Economy Improves, Medical Device IPO Market Still Flounders

This was supposed to be a growth year. With investment levels down considerably in 2009 (37 percent in dollars and 30 percent in deal volume compared with 2008), venture capitalists greeted the dawn of a new decade with great expectations: They envisioned a world in which the economy was well on its way to recovery, a world in which sagging capital markets had stabilized and investments had returned to pre-recession levels (or at least close to it).

Such a turn of events, they surmised, would most certainly help revive the comatose initial public offering (IPO) pipeline. So much for those great expectations.

The economy, of course, has improved over the last 12 months (according to some economists, anyway). But it still has a long way to go before it can work its magic on capital markets and boost investor confidence enough to spawn some IPOs, according to financial analysts who spoke with Orthopedic Design & Technology.

“What would really benefit the IPO market right now is a strong economic recovery,” said Bill Miller, life science partner at global advisory firm Ernst & Young. “But there is still some uncertainty over whether we have hit the bottom. Some clients that I’ve talked to and others out there are not really sure whether we truly are on the road to recovery.”

Economists aren’t sure either, and for good reason—the economy itself seems to be sending mixed signals. Encouraging signs of growth over the last few months have been tempered with sobering reminders of the recession’s lingering effects. For example, the economy added 162,000 jobs in March, including 17,000 in manufacturing, according to the U.S. Department of Labor’s Bureau of Labor Statistics. But the March unemployment rate remained stubbornly high at 9.7 percent, and both the financial and information industries shed jobs (21,000 and 12,000 respectively). Plus, only 16 of 384 metro areas have recorded job gains over the last year, according to data from Moody’s Economy.com, and msnbc.com.

Similar contrasts exist in the housing market. Economists have forecast sales of previously occupied homes to rise to 5.4 million this year, a marked improvement from the low of 4.9 million recorded in 2008. But there’s a catch—sales are forecast to rise in part due to an additional wave of foreclosures that experts claim will hold prices steady and keep consumers from spending freely.

Such a wave may already have begun. Foreclosures hit a new high in March, and approached the 1 million mark during the first quarter, ended March 31. Foreclosure filings—default notices, scheduled auctions and bank repossessions—were reported on 932,234 properties in the first quarter (ended March 31), a 7 percent increase compared with the previous quarter and a 16 percent jump compared with the first quarter of 2009. One in every 138 U.S. housing units received a foreclosure filing during the quarter, according to RealtyTrac, an online provider of foreclosure data.

The constant mix of contradictory economic news seems to be lost on consumers (the Conference Board Consumer Confidence Index rebounded in March, rising to 52.5 from 46.4 in February). The same, however, cannot be said of venture capitalists. Having been blindsided by the sharp decline in device investments last year and a retrenchment in mergers and acquisitions, investors are being more careful with their money and more selective of their ventures. They’re also more reluctant to take their investments public.

Maybe a little too reluctant. In the last two years, the number of medical device companies withdrawing IPOs has outnumbered those offering their stock by a near 3-1 margin. Between January 2008 and April 2010, just six device companies filed IPOs, and data show those filings were bunched 20 months apart. During that same time period, 17 device firms withdrew their IPOs; another that was considering going public decided against it and never filed the necessary paperwork with the U.S. Securities and Exchange Commission (SEC).

Half of the companies that withdrew IPOs did so in the second half of 2008 as the global financial crisis mushroomed with the collapse of Lehman Brothers Holdings Inc. Most of the firms that withdrew IPOs during that time—including Salient Surgical Technologies of Portsmouth, N.H., Cardiovascular Systems Inc. of St. Paul, Minn., Acclarent of Menlo Park, Calif., and TransMedics Inc. of Andover, Mass.—cited “unfavorable market conditions” as a reason for the about-face, according to data from Ernst & Young and Renaissance Capital, a Greenwich, Conn.-based firm that provides research and investment management services on newly public companies.

The glut of withdrawals in 2008 (there were a total of 15) helped create a six-quarter drought in medical device IPO activity, the longest dry spell in recent memory, experts said. While the economy’s nosedive certainly discouraged many companies from going public, other factors contributed to the shortage as well, including the U.S.

Food and Drug Administration’s (FDA) device approval process and uncertainty over healthcare reform.

The amount of time and money it takes to go public most likely was a factor as well. Venture capital firms that invest in medical device companies must be more patient and have fatter pocketbooks to go public with their investment. According to Ernst & Young’s 2009 medical technology report “Pulse of the Industry,” the number of years and amount of funding required to take a company public increased significantly over the last decade. Between 2000 and 2002, companies took about 5.5 years and spent an average $48.8 million to go public; between 2006 and 2008, those numbers rose to 9.7 years and $62.1 million, the report stated.

