GUIDE TO OUTSOURCING: OUTSOURCING LANDSCAPE
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The medical contract manufacturing industry has been in a period of heated evolution involving significant structural change. Over the last 15 years or so, consolidation driven by both private equity groups and strategic buyers has altered the competitive landscape. This process is far from complete.
In the face of these industry changes, suppliers have scrambled to redefine their businesses. Many companies have broadened their capabilities and associated business definitions into new messages of “one-stop shopping,” “full service,” and “total solutions.” Many focused-capability specialists have been acquired by contract manufacturers seeking to achieve breadth. This transition of the historic suppliers along with the influx of new entrants is creating a wealth of broad-line manufacturing generalists and reducing the number of focused-industry specialists.
The medical device industry is far from the first to undergo structural changes associated with an increasing shift toward contract manufacturing. Electronics, pharmaceuticals, and automotive all provide examples of how industry organization can change over time if vertically integrated original equipment manufacturers (OEMs) revise their approaches to focus more on product development and marketing than on manufacturing the products themselves. The causes for this evolution—such as OEM desire to focus on core competencies, reducing time to market, efficient utilization of capacity and access to specialized resources—have been well documented and are likely to continue for the near term.1,2
Similarly, two basic strategic frameworks provide insight into the competitive factors ultimately affecting the near-term and long-term competitive advantages of the industry's participants. To gain reasonable insight into where the industry may be headed, we can begin by examining the current state of the industry against Michael Porter's seminal work, Competitive Advantage, and associated strategy typology. We can also examine the more recent resource-based strategy theory to extrapolate the important factors required when determining long-term corporate strategy.3
Porter's Competitive Advantage
Michael Porter suggests that a firm may maximize its earning potential to achieve long-term competitive advantage by adopting one of three primary postures. The first option is to focus on becoming the low-cost producer for the industry through the use of scale advantages. Primarily, although not exclusively, by achieving a certain size, a firm should be able to spread overhead costs across its business portfolio, maintain lower unit-cost production processes not available to smaller firms, exert power over its suppliers to achieve lower purchased goods costs, and ultimately win business by using these scale advantages to provide customers with equivalent products at lower prices.
The second strategic option in Porter's framework is differentiation. Firms without low-cost production advantages may create long-term competitive advantage by producing products with distinction from others available in the market, typically with features and value beyond those offered by the low-cost producers. These players are typically smaller, catering to market subsets that value the products' features.
Figure 1. (click to enlarge) The evolution of medical device outsourcing.
Each of these two primary strategies can be matched with market focus, creating a third option. Firms may choose to focus on certain subsegments of the overall market in an effort either to enhance their differentiation or to aid in cost reduction. For example, Symmetry Medical is both focused upon the orthopedics subsegment of the device market and has worked to achieve a scale advantage in relation to its competitors. By contrast, Accellent is broadly focused, with scale as its primary differentiator. However, differentiation with or without focus necessarily implies specialization. For a firm's served market, this typically implies relatively smaller size to broad-line competitors. The combination of large low-cost producers and small differentiated players often leads to a barbell-like industry structure where being in the middle makes long-term success difficult. The representation of industry evolution in Figure 1 demonstrates this phenomenon.
Early-mover advantages in carving out market real estate should also be considered. Once a number of firms establish sufficient size and begin to occupy the larger broad-line positions, the opportunities for others to ascend to that level decrease. Not only are the consolidation plays reduced as smaller firms are absorbed by larger players, but also the relative lead that the large firms have makes it difficult to catch up.
There has been a great deal of change to industry organization in the medical device contract manufacturing industry over the last 15 years. Whereas 15 years ago it was difficult to find contract manufacturing firms with more than $100 million in revenue, today the industry has numerous players of that size and larger, and an increased population of companies between $50 million and $150 million.1 This has come from a combination of firm growth and industry consolidation.
