Trends & Themes in the Medical Device Market
A macro view of an evolving industry
By Bryan Hughes
Director and Head, Medical Technology
By Eric Valyko
P&M Corporate Finance LLC
In last year’s SME Medical Manufacturing Yearbook, P&M Corporate Finance provided an update on regulatory, reimbursement, M&A and venture capital activity. This year’s article will address several of the same areas, as well as provide an outlook for 2012. Several key dynamics are currently impacting the medical device industry. Those that are the subject of this article include sweeping regulatory changes, a shift in demand, and the economic challenge facing the industry amidst the 2.3% medical tax that will become effective in 2013.
With respect to regulatory changes, perhaps the most significant factor to consider is the ever-changing nature of the 510(k) approval process. Amidst several high-profile device and consumer health related recalls, the FDA became the target of much criticism regarding the medical device approval process. Specifically, through "town hall" meetings industry groups expressed their belief that the 510(k) process had become "unpredictable, inconsistent and opaque," while consumers and healthcare professionals contended that the review process is not robust enough. Resulting from this criticism, the FDA became more stringent, often requiring additional information from companies in order to prove substantial equivalence ("SE"). In fact, the FDA has started to request information which previously would not have been required. The percentage of first-round 510(k) submissions requiring additional information increased from 36% in 2002 to 77% in 2010. Unfortunately, this increase in requests for additional information has resulted in longer approval times, much at the expense of industry participants.
Acknowledging the additional burden placed on industry organizations, the FDA issued 25 actions to be implemented throughout 2011 intended to improve the 510(k) program. The FDA asserts these actions will result in "a smarter medical device program that supports innovation, keeps jobs here at home, and brings important, safe, and effective technologies to patients quickly." That being said, it is reasonable to anticipate that the increased cost associated with rolling out these changes will be passed through, in part, to medical device manufacturers.
Another significant market dynamic is the 2.3% medical device tax (effective in 2013) that came about as a result of the Patient Protection and Affordable Care Act. This tax will be applied to top-line revenue, thereby making all medical device manufacturers subject to the tax, rather than limiting the population to those companies yielding a positive operating profit. Unfortunately, the economic hurdles do not end here.
Group Purchasing Organizations ("GPOs"), established to help hospitals achieve discounts given their significant purchasing power, maintain a strong presence within healthcare. Not only must medical device manufacturers look forward to costs of the new medical device tax, but they have seen pricing pressure from GPOs increase dramatically when negotiationg purchasing contracts.
Naturally, there are several mitigating factors to the dynamics previously discussed. First, healthcare reform will significantly increase the number of insured individuals. This increase, in addition to a generally aging population, will yield greater physician visits and ultimately, more diagnoses of conditions that require a medical device for treatment. All things considered, this may help mitigate the purchasing power GPOs currently maintain due to a shift in demand, and will help offset the device tax.
Based on the foregoing, we anticipate several changes in the medical device industry, as noted below and discussed later in this article: (i) innovation among early-stage companies will be impacted as these companies try to navigate the increased regulatory burden and the medical device tax; (ii) large medical device manufacturers may begin to outsource manufacturing in order to streamline production and increase profitability; and (iii) large medical device manufacturers will continue to make strategic acquisitions in order to gain new technologies and leverage synergistic opportunities.
Clearly, the current set of circumstances have created an ever-evolving environment for the medical device market.
For the purposes of this overview, the medical device industry covers implants and instruments intended to affect the structure or any function of the human body in a therapeutic manner. Products not included within the data are devices such as diagnostic tools or imaging, hospital supplies, and healthcare IT.
Industry Overview & Market Players
While the medical device industry has experienced constant consolidation, market concentration remains considerably low with a significant number of small businesses and early-stage medical device companies. Census data suggests that over 50% of US medical device companies employ less than 20 individuals. Although the bottom 50% of companies are quite small, the top 10 industry participants are diversified globally and account for a considerable portion of worldwide medical device revenue. By examining these companies, it is possible to determine where the industry has been, where it likely is headed, and how this outlook will impact those engaged in medical manufacturing.
