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Take the med tech tonic

Created:

15 May 2008

Written by:

Richard Hemming

The healthcare industry has been more infamous than prosperous in the past year, but there is a risk, in the UK, that the medical technology baby has been thrown out with the biotechnology bathwater.

The healthcare industry is reeling from a series of failures and adverse publicity. In February, Renovo's scar removal therapy was found to be less effective than hoped, prompting a 50 per cent share price fall. This followed on from the US Food and Drug Administration's rejection of Vernalis's migraine treatment. In the past year, almost all biotechnology shares have fallen.

And orthopaedics specialist Smith & Nephew's bombshell that it will lose $100m (£51m) a year in sales due to "unethical" sales practices by Plus Orthopedics, acquired for $889m last year, didn't help. Smith & Nephew's share price fell 13 per cent on the day and confidence in management has been dented.

A bigger issue, however, is the widespread practice in the industry of providing excessive incentives for doctors to recommend particular devices. In the US, in the past six months, major orthopaedic businesses have been fined by the Department of Justice over the use of illegal sales tactics such as these.

But bosses in the medical technology sector argue that, far from providing an incentive against investing in the sector, it promotes value at the smaller end because it reduces the competitive edge for the bigger medical device producers, which have much more money and resources for marketing.

"We see it as a positive because it reduces the marketing stranglehold that the big boys have. They have tied in so many surgeons, which they aren't allowed to do any more," says Charles Spicer, chief executive of MDY Healthcare, which invests in companies across the healthcare sector.

Sentiment of fear

Despite this upbeat analysis, the sentiment of fear has permeated the healthcare sector as a whole. In the past 12 months, the FTSE All-Share Pharma and Biotechnology index has fallen more than 23 per cent, compared with the 8 per cent fall of the FTSE All-Share index. Consequently, Mr Spicer says that there are many investment opportunities in the medical technology arena. "We think medical technology is fundamentally good value," he says. The business model of medical technology companies stands out against other areas of healthcare because of its reliance on developing specialised products, according to Mr Spicer. "In medical technology, you start by addressing a niche and then develop a world-class product. You either develop it to commercialisation, or your shareholders are offered a killer price."

Corporate activity in the medical technology sector

But if individuals and fund managers aren't seeing value in British medical technology companies, interest is emerging from competitors and private equity. Medical technology developer Gyrus, for example, was snapped up for close to £1bn by Japanese conglomerate Olympus.

Gyrus's success as a mid-cap medical technology company relied on its leading position in a number of surgical end markets, including urology and gynaecology. It pioneered the 'see and treat' technology, providing both imaging and treatment devices to surgeons. It specialised in developing plasma-based surgical tools that minimised patient trauma during a variety of operations such as prostate surgery and hysterectomies.

Most recently, private equity group ECI Partners swooped on distressed clinical trials operator Premier Research, paying nearly £60m in late March. Tissue Science Laboratories, manufacturer of surgical implant tissues, received an all-cash offer in March worth £38m from US-based surgical instruments manufacturer Covidien. Laboratory equipment provider Whatman announced earlier this year that it is being taken over by US giant General Electric's Healthcare Life Sciences division for £363m. And Cardiff headquartered diagnostics manufacturer British Biocell International was taken over for close to £84m by US-based Inverness Medical Innovations.

One reason for the predatory interest from overseas is the discount UK medical technology companies are trading at to their US counterparts. Prior to offers being tabled, Gyrus and Whatman were trading at forecast price-earnings multiples of close to 18 times and 13 times, respectively. By contrast, the average multiple of a medical technology company in the US is between 25 and 30 times.

Biotechnology – a different matter

But the corporate activity in the medical technology sector also highlights the lack of activity in the biotechnology arena. Research and development failures in the biotechnology industry aside, the business model of that part of the industry is too risky for many, including Mr Spicer. He is referring to the cost of developing a single drug, which, including marketing spend, might be as much as £2bn. By contrast, the development costs in medical technology are about one-quarter of this, on average.

