As Outsourcing Increases, So Does ConsolidationAs Outsourcing Increases, So Does Consolidation

Originally Published MDDI March 2004

Guide to Outsourcing

More and more medical device companies are looking for one-stop options for outsourcing manufacturing. The result is an upsurge in consolidation of these providers.

Andrew Kinross

When Johnson & Johnson announced in December 1998 that it would simultaneously lay off 5800 manufacturing personnel (closing more than one-quarter of its medical device manufacturing facilities worldwide) and hire 1700 engineers, some industry observers said it was a sign of weakening sales for the company. Contract manufacturers saw quite a different signal: that J&J had made a strategic decision to focus its internal efforts on research and development and to outsource vast amounts of manufacturing to vendors. Five years later, J&J's sales have shown no signs of slowing, with total revenues rising from $23.7 billion in 1998 to $41.9 billion in 2003 and medical device revenues increasing from $8.6 billion to $14.9 billion. Meanwhile, contract manufacturing has gone mainstream.

The last several years have been an active period of evolution for the medical device contract manufacturing industry. Once a highly fragmented industry with a base of more than 4000 companies, it has become much more consolidated, with large groups emerging from the field and laying claim to leadership positions. Original equipment manufacturers (OEMs) have made conscious decisions to outsource more and more manufacturing, and suppliers have been refining business models to achieve the greatest success.

Following the J&J announcement, other large OEMs followed suit. For example, in 2000, Boston Scientific announced that it would lay off 1950 manufacturing workers as it shifted manufacturing to its Miami and Ireland facilities, and make more use of contract manufacturing. Medtronic's Cardiac Surgery division reduced its number of manufacturing plants from 16 in 1998 to eight currently and expects to operate no more than three or four in the future. Most of the plants have been sold to contract manufacturers with whom Medtronic entered into supply agreements. Other plants were closed.

What is driving this trend? In a word, economics. If a company's base of contract manufacturers is cheaper, faster, and more technologically savvy than its internal operation, the case has been made to outsource. In addition, many OEMs believe that manufacturing is not a core competency; rather, they believe product design and marketing are their core competencies. Therefore, at a high level, device companies decide to focus on the product design and marketing and to outsource the manufacturing. The decision to outsource now is propelled by shareholder value. Historically, medical OEMs have driven earnings growth through mergers and acquisitions as well as price increases, but companies place much less reliance on these drivers today.

The medical device industry is not the first to experience an outsourcing curve. The automotive, electronics, and aerospace industries have already gone through this curve. For example, today some 90% of electronics for computers and networking is outsourced, whereas 10–20 years ago less than 20% was outsourced. The extent to which medical device manufacturing is outsourced is of significant interest. 

Approximately 25% is currently outsourced; however, that percentage will almost certainly increase. How much it will grow is open to debate.

The Markets Today

In 2003, worldwide revenues in the medical device and equipment market were $176.2 billion and were expected to grow 6.5% over the next three years, according to Frost & Sullivan. Although the device market includes thousands of firms, it is relatively consolidated, with the top 40 companies accounting for some 80–85% of the market. Johnson & Johnson is the largest company, with revenues of $14.9 billion, or 8.5% of the worldwide market.

The $176.2 billion market size incurs approximately $61.7 billion of cost of goods sold, or 35%. Of this amount, roughly $16.7 billion (or 27%) was sent out to contract manufacturers in 2003 (see Table I). The U.S. portion of this amount is roughly $8.3 billion, or half of the worldwide market. OEMs typically focus on product design and final assembly, and they opt to outsource components—metal, plastic, or electronics—to contract manufacturers. Another trend is that OEMs have been more willing to outsource engineering and assembly services, particularly when they build strong relationships with strategic partners.

Margins for contract manufacturers tend to be highest for metal components, particularly for precision metal machining. These higher margins can be attributed to the high degree of quality and expertise required and the comparatively limited number of qualified suppliers. Some metal components become part of implantable devices. These devices have the strictest tolerances and other tough requirements. Plastics and electronics are viewed much more as commodity service offerings, and thus are typically offered at lower margins.

