September 01, 2010

Medical device and equipment manufacturers have faced their share of challenges over the last several years. Healthcare reform, increased regulatory scrutiny, reduced hospital budgets, tight credit markets, and a sluggish economy have all negatively impacted the valuations of companies in the $300 billion global industry. Device and equipment merger & acquisition (“M&A”) activity, which is typically robust, has also slowed due to the economic downturn. Despite these tribulations, an aging population and advances in medical technology are expected to keep demand for medical devices and equipment strong which should translate to a revived M&A market in the long run.

Impact of Healthcare Reform

Healthcare reform dominated dinner table discussions and political debate for the majority of the first quarter of 2010 and was ultimately signed into law with the Patient Protection and Affordable Care Act (the “Act”) on March 23rd. The Act will have a widespread impact on insurers, providers, and companies operating in the healthcare industry. Medical device and equipment manufacturers were not spared from the costly impact of this legislation. The Act imposes a new 2.3% excise tax on the price of medical devices at the point of sale to help fund healthcare reform. Medical device manufacturers and the world’s largest medical device trade group, the Advanced Medical Technology Association (“AdvaMed”), lobbied heavily against this tax and were successful in mitigating its impact. As such, the excise tax, initially set at a higher rate, was reduced which led to a decline in estimated revenue raised from $40 billion over a ten-year period to current $20 billion estimates. Additionally, the effective date of the tax was delayed until 2013 to give manufacturers time to plan for its impact. Certain products that are generally available to the public for retail purchase are exempt from the tax, including eye glasses, contact lenses, and hearing aids as well as other similar items.

Industry experts have speculated that the device tax could lead to decreased investment in medical device start-ups and a reduction of investments in existing companies. According to the Medical Device Manufacturers Association, the bulk of the innovation in the medical device industry comes from small manufacturers that work with hospitals and clinicians on the development of specific products or treatments. Developmental medical device companies will be the most impacted by the tax because while they often have viable products they are often not yet profitable or are less profitable due to relatively higher research & development (“R&D”) expenses than more established firms earning higher margins. With reduced cash flow as a result of the device tax, start-ups may have less capital for R&D, take more time to achieve profitability, or require more capital funding. AdvaMed dismissed lawmaker’s assertions that the higher taxes would be offset by the increased demand caused by millions of additional Americans having access to insurance.

Regulatory Environment

Device manufacturers may face increased regulation from the Food and Drug Administration (“FDA”) as the FDA reviews its 510(k) clearance program, sometimes referred to as the “fast track” approval process for medical devices. Most devices receive FDA approval through one of two review processes, 510(k) or premarket approval (PMA). PMA is the more stringent of the two approval procedures and requires the submission of clinical trial data. PMA approval can take up to two years whereas receiving 510(k) approval can take as little as three months. Device manufacturers decide which regulatory review course to pursue (PMA or 510(k)), but the FDA has 60 days to comment on the appropriate course of action. The majority of devices in the U.S. reach market through the 510(k) process. In response to numerous recalls of medical equipment approved through the 510(k) process, critics charge that this process is not as vigorous and robust as is necessary. The FDA’s guidelines are vague with regards to which approval process should be followed for specific devices and this lack of clarity may have allowed high risk medical devices to be approved through 510(k) rather than a more robust PMA process. Critics also assert that the penalties for submitting inaccurate data are not severe enough, there are too few experts reviewing each 510(k) submission, and post-approval monitoring and surveillance is severely lacking. In September 2009, the FDA commissioned the Institute of Medicine to conduct a thorough review of the 510(k) process and recommend changes. The Institute of Medicine’s findings are due out in mid-2011, but it is expected that they will recommend changes making the 510(k) approval process more rigorous, which will lead to higher costs, lengthen the time to market, and lower approval rates for medical device manufacturers.