Growth in the percentage of outsourced devices on top of growth in the device market itself has led to strong underlying economic trends and attracted much investment. Estimates for growth in the contract manufacturing market range around 15% per year as the percentage of outsourced products continues to climb.1 Private equity groups have been instrumental in building some of the industry's largest players and accelerating the restructuring of the playing field by changing the competitive order of magnitude. Notable examples of companies built through private equity capital include Accellent, Avail Medical (now part of Flextronics), The Orchid Group, Greatbatch, American Medical Instruments Holdings (now part of AngioTech), and Symmetry Medical.
However, not all of the investment and growth in firm size has come from the injection of outside capital. Some of the investment has come from internally generated returns from incumbent players that have sought to increase the size and scope of their operations through reinvestment. Businesses in this category represent the new mid-majors of the device manufacturing industry—not as large as the top-tier broad-line producers, but larger than the typical big players of 15 years prior.
Analyzing the current structure of the industry against the basic Porter framework, it seems clear that the evolution of the contract manufacturing competitive landscape is far from complete. Very large players like Accellent (~$490 million),4 Avail (~$250 million),5 Greatbatch (~$364 million),6 and Symmetry (~$293 million)4 appear positioned to become the low-cost producers of the future through the use of scale advantages. Symmetry currently has a commanding 70% share of the orthopedic OEM market for cases and trays, with a 24% share of instruments.7 Avail's scale allows the company to employ a global network of facilities, including low-cost production in Mexico and Asia, with 18 manufacturing sites and 3500 employees.5
As evidence of the cost-competitive nature and low-cost production destination, it is interesting that the larger companies operate on margins typically lower than historic industry norms. At the time of its sale to Flextronics, Avail's operating margins were estimated to be 4.5%.5 Accellent and Symmetry both have operated recently with EBITDA margins in the 16–18% range.4 Greatbatch's first quarter operating margin was recently estimated at 4.5%.6
But what about the rest of the industry? Take the mid-major group as an example. These businesses have recently broadened their messages to mirror the full-service, one-stop-shopping value proposition associated with the large companies. They now present a message to customers much more in line with that of Accellent or Avail.
But with relative sizes at an estimated 15–20% of Accellent in revenue (based on internal estimates and Accellent SEC disclosures), can the mid-majors succeed as generalists under the Porter framework? Can the mid-majors now view themselves as either headed toward being large players, or are they likely to be absorbed themselves by current industry giants? If Porter is right in his assertion about strategic typology, it is unlikely that companies that take a generalist path but that do not achieve the requisite scale will be able to build long-term competitive advantage.
Moreover, the number of mid-major generalists is growing. Riverside Partners' purchase of Accumet Laser, New England Precision Grinding (NEPG), J-Pac, and American Medical Instruments (AMI) appears headed toward the assembly of several dissimilar specialists into one broader mid-major generalist. While they have not publicly announced an overarching strategy and business definition for these companies, it is clear that for the previous specializations (NEPG in wire products, Accumet in laser processing, AMI in high-volume needle production, and J-Pac in packaging) to become unified, the message must get broader and thus more general.
Similarly, Kirtland Capital's investment in MicroGroup and the associated purchase of Bolt Industries appears headed toward the creation of another mid-major generalist. Where MicroGroup has long been associated with tubing supply and fabricated tubing components, Bolt Industries is certainly steps away from the definition. Even the declared acquisition focus of MicroGroup/Kirtland implies a further broadening of definition: “MicroGroup seeks to acquire companies that specialize in manufacturing components and subassemblies for medical device and analytical instrument customers that will broaden the company's current manufacturing capabilities or expand its geographic scope.”8
There are plenty of other examples, but the broader question relating to industry organization remains clear: If Porter is right about industry structure and competitive advantage, how many broad-line generalists will the industry support, and what will be the requisite scale for low-cost production as a competitive advantage?
More recent than the Porter model, but also widely accepted as a strategy framework, is the resource-based view. In this framework, long-term competitive advantage of a firm is linked to whether the firm's resources are valuable, rare, inimitable, and nonsubstitutable. Resources refers to assets, capabilities, information, and knowledge under the firm's control.9 Basically put, the more enduring, valuable, and rare resources a firm has, the better the firm's long-term competitive advantage.
