4 Strategies to Avoid Commoditization

EY
John Babbit

John Babitt,
Partner, Life Sciences,
Transaction Advisory Services,
Ernst & Young LLP

 

Unsustainable healthcare costs and payer austerity are pressuring pharmaceutical and medical device companies to alter their business models to showcase how products improve patient outcomes while simultaneously lowering total spending.

This is more difficult than it sounds, in part because bioscience and medical technology (Bio/Med) innovation occurs in a stepwise fashion that builds on small but significant improvements in the standard of care. That model favors a market in which the physician is the buyer — if doctors value the improvement, the product can gain market share.

Today, as purchasing power shifts to payer and provider administrators, small, iterative improvements matter less than a “good enough” product at a lower price point. In effect, buyers are treating products more like commodities, unwilling to pay premium prices for features that, in their view, don’t distinguish a product from its competition.In this environment, it becomes critical for companies to find creative ways to differentiate their products, and some firms are taking major steps in that direction.

The New World Order

Until recently, commoditization pressures were a challenge primarily for medical technology (medtech) developers. Now, pharmaceutical companies are getting squeezed as well.

As prices of specialty therapeutics continue to skyrocket, the value of those drugs is increasingly being debated. Indeed, as market forces shift power to payers in both Europe and the US, the window of pricing flexibility continues to close. Case in point: the high-profile stance by the pharmacy benefit manager Express Scripts to exclude Gilead Sciences’ effective, but expensive, hepatitis C products in favor of a competing medication from AbbVie. 

Hepatitis C products are hardly the only medicines subject to exclusions these days. Payers have signalled they will closely manage the utilization of other high-priced products. Products already caught in the crosshairs include the PCSK9 inhibitors, curative gene therapies, and immuno-oncology agents. 

Buyers are treating products more like commodities, unwilling to pay premium prices for features that don’t distinguish a product from its competition.

The ability to create exclusionary formularies is aided by consolidation among both provider and payer stakeholders, giving these groups increased bargaining muscle. Hospitals and healthcare providers remain active acquirers as they seek to create critical mass in their local geographies. Insurers have been active too. Since March 2015, we have witnessed several major deals: UnitedHealthcare/Catamaran, CVS Health/Omnicare, Centene Corp./HealthNet, Anthem/Cigna, and Aetna/Humana.

Similarly, the shift to “accountable care,” which prioritizes delivering improved population health outcomes for lower costs, also puts pressure on product prices. To deliver high-quality, cost-effective accountable care, providers and payers must standardize medical practice via evidence-based formularies. Products excluded from formularies face obvious commercial disadvantages. Yet, as the leverage of payers and providers increases, these two groups can use the threat of formulary exclusion to bring product developers to the bargaining table.  

Provider-payer risk sharing, another central feature of accountable care, will also constrain product pricing. That is because providers stand to gain — or lose — income if they cannot deliver quality care at pre-specified cost thresholds. In a recent interview with EY, Michael Sherman, chief medical officer of the regional US payer Harvard Pilgrim Health Care, outlined the behavioral shift at work. Providers in his network “sometimes argue for tougher utilization criteria for high-cost therapeutics than we do,” he says. They tell his plan, “We don’t want our physicians using high-cost drugs unless they add real value.” Finally, patients are becoming more cost-conscious as they play a bigger role as healthcare buyers, while new tools such as Memorial Sloan Kettering Cancer Center’s Drug Abacus and Real Endpoints’ RxScorecard threaten to disintermediate drug manufacturers from the value discussion.

Patients are becoming more cost-conscious as they play a bigger role as healthcare buyers.

Differentiating Differently

In this new world order, companies need to embrace the notion that innovation will not be defined by a particular mechanism of action or product attribute, but rather by the outcome achieved. To avoid commoditization, companies must therefore differentiate themselves via new bases of competition. These include:

  1. Increase scope through services and solutions
  2. Increase scope by adding product offerings
  3. Offer products that remove costs from the healthcare system
  4. Offer innovative pricing models 

1. Increase Scope Through Services And Solutions

As bundled payments become one of the leading strategies for reducing healthcare costs, it will become more important for companies to try to “own” more of the bundle. However, currently, manufacturers typically view the relationship as transactional rather than a partnership. This view needs to change. “The endpoint of the relationship between a medtech company and a care provider is no longer a sale,” says Dr. James Rawson, Chair of Radiology at Georgia Regents Medical Center in Atlanta. “The endpoint is an improved patient outcome. That’s where the industry has to go.” 

Proving his point, Georgia Regents entered a 15-year, $300 million agreement with Philips Healthcare in 2013, in which Philips is paid for supplying and maintaining equipment — including that of rival firms — as well as for improving patient care.

Patient-focused service relationships with provider networks can also add value through reduced costs and improved outcomes. Accountable care organizations (ACOs) need help achieving federally mandated quality goals. In this setting, both pharmaceutical companies and medtech can be valuable partners — if the product manufacturers are willing to assist in the development of product-agnostic solutions.