The FDA has already implemented some changes to the PMA advisory panels. Beginning May 1, 2010, the FDA will require separate votes by outside experts on the safety and effectiveness of a medical device up for PMA review. Before, the FDA only required the expert advisory panel to simply vote on the approvability of the PMA application for the device. In addition, panels will now vote by ballot, rather than by a show of hands and the votes will be made public. The new balloting procedure is intended to allow panel members to vote without the immediate influence of other members.1 In addition to the FDA implementing changes, the Center for Device and Radiological Health (“CRDH”), which is responsible for ensuring the safety and effectiveness of medical devices, is in the process of implementing changes to keep the advisory panel members focused on science as opposed to the regulatory issues. The medical device industry has issues with the panels in their current form due to inexperience, lack of expertise, and potential conflicts of interest of members sitting on the panels. However, the CRDH contends the pool of qualified, experienced candidates that are interested in sitting on these panels is limited.

Hospital Spending and Payor Trends

Equipment and device manufacturers are significantly impacted by the spending habits of their key customers: namely hospitals. Hospital spending has declined over the past several years due to the overall economic decline. S&P estimates that capital expenditures of publicly-traded hospital chains declined from 7.7% of revenue in 2006 to 5.9% in 2008. Decreased spending is a result of greater levels of uncompensated care due to higher unemployment, declining endowments, and tight credit markets.2 Our analysis of hospital capital expenditures on a quarterly basis supports S&P’s conclusions as presented in the adjacent chart. MEDACorp’s October 2008 – October 2009 Hospital Administrator surveys referenced in Leerink Swann’s Medical Supplies and Devices October 14, 2009 report also cited declines in capital budgets, but noted that estimates of budget declines were lowered throughout 2009. Survey respondents estimated only a 4% capital budget decline for the year in October 2009, whereas in the January, April, and July surveys, respondents estimated declines ranging from 10% to 14%.

2010 capital equipment budgets are expected to be flat3. Industry analysts reason that manufacturers of high ticket purchases (e.g., MRIs, radiation therapy equipment) have been impacted more by decreased spending than manufacturers of devices that may be implanted as part of a non-elective surgery (e.g., pacemakers, stents, etc.). Cost containment and comparative effectiveness research (“CER”) continue to be major focuses of both public and private payors. The American Recovery and Reinvestment Act of 2009 set aside $1.1 billion for CER efforts, which will undoubtedly lead to further margin pressure as device manufacturers will be forced to defend their product’s effectiveness and pricing versus that of alternative solutions. Such trends could spur additional industry consolidation as smaller manufacturers may lack the resources to rebut claims of a device’s ineffectiveness.

Merger and Acquisition Activity

Deal activity within the medical device industry declined both in terms of number of transactions and transaction size in 2009. According to Capital IQ, 2009 witnessed 168 transactions worth $14.2 billion, down approximately 27.6% in transaction volume and 7.6% in transaction size from the prior year.4 Transaction volume in the first six months of 2010 increased over the same period last year with 84 closed transactions, up 33% year-over-year. However, the volume has been dominated by smaller transactions evidenced by a nearly 50% drop in transaction value over the same period in 2009. Despite the lull in deal activity since the recession began, two major acquisitions have been completed and three more announced (as of the writing of this article) by the industry’s largest players.

