provides a great deal of detail that can amplify understanding. But it may still be too soon to tell what these figures mean.
Advance fourth-quarter earnings reports that began to appear in the middle of January suggest that there is continued sales strength in the medical device industry--at least among the largest companies. If those results are echoed in the reports of other companies, they could help to support the recession-resistant standing of the industry.
Big and Small
For large companies, the issue of recession-resistance may be important for planning research and development (R&D) budgets and determining appropriate staffing levels. But for smaller companies, this information could become a matter of company life or death.
"The big guys have deeper pockets, less dependence on financing for operating capital, and relatively stable existing revenue streams--unless their businesses are heavily weighted toward elective procedures (cosmetic or otherwise)," says Driscoll. "For early-stage companies, the opposite is true: shallow pockets, dependence on financing for operating capital, and little or no existing revenue streams."
"Large cap medtech companies have a couple of advantages in comparison to their smaller competitors and companies in other market segments," says Scholz. "One, of course, is their generally stronger balance sheets, which do not require deleveraging to the extent their smaller (still growing) competitors need. Another is their lesser dependence on discretionary spending. Medical equipment and supplies are purchased with long sales cycles and under longer-term purchasing agreements. Hence, the impact of economic trends on their sales is delayed in comparison to more consumer-oriented products."
As a result, says Scholz, he expects a slower recovery of medtech companies during 2009, compared to consumer-product companies.
Without question, large cap companies have an easier time of making it through challenging economic conditions. "Large cap companies that have been successful historically have name recognition, so when bids go out they are invited to the dance," says Greg Stett, a clinical analyst with MD Buyline. "Their large cap allows for large R&D, hence the companies can keep their fingers on the pulse of emerging clinical needs, and retool quickly to accommodate those future needs. Such product-line diversity allows for a one-stop-shop approach and the advantages that bundling can afford.
"Smaller companies tend to follow the leaders," adds Stett.
But not everyone sees small company size as a disadvantage. "The economic recession may have an impact on i nvestments in emerging technologies, hospital purchasing trends, patient preferences for care, and even the types of care provided," says Frost & Sullivan's Rajan. "But that is not to say there are not opportunities for growth and innovation. Challenges give rise to new opportunities and innovative problem solving.
"When things are going well, there is often a reluctance to alter practices and strategy. But as healthcare providers and medical device manufacturers begin to struggle, they could seek to launch new practices and technologies that streamline the provision of care," he explains. "Issues that were once merely concerning may be amplified in importance, and could become the difference between maintaining the organization's bottom line and business failure.
Rajan believes the individuals and entities that are most ready to adapt and take advantage of new opportunities should come out of the recession stronger and more ready to compete in the industry for the long term. Meanwhile, he says, stodgy, weaker firms working under older paradigms will fall away.
"The measure of a company's potential for success isn't necessarily what products it offers, but the type of solution it is able to provide," adds Rajan.
Mergers, as Usual
One trend that appears undiminished by the current recession is the usual cycle of M&A, which gives the medical device industry its characteristic flow of emerging technologies and companies. A number of industry's largest companies have taken advantage of the economic environment to acquire smaller companies, often at valuations below previous expectations (see Table III).
The recessionary economic climate has set up the current dynamic for acquisitions, says Driscoll. "The big guys don't doubt that they will weather the downturn, and they see beyond it to a time when they will need innovation to fill their product pipelines," he says. "As a result, early-stage companies now have bull's-eyes on their backs."
The companies most likely to become targets for opportunistic acquirers include early-stage companies that can't make ends meet. "Prerevenue medtech companies that stumble with FDA are particularly vulnerable in today's financial climate," says Casey Lynch, managing director of NeuroInsights (San Francisco). "For example, Northstar Neuroscience and Cyberkinetics, which have promising technologies that could be further developed with additional funding, have had to discontinue operations.
"We expect to see quite a bit of mergers and acquisitions activity, including roll-ups of these sorts of companies, which are being undervalued by a highly risk-averse market," she adds.
In the absence of an active market for initial public offerings--an option that has been missing from the medtech scene for nearly a decade--an active M&A market is a good thing. The fact that the current economic downturn hasn't prevented medtech's largest companies from pursuing timely acquisitions is generally viewed as the mark of an industry that is continuing to function as usual.
Even so, beware of the bears, say analysts.
"There may be increased interest and M&A activity for established or safe technologies," says Rajan, "but the real concern is for emerging therapies and treatments. A general unwillingness to take risks on emerging or more developmental technologies could lead to a diminished flow of ideas and products, some of which might otherwise have challenged the existing forms of care in the near future."
Another concern is whether medtech M&A activity can be maintained at a level sufficient to encourage early-stage investors and keep their money in the market.
"Of course, times of distress create opportunity," says Scholz. "Unfortunately, the current level of M&A may not be sufficient to prevent the collapse of some promising development-stage companies. Much early-stage funding comes from venture capital (VC) investors, who now have to protect their existing investments. Consequently, funding availability for new technology is scarce. This creates great opportunity for visionaries with money to invest, but I don't see much of that happening yet."
According to Driscoll, funding availability isn't much of an issue for large-company acquirers. "The portent of a 'credit crunch' still lingers (if anyone is still using that term), but the reality is that interest rates will never be lower in our lifetimes. So if you're not a bad-risk home buyer seeking a mortgage, how difficult can it really be to find financing?
"The small company will just have a tougher sell on financing than the big company," he adds.
"The best strategy for consumer-based product companies is to hunker down and preserve cash until the storm passes," says Scholz. "The recovery for companies focused on elective medical procedures won't be fast so long as consumer uncertainties prevail. But it should still be faster than in the housing and automotive sectors, where large inventories weigh down a recovery."
While many other industries have watched revenues and jobs slip away as a result of the recession, so far the medical device industry has continued to show both strength and growth. If current trends continue, large companies will likely emerge from the downturn with even greater strength than they had before.
"Ironically, for big companies this recession may be all about opportunity, with the price coming down on potentially valuable innovation at early-stage companies," says Driscoll. "Though this may sound like Mr. Potter buying up the assets of the panic-stricken in Bedford Falls, the reality is that adversity is almost always synonymous with opportunity."
Moreover, analysts warn, the medtech industry has yet to go through the worst of that adversity. "We are still faced with the impact of budget cuts migrating through the healthcare system," says Scholz. "It takes a while before hospital consolidation and other budget-cut measures hit medtech orders. Furthermore, the impact of international markets comes at a delay--and the strengthening dollar doesn't help profits either.
"On the bright side, this delay (compared to housing, automotive, and consumer products) gives medtech executives more time to prepare for the impact of budget cuts," says Scholz. "Overall, medtech companies should still provide steadier investment performance than companies in other industries."
The recession also offers lessons for small medtech companies, says Driscoll. "In a downturn, the worst thing a company can do is panic," he says. "Small businesses need to focus on the value their products offer and consider whether that value has changed as a result of the recession. Businesses then need to consider what funding they require to bring products to market, and pursue that aggressively."
In the meantime, medtech industry analysts will be watching closely as the earnings reports for the final quarter of 2008 roll out. With a little luck, industry's key story will continue be one of investor appeal and strong resistance in the face of the harshest economic conditions of recent times.