“The lack of [device] IPOs is actually a result of a few different things,” Miller noted. “The uncertainty about the overall economy has dragged down investor confidence. Companies also have concerns about the FDA’s approval process and the impact of the medical device excise tax. The appetite is there for medical device IPOs but it’s been a struggle.”

Some companies, though, have managed to overcome that struggle. In the last six months, three medical device firms have filed IPOs, giving venture capitalists hope that the frozen IPO landscape in the device sector is finally beginning to thaw. The filings are the first since the first quarter of 2008, when MAKO Surgical Corp., CardioNet and Lifeline Scientific Inc. raised a total of $115 million in public funds.

The most recent IPO activity—a trickle compared to past filings—began in October 2009 with the sale of 13.75 million shares of stock by AGA Medical Holdings Inc., a Plymouth, Minn.-based developer of devices that close structural heart defects and abnormal blood vessels. The company raised $199.4 million, well below the $275 million it previously had estimated. Weak demand forced AGA Medical to lower the expected price range for its IPO to between $15-$16 per share from $19-$21 per share, though the final per share price fell even further, to $14.50.

The next device IPO occurred shortly before Christmas when SurgiVision Inc. decided to go public. The Memphis, Tenn.-based firm filed for a $30 million IPO, outlining its plan in SEC documents to sell shares under the SRGV ticker on the NASDAQ exchange. SurgiVision develops MRI-guided, minimally invasive technology for brain and heart imaging.

Over the winter, European private equity firm Montagu toyed with the idea of listing portfolio company BSN Medical, but ultimately decided against it due to market uncertainty. Montagu first considered the IPO in January, though it remained open to bids from strategic buyers such as 3M and Kimberley Clarke, and private equity firms Apax Partners and Bain Capital.

Montagu acquired BSN Medical from parent companies Smith & Nephew and Beiersdorf for 1.03 billion euros, or $1.23 billion U.S. dollars, in December 2005. Montagu tried selling the German bandage maker more than 18 months ago, but the global financial crisis forced it to scrap the sale. BSN Medical develops products for general wound care, non-invasive orthopedics and phlebology.

With Montagu’s IPO off the table, activity disappeared again in the first quarter of 2010. However, it resurfaced in early April with a filing by Kips Bay Medical Inc. of Minneapolis, Minn. In an SEC filing, Kips Bay officials said they hoped to raise $57.5 million from the public offering of stock to seek regulatory approval for the company’s eSVS Mesh. The device is a flexible metal mesh designed to strengthen vein grafts used in coronary artery bypass surgeries. Kips Bay executives said they expect to begin selling the device in Europe during the second half of 2010, and begin enrolling participants in a U.S. study of the device later this year, according to the company’s SEC filing.

Though the recent IPO activity is encouraging, the funding environment for medical device firms still remains shaky. Ernst & Young’s report predicts it will take “more than a few months or quarters” for the sector to regain its footing. “Any recovery will need to include improved consumer and investor confidence, as well as an opening of the credit and debt markets to credible, cash-flow positive companies.”

Miller agrees, but believes strong first-quarter earnings reports also will help spur more activity in the IPO market.

“If some of the high-growth medtech companies report strong earnings, that should add fuel to the fire for additional IPO filings,” he said. “It could help rewet the appetite out there for device company IPOs.”

VCs Predict Device Tax Will Kill Innovation and Stifle Job Growth

Venture capital firms that invest in medical device companies must be more patient and have fatter pocketbooks to go public with their investment.

There’s just no way around it. When small medical device startups are taxed 2.3 percent on their sales three years from now, their payment options will be limited. They will be forced to look for the cash in one of two places, venture capitalists predict: their research and development budgets, or employees’ salaries.

“Most young startups are not profitable,” said Kelly Slone, director of the Medical Industry Group at the National Venture Capital Association (NVCA), based in Arlington, Va. “Their cash is in R&D. They’re going to have to pay this [medical device] tax, and the way they’re going to pay for it is through their R&D budget or through new jobs. The VCs I’ve been working with tell me those are the only two places to get the money.”

The nation’s revamped healthcare system—crafted by legislation that was signed into law by the president in late March—extends health insurance to 32 million Americans who currently do not have coverage. It bars insurers from refusing coverage to people with pre-existing medical conditions, expands Medicaid’s insurance program for the poor, and imposes new taxes on the wealthy.

