Thus far, this century has seen rapid growth and structural changes in the medtech supply chain. This year the industry’s supply chain is expected to generate $85 billion in global revenue, a more than three-fold increase from its $25 billion total in 2000. On paper, that increase translates into a 5.5% compound annual growth rate for 24 consecutive years, but the actual rate has been inconsistent. Between 2000 and 2010, for example, the industry expanded at a slightly slower rate but then growth accelerated to around 7% in recent years. Regardless of its irregularity, this steady growth has drawn large investments, particularly from private equity funds. These investments in acquisitions as well as plant and equipment have transformed the relationship between medtech OEMs and their suppliers.

Relentless Consolidation

Fifteen thousand companies supplied the U.S. medical device industry (as it was once called) in 2000. Many chose or were pushed to the medical device sector as American manufacturers retreated from once-dominant positions in the automotive, consumer products, and electronics markets. Surprisingly, the number of medtech suppliers is still around 15,000 but a closer examination reveals that most of the work is concentrated in a few hundred firms. The largest 10, all with sales near or over $1 billion, dominate 12% to 15% of the medtech supply chain. A contract manufacturer with sales over $50 million in 2000 was considered a giant. Today it is a mid-size supplier, at best. 

What led to the creation of these contract manufacturing behemoths? An instructive early example is Accellent Technologies. Backed by private equity funding, buttressed by low interest rates, and open to mining a reliably growing industry, Accellent levied acquisitions of smaller, specialized contract manufacturers (CMs) to form the first large CM capable of building a finished device. As rapidly as Accellent made medical devices, it also bought companies to grow its manufacturing capabilities. Between 2002 and 2004, the company grew from $135 million to $320 million, topping out at more than $500 million in sales later in the decade. Eventually, the company was broken up but its core businesses still generate over $1 billion annually of medtech contract manufacturing as part of Integer Holdings.

The Accellent “roll up” strategy has been successfully duplicated by a number of capable financiers who partnered with experienced operators. Consequently, a greater portion of the growing medtech supply chain is now controlled by fewer, larger CMs.

OEMs’ Role in Supply Chain Consolidation

Consolidation has not transpired in a vacuum. Major OEMs have welcomed the effort, and for good reason—from an operations perspective having fewer, larger suppliers capable of tending to large amounts of a device’s content makes vendor management easier and less expensive. Additionally, the larger rollups have prompted the supply chain to modernize facilities and quality systems, as well as ensure that plants comply with the ISO 13485 standard. The rocket fuel driving medtech outsourcing was and still is the average 3% to 10% savings that OEMs have come to expect compared with in-house manufacturing. One of the greatest benefits of consolidation to OEMs, however, was and remains less visible. In awarding programs to larger CMs, OEMs converted the supply chain into a shadow bank.

OEM accounting departments were overjoyed as large CMs assumed the responsibility of building new plants to accommodate growing order books, thereby sparing multinational behemoths the need to borrow hundreds of millions of dollars. Why tie up large blocks of capital if a supplier was willing to do it? OEMs also shifted a portion of their working capital requirements from their balance sheets to their CM partners by requiring their suppliers finance inventory and carry payables. No matter how hard OEM manufacturing executives argued for keeping work in-house, a quick look at the spreadsheets often shifted the odds of award in favor of the supply chain.

An Uneasy OEM-Supply Chain Stasis?

What is the relationship between OEMs and CMs going forward? There are two popular theories. The first argues that outsourcing is reaching its zenith because larger CMs are beginning to pose threats to their OEM customers. Two issues stand out here. The first is size—the largest CMs have become so large that once intrenched, they gain pricing power over their customers. An OEM caught in this situation would face a long, costly switch to an alternate source. Hence, many OEMs will pay higher prices to the incumbent as long as that price is lower than the cost of switching. Caught in this situation, the long-term OEM strategy will be to move new work to smaller suppliers incapable of such leverage. If these switches were to occur en masse, the growth of large CMs would be capped despite underlying market expansion. Put simply, the pendulum would swing to smaller CMs.

Logically this scenario is possible but for a major OEM to find itself at risk of a CM dictating price without an alternative represents poor vendor management by that company. Further, from the large CM perspective, playing pricing chicken with the only customers capable of supporting its large scale operations is incredibly risky. Still, the argument is not out of the question.

The second threat is channel conflict. For the unfamiliar, channel conflict occurs when a supplier goes into direct competition with its customer. It’s easy to understand why a large CM might be tempted to offer branded products. The average OEM enjoys an average 60% gross margin, though the number varies by product type. In comparison, a well-run CM is lucky to see a 35% gross margin and many have gross margins under 30%. Most large CMs offer a broad range of design, regulatory, and manufacturing services, and many can design and build a complete device in-house or use their exceptional sourcing capabilities to fill any holes they may have. Why sell to an OEM when a sale could be made to an end-use customer at twice the profit? Why not cut out the OEM altogether?

Most CMs reaching this fork in the road of strategic planning avoid going into competition with their OEM customers. The most compelling reason is that OEMs—wisely—would sever contract manufacturing projects with the CM as soon as possible. This includes OEMs not directly threatened by the turncoat CM. Who would trust suppliers with such a profound economic incentive? Time becomes central to this argument: Since it takes years for a CM to become a major organization, the loss of interim contract manufacturing work could bankrupt the company regardless of its technology in development. Another barrier keeping highly capable CMs from flooding medtech markets with their own branded products is the lack of international sales and distribution organizations developed by major OEMs over several decades. Even a modest commercial initiative costs tens of millions of dollars with no guarantee of success.

Despite the risks, some CMs have moved to branded products. Likely the most successful practitioner of a hybrid OEM/CM model is Teleflex. Originally a telecom supplier in the 20th century, Teleflex moved into medtech contract manufacturing in the 1990s. Carefully picking its battles, Teleflex management launched or acquired a number of branded product lines, reaping higher profits on in-house manufactured devices. Today, Teleflex is a $3 billion all-life sciences firm offering both its own developed products and contract manufacturing services. 

As with the pricing power argument, CMs should prefer other CMs incapable of becoming competitors. This threat of competition should lead OEMs away from large, well-funded CMs with broad manufacturing capabilities. Still, the benefits of outsourcing to larger CMs demonstrably content with their place in the market outweighs the rare successful efforts of CMs to take meaningful market share from OEMs.

In the end, the OEMs have the supply chain they want and there is room for supply chain growth. As of 2024 the total cost of medtech goods sold is roughly $250 billion annually. The supply chain, at $85 billion, is just over a third of that total. While some manufacturing will likely remain in OEM factories, significant opportunity exists for CMs due to general industry growth and available outsourcing business.

Tony Freeman is president of A.S. Freeman Advisors in New York City. His firm advises on mergers and acquisitions and on corporate valuation strategies. He also is an avant-garde musician, a crack marksman, and an afficionado of fine Western wear. He can be reached at tfreeman@asfreeman.com.