A recent Reuters article indicates medical devices M&A activity is poised to take-off in 2013. This after activity has fallen to a near low since 2009. Is there a way that investors can benefit from such mooted M&A activity?
With all the pressures from payors, the 2.3% medical devices sales tax and healthcare reform, companies are looking for angles to optimize operations, and add new innovations to boost future revenues and profits.
Should you follow tips?
The article goes on to suggest analyst picks for companies which could benefit in the buy-out boost. Are these recommendations (or tips) worth investors following? Can you profit by buying suggested companies ahead of time, and waiting for the analyst predictions to turn true?
Probably no (if accuracy of analyst predictions are anything to go by). Let’s see why.
The article suggests companies within the orthopedics and cardiovascular space are most likely to benefit. That’s actually quite reasonable since large medical devices companies in these spaces are very profitable and cash-rich. They’re also hungry for new innovation, much of which will be sourced from outside. Also, in these sub-sectors innovations can be very much game changing (clinically and commercially) with opportunities to tap large markets.
It also highlights nine specific companies which investors may want to consider. So what are the companies suggested in the article, and what do the valuations look like. I took the list and using Yahoo! Finance, did some very basic digging to look at revenues, enterprise value and EV/EBITDA multiples. Here’s what I found:
The first thing that’s worth looking at is revenues. Each of the companies listed has meaningful revenues, ranging from $84 M to just under $600 M (even though three are not profitable). [Side note to entrepreneurs – Do you have a plan to develop meaningful revenues in your medical devices company? You’ll need them to attract buyers.]
A really useful ratio
Moving on to valuation, EV/EBITDA is a good and useful measure. This important ratio is considered by private equity buyers and strategic buyers when valuing a business, enabling an assessment irrespective of its capital structure.
Private equity buyers will typically pay an EV/EBITDA multiple of 7-10x. This enables them to use considerable debt to leverage the transaction and still have sufficient cash-flow to pay down the new debt.
Strategic buyers are often willing to pay more. They may use less debt to facilitate the transaction (typical financing routes include using cash on balance sheet, share transactions and of course, debt). But a strategic buyer is also usually looking for some kind of business synergies. This could include leveraging a sales force, utilizing existing expertise in a given space, cost synergies and other rationales.
But even then, a strategic buyer will pay typically 10-20x EV/EBITDA multiple. As mentioned in a recent post, when Hologic acquired Gen-Probe for $3.8 Bn, it paid a full EV/EBITDA multiple of 20x. For a buyer to pay over 20x EV/EBITDA, the acquisition has to work out fantastically well. Occasionally they do. More often they do not.
On reviewing the list suggested by analysts, current EV/EBITDA multiples range for profitable companies from 12x (for Thoratec and Nuvasive) to over 30x (for Tornier, Edwards Life Sciences and Volcano). As mentioned earlier, the list includes three loss-making companies – Heartware International, DexCom and Endologix.
Of the nine companies suggested, only three seem to be within the strategic buyer sweetspot on valuation – Nuvasive, Wright Medical and Thoratec. Clearly, this post is not considering the company specifics, anticipated growth rates, closeness of strategic fit and rationale. It’s just a back of the envelope, quantitative view (using twelve month trailing – ttm -figures, so NO speculation).
But do you know what? A quantitative sanity check like this can go a long way to making sure you don’t overpay for any company. And while company executives and management may be able to justify the cost to existing shareholders, it doesn’t mean you, as an investor, have to follow suit.
What are you interested in – a sexy story, or a solid return?
And do remember, the financial whizzes that manage $billions of funds for private equity investors are no fools. There is a very good reason why they generally stay between a 7-10x EV/EBITDA multiple – because at this level, they have a very good chance of earning a positive return.
Keep value in mind
So, what can investors do to benefit from any impending M&A wave in medical devices companies? Simple. Keep value in mind, practice Ben Graham’s philosophy and in his words, recognize that “in the short-term the market is a voting machine, in the long-term it is a weighing machine.”
Consider using a value based approach to medical devices stocks, as described in Medtech Value Investor’s Magic Number and Improving Investor Returns: 3 Benefits of Watchlists – then you’ll end up picking companies that have good business fundamentals AND good valuations. These are as likely as any to be picked up in an M&A boom or consolidation environment.
If any of your companies are subject to such strategic M&A, you’ll get the uplift in valuation – consider it a bonus. But most importantly, you’re not relying on speculation, hope or future promise to get your return. Over time, you’ll do just fine because you’re not overpaying.
Read our DISCLAIMER. At the time of writing, the author DOES NOT own any positions in the companies mentioned.
This post is by Raman Minhas.