Peter Schmidt05.21.08
Considering the Pros and Cons of the Offshore Supplier Market
International markets offer real opportunities for medical device manufacturers that understand the risks, rewards and how the game is played.
Peter Schmidt, Cronus Partners LLC
Healthcare spending in the United States has been growing at a compound annual rate of approximately 7% during the past 10 years while in the same period, gross domestic product has increased at a rate of 3% annually. With the market for most medical devices equaling or exceeding the overall healthcare sector growth, these have been good times for medical device suppliers and OEMs. This strength has drawn the attention of global competitors, however, and suppliers that traditionally target the North American market need to become global players to maintain their positions. Rising competition and the declining dollar make this a great time to target global markets.
Chinese contract manufacturers already have begun to target the medical market. They increasingly are eyeing the higher prices for medical devices as an option to increase the return on investment for their capabilities. Many Chinese manufacturers have highly qualified experts on molding, machining and assembly who are targeting low-cost products and who easily could benefit from aiming their capabilities at higher-value products. Chinese businesses also have minimal foreign exchange risk for trading with the United States as long as their currency remains closely pegged to the dollar, and they have been experiencing high volatility in foreign exchange (FX) markets for other currencies because of that peg. (Despite the 2005 partial float of the Yuan, its fluctuations have been small in magnitude and predictable.) This lower FX risk opens up debt financing options for dollar-denominated trade; lenders typically hesitate to lend against foreign trade due to this risk. The decline of the dollar, which also pulls down the Yuan with respect to other currencies, cuts into global margins on low-cost consumer goods.
Conversely, the Chinese consumer market offers opportunities for US suppliers. Imported products maintain a high degree of cachet to affluent Chinese citizens, and, coupled with a consumer-influenced Chinese healthcare market, this suggests an opportunity to make inroads with proven, branded medical devices—an opportunity being exploited by most major OEMs. The Chinese health financing model is very similar to the American one, and even with a large majority with minimal coverage, the Chinese healthcare market is growing rapidly and is projected to be in the top 10 markets globally by 2010. This rapid growth, coupled with reduced FX risk, makes China a very attractive expansion market for American medical device companies.
Looking east instead of west, the strong United Kingdom and European currencies offer compelling markets for American manufacturers hoping to build exports. A $100 component today costs just 64 euros, compared with 75 and 94 euros one and five years ago, respectively—a 17% discount in just one year. While the Yuan’s dollar peg allows Chinese suppliers a similar benefit from this same devaluation, both cultural differences and recent quality issues give countries with a history of higher standards for consumer protection an advantage. Companies doing business in Europe should remember to expect some volatility in euro exchange rates: Despite the euro’s current strength, US federal interest rate cuts have pushed forward exchange rates to favor the dollar.
Generating Foreign Sales
Manufacturers traditionally have sold products into foreign markets through the use of import/export agents. A 2004 analysis by management consulting firm McKinsey & Co. found that most imports from China passed through at least two intermediaries, resulting in as much as a 50% markup. However, there are several other options. First and most simply, companies can grow a sales organization organically in the target market. Faster bootstrapping can be achieved through merging with or acquiring a strategic player in that market. For niche players in a broader industry, such as tray manufacturers targeting surgical suppliers, establishing a supplier relationship with another vendor can exploit synergistic sales and marketing capabilities.
For some organizations and markets, organic growth is the optimal solution. If a major European OEM decided to add outsourced components based on an existing design, an American, Chinese or French contract manufacturer very easily could bid for that business, advised by attorneys and accountants who specialize in the contract jurisdiction. For large contracts, the manufacturer’s senior management would be engaged in the sales process regardless of what agent was managing it.
Once a supplier has established sales in a new market, it is not uncommon to build out a sales support organization in that region to handle account servicing. This is not simply a loss leader. For example, one New Zealand-based company (with which the author was affiliated) found that in its business with a large US provider organization, because of the customer’s accounting practices, it took approximately two to three months from invoice date until the funds were available in New Zealand. With a US-based subsidiary sending the invoices, the customer had a streamlined payment process and that time was cut to about 10 days. Borrowing at 10% percent, the New Zealand-based company saved as much as 2% on every transaction.
With growth in the Chinese medical device market, companies increasingly are establishing sales support and distribution subsidiaries and joint ventures based in that country; these subsidiaries typically serve the Asian market but are located to meet growing Chinese demand. Surgical product manufacturer Precimed’s Guangzhou office and Exactech’s sales operation in China were created in this model. Exactech launched its Chinese sales subsidiary as a joint venture but subsequently bought out its partner.
While some suppliers such as Kinamed are leveraging their economics and surplus capacity to offer self-branded products, some OEMs are expanding into new markets as suppliers. The Corin Group PLC, a successful OEM in the United Kingdom and Europe, has taken this approach to access the US and Japanese markets: Through a reseller relationship with Stryker in the United States and with Kobayashi Pharmaceutical in Japan, Corin has gained entry to those markets. However, this strategy is not ideal—Corin is only selling its Cormet hip-resurfacing component through Stryker, as this fills a niche in which Stryker does not compete.
