Originally Published MDDI March 2005

Outsourcing Trends

Outsourcing Partners Take on a Bigger Role

Medical device outsourcing partners pursue innovation, low-cost manufacturing, and more business from OEMs.

Andrew Kinross

When Boston Scientific received FDA approval for its Taxus stent on March 4, 2004, it became an overnight case study in medical device company management. Boston Scientific's stock had reached as high as an eightfold increase since late 2000, and widespread media coverage praised the company for its strategies and tactics. The company garnered press attention for funneling virtually all of its available capital into development of its stent. It also manufactured the stent to inventory before receiving FDA approval. Finally, it dedicated a large number of personnel to understanding and managing the regulatory process.

But for the most part, the media failed to mention one key fact: Boston Scientific saved hundreds of millions of dollars by outsourcing. And the fact that the company was able to redirect those savings to the Taxus effort helped speed up the product launch.

Sales of Taxus reached, and then exceeded, $10 million per day in early 2005. Seeing this success, medical device companies witnessed the gains possible through a good outsourcing strategy.

Boston Scientific and other companies have benefited immensely from outsourcing, or partnering with suppliers to focus on efficiency and speed. As OEMs have continued to outsource, the supplier base has strengthened and consolidated. Such trends in outsourcing continue. This article updates an article included in an earlier issue of MD&DI's Guide to Outsourcing.¹

Innovation Reaches the Vendors

In the medical device industry, product innovation is the primary source of financial return. In recent years, medical device companies have ratcheted up their R&D spending at an astounding rate as they look for new blockbusters. R&D, as a percentage of sales, has risen from 5.4% in 1990 to 11.4% in 2002 (see Figure 1).² The medical device industry trails only pharmaceutical in R&D spending (12.9% in 2002).

Given the strong top-line growth of medical companies, the absolute dollars spent on R&D have skyrocketed. To support this R&D effort, outsourcing partners have built up their own engineering departments, as capturing even a small percentage of the large OEM R&D budget can be lucrative. A few outsourcing companies now have more than 100 engineers on staff.
Outsourced engineering departments play two main roles. First, they work with customers to codevelop new products. Second, some even develop proprietary products and technology in-house.

Historically, outsourcing partners have merely been contract manufacturers of devices. In other words, they would receive a drawing from their customer and build to specifications. Vendors would not retain the intellectual property (IP) related to the product.

Now, vendors are, in some cases, actively engaged in developing their own IP. Many companies have built impressive patent portfolios and, in turn, have become more tied in with their customers.

Areas in which vendors are developing their own IP typically have been overlooked by OEMs. This may be because the OEM feels it is a commodity item, or it may be some other reason. However, the vendor can often get a higher margin and economies of scale. Thus, vendor IP development is a win for both sides.

But product innovation is not the only form of innovation. Process innovation and business innovation are also critical to medical device companies. Manufacturing processes and technologies are the backbone of both OEMs and vendors, and business innovation can lead to financial gains.

Take as an example a healthcare-related business innovation. A company called American Healthways innovated its lines of business and reaped huge rewards. This company proposed to health plans and hospitals that it would manage patients with certain diseases, such as diabetes, asthma, congestive heart failure, and others.

Before this proposal, doctors would prescribe approaches for disease management, but patients would often not comply correctly. Because of the poor compliance, proper treatment fell through the cracks.

American Healthways proposed handling these patients on a case-by-case basis. It used more-sophisticated guidelines and measures, helped patients set attainable goals, and provided local centers to which patients could go for treatment. As a result, American Healthways' stock has increased more than tenfold over the past six years. Successful business innovation can happen in any industry.

Next Stop: China

The lure of low-cost manufacturing in China has drawn the first wave of U.S-based outsourcing partners. Labor-intensive and high-volume product lines are the most appropriate for China, since companies leverage the lower labor costs. Nypro, a Clinton, MA–based injection molder, began manufacturing blood glucose monitors in one of its Chinese facilities in 2004. The company's decision followed years of successfully manufacturing consumer products, electronics, and automotive products there. Soon after, Nypro began building 10 new facilities in China to absorb the growth in all of its sectors, including medical devices. Avail Medical Products also announced in January 2005 that it would build a facility in Shenzen, China.

The migration to China follows years of expansion to Ireland and Mexico for U.S.-based vendors. Both locations have successfully reduced costs for vendors compared with U.S.-based manufacturing. But over time, efficiencies have been harder to come by. Labor rates have increased amidst a tightening labor market, and government incentive programs have lessened.

But by no means is the move to China without its potential pitfalls. It means long-distance logistics and travel for U.S. companies. And companies must reconcile significant cultural and language differences and business methods. In addition, the quality levels are not always up to world-class standards. Macroeconomic factors, such as the economy overheating, and political factors also play into the risk involved in outsourcing to China. But if the right partners are found and the business climate remains buoyant, China could be a strong manufacturing force.

Consolidation Continues

The big merger news in 2004 was that of UTI and MedSource Technologies. The company, renamed Accellent, now represents about $400 million in revenue. This merger came on the heels of Symmetry Medical's acquisition of Mettis in 2003.

Both Accellent and Symmetry had terrific years in 2004. Their organic growth was 16% and 30%, respectively, through the first 9 months and for the full year of 2004. These numbers exceeded the growth in the end markets. This means the companies benefited either from increased outsourcing or gaining market share from smaller players, or both.

Other large players are also in the midst of 20% or more revenue growth. One such example is electronics provider Plexus, which increased its medical business from $259 million to $323 million, a 25% growth. To put the consolidation trend into perspective, Accellent's $400 million in revenue is almost an order of magnitude larger than the largest metal or plastic outsourcing partner from a decade earlier.

Other merger and acquisition activity in 2004 included the following:

• Memry purchased Putnam Plastics.
• Gore Medical purchased Adam Spence.
• Trivirix purchased Medtronic facilities in Salt Lake City and Copenhagen, The Netherlands.

Is this consolidation unexpected? Not if you look at trends in other industries. The aerospace, automotive, and electronics industries all underwent a similar trend of consolidation. It started with the automotive industry in the 1970s and 1980s, moved to the electronics industry in the 1980s and 1990s, and finally hit the aerospace industry in the 1990s. Twenty years ago, the electronics industry outsourced roughly 20% of its manufacturing. It now outsources about 90%.

Conclusion

Innovation, migration, and consolidation look to play important roles in medical device outsourcing in the future. The question of who will be the winners and who will be the losers in this trend of consolidation and strengthening partnerships is uncertain. However, one thing does seem certain: those who follow the status quo may be missing the boat to prosperity in the latter half of this decade.

References

1. Andrew Kinross, “As Outsourcing Increases, So Does Consolidation,” Medical Device & Diagnostic Industry's Guide to Outsourcing 26, no. 3 (2004): S-22–S-28.
2. The Medical Technology Industry at a Glance 2004 (Washington, DC: AdvaMed, 2004).

Andrew Kinross is a managing consultant with Navigant Consulting (Burlington, MA). E-mail him at [email protected]m.

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