Medtech offers a compelling value proposition for investors. With high barriers to entry, sophisticated technology innovations, and substantial clinical and nonclinical unmet needs to address, the industry looks set for a future of profitable growth. Over the past three decades, the industry has outpaced the S&P index by almost 15 percentage points, with stellar periods in the early 1990s, mid-2000s, and late 2010s. Yet creating value has become more difficult in the past five years, especially for large diversified companies. In fact, the top 30 cross-category companies have underperformed the S&P over one-, three-, and five-year periods (Exhibit 1).1
This stalled value creation largely stems from investors’ apprehensions about the growth prospects of large companies. In medtech, growth can create a valuation “flywheel”: a fast-growing top line compels investors to prioritize revenue over profit and cash flow, and that in turn allows companies to invest more in R&D, M&A, and market creation, fueling yet more growth in sales. As of January 1, 2022, companies projected to grow by more than 10 percent CAGR2 traded at a multiple of almost 11 times revenue. By contrast, those with projected growth rates below 10 percent traded at less than four times revenue. Growth and growth expectations are driving medtech valuations (Exhibit 2).
Although the industry’s revenue growth has accelerated, on average, during the past ten to 15 years, much of the improvement has come from small- and midcap companies.3 In 2016, analysts’ consensus growth estimate for these companies was 11 percent CAGR; by 2022, it had topped 17 percent. For large diversified medtechs, growth expectations barely budged: from 4.6 percent in 2016 to 4.7 percent in 2022.
Why growth expectations are declining
A number of factors have contributed to the lower growth expectations for large-cap medtech companies:
The drag of the legacy business. Most larger companies remain overexposed to low-growth markets that depress overall growth rates and muffle the impact of innovative new products. High-growth markets do exist—in fact, 25 percent of the total medtech market is projected to grow at 6 percent or more a year from 2022 to 2025.4 But the legacy businesses in the portfolios of large medtechs tend to distract them from these markets. From 2016 to 2019, at least one portfolio segment in 27 of our sample’s 30 large diversified medtechs was growing at less than 3 percent CAGR.
The burden of scale. A company with $10 billion in sales must generate $500 million to $600 million of new revenue every year to keep pace with market growth. Put another way, to be considered an average grower, that same company must create the equivalent of a new midsize medtech business every year.
The slowing pace of therapy adoption. Less than two years after the launch of the first drug-eluting coronary stent, in 2003, product revenue reached $1 billion.5 Today’s road to $1 billion involves more speedbumps. For an innovation that seeks to improve on an existing product, such as a new endoscope, the manufacturer must hurdle a high bar for clinical evidence demonstrating superior outcomes and cost-effectiveness compared with the predicate. For innovations that create new procedures or standards of care, such as transcatheter valve replacements, the road gets longer and steeper. Training even one physician or care team in novel diagnostic paradigms, processes for selecting patients, and procedural workflows can take months.
The lure of near-term earnings. We hear a common refrain in portfolio-review boardrooms across the globe: “We’re very excited about some of these ideas, but for now we have to prioritize the near term.” The result: innovation portfolios at large companies are weighed down by incremental programs that will “fix” the next quarter, not ideas to unlock transformative new treatments for underserved patients or plans to seize opportunities presented by technological advances. Over the past 30 years, the R&D Vintage Index—a widely used industry metric that measures R&D output by dividing incremental revenue for a given year by average R&D spending for the previous five years—has declined from more than 3.0 in the 1990s to 2.2 in the 2000s and to 1.5 in the 2010s.
These growth barriers are not unique to medtech. Large biopharma and biotech companies face similar challenges, often with higher innovation costs. Even so, the top diversified pharma companies (excluding manufacturers of COVID-19 vaccines) have seen returns significantly above those of their medtech peers: 25 basis points higher in 2021 and eight basis points higher from 2019 to 2021. Similarly, while growth expectations for large medtechs held steady from 2016 to 2022, five-year-forward CAGR projections for leading pharma companies soared by 250 basis points.6
The role of M&A
Why have pharma companies achieved more value-creating growth than medtechs? One plausible explanation lies in their higher levels of inorganic activity. Historically, M&A, divestitures, spin-offs, and other portfolio moves have helped both pharma companies and medtechs to clear growth barriers. By exiting lower-growth businesses and entering higher-growth segments, these companies have accessed transformational opportunities, without years—or decades—of uncertain, expensive R&D. McKinsey research has shown that active acquirers outpace their peers across industries and that acquirers following programmatic approaches to M&A outperform organic growers.
