Originally Published September 1999
MARKET ANALYSIS
Street Beat
From Main Street to Wall Street, the world has its eyes on the advancing markets in medical technologies.
Thomas J. Gunderson
Over the past two years, Wall Street has been conducting a very public love affair with large-cap stocks. The repercussions of such focused attention to market cap have been magnified among medical technology companies.
Consider the U.S. Bancorp Piper Jaffray medical technology indices (see Figure 1). Year-to-date, the large-cap stock index has increased 11.24%, while its small-cap counterpart has declined 0.4%. Performance over the trailing 12 months is even more one-sided: large-cap med-tech companies are up 24.2% versus the 5.5% decline of their small-cap counterparts. To put these numbers in perspective, the technology-heavy NASDAQ index increased 27.4% and 44.0% over the same respective periods.
Figure 1. The U.S. Bancorp Piper Jaffray medical technology indices for January through June 1999 illustrate Wall Street's current favor toward large-cap companies.
For the medical technology companies that populate Main Street, a large company means marketing clout in the form of capacity to collect cost-effectiveness data, cash flow to endure the product approval process, global distribution potential, opportunities to bundle core products with "hot" products, and a leverageable sales force. Ultimately, larger size means greater profitability.
For Wall Street, larger company size means liquidity—the flexibility to move into and out of stocks easily. Large, liquid stocks enable fund managers to place large "bets" that can make a difference in the performance of their portfolios, enabling them to meet their return targets with as little risk as possible.
Wall Street love affairs never last forever; already, the second quarter of the year has shown the beginning of a trend in favor of small-cap stocks. Even so, Wall Street investors consider company size an important factor in valuing medical technology companies. The size of a company not only determines its current profitability, but also its potential for growth. The pervasive influence of company size can be plainly seen in the different ways that large and small companies are affected by trends in four key areas: consolidation, globalization, regulation, and reimbursement.
Consolidation
Mergers and acquisitions have been a major part of Wall Street's mantra for the past several years. In 1998, this chant rose to an even higher pitch, as medical technology companies engaged in 28 mergers worth $27 billion—more than double the previous year's dollar volume of $13 billion on 26 deals.
For medical technology companies, such deals offer a strategic means to enter new markets, capture market share from competitors, leverage synergies, and cut costs. For the most part, Wall Street likes mergers and acquisitions. Investors assume that small medical technology companies grow big—and big medical technology companies grow bigger—by aligning with one another, more often than not through acquisitions.
Alliances among large companies achieve growth by eliminating duplication while continuing to increase sales. Such newly combined entities are able to leverage the potential for cross-fertilization of ideas and products, as well as the power of their united sales teams, to form a dominant force in the marketplace. Often, such mergers create the critical mass needed for a company to be competitive on a higher level, or to open global markets for the new company.
The current market encourages large companies to play a role in supporting venture-capital and early-stage public companies, in the hope that one or more will prove profitable. Wall Street insiders appear to believe that such investments are an efficient use of capital and time.
When large and small medical technology companies align, the roles played by the partners are very different. Small companies are frequently more entrepreneurial than their larger counterparts, and it often becomes their role to serve as new-product skunk works for the parent entity. In return, the small company gains distribution clout as well as access to an established sales and marketing program.
Globalization
Countries outside the United States can offer new markets for all medical technology companies seeking growth. Often, a European product launch can offer insight into the U.S. market potential for the product.
When it comes to assessing the global potential of a medical technology, however, international experience is not always the bellwether that companies and investors seek. For instance, European product launches of stents and catheters accurately signaled their success in the United States, while launches for spinal fusion cages and alternative wound-closure products indicated quite the opposite fortune. For imaging and other computer-based, personnel-reducing technologies the jury is still out as to whether foreign and U.S. demand curves are aligned.
To Wall Street investors, expansion abroad certainly fuels desire for growth. Large companies are most likely to be rewarded for such expansion outside the United States. By contrast, smaller companies are likely to experience intense scrutiny, as investors look for any sign of weakness in the companies' ramp-up of European sales.
Regulation
From Wall Street's perspective, the product approval process at FDA's Center for Devices and Radiological Health (CDRH) was out of control for many years. However, recent reforms have transformed the process into a more understandable and quantifiable sequence of events. Investors have applauded these changes because they make it easier to calculate the potential risks and rewards that may be involved in a particular product's development and approval to market. In short, FDA is the devil that investors know—and are learning to love.
