Healthcare Industry: Innovation Is Necessary, But Not Cheap

In previous posts, I cited several reasons for optimism regarding the U.S. healthcare industry. This includes new major revenue sources such as the expansion of coverage to the uninsured and aging baby boomers. We also export our expertise and the global population is swelling.

Although these developments remain strong indicators of a robust demand for the healthcare industry, they also paint a macabre picture of the future of our country, and its economic condition. In short, what is good for healthcare providers may not be good for America. Healthcare expenditures in the U.S. currently consume roughly 16-17% of our GDP and are rising at an alarming rate. From a 2008 study by the U.S. Department for Health and Human Services:

Over the full projection period (2008-2018), average annual health spending growth is anticipated to outpace average annual growth in the overall economy (4.1 percent) by 2.1 percentage points per year. By 2018, national health spending is expected to reach $4.4 trillion and comprise just over one-fifth (20.3 percent) of Gross Domestic Product (GDP).

In 1789, Thomas Malthus predicted that the exponential growth of the human population would overwhelm our arithmetically growing food stores, returning us to subsistence-level conditions. (His gloomy predictions led historian Thomas Carlyle to dub economics the dismal science.) Lucky for all of us, he was wrong. The Industrial Revolution provided us with efficiency-enhancing technology, enabling us to produce food at a faster pace.

Today the situation in healthcare is not much different. Left unchecked, healthcare expenditures will continue to sap economic productivity and output, not to mention fiscally bankrupt the U.S. government. The disquieting projections of the DHHS present us with a Malthusian situation. Although healthcare is decidedly more complex than agricultural production, the solution is no different than it was two centuries ago: disruptive innovation.

The case for disruptive innovation in healthcare is most effectively championed by Clayton Christensen, a former Rhodes scholar and professor at Harvard Business School. In The Innovators Prescription, Christenson and his co-authors (both MDs) diagnose the industry with a lack of innovation, both in terms of its technological progress and its outdated business models. They argue that in order to keep healthcare providers and insurers off government provided life support, new technologies need to be developed in order to increase efficiency, while simultaneously improving the overall quality of care. In turn, these technologies must be applied to business models that align the interests of patients, practitioners, insurers and policymakers.

Examples of technologies that have simultaneously reduced costs while increasing quality of care include those used to treat atherosclerosis, or fatty buildup in blood vessels. In the past, bypass surgery was used to divert blood flow around the obstruction. Then angioplasty procedures were developed, enabling surgeons to widen the blocked vessels using tiny balloons. Nowadays, doctors often prescribe cholesterol-lowering statins, both as an ex-ante and ex-post treatment for cardiovascular disease, making more risky and expensive bypass surgery less common.

Unfortunately, innovation does not come cheap and throughout the recent financial crisis, financing sources for entrepreneurs have effectively flat lined. Venture capital funding, the preferred source of backing for fledgling enterprises, fell a staggering 37 percent between the first quarter of 2008 and the first quarter of 2009. A primary reason for the lack of funding is that the traditional exits for VC firms through acquisitions or IPOs have been blocked. But there is a light at the end of the tunnel for healthcare startups. Recent reports show that venture funding in the biopharmaceutical field jumped 72 percent in the second quarter of 2009 and overall VC investment in healthcare surpassed the IT sector traditionally a stalwart leader in venture capital investment.

A confluence of factors has contributed to the recent improvements. First and foremost, economic stability seems to be returning, making the foreseeable future more, well, foreseeable. Improvements in the credit markets reduce the financing risk for new ventures, allaying fears that VC investors would need to continue pouring cash into their investments to keep them afloat through the recession. Additionally, in response to the previous dearth of available funding, startups are now seeking the lowest valuations from VC investors since 2003. Most importantly, though, large healthcare and pharmaceutical companies are becoming more acquisitive, providing profitable exit opportunities for early investors.

Bristol-Myers Squibb Co. (NYSE: BMY) announced the purchase of already public (founded 1987 during a healthcare start up boom cycle) Medarex, Inc. (NasdaqGM: MEDX) for a major premium, potentially launching a rush to launch more biotech firms and innovation. Human Genome Sciences, Inc. (NasdaqGM: HGSI) is gaining additional commercial traction and could attract a buyer with a market cap under $2 billion. The majors such as Pfizer Inc. (NYSE: PFE), Merck & Co. Inc. (NYSE: MRK) Johnson & Johnson (NYSE: JNJ) have strategic planning departments seeking where the future of their firms will be two, five and ten years from now. None may be looking at HGSI, but be sure, they are seeking innovation to thrive in an ever changing world.

Regardless of the results of the Obama plan, innovation will be necessary to revitalize the U.S. healthcare industry. As such, the increase in venture capital funding for this sector is a welcome development. If a stone is dropped in a pool of water, the size of the wave created depends on the mass of the stone. By choosing to support or not support promising startups, venture capital investors, and the majors effectively determine the size of the ripples that lead to innovation, entrepreneurism, and ultimately, new procedures and cures for humankind, and benchmark beating returns for investors.

Shout out: to intern Colin Sloand for herculean assistance with this post.

Disclosure: Mr. Corn is Chief Investment Officer – Equities of Beacon Trust Company. Through various equity strategies under his supervision he is long BMY, MRK, PFE and JNJ.

Comments

[YoYoMama]

It is difficult to see an environment where health care companies can innovate when they - and the health care professionals who use the products, services and technology they provide - have to constantly look over their shoulder for the next big law suit that will be filed against them.

Institute torts reform and you will see many of the financial and delivery service issues of our system be brought in line.

2009 Jul 24 11:20 AM