Agents, subsidiaries, joint ventures and resellers can be valuable as they might be willing to take inventory off the supplier’s balance sheet and should be expected to manage taxes, duties and regulatory issues. Given access to legal, tax and accounting professionals who specialize in the region, the sales process and post-sales support often can be handled remotely and the shipper can assist with import/export logistics. With a small number of customers and a largely pass-through shell company, the New Zealand-based company spent just a few hundred dollars annually on accounting advice to repatriate its revenue. Potential customers with operations in a supplier’s market can simplify this process dramatically—this is the sourcing strategy that Wal-Mart pioneered and subsequently has been emulated by many large importers. Determining whether potential foreign customers maintain local sourcing operations can offer a route to international sales that eliminates risks in currency fluctuations and the expense of middlemen.
Mergers and acquisitions offer excellent opportunities to enter a new market. On the sourcing side, Medtronic’s recent purchase of Shandong Weigao Group Medical Polymer offered substantial scale and improved margins over existing sourcing options. This has proven quite successful in providing a strong foothold in a new market: Wright Medical bought an Italian OEM, Cremescoli Orthopedics, in 1999 to expand its European sales from $8 million to $41 million and subsequently standardized on its North American product line, leading to additional growth to more than $70 million by 2003 and $96 million in 2007. After the purchase of Cremescoli, Wright Medical’s European sales jumped from 8% of gross revenue to 25%, and subsequently grew at a CAGR of 10.6% contrasted with US sales growth of 9.1% during the same period.
Financing Growth
There are several options for financing a supplier’s growth into a new market. The first option is self-financing of growth through spending the company’s existing capital on building out sales infrastructure or offering a commission on future revenue to a business partner. Establishing a relationship with an agent assumes the latter; the agent would take a percentage of sales but require no upfront investment and can be an effective way to jump-start sales.
If financing is necessary to build out a foreign sales operation, the first step is a business plan. It helps to have some experience in the market already (note that Wright Medical had European revenue of $8 million before buying Cremescoli) and to be cash-flow positive in existing markets. If debt financing is desired, it is important to demonstrate that the company can cover the debt service from existing lines of business, as this is a gating factor for many lenders. Equity financing for growth is available, but many investors will be looking for liquidity within three years, so a realistic plan to provide a substantial return and liquidity in that timeframe is critical. Clearly, a capital raise around expanding existing business established through direct sales, an agent or marketing partner makes estimates and projections a lot more realistic. Success with direct sales abroad suggests a strong opportunity, and with agents and marketing partners the company can look to capture the full sale price.
Many financial investors offer strategic benefits. For example, private equity funds may seek to leverage their own or their portfolio companies’ foreign operations to add value to new investments. While many of these funds will invest only in controlling stakes in companies, there are some that will purchase a non-controlling stake. It often is possible to structure a deal that allows participation of current stakeholders in the future success of the company, even after sale of a controlling stake. This can be attractive to equity holders when the new investor offers access to new markets and resources in those markets that other options leave out of reach. A financial advisor who has experience with private equity investors in such cases can offer insight into the portfolio value that the potential buyer sees over and above the value of the standalone company, and this insight is helpful in negotiations.
Accounting for Currency Effects
One critical issue for financing growth is preparing historical and projected financials covering experience with foreign sales and expected performance in those markets. For historical performance, an accountant will separate the difference between business expansion and the impact of variation in exchange rates, as this provides insight into sales growth in contrast with gains or losses due to factors beyond the company’s control. Gains or losses in domestic revenue due to exchange rate fluctuations are called flow effects. Additionally, cash held outside of the country will gain or lose value due to these same fluctuations. Such gains or losses are called holding gains or losses.
Companies report in a single currency (the reporting currency) for accounting purposes. With assets and liabilities priced in multiple, non-constant currencies, an exchange rate must be chosen for doing the translation into the reporting currency. There are two choices: One may report in the historical rate (the exchange rate at the time of the transaction) or the current spot rate. The company’s accountant will guide the company through the process of translating to the reporting currency. Different transactions or types of transactions may be most appropriately reported at different exchange rates—for example, fluctuating values could add unnecessary complexity to asset depreciation.
According to US generally accepted accounting principles, foreign subsidiaries that essentially are sales and sales support outlets and, thus, are significantly integrated with the US operations typically will report in the parent company’s currency. There are exceptions where the subsidiary makes not just sales but operating, financing and investing decisions based in the local currency, but for most mid-market suppliers with consolidated financials, their financial statements will report in the currency of the parent.
