|Thomas Gunderson is a managing director and senior research analyst at Piper Jaffray following medical technology companies. In over 15 years as an analyst, Gunderson has been recognized by several industry publications, including the Wall Street Journal, Institutional Investor, First Call and Medical Device and Diagnostic Industry. He holds a bachelor's degree from Carleton College and graduate degrees in cell biology and business administration. He recently sat down with Ken Liebman of Faegre & Benson LLP for an across-the-board interview on topics ranging from the future of the medical technology industry in Minnesota to how potential litigation outcomes factor into securities analysis.|
KL: Thom, you have been analyzing the medical technology industry in Minnesota for almost two decades. What does the past tell you about the future of the industry in Minnesota?
TG: Medical technology will certainly continue to be one of the strengths of the Minnesota economy. With Medtronic and the two other major CRM companies [Boston Scientific and St. Jude] all located here, Minnesota clearly has an anchor set of companies upon which to build. There are also newer growing companies like Tornier and Lutonix, to name just two, that are still private and that hold a lot of promise for the future.
However, I think the glory days of venture capital investment in Minnesota medical technology are probably over. Although there is a very strong infrastructure of talent—both on the business side and on the technical side in segments such as cardiovascular, orthopedic and urology—there is a shortage of indigenous venture capital and less of a need for venture capital located outside of Minnesota to venture here.
As other centers of the industry on both coasts have grown, Minnesota has lost its comparative advantage. It used to be that a venture capitalist would have four or five companies located here. When that gets down to one company at a time, it's no longer worth it to focus on Minnesota when there are so many opportunities elsewhere. So, from the time when Medtronic was started until at least the late 1990s, you had a combination of talented entrepreneurial risk takers and local investors. Today I think we have the risk takers but not enough local investors with sufficient capital, particularly as the capital requirements have gone up substantially due mainly to FDA requirements.
I still see Minnesota as an active participant but the momentum is clearly elsewhere, particularly the Bay Area. I've lived here long enough to remember when this was the hotbed area for the computer industry with several of the early pioneer companies located here [Control Data, Univac, Sperry]. I see the same thing happening in medical technology as in the computer industry—Minnesota will retain a robust set of companies but the momentum of the industry will largely be elsewhere.
KL: Is there anything Minnesota can do to rebuild its competitive advantage?
TG: I don't see taxes coming down and the state's high tax structure is clearly an impediment to the growth and maintenance of the local venture capital community. The University of Minnesota should have been more of an incubator of first resort, but until recently the university was more of a barrier to establishing medical companies. The university's reputation of being too complex to deal with and not creating a conducive environment is being addressed. Recently some forward thinking innovators in the patent licensing, engineering and business schools have been working with the local companies to remove the barriers.
In my opinion, Stanford University is a major reason that Silicon Valley is so successful in medtech lately. I've noticed a more pro-business attitude in the Bay Area among university administrators, physicians and professors.
KL: Let me ask you about another geographic area that seems to be on everyone's mind lately: China. How does the Chinese market figure into your analysis of companies and what do you see for the future?
TG: China is not yet a significant market for most medical device companies, but of course it will be. Japan and the major E.U. countries are still much more important today for almost all medical device companies because of their highly developed health care systems.
GE and other large capital equipment companies have made inroads in developing the hospital system infrastructure in China. Our area's largest medical device company, Medtronic, has stated that it has an objective of vastly expanding its market in China to the extent that in a decade China will be its second-largest market. But the health care system in China is still rather undeveloped, so it will be some time before the higher margin products can gain a foothold.
In 2009, I see China mostly in terms of an opportunity for Chinese startups to create lower-cost solutions for their domestic market and then export those products elsewhere as the cost containment issues become increasingly important in the more developed nations. But the creation in China of an insured middle class will drive medical imports over time. Ask me again in five years. Things are changing so fast that the situation may be completely different by then.
KL: Thom, let's move to another topic. Our firm does a lot of litigation. In the medical device industry potential damages often can be in the several hundred million dollar range and injunctions are sought as a matter of course. As a securities analyst, you have very sophisticated mathematical and analytical tools to value companies. How do you go about assessing whether a pending case will affect a company's earnings or stock price?
TG: We've never done any type of formal risk analysis or used metrics to evaluate litigation. I know there are some litigation risk tools out there, but we have never tried to use them and from attorneys I speak to, they do not use them a lot either.
For me, analyzing the potential effect of a case is really an impressionistic process. I usually read what I can from the companies themselves and the media. If a case is important, I usually consult off the record with others who may know something about the case, such as attorneys who do not represent any of the companies involved. From doing this long enough, I have learned that it is not practical to try to handicap the outcome. There are too many variables and too many unknowns.
In addition to the complexity of most cases, confidentiality orders really prevent us from learning too much about what is actually going in a lot of these cases. So, in the end, I usually view the outcome of a case as a coin toss.
KL: Even if a case has a 50/50 likelihood of a particular outcome, if the damages are large enough or an injunction is sought, does that affect your overall analysis?
TG: Litigation takes long enough that at the start it's usually a non-issue. While a case filed against a private company seeking financing may have some effect on valuation, we look at most litigation involving public companies in this industry simply as a cost of doing business.
Wall Street pretty much ignores litigation filings because the court system takes so long. Look at the stent litigation; it has been going on for years and in the meantime, the market, the technology and the clinical data have been advancing. As a case gets closer to a conclusion one way or the other, valuations could be impacted. Wall Street does not like uncertainty so the very fact of uncertainty about the outcome can have a depressing effect on valuations. Oddly, once a case is decided, there is less uncertainty so valuations may go up even for the losing side.