The new healthcare system also imposes a 2.3 percent excise tax on all medical device sales beginning in 2013. The NVCA had lobbied Congress for a graduated tax system, proposing that firms with revenues of $100 million and less be exempted from the levy and companies with revenues between $100 million and $150 million pay 50 percent of the tax. Without such a system, the NVCA argued, emerging companies could lose the ability to raise the risk capital needed to bring “innovative technologies” to market and create or maintain U.S. jobs.

“Our big issue with this tax is that it affects young companies most,” Slone told Orthopedic Design & Technology. “Some younger companies may have $100 million in revenue and that may sound like a lot, but the fact is they’re not yet profitable. How can you think that it’s the right public policy to tax a company that is not profitable? The medical innovation is coming from these young startup firms, not from the larger companies. I would think our politicians would want to protect these companies because this is where the innovation and job growth is coming from.”

NVCA officials outlined their concerns about the device tax in several letters it sent to President Obama, House Speaker Nancy Pelosi, Senate Majority Leader Harry Reid and other members of Congress last fall and earlier this year. In a letter to Pelosi and Reid dated Oct. 15, 2009, the NVCA warns that the tax will send capital investment and jobs to foreign countries.

“Many forces are already driving capital and jobs away from the U.S. healthcare sector,” the letter stated. “The increasing time and expense of developing and bringing new medical technologies to market in the U.S. is causing investors and companies to focus their attention on overseas markets. A tax on smaller, pre-profit U.S. companies will only accelerate this migration abroad.”

Several members of Congress supported the idea of a small company carveout, but such a provision was never drafted because the legislation was not subjected to a House-Senate conference, venture capitalists said. NVCA executives still hope that such a provision can be included in new, corrective legislation before the tax goes into effect. While venture capitalists applaud the government’s efforts to reform healthcare, they claim that the new law fails to address the cause of skyrocketing costs (hospitals are the true culprits). It also discourages innovation.

“If we really want to think about healthcare, what is going to take us to the next level and be able to take costs out is innovation,” said Harry T. Rein, a general partner at Foundation Medical Partners, a national healthcare venture capital investment firm based in Rowayton, Conn. “To be able to deliver the same amount of care for the same amount of dollars to more people, you’re going to have to innovate. There is no other way to do it. But we’re making it harder, we’re not encouraging the innovation community.”

Symmetry Reports Sequential Gains for Q1

Symmetry Medical reported a 17 percent drop in first-quarter revenue (ended March 31) compared to the same period last year. For Q1 2010, the Warsaw, Ind.-based firm showed $84.5 million in revenue, down from $101.4 million in 2009. Sequentially, the first quarter showed 11 percent growth compared to the last quarter of 2009—$84.5 million up from $76.4 million.

Gross profit for the first quarter of this year was $17 million, down compared to the $24.6 million reported for the same period last year, but up 21.4 percent on a sequential basis from the $14 million reported in the fourth quarter 2009.

“We are encouraged with the improving environment in the orthopedic industry and the results of our cost control initiatives, both of which contributed positively to our first quarter 2010 results,” said Brian Moore, president and CEO. “Our strong 11 percent sequential revenue growth was driven by the ongoing stabilization of our business that began during the fourth quarter 2009. We are continuing to see positive signs of recovery with order intake greater than reported sales for the second consecutive quarter. Our strategic focus remains on positioning ourselves for the re-acceleration of orthopedic industry growth and increasing our market share.”

For 2010, company officials are increasing the firm’s revenue guidance to a range of $330 million to $340 million, up from the previously announced range of $320 million to $340 million. The increase is based on current order flow and anticipated customer demand for the remainder of 2010, company executives said.

Articulinx Completes $10 Million Series B Round

Articulinx, Inc., a medical device company developing a novel, minimally invasive approach for the treatment of osteoarthritis, recently closed a $10 million Series B financing led by US Venture Partners of Menlo Park, Calif. Existing investor De Novo Ventures, of Palo Alto, Calif., completed the round.

According to company officials, the funds will be used to continue development of the Articulinx spacer technology and to fund ongoing operations.

“Today’s announcement is an important validation of the Articulinx technology,” said Michael Orth, president and CEO. “We are very pleased to have two such experienced investors partnering with us to develop and commercialize devices for the treatment of osteoarthritis, the most common joint disease worldwide.”

The company’s first product, the Articulinx CMC Spacer, is implanted through a small incision under local anesthesia. The device acts as a spacer to separate bones in joints where the articular cartilage has degenerated.