“Sam earned his undergraduate degree in three years. Can you believe it?” or “It only took Jane two years to turn her idea into a million-dollar business.” The degree and revenue surge are noteworthy accomplishments by themselves. But the time element added to the equation further shapes the context. For example, if one of the examples above is slightly changed: “It took Sam seven years to get his degree.” Wow. The seven-year plan. We’re thrilled he finished school and earned a degree (finally), but it sure took Sam a while. The length of time alters our perception and—perhaps unfairly in many cases—how we value the feat.
Observing anniversaries is part of the same pattern. While they may not always be about celebrations, they certainly are mile markers along life’s personal and professional journeys. In this issue of Medical Product Outsourcing, it is about a celebration—10 years since the magazine’s first issue was published. Throughout the year in MPO to mark the occasion, we have examined, where appropriate, various medical device and outsourcing trends during the last decade (and we’ll continue to do so for the remainder of 2013). In this issue in particular, however, we dig a little deeper. This feature will explore how the outsourcing market for medical technology has matured, what OEMs have come to expect from their manufacturing and product development partners, and what to expect in the future.
(Don’t miss the feature titled “Decade of Discovery,” which looks at medical device technology trends and breakthroughs in the last decade.)
Making the Case
In the scheme of things, it may not seem like 10 years is a lot of time but, as industry experts tell MPO, before the medtech outsourcing market could come into its own, it had to wait for the medical device market to mature, which really began when the U.S. Food and Drug Administration (FDA) was given the authority to pre-approve medical devices under the 1976 Medical Device Amendments. In signing the law, President Gerald R. Ford said the amendments eliminated the deficiencies that accorded the FDA “horse-and-buggy authority to deal with laser-age problems.”
As medical device manufacturing found its stride, the suppliers and contract manufacturers that grew within and around it had to develop to meet customers’ growth and developing needs.
“Ten years ago, in reality, outsourcing in our sector was still young—particularly if you compare it to more traditional industries such as aerospace and automotive, which have had a much longer outsourcing history,” said Mark Bonifacio, a 25-year-veteran of the medical device contract manufacturing industry who now runs Bonifacio Consulting Services in Natick, Mass., which helps clients with mergers and acquisitions, business development, as well as technical and operational services. “So we’ve seen a little bit of growing up, if you will, of the contract manufacturing and outsourcing sector.”
Many of those growing pains were the result of trying to develop and provide the right balance of services at the pace at which the medical device sector innovates.
“When you look at contract manufacturers 10 years ago compared to the companies today, the landscape from a supplier’s perspective has changed dramatically, and that’s been a result of OEMs’ increasingly greater use of outsourcing,” said Ben Dunn, a managing director with Boston, Mass.-based Covington Associates, a specialty investment banking firm focused on the business services, consumer and industrial, healthcare, and technology sectors. “We’ve watched as suppliers have worked to perfect the outsourcing model.”
Dunn explained that 10 years ago, there were a few large, “blockbuster” mergers in the medtech outsourcing space that were significant in scope because they brought together companies with a host of smaller shops and capabilities under their umbrella of services—the “first stab at a one-stop shop,” Dunn called it. But time has proved that such deals may not have been the best solution for the marketplace. One-stop-shops of course are great solutions, but it took awhile for organizations to master tying together so many capabilities under one roof, particularly if those talents were gained through acquisition.
“Now you have some large players, but you also have more specialized outsource providers that picked specific segments—be they orthopedics, metals, interventional implantable devices or catheters—and so we’ve seen much better specialized outsourcing companies that are focused on specific niches,” Dunn said. “We’ve also seen much greater appreciation recently for design and development capabilities—the understanding on both sides that to be a good outsource partner, you need to get involved earlier in the process, that you can be much more effective if you can design for manufacturability. It’s much more of a partnership model than what we saw initially. These are all things that have happened over time.”
As both buyers and providers have matured, they are able to “see and feel” where outsourcing drives business value, noted Marc Tanowitz, principal of Pace Harmon, a management consulting firm based just outside Washington, D.C., in Vienna, Va. “This influences where the providers are focusing their investments and influences the scope of services desired by the buyers,” he said.