Wall Street looks at the long-term earnings for medical technology companies because these companies typically have a multiyear earning stream from their products. Damage awards are a one-time event so they don't matter as much. Having the event settled is often seen as a positive, so even a large award does not have too big an effect on the future earning stream.
KL: What about the threat of an injunction? Does that have a greater impact than a damages award?
TG: These cases usually take so long and injunctions are rare enough that they are generally not a significant factor for Wall Street. Any company that can't figure out over several years how to design around a patent probably has other issues.
While every once in a while an injunction may in effect shut down a company, the real impact on the industry is that the larger companies have such an array of patents that they create barriers to competitive aspirants who have trouble obtaining financing. No one tries to compete directly if they are not already in the business with their own set of patents. This may hinder innovation in that there is less competition for expansion into the existing technologies, but it also spurs innovation in "disruptive technologies" that approach a problem from a completely different angle.
KL: Have you ever changed a recommendation for a stock based solely on the outcome or potential outcome of a case? What happened?
TG: I did once. The company I was analyzing was the plaintiff and it received a large award. I predicted that the stock would go down because the good news was already in the price of the stock before the verdict. Sure enough, the stock did go down in the next few months after the verdict.
KL: What are the legal issues you consider to be most important for securities analysis?
TG: Obviously if you include regulatory issues then FDA approval is by far the most important. Without it there is no product in the United States, and without the domestic market there probably are no profits in most cases.
Reimbursement probably comes next for many classes of products. After that there are a host of other issues, including infringement and product liability, that can seriously affect a company. But FDA approval is the big one.
KL: Let's turn to one of those issues. The Department of Justice has been active in recent years in going after the relationships between companies, particularly the spine and cardiovascular companies, and consulting physicians. What do you see as the impact of these investigations and the settlements?
TG: I think the government is taking good cases where it finds them, so I don't anticipate it will be going after particular segments one at a time. If they find a case they will go after it, so I think almost any segment of the industry is at risk.
The larger companies can weather the storm and see it as a cost of doing business. That said, "headline risk" is not good for any company. Furthermore, to the extent that the relationship between physicians, especially surgeons, and the companies is more constrained, there will be some impact on product development.
However, I think a number of smaller companies will be helped because one of the advantages that the larger companies have had historically is their close relationships with physicians. The dismantling of the close financial ties between the larger companies and some of the key opinion leader physicians has leveled the playing field.
KL: Has the economic situation of this past year affected your view of the future for the industry?
TG: Not yet. Short term, there clearly has been an effect. Hospitals have been cutting back on capital equipment. Increases in consumer co-pay requirements have turned surgery previous thought of as necessary into elective surgery. Consumers have made do with fewer pills than were prescribed and slowed down spending on health care just like everything else.
What really surprised me as the market went to new lows in March was that investors were throwing in health care with everything else. Stocks which usually held up well as defensive plays took a beating. For example, we had medical device companies trading at lower than one times sales. Household names in medtech were trading at a significantly lower multiple than the S&P. That made no sense and there has been a slight rebound, but many medical device stocks are still undervalued, at least by traditional metrics. Why? The prospect of health care reform has brought an undefinable amount of risk into the equation.
KL: The medical technology industry is one relatively small piece of the entire health care industry and one of the potential drivers of savings in the system. Has the economic situation changed your view of the long-term future?
TG: While there will be an increasing emphasis on comparative effectiveness, we are too early in the debate over health care reform for me to make any reasonable predictions about how the industry will be impacted by legislation. With the baby boomers retiring and aging, demographics suggest that medical device companies should have a strong run for as long as I'll be around.
If this recession extends long enough, many of those people who put off treatments are likely to need even more aggressive and expensive treatments down the road. Those innovations that clearly drive better clinical outcomes and are more cost effective will be the big winners.
KL: With that in mind, what do you see as the hottest industry segments in the next few years?
TG: The biggest change driving new medical technology advances is the advancing obesity of the population. Neuromodulation, surgical advances and other new treatments for obesity or for the resulting diabetes are definitely at the forefront. However, obesity also creates a host of other issues. For example, the obese are more likely to need knee and hip implants. So we have to look at both the direct and indirect effects of the obesity problem.
In the cardiovascular area, which historically has been the largest driver of new companies and products, atrial fibrillation is the next area, but it seems to be more of an add-on to CRM products than a stand-alone area.
Anything for the boomers, like ocular treatments, urological products and advances in plastic surgery are likely to be hot segments for some time. However, I want to emphasize that any area that has a significant need for therapy can be hot if new innovations come along.
KL: Thom, any final advice?
TG: There's an axiom in politics that if one wants to remain a politician, don't stand between an old person and access to health care technology.
Disclosures for universe of: Thom Gunderson
- I or a household member have a financial interest in the securities of the following companies: none
- I or a household member is an officer, director, or advisory board member of the following companies: none
- I have received compensation within the past 12 months from the following companies: none
- Piper Jaffray or its affiliates beneficially own 1% or more of any class of common equities of the following companies: none
- The following companies have been investment banking clients of Piper Jaffray during the past 12 months: DXCM, VNUS, XTNT
- Piper Jaffray expects to have the following companies as investment banking clients within the next three months: VNUS
- Other material conflicts of interest for Thom Gunderson or Piper Jaffray regarding companies in my universe for which I am aware include: DXCM: underwriting
- Piper Jaffray received non-investment banking securities-related compensation from the following companies during the past 12 months: CYBX, EVVV, VNUS, XTNT
- Piper Jaffray makes a market in the securities of the following companies, and will buy and sell the securities of these companies on a principal basis: AMMD, BCR, BFRM, CUTR, CYBX, DXCM, EVVV, VNUS, VOLC, XTNT