When that subsidiary acquires fixed assets or inventory, those assets typically will be reported at the exchange rate at the time of the transaction. Conversely, if it incurs debt or acquires monetary assets denominated in a foreign currency, these will be measured at the current exchange rate. Gains or losses due to exchange rate variability are reported on the income statement. Inventory or fixed assets acquired for 100 euros in 2003 and sold for 100 euros now would be on the balance sheet for $106 and sold for $156, with the $50 gain shown as profit from operations. (If the subsidiary is independent of the parent and maintains its own books in the local currency, the inventory and sales are computed at the current exchange rate and the FX gains or losses are reported in the cumulative translation adjustment in the stockholder’s equity section.)
The effects of exchange rate fluctuations represent real changes in cash flow. While changing values of assets may not have a direct impact, fluctuations in the value of cash and securities, debt and accounts payable, and inventory and accounts receivable will have direct impact on cash flow unless inflows and outflows are exactly matched in each currency.
Managing FX Exposure
Exchange rate exposure commonly is accepted as a risk of doing business. For example, the previously mentioned New Zealand-based company sold systems for monitoring chronic disease to a major American healthcare provider in 2005 that included a one-time dollar license payment
that was to occur two years later. The same contract included pricing for professional services at approximately $125 per hour. During the interval between contract signing and payment date, the declining dollar erased more than 11% of the value of the contract to the New Zealand-based investors. With costs of goods sold denominated in New Zealand dollars and assuming that the systems were sold at a typical gross margin of 60%, this erased almost 20% of the gross profit for this sale and had a larger impact on net income. In addition, with costs denominated in New Zealand dollars, the contract bound the supplier to provide ongoing professional services to the health maintenance organization at these tighter margins. Without hedging the exposure, the chief financial officer of the supplier inadvertently speculated on currency fluctuations to the detriment of the bottom line.
Some countries address the challenges of exchange rate exposure by pegging their local currency to that of a major trading partner (China, for example), others by adopting a regional currency (the European Union’s euro and the Organization of Eastern Caribbean States’ EC Dollar are examples). This protects trading partners from exchange rate exposure. For international sales outside such a region, creditors, who lend against a company’s EBITDA (earnings before interest, taxes, depreciation and amortization), are much more focused on income margins. Leveraged companies that rely on their margins in foreign sales for debt service typically are required to hedge against losses due to exchange rate fluctuations.
To do this hedging, there are three financial instruments: futures, forward contracts and swaps. Futures involve a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures typically are the instruments employed by speculators—gains and losses are settled daily from the cash balances holders maintain separately, and this margin requirement essentially eliminates the risk that investors holding losing positions can default on their obligations. This means that using a future to hedge FX risk on a future payment could result in substantial margin calls and cash outflow prior to the payment. Thus, forwards and swaps are more commonly used to hedge FX risk. Both involve two parties who agree to pay each other according to set terms in different currencies.
Forward contracts result in a one-time payment at a future date, and would be applicable to the New Zealand-based company’s license payment. Swaps are essentially two bonds—one denominated in each currency and with one party the creditor for each. With a swap, each party pays the other a fixed amount in the recipient’s currency. In theory, swaps are entered into between two companies in different countries with a revenue-generating subsidiary in each other’s home country. The companies swap a portion of the revenue generated by their subsidiaries, providing both risk amelioration and tax and exchange benefits. In practice, both forwards and swaps most often are offered by the same banks that demand their use in debt covenants: In the United States, the 937 national banks hold derivative contracts with a notional or face value of $172 trillion (as of Sept. 30, 2007); of this amount, $111 trillion is in swaps and $13.6 trillion is in forward contracts. With $91.7 trillion in derivative contracts, JP Morgan Chase is the largest counterparty; it holds $5.7 trillion in foreign exchange swaps, forward contracts and futures—with futures the smallest component.
For companies that need to hedge their FX risk, it is worth noting that swaps and forward contracts are priced according to interest rates in order to eliminate arbitrage (the practice of taking advantage of a price difference between two or more markets) opportunities, and the pricing does not reflect speculation as to the direction of future exchange rates. A swap or forward contract will be priced so that arbitrageurs can neither buy nor sell a basket of low-risk government bonds in combination with the contract to guarantee a positive return. Futures, being marked to market daily, may reflect speculation on future rates in their pricing, although these, too, offer opportunities for short-term arbitrage.
Tackling the Opportunity
The growing competition from low-priced foreign manufacturers for medical device manufacturing threatens the traditional contract manufacturing market. However, the weak dollar provides an opportunity for manufacturers to develop a defense against this in profitable European markets and fast-growing Asian ones. China, with its increasing standard of living and preference for foreign goods, has been an attractive target for many companies targeting its domestic consumers. Similarly, Europe, with its higher labor costs and strong currency, offers little competition for quality manufacturers from outside the European Union, with the potential for profits not just from the euro’s relative strength to the Chinese and the American currency but also diverse national currencies from Canada, Mexico, Russia and India, as well.
There are many issues to consider in establishing and financing an offshore business and managing the foreign exchange exposure. However, with the support of knowledgeable and experienced advisors, today’s international market offers opportunities that complement and augment those in the US market.