Most larger companies remain overexposed to low-growth markets that depress overall growth rates and muffle the impact of innovative new products.
Although both the pharma industry and the medtech industry have been sculpting their inorganic portfolios over the past four decades, in the past five years activity among medtechs has fallen while pharma companies steamed ahead. In 2021, the value of medtechs’ M&A deals was only half the total for 2016, when the industry was almost 20 percent smaller (Exhibit 3). By contrast, pharma M&A grew by almost 40 percent over the period. The divestiture story is even starker. Pharma companies divested more than $10 billion of total enterprise value in four out of the five years from 2016 to 2021; medtechs topped $1 billion only in one year.
The near term could represent a pivot point for the medtech industry’s portfolio moves. The uncertainty around COVID-19 and its impact on operations has waned even if the virus itself has not, allowing businesses to shift their focus to external matters. Cash flows are returning to normal, and the top 30 large diversified medtechs now hold more than $300 billion in dry powder (cash or cash equivalents).7 If an interest-rate hike comes to pass, it could make borrowing more expensive, but in any event the median leverage ratio across our top 30 has fallen by more than 40 percent since 2019.
Notably, high-growth small and midcap stocks have become more affordable over the past 12 months, following years of swelling valuation multiples. Most of these companies have maintained the attributes that make them attractive targets for larger acquirers: healthy growth prospects, well-stocked innovation pipelines, and portfolios ripe for acceleration through larger commercial engines. Their valuations, for the most part, have been compressed not as a result of poor performance but of macro forces, including speculation that rising interest rates will increase risk levels for unprofitable smaller companies (Exhibit 4).
Diversified medtech acquirers have the benefit of not only an improving financial environment but also an advantageous value creation opportunity. In the wake of the pandemic, providers are seeking stable and simplified supply chain partners. Patients and physicians are increasing their digital engagement with manufacturers. Large manufacturers with reliable supply chains and well-funded omnichannel commercial models are now in a stronger position to accelerate a target’s performance, both operationally and commercially.
As a result of these shifts, we believe the industry can again see portfolio activity as a critical value creation lever. Renewed activity is already in evidence—take Baxter’s acquisition of Hillrom in 2021 and Cooper’s recently announced acquisition of Cook Medical’s reproductive-health business—and seems likely to increase. We expect the next wave of portfolio activity to have these characteristics:
- A focus on programmatic M&A. McKinsey research has demonstrated the benefit of this approach, which offers a risk-reduced pathway for large medtechs to access higher levels of innovation and market growth.
- More proactive portfolio management. When companies review the industry landscape that emerges after COVID-19, they should continue to ask whether their lower-growth segments are critical to their portfolios and whether they are the natural owners of their businesses. The top ten medtechs in 2021 had revenues twice the size of the top ten in 2010.
- Selective large deals. Bigger deals are bigger bets. The upside can be significant for medtechs looking to enter new markets, new patient pools, or new technologies at scale. As our research shows, companies with the right due diligence and a sustained commitment to programmatic efforts can win with large deals.
- Greater creativity in selecting targets. As software and digital solutions become embedded in physician and patient journeys, more companies will look beyond core medtech devices and equipment to differentiate their offerings, as indicated by Stryker’s acquisition of Vocera.
- The rise of alternative approaches to deals. Companies are looking beyond traditional M&A and divestitures to access external innovation. Some, for instance, are participating in early venture rounds at medtech start-ups, using venture arms to gain option value for future acquisitions.
Questions remain about the pace and magnitude of portfolio moves in the next few years. They include whether elective-procedure volumes will continue to fluctuate, whether shareholders of growth stocks will be willing to sell, and what role geopolitics will play in M&A strategies. However, the fundamentals remain. Growth drives valuations, portfolio moves can accelerate growth, and today’s financial and strategic environment is attractive for M&A.
Large medtechs face a value-creation challenge. Time will tell whether they use portfolio moves as part of their solution.