One Size Doesn’t Fit All:  Round Table on China - Ernst & Young 2010 Medical Technology Report

Jul 15 2010

As margins and growth rates get further squeezed in Western markets, medical technology companies will increasingly rely on overseas sales to accelerate their future growth. Unlike any other emerging market, China will provide US and European medical technology companies with a tremendous opportunity for expansion. While China’s ever-expanding middle-class has driven the first wave of medtech’s market development, the Chinese Government’s ongoing US$125 billion investment into overhauling the country’s health infrastructure will make health care available to the masses and provide foreign medtechs with millions of potential new patients — if the Government has the right strategy and product offerings.

To help us better understand the medtech landscape in China, we sat down with three industry veterans who have firsthand experience of operating in the Middle Kingdom. Richard Mao, the panel’s lone Chinese national, is responsible for Johnson & Johnson Medical’s business development function in the Asia-Pacific region. Also on the panel was John Barrett, Vice President of Finance for Medtronic. Based in Tokyo, John has held multiple roles within China and throughout Asia for nearly a decade. Finally, Immanuel Thangaraj, Managing Director for the venture firm Essex Woodlands Health Ventures, has an active portfolio of China-based medtechs. The roundtable was moderated by Dave DeMarco of Ernst & Young.

The panel’s tone is one of immense optimism as China presents magnificent possibilities for the global medtech industry. However, in order to be successful, foreign medtechs must be able to adapt to China’s unique culture, languages, business protocols, politics and Government regulations. They’ll also need to be knowledgeable of the country’s different markets and what drives their purchasing decisions, and be prepared to compete with an increasingly sophisticated homegrown medtech industry.

DeMarco: What rules of the road should medtech organizations know when they establish operations in China? What are the biggest barriers to entry?

Mao: Foreign medtechs need to do their homework before jumping into the Chinese market. China’s needs and rules are different from those of developed nations. Companies must have the right product for the right market, and they need to be cognizant of China’s unique regulatory and compliance environments.

After companies complete their homework, the next critical step is to establish distribution capabilities with a knowledgeable local partner that can help foreigners address many of the Chinese market’s challenges. If a company decides to use an acquisition to enter or expand in the Chinese market, it will need very rigorous due diligence to address local risk factors such as product quality, regulatory approval and talent retention. Buyers would be best served letting the acquired company continue to act as a stand-alone entity — preserving the company name, culture and so on — to ensure a smooth transition and to preserve its value and knowledge.

Barrett: In past years, China was known as the low-cost manufacturing capital of the world. Recently, the Chinese Government has been actively promoting high-value business and the manufacturing capabilities of Chinese firms have moved up the value chain. One of the biggest challenges we face as a foreign multinational is how to distinguish ourselves from the local companies as they come up that value chain.

Thangaraj: So far, Essex Woodlands has only invested in two Chinese companies that were producing revenue at the time of the transaction, and these firms were already profitable. Through this investment strategy, we’ve been able to partner with local investors and bypass some of the obstacles related to establishing operations from scratch.

That being said, the differences in language and culture are challenges for us. Unlike the Chinese teams at most foreign firms, our investment team doesn’t consist of Chinese nationals at this time. So we don’t understand all of the cultural aspects of China, which are often significant. To address this issue, many firms hire Chinese professionals, but there are relatively few candidates with solid investment experience and local experience. When we are ready to open an office in China, we either need to find someone with a US knowledge base — such as a Chinese national trained in the US — or we have to build expertise on the ground in China, which takes time.

DeMarco: How should foreign medtechs work with Chinese authorities to ensure a favorable relationship?

Barrett: The Chinese Government has come a long way over the past 20 to 30 years. While Government officials will readily acknowledge that they don’t have all the answers to some of the market’s problems, they are smart and learn quickly. Government officials are open to partnering with foreign companies. Thus Medtronic, being a global technology leader, has been able to develop a partnership where we’ve educated them on our therapies and provided feedback on various policy proposals. Regulations can still at times be confusing, but overall, they are very smart people and we’ve found that it’s very beneficial to collaboratively work with them.

DeMarco: The rise of China’s middle class and the Government’s massive investment in health care present opportunities for medtech companies. How are you targeting these new patient populations?

