By: Alex Ponte along with Karim Nassar, Co-Founder and former CEO at Mednow Inc (TSX.V: MNOW)
In the 1840s, if you were a railway entrepreneur, it could’ve been the optimal time to issue public equity as the ground-breaking technology caused railway stocks to trade at absurd multiples. In Melbourne Australia during the land boom of the 1880s, real estate developers could obtain a huge premium for issuing shares in the public markets. Fast forward to the late 1990s and early 2000s, tech entrepreneurs were able to receive boatloads of cash for issuing
stock in the public markets. There is no doubt that when investor sentiment is positive and the risk-on mindset has eventuated, taking a company public for a premium equity multiple sounds like a good idea. However, in all three previous scenarios mentioned above, most of these companies that publicly issued their shares during these periods either went bankrupt or were subsequently acquired for a significantly lower valuation than when they went public.
Timing is not everything...
Timing doesn’t necessarily mean when public healthcare indices are trading at their highest multiple as demonstrated by some of the examples above. Rather, it’s when the company has been able to determine a strategy to maximize consumer surplus, while either achieving or becoming close to achieving enough scale to begin generating residual cash flows for equity holders as we discuss in the next section.
Although it may be tempting to file for an IPO when companies are hitting the markets at egregious valuations, these strategies rarely work out in the long term. The fuel for a lot of these stretched valuations is low real interest rates forcing investors to seek yield, eventually leading to irrational exuberance. Historically, a significant portion of these unprofitable IPOs don't survive in the long run because the focus becomes more on the marketability of their new equity instead of the underlying operations. Eventually, because markets have cycles, the punch bowl of cheap financing goes away, investors turn to a risk-off sentiment, and these companies which at one point raised cash so easily through public offerings are either greatly distraught or become dependent on very unattractive means of financing. In the North American healthcare space, managers and advisory boards must synthesize their evaluation of the company’s positioning before determining if it’s the optimal time to hit the public markets.
To be very clear, this isn’t an argument against going public, however, when seeing healthcare giants such as Teladoc (NYSE: TDOC) record a $6.6 billion impairment charge with shares down nearly 80% from their 2020 peak, healthcare companies should be conducting an adequate cost/benefit analysis before filing for an IPO. In this write-up, we identify a few factors to consider before a healthcare company decides to file for an IPO.
Scaling up in a public versus private healthcare model
Ability to capture rents given the regulatory environment
Organic growth versus inorganic growth strategies
Scaling up in public versus private healthcare models:
The path to scalability is determined by the healthcare market the company is operating in. If a company operates in a private healthcare system such as the U.S, their path to scalability is different than a company operating in a socialized healthcare system like Canada.
First, we explore a healthcare company’s sales channel as it relates to the demand side of healthcare. Healthcare companies can either sell direct-to-consumer (D2C), business-to-business (B2B), or both. Direct-to-consumer verticals tend to be more difficult, especially within public healthcare models where consumers do not have the habit of making paid healthcare purchasing decisions causing the private healthcare market to be inefficient and opaque. This along with the high implicit switching cost from one healthcare service to another makes converting customers difficult and expensive from a marketing point of view.
The risk of receiving inadequate healthcare and loss of health is the indirect cost in which consumers must bear to switch healthcare providers. Therefore, companies should deploy adequate marketing expenditure to convince potential clients to trust them with their health and give them a try. Compare this to a company in another direct-to-consumer channel such as online furniture sales where a consumer can easily change their mind after making a bad purchasing decision without affecting any of their long time prospects of health or life expectancy.
Although direct-to-consumer sales channels are more expensive, it is easier to deploy this strategy in a private healthcare market such as the U.S. The private healthcare landscape turns healthcare services into a hybrid between a basic human need and a consumer good. Meaning if an American can afford it, he or she will likely want to spend money on a premium healthcare product/service thereby creating a more efficient market. In a socialized healthcare market like Canada, healthcare is simply a basic human right. This makes Canadian healthcare consumers view healthcare offerings as commoditized. Unlike the U.S, Canadians are much more reluctant to switch or spend money on a differentiated healthcare service because tax dollars already fund most of their healthcare needs.
Customer acquisition costs for direct-to-consumer healthcare companies are still expensive in a private healthcare market, usually costing around or sometimes over $1,000. Consider the example of how marketing expenditure can eat up a healthcare company’s bottom line. GoodRx (NASDAQ: GDRX), a U.S based publicly traded prescriber, is an application that helps consumers navigate the complexities of the U.S. healthcare system while also attempting to help them save money on drug spending. During a great year of customer acquisition by the company’s standards, the company was still paying over $400 to acquire a customer.
