An MD&DI January 1997 Commentary
A. Jay Graf
President, Cardiac Rhythm Management Group
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.