Despite the outsourcing market’s willingness and enthusiasm for expansion, the speed at which the market progressed also was tempered by the reluctance of many OEMs to “let go” of varying parts of the process. One of the biggest obstacles was the reluctance of medtech corporate cultures to shift their approach to product development, said John P. Carey, senior vice president of business development for Foliage Inc., a product development and technology consulting company in Burlington, Mass.
“The cultural tendency was to control as many aspects of product development and support as possible—including manufacturing,” Carey said. “This led to large and expensive R&D and support groups that were not interested in outsourcing because it meant reductions in human resources and a new way of doing business. Therefore, the medtech culture was naturally attracted to maintaining the status quo and naturally resistant to outsourcing. Another obstacle has been concern over the leakage of intellectual property (IP). Medtech companies have been very cautious about outsourcing because they fear that their core IP will be copied and sold in emerging markets with little recourse due to variances in IP protection law.”
Being a highly regulated industry also played a factor in OEM adoption of outsourcing service.
“We are in such a regulated industry, and there were control issues and quality issues that everybody was somewhat fearful of,” Bonifacio said. “There were some products—Class III products, for example—that had never really been manufactured in a contract manufacturing environment, and OEMs and suppliers had to get over those kinds of hurdles. It made adoption a little bit slower. Ten years ago it was a quagmire given the number of different companies trying to develop and validate different services, and now it has started to become a little bit more defined with tier-one and some tier-two companies that can offer full service, and then there is a full suite of more niche and specialized tier-two and tier-three suppliers.”
Charlie Whelan, director of consulting, healthcare and life sciences, North America, for Frost & Sullivan in San Antonio, Texas, said there were (and continue to be) multiple factors contributing to OEMs’ greater acceptance of contract manufacturing options.
“There are a number of big variables,” he said. “The first is competitive pressure. OEMs know that they need to improve their margins and that they are in a marketplace that is highly price competitive, and they consider contract manufacturing as an option to pursue. They ask themselves, ‘Is this really core to what we do or can we farm this out?’”
Contract manufacturers’ increasingly sophisticated capabilities help, particularly if they have a broad global footprint, Whelan noted.
“The combination of the competitive pressures and the fact that the contract manufacturers have really stepped up their game in terms of the sophistication of their technology and equipment, their staff, their sourcing, their locations, their transparency in documentation, really lowers that risk threshold so that device companies are much more comfortable with what they are doing,” he explained. “So medtech OEMs see that there are high-tech, high-precision industries such as IT and aerospace doing this, and they realized that there is no good reason why they couldn’t do it, too. So, I think they have taken on a lot more than they did a decade ago.”
In the first wave of outsourcing, the industry learned that the cost savings is not the only factor to consider, and that companies needed to learn how to manage the outsourcing process for maximum project value, Carey noted.
“With cost as the only driving factor, many companies suffered through quality issues and missed market windows before they arrived at the right mix of outsourcing and in-house competencies,” he said. “The effective management of outsource partners is another competency that has to develop on the part of the medtech firms—and we have seen great progress on this front. Companies are investing in this competency.”
Covington’s Dunn agreed that OEM confidence with the outsourcing process has increased through a better understanding of the process.
“A growing comfort level has been a factor in the last 10 years,” he said. “Medical device companies have figured out how to use outsourcing more beneficially. They have realized that it’s a more efficient use of capital, but also that there are outsource partners who have capabilities that they don’t have, that can more quickly and efficiently bring products to market and actually make things better than they could do themselves in certain areas. They’ve also realized that outsourcing gives them much greater flexibility in how they run their own operations and how they deal with business cycles.”
Still Going Strong
The result of the growing pains that experts cited has been a series of valuable lessons learned. And despite continued market challenges to the medtech sector, and indeed healthcare as a whole, outsourcing providers may be uniquely positioned to help medical device makers seize opportunities when they come along, experts noted.
“In the next few years, I think we’re going to continue to see outsourcing grow,” Dunn predicted, estimating that the outsourcing market has experienced year-over-year growth of 10-15 percent “conservatively,” though it varies among different sectors. He expects that rate to continue in the near future.
“As businesses have more experience with the expertise and knowledge around how to effectively use outsourcing, it should be almost a no-brainer for OEMs to continue to employ it, if they can employ it effectively,” Dunn continued. “And that is a combination of experience, but then also, having world-class providers with whom you can work.”
