Trends & Themes in the Medical Device Market
A macro view of an evolving industry
By Bryan Hughes
Director and Head, Medical Technology
By Matthew C. Smith
P&M Corporate Finance LLC
In previous editions of the SME Medical Manufacturing Yearbook, P&M Corporate Finance has provided commentary on a variety of market forces impacting medical device manufacturers, such as regulatory considerations, reimbursement, M&A and venture capital activity. This year’s article will touch on several of those same dynamics, with a focus on the 510(k) approval process and the 2.3% medical device tax, which went into effect on January 1, 2013.
Among the most significant dynamics affecting the medical device community in recent years has been the changing nature of the FDA’s 510(k) review process. In 2010, the FDA began holding town hall meetings to address concerns from industry participants that the 510(k) clearance process had become unpredictable, inconsistent, and opaque. Yet other critics of the process complained of a lack of stringency. For example, a 2011 study published in the Archives of Internal Medicine noted that 98% of devices recalled from 2005 to 2009 were the allegedly less-risky Class I devices.
As a result of these and other criticisms, the FDA has become broadly more stringent over the past decade, often requiring additional information from companies in order to prove substantial equivalence (SE). The percentage of first-round 510(k) submissions requiring additional information increased from 36% in 2002 to 74% in 2012. Although still near the 2010 high of 77%, the percentage of 510(k) applications garnering Additional Information (AI) requests appears to be leveling off, likely due to feedback received in the town hall meetings. This high rate of AI requests has had the impact of slowing the overall 510(k) approval process.
Another significant market dynamic is the 2.3% medical device tax (now effective) that accompanied the Patient Protection and Affordable Care Act. This tax is applied to top-line revenue, thereby making all medical device manufacturers subject to the tax, including start-ups and other medical device companies with negative earnings.
Many companies are juggling cost structures in order to absorb the additional cost. Medtronic, which expects to pay $40–$60 million this year on the tax, has moved to offset the additional cost with reduction in capital expenditures. Other large corporations have announced job cuts to fund the added cost, with Zimmer and Stryker cutting 450 and 1000 employees, respectively.
Cardica, a manufacturer of tools used in heart surgery, has announced that it plans to pass the entire amount of the cost onto hospitals, raising the specter that patients and payers will ultimately bear the burden.
Perhaps the largest burden will be placed on small, innovative start-up companies which face significant headwinds, such as cash-burn problems, and the lengthening 510(k) clearance timeframe. These companies tend to drive the latest innovations in the market, and a 2.3% tax on revenues could be enough to push many towards insolvency. Thus we anticipate a slowing pace of innovation in the years ahead.
Clearly, the current set of circumstances have created an ever-evolving environment for the medical device market.
Note: 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
The medical device industry consists of thousands of companies, yet it is still concentrated in terms of revenues, with the largest 10 companies generating the majority of the industry’s revenues.
The 10 largest publicly traded medical device companies generated approximately $55.9 billion in revenues for the latest 12-month period, a figure which remained roughly flat from 2011. Average Cost of Goods Sold (COGS) for these companies represented 32% of revenue, which was in line with recent levels. Despite this consistency, manufacturers are likely to see increased margin pressure as a result of the medical device tax, which may lead to increased reliance on contract manufacturers to gain 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 vs. long-term contracts. Average inventory days remains at the high end of the 10-year range at approximately 171 days as of September 30, 2012. Therefore, while the top 10 companies will continue to submit orders that will increase overall inventory, in general, it is unlikely large orders will be made in the near-term to restock depleted inventory shelves.
Spending trends on Research & Development are often predictive of longer-term revenue growth for the major market participants. In the 12 months ending September 30, 2012, $4.6 billion, or 8.3% of revenue, was spent on Research & Development by the 10 largest public medical device companies. While R&D spending as a percent of revenue has trended slightly downward for the past several years, this figure is still well in line with the 10-year historical average of 8.5%. This suggests that, despite the concerns of the medical device tax and lengthening timeframes for 510(k) approval, companies have yet to dial back on new product development.
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 (1) the US classification system for medical devices, (2) the two pathways to receiving clearance in the United States, and (3) historical device review 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. Forty-seven percent of medical devices fall under this category and 95% of these are exempt from the regulatory process. Many Class I devices are exempt from the premarket notification and/or the QSR requirements, though they still have to comply with the other general controls. A device is exempt if the FDA determines that it presents a low risk of illness or injury to patients.
