Deal making in orthopedics

Orthopedics has been a hotbed for mergers and acquisitions (M&A) in the first half of 2014, with a frenzy of deals ranging from the acquisition of new technologies to a mega-merger. It’s been a trend the past few years, from Johnson & Johnson’s acquisition of Synthes in 2011 to multiple acquisitions made by Stryker, Medtronic, Integra Lifesciences, Zimmer, and Smith & Nephew from 2011 to 2013 period, but now it is coming to a head.

In the past four months alone, Zimmer announced the $13.4 billion acquisition of Biomet, Medtronic appears to be considering buying Smith & Nephew after Stryker passed, Wright bought Solana Surgical and OrthoPro on the same day, and Smith & Nephew bought Arthrocare for $1.7 billion.
 

What’s driving the trend?

There are two dynamics driving the overall M&A trend. The first is downward pressure on reimbursement and pricing, utilization of costly procedures such as knee and hip implants, and increasing commoditization in that space, which we have also seen in spine surgery. The Affordable Care Act (ACA) has been promoting the pressure on reimbursement and utilization, prompting large orthopedic players such as Zimmer and Biomet to come together to increase scale and reduce the number of competitive players in order to help sustain pricing.

The market has been reacting favorably to these mergers because of the significant operating synergies and reduction of market fragmentation that can be achieved. For example, Zimmer is paying four times the revenues for Biomet, and on the day of the announcement, Zimmer’s stock rose more than 17%.

The second dynamic is the need to drive growth. As the large players consolidate, it solves only half the problem – allowing them to better sustain pricing and margins on their core products. They still need to solve the other half of the problem: the need to continue to drive high single-digit top-line growth and double-digit earnings growth. To achieve that level of growth, in addition to continuing to drive growth in their trauma businesses, companies must extend into, or expand their presence in, higher growth areas such as:

• Extremities (foot and ankle, hand and wrist, elbow, shoulder)
• Minimally-invasive surgical devices
• Biologics
• Device/drug combinations
• Sports medicine
• New quasi-orthopedic physician specialties, such as podiatrists that are increasingly performing surgery
   

Acquirers and their targets

Smaller medical device companies are typically the innovators, so they are being acquired once they have proven their technologies work and they have achieved some traction in the marketplace. Wright’s acquisition for $90 million of Solana Surgical, a maker of specialized foot and ankle implants, is a prime example. Others include Tornier’s $135 million acquisition of Orthohelix, Integra’s $65 million acquisition of Ascension Orthopedics, and Zimmer’s acquisition of Knee Creations.

The acquirers are also flush with cash, their stock prices are at all-time highs, and lending availability is at its strongest since 2007. There has seldom been a time as attractive as today for large medical device companies to make acquisitions, and they are taking advantage of it.

The “buy-versus-build” equation right now is pointing to “buy.” As the sizable companies evaluate the financial alternatives of utilizing their capital, the return on investment of many acquisition opportunities becomes higher than other uses – such as investing in their own research and development or expanding their sales force – because capital is inexpensive and these companies have tremendous ability to achieve operating synergies.

In the first half of 2014, valuations have been healthy in the orthopedic device M&A world, with the median enterprise value/revenue multiple at close to five times, and we understand that a couple of deals were valued in the higher single digits as a multiple of revenues. Going forward, buyers of small-to-mid-sized companies are likely to include Stryker, Synthes (J&J), Medtronic, as well as Zimmer buying additional companies, particularly in extremities. Integra Lifesciences is also acquisitive, although they are a relatively value-oriented buyer.

As mid-sized players, but leaders within niches such as extremities, Wright and Tornier are acquisition targets. Wright is trading at a high valuation, nearly six times revenues, so bigger players are holding off until that potentially cools off.

Smith and Nephew is interesting. Is it a buyer or a seller? Smith and Nephew is a relatively sizable company that has been making acquisitions, and yet there has already been a lot of buzz around them being looked at by Stryker and Medtronic. Other acquisition targets include Orthofix, which might also be a buyer now that debt coverage issues have been addressed, OsteoMed, Arthrex, and ConMed.
 

Beyond orthopedics

We have been seeing some activity in other medical device areas as well, such as respiratory and cardiovascular. Carefusion acquired the Vital Signs business from GE for $500 million while St. Jude Medical acquired CardioMEMS for $375 million from a syndicate of financial investors.

Cardiology, including interventional cardiology, is another space challenged by commoditization and downward pricing/reimbursement pressures where we believe there will be further consolidation. TAVI, a method of replacing a heart valve without open-heart surgery, remains the big buzz word on the growth/innovation side of interventional cardiology now that renal denervation to treat hypertension has cooled off due to the need for further research. The majority of TAVI devices have been developed by small companies; Medtronic entered the market by acquiring CoreValve.

Other areas where we see strong prospects for growth and innovation, and increasing interest among the large medical device companies, include neurosurgery, interventional radiology and neuroradiology, urology, ob/gyn, general surgery, and novel surgical and ablation approaches to treat cancer.

Finally, the medical device contract manufacturing industry is likely to benefit overall from the pressures and growth opportunities facing the proprietary medical device OEMs such as Medtronic, Boston Scientific, and St. Jude. Large medical device OEMs are increasingly focusing on their sales and marketing operations and outsourcing their manufacturing. Further, both large and small OEMs and device developers need the design and prototyping services many of the contract manufacturing organizations (CMOs) offer.

While the medical device OEM industry is projected to grow at 6% to 7% annually during the next 5 years, the CMO segment is projected to grow 11% to 12% annually for the same period. The CMO segment is, however, even more highly fragmented than the OEMs, with hundreds of small players making a relatively small range of parts for a few handfuls of customers. As the medical device OEM customers of many of these CMOs merge, it will drive many of them to do the same. We have seen the emergence of a dozen or so leaders in the CMO industry, some of which have been consolidators, including Accelent, Symmetry Medical, Greatbatch, and Flextronics.
 

Staying the course

Medical device M&A is unlikely to slow down any time soon. We expect the activity to continue throughout the next few years because the industry is still relatively fragmented. M&A will remain under pricing and utilization for a while, constant innovation is key to driving growth, and the need for scale and pricing leverage is crucial.

Mesirow Financial
www.mesirowfinancial.com/investmentbanking

About the author: Paul Teitelbaum is a managing director with Mesirow Financial and can be reached at 212.351.8188.