Medical Device Link.

Originally Published MX March/April 2002

FINANCE

Value-Plus Management

Medtech executives can maximize returns for shareholders by identifying and managing their company's key value drivers.

Stuart Jackson

Total shareholder return, which is defined as dividends plus stock-price appreciation, is the benchmark used by shareholders to measure the success of a company. Ensuring superior returns over time—and thereby creating long-term shareholder value—is one of senior management's primary responsibilities. Yet many companies do not take advantage of tools and techniques that can help actively measure and manage shareholder value.

In rapidly changing industries such as medical technology, the focus on growth may distract company executives from the fact that their investments sometimes produce low returns and, in some cases, have even destroyed value. This is demonstrated by the fact that in four of the past five years, medical device and supply companies have underperformed the S&P 500, despite benefiting from continued growth in healthcare spending (see Figure 1).

Figure 1. One-year total shareholder returns from 1996 to 2000 indicate that medical supply and device companies have underperformed for shareholders in four of the last five years. Source: Wall Street Journal Shareholder Scoreboard and l.e.k. Consulting (Boston). (click to enlarge)

However, implementing a shareholder value approach can be challenging for medtech executives, as cost structures in the medical technology industry make it difficult to identify and manage those performance measures that have the greatest effect on shareholder value. High R&D costs; high selling, general, and administrative expenses (SG&A); and high gross margins combine to obscure the true value contribution of individual products and product lines. Add to this the large amounts of capital employed in many projects and it is no surprise that some medtech executives have an unclear and sometimes erroneous understanding of which activities are truly driving value.

In spite of these challenges, however, medtech executives have an ongoing mandate to maximize the returns of their stakeholders whether their company is publicly traded or privately supported. This article aims to provide some insight on identifying and managing value drivers specifically for medical technology companies.

Limitations of Traditional Accounting Measures

While the idea that companies should be managed to increase shareholder value is well accepted in both the business and investment communities, in practice medtech executives are faced with the difficult problem of how best to implement a shareholder value approach. Many medtech company executives therefore fall back on traditional accounting metrics such as return on investment (ROI) or growth in earnings per share (EPS) to determine their company's value.

The practice of using accounting measures to assess economic value stems from the fact that they are comparatively easy to calculate and have been broadly understood and accepted within organizations over the years. However, both EPS and ROI have serious shortcomings that may cause medtech executives to make decisions that are contrary to the goal of increasing long-term shareholder value.

Consider the ROI measure. Typically, a project is considered successful if its ROI is higher than the company's weighted average cost of capital. The fundamental problem with this approach is that it compares accrual accounting returns (apples) with an economic return demanded by investors (oranges).

Accrual accounting returns differ from economic returns in two ways. First, ROI is a single-period measurement, while investors care about the entire economic life span of a project. Second, ROI is heavily influenced by accounting policies such as capitalizing versus expensing investments and depreciation rates (fast versus slow), resulting in understatement or overstatement of true economic return in any given period. As a result, ROI is an incomplete measure of value creation.

Other accounting-based metrics, such as EPS and return on equity (ROE), have similar problems, especially in the medical technology industry, which is knowledge based and has a smaller percentage of investments capitalized for accounting purposes. There is, however, an alternative valuation technique based on discounted cash flow that medtech executives can use to better assess the economic value of their company. This method is called the shareholder value approach.

Pioneered by Alfred Rappaport, the shareholder value approach is by definition forward looking, cash based, long term, and risk adjusted. This method is more difficult to implement than merely tracking accounting numbers like EPS, because it requires medtech executives to understand the economics of their business on a fundamental level. But the rewards more than make up for the energy expended, for the results ensure that company executives know the factors that most influence value, as well as which ones can be most easily affected.

