Medtech Industry Coping With a New Normal

Medtech Industry Coping With a ‘New Normal’

Michael Barbella • Managing Editor

Since the start of the Great Recession in 2008, financial analysts, economists, politicians and business leaders have grown very fond of the term “new normal.” The phrase is used each time new jobless figures are released (“What is the New Normal Unemployment Rate?” a Federal Reserve Bank of San Francisco economic letter asked earlier this year), it’s been used to describe the U.S. stock market’s newfound bipolar disorder (“Volatility is part of the new normal, it’s here to stay,” Neel Kashkari, head of global investment equities at PIMCO, told CNBC late last month), and it’s been repeated ad nauseam by politicians forced to deal with deep cuts in government services over the last several years. “People are used to a higher level of service,” Merced, Calif., Mayor Bill Spriggs told a USA Today reporter in early February. “But this is the new normal.”

Though it has become synonymous with the most tenacious economic slowdown since the Great Depression, the phrase “new normal” was first coined during a more prosperous time in the world’s financial history. It surfaced shortly before the recession began, in a book written by Mohamed A. El-Erian, CEO and co-chief information officer of PIMCO, the Newport Beach, Calif.-based global investment solutions provider best known for bond investing. El-Erian used the term “new normal” in his book, “When Markets Collide: Investment Strategies for the Age of GlobalEconomic Change,” to explain a permanent shift in the world’s engines of economic growth. Under the new normal, El-Erian argues, emerging markets such as Brazil, India and China will drive the global economy, dethroning longtime monetary monarchs such as the United States and Germany.

El-Erian’s book predicts a post-recession world of lower investment returns, slower economic growth and higher odds of another unexpected fiscal crisis. Put simply, the world is headed toward a future where the range of financial outcomes—and risk—is much wider than usual.

“We are not going to go back to where we’ve come from,” El-Erian warned during the Milken Institute Global Conference in April 2009. “The notion should not be, ‘Is this recession going to be over?’ [The notion] should be, ‘What does the new normal look like when the system stabilizes?’ ”

Though the system is still stabilizing, El-Erian and those who subscribe to his theory believe the new economic landscape in America will resemble life in less- wealthy countries, where residents have struggled for years to overcome lower standards of living, high unemployment, stagnant corporate profits, heavy government intervention in the economy and disappointing equity returns.

Many of the implications for thenation’s future under the “new normal”already are being played out with alarming consequences in the business realm. The automotive industry, for instance, has had to adjust to a new reality of lower sales, fewer car manufacturers and dealerships, reduced inventories and more tradesbetween dealers as customers ordervehicles to their specifications.

Homeowners have had to cope with a “new normal” of rising foreclosure rates, more complex mortgages, larger downpayments and falling home prices that show no signs of bottoming out and—perhaps more importantly—challenge the conventional notion that homeownership is a solid investment. “Owner-occupied homes will always be the basis for healthy and stable neighborhoods,” Robert Bridges, a professor of clinical finance and business economics at the University of Southern California’s Marshall School of Business, wrote in a Wall Street Journal article on July 11. “But coming generations need to realize that while houses are possessions and part of a good life, they are not always good investments on the road to financial independence.”

Many venture capital firms have reached the same conclusion about medical technology companies. From 2006 to 2008—a period financial gurus have dubbed the “Easy Money Era”—venture funding poured into medtech firms by investors eager to capitalize on the latest innovations. Not anymore. Growing regulatory and pricing pressures as well as the preference of strategic buyers for later-stage exits seem to have permanentlyaffected venture capitalists’ sentiment and behavior toward medtech deals. Investors now seem to favor more “de-risked” assets and venture capitalists are more apt to carry their portfolio companies longer due to challenging exits, according to acomprehensive report on the medtech sector by global advisory services firm Ernst & Young. As a result, the industry has experienced a marked decline in the share of venture funding going to early rounds.

It’s part of the medtech industry’s“new normal.”

“It’s now becoming increasingly clear that medtech faces its own new normal,” states Ernst & Young’s report, ‘Pulse of the industry—Medical technology report 2011.’ ”This is an environment where companies face a confluence of risks and challenges: heightened regulatory scrutiny and payer pressure, a fundamentallydifferent funding climate and a rapidly changing customer base.”

Implications of an Altered Regulatory Landscape

By far, one of the greatest challenges the medtech industry currently faces is the daunting, often confusing and always frustrating regulatory requirements companies must follow when seeking approval for their products. In recent years, the U.S. Food and Drug Administration’s (FDA) premarket approval process, otherwise known as the 510(k) program, has become a particular nuisance for many device firms due to its perceived complexity, lack of consistency and propensity for prolonging product clearances. According to Ernst & Young’s report, average 510(k) approval times soared 45 percent in the last three years, going from 3.1 months between 2003 and 2007 to 4.5 months in 2010.

