Originally Published MX January/February 2006
COVER STORY
Resounding SuccessInterview by Steve Halasey
Medical device executives continually strive to identify new technologies with clinical value and untapped market potential. When they succeed, the result can be a set of market-changing products that offer significant benefits to healthcare professionals and their patients. Sometimes those products even constitute a solid foundation for an entirely new company.
That's certainly been the case for SonoSite Inc. (Bothell, WA), the company that pioneered the development of hand-carried ultrasound devices for clinical applications and has taken a leadership role in developing the markets for such devices. SonoSite's systems rely heavily on advances in application-specific integrated circuits (ASICs) that were initiated during the 1980s and 1990s by its parent company, ATL Ultrasound. In the early 1990s, when ATL became the industry leader in using ASIC technology to drive ultrasound systems, the company began to investigate the possibility of condensing large, cart-based systems into smaller units.
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| SonoSite president and CEO Kevin M. Goodwin on fast growth and great prospects for hand-carried ultrasound |
Now president and CEO of SonoSite, Kevin M. Goodwin took charge of ATL's hand-carried ultrasound research project in February 1997. A little more than a year later, in April 1998, he presided over the spin-out of the project to form SonoSite, a new company launched as a public entity before it even had a working prototype of its product. Goodwin admits that the move was a risky one. "Although we had a strong hypothesis that the device could be generally useful in medical applications, we had no clue who would want to buy it—if anyone," he says.
ATL was acquired by Philips Electronics in October 1998, forming the basis of what is now Philips Medical Systems (Andover, MA). At almost the same time, SonoSite's engineers unveiled the prototype of the company's first-generation hand-carried ultrasound system, the SonoSite 180, which was launched commercially in September 1999.
Since then, SonoSite has advanced the technology base for hand-carried ultrasound to a third generation, embodied in its latest system, the MicroMaxx, which was launched in April 2005. And along the way, the company has established itself as a market leader with a track record for rapid growth and prospects for continued innovation well into the foreseeable future.
In this interview with MX editor-in-chief Steve Halasey, Goodwin describes the roots of his company's dominance in the field of hand-carried ultrasound, how the company sets priorities to achieve growth, and the opportunities that lie ahead for expansion into both new clinical applications and new regional markets.
MX: You were with ATL Ultrasound when the company began to develop the technology that now provides the foundation of SonoSite. It's a chicken-and-egg question, but which came first for ATL, the technology breakthrough or the identification of a clinical need?
Kevin M. Goodwin: Technology performance led the move, and the main architect was Jacques Souquet, PhD, who was the chief technology officer of ATL in the late 1980s.
Interestingly, Souquet received his doctorate in acoustics from Stanford University, where his academic advisor was William Shockley, the inventor of the transistor. His academic cohort encompassed a number of people who have become very familiar figures, including Gordon Moore, Andy Grove, and Steve Jobs. While he was a doctoral candidate, in 1978, Souquet wrote a paper that predicted ultrasound would one day become a digital technology and would converge with silicon chips, and we would have an imaging stethoscope.
So Souquet started the whole movement of ultrasound toward digital beam forming, which involves using a transducer to send a sound beam into the body and then processing the microwave forms that bounce back into a single image.
For 10 to 15 years, ultrasound machines accomplished all this complex signal processing using analog circuits. But the result was that the machines got bigger and bigger because the more circuits they contained, the more information they could process and the better the resulting images. So ultrasound got big—and expensive.
What happened to disrupt the growth of ultrasound into even larger and more expensive analog systems?
In the early 1990s, Souquet pioneered ATL's move to displace the older and larger analog circuits by using digital circuitry. The circuitry was etched onto a silicon chip in a binary format—lots of zeros and ones—and then controlled using software. So ATL actually started introducing all-digital cart-based ultrasound systems in the early 1990s. As techniques for manufacturing integrated circuits improved, enabling more and more circuits to be put deeper and deeper on a silicon chip, Souquet started a skunk works project to develop an ultrasound device that could be carried. By the end of 1995, that skunk works turned into a project funded by the U.S. government's Defense Advanced Research Projects Agency (DARPA), to create a product for the military.
By the end of 1996, the skunk works team had pretty much concluded that it would actually be possible to develop a credible hand-carried ultrasound device for use in medical applications. Until then, it was uncertain whether the size constraints could be met or whether the image would be good enough for use in medicine.
After ATL had launched its skunk works and the technology was being developed, who made the connection that this was a project that might interest DARPA? Did DARPA come to you folks, or the other way around?
