Medical technology, commonly referred to as medtech, presents an enticing value proposition for investors. With formidable barriers to entry, a constant stream of technological innovations, and a plethora of unmet clinical and nonclinical needs, the industry seems poised for a future filled with profitable growth. Over the last three decades, Medtech has consistently outperformed the S&P index, outshining it by nearly 15 percentage points. This stellar performance witnessed notable peaks in the early 1990s, mid-2000s, and late 2010s. However, the landscape of value creation has shifted in the past five years, particularly for large diversified companies. Astonishingly, the top 30 cross-category MedTech companies have underperformed the S&P across one-year, three-year, and five-year periods.
Challenges Faced by Large MedTech Companies
The stagnation of value creation in the medtech sector largely stems from investors’ concerns about the growth prospects of these behemoth corporations. In the field of medical technology, growth often sets off a valuation “flywheel”: a rapidly growing revenue stream compels investors to prioritize revenue over profit and cash flow. In turn, this enables companies to allocate more resources to research and development (R&D), mergers and acquisitions (M&A), and market expansion, further fueling their growth trajectory. As of January 1, 2022, companies projected to achieve a Compound Annual Growth Rate (CAGR) of over 10 percent were trading at nearly 11 times their revenue. Conversely, those with growth rates below 10 percent were trading at less than four times their revenue. It’s evident that growth, along with growth expectations, is the driving force behind medtech valuations.
Although the industry has witnessed accelerated revenue growth over the past decade and a half, much of this progress has been spearheaded by small- and mid-sized companies. In 2016, analysts’ consensus growth estimate for these companies stood at an 11 percent CAGR. By 2022, it had surged to an impressive 17 percent. In contrast, for large diversified medtech firms, growth expectations barely budged, inching up from 4.6 percent in 2016 to a mere 4.7 percent in 2022.
Factors Contributing to Declining Growth Expectations
Several factors have contributed to the diminishing growth expectations for large-cap medtech companies:
Legacy Business Constraints: Larger companies often find themselves overexposed to stagnant markets, which weigh down overall growth rates and overshadow the potential of innovative products. While high-growth markets exist, with a projected 6 percent annual growth rate in 25 percent of the total medtech market from 2022 to 2025, large medtech corporations are often diverted by their legacy businesses. Between 2016 and 2019, at least one segment of the portfolio in 27 of the 30 large diversified MedTech companies in our sample exhibited growth rates of less than 3 percent CAGR.
Scale Challenges: A company boasting $10 billion in sales must consistently generate $500 million to $600 million in new revenue annually just to keep pace with market growth. In other words, to be considered an average grower, such a company must essentially establish a new midsize medtech business every year.
Sluggish Adoption of New Therapies: Achieving $1 billion in product revenue has become a more formidable challenge. For innovations aiming to enhance existing products, rigorous clinical evidence demonstrating superior outcomes and cost-effectiveness compared to the status quo is essential. Innovations that introduce entirely new procedures or standards of care face an even steeper uphill battle, including the time-consuming task of training healthcare professionals in novel diagnostic paradigms and procedural workflows.
Emphasis on Near-Term Earnings: Many companies prioritize short-term earnings over long-term innovation. This leads to innovation portfolios at large corporations being weighed down by incremental programs designed to deliver immediate returns, rather than transformative solutions for underserved patients or plans to seize opportunities stemming from technological advances. Over the past three decades, the R&D Vintage Index, a widely recognized industry metric measuring R&D output, has declined significantly.
Comparative Analysis with Pharma Industry
These growth challenges are not exclusive to Medtech; they also afflict large biopharma and biotech companies, often entailing even higher innovation costs. Despite this, diversified pharmaceutical companies (excluding manufacturers of COVID-19 vaccines) have consistently outperformed their medtech counterparts. Their returns were 25 basis points higher in 2021 and 8 basis points higher from 2019 to 2021. Additionally, growth expectations for large pharmaceutical companies surged by 250 basis points from 2016 to 2022, whereas medtech firms witnessed a stagnation in growth expectations during the same period.
