Summary of article key points

The medical device industry and its associated contract manufacturing providers (plastics and precision machining, in particular) are very M&A-active now.  There are several reasons why.

1. Government policy and other changes to the healthcare system are squeezing costs from healthcare providers. In response, hospitals have merged and seek cost reduction wherever possible.  One place they seek it is from the medical device companies; they want cost reduction.
2. Meanwhile, the device companies are still haunted by the fear of the 2.3% excise tax on medical devices – depending upon Congress, it may return January 1, 2020.  U.S. Food and Drug Administration user fees for medical device registrants increased Oct. 1, 2017.  Standard FDA registration fees for larger companies went up by a third, with the 510(k) application fee more than doubling.  Apple, Google and others are spurring medtech innovation, but raising expectation for other medtech industry participants to accelerate innovation, too.  Those device companies not aligned with them may face new competitive pressures.  All this makes it increasingly difficult to compete as a smaller medical device company.  Device original equipment manufacturers (OEMs) seek immediate growth and cost efficiencies.
3. So, the device companies are responding in a few ways.
   1. They have been consolidating. M&A activity among medical devices over the past several years demonstrates a trend to fewer but larger medical device OEMs seeking greater power over both their customer base and supply chain.
   2. Seeking greater buying power and operational efficiency over their supply chain, device companies intend to pare suppliers: fewer contract manufacturing organizations (CMOs), whether providers of plastics, machining or electronic manufacturing services (EMS), and component providers. Just recently Smith & Nephew announced an effort to cut $160 M by 2022; Medtronic plans $3 billion over the same period.  (See announcement excerpt in blue box)
   3. As always, they buy or invest in innovation created both internally and outside by other entrepreneurial companies, but there is a trend toward corporate venture capital (CVC) investments going even further to diversify outside their core capabilities. Is this trend a response to the role of data and Google and Apple’s increasing involvement in medtech?  Probably.  How many device companies talked of things like artificial intelligence (AI) three years ago?  Not many.  So, unless the smaller device companies bring innovation substantial enough to warrant the attention of the big device OEMs, it’ll be increasingly difficult for the small ones to compete.
4. “Trickle Down Economics” – The trend is flowing downstream to the plastics and machining contract manufacturers, thus catalyzing M&A among them. Below Tier One and Two, the providers are highly fragmented and redundant. There are a lot of small, private companies comprising a robust prototyping and high-mix/low-volume advanced manufacturing ecosystem that fosters innovation by easy, local access to highly experienced resources, but which provide essentially the same services.  Most industry participants generate less than $10~15 million of revenue per year, and 80% have fewer than 50 employees.  Few break a hundred million dollars of revenue.  Wisely, many of these companies diversify their customer base into other industries such as aerospace & defense, instrumentation, semiconductor and motorized vehicle companies, but that is no panacea because these industries challenge smaller players, too.  For instance, increasing competition and pressure on aerospace & defense profit margins have been catalysts for industry consolidation and have resulted in some of the largest acquisitions in history, as suppliers seek synergies.  It’s happening in that, too.

Implication

The contract manufacturers’ fragmentation is probably not sustainable long term, and there is consolidation occurring among those contract manufacturers who seek to strengthen their competitive position. (See examples following) The larger contract players seek a more influential role with bigger, but fewer, device companies.

The consolidations bring a variety of services under one brand, such as injection molding, additive manufacturing, precision machining, electro-mechanical assembly and packaging.  This one-stop-shopping proposition streamlines the purchasing process for the device OEMs, delivering greater value to them, while strengthening the competitive position of service providers by increasing scale and attracting new customers to the other services.

A reasonable expectation is that smaller contract manufacturers will get edged out over time, though the ones with proprietary niches will be better positioned to hold their device business.

In any case, one long-time observer of the industry feels it’s likely that proportionally more of the new revenue over the coming years will go to the bigger players, even if some OEM relationships with the smaller contract manufacturers remain intact for a transitional period.

Meanwhile, of course new innovation keeps coming to market, further increasing the pressure.  For example, Finnish company TactoTek, a developer of injection-molded structural electronics, raised $23 million in its 5^th venture financing round, partly to expand their presence in the U.S. market.  The company integrates flexible printed circuitry and discrete electronic components into 3D injection-molded plastics.

Could their product successfully compete against some existing injection molders serving the devices industry?  Probably.

Electronic Manufacturing Services (EMS)

Electronic manufacturing service providers, also known as Electronics Contract Manufacturing (ECM), serving the devices industry tend to be fewer and larger companies – many public – though small to medium-sized EMS companies worldwide do most of the outsourced medical product assembly.

These companies are well-positioned for future growth, given increasing digital sophistication of medical devices in addition to their other opportunities such as Internet-of-things and robotics.

Most of the low-to-no margin high volume printed circuit board assembly (PCBA) business long ago left the U.S.  Electronics manufacturing still done here is mostly low volume and/or added-value processes such as integrated circuit manufacturing, medical and military assembly – work that is less likely to go overseas.  EMS accounts for almost 40% of all worldwide electronic assembly and is projected to grow from $425 billion in 2016 to $551 billion in 2021 – approximately 5.3% compounded annually.” [1]

Nevertheless, since this industry has historically struggled to produce attractive profit margins, some providers are addressing that problem by offering added-value activities, such as logistics support, design and testing services, thus moving toward joint design manufacturing (JDM) and outsourced design manufacturing (ODM).  Smaller, innovative providers may make very attractive M&A targets for large EMS providers needing to fill service offering gaps and/or expand geographically.

According to industry recruiters (a leading indicator source), the new lower corporate tax rates and strong economy are catalyzing industry growth plans, both from organic growth and M&A, especially serving Industrial, Medical and Defense end markets.[2]  Though fewer than for medical equipment or plastics, there is a large number of corporate and private equity groups seeking to invest in private companies operating in electronics manufacturing.

Conclusion

The structural dynamics described create somewhat of a “musical chairs” imperative for contract manufacturers: those who act swiftly to acquire, be acquired by, take investment from, or otherwise align with strategically relevant providers of other contracted manufacturing services will be more likely to thrive – or at minimum survive a shakeout – over the coming years.

Some providers without proprietary processes or technologies — particularly the smallest ones — may find their business ownership non-transferable at an appealing price.  The longer owners wait, the greater the risk this dire disappointment may occur.  Owners would be wise to discuss their options with a knowledgeable investment banker sooner rather than later.

A Select Few Device and Contract Manufacturing Buy-and-Build Transaction Examples

[1] The Worldwide EMS Market – 2017 Edition

[2] http://www.stepbeyond.com/

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Mid-Market Securities, LLC is a boutique investment banking broker-dealer that provides smaller to mid-sized companies the international access, insights, processes and professionalism larger companies command. 

Generally, we provide strategic and financial solutions to lower middle market companies to support their growth goals, address challenges to the business and/or facilitate owners’ personal financial goal of achieving some liquidity.

Our services help business owners who are motivated to build and/or harvest their wealth tied up in the business – and want proven methods for doing so in the most market-competitive, tax-advantaged manner possible.  Part of our role is to help them understand what options best support their needs, and what the company qualifies for.  Then we provide the insight and implementation to support the desired outcome. 

McGavock Dickinson (Dick) Bransford is a Managing Director in San Francisco with Mid-Market Securities, headquartered at 11 East 44th Street, 19th Floor, New York, New York 10017. Member FINRA/SIPC.  He can be contacted at (415) 294-0002 or mdb @ mid-marketsecurities.com.

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