In this episode of William Blair Thinking Presents, Ryan Daniels, CFA, group head of the healthcare technology and services research sector, discusses the latest trends in the digital healthcare marketplace, focusing on consumer-facing solutions, the rise and fall of digital health companies, and the evolving investment landscape.
Podcast Transcript
00:21
Chris T
Hi everybody. Welcome back to William Blair Thinking Presents. Today is Wednesday December 18th and we are joined once again by Ryan Daniels. He's William Blair’s group head of the healthcare technology and services research sector. Ryan and his team released their newest health care mosaic at the beginning of this month. And as a reminder, this is a report they release every quarter to cover a far-reaching topic of interest in the health care space, analyzing its impact for the broader health care marketplace.
And then this one in particular is called “Digital Health Update: No Longer Unicorns, But Phoenixes Abound.” It does a deep dive into the digital healthcare marketplace with a focus on consumer-facing solutions, focusing on the rise and fall of publicly traded digital health care companies, key industry trends that you believe provide support for continued growth in digital health solutions, key areas of employer focus and expected purchasing trends for digital health solutions, along with company specific takeaways including recent deals, market positioning, and then the companies you expect to benefit from these trends, which unfortunately, we won't really be able to cover on this podcast, but it's well worth a read for those interested.
So, with that, Ryan, welcome back. Always a pleasure to have you on the show. Before we jump into these specific areas, how would you personally describe the report and why the focus specifically on consumer facing solutions?
1:37
Ryan D
Sure, Chris, first off, thanks again for having me on the podcast. I've really enjoyed doing these each quarter in tandem with our quarterly healthcare mosaic reports. So again, very appreciative of all your ongoing support.
And just as a quick reminder for the audience, you mentioned this as well. We complete one of these reports each quarter, and our goal here is to find a topic that's not only far reaching across the broader healthcare landscape, but also one that we think is really timely based on current market trends and investment opportunities.
So, to answer the second part of your question, first, the reason we chose to focus on these consumer facing digital health solutions in this report is because we actually see a lot of opportunity in the marketplace for these products, both from the standpoint of employers using them to help control health care cost and engage employees. And also from an investment perspective, there's a lot of VC and private equity money that continues to flow in the market.
And we really think the risk reward for the publicly traded stocks looks very compelling. So, it just felt like the right time to focus on this for our Q4 report. Now, as for the first part of your question, I would describe the report first off is a bit of a look back, as you said in the intro on the boom and bust period we witnessed in the digital health care market over the past 3 or 4 years, and it's really a fascinating time period to analyze this space as it coincides with the COVID-19 pandemic, which just spurred a ton of innovation and care delivery models outside of the traditional four walls of the hospital or doctor office. And this was paired with a zero-interest rate environment where growth, equity funding and IPOs were super plentiful. In fact, we state this in the report. But in three years, post Covid, there was about $60 billion invested in digital health, which was about 50% more money than in the prior eight years combined.
And as the report title states, and many of these names easily exceeded the unicorn threshold. So more than a billion valuation. So, this time frame was literally the largest IPO wave and funding wave I've seen in my 22 years in equity research. But as we highlight in the report, that euphoria was pretty short lived and seven interest rate hikes throughout 2022 dramatically increased the cost of capital for companies.
And valuations on these names in particular got pressured as most of them were nascent organization. They were still losing money and burning cash. So, from a present value basis, the higher rates meant future cash flows were more heavily discounted and valuations got crushed.
Now another thing that took place during this time period is there were so many companies competing for market share after they got all this funding that it led to a lot of price competition in the market. It led to confusion among buyers about how to differentiate all these consumer facing digital solutions. What really worked. So, most of these names from an investment standpoint started to struggle. And from the public equity markets, they went out of favor pretty quickly. And that brings us full circle, really to conclude where we are today. So, at this point, we think the overall ecosystem for digital health solutions is actually much better positioned right now. Is the market started to actually determine who are the winners and losers in the space and create value. The competitors are much more disciplined on pricing, is capital is really dried up and they need to generate profits. And demand for these solutions is actually really strong today. So again, it seemed like a great time to revisit the sector to help our clients identify what we refer to as the potential phoenixes, if you will, that could really rise from the ashes and become larger organizations in the near future.
So, a bit long winded there, but hopefully that hits kind of the purview of why we did it.
05:14
Chris T
I think it'd be worth digging into that even further, you know, so the first section of the report is all about the boom-and-bust cycle of, of 2020. And, you know, through 2022 and the decline in market capitalization of the space. And yet you say clearly within the same section that despite all of this, and as you just said, the digital health space still presents a compelling long term investment opportunity that ultimately you believe the delta between investor sentiment, equity market performance and earnings expectations present one of the most compelling signs of investment opportunity in digital health.
Do you mind just digging into that a little more? How so?
05:48
Ryan D
Yeah. Great question. Let me dive into that and add on to what I just mentioned. So, one thing I would reference in our report, which again we be happy to provide any listeners, we actually analyze the stock market performance and the change in market cap from peak valuations of these entities to today. And based on our work, the average public digital health stock is down about 84% from peak levels.
