Medical Device & Diagnostic Industry Magazine
MDDI Article Index
Originally Published MDDI December 2005
The trends in 2005's mergers and acquisitions, along with the good health
and growth prospects of the industry, mean that the window of opportunity is now open for owners of medical device companies to sell to the highest bidder. Here's how to do it right.
By Clyde A. Burkhardt and Stephen Tardio
The three major segments of the medical device industry—OEMs, component and subsystem suppliers, and contract service providers—continued to consolidate over the past year. In the first three quarters of 2005, merger and acquisition transaction volume increased, with a total of 115 deals completed, as compared with 102 deals during the same period in 2004.
Aggregate dollar volume, however, decreased to an estimated amount of slightly more than $10 billion in the first three quarters, from an estimated $17 billion in 2004. This can be attributed to the fact that fewer billion-dollar-plus transactions were announced this year (the proposed $25 billion Johnson & Johnson/Guidant deal being a notable exclusion from both years' statistics). The middle market, defined as transaction values between $50 million and $1 billion, took center stage in 2005 with no fewer than 25 transactions completed. However, as many as twice that number were registered with undisclosed transaction prices.
Many experts agree that the industry's consolidation will continue in the coming year. The positive implication is that a window of opportunity is now wide open for owners of independent privately owned companies and publicly held and venture-capital-backed companies to explore being acquired. For most companies, there will be several potential buyers.
Relatively speaking, prices paid for acquisitions, or valuation, within the medical device industry were strong in 2005. They should remain strong for all segments of the industry in 2006, barring a major catastrophic event such as the confluence of several major medical device failures or product recalls. As is true historically, a firm with a proprietary product, technology, or process, or strong intellectual property, will attract the most interest and sell at the highest price. That price, however, will depend greatly on the potential acquirer's assessment of the long-term growth and profit potential of the company.
From a valuation standpoint, the device industry, particularly the OEM segment, is quite different from most other industries. For example, middle-market companies across all industries in 2005 sold for between four and eight times their operating earnings (known as earnings before interest, taxes, depreciation, and amortization, or EBITDA). By contrast, there are many examples of medical device companies this year, especially those with a unique potential product pipeline, technology, or R&D capability, that lacked any earnings whatsoever. Yet these firms sold for four to eight times last year's actual sales revenue or even next year's projected sales revenue.
When talking specifically in terms of medical OEM transactions, major driving forces behind consolidation include the acquirers' desire to increase and diversify their revenue bases and gain access to intellectual property and new products. J&J's proposed merger with Guidant is an excellent example of this type of transaction. Reportedly, J&J had wanted Guidant for years. J&J viewed Guidant as a way to diversify its product base and enter a medical device category with high growth potential.
Boston Scientific's acquisition of Advanced Stent Technologies is another good example of an OEM acquiring a company for technological capabilities and products that will allow it to enhance and protect a leadership position. St. Jude Medical's $1.3 billion acquisition of Advanced Neuromodulation Systems (ANS) is an example of a diversification acquisition. It will allow St. Jude to expand beyond the cardiac market into neurology. As St. Jude Medical's chairman Daniel Starks said in an October 2005 news release, the ANS acquisition “is consistent with our efforts to create additional long-term growth drivers that diversify our business mix.” From the standpoint of ANS, its shareholders received a 30% premium to ANS's closing price prior to the announcement of the transaction. St. Jude Medical also gives ANS the resources, infrastructure, and distribution channels to quickly ramp up its international sales.
The OEM landscape has changed dramatically over the past decade because of mergers and acquisitions, and it will continue to change as consolidation continues. Multinational manufacturers are consolidating to establish greater presence around the world. The list of consolidated companies is long. For starters, J&J has Ethicon, DePuy, Cordis, J&J Medical, and Critikon, and may soon have Guidant. Boston Scientific has SciMed, Microvasive, Schneider, and EP Technologies. Baxter has IV Systems, Edwards Laboratories, Hyland Laboratories, Clintec, and Renal Therapy. Cardinal has Allegiance and Alaris Medical Systems; and Tyco International has Kendall, Sherwood Davis & Geck, and U.S. Surgical. Most of the large device OEMs, including GE, Baxter, J&J, Boston Scientific, and Medtronic, have extensive cash hoards to facilitate acquisitions. They are aggressively seeking more firms, and over the next year other substantial transactions may be announced.
Consolidation of the contract services segment of the device industry began in earnest in 1996 when private-equity sponsors funded UTI Corp. (now Accellent Inc.) and MedSource Technologies. The blockbuster transaction in this segment, which is expected to close by the end of 2005, is the sale of Accellent by two smaller equity firms to Kohlberg Kravis Roberts (KKR), one of the largest equity firms in the world. The transaction also includes MedSource Technologies, which Accellent acquired in June 2004.
KKR's proposed acquisition of Accellent is a watershed event for the device industry. It essentially validates and draws further attention to the industry as an attractive one for private equity funds to explore. Several equity funds have recently indicated they are interested in making platform acquisitions in the industry, and many more will likely become active over the next year. What is particularly interesting about the Accellent transaction is that two smaller equity funds were responsible for putting Accellent together and the sale to KKR is a major liquidity event for them. Nevertheless, it is very likely that Accellent will continue to seek acquisitions.
Many other companies and equity investors are interested in acquiring outsourcing companies with broad capabilities to produce high-quality products. The driving force behind the trend of OEMs to outsource is the simple fact that most large OEMs, like J&J and Medtronic, increasingly regard research and development, product design, and sales and marketing as their core competencies. The outsourcing trend by all accounts will continue, and consolidation of the highly fragmented contract services segment also will continue. This is because OEMs want to work with contractors that have extensive facilities and technical capabilities to produce large runs of products, often on a global basis.