The coefficient was calculated by taking the cumulative marketing expenditure from Q3 2020 to Q3 2021 and dividing it by the change in total prescribers and subscribers over that same period. Additionally, GoodRx is consistently spending around 45% of total revenues on marketing, which has consistently been the company’s largest expense and has been a barrier to the company’s profitability.
Keep in mind, GoodRx’s business model isn’t a source of primary care such as pharmacy or chronic care management and instead, it’s one where the benefit their offering provides is quite evident, namely being measurable and objective savings on medication purchases.
When considering that it requires even more trust to acquire a customer to a primary care service as providers of such a service cannot as evidently be compared based on perceived benefit as it’s not as clear cut as the dollars saved on a prescription. This is why direct-to-consumer healthcare provider companies can face significant customer acquisition costs and undergo an uphill battle to achieve profitability.
B2B clients like employers look to provide better healthcare for their workforce to increase employee efficiency and happiness thereby making employers more probable to spend money on premium healthcare. A healthcare service company would still need to build trust with a B2B client but are more likely to achieve economies of scale by acquiring patients in bulk.
Now that we’ve covered the demand side of healthcare, let's talk about the supply side. In Canada, the main supplier in healthcare is the government, making the aggregate supply of healthcare services much more inelastic than the healthcare supply curve in the United States. This may put an upper limit on margins for Canadian healthcare companies, further emphasizing the importance of obtaining the volume necessary to support operational density. This once again circles back to why Canadian healthcare companies should consider the B2B sales channel. Customer acquisition costs need to remain low, and volume must be obtained to support the lack of margins that exist in a socialized healthcare market.
To conclude, healthcare companies must consider the healthcare market they’re entering. Whether the market is publicly funded or privatized will have big implications on a healthcare company’s go-to-market strategy, sales channel, and supply distribution.
Ability to Capture Rents given the Regulatory Environment
The healthcare industry provides another unique challenge around companies within this industry being able to capture rent directly. This is particularly relevant in socialized healthcare systems.
Building on the GoodRx example above, there are sometimes valuable insights to be gained around the difference between being able to influence buying decisions of a B2B or a DTC buyer via channel partnerships versus being able to more directly capture that rent.
In the case of GoodRx, they’ve actually taken on the two approaches simultaneously as described below.
Via their Pharmacy Benefit Managers (PBMs) contracts, they’re able to negotiate discounts on drug pricing and partner with pharmacies to create for them foot traffic and an opportunity to gain a customer that they would have otherwise lost due to their drug being priced above market. This is especially relevant in the US market where both the consumer and pharmacist do not influence drug pricing and have no way to predict what the price, given PBM pricing, will be until the claim is made.
This service would have no traction in a socialized healthcare system such as Canada’s as prices are set at both a federal and provincial level and the lack of price transparency and subsequent arbitrage opportunity that GoodRx capitalizes on does not exist in Canada. Hence how the regulatory environment directly affects the exact same service, in this case, pharmacy, and the ability of vendors to participate in that channel to collect rent.
This pricing service gives GoodRx control over the pharmacy channel and puts it in a place where it can build significant exposure and a consumer base that allows it to scale B2B more easily and DTC plays. A good example of such a business is telemedicine as discussed below.
GoodRx built on its channel exposure by launching a telemedicine service that aligns it closer to its pharmacy partners by directing prescriptions to them; however, this also allowed them to charge the consumer directly for their service thereby exerting even more control on the supply chain given the existing volume of users on their platform.
This is an example of how healthcare businesses scale, they can add more variety to their approach than when they are just getting started. Said differently, synergies between businesses in healthcare are almost always only possible after achieving a certain level of scale.
The next question, therefore, becomes how this scale can be achieved as soon as possible to permit these possibilities of revenue and reduce the risks to the sustainability of a business. In healthcare, the notion of synergies has further ramifications on how and if scale can be achieved.
Organic growth versus inorganic growth strategies
A healthcare company has two routes to deliver top-line growth. A company can either pursue an organic growth strategy which means that they're reliant on internally generated sales growth, or they can pursue an inorganic growth strategy through M&A activity and partnerships. During 2020 and 2021 many emerging healthcare companies pursued the latter option. Although, it does appear that the healthcare market is becoming more conservative with its M&A activity.