So, the punchline here is that we think the risk reward is much more favorable, given how beaten down most of these names are. And I know we don't mention specific stocks in these podcast, but if listeners read the report, the first exhibit in the piece shows us in detail in it. It's really amazing. There's some companies in the space, like the largest telehealth provider, they had a market cap above $40 billion, but they now sit at a $2 billion valuation.
So, you can see the massive decline in value that took place over the last few years. Now, in tandem with this, obviously valuations have clearly become massively reduced as well. In fact, the average name in the space traded about 21 times sales at the peak. But that's now down to below three times sales. So again, part of our thesis is a valuations attractive and downside risk from these levels appears pretty limited.
Second thing I would mention and I mentioned this earlier as well, a lot of the startups in the space that were causing this buyer confusion, trying to steal market share were driving purchasing fatigue among customers. They've either run out of capital, they've been acquired, or they've been proven to have offerings that really don't add value. So, the market's getting a lot cleaner.
And at the same time, the bellwethers in the space are actually starting to generate consistent cash flows and profits, which we think makes them more attractive investment candidates. In fact, we highlight this in our report as well. But almost all the public companies are now not only profitable, but they've actually been guiding towards higher profit profiles over the last year.
So, we're seeing very good momentum in the space. Yet despite that, they've not generated a ton of investor interest at least yet. So, we see a lot of disconnects, as you said, between valuations today and intrinsic values, which we discuss in detail in the report, where we call out some specific names we think are set to rebound nicely in 2025.
And then lastly, there's a big disconnect between recent funding and valuations of private players in the space and the public companies. So, we think it's only a matter of time before these valuations rise or the companies perhaps become take up targets. So, either way we think again that's a pretty compelling risk reward outlook for investments in the sector.
08:17
Chris T
All right. So, another one of your key takeaways is that digital health solutions remain highly relevant in today's marketplace with demand remaining robust which may surprise some investors. What's driving this demand?
08:28
Ryan D
Yeah, this one's pretty easy to answer. In a nutshell, it's higher health care costs. More specific, It appears that 2025 health care cost trends are set to hit record levels, meaning the average cost to provide employer sponsored health insurance should be the highest level of all time in 2025. And that means that employers are not only spending more on health care, but that employees are going to be on the hook for higher levels and spending as well.
There's also a ton of data in the marketplace, mostly coming from the leading benefit consultants. That indicates that not only is the absolute cost level going to peak in 2025, but that the year over year increase in cost is running at the hottest level in well over a decade. So, employers clearly need to find solutions to bend the cost trend. And that's one big demand driver.
Second, and this is going to become a bit of a recurring theme here after a lot of noise in the market, given the absolute number of digital health offerings in the space, I believe that today we've seen a market where the winners and losers have really been more clearly identified. So, if you're an HR manager and a large employer, or if you're a purchaser of a large insurer, you can be a lot more comfortable now investing in these solutions because they've come out and, you know, proven themselves. They've got ROI studies. I think the value is there.
And then final point I'd make, it's still a really tight labor market. I mean, unemployment's just over 4%. There's a need to meet workforce demand for certain solutions. So, in areas like mental health care or fertility or now increasingly weight management with GLP one, you know, even if these aren't pure cost reduction solutions, I would say there's some independent areas where we're seeing more growth simply because you need to offer them to employees as they're demanding them to be part of a comprehensive benefit offering.
So, I think it's those items that are kind of creating a favorable environment today.
10:16
Chris T
Let's talk a little bit about what buyers are looking for in today's marketplace. You know, in the report you call out ROI and user engagement validation studies, employee level ROI, utilization-based pricing models, and fully integrated and key point solutions. Can you briefly walk through each, at least the ones that you feel are, you know, most important and their importance to the market?
10:37
Ryan D
Yeah, be happy to. First off, again, most HR managers today want to ensure that the solutions they’re buying actually save money. A lot of these digital health offerings made big claims but never came through with savings. So, this burnt a lot of goodwill in the space. And it's imparting a lot more purchasing discipline in the market. So, the smart digital health companies have worked with auditors to really prove their return on investment or ROI, with very disciplined process.
And we've seen some very credible studies from a number of companies that actually validate this ROI. So, in areas like MSK or musculoskeletal health, there are some solutions that provide things like on demand physical therapy using AI generated assistance. And they offer 3 to 1 savings because it helps individuals avoid things like unnecessary surgery. And you know that not only saves a lot of money, but it eliminates a lot of unnecessary pain and suffering for users.
Second point, you mentioned end user engagement. And that's also become a key criteria today. And it ties into most of the pricing models. And this is actually something that probably requires a little bit more explanation. So, if we go back, you know, 4 or 5 years ago, a lot of the solutions were sold on a per member per month or pmpm basis, which meant that an employer like a William Blair would pay a small monthly fee for every employee in the workforce.
So, it might be $0.25 to get access to a benefit. And for many of these vendors, and actually became more profitable, at least in the near term, to just collect that fee and not have people use the program, which would drive cost. But that also meant that employees didn't really use the benefit, and if they didn't use a benefit, there's no ROI, there's no long-term impact.