But more important, from an investor's perspective, is the fact that the returns are binary – either success, or failure, which contrasts to the ongoing sales achieved by orthopaedic tools and other medical devices.

"A lot of biotechs aren't selling anything until they make: A) a big scientific breakthrough; B) trial it on everyone; then C) get regulatory approval," says Mr Spicer.

It is not uncommon for a biotechnology company to sell nothing for seven to 15 years and then make hundreds of millions of dollars, if everything goes well. But the odds are that everything won't go well.

Medical technology companies, on the other hand, are – in the majority of cases – already selling their products, then improving on those products to increase sales.

"[Medical technology] companies aren't taking a single bet on a single scientific concept that looked promising when young and unproven in human beings," says Mr Spicer.

Brian Steer, former executive chairman of Gyrus, is now chairman of Stanmore Implants, a company originally spun out from University College London's Centre for Biomedical Engineering in 1996. Stanmore is an orthopaedic business that designs, manufactures and markets implant products for limb salvage and joint replacement. It's on the lookout for suitable acquisitions.

Mr Steer says his company's latest acquisition gives a flavour of the type of investment it is looking for. Stanmore is developing a device based on research into deer antlers that enables prosthetic devices to be directly attached to the skeleton of amputees, integrating them with the skin to prevent infection. Although the full development of this project might be a few years away, the company is generating £4m of sales a year and has been profitable "for several years". Mr Steer is a great believer in "small companies not going head to head with big companies but developing niche businesses".

The company's existing products underline why many medical technology products have an impact on both life expectancy and quality of life, says Mr Steer.

He refers to a technology that allows a child with bone cancer in his thigh bone to be fitted with an artificial thigh bone that grows at the same natural rate as the other leg. Prior to this innovation, the only way to increase the implant length would be to operate every six months. For a 10-year-old child, this might mean up to a dozen operations (twice a year for six years) instead of a single operation.

Medical device producers - a key sub-sector

'Medical technology' generally refers to manufacturers of healthcare tools and equipment. A key sub-sector of this is medical device producers. According to the US Food and Drug Administration (FDA)'s definition: "The term 'device' means an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article, including any component, part, or accessory."

This sub-sector is inherently less risky than biological compounds or drugs as devices are not dependent on being metabolised by the human body. Drugs change the body's biology in some way and can cause side-effects. There are also a host of safety issues that need to be investigated by the regulatory authorities before a product can come to market. The issue of safety is the primary reason why a drug may not be granted approval, or why it is pulled from the market post approval.

Take the high-profile withdrawal in 2004 of Merck’s arthritis drug, Vioxx, which was linked to heart attacks. This development has made it harder for investors to buy into a sector in a climate where riskier investments are already out of vogue.

In the 1950s, the average FDA submission for a drug was between two and four lever arch files, but now it’s the equivalent of 16 truckloads of paper work. The clinical trials needed to prove a drug’s viability are growing in number and data needs to be maintained on every interaction between the clinician and the patient.

Opportunities

Despite the hurdles, there are some big successes in the biotechnology world but, unfortunately for British investors, most of them have been in the US, a point which Charles Spicer concedes. Companies such as Genentech and Amgen (which have a combined market capitalisation of over $125bn) got the "scientific low hanging fruit", he says. Consequently, new treatments and therapies are becoming harder to find.

"A lot of the early biotechnology drugs, like insulin and human growth hormone, were relatively simple replications of agents that exist in the body anyway. Scientists replicated these naturally produced hormones. But using biology to cure cancer for example, is much harder, because the body doesn't have mechanisms that enable this."

The US market is bigger not just for pharmaceutical companies, but also for medical device businesses. But there are many opportunities for UK investors – because, with medical technology, where the business model is partly based on discovering a niche market, the cliché 'size isn't everything' counts. Investors need only look at the latest bout of corporate activity in the sector to realise that there are opportunities to make money.

We've classified the different types of medical technology specialists and have come up with six companies we believe represent great investment opportunities – even if they aren't taken over:

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