Mao: Historically, J&J has largely focused on the premium, urban patient market — what we call the “S1 segment.” However, an equally important opportunity exists for us in the lower-income, mass market, or the “S2 segment” — a patient group that will begin to enjoy some degree of coverage through health care reform. Since the needs of the S1 and S2 segments are very different, we maintain distinct business models and product mixes for each group. In fact, J&J has established a separate company called “HCS China” that specifically distributes products for the S2 market. J&J also decided to create a Medical Device and Diagnostic R&D center in China that will focus on market-appropriate innovation that enables us to be quicker and efficient and, most importantly, to better understand and satisfy the local needs of patients and physicians.

Barrett: Medtronic also segments the Chinese market, but we’ve broken it down into three product tiers — premium, value and low income. “Premium” would be products imported by multinationals with a strong global clinical background. The “value” segment would be high-quality locally produced products. I agree with Richard that foreign medtechs must adapt to the Chinese market. Rather than exclusively selling US- or Europe-developed premium products in China, companies need to adapt and compete with the products being developed locally by local companies. Medtronic has adopted some strategies over the last two years that have worked very well. These have ranged from partnering with local Chinese companies to developing both products and distribution strategies that combine the strengths of each model.

Thangaraj: I also see a trifurcated market in China that consists of the super rich, the middle class and the lower-than-middle class. The late University of Michigan economist CK Prahalad famously noted that big companies can make a lot of money making inexpensive products for large, lessprosperous populations. So while Western multinationals will continue to sell premium devices to the super rich, there’s also a huge opportunity to target the ever-expanding middle-class population with products adapted for the local market. As for the lower class, I think local companies are most likely to focus on that group.

DeMarco: In 2008, an Ernst & Young survey identified “human capital” — high employee turnover and lack of homegrown middle management — as one of the biggest obstacles to success in China. What steps have organizations taken to better recruit, manage and retain employees?

Barrett: As a result of Medtronic’s heavy investment in talent development, training and education, the issue of turnover has steadily improved over the last five to six years. We’ve recognized Chinese workers’ tremendous thirst for development and education opportunities by developing management and leadership camps. We’ve also enabled the high-potential employees to have opportunities to speak with our management board and thus ensure that their ideas are shared and that growth opportunities are available across the company. Despite progress on this front, there is still a huge shortage of talent at the executive and board level. As Medtronic has grown from a company with US$100 million in Chinese-based sales to one with more than US$300 million, we’ve required different types of leaders along the way. The mix of skills we have today may not be the right ones to take us to US$500 million or US$1 billion in Chinese sales. So developing and maintaining strong leadership will remain a challenge in China.

Mao: I can relate to what John is saying. Since J&J’s business in China is growing fast, developing the right management and firstline sales team can present a challenge. We advocate the use of local management teams to manage the local business since they are best positioned to understand the specific needs of Chinese customers. We view people as our greatest asset, and we are committed to providing continuous training and career development for our managers. While compensation is obviously very important, we believe talented employees will stay if they see opportunities for personal growth and advancement as the company expands.

DeMarco: How do you manage your product portfolio mix in China?

Thangaraj: MicroPort, one of our Chinese portfolio companies, took advantage of unprotected IP to legally produce a drug-eluting stent based on the design of a leading Western product. Today, MicroPort’s stent has equal, if not better, quality, is manufactured at a lower cost and is sold for much less than its Western competitors. As such, it has become the market leader in drug-eluting stents in China, beating out other foreign multinationals that are active in the space. While the super wealthy in China may be willing to pay premium prices for Western products, the majority of patients — who often need to dig into family savings to pay for health care — will more often than not choose a product that delivers comparable care at a fraction of the cost.

Barrett: Market segmentation is critical. I believe there are two components to managing your product portfolio mix in China. First, there is a lot of R&D and clinical research that goes into Medtronic’s premium products, so we will always sell those premium products in the China market. The second component is to customize the product specifications for the local market — can the product be simplified and made cheaper, and, most important, who is going to pay for it? However, it is very hard to customize products in China because the regulatory cycle for these new products is typically two years. By the time we’ve modified a technology and earned regulatory approval, the technology will have moved on. One of Medtronic’s most important priorities is to increase patient access to our therapies, and a key component of being successful in China will be to continue to adapt the product portfolio and take advantage of the capabilities locally to begin developing more and more locally produced products.

DeMarco: How will the Government’s expansion of health care coverage impact the future of China’s pricing and reimbursement landscape? Will privatepay patients continue to be the primary customers for Western products in China?

