Stop Worrying About Medtech Contract Manufacturers

Yes, there are going to be some tough times in the immediate future. But a recent report from S&P explains why the long-term prospects look good. 

Nancy Crotti

Medtech's contract manufacturing industry faces some near-term turbulence, but has a healthy outlook going forward, a Standard & Poor's report concludes.

The report, by S&P Ratings Service analyst David Kaplan, also rates three manufacturers: publicly traded Integer Holdings Corp. (formerly Greatbatch Inc.), sponsor-owned Phillips-Medisize Corp., and Tecomet Inc. The ratings company, which originally gave Integer higher marks than the other two, has since downgraded the larger company's credit profile from a B+ to a B, equaling the others.

Consolidation among OEMs, healthcare-reform-related pricing pressures, a drop in orders, and fewer new product launches will combine to produce headwinds in the near future, Kaplan writes. S&P expects the turbulence to be short-lived.

"We believe this turbulence is a period of digestion following a wave of OEM consolidation and that inventory reduction initiatives are finite and likely to be complete soon," the report says. "We expect (contract manufacturing) industry growth to resume the low- to mid-single-digit growth rate we expect for the medical device industry."

The ratings company also expects the contract manufacturers it follows to grow gradually in the coming years, enabling them to outpace industry growth rates, as OEMs continue focusing on cutting the numbers of their suppliers while favoring large contract manufacturers that can provide a broad range of products and services. Consolidation among contract manufacturers should improve their economies of scale and manufacturing capabilities, but the industry's fragmentation and population of manufacturers with similar capabilities made S&P hesitate to give it higher ratings.

"There's not much difference among what they can make," Kaplan said in an interview."They've been trying to offset it by getting involved in medtech companies in their development stage to help design the components, but it's still very price-based."

Mergers and acquisitions among OEMs have reduced duplicate inventories and projects, and delayed or led to the abandonment of some previously planned projects, the report says. Kaplan declined to give specifics, citing confidentiality concerns.

"We think the OEMS will try to use fewer outsource manufacturing companies, especially the larger (OEMs) that have more offerings, but also try to get better prices from those manufacturers in return for that greater volume," he predicted.

Performance by Frisco, TX--based Integer, which recently changed its name from Greatbatch Inc., fell short of S&P's expectations and the company's own guidance for three of the past four quarters.  Integer's stock, which changed to the ITGR ticker symbol on the New York Stock Exchange on July 1,  has actually been one of the worst performing this year among major medical device companies.

Integer attributes the ongoing disappointing results to a combination of delayed new-product launches, existing programs tapering off sooner than expected, delays in the integration of Lake Region Medical (acquired last year for $1.73 billion), and customers aggressively working down their inventory levels.

"They kind of recognized that this is not a temporary thing," Kaplan said.

S&P consequently slashed its expectations for Integer by about 10% to $1.38 billion in sales and $300 million in earnings.

"The company offers a broader array of manufacturing services than other smaller CMOs, has good profitability, and like peers has sticky and long-term contracts and relationships with customers," Kaplan wrote in an updated report on Integer. "Still we view the scope of the company's services as somewhat narrow and having limited barriers to entry, as well as exposed to intense price-based competition."

Integer's business is concentrated in cardiac and neuromodulation (49%) orthopedic devices (21%), followed by portable medical (10%) and vascular (8%), with the rest in medical product innovation and energy, according to the original S&P report. It listed Phillips-Medisize concentrations generally as medical (50%), commercial (30%), and preproduction (20%), and Tecomet's as orthopedic (76%), other medical segments (16%) and aerospace (8%).

"We view Phillips-Medisize as having a marginally stronger business risk profile than Tecomet because we believe Phillips-Medisize's better geographic, industry, and customer diversification more than offsets its weaker operating efficiency and profitability (stemming from substantial exposure to lower-margin industries outside of health care)," the report says.

Nancy Crotti is a contributor to Qmed.

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