What actually happened was that the fellow in charge of military sales for ATL, Ron Dickson, began using a mockup of a hand-carried ultrasound system as a door opener for selling the company's large, cart-based systems. Pretty soon, all the Department of Defense (DoD) wanted to talk about was the hand-carried system. And soon after that, Souquet began flying around and talking to various people in the military, and those conversations eventually led to the DARPA grant. When SonoSite was spun off and Souquet became a member of the company's board of directors, Dickson was named the company's first vice president of sales.
One result of this background is that our very first product—and every one of our products since then—was built to satisfy military specifications (MIL-SPEC) for battlefield use. So, for example, all of the products meet military specs for waterproofing, durability, and reliability. Right now, the U.S. military and other militaries around the world account for several hundred systems.
Was DARPA's primary interest always for medical applications of this technology?
The DARPA grant came as part of the DoD's Battlefield 2000 initiative, which was intended to develop ways to reduce battlefield mortality through interventions during the so-called 'golden hour'—the hour immediately after a soldier is wounded. The idea was that if medical personnel could image a patient's thorax and abdomen during that first hour, they would be better able to save the patient's life. So the driving force was to create a device that could go in a medic's backpack and be used during the golden hour, even under battlefield conditions.
But along the way, we have always viewed the technology as potentially useful for a bunch of other industries. The Norwegians and Dutch have considered it for looking at cheese thickness. European Union authorities have studied it for noninvasive imaging of the stomachs of people suspected of trying to smuggle drugs by swallowing them. And there has been interest in the technology for nondestructive fatigue testing, looking at subtle cracks in load-carrying beams and similar components.
So a lot of other applications have been considered, and you can pretty much let your imagination run wild with all the possibilities.
How did you become involved with this project?
In December 1996, I had dinner with Dennis Fill, the chairman and CEO of ATL, and he asked me if I would be interested in taking over commercial strategy development for the handheld ultrasound group. I shifted over to the group in February 1997 and began doing research all over the place—internal, external, formal, informal. We just ran all over the world and tested out the notion of a hand-carried ultrasound machine.
Did you hesitate at all when you were offered the chance to lead the unit? After all, in December 1996 the technology wasn't quite proven yet and the project did not have a whole lot of money. It could have been a career-breaking decision.
In 1991, I had taken over a division of ATL's international business that was doing about $26 million a year in revenues. In 1996, after I had been leading the unit for five years, revenues had increased to something like $85 million or $89 million. So this new project seemed to be right up my alley, because I have that kind of entrepreneurial streak in me. Moreover, ATL's CEO felt that I was probably the right kind of personality to handle the project and, as he told me, just crazy enough to try.
What I did not anticipate was some of the challenges of leading the unit as a public company. Most people would probably say that SonoSite should never have been born public. We had a lot of learning to do, and we did it as a public company. That caused some moments of both joy and sorrow. But overall, taking over SonoSite has been a great move for me.
You've been at this a long time. Does it ever begin to wear on you?
It has been a ton of work since I started in February 1997, and it has been even more intense since we went public and I was born into a public company CEO job. But I am just as enthusiastic today as I was when we started. More so, in fact, because today we know more about the markets and more about the problems. We fit right into medicine's sweet spot, which is giving clinicians technology to help them solve problems without increasing expenses.
Federal funding usually comes with fairly specific requirements for the achievement of certain milestones. What kinds of expectations were placed on the original project?
There were milestones, as there always are. The most important one was that by October 1998 we had to have an imaging system designed against the assigned specifications. And in addition to solving the problem that the military specified, the company also had to put the technology to work commercially in order to create jobs. We did both.
When we put our first imaging system together, in October 1998, the company had about 35 employees. We all walked back to the engineering lab and watched the engineers turn it on and scan with it for the first time. You could've heard a pin drop, because the image looked a lot better than anybody thought it would look. That was a major breakthrough.
Since then, the company has increased its workforce to 470 employees. And we're probably heading toward 500 by the end of this year.
How much funding did DARPA contribute to the original project?
By the time SonoSite was spun out, ATL had probably spent about $20 million to develop the technology, before and after April 1998. DARPA picked up about $5 million of that.
Growing a New Company
At the end of 1997, SonoSite's technology was just beginning to take shape. But the company went public the following April, even before it had a working prototype. What were the factors that went into making that decision? Was it a difficult call to make?
It wasn't all that difficult, for a couple of reasons that ATL's CEO wisely recognized. First, inside a large, cart-based ultrasound company, a technology project like this would probably be killed off or at the very least held back. Disruptive technologies such as these never see the light of day if there is any risk that they might cannibalize the company's core business.
Second, in order to move the needle forward, we needed to spend more money on the new business. That need was inconsistent with ATL's focus on increasing its profitability.