By far the loudest applause has gone to FDA's ongoing efforts to speed up review times. Investors love numbers, and the 1998 annual report of the CDRH Office of Device Evaluation (ODE) offered some welcome metrics. Last year, ODE set a record by approving 39% of its premarket approval (PMA) applications in less than 180 days, and 79% in less than 360 days. Compared with the one to five years that the agency was taking to process PMAs not too long ago, the new figures are encouraging.
Nevertheless, from the viewpoint of a company seeking to get a product to market, the timeline has changed very little. By imposing heavier data requirements up front, the agency has merely shifted a portion of the time required for product development into the manufacturers' portion of the timeline.
Of the four areas discussed in this article, FDA regulation is the one least affected by a company's size. Because the agency's product approval process is similar for all companies, regardless of size, it represents a level playing field on which new technologies can seek to make their mark.
Because FDA's approval process takes time, potential competitors inevitably become highly visible. Such visibility offers both potential investors and competing companies ample time and information to assess the impact of new entrants to the marketplace. With such intelligence in place, established companies can often make it very difficult for a newcomer to capture a significant market share. And although FDA's playing field may be level up to the time that product approval is granted, large companies may still be able to launch products with enough marketing and distribution power to deliver a knockout punch to smaller competitors.
Reimbursement
The issue of reimbursement is cluttered with anomalies, and is sufficiently complex to worry even the most seasoned CEO, venture capitalist, or Wall Street investor. It is a highly unusual twist of modern capitalism, for instance, that the market prices of medical products are determined not by their ultimate consumers, but by third parties. But whatever its oddities, the current reimbursement system has enormous influence in determining the success of a company and its products, and Wall Street has learned to pay attention.
When developing new products, companies can either enhance an existing technology that already has current procedural terminology (CPT) reimbursement codes, or create an entirely new technology with new CPT codes. The first path is easier, but entails the risk of attacking an established market. The second path may have greater potential for profit, but can lead to a dead end unless company executives have the missionary zeal needed to sell their products to many constituencies, including third-party payers.
Investors want to be able to quantify such risks. But in the muddy waters of reimbursement—centered on the perennially "bankrupt in the year 20XX" Medicare system—risk has proven anything but measurable. The inability of Wall Street to quantify the risks inherent in the reimbursement process has begotten a fear that has driven many a potential investor away from medical technology stocks.
At least some types of reimbursement-related risk have been reduced in the past few years. For example, the risk of a rate-limiting socialized medicine system, which was palpable during the early years of the Clinton administration, has virtually disappeared. Americans, it is fairly clear, do not want socialized medicine. And even in the HMO-heavy environment that has grown up in the past decade, there has been some easing of pressure for rate reductions. Payers are moving away from the "how-much-can-we-cut?" model, and showing interest in a more-balanced approach in which there is a willingness to pay for value.
Such a balanced approach may eventually relieve rate-cutting pressures, but in the meantime Wall Street investors (and payers) want hard numbers to justify their decisions. For a new technology, they want to see definitive cost-effectiveness data up front, and they have learned to ask "Who will pay for it?"
In anticipation of such questions, more and more companies are starting to conduct concurrent trials of their products—one for safety and efficacy, and one for cost-effectiveness. Carrying out such extensive testing requires significant resources, and therefore tends to favor larger companies with deeper pockets.
Conclusion
A company's size is important in the arena for new medical technology because of the increasingly time-consuming and expensive process of conducting concurrent cost-effectiveness, clinical utility, and clinical outcomes trials. In the near future, at least, the ability to develop breakthrough technologies will tend to be found mostly among companies with deep pockets, a factor that favors large companies.
On the other hand, smaller, entrepreneurial, pedal-to-the-metal companies will continue to be the wellspring for innovative medical products. In such an environment, large and small firms will have abundant opportunities for alliances that can create efficiencies for medical technology companies and opportunities for investors.
Thomas J. Gunderson is managing partner and senior analyst for U.S. Bancorp Piper Jaffray (Minneapolis) and a member of the Medical Device Executive Portfolio editorial advisory board.