There are many qualified suppliers for these components. In general, metal components and value-added services (i.e., engineering and assembly) are seeing the most growth, driven primarily by the end markets and an increased outsourcing rate. Growth of plastic and electronic components, by contrast, is moderate. Accurate market size estimates don't exist; however, the plastics market is considered the largest, and the other three are all smaller and roughly similar in size.

Geographically, medical device manufacturing is concentrated in three major areas in the United States: the Minneapolis area, California, and New England. Internationally, Ireland, Germany, and Switzerland have been long established bases of manufacturing. Mexico and Asia (in particular Singapore, Malaysia, and China) represent emerging locations. As discussed later in this article, manufacturing has been moving slowly in some cases and quickly in other cases to these emerging low-cost sites.

The Big Become Bigger

Over the past several years, private equity companies have pushed the consolidation of the supplier base. Beginning in 1996, three companies alone, MedSource Technologies, UTI Corp., and Symmetry Medical, backed by private financial partners, have consolidated some 31 of the largest contract manufacturers focused on metal and plastics machining (see Table II). In addition, UBS Capital Americas owns Avail Medical, which when it merged with Horizon Medical in 2002, formed one of the largest players in the outsourcing industry.

On the electronics side of the business, the supplier base comprises a handful of publicly traded medical focused companies (i.e., Plexus and HEI), several large publicly traded electronics manufacturing services (EMS) companies that have developed medical electronics businesses (i.e., Flextronics, Sanmina-SCI, and Solectron), and other private companies, some of which have grown aggressively through private equity backers (e.g., TriVirix, which received $25 million in funding in December 2002). To date, there has been little crossover among electronics houses and plastics and machining houses.

Plexus, with FY 2003 medical revenues of $259 million, has emerged as the largest provider of electronics. MedSource Technologies, with FY 2003 medical revenues of $177 million, is the largest provider of metal and plastic machining services. Wilson Greatbatch had FY 2003 medical revenues of $190 million, consisting of a unique combination of $91 million in metal components, $68 million in batteries, and $32 million in capacitors.

The Advent of the One-Stop Shop

As these larger players emerged from a fragmented industry, OEMs were also making significant changes to their vendor bases. The trend has been for OEMs to pare down their base to a more manageable size and gain efficiencies from using some of the larger vendors that have become one-stop shops. Medtronic, for example, has gone from 2500 vendors in 1998 to 700 today, a 67% reduction. Many other OEMs have similarly reduced the number of outsourcing partners.

These one-stop shops generally offer more value-added services than smaller shops, such as engineering, assembly, and supply chain capabilities, including vendor-managed inventory. In addition, they can provide a strong company-wide quality system that OEMs demand.

One implication of the trend to consolidate is that smaller contract manufacturers are vulnerable. In the past, smaller operations have often had a particular expertise and quietly manufactured a component for years and years. Now, however, OEMs may shift that work to a larger, highly capable supplier that can pick up the new work quickly. Because the larger vendor has economies of scale, OEMs might even get a price concession.

Price Pressure and the Imperative to Cut Costs

Although contract manufacturers have seen healthy volume increases, such growth has come at a price—literally. The managed care environment has sought ways to reduce healthcare costs, and that objective translates into price pressure for OEMs and, in turn, for contract manufacturers. Compounding the problem is that OEMs are looking at cost-structure efficiencies as a means of achieving stock-price improvements. All of these factors are causing OEMs to squeeze contract manufacturers on price.

Pricing has remained fairly constant over the past four years, but the last 12 months have seen increasing price pressure. In addition, especially for high-volume spending, OEMs are able to drive down prices merely by threatening to switch to another supplier. It is important to mention that not all areas of the medical device industry are experiencing the need to reduce prices, but the exceptions are minimal.

In general, the contract-manufacturing base in the United States has been insulated from price pressure over the past several decades. Representing a small amount of the final price of the product, OEMs weren't terribly sensitive to outsourcing costs. A record of good quality products and on-time delivery was usually sufficient. Those metrics have become threshold, and now OEMs are taking aim at any excess margin. Vendors have employed various strategies to deal with price pressure, including:

• Outsourcing to off-shore locations such as Mexico, Ireland, and
Asia.
• Plant consolidation.
• Operational excellence.
• Reducing overhead.