He did note, however, that one trend he sees continuing is OEMs’ “supply chain rationalization.” It is a consequence of medical device companies better managing the outsourcing process—reducing redundancies and keeping a better handle on cost and quality. And as result, these companies will continue to pare down the number of suppliers with which they work, and in turn look to better manage more services and capabilities from a smaller network of dedicated contract manufacturers and supplier partners with niches and systems best suited to an OEM’s needs.
“I think that trend is absolutely going to continue and it is going to drive consolidation [in the outsourcing market],” Dunn said.
Frost & Sullivan’s Whelan said that price pressures in the medical device sector aren’t going away any time soon, and that companies that pursue the global healthcare market will be better positioned overall. Specialized capabilities or technology also will help to differentiate contract service providers.
“I think it is going to continue to be an increasingly price-competitive marketplace. It also is going to be increasingly globalized,” he said. “For contract manufacturers to have a global presence and footprint will be increasingly important and valuable. Being able to have the flexibility to manufacture smaller batches, more customized technologies and products that maybe meet the needs of a specific sub-segment of customers, or the specific needs of individual countries, will be extremely valuable.”
Tanowitz agreed that the global footprint is here to stay—though where devices are manufactured may change. But it isn’t simply about a low-cost labor option and then repatriating parts or finished devices back to the United States. U.S.-based firms are manufacturing product in foreign locales specifically for those markets.
“In many cases, global companies are engaging offshore manufacturers to provide product in market and outsourcing in this manner is being used to minimize supply chain costs by manufacturing close to the point of demand and consumption,” he said. “The regulatory environment still drives many manufacturing decisions and the complexity of this often prevents medical device firms from shifting manufacturing providers and locations.”
Bonifacio said many of his clients are reporting manufacturing in regions to serve growing international sectors such as China, Brazil or India. “Right now, the popular play is ‘Asia for Asia’ or “Brazil for Brazil,’ where you are manufacturing and selling in that market. That is going to really ramp up because those markets are maturing. And 10 years from now, you and I are going to be saying ‘Wow, can you believe how big that Brazil market is? Can you believe how big the China medical device market got?’”
But the low-cost-country option just for manufacturing, however, hasn’t gone away yet, and remains a viable option for many companies, Bonifacio hastened to add.
“There will still be an export component, despite all this talk of ‘re-shoring.’ We have some clients that are coming back [to the United States]. But we also have clients that are still going the other way. For the right product line, for the right mix or the right labor component, you are still going to look at the Dominican Republic, Costa Rica, Mexico or China as an alternative.”
Anything that helps their clients solve, manage or improve supply chain issues also will be increasingly significant, particularly as companies tackle international models, Whelan said.
“I am a big believer that supply chain solutions are a big opportunity as well. So, if a contract manufacturer has distribution and supply chain capabilities as well as manufacturing, that would be very valuable,” he said. “I also think that with the development of unique device identifiers, the rules for which the FDA is going to be rolling out this summer, that is going to begin a longer-term trend toward transparency on sourcing for materials and components and for certain classes of devices. So, if you have got a Class III device, be it a pacemaker or something like that, in the future I could envision the FDA and other regulatory bodies—maybe even purchasers and payers—are going to want to know that the device came from Medtronic or St. Jude, but also where the battery came from, and who made the circuits and the electrodes. Going back a couple of levels in the value chain so there’s transparency of the supply chain, forward and backward, to counteract counterfeiting, to lower risk and improve reliability is going to be important. And I think by nature of that, the contract manufacturers are going to start to have to assume more risk for the end-product, whereas maybe they did not in the past.”
And then there’s the much-maligned 2.3 percent medical device excise tax, which was part of 2010’s sweeping Affordable Care Act (commonly called “Obamacare”), and went into effect this year. The tax, OEMs claim, puts significant pressure on their abilities to innovate, hire new workers and remain profitable.
For example, consider a recent announcement from the CEO of Buford, Ga.-based Theragenics Inc., a maker of surgical products.