Although large transactions like Accellent and ANS attract most of the attention, the vast majority of transactions over the past year (see Table I on page 43) were much smaller. In addition, many other transactions involved companies that produce components for the OEMs. A good example would be the November 2004 purchase of Putnam Plastics by Memry Corp. for $26 million last year. This transaction brought together two component manufacturers with complementary products sold to some of the same medical device OEMs. There are thousands of privately owned companies producing various types of components: valves, filters, adhesives, pumps, tubing, motors, etc. Many of these companies sell their components and subsystems to companies in other industries, such as aerospace, chemical, food, pharmaceutical, and telecommunications. There are a number of large component companies, including Parker Hannifin, Emerson, Smiths OEM Group, IDEX, and others, that are owned by equity funds that are seeking acquisitions to broaden their product offerings.
Table I. A sampling of key mergers and acquisitions in the medical device industry in 2005. Mergers are ranked by deal size (US$ millions). Source: Bloomberg and HT Capital Advisors LLC. (Click to enlarge table)
How to Sell High
The likelihood that the high level of interest by strategic and equity fund financial buyers alike will continue is high. This means that the next few years could be the perfect time for the owner of a medical device OEM company, a component manufacturer, or outsourcing provider to explore the sale of the company. For owners of privately held companies, and usually for the management of most publicly owned companies, selling a company is a once-in-a-lifetime event that can be very emotional. There are some basic guidelines to follow and mistakes to avoid to successfully sell a company.
It is often said that successful entrepreneurs begin to prepare their companies for a sale when they first hang out the shingle. The characteristics of a business that lead to the buildup of value take time to develop. Whether owners have just begun toying with the idea of selling, or believe that it will take a few years to make such an exit worthwhile, they should focus on the value characteristics of the business so that when the time does come to sell, they will be in a better position to receive a strong offer. Such value characteristics include the following:
• Management depth, comprising several talented individuals with overlapping and complementary skills.
• A history of financial statements prepared by a reputable accounting firm.
• Consistent reinvestment into the business, as opposed to taking all of the earnings out personally.
• Disciplined business planning and a track record of meeting financial projections.
• A focused strategic growth plan, i.e., knowing where you want to go and how to get there.
• A clean bill of health on legal and environmental issues, e.g., no lingering unanswered questions.
Once an owner has made the tough decision to proceed with a potential sale, there are important steps to take. The most prudent step at this point is to put together a team of professional advisers to orchestrate and guide the owner through the process. Typically, this team consists of accountants, attorneys, and investment bankers.
Attempting to sell a company by oneself might be successful but, more often than not, such a decision is penny-wise and pound-foolish. Most business owners simply do not have the time or expertise required to deal with the intense, three-to-six month process of selling a company. Also, selling a company can be an emotionally challenging experience. Sellers can benefit greatly from the objective advice of professionals who have been through the process many times and know the tricks of the trade.
The next major step in preparing a company for sale is the creation of a confidential, descriptive sale memorandum. This document typically ranges from 25 to 100 pages and is the initial package of information that will be given to interested buyers after a confidentiality agreement is executed. In its most elemental form, the memorandum describes the company, its history, products, R&D capabilities and intellectual property position, markets, personnel, facilities, past financial performance, and future prospects in a way that highlights the company's strengths and potential. It is extremely important to provide realistic revenue and earnings forecasts. Also, a seller should always disclose a problem or weakness to the financial advisers. Such problems include a possible patent lawsuit, loss of a major customer, or product recall. The advisers will know the best way to disclose such issues.
But the confidential memorandum is more than that. It is an owner's unique investment story—a precise, compelling presentation of the merits of the company's potential from the standpoint of potential buyers. The memorandum should convince potential buyers that the opportunity to acquire the business is not just another investment. Rather, it is a chance to realize potential that cannot be duplicated in any other way.
While the sale document is being prepared, the owner and his advisers should develop a targeted list of potential buyers. Depending on the circumstances, including confidentiality issues, the list should be as broad as possible, drawing from the following categories:
• Companies providing similar products to customers.
• Customers looking to capture distribution channels.
• Companies with complementary technologies.
• Private equity groups.
• Foreign companies.
Typically, potential buyers on the broad list will be screened and ranked from most to least logical. This requires an assessment of how certain characteristics, such as the following, apply to a particular buyer:
• Strategic fit.
• Value of the seller's product or intellectual property to the buyer.
• Announced intentions concerning acquisition.
• Previous knowledge or involvement with the company or the device industry.
• Financial resources to close the transaction.
• Management philosophy and culture.
Sellers should also keep in mind that if the contact process results in a wide distribution of the descriptive memorandum, the probability of achieving a high price is increased. However, the likelihood of damaging the company by sharing sensitive information with too many people also increases. Although competitors may be the most logical buyers, they can also inflict the most harm on a business if they are made privy to confidential information.
Once the decision has been made to sell, an owner should resist the urge to immediately market the company. The investment made in preparation will pay off at the end of the process. By defining key value characteristics, assembling an experienced team of advisers, documenting a unique investment story, being realistic in terms of price expectation, and broadly defining the universe of potential buyers, an owner will maximize the chances of a successful sale outcome. Well-prepared company owners wield the greatest possible leverage in negotiations with potential buyers and are more likely to realize the highest price possible.
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