Mao: In addition, China’s reimbursement system is rather complex and varies from state to state and product to product. With the advent of health care reform, more of the Chinese population will have access to better health care and Government reimbursement will obviously play a bigger role moving forward. From J&J’s perspective, our objective is to provide the right products and solutions for patients and physicians, at the right price point.

Barrett: The Chinese Government currently reimburses a portion of certain product costs, and individuals are responsible for paying the rest. While it’s true there are a lot of therapies that receive no Government reimbursement, some high-end technologies like coronary stents do, and as a result, the market for stents has absolutely exploded over the past 5 to 10 years.

Government coverage and reimbursement will undoubtedly increase over the next several years. However, I suspect the fortunes of companies in our field will be more positively impacted by the expansion of private health insurance. Private insurance has yet to take off in a big way, and that is one area where we see a huge opportunity for expansion — particularly at the top end of the market. There are many people who have salaries comparable to those in the US or Europe, and they can afford private health insurance. As a result, they’ll be able to access the top therapies.

Thangaraj: To sell a medtech product in China, companies need to go through regional tender processes that usually position a Chinese manufacturer against a foreign company. While the Chinese companies usually face greater pricing pressure, they also have greater access to the tender process. No matter who wins the tender, if a company has a good hospitalbased product with demonstrated results, I would suspect that it will have a good chance of gaining Government reimbursement. Conversely, it will take some time before Government reimbursement is pervasive enough for companies to focus on selling devices to individual patients. In the interim, many companies will continue to operate on a cash payment system.

DeMarco: How do you manage the potential risks of your vendor supply chain in China? Conversely, how do you manage the risk of distribution to hospitals?

Thangaraj: We found there are cultural factors in the supply chain that we were not accustomed to. Disruptions such as strikes or national holidays can shut down an entire country and cripple your supply chain. Also, while the infrastructure within the country is very good, there is more competition for people, and this has resulted in rising compensation and increasing costs in the supply chain. On the distribution side, we’ve found it much better to use distributors as opposed to direct sales forces. We’ve seen multinationals come in and try to engage in sales activities directly with physicians, but they never got good traction.

Mao: Physicians and patients are always our first responsibilities at J&J, and we base our reputations on the value we bring them. Consequently we observe very high medical standards in China and maintain a strict policy to fully comply with the local laws and regulations. We hold the same standards for our business partners, and for this reason, we provide training to ensure they are also fully compliant with local laws and regulations.

DeMarco: How would you rate the level of domestic medtech players, and where do you see the level of competition increasing over the next three to five years?

Barrett: Today, there are many Chinese medtech companies that are well run — highly profitable and well monitored. As was mentioned by Immanuel earlier, some of these companies have gained an advantage by using unprotected IP to produce similar products, and they have then done a very good job of further developing the market with those technologies. These firms have a fantastic ability to manage large sales and distribution networks and manufacturing facilities — and they truly understand how to work with dealers and hospitals.

But their biggest challenge moving forward will be identifying where the next products in their pipelines will come from. While they’ve been able to differentiate themselves in the past by taking existing technologies and making them better for the local market, multinationals have become much more adept at patenting technologies in China, thus protecting their IP. On the flip side, local companies tend to have much smaller R&D budgets. But the Chinese Government is encouraging local companies to spend more on R&D, and if it decides to directly finance more R&D spending, it could become easier for Chinese medtechs to address their pipeline issues.

Mao: Demand for high-quality, low-cost medical products in China is very strong. As a result, competition from local companies is fierce and the number of players is expanding every day. While local companies may initially enter the market with a specific product, they are very nimble and can quickly move to the next market opportunity — even if it is outside their existing core competencies. In the next three to five years, innovation will be the key differentiator. To succeed, companies — regardless of whether they are multinationals or local medtechs — will need to truly understand the needs of Chinese customers and be flexible enough to quickly develop innovative, market-appropriate products for China.

Thangaraj: I agree with Richard. Chinese medtech companies are extremely innovative and entrepreneurial. While Chinese companies have the capability to deliver Western-style product innovation, they are really succeeding in what Richard termed “market-appropriate” innovation. The Chinese are very good at adapting their products for local consumers, and they’re going to continue to develop products that don’t have all the features of Western products but are cheaper and still satisfy the needs of local consumers. Over the next few years, expect to see Chinese companies successfully develop low-cost, high-quality innovation models. Expect to see more of them go head-to-head with foreign multinationals in certain premium product segments — both within China and elsewhere.