By popular demand we’re doing a new overview, this time focusing on healthcare (Finally!). We’re going to keep this simple and stick with three basic buckets. 1) Healthcare Equipment, 2) Bio-Technology and 3) Pharmaceuticals. If there is a lot of demand for an additional space (or sub-segment within the sector) we’ll add it but this should serve as a solid overview given that these three sectors are in the news everyday (so it seems).
Notably, interest in the healthcare sector is likely being bid-up because of recent M&A activity (tax inversions) and stock price performance on the bio-medical side (breakthrough drugs). In short, a lot of people are interested in health care simply because it is *hot* right now. This is similar to the high level of interest in the internet sector.
With that said, here’s the high level overview….
Notes to Be Aware of Before Beginning
1)If you are shooting for investment banking, having a background in healthcare is certainly not necessary. It may help with your spin (IE: a dual major in biology and finance would be better than solely finance) but certainly isn’t needed.
2) If you are shooting for healthcare from an investment perspective (think Equity Research, Healthcare specific investing funds) then advanced knowledge certainly helps. IE: many Equity Research analysts have PHDs in the healthcare space (naturally this applies to the buyside as well if they make the switch).
3) We are not covering hospital management, health care services (similar to biz services), health care insurance or Healthcare REITs. The reason why is these segments can be classified under different umbrellas. As an example healthcare REITs could simply be under real estate and Insurance could simply be under FIG (we already covered Insurance in detail). Finally, the last sector we *should* touch on is life sciences, but we’ll wait to see if people are interested in the space.
Valuation Backdrop: First and foremost, the healthcare sector derives much more of its value from the products and medical treatments created than any valuation metric used. In fact, this is exactly why valuation is the least important part of the process. The real value in healthcare stocks, and why they can be extremely volatile in spaces such as bio-technology come from the products. Products, products, products!
Now that we’ve gone over the importance of understanding the drugs and products, if you’re looking for specific metrics for valuation you should then turn to the following:
2) Discounted Cash flow
3) Price to Earnings
4) Free Cash Flow Multiples
The most common starts with the EBITDA metric as it is used across the Health Care space. The EV/EBITDA metric starts as the baseline and as you become more interested in the asset you’d build out a full discounted cash flow model and predict earnings power/upside to drug/product launches. Nothing fancy and as expected, higher growth companies would lean toward EV/Sales metrics.
With that lets go ahead and look at each sector.
Healthcare Equipment/Devices (SYK, JNJ, ISRG)
One of the larger segments within healthcare, equipment and devices can include: 1) joint replacements, 2) trauma surgeries; 3) surgical equipment and navigation systems; 4) endoscopic and communications systems; 5) neurosurgical, neurovascular and spinal device.
Instead of going through each one of these major segments we can simplify it as follows:
Reconstructive Surgery (joint replacements, trauma): While difficult to pin down, for the surgery market you’re going to look at the market in terms of overall replacements and market share within this space. As a simple example, you can expect a million or so hip/knee replacements per year (costs per surgery can exceed $10K)
We can do an entire post outlining different estimates for each type of surgery or procedure (~4+ million hernia repair procedures, ~2M appendix removals a year, partial removal/reconstruction of a colon at ~2.5M per year) however the point is to estimate the number of procedures by market and build from there. Each surgery company you work with will have a different market it is addressing. Total costs of each surgery also have wide bands that range from as low as a few thousand dollars to tens of thousands.
Medical Devices (Instruments, Endoscopy): This sub-segment focuses on products to help examine the human body (particularly inside organs as you are all well aware). Roughly speaking, the endoscopy equipment market is estimated to be $28.2 billion in size as of 2013 and is expected to grow at 5-7% CAGR.
This is a bit easier to understand at a high level as most are more familiar with these products. You can splice the $28.2B into smaller sub-segments as well: cameras, processors, displays/monitors and other accessories (brushes, fluid devices).
NeuroTechnology (neurosurgical devices and spine related issues): Finally, we reach the neurotechnology/spinal market. While the neurotechnology market is difficult to size, if you are looking for spinal implants it is a ~$5-6B market (low single digit growth). In addition, if you want to split the spinal arena into spinal devices as well, you find that the market is growing at ~4-6% annually (2013 market is roughly $10-12B).
You were asking about M&A? As noted at the top of the post, lots of M&A continues to occur in this space. There is a reason why… Tax inversions AND aggressive M&A targets.
Tax Inversions: These are specifically *hot* in the healthcare space and a quick Google search will get you up to speed on why companies are doing this, the simple answer is this… to save on US taxes. You purchase a company overseas and reincorporate to avoid paying US taxes.
Clear M&A Strategies: An overlooked reason beyond tax inversions for the recent M&A activity is the relatively low hurdle rate to take on more acquisitions. Companies are spending more and more on M&A to obtain market share and grow revenue: hurdle rates as low as ~12% IRR.
Valuation: Here we’re looking at more classic healthcare valuations. So you should be thinking in terms of EBITDA/Cash flow and various forms of return metrics (IRR and ROIC).
Some Final Takeaways: Given the backdrop to healthcare equipment companies, you should also be aware of the importance of organic vs. inorganic revenue. This is certainly key as rampant M&A (as seen in this space) must be met by additional scrutiny from investors/shareholders as growth within each segment (Spine/Surgery/others) should not be 100% due to acquisitions.
Bio-Technology (GILD, AMGN)
This is one of the hottest spaces within the Health Care industry.
