Ongoing Consolidation Across the Medical Device Sector
Accompanying the aforementioned growth-driving trends is a strong wave of consolidation among medical device OEMs—which, in turn, has significant implications for contract manufacturers looking to partner with them (Figure 5).
This consolidation takes two forms. At a high level, OEMs themselves are consolidating, as illustrated by a number of marquee transactions, such as Stryker’s recently announced acquisition of Wright Medical, Johnson & Johnson’s purchase of DePuy Synthes, Medtronic’s acquisition of Covidien, and Becton Dickinson’s purchase of CareFusion.
But OEMs also are actively consolidating their supplier bases, and that includes contract manufacturers. OEMs are looking to simplify and streamline their supply chain and make it more efficient by cutting the number of contract manufacturers they work with—preferring fewer trusted partners of scale that can alleviate OEMs’ concerns about product quality, consistent delivery, and overhead costs. Large OEMs especially value manufacturers’ ability to provide everything from design to commercial launch and beyond, as well as top-notch customer service and access to specialized manufacturing technologies.
“Contract manufacturers that want a seat at the table with OEMs need the scale and capabilities across a broad range of products the OEM is looking to outsource, or a service or capability that no one else in the value chain has,” observes Will.
Yet the precision contract manufacturing industry remains highly fragmented, populated by many smaller providers with limited scope and scale. As a result, the larger, full-service manufacturers are in high demand among OEMs—as well as among buyers looking to enter or expand their presence in the sector. In fact, precision manufacturing comparables are trading near a five-year high, based on the more than two dozen relevant transactions completed by both strategic and private equity buyers in recent years.
Keys for Buyers
There are significant growth opportunities for buyers in the medical device contract manufacturing sector, and two main ways to capitalize on them. One route is to “go narrow and deep”—develop truly distinctive capabilities that are difficult to replicate and that enable the company to be the best at producing something very specific that could have myriad applications. The other alternative is the “big and broad” approach—use a midsized, more-diversified acquisition as a springboard to creating a much larger platform through strategic bolt-on deals, enabling the company to develop solution suites to become a “one-stop shop” for OEMs.
On the topic of size, Bradshaw notes consolidation has created a market “barbell.” In other words, it is composed primarily of either very large or very small businesses, with a scarcity of midsized participants. “True middle market platforms enjoy a scarcity value,” says Bradshaw. “Assets generating between $20 and $50 million in EBITDA are commanding premiums in the market.”
In addition to size, several key factors can affect the value of a potential acquisition. Of course, a positive revenue and profitability track record is what attracts initial investor interest. But it’s also important to look beyond the figures to understand how the company makes money.
Customer Mix and Profile
For most contract manufacturers, a few large customers typically account for a large proportion of revenue. That shouldn’t be a surprise, as large OEMs have the biggest budgets, and most contract manufacturers built their businesses by establishing a relationship with these OEMs and expanding it over time. In fact, a lot of business from such customers is critical to a contract manufacturer’s stability and ongoing viability. “The majority of contract manufacturers’ revenue is going to come from the big OEMs, because that's just where the big pockets of cash are,” says Will.
The nature of the relationships with such marquee customers can influence a contract manufacturer’s financial position, says Bradshaw: “For instance, let’s say one OEM accounts for 40% of a manufacturer’s revenue, or $50 million. Does that come from 10 different $5 million programs, or two $25 million ones? And are those single-sourced programs or are several different manufacturers involved? How long have the programs been in place, and how effectively have you won new customers within those programs?”
“Having a diversity of programs within a single large customer helps lessen the risk of losing a significant chunk of revenue if a program is canceled or awarded to a different provider,” Will observes. “And if you’re the sole source for these programs, even better.”
Then there’s the issue of the remaining value in these programs—how many more years will the OEM’s intellectual property be attractive and relevant to its customers, and when might that IP be vulnerable to a competitor’s entry?
And while retaining these big customers is critical, a contract manufacturer also has to have its eyes on the next generation of OEMs to balance current and future revenue. “There’s a pool of young, innovative companies—‘challenger’ medical device companies, if you will—that a contract manufacturer should also be courting,” says Will. “Establishing relationships with these OEMs is critical to creating longer-term growth opportunities.”
The medical device sector is highly driven by innovation. Thus, contract manufacturers must offer distinctive capabilities that differentiate them in the market. For instance, one manufacturer’s ability to add a proprietary protective coating to a piece of metal it has just fabricated makes that company far more attractive to OEMs than a manufacturer that only produces pieces of polished metal. It also creates the opportunity to charge a premium for that unique capability, resulting in higher margins.
End Markets Served
Finally, as discussed earlier, while the medical device market overall is growing strongly, growth is not equal across the market’s various subsectors. In particular, buyers are ascribing value to the rapid growth associated with certain medical subsectors, including neuromodulation, cardiovascular health, and pulmonary health.
In 2018, Americans collectively spent $3.65 billion on healthcare, according to the U.S. government.1 That’s expected to grow at an average annual rate of 5.5% through 2027.2 This growth means medical device OEMs—and their contract manufacturing partners—can expect increasing demand for the foreseeable future.
“There’s a steady stream of innovation in this market, but it also has great long-term fundamentals,” says Bredrup. “It benefits from all the tailwinds driving interest in healthcare, and its fragmentation creates significant opportunities for buyers to create value. In general, the valuations in this market will continue to be high. But the current performance and long-term prospects of strong assets in the sector make them worth it.”
Published December 2019
1. “U.S. Health Care Costs Skyrocketed to $3.65 Trillion in 2018,” Erik Sherman, Fortune, February 21, 2019, https://fortune.com/2019/02/21/us-health-care-costs-2/
2. “National Health Expenditure Projections, 2018–27: Economic And Demographic Trends Drive Spending and Enrollment Growth,” Andrea M. Sisko et al., HealthAffairs, February 20, 2019, https://www.healthaffairs.org/doi/abs/10.1377/hlthaff.2018.05499?journalCode=hlthaff