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While the broader markets have experienced systemic turbulence stemming from the credit crisis that began last summer, the orthopedic sector has remained largely unshaken and is strongly positioned for another solid year. As indicated in Table 1 (page 24), orthopedic valuations—both for OEMs and their suppliers—far exceed the overall market. Since the woes of the sub-prime mortgage market began six months ago, the orthopedic market has fared comparatively well with share prices of its publicly traded constituents appreciating 1% during the second half of 2007 at the same time the S&P 500 declined by 4% for the full year 2007; the orthopedic market significantly outperformed the broader market with 12% share price appreciate versus 4% for the S&P 500.
Despite the moderation of overall merger and acquisition (M&A) activity in the second half of 2007, reflecting the tightening of credit that particularly impacted leveraged lending and publicto- private transactions, orthopedics experienced a significant rise in the volume ofM&A transactions.OEMand supplier segments together showed a 57% increase in the number of announced deals compared with the second half of 2006 (see Table 2 on page 26). For fullyear 2007, M&A activity within orthopedics in-creased 73%.Consolidation activity should continue to advance for the significant benefit of buyer and seller.Following is a look at why.
While various industry sectors may continue to be impacted by tightening credit markets, resetting asset values and slowing growth, orthopedics is comparatively sheltered from macroeconomic fluctuations. Orthopedic implants and associated instruments are not discretionary items. They are purchased to alleviate acute or chronic pain, which are functions of disease or trauma among a specific demographic— therefore less driven by liquidity, interest rates or real estate values. Further, as highlighted in Table 1, orthopedics typically utilizes modest leverage; with robust growth, high margins and solid cash flows, industry players can finance their growth internally or by readily accessing the capital markets that consistently have a strong appetite for orthopedics—even during broader economic downturns. Orthopedics certainly has industry-inherent exposure due to the regulated nature of the industry as illustrated by the recent US Department of Justice investigation of financial relationships with consulting surgeons; however, that cloud dissipated with the settlements announced in September.
Burgeoning demographic growth drivers and technology advancements are cushioning pricing pressures from hospital purchasing managers intent on streamlining vendors despite surgeons’ reluctance to switching brands. Consolidation should advance at attractive values for companies with value-added positions along the orthopedic food chain. Within the supplier segment, the market slowdown that began in late 2006 saw purchasing return to normal levels by mid-2007, though pricing pressures from OEMs always will be the rule.
Venture capital continues to pour into innovative orthopedic devices and technologies. Investments in orthopedic companies increased in 2007, and 2008 should be no different. Technologydriven companies tend to raise institutional capital due to the significant funding requirements and risks inherent in developing and commercializing a novel, proprietary orthopedic product. Once commercially viable, these niche companies then are poised to serve as growth catalysts for larger orthopedic players. Recent examples include Exactech’s acquisition ofAltiva, which represented the culmination of investments starting in 2003 that now provides Exactech with an expanded presence in spine as well as biologics; Synthes’ introduction into dynamic stabilization technology through its acquisition of venture-backed N-Spine, with at least 60% of the purchase price payable on achievement of milestones; and Wright Medical enhancing its ankle and foot portfolio with the purchase of subtalar implant assets from Metasurg, with much of the purchase price being performance based.
With advancements in orthopedic technologies, OEMs seek external growth by filling in gaps in important product lines through acquisitions or strategic partnerships. Critical mass is a driving force behind the robust acquisition activity. As big companies become larger, it becomes more difficult for them to achieve the impressive growth rates that are expected in orthopedics. OEMs will continue to acquire companies with market-ready technologies to leverage their marketing and distribution infrastructure.
The merger of DJO Inc. and ReAble Therapeutics, Zimmer’s acquisition of ORTHOsoft and Kyphon’s combining with Medtronic are but a few recent examples of transactions involving meaningful cross-selling and other synergistic opportunities.
The OEMs also accelerate earnings growth by enhancing margins, the eternal challenge of their vendors. While suppliers have seen their OEM customers replenish inventories, raise forecasts and launch new programs, OEMs remain intent on both reducing prices from and consolidating their supply chains. These dynamics continue to drive consolidation at the supplier level as vendors strive to expandmanufacturing capabilities, absorb idle capacity, enhance cost efficiencies, diversify customer and product mix and increase their importance to the OEMs. Examples include the recent half-dozen acquisitions by Symmetry, including its most recent agreement to acquire an instrument manufacturing facility from DePuy; Sandvik’s platform acquisition of Doncasters’ orthopedics business followed by the bone screws business of JKB and an instrument manufacturingfacility from Medtronic; Greatbatch’s recently announced purchase of Precimed, which itself had recently acquired Carr Metal; Orchid’s four acquisitions since 2006 involving several specialized machining operations as well as a polymer-based products business; and multiple acquisitions by Paragon including an instrument and implant manufacturing facility from DePuy, a metal finishing operation, an implant machining business and a development services provider.
Coming off a very good year and with high valuations, considerable balance sheet strength and strong cash flows, financing and M&A activity should advance across all spectrums of orthopedics. Traditional buyers will remain highly active as they compete for opportunities to enhance market positions. Middle-market sized players, with private equitysponsored companies in particular, may find competing for acquisitions with customary leveraged financing more difficult until the credit crunch eases. More likely, many private equity-backed companies formed and leveraged several years ago to consolidate orthopedic businesses will begin preparing to exit their investments in this environment. Finally, foreign buyers in particular are likely to target domestic companies to capitalize on local currencies’ purchasing power relative to the dollar which, weakened by slowing GDP growth, low interest rates and large trade deficits, has plunged 44% against the Euro since its October 2000 peak. While currency arbitrage does not drive M&A deals, it certainly adds degrees of confidence to buyers pursuing attractive strategic transactions. To capitalize on this robust M&A environment, sellers more than ever will be best served by employing a highly orchestrated, competitive and confidential process that carefully positions their value-drivers with ideal buyers. For buyers, it will be critical to carefully assess the value each opportunity can bring to their strategic objectives in a timely manner in order to not miss out on attractive opportunities as well as to know when to bow out of overpriced deals.
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 DReilly@ViantGroup.com. Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or rofessional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.