Once the spin-off decision was made, the CEO wanted to ensure that the investors who had supported ATL for such a long time would get full value out of this fledgling technology. So he orchestrated a spin-off whereby all those shareholders ended up with a tax-free dividend. For every three shares of ATL they got one share of SonoSite.
So there we were: born public. It wasn't by any means a snap decision, but in the long run I think it was a very good decision. The company went through its first four or five years trying to figure out what to do, where to do it, and how to do it. And in 1998 it showed in our average market capitalization, which was maybe $50 million at the most.
Today, the company has a good sense of what it is doing, and with three generations of ASIC technology behind it, there's a lot to work with. The company's market cap is $575 million, and we're really still just getting started.
In those initial years, how did the company go about figuring out how to commercialize its technology?
During our first three or four years, we went through an intensive phase of excavating market opportunities. Although we had a strong hypothesis that the device could be generally useful in medical applications, we had no clue who would want to buy it—if anyone. A lot of people told us that if the device could do such-and-such, it would change everything. But we weren't sure who would write a check for it.
So we did a tremendous amount of excavating and market learning—learning by doing. We studied all the disruptive innovation research done by Clayton M. Christensen, DBA, a professor of business administration at the Harvard Business School. In fact, Christensen became kind of an informal adviser to the company.
Ultimately we found a number of different customer groups that were most interested in the technology. We established market traction, and today clinicians in a wide variety of specialties are either using the technology or want to use it. Users range from radiologists, who are the traditional users of ultrasound devices, all the way to internal medicine specialists, who are starting to use SonoSite devices for assessing cardiovascular disease risk.
What kind of intellectual property (IP) foundation was provided for SonoSite, and under what terms? For instance, did ATL retain any ongoing shares in the new company?
As part of the spin-out we executed a very specific licensing agreement for market rights to our technology and intellectual property. The market rights were defined in two areas: hand-carried ultrasound, which are devices weighing less than 10 lb, and highly portable ultrasound, which are devices weighing under 15 lb. Within those two defined categories, we have full use of all the pertinent technology and IP that ATL developed through April 2001—that is, three years after the spin-out.
ATL did not keep any equity in the new company, but it has been getting royalty payments. The rate of the initial royalties was set at 3%, dropping down to the current rate of 1.5% after a few years and eventually ending altogether in September 2007.
ATL launched the spin-out by providing us with $30 million in cash. It also performed a bunch of paid services for us, including manufacturing. So although we started with $30 million cash in hand, we paid a high percentage of that back to ATL over the first 18 months of the company's life. By the end of 2000, we had pretty much broken all the cords and were essentially on our own. We stopped buying services from ATL and started our own manufacturing operation, which has helped the company immensely.
Now that ATL is part of Philips, a key competitor, is it a little galling that you are still paying royalties to that firm?
Not really; that's just part of the process of being spun off. The bottom line is that it is what it is, and SonoSite is moving forward to make the most of its independence.
What kind of response did you get when the public spin-out was announced?
It was quite interesting as we went around and did our road show for public shareholders. On the final day of the road show a major investor said to me, "Wait a minute. You are being spun off and you don't even have a product yet?"
And all I could say was, "Yes." Because at that point, we knew that we could produce the product. But of course we did not have one yet.
Beyond the initial capital that ATL provided, what other capital did you have to work with?
Unfortunately, SonoSite went public in 1998, which was a terrible year for small-cap medical device companies. That year, in fact, I remember people saying that investing in a small-cap medical device stock was like going into a roach motel: once you get in, you can't get out. But we raised money in 1999 and in 2001, and we even raised $45 million in the middle of 2002, which was one of the worst stock markets most people had seen in years.
All together, we have raised more than $140 million of capital in the public markets. I wouldn't say it was easy because it was a lot of work, but we did not have much trouble doing it. So today we have $65 million in cash, no debt, a very strong asset base and balance sheet, more than $100 million in annual revenue, 25,000 installed systems, and 470 employees. That's a pretty strong foundation for future growth.
One other asset that has been very important for the company is having an excellent board of directors. Building a strong board is the one thing I was encouraged to do right from the beginning, and we have been fortunate in being able to pull together just such a group.
Once SonoSite was independent, how did you prioritize your spending to grow the company and expand adoption of the technology into the variety of fields that you wanted to enter? In what order did you scale up the varied types of personnel that the new company required?
First we had to make some decisions about our market priorities. In 2000, we were selling to probably 25 different markets just because that many markets were interested. But during the course of that year, we whittled down our efforts to focus on just four core markets. In 2001 and 2002 we expanded our reach to six markets, and today we are focusing on just six to eight areas that I would call core markets.
