Device RD Outsourcing Trends

More than ever, R&D outsourcing for medical devices is being driven by industry and economic forces. As device companies accelerate the development cycle and product development companies realize the long-term business implications, R&D outsourcing will continue to gain momentum.

During the past few years, we’ve seen a recession, near closure of the IPO market, a war on terrorism and economic uncertainty. Our healthcare system is strained with worker shortages, increased patient loads and reimbursement limitations. Accompanying this is a large dose of risk aversion for most medical device companies.

Still, medical device venture capital investment has been stable compared with the roller coaster ride of the Internet and telecom industries. In fact, the medical device market has grown due partly to an aging population. According to Frost & Sullivan, the U.S. medical device market in 2002 exceeded $55 billion—a 10% increase over 2001.

Steve Maylish Aubrey Group

Steve Maylish is director of business development at Aubrey Group, Inc. He has more than 20 years experience with product groups such as kidney dialysis, high-frequency ventilators and numerous others. His experience includes serving as an international service manager and product manager for Sorin Biomedical, senior product manager for Baxter, director of marketing for Edwards Lifesciences and director of the hardware division for Jostra Bentley. He has a BS in business from the University of La Verne. and an MBA from the University of California, Irvine.

Cost-effective Approach

So what does this all mean for medical device R&D outsourcing? As the population grays, demand is strengthening . But as the burden on the healthcare system increases, the need to cut costs mirrors that trend. Growing demand combined with price sensitivity creates the need for value-added, innovative products versus incremental product improvements. Medical devices that can combine improved patient outcomes with increased cost efficiency will be most successful. And because these drivers will be in place for the foreseeable future, medical device companies need to become more innovative, or at the very least, more competitive.

These companies are, therefore, confronted with a growing market, the innovator’s dilemma and concerns about risk. To answer these challenges, companies are looking for more cost-effective ways to bring innovative technology to market while focusing efforts on fewer, more promising projects.

There are a number of ways to accomplish these goals. One is internal product development focused on innovation. Another is acquiring technology and innovation through merger and acquisition, a noticeable trend of the 1990s.

R&D support: A top reason to look to external resources

Reasons for outsourcing cited by life sciences companies in the San Diego area. Source: Ernst & Young/BIOCOM

A third option is license agreements in return for capital investment in developing companies, much like previous trends in biotech and pharma sectors. And, finally, there is R&D outsourcing, a growing option for many companies looking to decrease development time.

Consolidation in the medical device industry has pushed most companies into one of two categories: larger corporations and small businesses. Many small and startup businesses do not have the financial resources to support an entire R&D department, yet small and startup businesses are where many larger corporations now turn when acquiring innovative or cutting-edge technology.

Industry Forces

Certainly there is still a large portion of R&D performed internally in the medical industry, but in the past few years, the role of R&D is changing. In the early 1980s, R&D was considered an essential core competency. Capital equipment and disposables were less dynamic, and new equipment models were released every 5-10 years. R&D outsourcing was seen as a threat to company viability. Keeping research and development inside was the norm and a means for maintaining competitive advantage. After all, no one wanted to outsource their core competency.

But then rising costs and payer concerns became apparent. Group purchasing organizations (GPOs) took root. Clinical purchasing decisions began moving from users to purchasing departments. Purchasing decisions were based on more on bundling options, product acceptability and quantity discounts. The results? Increased market competition, which led to consolidation.

In the 1990s, mergers and acquisitions were a sign of the times. Large corporations such as Medtronic, Guidant and Boston Scientific acquired handfuls of mid-sized companies. As technology solved unmet needs and created new ones, healthcare costs began to rise. With the demand for more value-added rather than premium-priced medical products, device companies started feeling the need to decrease time to market and costs associated with development. Yet at the same time, corporate reengineering and public outcry over rising healthcare costs gave companies a platform to evaluate profitability and efficiency.

As innovation took precedence over incremental design changes and budgets became tighter, the cost of acquiring technology was balanced against internal development. At the same time, large companies sought new profit opportunities while facing growth problems and shrinking margins. As technology and revenue growth were emphasized within larger corporations, innovation and growth through M&A activity became the new business model and a core competency.

In the past few years, M&A activity has dropped significantly. With a large number of mid-cap medical device companies previously acquired by larger corporations, acquisition targets are harder to find. Recognition of knowledge-based competencies and the need for faster product development has caused companies to seek external sources of technology through alliances, outsourcing and vendor relationships.

Earn-outs or license agreements with startups, OEM partnerships with suppliers and R&D outsourcing can reduce risk while supplementing the need for innovation and growth. In the past few years, all three options have increasingly helped large corporations feed their product pipeline.

Last year Ernst & Young and BIOCOM surveyed 111 San Diego life science companies with 2,300 products on the market. The products included drugs, diagnostics, medical devices and research tools and supplies. Of these companies, about 85% were seeking alliances. When asked about the need for partnerships and outsourcing, they cited five reasons for outsourcing:

• Distribution (23%)
• Manufacturing (21%)
• Sales/marketing (20%)
• R&D (19%)
• Clinical trials (17%)

In the survey, nearly as many companies cited R&D as their need for external sales and marketing with an overwhelming majority of companies looking for alliances to grow their businesses.

Aside from demand for innovation and improved patient outcome, technology is converging in the medical device sector. We see this in areas such as biodefense, microfluidics, MEMS (Microelectromechanical Systems), tissue engineering and bioengineering. Integrated products are bringing together different disciplines such as microfluidics and point-of-care diagnostics, catheter-based injection systems and targeted delivery of drugs, MEMS implantable sensors and wireless communications and imaging in conjunction with surgical techniques.

