Investment in R&D and New Products
Over the past few years the way the medical devices industry assesses innovation and new technology has changed. The old dynamic of the physician as judge of value has been replaced with the government, private insurers, and consumers increasingly determining what sells and at what price point. Consumers refuse to pay for incremental enhancements that add bells and whistles that do not improve health or reduce cost. The faster, better, smaller, cheaper innovations in medical devices are the devices that will maintain a sustainable advantage. We have witnessed a similar metamorphosis in the electronics industry over the past decade, and it will be the future of the medical device industry. Smaller and cheaper devices will dominate.
Recently, emerging-market countries such as China, India, and Brazil have been taking the lead in developing lean, frugal, and reverse innovation. This type of innovation simplifies devices and processes, retaining essential functions, while applying new technologies that are more versatile, mobile, and adaptable to consumer’s needs and are less expensive.
We see three primary trends in the R&D environment for medical device technology:
- The medical device innovation centers dominated by the United States are gradually moving offshore. Increasingly, medical device innovators are going outside the United States to seek clinical data, new product registration, and the initial streams of revenue.
- U.S. consumers are not always the first to benefit from advances in medical technology. Innovators already have a preference for countries like Germany, the UK, France, and Israel. By 2020 they will likely move into emerging countries before entering the United States, due to growing complexity of regulation and reimbursement limitations in the U.S. market.
- The geographical locus of innovation has changed. Non-U.S. developed nations have become leaders in the medical device space. Outside of the United States, there are six countries with very strong R&D capacities and capabilities—Germany, the UK, France, Japan, Israel, and China.
Medical technology R&D has often been an outside-in approach. Iterative innovation has often originated at the bedside, as physicians provide feedback that sows the seeds for the next generation of product. Today, sunshine laws, which effectively limit a company’s access to physicians, could potentially place some of this process at risk. With a new health environment there exists a need to cast a wider net. Medtronic for example, had begun crowdsourcing some of its innovation with the November 2010 launch of Medtronic Eureka, a European web-based portal that allows physicians and medical technology innovators to submit new product ideas.
During the past 40 years, the United States has provided an ideal and robust innovation environment that has facilitated significant advancements in medical technology. The U.S. dominance of this space has stemmed from its strength in the five innovation pillars—powerful financial incentives made up of market incentives and financial incentives; innovative resources; the regulatory approval process; healthcare demand and price sensitivity; and a supportive investment environment.
In order to develop the type of medical technology environment required for success in 2020, countries and companies will have to adapt to what we view as the following new five pillars of innovation:
- System-oriented and value-based incentives.
- Global networks of medical centers and medical professionals.
- Competing regulatory systems.
- Individualized solutions and price sensitive customers and
- Global financial networks.
The industry is shifting from U.S.-centric to a global span. Although we expect the United States to continue to play a leading role in medical device R&D for years to come, the country will most likely no longer dominate the industry. The supportive U.S. environment that created this dominance brings with it limits to change and encourages an incremental rather than a disruptive path to innovation. The radical innovations that are more likely to permanently change the cost curve are ikely to emerge from developing countries such as China, India, and Brazil.
During the past few years and through the Great Recession, companies in the medical device industry have continued to increase spend on R&D. An anemic 2% increase between 2008 and 2009 was followed up by a 7% increase in R&D spend between 2009 and 2010. Overall R&D investments were up by 11% over two years (2007-2009) and up from $11.6 billion in 2009 to $12.4 billion in 2010.
One of the reasons that this industry segment weathered the storm of the past several years relatively well is because it continued to incrementally increase R&D spend. The companies that consistently did so had a more robust pipeline of potential products, another key ingredient to survival and success of the industry. The companies best positioned for success are those that will develop new products that are most relevant to this changing ecosystem. Medical device companies have always taken on the risk to innovate with new technologies. Going forward, one of the most significant risks may be the failure to innovate beyond the product and develop new technologies and services.
High Rate of Mergers & Acquisitions (M&A). Compared to many established industries, today’s medical device business is characterized by strong topline revenue growth in the top firms, generally highly profitable, and not concentrated. The fact that there are 25 top-playing firms in a related sector focused on a common set of problems—human health—is testimony to the lack of concentration. While the largest firm in our Top 25 (Abbott) is roughly 130 times the size of the smallest (Tornier, a recent IPO), there is a large group of firms, 17 of the 25 companies, with revenue in the $2 to $7 billion range, and another group of 8 firms with revenue in the $7.5 billion to $15 billion range. The overall concentration ratio for the top 4 among the 25 firms covered in this study is a low 35.2%; the top 8 make up 47.6%, which is still in the low range of concentration ratios. Using the Herfindahl-Hirschman index, a more complex measure that weights for the size of all the firms in the sector, yields a concentration index of .08, which places this sector in the range described as “unconcentrated”.1 While there has already been a small increase in the concentration of this sector in the years from 2006 to 2010, the low level of concentration present points to ample opportunity for further mergers and business combinations.