Just as in other industries, migration of manufacturing to low-cost locations has been taking place in the medical device industry—to a degree. Although not as dramatic as in other industries, this trend definitely deserves attention. In recent years, manufacturing has shifted out of the United States. In particular, cleanroom assembly—by virtue of its high labor content—represents an attractive option for a low-cost 

location. UTI Corp. (through its recently acquired Venusa), Avail Medical, and MedSource Technologies have all invested in Mexican facilities in recent years. UTI opened an Ireland facility in 2002 to serve the European market. In January 2002, Plexus acquired its first facilities in Asia: one in Penang, Malaysia, and another in Xiamen, China. One of its largest facilities is in Juarez, Mexico.
 
U.S.-based suppliers face increasing competition from Asia. For example, Singapore-listed Spindex Industries, a $30 million (U.S. annual revenue) company with plants in Singapore, Malaysia, and China, announced in 2003 that it would build a new plant dedicated to the production of orthopedic implants as its entry into the medical device market. Singapore-listed 

Beyonics, a $300 million company with 13 plants scattered across Asia, already serves the medical device market. China is highly active right now, and migration of more manufacturing to China could certainly occur over the next few years.

Network optimization is another tactic that the larger contract manufacturers are using to reduce cost. For example, UTI completed consolidation of its Micro Med Machining unit into its Spectrum Manufacturing unit in May 2003. Such consolidation can improve utilization and minimize overhead expenses. MedSource consolidated plants as part of a restructuring program in 2001. It announced another restructuring program in 2003 that aimed to save $6 million to $8 million annually by FY 2006 at a cost of $15 million to $20 million. The second program involved the consolidation of one facility and other, as yet undisclosed, initiatives.

Operational excellence has been another area in which contract manufacturers are reducing cost. Six Sigma and lean manufacturing techniques are the driving forces behind this trend. Wilson Greatbatch adopted a Six Sigma program in 2001, and MedSource Technologies hired a business excellence executive in 2002 to implement Six Sigma and lean manufacturing initiatives for the company. Today many customers expect their vendors to have such programs in place.

Finally, overhead reduction has played a central role in becoming cost competitive. Costs for sales, general, and administration (SG&A) expressed as a percentage of sales need to be kept low to be competitive. MedSource has reduced its SG&A from 20.4% in 2001 to 18.9% in 2003 and to 16.9% in the second quarter of FY 2004, a reduction of 350 basis points over three years. Although small shops normally have very low overhead to begin with, the current climate prevents them from adding to their sales and marketing efforts.

Conclusion

For what has historically been a steady, almost sleepy, industry, changes in medical device manufacturing have been quite radical in the last five years. Much has changed, and it is likely that much change remains. So where does the industry go from here?

It is clear that cost leadership is a primary success factor for contract manufacturers. Companies that can achieve cost leadership will be positioned for more work in the future. Will that mean that manufacturing will migrate to Mexico and Asia? If so, to what degree? It seems that EMS companies have already determined that this shift will occur to a certain extent. However, there seems an inherent desire on the part of medical device OEMs to keep some manufacturing, implantables in particular, in the United States.

It almost seems inevitable that there will be more consolidation within the industry, resulting in cost efficiencies. Although the larger shops will likely lead this trend, it will be interesting to see what tactics, if any, smaller shops will take to address the trend. For example, the consolidation of two competing small- or medium-sized shops could mean their survival. Such small firms are indeed vulnerable. Being acquired by a large player is another option. Unless small firms have a lock-in with a customer by virtue of a relationship, an exceptional competency, or exceptionally low cost, they could see major revenue erosion.

And will the trend toward outsourcing continue? The answer to that question depends in large part on how contract manufacturers can rise to the occasion and make companies like J&J, Medtronic, and Boston Scientific look good in 2004, 2005, and beyond. 

Andrew Kinross is an independent consultant. He can be reached at [email protected]. Kinross formerly served as director of market development for MedSource Technologies. Prior to that, he spent five years as a strategy and finance consultant at Arthur D. Little.

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