Valuation Guide: Medical Device Industry

Industry Description

The medical device industry (SIC 3840, NAICS 339112) consists of companies engaged in manufacturing medical and surgical instruments used to diagnose and treat healthcare patients.  The United States is both the leading producer and consumer of medical devices.  The industry experienced annual double digit growth from 2007 to 2012^[1]; however, it experienced negative annual growth of 0.8 percent from 2012 to 2017.^[2]  In the coming years, the industry is expected to grow at a pace in line with rising per capita income.

Medical device manufacturers compete by developing superior products and technology; thus, research and development (R&D) is critical. New product innovation plays the most prominent role in sustaining growth for medical device manufacturers. Larger companies experience economies of scale in research and development, which is one of several factors that have led to increasing consolidation in recent years.  The top 10 medical device companies worldwide by sales follows:^[3]

1. Johnson & Johnson
2. Medtronic Inc.
3. GE Healthcare
4. Siemens Healthcare
5. Philips Healthcare
6. Cardinal Health
7. Danaher Corp.
8. Becton Dickinson
9. Baxter International
10. Stryker Corp.

The industry continues to be heavily regulated.  In the U.S., the Food and Drug Administration (FDA) is responsible for oversight of the medical device industry.  In response, the industry devotes considerable resources to product approval processes, clinical trials, plant audits and inspections.  Additionally, there are thousands of medical device recalls every year; recalls on devices occur throughout its’ life cycle, ranging from less than 1 year to over 15 years on market.^[4]  Recalls and lawsuits can have a significant impact on the value of medical device companies.

Industry Trends

Trends in the medical device industry have continued to change over the past several years, especially in response to shifting demographics (aging population, and increased incidence of modern diseases) and technology.  Some of the most significant trends include the following:

1. Older populations use a disproportionate share of medical services.  As the U.S. population ages, the incidence of health issues increase and drive up the demand for medical devices. The ongoing increase in the older demographic will help maintain growth in the industry.  The global population is also aging, with the United Nations estimating that people age 60 and up will make up more than 15 percent of the world’s population by 2025.^[5]
2. Industry revenues will maintain steady but slow growth.  Slow growth, decreasing profit margins and market competition for innovation will likely continue to drive the pace of merger and acquisition (M&A) activities.  The United States will continue to be the largest market despite a thin growth forecast.
3. To help offset the cost of the 2010 Affordable Care Act, the federal government instituted an excise tax on medical devices as of the beginning of 2013. The tax required medical device companies to pay 2.3 percent of total revenues whether or not they generate a profit.  The tax was suspended in December 2015.  Many industry opponents to the device tax claim that the tax has cost many U.S. jobs.  Supporting that claim is a survey commissioned by the Medical Imaging & Technology Alliance (MITA), released in July 2016.  The survey results include an increase in hiring since the tax was suspended in December. The survey found that 69 percent of respondents are likely to hire more U.S. based employees, and 77 percent are likely to invest additional resources in research and development (R&D) given the two-year device tax suspension. A permanent repeal of the tax may result in more gains for the U.S. medical device.

Key Performance Metrics

The following are performance metrics that are typically used by medical device manufacturers to benchmark their performance against others in the industry. These performance metrics are common to a broad range of industries:

1. Operating margin
2. Costs of goods sold as percentage of sales
3. Days of inventory on hand
4. Inventory turnover

Industry Organizations and Publications

Some organizations that publish helpful information about the medical device industry include:

1. Medical Device Manufacturers Association: www.medicaldevices.org, a national trade association of entrepreneurial medical technology companies
2. Advanced Medical Technology Association (AdvaMed): www.advamed.org, a trade association of medical technology companies representing 80% of the medical technology firms in the United States
3. Medical Device and Diagnostic Industry: www.mddionline.org, a magazine relating to medical device and in vitro diagnostic equipment manufacturers

Summary of Valuation Approaches

There are four different types of valuation methods that can be used to value medical device companies, as follows:

1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities. This approach is also sometimes referred to as a “cost-based approach”; that is, the business’s value is equal to the cost of acquiring its physical assets. This approach is seldom used for a medical device company because its value is more closely related to its earnings and cash flow.
2. Income approach to value (capitalization of earnings): This method is most applicable to companies that face predictable and constant growth in earnings and have a long history of operations.  The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate).
3. Income approach to value (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, but requires predicting changes in future cash flows.
4. Market approach to value: This method utilizes market indications of value based on metrics from guideline publicly traded device manufacturers and privately held businesses.  The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value.

Benchmark Statistics

The following benchmarking data is based on the financial performance of various medical device manufacturers.^[6] Before using this data for specific valuation purposes it should be evaluated for appropriateness.

	2016	2015	2014	2013	2012
Gross Profit %	50.8%	50.8%	46.9%	45.2%	46.8%
Operating profit %	9.1%	9.1%	7.2%	7.9%	8.1%
Inventory Turnover (Median)	3.8	3.8	4.0	4.5	4.2
Current ratio (Median)	2.4	2.4	2.2	2.4	2.0