FIRST PERSON:Challenges to Competitiveness in a Changing Medical Device Market

An MD&DI January 1997 Commentary


A. Jay Graf
President, Cardiac Rhythm Management Group
CPI/Guidant

Most medical device companies today compete in technology-drivenmarkets that respond eagerly to a steady stream of innovative new products. Myown company, CPI/Guidant, is acase in point: 55% of its sales in the first 9 months of 1996 came from productsintroduced in the previous 12 months. Such rapid product development is anecessity in the health-care market, for it is the ability to bring innovativetechnology forward in a cost-effective and clinically relevant way thatdistinguishes winners from losers.

I do not believe that this basis of competition will change in the future. Butit will be challenged by the expectations of the capital markets and thedynamics of the rapidly changing health-care marketplace. Device companies notonly will need to continue their innovations, but they will need to do so whileincreasing sales volume, reducing production costs, and, in fact, speeding upthe pace of R&D still more.

A TENTATIVE VOTE OF CONFIDENCE

The recent stock market performance of the health-care industry as a whole, andof the device industry in particular, indicates a strong vote of confidence byWall Street in the collective future of our companies. Investors clearly agreewith us that vast opportunities remain for companies with innovative productsand solutions.

But a closer look at the impressive earnings growth behind these stock marketgains suggests that another dynamic is at work. It suggests that growth in mosthealth-care companies was a function of improving margins, primarily fromproductivity programs implemented in recent years.

As a source of growth, this approach has distinct limitations. Ultimately, themajor source of increased earnings will have to be revenue growth. Single-digitrevenue and earnings growth clearly will not sustain the price-earnings ratiosthat many medical device companies enjoy today. In the future, then, thechallenge for medical device companies will be to move beyond incrementalsavings and to bring to market innovative products that provide clear costjustifications as replacements for existing products or that offer entirely newtherapies.

NEW MARKET REALITIES

This growth will have to come in a rapidly consolidating market that is placingfundamentally new demands on its suppliers. The cause of this consolidation canperhaps be traced to the moment that the United States became the first nationin which health care exceeded 10% of the gross domestic product. This startlingstatistic gave new visibility to the issue of health-care costs. Soon after,U.S. businesses, which for years had watched the costs of health-care benefitsrise faster than most other items on their ledgers, warned that enough wasenough.

In response to the pressures from both the private and public sectors to reducecosts, payers and providers began consolidating in order to gain economies ofscale, reduce costs, and increase purchasing leverage. Managed care, with itsemphasis on cost control, began its steady and rapid growth.

Just three years ago, there were about 5000 independent hospitals in the UnitedStates. In the not-too-distant future, it is likely that their place will betaken by 150 to 200 integrated systems nationwide. These systems will use theirenormous purchasing leverage to reduce their materials costs, pushing morevolume through fewer suppliers.

They will, of course, use this leverage to exact price concessions from us. Inthis situation, even physicians, once a countervailing force against the bias ofhospital administrators toward price rather than product functionality, can nolonger be counted on. Increasingly, as network employees who sit on purchasingcommittees, doctors are motivated by financial incentives that look much likethose of their administrative counterparts.

IMPLICATIONS FOR INDUSTRY

The consolidations taking place among payers and providers are clearly havingtheir effect on the medical device industry. Consolidation of device companiesallows them to lower costs and offer providers one-stop shops through broadenedproduct lines, and price concessions through increased volume. In many cases,medical device companies will not have the resources needed to create the broadproduct portfolios the integrated networks demand from suppliers, and will needto consider strategic acquisitions or partnerships. This process began inearnest in 1995. From 1991 to 1994, the average number of acquisitions andmergers per year was 50, with an average annual value of $1.8 billion. But in1995 there were 88 acquisitions, valued at $66.4 billion.

Acquisitions and mergers are just two responses that must be explored. In addition, device companies will have to reduce the fundamental manufacturingcosts of a device itself. This challenge will need to be addressed during thedesign of the product, since opportunities to reduce costs once a device reachesthe manufacturing floor are limited. Cost targets will need to receive equalbilling with the two traditionally dominant priorities in productspecification--feature functionality and time-to-market.

Similarly, the cost of research and development will require strictermanagement. If the industry is to sustain the current rate of innovation in thischanged environment, R&D productivity will need to increase. This will meanstill shorter product development times driven by the following:

Finally, medical device companies must find a way to reduce the regulatory coststhat are associated with the design of new devices. These costs have risen farfaster than any other element of R&D. The cost of evaluating a product'sreadiness for market release has increased dramatically over the past fiveyears. The immense costs associated with an uncertain and unpredictableregulatory process affect all the fundamental cost drivers, including labor,overhead, inventory investment, and obsolescence.

Inherent in these challenges to our industry is the opportunity for aggressiveand agile medical device companies to grow substantially in the next five years.Cost-effective and clinically relevant product innovation in rapidly changingcustomer markets is imperative to remaining competitive.

Copyright © 1997 Medical Device & Diagnostic Industry