  • Novartis Pharmaceuticals Corporation (“Novartis”) completed its acquisition of a 52.2% interest for $28.4 billion as part of its bid to acquire a majority stake in the eye care company, Alcon, Inc. (“Alcon”). The transaction, which began in 2008 with Novartis acquiring a 25% stake in Alcon from Nestle S.A. with an option to purchase Nestle’s remaining stake in Alcon, ultimately closed on August 26, 2010.
  • Merck KGaA completed its acquisition of Millipore Corp., the American manufacturer of supplies to the biotechnology industry, on July 15, 2010, for $7.0 billion. With this acquisition, Merck becomes the latest pharmaceutical company to announce a large acquisition during a period of industry consolidation and gives the drug maker a larger presence in products for the biotechnology sector.
  • Abbott Laboratories completed its acquisition of Advanced Medical Optics, Inc. (“AMO”) in a cash deal worth $2.8 billion on February 24, 2009. The acquisition of AMO strengthens Abbott’s mix of medical device businesses as AMO holds the number one position in LASIK surgical devices, the number two position in the cataract surgical device market and the number three position in contact lens care products. The closing price of the deal implied a 10.1x EV to trailing EBITDA multiple.
  • Covidien plc (“Covidien”) completed its acquisition of ev3, Inc. in a $2.7 billion deal on July 9, 2010. By buying ev3, Covidien will move into a higher margin, faster growing market for medical devices. ev3’s products are used in vascular surgery which is done through blood vessels.
  • Johnson & Johnson acquired aesthetic and general surgery device manufacturer Mentor Corporation on January 16, 2009 for $1.2 billion in total consideration. Johnson & Johnson intends for Mentor to become part of its growth strategy for aesthetic medicine.

The table below identifies other recent transactions of note.

The medical device industry’s shrinking transaction activity is reflective of a number of factors including the lack of available credit. Due to the scarcity of financing, acquirers are forced to finance deals with operating cash flow and existing lines of credit. As a result, strategic acquisitions (as opposed to acquisitions by financial buyers) are expected to dominate transaction roosters in 2010 and beyond. The strategic deal market has been driven by the desire of larger manufacturers to acquire new technology developed by smaller competitors to fill in gaps in existing device portfolios or to enter new product markets, which may offer cross-selling opportunities through developed sales channels. Also, the effects of higher taxes on medical devices and CER from healthcare reform will partly drive larger companies to acquire smaller manufacturers due to the inability of smaller manufacturers to absorb the additional costs. In addition, current valuations may be approaching a new long-term fair value level as evidenced by the increase and subsequent leveling off of EBITDA multiples from the lows experienced in the first quarter of 2009. Industry experts anticipate that M&A activity will pick up once buyers have more visibility on the regulatory environment, the effects of healthcare reform begin to be felt, and the availability of credit becomes more widespread.

Equity Valuations

As the equity markets tumbled in late-2008 and 2009, the medical device and equipment industry followed suit and saw valuations fall to historic lows in the fourth quarter of 2008 and the first quarter of 2009. Medical devices manufacturers bottomed out between 9.0x and 10.0x trailing twelve-month (“TTM”) EBITDA levels. As presented in the adjacent charts, valuations and stock prices have recovered and medical device stocks have been outperforming the overall market, but multiples still remain below the five-year average of 12.8x, settling into a narrow band between 10.0x and 11.0x TTM EBITDA. When hospital budgets begin to stabilize after seeing massive cutbacks in recent years, investors should be lured back into this space. The expectation of an improving economy, increased discretionary spending, and greater clarity in the regulation environment could bode well for the M&A market picking up steam going forward as management teams, especially management teams at larger and cash rich companies, will be more confident in a recovery and prospects for growth.

Conclusions for the Medical Device and Equipment Industry

Although the industry is still likely to experience headwinds in the coming years as a result of pending and current legislation, regulatory reforms, and the overall effects of a slowly recovering economy, we feel that there is currently more upside than downside to the industry. A number of factors contribute to this greater upside potential, primarily an aging population, but also consumer expectations for better healthcare driving technological advancement and the expectation of continued improvement in the global economy. M&A activity also has upside potential as credit loosens, the economy improves, and management teams are more confident in the growth prospects for the industry.

1 Weixel, Nathaniel, “Medical Devices Law and Industry Report,” The Bureau of National Affairs June 2010.

2 “Industry Surveys Healthcare: Products & Supplies,” Standard & Poors 4 February 2010.

3 Rick Wise, CFA, “Medical Supplies and Devices,” Leerink Swann 14 October 2009.

4 Capital IQ. Retrieved October 4, 2010 from