Critics have pressured the FDA torevamp its 510(k) program, contending it allows potentially dangerous medical devices to reach consumers. The FDA conducted its own assessment of the system and asked the Institute of Medicine (IOM) to review procedures as well. In July, the IOM recommended scrapping the 510(k) process and replacing it with an “integrated premarket and post-market regulatory framework that provides a reasonable assurance of safety and effectiveness throughout the device lifecycle.” The FDA, however, is refusing to discard the program and start anew, preferring instead to implement its own overhaul of the program.

Such infighting and power plays among government agencies only has added to the uncertainty and mystery surrounding the regulatory environment in the United States. As a result, medtech firms have fine-tuned their marketing and growth strategies to seek overseas approval for their products before embarking on a domestic regulatory journey, the Ernst & Young report claims.

Another “new normal.”

Compounding this uncertainty with a challenging regulatory process is an equally difficult reimbursement environment that is forcing medtech companies to prove health outcomes for patients.

“Payers—both public and private—have seen their budgets squeezed and are, in turn, pressuring medtech companies to demonstrate how their products improve health outcomes for patients and efficiently use healthcare resources,” Ernst & Young’s report reads. “Even if clinical trials are not required to get a product approved, payers will increasingly focus on post-marketing data on the comparative effectiveness of different interventions.”

Welcome to the “new normal.”

Realignment of theCustomer Base

For decades, medtech companies sold many of their products directly to doctors and hospitals. But the emergence of several trends is creating a fundamental realignment of the customer base to which companies traditionally have sold their wares—increasing the importance of some customer channels while reducing the significance of others.

Hospitals are being pressured to cut costs as governments in most major markets attempt to reduce ballooning healthcare expenses. These pressures, along with reduced margins from the 2008 recession, have triggered a spate of hospital mergers over the last four years, and a greater

reliance on technology assessmentcommittees as well as group purchasing organizations to consolidate and standardize purchasing decisions. Surgeons and other physicians who have always had free reign to choose the devices they preferred to work with now are finding their options limited. In many cases, hospitals are imposing price caps and/or reducing the number of vendors from which they will purchase.

Going forward, medtech companies that habitually relied on close relationships with doctors to sell their products will need to rethink the kinds of products they sell, the ways in which they sell those products, and even the way in which they develop their products, according to the Ernst & Young report.

The “new normal” strikes again.

Funding Follies

Publicly traded medtech companies in the United States and Europe turned in a solid performance in 2010, but the numbers are a bit deceiving. Net income for non-conglomerates, for example, totaled $17.4billion, a 43 percent increase compared with the $12.2 billion reported in 2009. However, the Ernst & Young report attributes the increase to large, one-time charges in 2009; without those charges, net income growth would have totaled only 9 percent. Revenues for all publicly traded medtech firms in the United States and Europe amounted to $315.9 billion last year, a 4 percent rise from 2009.

The data on capital raised by American and European companies in 2010 is just as misleading. While capital raised by medtech firms reached $23.6 billion last year—a whopping 66 percent increase compared with the $14.1 billion companies put together in 2009—financial experts claim the increase was not driven by a fundamental improvement in investor sentiment toward the industry. Rather, the rise in capital was driven by a handful of mature companies that took advantage of historically low interest rates to raise debt and then restructure their balance sheets, finance acquisitions or fund general operations.

“On the surface it seems like good news that the amount of capital raised is up so dramatically,” said Dave DeMarco, a principal at Ernst & Young. “But a majority of the increase was driven by large debt offerings. When you look at the venture capital picture as a whole, the most poignant conclusion you can make is that the amount of venture capital going into early [funding] rounds has decreased for the third consecutive year. Venture capitalists appear to be placing their money in safer bets. We’ve seen more money go into areas like non-imaging diagnostics, for example. It’s all part of the new normal.”

Venture funding did indeed fall in 2010, though the amount raised remains consistent with pre-recession levels, according to the report. Venture capital investment fell 13 percent compared with 2009, while venture funding in the United States plummeted 15 percent to $3.5 billion. In Europe, venture investment was up 4.7 percent to $707 million.

After two years of sluggishness, initial public offerings (IPO) picked up once again in 2010, but at a significantly slower pace compared with the years leading up to the global financial crisis. Nine medtech companies in the United States or Europe completed IPOs last year, grossing a total of $568 million. In 2009, only two IPOs took place, thanks to less-than-enthusiastic investor sentiment. And, of course, the “new normal.”