Second, from a technology standpoint, we knew that we would need to turn over our ASIC chips to a new generation every two years, because that would enable us to increase performance while minimizing the size and cost of our devices. So, for example, our second-generation ASIC chips improved overall ultrasound performance and capabilities by about a third over our first-generation systems. And the third-generation products that we began releasing earlier this year represent a performance improvement of about four times over the second-generation products. Knowing that these technical improvements would enhance the marketability of our products obviously made them a high priority for company spending.
We've been helped in that second effort by having an engineering group that has done a very good job of making its schedules. We decided early on that it was not a good idea to permit senior management to legislate the schedule for engineering achievements. Instead, we have empowered our engineering group to set an aggressive schedule and take responsibility for meeting it. Since SonoSite has been independent, I don't think our engineering group has ever missed a schedule.
But otherwise, prioritizing the use of the company's resources has flowed rather naturally. We started off with an engineering capability to drive the company. By the end of 2000 it was clear that we should build up a manufacturing capability, so we did that. In 2000, we started adding sales capabilities in the United States. In 2001, we expanded those capabilities into the UK, and in 2002 we went into the rest of Europe. Today we are in 75 markets. Direct sales in nine of those markets, including the United States, contribute about 70% of the company's revenue. In the rest of the markets we sell through dealerships or strategic partnerships.
Because we had the capital and could take advantage of what we were learning, each year we added different parts of the business equation. We have a marketing capability that is getting better. We have a customer education capability. We have our own internal regulatory capability, and along the way we hired a general counsel who has helped us immensely. The company also has a pretty substantial medical relations function that works with all the physician organizations and payers.
So today we are a fairly well integrated company. And a lot of the credit for that achievement goes back to our board's advice on when and how to raise capital, and its advice to take a long-term view.
Many of the members of SonoSite's management are former ATL folks. Have you known most of the team for a long time?
A fair number of them, yes. The people who have come in and worked for SonoSite have helped us move the needle from zero to a certain level. But to find the kind of talent that is capable of taking the company up to a much higher level, we really needed to expand beyond the ultrasound business. So more and more we are recruiting people from outside the domain.
So, for example, our senior vice president of U.S. sales comes from the pharmaceutical industry, from Immunex. And our new senior vice president of marketing, Tom Dugan, has enjoyed a very distinguished career outside of ultrasound as a senior vice president of marketing and business development.
Today, I would say that SonoSite probably has the healthiest mix of ultrasound and nonultrasound people that it has ever had.
Balancing Financial Priorities
What was the company's financial performance like after the 1998 spin-out?
In our early years, a lot of the big ultrasound companies scoffed at us. They thought we would never be able to pull off the technology successfully. And if we did, they said, no one will ever buy it.
As we headed into 2000, we forecast that we would achieve $50 million in sales revenue. We ended up doing $32 million, and we thought that was terrible. But it still put us in the top 5% of first-year medical device companies.
In prioritizing SonoSite's growth strategy, were there ever any decisions that you felt were particularly risky—ones that could have taken the company down the wrong track or cost a lot of money?
When we launched our first product, in September 1999, we started out by using a distributor to sell our products. We did that for two quarters, and pretty quickly realized that it was a major-league wrong decision. So the good news was that we exited that decision pretty quickly.
But when we started direct selling, in February 2000, we did not know whether we would be able to gain any traction. We hired 28 people, and that year they produced about $8 million in revenue. By the end of that year, we figured out that we needed to focus on a smaller number of markets, and we needed about twice as many reps as we had originally hired. So in 2001 we doubled our sales force and produced $23 million in revenue—a 3X gain. In 2002 we moved up to $45 million in revenue, and we have been stepping up every year since.
The early stages of that decision to begin direct selling was certainly one of the company's scariest moments. We were already trying to figure out how much cash we would have left if it didn't work, if customers couldn't be enticed to buy our devices. But that was the only decision that I would say was really daunting.
SonoSite currently has similar distribution relationships overseas, but it is starting to convert those to direct sales. Is that correct?
Yes, at least in those markets where we think there is enough scalability to make it worthwhile. So we have migrated toward direct selling in Australia, Canada, France, Germany, Japan, Spain, and the UK because that approach works best. In those markets, it is more effective to sell directly, using our own people, and to focus on the particular customers we're most interested in reaching. And we're able to sell at high gross margins.
In the markets where we're not selling directly, it's usually because we don't think there is enough market, there is too much risk, or we're just not ready. In China and India, for instance, we are setting up representative offices from which our local employees will manage local distributors, but we won't have our own direct sales people. Those markets either have too much risk or we are just not ready to go direct yet.
Our approach has worked pretty well. And as our direct sales organizations become more effective and efficient, the company's revenue growth and profitability will both be improved.
Where does the company execute its manufacturing?
