Last week’s reports of rumors of JNJ (Johnson & Johnson) buying SNN (Smith & Nephew), which started with random trader rumors and then matriculated to “anonymous sources” in The Daily Telegraph and knowledgeable sources in SkyNews. The rumors, repeated by the Financial Times and the Wall Street Journal, evaporated into a vague whiff of stock market manipulation by the end of the week.
UK newspaper The Daily Telegraph said early in the month that privately owned U.S. orthopedics’ group Biomet Inc. (BMET) was set to begin informal talks with SNN about a potential GBP15 billion merger.
Then, on January 8, London-based SkyNews City Editor Mark Kleinman wrote in his blog that JNJ had made an indicative offer of more than 750 pence a share for the shares of UK-based Smith & Nephew. According to Kleinman, SNN’s board rejected the proposal because it “substantially undervalued” the company. Kleinman didn’t say where he got the information.
The next day Bloomberg picked up the news and shot it across the world. Then the Wall Street Journal upped the ante with additional information on January 10: “Where there’s smoke there’s fire, and Smith & Nephew is clearly now in play, ” was how one banker summed up the company’s week.
Then on the 14th SNN put out a statement through the London Stock Exchange that said “Smith & Nephew has a long-standing policy of not commenting on press speculation, unless there is a regulatory obligation to do so. However, exceptionally, Smith & Nephew wishes to clarify that it is not engaged in any discussions which could lead to a merger or a takeover.”
So there! Put a fork in it, the rumor is over and done.
Still…those reports sure got a lot of airtime and more than their 15 minutes of circulation. After all, “everyone” knows that the orthopedic industry is due for consolidation. Even SNN’s CEO David Illingworth has been quoted as saying that orthopedics is likely to go through a period of consolidation.
At last week’s JP Morgan conference in San Francisco, CEOs from Zimmer and Stryker acknowledged that the orthopedic industry was likely to go through a period of consolidation sooner than later.
Consolidation is accepted wisdom. Except, isn’t orthopedics already one of the most consolidated of all industries?
Seven orthopedic suppliers, for example, generate more than $30 billion in orthopedic product sales annually and represent about 90% of all shipments. That’s right. Seven companies ship 90% of all orthopedic products.
In hip and knee reconstruction, five companies (Zimmer, DePuy, Stryker, Smith & Nephew and Biomet) sell nine out of every ten such implants to hospitals.
In spine, nine companies (Medtronic, DePuy, Synthes, Stryker, Zimmer, Orthofix, Biomet, NuVasive and Globus) have a consolidated 83% market share.
In trauma, five companies (Synthes, Stryker, Smith & Nephew, Zimmer and DePuy) hold 80% share.
Could this industry consolidate further? If so, why would they and how would they?
Harvard professor and strategic theorist, Michael Porter developed the famous Five Forces of competitive and consolidative strategy. They are:
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The threat of new entrants (low in orthopedics)
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The bargaining power of buyers/customers (average but getting much stronger. There are, for example, virtually no costs for switching hip, knee or spine implants.)
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The bargaining power of suppliers (orthopedic implant manufacturers have historically been very effective negotiators within the fragmented hospital market. But, like the rider on the back of a bicycle built for two, insurance companies are leaning very heavily on hospitals to steer their payment decisions with manufacturers.)
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The threat of substitute products (thanks to the FDA and CMS [Centers for Medicare and Medicaid Services], that threat is low and declining).
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Rivalry with competitors. (It is intense in orthopedics. With every surgeon worth roughly $6 million in annual purchases, virtual wars have erupted between manufacturers, rep organization and individual sales people over the signing of contracts with hospitals and clinics).
Balance of Power and Disintermediation
What may be changing is the balance of power between orthopedic implant buyer and implant supplier. Historically, buyers were fairly (and are still) fragmented. Buying decisions were and still are to some extent driven by individual surgeon preferences. In those cases the role of the sales rep is important since they can play a critical role in convincing a surgeon to purchase one product over another.
But new demands from hospitals for comparative effectiveness data, new surgeon consulting restrictions and a more difficult reimbursement environment are, at a minimum, undermining the surgeon champion of years past and may be pushing a form of disintermediation.