The ten largest publicly traded medical device companies generated approximately $57.5 billion in revenues for the latest 12-month period, an increase of nearly 6.0% year-over-year. Average Cost of Goods Sold (COGS) for these companies represented 29% of revenue, which was in line with recent levels. This consistency reflects the consideration industry participants are giving to purchasing decisions and, more specifically, cost control. Important to note for contract manufacturers organizations (CMO), however, is the significant increase in the absolute value of COGS over the past 10 years, indicative of increasing market potential. This is an important variable given the impending medical device tax and other pricing pressures facing the industry. In response to increased margin pressure, many medical device manufacturers are turning to contract manufacturers to gain various cost savings and operational flexibility.
Another key metric to analyze is average days in inventory as this information can be used as a proxy for evaluating short versus long-term contracts. While a longer days in inventory metric often reflects inferior inventory turnover, this can be viewed positively within the context of the healthcare industry. Specifically, if a manufacturer were to enter into a long-term contract, the risk of stockpiling inventory would be reduced. Based thereon, higher than normal inventory levels may be reflective of a manufacturer’s favorable revenue backlog. High inventory levels may not be beneficial for CMOs, however. But for new contracts, sustained levels of abnormally high inventory may suggest that manufacturers have reached their quota and do not need the services of CMOs in the near term. Average inventory days remain near the high end of the 10-year range.
One important factor providing better care for patients, advancing healthcare and negotiating with hospitals, is having access to the most innovative technologies. In this regard, research and development has remained relatively constant between 7.5 and 9.0% of revenue over the past 10 years. This level of R&D reflects the continued effort by medical device manufacturers to support ongoing innovation amidst a challenging funding environment and uncertainty within the 510(k) process.
Regulatory Approvals: A Review
As discussed in prior updates, access to the largest medical device markets requires regulatory approval by specific government agencies. Below is a discussion of (i) the US classification system for medical devices, (ii) the two pathways to receiving clearance in the US, and (iii) historical device reviewal activity.
Class I—These devices present minimal potential for harm to the user and are often simpler in design than Class II or Class III devices. Examples include elastic bandages and tongue depressors. Nearly half (47%) of medical devices fall under this category and 95% of these are exempt from the regulatory process.
Class II—Most medical devices are considered Class II devices. Examples include devices ranging from powered wheelchairs to implants used in knee, hip, or spinal surgery; 43% of medical devices fall under this category.
Class III—These devices, usually designed to sustain or support life, are implanted, or present potentially unreasonable risk of illness or injury. Examples of Class III devices include implantable pacemakers and breast implants. A tenth of medical devices fall under this category.
The 510(k) is intended for Class II devices which can be proven to have a similar, or predicate, device already commercialized. Historically, a 510(k) required significantly less paperwork and data when compared to the premarket approval (PMA) pathway, and therefore required considerably less time and cost. As outlined in the introduction, increased scrutiny by the FDA has led to increased approval timelines and costs which have forced many companies and investors to be increasingly patient.
The number of 510(k) clearances has slightly declined over the last five years at a CAGR of negative 1.0%. Mitigating significant decreases in prior years was an 11% increase in 2011, which can be attributed to a proportionate increase in the number of 510(k)s submitted with summaries. Specifically, a 510(k) Summary includes information upon which a claim of substantial equivalence is based. This tends to shorten the process as the alternative 510(k) Statement requires the owner to provide safety and efficacy information to the FDA at some point during the review cycle. As discussed earlier, choosing to submit a 510(k) with a Summary is beneficial in instances where companies expect the FDA will respond with a request for additional information.
Class III devices are required to pass more stringent mechanical and clinical hurdles set forth by the FDA. Specifically, these devices must utilize the PMA Pathway, taking upwards of several years and tens of millions of dollars to accomplish.
The number of PMAs bottomed in 2009, with 15 original PMAs approved throughout the year. The following year, 2010, marked the first increase in year-over-year approvals since 2006, and the subsequent increase in 2011 returned approvals to more favorable historical levels. In addition, the number of PMAs under review for greater than 180 days has fallen 33% from 5.2 PMAs in 2006 to 3.5 PMAs in 2011, representing a five-year CAGR of negative 7.7%. The inverse relationship indicates that the FDA has been able to tackle the backlog of PMA submissions amidst ongoing changes with the review process. Should the current trend within PMA approvals continue, one would expect innovation to increase. Conversely, a reversal of the current trend would tend to stifle innovation. Unfortunately, opining on the outlook with innovation is too subjective amidst the ongoing changes within the FDA.