The Role of M&A
The superior growth achieved by pharmaceutical companies as compared to medtechs can be attributed, in part, to their higher levels of inorganic activity. Historically, activities such as mergers and acquisitions (M&A), divestitures, spin-offs, and portfolio adjustments have aided both pharmaceutical companies and medtechs in overcoming growth barriers. Exiting low-growth segments and entering high-growth domains has enabled these companies to access transformative opportunities without the protracted and costly process of in-house research and development (R&D). McKinsey’s research indicates that active acquirers consistently outperform their industry peers, and companies embracing programmatic approaches to M&A tend to outshine purely organic growth strategies.
Intriguingly, while both the pharmaceutical and medtech industries have been refining their inorganic portfolios over the past four decades, the last five years have seen a stark contrast in activity levels. In 2021, the value of M&A deals in the medtech sector amounted to only half of the total for 2016, despite the industry being nearly 20 percent smaller in 2016. Conversely, pharmaceutical M&A grew by almost 40 percent over the same period. The disparity is even more pronounced when considering divestitures. Pharmaceutical companies divested more than $10 billion in total enterprise value in four out of the five years from 2016 to 2021, while medtechs only reached the $1 billion mark in one year.
The near future holds the potential to serve as a turning point for the medtech industry’s portfolio strategies. The uncertainties surrounding COVID-19 and its operational impacts have largely subsided, allowing businesses to shift their focus to external matters. Cash flows are returning to pre-pandemic levels, with the top 30 large diversified medtechs collectively holding more than $300 billion in cash or cash equivalents. Even if interest rates increase, which could raise borrowing costs, the median leverage ratio among the top 30 medtech companies has decreased by over 40 percent since 2019.
Notably, high-growth small and mid-cap medtech stocks have become more attractively priced over the past year, following a period of inflated valuation multiples. Most of these companies retain the attributes that make them appealing targets for larger acquirers: robust growth prospects, well-developed innovation pipelines, and portfolios ripe for acceleration through larger commercial engines. Their reduced valuations are primarily a result of macroeconomic forces, including speculation about rising interest rates affecting the risk profiles of unprofitable smaller companies.
Diversified medtech acquirers now find themselves in an advantageous position, benefiting from a more favorable financial environment and an opportunity for value creation. In the post-pandemic landscape, providers are actively seeking stable and streamlined supply chain partners, while patients and physicians are increasingly engaging with manufacturers through digital channels. Large medtech corporations, equipped with reliable supply chains and well-funded omnichannel commercial models, can significantly enhance the operational and commercial performance of their targets.
As a result of these shifting dynamics, we anticipate a resurgence of portfolio activity within the medtech sector. This renewed activity is already evident in recent deals, such as Baxter’s acquisition of Hillrom in 2021 and Cooper’s announced acquisition of Cook Medical’s reproductive-health business. The next wave of portfolio activity is expected to possess the following characteristics:
Programmatic M&A Focus: McKinsey’s research highlights the advantages of this approach, offering a risk-reduced pathway for large medtech companies to access higher levels of innovation and market growth.
Proactive Portfolio Management: In the post-COVID-19 industry landscape, companies must continually assess whether their lower-growth segments are vital to their portfolios and whether they are the most suitable stewards of these businesses. In 2021, the top ten medtechs had revenues double the size of the top ten in 2010.
Selective Large Deals: Larger acquisitions can lead to substantial rewards for medtechs looking to enter new markets, tap into new patient pools, or adopt new technologies on a significant scale. Our research indicates that companies committed to diligent due diligence and sustained programmatic efforts can reap the benefits of large deals.
Innovative Target Selection: As software and digital solutions become increasingly integrated into physician and patient journeys, MedTech companies will explore opportunities beyond core medical devices and equipment to differentiate their offerings. This is exemplified by Stryker’s acquisition of Vocera.
Alternative Approaches to Deals: Companies are exploring unconventional avenues beyond traditional M&A and divestitures to access external innovation. Some are participating in early venture rounds with medtech start-ups, leveraging venture arms to secure options for future acquisitions.
While the prospects for increased portfolio moves in the coming years appear promising, several questions linger. These include uncertainties surrounding fluctuations in elective-procedure volumes, the willingness of growth stock shareholders to sell, and the role of geopolitics in shaping M&A strategies. Nevertheless, the fundamental principles remain steadfast: growth propels valuations, portfolio adjustments can accelerate growth, and the current financial and strategic landscape presents an attractive environment for M&A activities in the medtech sector.