Part of the accepted wisdom of consolidation is that larger suppliers will generate more scale efficiencies. Higher sales volumes equal lower per unit production or marketing costs.
But here, we suspect, is where the industry’s ability to differentiate products will come under increasing pressure. Most hospital buyers view each manufacturer’s products as largely substitutable with another manufacturer’s product. Therefore there is really no cost to switching from, say, a Zimmer knee to a Stryker knee or from a Medtronic spine plate to a DePuy spine plate. Yes, there are differences. But are they substantial enough to impose a cost on the buyer who switches?
The Productivity Frontier
Ultimately, the differences between companies in cost or price is derived from hundreds of activities like design, implant profile, manufacturing, the way customers are serviced by their rep, assembling the products, navigating the FDA and CMS processes, training employees and incentivizing buyers to buy.
Porter refers to this as Operational Effectiveness. In many ways, operational effectiveness is at the heart of the current healthcare care system debate. The companies that are paying the healthcare bill in the United States—Medicare, United Healthcare, Cigna, Aetna, Blue Cross Blue Shield—are saying very explicitly that delivery of healthcare products in the United States is inefficient.
Think of the maximum value that a healthcare system (and manufacturers are part of that system) can deliver to patients as being a productivity frontier that constitutes the sum of all existing best practices at suppliers, hospitals, surgical technique, rehab, etc. at any given time. Think of it as the maximum value (healing, if you will) that our system can create at a given cost, using the best available technologies, skills, management techniques and purchases inputs.
The productivity frontier is constantly shifting. But its trajectory, slope and speed are determined by the pace of technological innovation, managerial innovation and distribution innovation, including the possibility of disintermediation and regulatory innovation.
For at least the past couple of decades orthopedic manufacturers have been preoccupied with manufacturing effectiveness and such programs as Six Sigma or TQM or other benchmarking strategies. But now managerial, distribution and regulatory effectiveness are moving up the priority list and will have more influence on the productivity frontier than ever.
The FDA is probably the greatest single barrier to innovation in orthopedics. Automobile manufacturers, for example, have adopted the practice of rapid changeovers and use that approach to lower cost and improve product differentiation simultaneously. The FDA will not allow for rapid incremental product changes. There is really not much that consolidation can do to affect this.
The Consolidation Strategy
Is consolidation a strategy? By definition, strategies are based on customer needs, accessibility and/or the variety of a supplier’s products or services. Stryker, alone among the major orthopedic companies, made a strategic decision years ago to supply hospital beds and other MedSurg equipment. Some years, the hospital buying cycle is off and MedSurg sales pull down Stryker’s overall performance. This past quarter, however, MedSurg sales rose more than 13% year-over-year and that, in turn, compensated for traditional recon’s much lower single digit growth rate.
Stryker’s strategy to diversify its product lines to include hospital equipment has given that firm a more consistent rate of sales growth. Stryker defines its customer as the hospital and the surgeon and, has come to the conclusion that a strategy of supplying a broad range of its customer’s needs will also create more value for its shareholders.
So, with hospitals looking at orthopedic products as being largely undifferentiated, where the cost of switching is not only low but may in some cases be negative, how does consolidation help?
It probably doesn’t.
Attractive Consolidation Candidates
With perhaps this one exception. Small to medium size companies with leading market shares in attractive niche markets might make the only attractive consolidation candidates.
Osteotech, for example, is a small company that has the biggest market share in the allograft bone void filler market with a product called Grafton. Late last year, Medtronic snapped up Osteotech.
Two companies, Wright Medical and Tornier, may also fit this one narrow criterion since they hold the leading market shares in such key extremity markets as hand, foot and shoulder.
Finally, Conmed’s Linvatec subsidiary is a kind of no-brainer fold-in under any consolidation strategy since it is the market leader in orthopedic power tools.
But consolidation between the top six or seven companies, as was suggested by last week’s flurry, seems very unlikely. Indeed, widespread consolidation within orthopedics seems roughly as likely as JNJ breaking up into independent companies. It might make sense as part of some academic exercise, but it won’t happen in the real world.