Our circuit boards are built for us in Thailand by a firm that is one of the largest OEM microelectronics manufacturers. But we do all our own systems assembly, testing, configuration, and software enhancements here in Seattle. We also build our own transducers, which are very important parts of the equation.
How did you decide to source your IC components from an overseas firm?
This company manufactures for many major names in the tech field. We got a ticket to the dance because we had made enough progress as a company. Because of the nature of our business and our level of success, our circuit board volumes allowed us to tap into that upper end of the supply chain. The benefit is that we get the lowest possible cost on circuit boards.
When did you first begin to suspect that your product was likely to become a commercial success?
Almost from the first moment that we began shipping product. From the very beginning, we have received stories that are just amazing.
We first began testing our product for emergency medicine applications at the Oregon Health and Science University (Portland, OR). One day, we received a call from Dan Price, MD, who was in charge of the emergency room and was testing the product. He told us that a little girl had come in with bruises all over her body, and he was so convinced that she was a victim of abuse that he was just about to call in Family Services. But he used our device to take a quick look at her abdomen, and he discovered an abscess. After further testing, he determined that she had leukemia.
Another emergency room episode involved a woman in Texas who presented with abdominal pain. The resident obstetrician/gynecologist turned on his SonoSite device and seconds later—because MIL-SPEC requires rapid booting—was able to confirm that the woman had an ectopic tubal pregnancy. He took her straight to the operating room, and later commented that if he had waited any longer he would have had to give her a blood transfusion.
At the University of California, Irvine, Medical Center, a 19-year-old kid was brought into the emergency room and presented as dead on arrival. But the attending physician used a SonoSite device to look at his heart real quickly, discovered that there was still some activity, and then determined that he had a tear in his heart. The hospital stabilized him, and the kid walked out of there three days later.
We have received literally hundreds of stories like that. That's one of the reasons that our growth hasn't been linear, because all on their own people keep finding places where this technology can make a valuable contribution.
Since we started the company, we have built up a ton of fans. Our original military customers love the product. The devices we delivered for use in Iraq were intended for deployment in MASH units; but the military has actually moved them forward into battalion aid stations, which are closer to the battlefield. And everywhere I visit in the marketplace, it seems I'm always bumping into someone who says, ‘Yes, I was there at the beginning. I have been rooting for you guys.'
How has SonoSite gone about penetrating clinical areas that have not traditionally used ultrasound devices?
This particular category in medicine is unusual because it is not just about ultrasound. Clinical ultrasound used to be its own discrete industry whose customers were concentrated among three physician groups: radiology, cardiology, and obstetrics and gynecology. Now, the availability of handheld ultrasound devices is broadening its role in medicine. This diffusion has resulted in all kinds of market opportunities, and that is really what has been driving the business.
The diffusion of our devices is a lot like what has happened in computing. You see hand-carried ultrasound units adding value in a lot of different settings. But the difference is that people aren't buying our devices as systems, the way an ultrasound department would buy a system. Instead, they are buying our products to use for one to four specific applications. So sales growth is very much driven by increases in the number of applications for which the technology is adopted.
Do you think the physician office market offers a natural area for growth?
Yes. There are only a lot of wins; there are no real losers here. Wherever it's used, this technology is very beneficial. Having an endocrinologist look at a woman's thyroid on her first visit is very beneficial.
In the breast cancer arena, a woman with a palpable lump gets referred to a surgeon. In the old days, it took as long as 50 days to get a diagnosis. Now, the breast surgeon can look at the lesion with ultrasound and, if need be, perform a biopsy right there in the office. This reduces the wait time by as much as half.
Amazingly, with all the money we spend on healthcare, it is still unusual for doctors to look at their patients' carotid arteries and aortas to make sure they are in good arterial health. But subtle changes in the thickness of the carotid arterial wall are a great predictor of whether a person is going to develop arterial plaque in a few years. In five years, we think it will be a common practice for primary care physicians to perform this kind of testing. And SonoSite expects to drive the adoption of this practice by offering devices that are simple, efficacious, easy to use, and cost-effective.
There are a bunch of physician-office applications like these that are being explored. Some we aren't working on yet, and a couple of others are confidential.
When it comes to adopting ultrasound for new applications, how responsive are physicians? If you decide to educate a certain specialty area about new possibilities, do you see an increase in uptake there as opposed to other fields?
Yes. That's the thing about this that is so exciting. The more we educate, the more uptake we get. We have concentrated on hospitals. Hospitals have the highest level of physician traffic, and that is where the uptake has been the best. In looking at the clinical markets and considering how many physicians and hospitals are out there, our penetration is still pretty marginal. But it is growing rapidly. We haven't spent as much time focusing on the physician-office market, but we will in the future. That should ramp up our growth.
