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

Jay GrafAn MD&DI January 1997 Commentary

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

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

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

A TENTATIVE VOTE OF CONFIDENCE

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

But a closer look at the impressive earnings growth behind these stock market
gains suggests that another dynamic is at work. It suggests that growth in most
health-care companies was a function of improving margins, primarily from
productivity programs implemented in recent years.

As a source of growth, this approach has distinct limitations. Ultimately, the
major source of increased earnings will have to be revenue growth. Single-digit
revenue and earnings growth clearly will not sustain the price-earnings ratios
that many medical device companies enjoy today. In the future, then, the
challenge for medical device companies will be to move beyond incremental
savings and to bring to market innovative products that provide clear cost
justifications as replacements for existing products or that offer entirely new
therapies.

NEW MARKET REALITIES

This growth will have to come in a rapidly consolidating market that is placing
fundamentally new demands on its suppliers. The cause of this consolidation can
perhaps be traced to the moment that the United States became the first nation
in which health care exceeded 10% of the gross domestic product. This startling
statistic 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 benefits
rise faster than most other items on their ledgers, warned that enough was
enough.

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

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

They will, of course, use this leverage to exact price concessions from us. In
this situation, even physicians, once a countervailing force against the bias of
hospital administrators toward price rather than product functionality, can no
longer be counted on. Increasingly, as network employees who sit on purchasing
committees, doctors are motivated by financial incentives that look much like
those of their administrative counterparts.


IMPLICATIONS FOR INDUSTRY

The consolidations taking place among payers and providers are clearly having
their effect on the medical device industry. Consolidation of device companies
allows them to lower costs and offer providers one-stop shops through broadened
product lines, and price concessions through increased volume. In many cases,
medical device companies will not have the resources needed to create the broad
product portfolios the integrated networks demand from suppliers, and will need
to consider strategic acquisitions or partnerships. This process began in
earnest in 1995. From 1991 to 1994, the average number of acquisitions and
mergers per year was 50, with an average annual value of $1.8 billion. But in
1995 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 manufacturing
costs of a device itself. This challenge will need to be addressed during the
design of the product, since opportunities to reduce costs once a device reaches
the manufacturing floor are limited. Cost targets will need to receive equal
billing with the two traditionally dominant priorities in product
specification--feature functionality and time-to-market.

Similarly, the cost of research and development will require stricter
management. If the industry is to sustain the current rate of innovation in this
changed environment, R&D productivity will need to increase. This will mean
still shorter product development times driven by the following:

  • Investing more capital in design tools.
  • Developing an organizational structure that provides for focus, autonomy,
    responsibility, and accountability in the product design effort.
  • Keeping true invention off the critical path of new product development
    efforts.
  • Creating design libraries of software and hardware building blocks that can
    be reused instead of reinvented.
  • Pursuing more partnerships and joint ventures with academic institutions to
    do basic research.

Finally, medical device companies must find a way to reduce the regulatory costs
that are associated with the design of new devices. These costs have risen far
faster than any other element of R&D. The cost of evaluating a product's
readiness for market release has increased dramatically over the past five
years. The immense costs associated with an uncertain and unpredictable
regulatory 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 aggressive
and agile medical device companies to grow substantially in the next five years.
Cost-effective and clinically relevant product innovation in rapidly changing
customer markets is imperative to remaining competitive.


Copyright © 1997 Medical Device & Diagnostic Industry

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