In the medical contract manufacturing world, resource rarity and resulting competitive advantages have changed substantially along with the industry in the last 15 years. Where business niches once existed for specific manufacturing capabilities, many of these capabilities have now become distributed and embedded in larger broad-line firms. For example, it was once possible for a firm to define itself around laser welding, medical packaging, injection molding, or stamping. These resources and capabilities are now widely distributed and are no longer rare or inimitable.
As medical device OEMs have decreased their appetite for purchasing manufacturing processes in a piecemeal fashion, the stand-alone manufacturing niches have also lost relevance. This OEM bias and its associated effect on industry structure was advanced notably by Andrew Kinross.10 Today, most of the large medical contract manufacturers either directly possess or at least control access to these capabilities, thereby making them no longer rare resources or sources of competitive advantage. This, of course, further fuels consolidation.
In the United States today, there are more than 700 stampers. That number is projected to drop by 50% through consolidation and industry rationalization.11 The manufacturing-capability-based resource advantages of the past are no longer as viable in the current environment. Resource-based advantages still exist, but they need to be rethought in the new customer and industry organization contexts.
Viewing the current state of the medical contract manufacturing industry through each of the strategy frameworks presented above leads to a few reasonably obvious conclusions.
The industry is not in its final and more-stable state of organization. In the long term—because of the need for fitting into one of the Porter strategy groups or based upon the decreasing rarity of historic resources—it is likely that generalists of varying sizes will not all be successful. Those that do achieve the size and scope required to be low-cost producers should find a permanent hold on market real estate.
The niches and specializations of tomorrow will be defined differently than those of the past, and with a few exceptions, they are unlikely to be rooted in basic manufacturing processes, which are now much more distributed.
The mid-major category is likely to be viable only while the industry sorts out its long-term structure. Companies without a differentiated focus, including scarce resources, and lacking the scales and scope of the large players should see increasing competitive pressure over time. They will neither have the cost positions of the scale players nor the focused resources of the specialists.
Companies seeking competitive advantage must either find new ways to define their businesses rooted in differentiated value for device OEMs or achieve sufficient size to become cost leaders. Developing a more evolved model of contract manufacturing is thus the primary challenge facing industry leaders. Forward-thinking business leaders in medical device manufacturing must think beyond total solutions to specific solutions. During the period when the industry is rapidly growing and opportunities are abundant, the underlying currents of industry reorganization will not be as pronounced. However, the long-term imperative remains. Those contract manufacturing specialists that succeed in identifying transformational value propositions have a compelling role to play in advancing medical device technology and healthcare. Those that do not will lose relevance and will face questionable long-term sustainability.
Peter Harris is CEO of Cadence Inc. (Staunton, VA). He can be reached at firstname.lastname@example.org.
1. BD Finn, A Strategic Review of Outsourced Manufacturing for Medical Devices (Boston: Covington Associates, 2007).
2. MB Houdek, Automotive OEM and Tier 1 Consolidation—Tip of the Iceberg (Farmington Hills, MI: Stout Risius Ross, 2003).
3. M Porter, Competitive Advantage (New York: Free Press, 1985).
4. H Reukauf, Accellent Research Report (Frankfurt: Deutsche Bank, 2008).
5. W Stein, Equity Research (Zurich: Credit Suisse, 2007).
6. J Mills, Equity Research (Vancouver: Canaccord Adams, 2008).
7. M Matson, Equity Research (Charlotte, NC: Wachovia Capital Markets, 2008).
8. Kirtland Capital Partners Web site [online], (Cleveland: Kirtland, 2008); available on the Internet: www.kirtlandcapital.com.
9. J Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17, 99–120.
10. A Kinross, “As Outsourcing Increases, So Does Consolidation,” in the Guide to Outsourcing supplement to Medical Device & Diagnostic Industry 26, no 3.
11. Private Equity in the Automotive Sector (Amsterdam: KPMG, 2008).