This sector is best explained with an example, starting with a Bio-tech Giant ($160B+) Gilead. The Company develops and commercializes medicine which can include hepatitis vaccines, work on HIV/AIDs related products and cardiovascular/respiratory issues.
As you can imagine, the key question here is:
“Does the cure work?”
This answer will then drive your total addressable market and your ability to sell the product at scale. If the vaccine/medicine works, margins and profits are high since the cost of re-creating the concoction is usually quite low.
As promised, here’s a large example:
Sofosbuvir (Sovaldi) was createdby Gilead to treat Hepatitis C. The product costs between ~$84K for 12 weeks of treatment to $168K for 24 weeks of treatment. Here’s the kicker… The cure works 90% of the time.
Needless to say this created a large opportunity for the firm as the Company generated revenue of ~$3.48B in Q2 of 2014 from Sovaldi sales due to the high $1,000/pill price tag.
Risk/Reward: While this is a large example where a single quarter in sales were larger than the entire previous year for the product line, the downside would be 1) changes in regulation, 2) competing drug products with higher cure rates, 3) similar products with less side effects.
In short the bio technology space is driven primarily by drug innovation. You’re going to follow updates from the FDA, the launch of the product in multiple geographies and monitor competitor drug releases as well.
While working in this space you would track drug trials for curing XYZ disease by comparing different response rates (example drug A has 50% effectiveness and passed X trials, drug B has 65% and passed Y trials etc.). Essentially, you create a landscape of the competitive drug market and flag each drug as it passes through Phase I, Phase II trials and so forth.
For more information on Sovaldi you can check out their website: http://www.sovaldi.com/
If you’re interested in learning more about newer drug releases then you can stick with another example and follow Zydelig (a leukemia related drug).
Valuation: Given the backdrop, these companies have higher volatility and trade at large multiples where 5-7x sales, 10-15x EBITDA and 15-30x earnings are not uncommon. From that basis, Bio-tech is a space where you’ll lean more to sales and EBITDA multiples and less towards the DCF.
Drivers of the Space: These companies generally have less revenue (as expected they are valued based on future of their drugs). Therefore the main driver is going to be a promising drug being released (would be on radars for acquisitions – depending on how far down the road they are) and the
Final Note: To be clear with regards to the Biotech space, we are not recommending any security. The industry requires quite a bit of research and the above explanation was simply an example of how an important medical breakthrough can lead to billions of dollars in revenue (a previous event). Solvadi is not a common occurrence as it won the FDA’s breakthrough therapy designation and was approved by the FDA in December of 2013. The goal of a top tier biotechnology investor is to understand when and where the next medical breakthrough will come. If you’re a banker, you’re looking to appropriately size the opportunity of the next break through (easier said than done).
Pharmaceutical Companies (JNJ, PFE, BMY)
Similar to Bio-tech we are going to use an example to highlight the main pieces of this segment. The biggest name brand company that people are aware of is… Johnson and Johnson. From a high level here are the primary markets they serve.
Immunology: This is estimated to be a ~$10B industry growing at mid-single digits. As the name implies, this refers to diseases caused by disorders within the immune system: Immunodeficiency (where immune systems fails to give a proper response), autoimmunity (immune system attacks its own host body). We can split the Immunology market into several pieces but we’re going to keep it simple for this post. Example product would be Stelara – used to treat psoriasis a skin disease (do not Google image that – you’ve been warned)
Oncology: This is a $4-5B market depending on who you ask growing at a faster clip of roughly double digits. Oncology in short is the study of tumors/cancer. To keep with the format, a sample product here would be Zytiga (prostate cancer treatment).
Diabetes: Another self explanatory market for you guys, here we’re looking at a ~$40 billion market growing at 6-10% annually. A good example of a diabetes drug would be INVOKANA (canagliflozin) a type II diabetes treatment.
Neuro/Mood Products: This market directly treats patients with mood disorders such as ADHD and schizophrenia. This market is roughly $40-50B in size and a sample product in this space would be esketamine.
Likely missing a few here but the above should serve as a solid high level view.
Valuation: In this space you can primarily look at the four classic valuation metrics given at the beginning of this post 1) EV/EBITDA, 2) Discounted Cash flow, 3) Price to Earnings and 4) Free Cash Flow Multiples. To provide some additional help for your napkin or back of envelope: Sales multiples of ~3.5-4.5x on a forward year basis, PEG’s of ~2-3x, P/Es of 15-30x
Drivers of the Space: As expected, the main drivers are positive trial results, changes in regulation and release of generics.
Final Thoughts: Similar to biotech we are looking at variable outlooks based on performance of new cures and treatment results from innovative products. That said the multiples are generally a bit lower due to large pharma companies having lower growth profiles relative to a large number of hyper growth bio-tech companies.
Some points to help you in recruiting – Generally, healthcare practices are located in NYC/New Jersey/San Francisco; Healthcare has quite a bit of activity so you would likely get experience in M&A and Equity/Debt raises improving your capital markets knowledge; Beyond products, tracking phases of drug trials, naturally regulations play a big part in this space as well
There you have it, a short and sweet (if you call 2,000+ words short!) overview. If there is another space within healthcare that people need more information on we may do a part two. However, the three spaces above cover the main sectors that are driving interest in the space. Finally, we’ll likely continue with these if people are interested in more sector overviews.Financial Institutions Group; Technology Part 1; Technology Part 2