Sunday, December 15, 2013

The next patent cliff

Much attention has focused on the "patent cliff" faced by pharmaceutical companies. As their proprietary drugs lose patent protect, the drug companies face competition from low-cost generic drugs.  With an exceptionally high cost and long lead time for new drug development, the pharmaceutical companies face significant strategic problems.

There is another patent cliff approaching that has not yet received much attention--the end of patent protection for many minimally invasive surgery devices.  Whether the basic stapling devices or more complicated instruments, the 20-year protection period on much laparoscopic equipment is coming to an end.

This change will be a major disruption in this industry.  Many of the equipment suppliers have been resting on their laurels for years, relying on relationships with surgeons to force sales of their equipment to hospitals.  Multi-product line companies also have buried the high cost of their instruments into an overall contract pricing regime with other hospital supplies. What most equipment suppliers have not done is to engage internal process improvement, taking waste and inefficiency out of their cost structure. Indeed, some have become separated from the potential for such improvement by relying on outsourced production. 

When new entrants to the market arrive, selling the same quality goods for a much lower price, the established equipment suppliers will face a challenge. Their ability to use contract pricing to hide the costs of this equipment will disappear.

From what I hear, the one company that seems ready for this change is Applied Medical.  Here's a quote from its website:

One of the main facets of our business model is vertical integration. Instead of outsourcing or offshoring our operations, we continuously focus on expanding our areas of expertise and manufacturing capabilities. As a vertically-integrated organization, we develop and manufacture our products in-house and provide exceptional customer service, support and education. Our high level of vertical integration allows us to quickly and efficiently make product enhancements and develop new technologies—reducing the amount of time required for innovative ideas to positively impact patient care. Vertical integration also allows us to control costs, closely manage supply lines and ensure the highest product quality, availability and compliance. 

I'm told that Applied Medical has currently been able to retain much of the extra margin it garners from efficiency improvements, as opposed to lowering prices to customers.  But is is ready for the day that prices drop in the industry. Its lower production cost will allow it to track down the price curve and still make a profit.  It may be one of very few companies that are able to do that and still maintain an active R&D program, allowing it to be a leader in the industry for some time to come.*

Something to watch as this new aspect of the medical arms race unfolds.
*Note: I have no financial interest in this company and am not providing investment advice.

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