Mid-Year Review: Orthopedic Market Continues to Roll

David Reilly

The orthopedic market continues to outperform the broader market—including significant relative performance during the first half of 2008. That’s a pretty easy feat in the current market, but even in its own right, the orthopedic market continues to perform fairly well. Despite gradually moderating sales growth (11% industry-wide in 2007), the market’s macro drivers remain intact, industry players continue to perform well operationally with relatively few exceptions, and credit constraints and general economic conditions remain much more significant to other industry sectors. With respect to merger-and-acquisition (M&A) activity, as predicted in this column’s 2007 year-end review (January/February 2008 issue, available at www.odtmag.com), activity within the orthopedic market continues at a robust pace. Musculoskeletal technologies remain an attractive place to put capital to work, in turn fueling a plethora of important innovations—which then become targets of larger players seeking to differentiate or at least complete their own product mixes. At the same time, suppliers continue to shape themselves into providers of choice for their OEM customers. Such investment and consolidation cycle most likely will continue.

Stock Price Outperformance

Stock price performance of the orthopedic market outperformed the S&P 500 during the first six months of 2008; during such time, while orthopedics declined 6%, the broader market declined 12%. Excluding the biologics segment, the orthopedic market outperformed the S&P 500 even more handily (pun intended).

   
As Table 1 shows, orthopedic valuations still far exceed those of the broader market, and though valuations across the board have compressed in the past six months, in the case of the orthopedic market this primarily reflects multiple compression as opposed to underlying operational performance. In fact, actual revenue growth has increased across all orthopedic segments and, except for a slightly moderated forecast for device OEMs, revenue growth estimates have even been revised upwards. At the same time, profit margins generally have expanded; for example, the median device OEM gross margin increased from 65% to 67%, with an increase in EBITDA margin from 14% to 16%. 

M&A Activity Continues to Be Robust

As reflected in Table 2, overall M&A activity within the orthopedic market remains active despite poor credit conditions and recession worries affecting the broader market. Throughout the 12-month period ending June 30, publicly announced transactions by orthopedic companies totaled 69, reflecting a 38% increase compared with the prior 12-month period. Both the OEM and supplier segments of the market contributed to such an increase, with a 28% increase in OEM activity and a 64% increase from the supplier segment.

   
During the first half of this year, almost one-third of announced transactions pertained to OEMs’ purchases of a product line, technology or collection of related assets as opposed to an outright corporate merger or takeover. As explained in the January/February column, consolidation by the larger players remains a critical means of filling in product lines, expanding bases for future growth and otherwise leveraging market-ready technologies across established marketing and distribution infrastructures, and should continue accordingly.
   
On the supplier side, several acquisitive players continued their campaigns during the first six months. These include (with the number of acquisitions in the past 30 months provided in parentheses) Orchid Design (five) acquiring Azary Technologies; Sandvik (four) picking up Eurocut from The Medical House; New England Precision Grinding (three) acquiring both American Medical Instruments and Accu-Met Laser; and Greatbatch’s Precimed (three) acquiring from DePuy an OEM manufacturing facility in Chaumont, France.
   
Also during this period, OEMs continued divesting manufacturing facilities to suppliers. Precimed’s purchase of a DePuy implant manufacturing facility, announced in the first quarter of 2008, marked the third recent such transaction. (In the fourth quarter of 2007, Sandvik acquired an instrument manufacturing facility from Medtronic, and Symmetry acquired an instrument manufacturing operation from DePuy in New Bedford, MA). For many OEMs, such manufacturing activities—forging, casting, machining, finishing, etc.—increasingly are deemed to be non-core, both from an operational and a financial perspective. The recent divestitures reinforce a consistent theme: OEMs will continue to seek to divest such operations. Incidentally, this should continue to be a relief to investors in the supplier segment of the market, where captive manufacturing properties of OEMs often have been viewed competitively rather than as assets acquired secondarily through other transactions.

Onward

Overall, and despite the overhang that will persist from the broader market’s woes, the orthopedic market is well positioned to continue on track. Operationally speaking, it would be none too surprising to see another modest increase in sales and profitability. Certainly, the slowdown that extended into 2007 seems to be behind us; as an example, Stryker posted double-digit growth in each key market segment in the United States in the fourth quarter of 2007 for the first time since the third quarter of 2004. There has been talk of a gradual easing of pricing pressures on OEMs, which theoretically could, but most certainly will not, in turn lead to decreased pricing pressures on their suppliers. 
   
Taking recent announcements by two of the market’s largest suppliers as a proxy for the segment overall, Symmetry is seeing a pickup in ordering patterns from its main customer base and also has reported stable pricing for titanium. It continues to focus on developing its Malaysian operations into a full-service capability for Asia, including adding capabilities (forging, machining, etc.), and expects 80% of production to ultimately stay within the region, including China. Whereas analysts’ estimates at the end of 2007 reflected a compounded annual sales growth rate of 16% for Symmetry during the next two years, as of June 30, analysts’ estimates have increased to 22%; certainly its $106 million, four-year supply agreement signed with DePuy helps in this regard. Accellent also has announced a strengthening of its orthopedic business, which was up 13% in the fourth quarter of 2007, and guidance going forward calls for approximately 8% to 12% annual growth.

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Overall, the orthopedic market posted solid first-half performance in 2008. With both operational results and growth prospects further expanding during the period, recent underwhelming stock price performance really can be blamed on the broader market and economy. Despite these effects, which very well may continue for the foreseeable future, an active M&A environment likely also will continue.

David Reilly is a managing director of Viant Capital LLC, an investment banking firm that specializes in mergers and acquisitions; private placements; and financial advisory services. He runs the firm’s healthcare practice, which has a focus on the orthopedic market.  David can be reached at (203) 682-1880 or [email protected].

Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.