“The decision to outsource our vascular access manufacturing outside of the U.S. was driven by a number of factors including the health of the medical device industry, new taxes such as the medical device tax, the regulatory environment in the U.S. and our recent results,” said M. Christine Jacobs, in a press release announcing the company’s first-quarter earnings (ended March 31). Revenues were down 9 percent, and operating income was $17,000 compared to $1.6 million in Q1 2012.
“As it pertains to outsourcing and cost reductions,” Jacobs continued, “we are closing our vascular access manufacturing facility in Garland, Texas, by the end of 2014. We will outsource most of this manufacturing to independent suppliers in Latin America. Some of the more complex manufacturing in this operation will be transferred to our specialty needle plant in North Attleboro, Mass. Once complete, we expect this restructuring to significantly reduce our costs and allow us to remain competitive in a highly competitive marketplace. We deeply regret the loss of jobs and having to take these steps. However, we continue to be responsive to our customers’ needs and to address and anticipate macroeconomic conditions. Regulatory issues, taxes and decreased demand across the sector dictate that we change with the environment.”
So, can outsourcing providers—not just across borders but at home as well—help to alleviate the tax’s impact on OEMs?
“In some ways, yes,” said Dunn. “It is beneficial because outsourcing can help them be more cost effective, but I also think it’s going to put big price pressures on outsourcers, and so outsourcers’ margins are going to be squeezed, too. Everybody is going to share the pain here, and the real question is if it will be disproportionate because the easy thing for a medical device company to do is to go to its suppliers, and squeeze them as hard as they can. So the real issue, in my mind, is if the outsourcing industry gets squeezed unfairly or disproportionately due to the medical device tax.”
A Moving Target
Experts continue to point to the numerous factors that point to continued success and expansion of the medical device contract manufacturer/OEM relationship. But issues such as the device tax illustrate the outsourcing issue is still at the mercy of a host of unknowns in the U.S. healthcare market.
Contract manufacturers have a lot of say and sway in the process—perhaps more than they realize. Clearly, they’re held hostage by market fluctuations and machinations in Washington, D.C., but they also have an active role to play. Experts said that the more contract manufacturers understand and actively engage in the healthcare discussion, the better prepared they’ll be.
“Healthcare in this country is at a turning point, but it is taking that turn relatively slowly,” said Whelan. “We’re in a situation where innovation continues to be important, but we are undergoing a transition in the healthcare space overall where cost is even more important than in the past. So, a lot of medical device companies are under pressure. They are wondering whether they should innovate or focus on their core markets with different types of strategies.”
He said large device companies are in a quandary. They have to decide between investing in their core markets and revenue drivers, which have seen margins erode, pricing go down and competition go up and pursuing slightly more risk that will cost a lot of money for research and development, but could have the opportunity for a significant growth.
“They are not as sure today that there is a pot of gold at the end of that R&D investment to the same degree as they might have been in the past,” Whelan said. “It is a more uncertain payer environment than maybe 10 years ago. The big challenge is people are continuing to be sick. People are getting older. All of those dynamics are pretty well understood. It is the economic side of the equation that is having a ripple effect on everything else. Devices that 10 years ago could be purchased and then marked up and resold under a fee-for-service schedule are under payment models that now are no longer reimbursable and are rolled under total costs.”
And that pressure will cause “a ripple effect” in outsourcing, Whelan predicted. Though companies also could decide to bring some processes back in house to save costs, the contract manufacturing model gives them multiple options.
“Devices won’t have the very healthy margins they historically have had. So, manufacturers could be turning increasingly to outsourcing providers to provide lower-cost manufacturing options. But OEMs will be shopping those contracts around, looking for outsourcing providers that can deliver lower costs and the right mix of services. The current state of healthcare has a pretty direct impact on the outsourcing and OEM communities”
Overall, however, experts seemed to agree that even with healthcare’s multiple moving targets, outsourcing growth would continue in the foreseeable future.
“Given the enhanced focus on core competencies and controlling the growth of full-time employees in medtech companies, we should continue to see outsourcing grow in the future,” said Foliage’s Carey.
“The big difference is that as medtech companies become more comfortable with the practice of outsourcing and much better at managing their outsourcing partners, the resulting higher quality, enhanced predictability, and greater productivity will see the demand for and use of outsourcing grow.”