Economic Forces

Medical device sales in the U.S. match those of the rest of the world, with foreign sales concentrated in Europe, Canada, Australia and Japan. According to PricewaterhouseCoopers’ HealthCast 2010, by 2030, the ratio of working taxpayers to non-working taxpayers in these countries will fall from the present level of three to one to about one and a half to one. As the world’s population grows older, healthcare expenditures are growing at about .5% for each percent increase in GDP per capita (wealth), according to Escalation of Healthcare Costs by B. Abel-Smith (OECD-Healthcare, Paris, 1996). As wealth increases in developing nations and populations age in mature markets, the healthcare market continues to grow and become more cost conscious.

Growth Spurs R&D Needs

According to Frost & Sullivan, the $55 billion U.S. device market is expected to grow about 10% annually for the next couple of years to reach $74.5 billion by 2005. In the firm’s April 2003 report, the top 50 medical device companies spent roughly $3.7 billion on R&D in 2002, an increase from $3.4 billion spent the year before. Overall in 2002, medical device companies spent roughly 8.8% of their revenues on R&D. As the U.S. market grows, it is also becoming more aware of cost.

In a recent study from The Freedonia Group, U.S. demand for disposable medical supplies will increase 5.6% annually to more than $79 billion by 2007. Intravascular, catheterization and related products will provide the best growth opportunities, with demand increasing 7.2% annually through 2007.

Unfortunately for startup medical device companies, venture capital investment began to dry up in 2001. Along with decreasing VC investment came decreasing corporate R&D investment as the economy went into recession. The 2001 recession, combined with economic uncertainty and closure of the IPO market, resulted in pervasive risk aversion in the healthcare industry.

According to venture capital research firm VentureOne and Venture Reporter, during the past few years healthcare and medical device VC investment has decreased dramatically. Despite these cut-backs, medical device VC investment in 2002 was $1.5 billion. As compared to either healthcare, IT or the biotech sectors, VC investment in the medical device segment has shown much less fluctuation. Analyzed over the long term, medical device VC investment is three times higher now than in the mid 1990s.

In addition to private and public markets, the federal government has increased its R&D spending. Since last year, federal R&D investment has risen 10%, mainly due to defense, biological science and homeland security. Much of this funding is passed through the National Institutes of Health, the National Science Foundation and university programs. Some of this money will likely become R&D seed funds for startup medical device companies.

Medical device manufacturers as integrators: with their many roles to fulfill, device OEMs need to retreat to their core competencies and look to outside contractors to bolster internal weaknesses, including R&D functions.

Product Development

R&D trends and the demand for innovative products will likely compress product development schedules. Developers will have to marshal design capability for projects more quickly and unload those resources sooner upon project completion. R&D should be considered a step function—first for design and development and then for intermittent technical support. This requires shifting financial and human resources to development projects quickly.

Accelerating early stage projects using additional technology and resources while limiting project duration, will create more value.

Properly allocating resources is critical. Because most medical device R&D is development related versus research, technical managers, who deal with outsourced projects, require internal engineering capable of understanding the design and having the skills to modify it. Hiring design engineers for a specific project may be less efficient than outsourcing riskier R&D projects to a medical product developer capable of long-term design support. This allows medical device companies to focus on core competencies and supplement company strengths.

Traditionally, large corporations outsource more during tough economic times. Today, larger corporations are investing more in startup companies and innovative technologies through partnerships. This aids the flow of innovative technology while earn-outs, license agreements and outsourcing reduce risk. Fueling R&D outsourcing directly and indirectly, large corporations are playing a key role in the growth of R&D outsourcing.

R&D departments within large corporations will increasingly be in a position of integrating technology and resources. R&D will involve internal development of core competencies, startup company support, partnerships with suppliers to develop specific technologies and outsourcing to product development companies. This will create long-term partnerships with development firms and a broader support role for R&D departments as well.

Development Implications

Both defense and startup industries have realized the need for long-term alliances as they outsource R&D. These alliances are based on development complexity and efficiencies gained in technical management after the development. As larger corporations seek out the same type of support, medical product development companies should be prepared to fulfill these needs.

Larger corporations will also need to be more efficient and cost effective, and these needs will be transferred to development companies. Development firms will have to offer innovation and technical advancement to complement corporate strengths. Technological advances in sensors, displays, control systems and embedded software will have to be integrated into areas such as MEMS, wireless communications, microfluidics, implantable sensors, web-based technology and bioengineering.

With increasing expectations placed on development companies, smaller support projects will also be expected as corporate alliances look to cover technical support as well. Although these projects are low margin, they represent a path to customer loyalty and revenue continuity.

Experiences at the Aubrey Group confirm these trends. In the past year, there has been a marked increase in larger corporations seeking specific expertise or R&D support as well as growth in corporate VC-backed startup projects. In addition, companies have expressed greater interest in technical management post projects and support for manufacturing and service.

Continued cost reductions and the push to improve patient outcomes have created the need for advanced technology. This trend will continue and be more prominent in the future. The growth of innovative and integrated medical devices has added to the complexity of design and development.

Core resources and competency will continue to make up the essence of a business. Today, large corporations and startup medical device companies consider R&D outsourcing a part of their strategies for creating value and improving their competitive edge. Because corporate investment also plays a role in startup growth, large corporations are financing R&D outsourcing directly and indirectly.

Outsourcing has been a successful model for years, especially in the defense industry and for startup companies. As medical device companies compete in a more dynamic and cost-constrained environment, development companies are increasingly being seen as a viable option to internal development.