Class II—Class II devices are the largest category of medical devices. Examples range from powered wheelchairs to implants used in knee, hip, or spinal surgery. Forty-three percent of medical devices fall under this category. Class II includes devices that pose a moderate risk to patients, and may include new devices for which information or special controls are available to reduce or mitigate risk. Special controls may include labeling requirements, mandatory performance standards, and postmarket surveillance. Currently 15% of all device types classified in Class II are subject to special controls. Although most Class II devices require premarket notification via the 510(k) process, a few are exempt by regulation.
Class III—These are 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. Ten percent of medical devices fall under this category. New devices that are not classified as Class I or II by another means, are automatically designated as Class III, although the manufacturer may file a request or petition for reclassification.
510(k) Pathway—Medical devices that are classified as Class II, and which can be proven to have a predicate device already commercialized, generally require 510(k) clearance. The 510(k) pathway requires significantly less paperwork and data when compared to the PMA pathway, and therefore requires considerably less time and cost.
The number of 510(k) clearances has remained relatively flat from 2007 to 2012, growing at a CAGR of 1.0%. 510(k)s submitted with Summaries represent approximately 90% of all submissions. A 510(k) Summary includes information upon which a claim of substantial equivalence is based. The 510(k) Statement is a certification that the 510(k) owner will provide safety and effectiveness information supporting the FDA finding of substantial equivalence to any person within 30 days of a written request. It appears that medical device companies have determined to provide more rather than less information to the FDA to avoid potential issues in the future.
PMA Pathway—Devices that are permanently implanted into the human body or may be necessary to sustain life and do not have a substantially equivalent device on the market are generally considered Class III devices and are required to pass more stringent hurdles. Receiving a PMA for a device can take several years and cost tens of millions of dollars. Upon approval, however, there are typically considerably fewer competitive devices on the market, making the process potentially quite lucrative.
The number of PMAs bottomed in 2009, with 15 original PMAs approved throughout the year. The following year marked the first increase in year-over-year approvals since 2006, and subsequent increases in 2011 and 2012 returned approvals to more favorable historical levels.
The FDA has made great strides in tackling the backlog of reviews, with an average of only 1.2 PMAs under review for longer than 180 days in 2012, down from an average of 7.2 just three years prior. In fact, the FDA stopped reporting the number of PMA reviews longer than 180 days as of its October of 2012 listing. This change was preceded by a consecutive seven-month period where either one or zero PMAs were beyond the targeted 180-day review period.
Mergers & Acquisitions
In terms of the number of transactions, 2012 was an active year with 39 deals announced. This marked the third consecutive year of increased activity, and the highest level seen since 2007.
As of December 31, 2012, the 10 largest pure-play medical device companies mentioned at the beginning of the article held over $10 billion in cash on their balance sheets. This stockpile is available to acquire emerging technologies and consolidate midtier market participants. Given the high levels of capital availability in the market, we anticipate industry consolidations will continue to be strong throughout 2013, particularly among CMOs which can offer acquirers cost savings to offset the 2.3% excise tax.
Through Q3 2012, venture capital investments in medical devices and equipment represented 9.1% of the total dollars invested. This represents a significant decline from 10.7% in 2011 and 10.2% in 2010. The decline is comparable in terms of the number of investments made as well, with YTD Q3 2012 volume experienced a decline of 17.4% from 2011. This decline likely reflects concern about the long time horizon for gaining necessary approvals and hesitancy to invest amidst an increasingly regulated environment. The time horizon for getting products approved and to market, and subsequently realizing a return, seems to have stretched too long for many venture capitalists.
Of the investments made in the most recent quarter, only the Medical/Health Products sub-segment saw an increase in Q3 2012 from Q3 2011, increasing 4% to $78 million. The Medical Diagnostics and Medical Therapeutics sub-segments both experienced declines during the same time period. However, the Medical Therapeutics category still accounted for 72% of the dollars and 50% of deals in the third quarter, with $311 million going into 33 deals.
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 the greatest growth since 2009, although Series D experienced a modest decline in 2012. The spread between Series A and Series B, which had been contracting in recent years, began expanding in 2010 with a significant expansion in 2012. This spread reflects the continued risks of early stage investment, particularly in light of the market dynamics discussed previously.
The medical device market continues to face dynamic market, regulatory and macroeconomic conditions. These changes seem poised to have the biggest impact on smaller companies and venture capital investors, while larger market players will be more capable of adapting to the changing landscape. Despite the many challenges facing the industry as a whole, we anticipate that the medical device market will continue to exhibit impressive growth well into the future.
P&M 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 2013 edition of the Medical Manufacturing Yearbook.
Published Date : 11/21/2013