Driven by rapidly increasing healthcare costs, the Center for Medicare and Medicaid Services (CMS), as well as other insurance providers, have implemented more stringent policies for reviewing claims to limit payments for many medical procedures. Further, the anticipated shift in the number of publicly insured individuals as a result of healthcare reform will likely further reduce payments as public payers tend to reimburse less vis-à-vis private payers. All told, there remains a significant amount of uncertainty regarding reimbursement. It is important for regulators to work closely with industry practitioners in this regard, as significant pricing pressures and cost containment concerns can ultimately stifle innovation that would otherwise bring noble devices to patients in need.
Given these macro drivers, industry consolidation is expected to continue as a result of increased pricing pressure, the importance of cost control, and readily available synergies upon integration among strategic competitors.
Mergers & Acquisitions
Following a familiar historical trend, M&A activity slowed through 2009, followed by a rebound in 2010 and 2011. Unlike in 2009, where the decline in average transaction price was reflective of an increase in the number of distressed transactions, the decline in average transaction value in 2011 was a function of depressed market multiples amidst the overall macroeconomic environment.
Based on the current dip in market multiples and the significant cash maintained by numerous global medical device companies, M&A activity is likely to be strong in the near future. While domestic acquisitions will continue as a result of companies seeking cost synergies amidst a changing regulatory climate, we anticipate considerable cross-border M&A activity. Specifically, acquisitions of foreign domiciled companies provide favorable tax advantages to global medical device companies with excess cash balances generated and held outside the US irrespective of geography, it is likely these companies will seek to earn a return on cash, thereby pursuing multiple acquisitions over the next several years. Beyond traditional acquisition rationale, we anticipate these acquisitions may be of companies that provide low-cost treatment alternatives that can be commercialized in economically disadvantaged and underserved markets.
In 2011, venture capital investment in medical devices and equipment represented 10.7% of total dollars invested, up from 10.2% over 2010.
In terms of the number of investments made, 2011 experienced a decline of 6.9% from 2010, primarily due to a 21.3% reduction in financings in Q3 2011 alone. This can likely be attributed to additional credit risk amidst the downgrading of the US debt as well as the European sovereign debt crisis.
Of the investments made in the most recent quarter, the top venture capital investment areas within the healthcare sector were (i) in vitro diagnostics, (ii) cardiovascular devices, and (iii) orthopedic devices. With respect to total deal value, the aforementioned segments followed the same distribution. In particular, this reflects the continued shift in VC investment to companies less prone to significant FDA review. That is, companies commercializing 510(k) products as opposed to those developing technologies requiring a 510(k). This will certainly bode well for contract manufacturers as principal investors will likely seek out CMOs to contain costs in order to streamline production and increase their returns.
Since 2009 there has been a significant increase in pre-money valuations for all investment rounds. Upon review of the growth in valuation for each series of funding, one can see that Series C and Series D have exhibited greater growth since 2009. This is indicative of the shift in VC investing from early stage companies to expansion and later stage companies. Although the spread between Series A and Series B has been declining historically, the spread did increase in both 2010 and 2011, which is to be expected given the additional risk of early stage investments amidst further economic concerns.
The medical device market continues to be a highly dynamic industry undergoing continuous change. Given the macroeconomic and regulatory factors addressed herein, the industry will be forced to adapt in order to provide clinically superior products to the market. While 2012 is highly speculative, it is our opinion that the industry will successfully adapt to these changes and take advantage of various strategic initiatives so as to continue to grow in these uncertain times.
PM Corporate Finance LLC, an investment banking firm, is a leading M&A advisor within the medical technology market. The firm specializes in providing merger and acquisition services to middle-market device and diagnostics companies in North America and Europe. P&M Corporate Finance is headquartered in Southfield, MI, with additional offices in Cleveland and Chicago.
This article was first published in the 2012 edition of the Medical Manufacturing Yearbook.