And so, employers really started to say, hey, we're not going to do these pmpm pricing models. And what this led to, and this is kind of the third part of your question is utilization-based pricing, where vendors now charge only for actively engaged employees, albeit at a higher rate than the pmpm fees, but it's a much better pricing model for the industry as it, you know, really aligns incentives because the vendors want to go out and find those employees who can benefit most from the solution and thus ensure a favorable return on investment cost savings for employers. And some of the vendors, as you reference towards the end of your question and move to outcomes-based pricing, where they only charge when they actually produce savings, which we believe is probably the next big pricing model for the space.
And it really requires vendors, if you will, to put their money where their mouth is. So again, going back to that MSK example, it went from, you know, you can pay a small fee for everyone in your workforce to access this app to the next generation being we’ll only charge you when an individual downloads the app and starts doing sessions. And now it's actually moved on to, we're not even going to charge you the full rate until people use it. And then there's cost avoidance like they see unnecessary surgeries go down. So that's been a big trend in the model.
And then on your very last point, fully integrated solutions versus point solutions, that's another big change we've seen over the last 2 or 3 years. And that's simply that HR managers really don't want to have to go contract with 10 or 15 different vendors. So, you don't want to have a telehealth vendor, a mental health, a weight management, a diabetes, a health coach, a navigator, you know, all these different contracts. It's just too much work for a company. So, the preference now is to go to a consolidated vendor, like a navigation company that might have a curated ecosystem of partners where you can buy all this under one contract.
Or we've seen other digital health care companies that were leaders acquire a bunch of additional point solutions so that they can go in with a one stop shop. So that that has been a big trend in the market.
Now, final point that being said, and I kind of indicated this earlier, there is still a market for some point solutions that are really big pain points.
So, if you think of something like MSK, we at William Blair still buy an independent MSK solution, musculoskeletal, because that's a really high-cost area for us. So, we wanted to go out. We said this is a big cost area. We want to get best of breed and try this. And we've been using it successfully for a few years.
Weight loss is another category with GLP-1. You just don't want to give people the drugs. We talked about this in a prior mosaic podcast we did. You need to support them with behavioral change, exercise, lifestyle coaching to maximize the benefits. And then there's other areas like behavioral and fertility benefits where there's just so much market demand that, you really need to offer those is standalone products if you don't have an integrative one.
So, a bit of a long-winded answer there, but hopefully, they could hit on all the topics you raised.
15:12
Chris T
It did. Can you also talk through some of the key trends you’re seeing as relates to private market funding and activity in the space, specifically looking for the influx of capital investment and larger, less risky entities, pre money valuations returning to peak levels and then M&A activity and IPO, which you laid out in the report.
15:28
Ryan D
Yeah. Yeah. It's really one of the most interesting dichotomies we noticed when working on this report. Put simply the private market activity has returned to near record levels of funding and valuations are rising towards near record levels. But the public markets are still at trough level relative to both valuation IPO activity. So, as I stated earlier, we think it's really only a matter of time for the public markets, which, to be fair, can be less risk tolerant and have shorter time horizons to normalize a bit.
Moreover, as interest rates has stabilized and dropped a bit, I haven't seen it. The Fed was meeting again today. They probably cut rates. We do think that's going to help M&A accelerate. And it's already started in the private markets. And we think that could happen in the public markets as well.
And then lastly, you asked this at the start of your question but I did not address it. We definitely have seen a bit more interest in funding for larger, more stable digital health providers, and that could simply be related to the risk tolerance levels of investors today, or the fact that they're continuing to invest more in their winners, which are going to be these larger, more stable, probably cash flow positive companies.
These companies with established client channels and solid distribution, probably also want more money to start acquiring some of the smaller point solutions. So, if you're a big vendor, good reputation, you have nice product portfolio. Go buy some tuck-in offerings so that you can provide that one stop shop. But, you know, I would say regardless of what's driving this, we definitely see a lot more dollars going into the more mature companies and a lot more, into the space in general.
17:00
Chris T
All right. Well, Ryan, really appreciate you walking us through this. Anything else you should mention, before we say goodbye?
17:06
Ryan D
No, not a ton. Another great conversation. So, as always, really appreciate your time and certainly want to wish everyone a safe and happy holiday season. As I've done in the past, I will again mention we're happy to send out the report to any listeners that are interested. You know, as I mentioned, this one in particular has a lot more company specific analysis than some of the others, and we can't really discuss these on the podcast, but it's probably worth pointing out, so that people can download that and take a look at the report.
And then gotta end again with a shout out to my favorite listener, mom. Hope you enjoyed this one. Everyone hopefully, has a happy holidays to everyone listening and have a very safe, happy and successful 2025, everyone. And Chris, thanks again for, all your time. I really appreciate it.
17:46
Chris T
And same to you, Ryan. And again, for those interested in reading the report, you can request a copy by reaching out to us at Williamblair.com/contact-us or to Ryan directly.
Thanks for taking the time to be with us today, Ryan. Also, to the audience and happy holidays.
18:00
Ryan D
Happy holidays. Thanks everyone.