Medical Device Link.

Originally Published September 1999

MARKET ANALYSIS

Stock Watch:
Investing in Medical Technology

Seven medical technology sectors, including surgical robotics and stroke therapy, could deliver great gains in the coming years.

Carol Winslow

As a category for investment, medical technology is a relatively young industry. Twenty years ago, only a dozen or so publicly held companies existed; today, nearly 240 firms occupy the marketplace and are contributing to the explosion of new technologies designed to improve clinical outcomes and remove costs from the healthcare system. With healthcare currently representing approximately 14% of the gross domestic product, the medical technology industry today represents an exciting and substantial segment of the U.S. equity markets.

The Year Past

The year 1998 proved to be volatile and difficult for medical technology stocks. Channel Medical Partners' proprietary Medical Technology Index (see sidebar, page 28) significantly underperformed the overall stock market in 1998, declining 11.0% versus a 31.9% rise in the Standard & Poor 400 and a 16.2% increase in the Dow Jones industrial average. Large-capitalization medical technology stocks—up a healthy 22.2% in 1998—significantly outperformed the rest of the industry for the second consecutive year. All other market capitalization categories declined considerably during the year with midcap, small-cap, and microcap stocks falling 18.2, 7.5, and 18.1, respectively (see Figure 1).

Figure 1. Distribution of returns by market capitalization (1998). For the second consecutive year, large-capitalization medical technology stocks, up a healthy 22.2% in 1998, significantly outperformed the rest of the industry.

The strength in large-cap medical technology stocks is consistent with overall market trends and reflects investors' current preference for liquidity and momentum. Investors still have not forgotten the brutal sell-off in small-cap emerging-growth medical technology companies that occurred in June 1996 following the hottest initial public offering market in the industry's history. Since then, investors have largely shunned all but the largest companies in the group, creating an extremely difficult financing environment for emerging-growth medical technology companies.

The year 1998 was clearly one for stock pickers. Even among large-cap companies, price performance varied widely. Sofamor Danek Group (Memphis), Guidant Corp. (Indianapolis), and Alza Corp. (Palo Alto, CA) performed the best, rising 86.6, 76.7, and 64.2%, respectively. The poorest large-cap performers were Sybron International (Milwaukee) and Boston Scientific (Natick, MA), both of which disappointed Wall Street with their financial results, down 42.1 and 41.6%.

Among the 12 industry sectors in the index, ophthalmics, orthopedics, and drug delivery provided the best returns in 1998, rising 26.3, 20.9, and 19.8%, respectively (see Figure 2). In the ophthalmics sector, VISX (Santa Clara, CA) and KeraVision (Fremont, CA) led the way with increases of 295.3 and 124.5%. A ferocious spurt in consolidation activity drove the performance of the orthopedic sector, with Sofamor Danek Group, Exactech (Gainesville, FL), and Hanger Orthopedic Group (Bethesda, MD), the best performers, up 153.7, 86.6 and 74.8%, respectively.

Figure 2. Distribution of returns by sector (1998). Ophthalmics delivered the highest returns in 1998 with VISX (Santa Clara, CA) and KeraVision (Fremont, CA) heading the top-performers' list in the category.

The weakest sectors in the index were urology/gynecology and diagnostic equipment, plummeting 51.2 and 34.7%. Several companies in each of these poorly performing areas declared bankruptcy, suffered liquidity crises, or reported severely disappointing financial results.

The Current Environment

Three macro issues have and will continue to alter the competitive landscape of the medical technology industry, creating a more complex business environment:

Market-Led Healthcare Reform. The U.S. healthcare delivery system has changed tremendously during the current decade, to a great extent because large employers and for-profit healthcare service providers are demanding better-contained healthcare costs and high-quality care. For the most part, this process has been economically rational, although it is important to understand the changing financial incentives of the participants in the system.

Under the old fee-for-service model, healthcare providers were reimbursed fully by the patient's insurer or Medicare as long as medical charges were considered reasonable and necessary. This system offered no incentives to control costs or to deliver medical care in a cost-efficient manner. Indeed, it encouraged providers to deliver more care.

Today's managed-care model, however, caps reimbursement. Individuals or their employers pay a monthly premium to a managed-care organization, which agrees to provide all of the necessary healthcare services covered under the plan. Medicare also has implemented a capitated system; that is, providers receive a set payment each month regardless of how many patients are seen and which treatments are provided. Clearly, economic incentives have been added: Healthcare service providers now seek to provide medical care as cost-efficiently as possible.

This changing landscape in healthcare reimbursement has created enormous opportunities for innovation in the medical technology industry. The companies that will be most successful are those that develop products that shorten operating room time, reduce the length of hospital stays, and help decrease other costs of providing healthcare services while, at the same time, providing meaningful clinical benefits to patients.

It is important to distinguish medical technologies that are cost-efficient and clinically beneficial from those that are simply lower priced. Innumerable innovative new medical devices appear to be enormously expensive but are extremely successful in the marketplace. For example, the worldwide market for implantable defibrillators to treat often-fatal arrhythmias is currently approaching $2 billion and is dominated by Guidant and Medtronic (Minneapolis). Even though the cost of each device exceeds $25,000, these two companies have succeeded because the technology saves lives and reduces the average number of annual hospital visits for these high-risk patients.

