Medical Devices Poised for Growth
August 30, 2004

By Natasha Lainer

The medical device industry is expected to continue growing and attracting attention from investors, according to industry analysts. Emerging medical device technologies include stents and sensor-laden implantables. For smaller industry players, growth is expected primarily in the neurostimulation and the orthopedic markets.

Both large and small-cap medical device firms have outperformed the S&P 500 in the past three years, says David Turkaly, a senior medical technology analyst with WR Hambrecht & Co. Top performers have consistently boasted high margins and a reasonable return on equity, and such favorable trends are expected to continue.

Steady growth in the $75 billion medical device industry is buoyed by winning products and reflected in sound financials. Drug-releasing stents and cardiac rhythm management devices characterized the successes of 2003, while the introduction of products in the heart valve and spinal sectors now holds the promise for future strong returns.

Drug-eluting stents in particular are generating the greatest buzz among analysts keeping a pulse on the medical device industry, as these products have been used to treat coronary artery disease and other problems associated with aging, and are coming at a time when the aging population is rapidly increasing. In addition, drug-eluting stents are showing promise in helping to treat conditions that affect the general population.

The companies that stand to gain the most from these recent trends are Johnson & Johnson, Boston Scientific, Guidant Corporation, and Medtronic, Inc. After its launch in March, Boston Scientific's Taxus coronary stent system captured over 70 percent of the stent market. This figure had deflated to 60 percent within several months due to recalls that started in July as a result of a manufacturing defect. Despite such recent setbacks, Front Line Strategic Consulting, a California-based firm, projects the drug-eluting stent market to triple to $6.3 billion in by 2008.

Changes and Restructuring at the Roots

As the medical device industry continues to enjoy the benefits of strong products and an ever-increasing customer base, contract manufacturing for its offerings has witnessed increased consolidation and growing popularity among original equipment manufacturers (OEMs).

Nearly 25% of medical device manufacturing is currently outsourced, and this figure is expected to grow. Firms such as Johnson & Johnson and Boston Scientific claim that their core competencies lie in marketing and product design, rather than manufacturing. The latter function is therefore expected to be increasingly outsourced to more skilled producers who could deliver the product more cheaply and efficiently. Plastics, electronics, and other components have generally been outsourced in the past, but the industry is increasingly outsourcing engineering and assembly services, especially when solid relationships exist with strategic partners.

As an increased rate of outsourcing is observed among original equipment manufacturers, the budding market for suppliers has pushed many to consolidate in an attempt to capture a larger piece of the pie. Private equity companies have been instrumental in consolidating the supplier base in recent years. The previously fragmented supplier industry has evolved into a smaller number of one-stop shops, a trend that satisfies the current needs of original equipment manufacturers looking to simplify their unmanageable vendor bases. Medtronic Inc., for example, has seen a 67% reduction in its vendors between 1998 and today, enabling it to gain efficiency and capitalize on value-added services not offered by small suppliers, who will inevitably suffer from the consolidation trend as specialized jobs shift to larger operations.

Effects of Price Pressure

Although the contract manufacturing base of the medical device industry has generally not been threatened by price pressures, the past twelve months have set a different precedent. Changes in managed care have placed pressure on OEMs to reduce costs - a demand that's passed down directly to manufacturers. Cost-structure efficiencies are also providing OEMs with the opportunity to bolster stock prices, encouraging many to threaten to switch suppliers if low cost production needs aren't met.

As with many other industries, outsourcing to foreign countries, including Mexico, Ireland, and Malaysia, has grown more common in the medical devices sector. Consolidation of plant units for increased network optimization has been another strategy by which companies such as UTI Corporation have reduced costs. Programs such as Six Sigma and lean manufacturing techniques are among criteria that OEMs look for when choosing a reliable, cost-effective vendor. Finally, overhead costs have also witnessed a reduction recently, as general and administration costs, seen as a percentage of sales, need to be minimized in order for companies to remain competitive. Once again, smaller suppliers are left increasingly vulnerable, as they must similarly reduce costs to maintain margins.

The Debate on Conducting Research Abroad

Among all the changes and developments characterizing the medical devices industry, the increasing popularity of conducting clinical trials abroad is a trend that bears mentioning. It is becoming increasingly common for American-based companies such as Q-Med and Coloplast Corporation to conduct studies in Europe to obtain a CE mark before completing the studies in the US and submitting materials for regulatory approval. The main advantage to this practice is the shorter study protocol approval time. Submissions to request approval of a study are made to the competent authority of the designated country. The absence of an FDA-like body, which withholds product approval until sufficient clinical data has been presented, expedites the research and development process for American firms.

Additionally, study costs are also lower in Europe compared to the United States. Investigative site costs are especially lower, as patients in studies are often not compensated or are awarded very modest payments. On the downside, European countries require companies to carry research liability insurance in case of any harm inflicted on study subjects. Another notable consideration is the tendency of European investigators to act more independently than in the United States. It is not uncommon for researchers abroad to demonstrate a less stringent compliance with protocol standards.

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