The Shareholder Value Approach

Figure 2. The value drivers of a medical technology business. Source: L.E.K. Consulting. (click to enlarge)

Simply put, the shareholder value approach can be defined as understanding and managing the key drivers that have the greatest effect on shareholder value. Medtech executives should think of their business as a vessel being filled by multiple faucets, each representing a different source of revenue for the company (see Figure 2). At the same time, water is constantly flowing out through various drains, representing the firm's cash costs. The water in the vessel represents the cash tied up in the business's buildings, equipment, and working capital. The overflow after filling the vessel is the company's net cash flow. This is the money available to improve shareholder wealth. For medtech executives, identifying and understanding the interaction of these value drivers is the first step in managing a business for shareholder value.

The second step comes in quantifying the effect of these drivers. For some of the faucets, a small turn of the handle will have a huge effect on cash flow and value; for others, even full flow will not be enough to make a significant difference. Once medtech executives have an understanding of the effect of different value drivers, they can use this information to pursue activities, projects, and product lines that create value, while deemphasizing those that do not.

In the medical technology industry, the greatest effect on shareholder value results from changes in value created per unit, rather than volume of units. For example, 1% improvement in gross margin will create more shareholder value than a 1% increase in units sold. Typically, when margins are slim or moderate, increases in value per unit will have more of an effect than increases in number of units. In other words, on a low-margin product, it doesn't matter much if a company sells a few more units, but it matters a great deal if the company can make a bit more on each unit sold. Conversely, when a product's margins are high, selling additional units will be more valuable than making a little bit more on each unit sold. Because medtech companies typically have moderate operating margins, value-per-unit measures will usually be of greater focus.

Identifying and Managing Key Value Drivers

Many medtech executives manage their business as if every operating factor were equally important. Usually, medtech company executives have a solid knowledge of the variables that affect business performance, and they manage that list aggressively. But problems can result if the list of variables is too long, or if it is prioritized against goals other than value creation.

Figure 3. The effect of key value drivers on the business of a manufacturer of blood-treatment devices and disposables. The base value shown is $250 million. Source: l.e.k. Consulting. (click to enlarge)

As an example, a manufacturer of blood-treatment devices and disposables organized its corporate goals and sales-force incentives around gaining market share by securing more machine placements on customer premises. The logic was that placing more machines locked in future higher-margin disposable sales. However, the real picture for shareholder value, revealed through an analysis of key value drivers, was rather different (see Figure 3).

In order to drive up machine placements, prices and terms had been driven so low that new placements contributed little to shareholder value, even after allowing for future disposable sales. In effect, the market-share war for machines had been undertaken at the expense of the most critical value driver of all: price.

The second effect of the low-priced machines was that customers had little incentive to manage their utilization. Most machines were being used only a fraction of the time—with a consequent decrease in disposable sales per machine, another key value driver for the business.

As a result of these insights, the company increased machine prices, shifted sales-force incentives, and slightly improved terms for high-volume purchasers of disposables. In the period that followed, the company did lose out on a few machine placements to lower-volume accounts, but profit margins improved significantly and the company actually increased its volume of disposables through higher share among the more-lucrative volume users.

Benchmarking Value Drivers against Competitors

Medical technology companies are used to competing for market share, customers, and patients. With the shareholder value approach, there is a different goal: competing for value. With this paradigm, although sales and market share are still important, the overall objective is for medtech companies to outperform their industry peers in delivering value to shareholders. Medtech companies that consistently deliver superior returns will, over time, siphon investment away from their competitors and achieve stronger long-term growth to the benefit of all stakeholders.

When the key value drivers are known, medtech executives should return to benchmark data to help set appropriate targets. Competitor benchmarks can show what is possible to achieve for a given driver or group of drivers. Looking at a competitor's strategy in conjunction with a company's own drivers is important, because different successful strategies will result in different driver levels. A low-cost strategy, for example, may result in low gross margins and low R&D, while a product-innovation strategy may result in high gross margins and high R&D costs. For medtech executives, knowing their company's strategy and capabilities will help put benchmarks into context when it comes time to set management objectives and performance targets.

Figure 4. Despite much larger sales volume, Big Co. is in danger of being overtaken by New Co. in competing for value. Source: L.E.K. Consulting. (click to enlarge)

For example, Big Co., an intravenous-fluids-delivery company, despite having the benefit of much larger sales volume than its key competitor, New Co., was being overtaken by the latter in the competition for value (see Figure 4). To understand where and how the company was losing out, top executives at Big Co. undertook to benchmark its performance against New Co. on key value drivers.