Medicare Reform. The Health Care Financing Administration (HCFA), the agency that administers Medicare, has been scrutinized increasingly by policymakers and industry. HCFA's cumbersome national coverage decision process is often a greater impediment to the successful commercialization of a new technology or procedure than FDA's regulatory process. Even for new technologies that reduce the total cost of care and provide meaningful benefits to patients, establishing Medicare reimbursement can be a long and laborious process. For example, several less-invasive technologies for treating benign prostatic hyperplasia are significantly less traumatic to the patient than conventional transurethral resectioning of the prostate and allow surgeons to perform the procedure on an outpatient basis rather than as a surgical procedure often requiring a several-day hospital stay. Despite the fact that at least two of these technologies have been commercially available in the United States for almost two years, with well-established clinical benefits for the appropriate patient population, HCFA has still not made a national coverage decision for Medicare reimbursement.

Not unlike the pressure FDA faced during the past few years to streamline its product approval process, HCFA is now the focus of the efforts of a coalition of health industry trade groups working to make national Medicare processes more understandable, predictable, and timely. The group has made several recommendations to HCFA, including making the results of meetings publicly available, making public notices of requests for technology assessments by third parties, providing a reasoned explanation of the basis for a decision, and, importantly, establishing a maximum one-year timetable for making decisions. With the current political climate in Washington, it is likely that the Medicare coverage process will become increasingly predictable and that decision time frames will improve dramatically.

Accelerating Merger-and-Acquisition Activity. Merger-and-acquisition activity in the medical technology industry has continued and, indeed, accelerated throughout the 1990s. As Figure 3 illustrates, 1998 saw record merger activity as measured by dollar volume. This heightened activity sustained itself during both healthy and weak public equity markets.

Figure 3. Merger-and-acquisition activity in dollar volume and number of transactions. In 1998, 61 mergers and acquisitions in the medical technology industry fueled a record-breaking year in financial transactions.

Critical mass is essential. Large companies need new technologies and broad product offerings to support their expensive sales and distribution organizations and sustain their growth rates. Emerging-growth companies need sophisticated sales and marketing capabilities to commercialize their products successfully. Recent high-visibility transactions include Medtronic's acquisitions of Sofamor Danek Group and Arterial Vascular Engineering (Santa Rosa, CA); Guidant's purchase of the pacemaker division of Sulzer Medica (Winterthur, Switzerland); Boston Scientific's acquisition of the Schneider division of Pfizer (New York City); and Tyco International's (Exeter, NH) purchase of U.S. Surgical (Norwalk, CT). This consolidation trend is only in its early stages. Of the approximately 235 public companies in the medical technology industry, only 19 have market capitalizations in excess of $2 billion while, in contrast, more than 125 companies have market capitalizations of less than $200 million.

Opportunities for the Future

Channel Medical Partners' fundamental outlook for the medical technology industry is positive. However, in today's increasingly competitive and cost-conscious environment, investors must be discriminating and selective in their investment decisions. Validating the attractiveness of market opportunities, confirming the pace of market acceptance, and identifying management teams that can effectively implement a company's strategy are critical to making money in the medical technology industry. We believe the following seven market segments represent enormous growth opportunities for medical technology investors:

Tools for Minimally Invasive Cardiac Surgery. While the conversion of cardiac surgery from open-chest procedures has been slower than many industry pundits anticipated, we believe that over time it will become the gold standard for most heart procedures. The key element to better market acceptance will be improved tools and instrumentation for performing these procedures.

Surgical Robotics. The application of sophisticated robotics to medicine is a market segment still in its infancy. However, with ongoing improvements in the technology, including giving the surgeon better "tactile feel" and higher-quality visualization, surgical robotics will significantly improve clinical outcomes and will surprise investors with its growth opportunities.

Stroke Therapy Technology. Even though stroke is the number-three killer in the United States and despite the success of Target Therapeutics (acquired by Boston Scientific in 1997), the medical technology industry has, until recently, invested little in the area. With the emergence and funding of several new start-ups, however, it now appears that significant resources are being committed to treat and prevent stroke more effectively.

Wound Closure. Sutures have been the standard of care for wound closure since at least the Civil War. Today, a plethora of new technologies is emerging to more effectively and less traumatically close wounds and achieve hemostasis. The primary driver of this growth is the application of new biomaterials to medicine.

Arrhythmia Therapy Technologies. This market segment is no stranger to investors because of the success of both emerging-growth and well-established companies in addressing the needs of this often-fatal disease. It is probable that new technologies to manage and to cure arrhythmias will continue to emerge, and the market will continue its exponential growth.

Orthopedic Biomaterials. The application of biocompatible materials to orthopedics has been an area of excitement for at least two decades. However, until recently clinical performance and commercial acceptance were limited. An array of new materials are expected to be commercialized over the next several years, including some that are especially well suited for spinal applications.

Radiation for Restenosis. Even with the explosion in stent technologies, restenosis remains the nemesis of the interventional cardiologist. Using radiation to reduce this problem represents an enormous opportunity. The critical factor in achieving success in this area will be the mechanism for delivering the radiation.

Despite recent weakness in the sector, the prospects for investing in medical technology are exciting. Given the pace of new developments and procedures and the aging of the overall population, prudent investment should provide significant benefits in the years ahead and current price levels should represent significant opportunities to investors.

Carol D. Winslow is a principal and cofounder of Channel Medical Partners (Skokie, IL), a private equity fund focused on late-stage investment in the medical technology industry.

Illustration by Warren Gebert.

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