Have you experienced market pull from a variety of different areas?
Yes. That is why we have brought in a professional marketing director who has medical device experience. We are building our marketing capabilities in the company. In the next three to five years, I anticipate a market-driven expansion of our business.
With such a wide variety of potential applications, how do you manage to characterize your customer base?
Generally speaking, the people who want to use a hand-carried ultrasound technology have a very specific task in mind. Some time ago, for example, an independent study concluded that one of the top ways of improving patient safety is to use ultrasound to guide the insertion of central venous catheters, which are placed in a patient's neck, and peripherally inserted central catheter (PICC) lines, which are placed in a patient's arm and used for long-term intravenous therapy. Five years ago, those procedures were simply done blindly using the landmark method. Then there was a time when putting in a line meant either moving the patient to an ultrasound unit or wheeling a big ultrasound machine up to the patient's bedside. Today, providers are using SonoSite's hand-carried units, and it's clear that this is becoming a standard practice.
The same thing is happening for other invasive procedures that require guidance. For instance, hand-carried ultrasound is being used to guide regional nerve blocks, where pain medication is delivered via a needle inserted in the patient's back, leg, or other parts of the body.
SonoSite's devices are being used all over medicine. In almost every application, these devices help to improve patient safety and increase patient throughput and the overall efficiency of the healthcare system. From the user's point of view, the cost of these devices is very viable, especially since their use is generally covered through existing common procedural terminology (CPT) codes for ultrasound procedures.
Self Study
To keep control of your efforts, do you sometimes have to make tough decisions about the kinds of studies you participate in?
Yes, we do all the time. We have a lot of physicians groups that come to us and say, 'Hey, over here! We would love to do XYZ. We think you should be doing this. This will change everything.'
Does SonoSite sponsor its own clinical trials, or is it primarily supporting others who are studying its products?
We encourage entrepreneurial and innovative medicine, and we periodically support small, simple studies. An increasing part of our portfolio is sponsoring application-specific trials of various sizes. For example, a New York hospital conducted a study of the use of ultrasound on inbound patients for triage, and it had some very nice outcomes. There was a time-and-motion study done in Germany comparing our device with a cart-based ultrasound unit in terms of saving time. There was a study done in a hospital in the UK in which they used our device to reduce queuing in their public healthcare clinic. All the outcomes have been excellent, very favorable to SonoSite.
In addition to working with individual physicians and their hospitals, is it part of your planning to work with various medical specialty societies?
Absolutely. The company has developed a strong capability for establishing medical society relationships, and we are very active in doing so.
Along the lines of the time and motion study you mentioned, many observers are now suggesting that medtech companies can speed adoption and improve their reimbursement positioning by conducting more cost-effectiveness studies of their products. Is that an area in which SonoSite is active?
Yes, informally. A lot of people are doing a lot of different things with our products. A hospital on the West Coast has 27 of our systems, and it is still buying them. That institution has done a variety of studies and has determined that its outcomes are much better and patient safety is improved when staff use our devices for certain applications. We see that happening in a lot of places.
We are just at the beginning of shifting from being a technology-push-driven company to a market-pull-driven company. More and more, we're looking at market problems and applying our technology to solve those problems. There are plenty of problems to solve, and there are plenty of segments out there interested in working with us.
The SonoSite Web site offers physicians guidance about how to code for reimbursement. What kinds of regulatory and reimbursement challenges has the company faced?
We have had a few problems. For example, in the women's breast surgery arena, not every commercial payer reimburses surgeons for performing an ultrasound procedure in the office. Sometimes that procedure is carved out for radiology, which is a policy that doesn't really put the patient first. But we have worked with the different payers and have had some success in changing their policies. Blue Cross of Michigan is one example.
In 2003, some of the Medicare carriers decided they weren't sure they were going to reimburse hand-carried ultrasound anymore. That was due to a lack of information about our technology's applications and what it could do. The carriers did not realize the true capabilities of our ultrasound systems and the fact that they can provide a complete ultrasound exam. Eventually, we were able to get that problem remedied. In fact, the process of educating those carriers turned out to be a very positive learning experience. It made us realize that reimbursement considerations need to be one of our priorities.
Is SonoSite's current study of physician office assessment of carotid atherosclerosis intended to lead toward completely new clinical applications and common procedural terminology (CPT) coding?
Yes. That is an example of an area where we will indeed one day pursue new coding once the data proves what our hypothesis suggests to be true. That hypothesis is that this application for measuring carotid intima media thickness (IMT) is valuable and will directly affect outcomes. We think IMT measurement could be a standard of care one day in terms of fundamental patient management in cardiovascular disease.