Figure 5. Despite its smaller scale, New Co. had lower cost ratios for SG&A and R&D. Source: L.E.K. Consulting. (click to enlarge)

The analysis showed that both companies had similar gross margins, but that New Co. had both lower SG&A and lower R&D costs as a percentage of sales (see Figure 5). This was surprising to Big Co. executives because the functionality of the companies' products was similar, and they expected Big Co. to have lower SG&A and R&D ratios because of its ability to spread these costs over a larger sales base. Rather than simply relying on arbitrarily negotiated budgets for future performance, Big Co. executives could now set performance targets for key value drivers based on competitive benchmarks.

Accurately Determining Value Contributions

As discussed above, understanding and benchmarking key value drivers at an aggregate level provides important insights on how medtech executives can improve their company's shareholder value. However, medical technology businesses are not homogenous; they have different regions, product lines, and customers—all with varying characteristics, performance, and needs.

Figure 6. Value performance for Big Co. varied widely across regions. Source: L.E.K. Consulting. (click to enlarge)

Figure 6 provides an indication of the value contributions of the different countries served by Big Co. The horizontal axis shows the different countries, scaled according to sales. The vertical axis displays return on capital employed, which is calculated by dividing pretax and preinterest operating profit by fixed and working capital employed in the region. The countries delivering returns above the cost of capital are currently creating value for shareholders. Attempting to increase sales in those countries that are operating below their cost of capital will actually destroy shareholder value if performance does not improve.

The fact that so many countries were not contributing to shareholder value was a major surprise for Big Co. executives. Previously, regional performance had been judged primarily on a gross-margin basis, and it was only after appropriately allocating all overhead and R&D costs that the true picture became apparent. In the case of R&D, Big Co. executives found that only a small proportion of spending was attributable to new-product innovation. The bulk was spent on customizing software and operating systems and meeting local regulatory requirements in the many different countries served.

Going back to the comparison with New Co. revealed that New Co. had a much more focused regional strategy. In fact, rather than spreading itself across many countries, New Co. focused on three major markets. Further investigation revealed that New Co. was effectively operating at a scale advantage compared with Big Co., despite being only half the latter company's size in total sales.

Conclusion

Creating shareholder value requires identifying and managing those drivers that have the greatest effect on value and are within company management's influence. Knowing the value contribution of each activity and product line can enable medtech executives to better allocate scarce resources among competing activities, and emphasize those projects and activities that generate the most value.

It is important for medtech executives to manage shareholder value actively—even when their companies show solid growth. Creating long-term value is by no means inconsistent with growth, but managing to a company's growth targets at the expense of value creation will jeopardize shareholder returns.

Figure 7. The top value creators in the medical technology industry have rewarded their shareholders with huge payoffs. Total shareholder returns indicate a starting value of $100 invested on January 1, 1991. Source: Wall Street Journal Shareholder Scoreboard and L.E.K. Consulting. (click to enlarge)

The potential payoff is huge for shareholder-value–focused medtech companies, as Figure 7 makes clear. The top companies in these medtech industry segments created value for shareholders many times above and beyond the value created by the average company in each segment.

Such shareholder-value growth is possible if medtech executives have the wisdom to make the most of all value-creating opportunities by doing the following.

• Understand how value is created in their company.
• Identify and quantify their company's key value drivers—those performance measures that have the biggest effect on value.
• Manage key value drivers to exceed competitor benchmarks.
• Use this information to drive management focus, allocate investments, and set marketing priorities and pricing decisions.

Stuart Jackson is vice president and head of the Chicago office of L.E.K. Consulting (Boston, Los Angeles, Chicago, and San Francisco), a business-growth strategy consulting firm that specializes in corporate strategy development, mergers-and-acquisitions valuations, and shareholder-value consulting.

Copyright ©2002 MX