Barriers to entry for new startups are moderate when compared to large capital intensive businesses, consisting largely of the need for regulatory approval, to gain access to decision makers such as doctors and hospitals, and to distribute through the medical supply chain. There is evidence of continual new starts by new companies with novel ideas, usually based either on a lab-based development of a new technology, or sometimes the concept and development of a particular doctor that gets funded and gains traction with other medical specialists. Within our Top 25, this ongoing rate of formation is demonstrated by the high rate of acquisitions of smaller firms; taken across the full set of 25, acquisitions of small, nonpublic start-ups runs about five to 10 in any given year.
Examples of start-ups and small firms acquired abound. Picking one large firm, Medtronic (2010 revenue $15.8 billion) made purchases in 2010 of ATS Medical for $370 million, Invatec for $350 million plus contingent payments, Arbor Surgical for $11 million; and acquisitions in 2009 of CoreValve for $700 million, Ablation Frontiers for $225 million, CryoCath Technologies for $352 million, Restore Medical for $28 million, and Ventor Technologies for $308 millino. Other examples of frequent and ongoing acquisitions abound and display ongoing evidence of a steady start-up rate of new firms with new technologies, treatments, or relationships.
Organic Growth in New Markets. Companies also drive for organic growth through more intensive coverage within existing markets, usually by expanding direct sales force coverage, or by acquiring established business partners in growing markets or local firms in growth markets that can provide a fast extension in distribution and sales reach. Organic growth is also fed by adding complementary products to existing product lines. The R&D section below will provide further examples of how R&D is used to extend product lines.
Companies in the Top 25 have taken successful several approaches to growth, including growth through product line extension by acquisition and geographic expansion to sell existing products to new markets. (Organic, internal new product development will be discussed in the R&D section.) Here are some examples:
- Hospira. Drove geographic expansion via purchases of Mayne Pharma (Australia) in 2007, and Orchid Pharma (India) in 2009.
- Fresenius. Acquisitions in Malaysia and distribution agreements to expand reach in Japan, Korea, and Russia in 2010. The firm’s 2011 annual report clearly stated their intent to “continue growth through acquisition of small and mid-sized companies.”
- B. Braun. Acquisitions of partners to extend distribution in Asia and in the Balkans.
- Getinge. Acquisitions in Brazil, and sales force expansions in China and Singapore from 2005.
- At the level of governance, several firms still have their original founders on the board or in leading executive roles. The founder of Synthes served as chairman on the board until their recent acquisition by Johnson & Johnson. A cofounder of Boston Scientific remains on their board, despite five years of money-losing performance following the firm’s acquisition of Guidant.
Manufacturing Devices for Regional Consumption. Another characteristic of the sector is a general practice to manufacturer products in the area of the globe where they are used and consumed. Thus many firms have plants in Europe for the European Union (EU) markets, plants in the United States or Canada for North America, and in Japan or China to serve the major Asian markets. For instance, Terumo, based in Japan, does manufacturing for the home and near Asian markets in Japanese plants, but builds products for the North American market at plants located in the United States. There is a sense—not often explicit—of wanting to make products or consumables for patients at close proximity in geography to where they live. For some firms, especially the joint replacement businesses such as Wright Medical Group and Zimmer, there is the demand for speedy, semicustomized manufacturing so that products can be adapted to unique patient needs.
For example, here’s a closer look at Wright Medical, which makes bone and joint replacement products for the knees and hips, and small joints (ankles). These products are manufactured largely from titanium and other high-tech materials that are expensive, difficult to machine, and require cutting-edge machine tools and computer aided design (CAD) systems. Wright and its competitors, such as Stryker and Zimmer, constantly innovate to adapt designs to varying patient bodies. They do this by constant and close consultation with doctors and surgeons—to the extent that their sales force working with the doctors is part of the R&D loop. As they receive feedback on the fit and use experience, the designs are adapted for future patients. The development process of a new device or material is iterative in nature and can take multiple iterations to perfect. To build the products, the adapted products are then fed in to a highly customized manufacturing operation that makes very few, highly adapted products to extremely demanding specifications and standards.
Wright recently closed its European manufacturing operation in France to concentrate manufacturing for its high-value, low-volume, and high-customization joint replacement products at a single plant in the United States. In general, this industry is not characterized by the highly integrated, single-source supply chains that have come to characterize the high-tech device industries such as computers, cell phones, or LCD displays and TVs.
Low Debt. On the financial front, most businesses have relatively low or no levels of debt financing. These businesses are generally not capital intensive because the high value-add in the manufacturing process and the relatively high margins that are paid for the expectation of quality control means that heavy borrowing is not required to fund infrastructure. The prime source of expense is usually marketing and sales, which is funded from and for ongoing operations.
One exception to the low debt rule is Biomet, which was taken private in 2007 in a classic equity investor privatization that added high levels of debt. Although privately held, the firm issues 10-K reports for the many continuing bondholders, which reveal it has lost money consistently since the privatization. This leverage-based technique may work for mature, low technology businesses like automotive parts, and even in rapidly consolidating businesses, such as software. It has been less successful in a business that requires continual investment in product technology improvements and high levels of spend on marketing, the characteristics of this medical device sector. However, Biomet has been losing less each year since 2008, with losses down to mere $47 million in 2011, and it will likely be positioned for an IPO once the economy is on a more solid footing, so the equity investors can cash out.
Yair Holtzman is director and global life sciences leader at WTP Advisors (White Plains, NY). Tom Figgatt, Sr., is an associate at the firm.