The Next Generation
SonoSite was launched on the basis of some significant intellectual properties (IPs). How has the company developed those and what do you see as the key IP achievements of the company since it was spun out?
We started off with about three patents and six pending. Now we have 35 patents and a number of others are pending. On top of that, we have built a tremendous amount of know-how while building our patent portfolio. I'm not sure which is more important: the legal IP or the actual know-how. But the know-how is what really allows us to go forward and conquer.
We have built strong technology capabilities, including both tangible and intangible IP. Our engineering department itself is well equipped with very good people. We have worked hard to retain them and to build-in longevity. All these considerations provide a strong backbone for technical innovation.
SonoSite's big news in the middle of last year was the launch of its third-generation system, the MicroMaxx. How long will it take for the company to attain broad penetration and adoption with that system?
As I've told some of our investors, we are not selling iPod nanos here. It is going to take us a full year, starting in the second quarter of 2005 and running all the way to the second quarter of 2006, to get the technologies fully launched in all the geographic markets in which we are interested. For example, we launched the product in Japan at the end of 2005, but we won't start launching it in China and the remainder of Asia until the second quarter of this year.
Meanwhile, we are also going to improve the product. We came out with a very solid product, and we have some very interesting innovations coming up for it that we think will be exciting.
And already the company has released several upgrades of the device, including a wireless capability.
Yes. We issued several upgrades at the end of 2005, and we expect to release two or three upgrades in 2006 as well. The wireless capability is designed around the needs of one particular market. We intend to use that capability to help that market get better at using our technology and position itself to grow faster.
Does SonoSite's intent to update its chip base every two years or so also set the pace of the company's pipeline for future products?
Yes. We have introduced a new chip platform about every two years. If you compare the first generation of our products with the second generation, you see a total changeover, not only in the product itself, but also in the pedestal for when it is used in a stationary manner. We added a lot of resident capabilities on that pedestal, or docking system. If a person bought a docking system, it had quite a few nice things on it.
As we move to generation three, the customer is able to keep the docking system and just buy or trade up to the new imaging system. It's like a dock for a computer. There are a lot of capabilities on it. New laptops can be plugged into it, and it provides substantially more capability. We build forward-looking technology into our products.
Because we are developing an ultrasound product line at much the same rate that personal computers evolve, we usually launch meaningful upgrades every six months and new platforms every two years. For example, we launched the MicroMaxx in the second quarter of 2005. We followed that with a major, meaningful upgrade.
Technology Challenges
What percentage of revenues does SonoSite currently invest in R&D?
Historically, it has hovered between 7 and 9%. But we don't really think about it in terms of revenue percentage. We do it on a project basis by examining initiatives we want to pursue. That is what drives our decisions.
The bigger challenge is that we have an abundance of market opportunities, and every year we have to decide which ones we are going to develop and which ones we aren't. For example, we are doing very well in the emergency-medicine market, as well as other acute-care and critical-care markets. But SonoSite has had to spend money up front to stimulate and educate those markets. We have to raise a market's awareness before we can reap the benefits of our investment. There are a lot of markets SonoSite could target, but there are only so many initiatives the company can fund.
The cardiovascular disease management domain is one we think is a very exciting long-term opportunity. By itself, that market could be bigger than the company is right now, but we are pacing our investment in that area as we grow.
What do you see as the technology challenges for advancing the field?
First, there is the staying-ahead challenge. We need to take our lead and maintain it, if not improve it.
Then there is the reinnovation challenge. That means throwing everything away, starting over, and redesigning the future as if it were five years from now.
Remember that ATL initiated its skunk works program in 1990 and formalized the project in 1994–1995. SonoSite shipped the first hand-carried ultrasound system in 1999. And today we are three generations deep into the development of hand-carried ultrasound.
Now the question is, 'What is going to be the innovation that redefines the architecture of ultrasound three or four years from now?'
Is the company's current R&D program designed to address that question?
That pretty much defines it.
What kinds of projects are helping you to develop your thinking about future applications for ultrasound?
We have seen this technology get used in a variety of arenas, including a research project with NASA Extreme Environment Mission Operations (NEEMO), which is a project sponsored by NASA and a Canadian agency to test astronauts' ability to use medical technologies in a submarine environment to simulate conditions in space. Our systems have also been used in other NASA projects and zero-gravity research projects. The technology has been applied all over the military in terms of mobile surgical units and in a variety of other areas.