EV/EBITDA multiples being paid for healthcare companies plummeted more than any other industry outside of technology in 2022. One explanation could be that the primarily pandemic-driven digital revolution that occurred in healthcare drove the impression that healthcare companies can scale entirely using technology and so should be rewarded for future growth almost as much as technology companies do from a valuation point of view. As it became evident to investors that technology is not always the path to growth, they started to value healthcare companies in their traditional sense of 3-4% CAGR thereby lowering valuations. Furthermore, where there are not a lot of public company comparables, it became harder to value the synergies that come from acquiring other healthcare companies, particularly ones that are in the provider space.
Inorganic growth strategies can offer plenty of benefits for healthcare companies such as obtaining economies of scale, diversified product offerings, rapid expansion, and improved competitive placement. However, inorganic growth strategies must be carefully evaluated as they require significant financial resources, potential regulatory issues, and dilution of company culture. Managers, advisors, and investors must assess the synergies not solely based on the aggregate revenues, but also on what the back-end synergies can create for the company. The following are considerations to be made when discovering a potential healthcare target.
Can these synergies help us obtain the scalability to support operational or logistical density?
Could the target company’s integrations increase consumer surplus? i.e., acquiring a HealthTech company to enhance in-person care, or partnering with a specific medical device company that enhances specific treatments.
Do the synergies enhance our healthcare ecosystem? i.e., acquiring a pharmacy, insurance company, or telehealth company to make a more holistic healthcare offering.
Does this acquisition increase your reputation as a healthcare provider?
Can the target’s operations integrate seamlessly?
Can the target’s company culture integrate with our company culture?
Can our synergies become cashflow accretive?
These questions are integral to determining whether a merger or acquisition will be an optimal decision for your healthcare company. Additionally, for managers and investors assessing the performance of the synergies after the acquisitions had occurred, per-share data must be analyzed as supposed to just the aggregate data. The following example is a health technology company listed on the TSX Venture Exchange that grew revenues through a series of acquisitions. The company’s aggregate revenue chart is parabolic.
Although the aggregate revenue chart looks fantastic, the chart displaying the same company's common shares shows that they needed to dilute their shareholders significantly to obtain this aggregate revenue growth.
Further diving into this company’s financials we find a year where revenue per share declined by 68% because the revenue growth couldn’t keep up with the share dilution. Additionally, we see that net loss per share has been increasing by 23% annually.
Currently, this company’s stock is down nearly 70% over the last 52 weeks. The example illustrates the importance of analyzing the synergies from a per-share basis, since that is the residual claim for equity investors. Investors only get impressed by aggregate top-line growth for so long, but if a company is unable to display organic growth, per share expansion, or progress towards profitability, the company begins to leave a sour taste in investors' mouths. Overall, healthcare managers must be able to describe how the back-end synergies from an acquisition will help the company capture economic rents. Furthermore, managers must also explain how the acquisition can be accretive on a per-share basis. Regarding organic growth strategies, healthcare companies must decide whether to sell B2B or D2C. This depends on your plan to achieve scale and the healthcare market you’re targeting.
Asymmetry of Information
A critical factor managers and advisors must consider is information asymmetry. Information asymmetry is a critical barrier to obtaining a positive perception from investors. Being able to convey your business’s value add, highlight idiosyncratic risk factors, and provide high-quality financial statements is integral for gaining investors' trust. Companies that are unable to convey these matters will suffer from higher costs of capital, as investors will perceive the information gap as an increased risk. It is important that healthcare companies build an adequate investor relations department so they can display these matters in a clear and concise manner.
The healthcare service industry needs these distinctions more than most industries. Assessing the quality of a healthcare service or product cannot be simply judged by patients or investors. It requires experienced healthcare professionals who understand the science and hospitality that goes into providing adequate healthcare remedies. Healthcare service providers should therefore consider disseminating reviews or statements made by licenced practitioners and other healthcare professionals.
Put concisely, healthcare service companies should seek a “professional's” opinion. Much like healthcare consumers, healthcare investors need to trust that your services are superior relative to the industry constituents and that your business can yield a robust return on investment (ROI). Reducing these information barriers will be an important determinant of the value that investors in public markets will place on your company’s equity.
In Closing: Look to the Left Side of the Equation Sign
The critical point is that healthcare companies need to mitigate the anchor adjustment bias that was commonly endured over the last few years when deciding to go public. It is critical that managers and advisors synthesize the evaluation of their company’s economic positioning before hitting the public markets. Knowing your path to achieve scalability, finding your optimal go-to-market strategy, and understanding how to navigate your business in either a public or private healthcare market is integral in the decision-making process that goes into determining if your healthcare company should file for an IPO.