It is another example of people saying, ‘Wow, I have a 5.5 lb or a 7 lb device that can do these things. I can now do XYZ in this environment.' People have used SonoSite's devices to diagnose mountain climbers on the top of mountains. The technology was used in the 2004 Indonesian tsunami rescue effort. We shipped systems down for Hurricane Katrina relief in New Orleans. When the earthquake hit Iran in late 2005, Massachusetts General Hospital donated some of our devices, and the relief workers loved them. The doctors in Iran were absolutely delighted with what they could do. We have also donated devices to organizations such as Partners in Health, which runs health clinics in Haiti.
Making New Markets
How does SonoSite prioritize its opportunities? What is your strategy for going after new markets, either regionally or in terms of clinical applications?
In clinical markets, the decision-making process flows through our marketing department. Then we line up our distribution capabilities with those markets.
Geographically—like deciding whether we should enter the market in China or India—those decisions are fairly easy because we know that we, as a company, want to be there for the long term. But we have taken our time in doing so. Otherwise, that process is something we constantly evaluate on a six- to nine-month basis, and we balance growth with structure and profitability.
In the past we invested in losses. Now we are investing in growth and profitability. For example, we want to grow our revenues 25% annually for the next three years and have our operating income grow at a much faster rate. So far, that is happening.
Is SonoSite's technology and market lead sufficient to enable it to remain an independent company for the foreseeable future?
Absolutely. We have all the assets of a large company. We have freedom to use as many as 200 Philips ATL patents in the realm of hand-carried ultrasound, which was part of the spin-off agreement. We have very good engineering talent. We have increasingly strong marketing and sales talent, including a large organization completely dedicated to hand-carried ultrasound. And we have a big balance sheet based on a commanding 60% market share in this category.
A couple of the big imaging companies are thinking about how to enter the market for hand-carried ultrasound. But it is a marginal new-product area for them, which they would have to pursue along with many other product areas. Two or three small companies are also thinking about entering the market, but they don't have the capital or the horsepower that we have.
The thing that matters more than anything else is that customers seem to like our company and its products. Every quarter we report the results of our customer satisfaction surveys to our board of directors, and so far these have shown strongly positive results.
Ultrasound machines are notorious for breaking—particularly the transducers. But our devices just don't break. And that's a novelty for medicine that our customers really appreciate.
Is the durability of SonoSite's products a legacy of the company's MIL-SPEC origins?
Yes, that's right. One reason our devices are so durable is because the ultrasound system is embedded in the chip, so the system is completely solid-state. In addition, our transducers were designed with a new process that is optimal for the military, so our failure rates are about one-tenth of the industry average. As a result, on our new high-end product we are able to offer a five-year warranty that is making a real splash in the marketplace.
For most major imaging companies, it would be a counterintuitive strategy to offer that kind of warranty, because those companies make their money on service. They hit customers over the head with very high fees for service contracts and for replacing transducers and so on. By contrast, we make our money on system placement gross.
Profitability and Beyond
SonoSite turned the corner into profitability in 2004 and expects to report the same for 2005. Does that achievement make it easier to prioritize spending and reinvestment in the company? Or, now that you really have money, does it make it harder?
It's always hard. It's a matter of probabilities. You have to assign a probability to your projected revenue—based on your pricing and margins—and then you have to decide just where and how much you are going to invest in order to capture that revenue.
At this stage, the changes just require much more discipline in how we manage going forward. But the management team is completely committed to being increasingly profitable, so that is the new task we are taking on.
Has profitability caused any change in investor sentiment?
SonoSite has enjoyed a strong cadre of long-term investors for a long time. A few investors that purchased stock in 1998 have remained very strong, and others have come in since that time. So we have a strong base of long-term money in the stock.
The company also has the usual amount of short-term trading investors. If things aren't perfect on a quarterly basis those investors tend to trade out, and then they trade in on momentum. And that's just true for all public companies.
Overall, SonoSite's investors are happy with the company's progress. Of course, they want us to deliver profits now along with growth. And that is what we are going to do.
In the future, do you expect SonoSite's overall growth rate to determine the pace at which it releases new technologies, or does the advance of the technology have a pace of its own?
I think the pace will maintain itself because we have a lot of technical assets that have been built cumulatively over time. The first generation of chips led to the second and third generations, and now we have four products out in the marketplace. So we have a lot of knowledge to work from and a lot of base opportunities that we can leverage—in addition to new technologies that we create. Overall, we are in a very good position that way.
How do you expect the investment community to view the future of SonoSite?
At SonoSite, we have certainly learned the hard way how to communicate with Wall Street regarding the company. We are an example of a company that you have to pay attention to in 6- and 12-month increments, as opposed to 90-day increments. Historically, if we had driven the company based solely on 90-day bites, we would have had a different outcome than we are having right now. We tend to think in one-, two-, and three-year swaths, and we really focus on our 6- and 12-month progress. That doesn't match up with quarterly reports, but so far, so good.
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