Currently, there are few publicly disclosed examples of ACO-industry partnerships, let alone metrics defining success. Two 2013 collaborations worth monitoring are Merck & Co.’s partnership with Heritage Provider Network and Fresenius Medical Care’s agreement with ApolloMed ACO. Merck & Co. and the Heritage Provider Network created an open-innovation challenge to develop new tools to help heart disease patients adhere to their medication regimens. In the same year, Fresenius Medical Care entered into a managed care agreement with ApolloMed ACO to coordinate care of patients with end-stage renal disease and to share the resulting cost savings. 

As manufacturers expand into services, they may need to seek the expertise of companies that are not traditional healthcare players. Evidence of this trend is seen in two collaborations that began this year: Novartis’ partnership with Qualcomm to develop systems to collect trial data remotely, and Biogen’s partnership with Google to use big data to identify environmental and biological factors contributing to multiple sclerosis.

2. Increase Scope by Adding Product Offerings

Medical product firms that offer an end-to-end solution in a given disease area may also have a competitive edge in the changing healthcare landscape. With a suite of products designed to address the continuum of care in a given disease area, companies can better equip provider groups to meet important care metrics that are now a necessary precursor for their own reimbursement. Also, by offering a spectrum of solutions, companies can help simplify the contracting complexity healthcare buyers face.

A number of recent deals showcase how companies are broadening the scope of their product offerings. One is Zimmer Holdings’ acquisition of Biomet, completed in June of 2015. The deal positions Zimmer as a leader in the musculoskeletal sector, with particular depth in knee and hip implants and the trauma market. 

Another example is the asset swap completed this year between GlaxoSmithKline (GSK) and Novartis. At the core of the complex deal is an exchange of Novartis’ vaccine assets for GSK’s oncology assets, allowing each firm to expand scope in areas of strength.

The Medtronic/Covidien megamerger pushes the case for deepening product scope to a whole new level, expanding product breadth across multiple disease areas. As a result of the $49.9 billion transaction, the bulked up Medtronic says it is now the leading medtech distributer in six of the top 10 hospital purchasing categories.

Magnifying Glass Guy3. Offer Products That Remove Costs From The Healthcare System

Recognizing that commoditization is a fait accompli in certain disease areas, medical device companies can also go on the offensive, devising products or technologies that provide better value because they reduce costs. There are two ways to achieve this. First, companies can reduce their costs of production, for instance, by engineering a simpler, lower-tech device or by, manufacturing the product more cheaply, and pass the savings on to the customer.

The second way is predicated on taking costs out of the system. In this scenario, how the product is priced is not the main focus; what matters most is whether it results in cost offsets that reduce the total cost of care. Existing products achieve this in a variety of ways, for instance, by reducing the need for office or emergency room visits, by eliminating the need for surgery, or by shortening recovery time.

Creating a new device often involves significant manufacturing, engineering, and research and development costs. To offset some of these costs, firms can either refine their engineering processes to create simpler products that can be sold more cheaply or shift manufacturing to markets with lower labor costs. Such strategies are already in evidence in India and China among both domestic and multinational companies. 

As firms redesign and adapt their portfolios to develop products for emerging markets, they may take advantage of this “reverse product flow” to build no-frills, lower-cost products for use in developed markets. That is what Smith & Nephew is doing via Syncera, an orthopedics-focused pilot that reduces the need for onsite technicians and other services associated with two key hip and knee replacement products. Smith & Nephew believes it can reduce implant costs by as much as 50% without affecting the quality of care. The company first introduced the Syncera pilot in emerging markets; in August 2014, it launched a similar experiment in the US and now plans to expand into other developed countries.

4. Offer Innovative Payment Models

Payment models represent another way to valuably differentiate one’s product from the competition. The current status quo is largely built around undisclosed rebates in which manufacturers agree to offer their products at a discount in exchange for better market access. Over time, such rebates lead to operating margin pressures. In the future, we believe companies that devise schemes to share risk and reward with payers will have a commercial advantage over those that do not.

Companies are not unaware of the theoretical advantages of these so-called innovative payment models (IPMs). However, IPMs have been challenging to implement. That said, win–win models are starting to emerge, particularly in Europe, where the existence of government payers fuels negotiations and the potential impact to best pricing statutes is not a concern. 

These new models are nuanced; the complexity of market access means there is no one-size-fits-all solution that is appropriate in all markets or for all products. However, two main types of models are coming to the fore, and they are simple and flexible enough for all healthcare stakeholders to adopt:

  • Financial-based agreements, which allow payers to manage the budgetary impact associated with a drug or device
  • Performance-based agreements, which are designed to limit utilization to patients most likely to benefit, while potentially providing additional evidence regarding efficacy

Regardless of the specific type of payment model employed, the overarching goal is to align the disparate interests of payers, providers, and manufacturers. Indeed, just as we are tailoring medicines to individuals based on specific genetic information, these new payment models allow companies to create access schemes that are customized to the individual needs of the payer in question based on market, therapeutic area, and disease severity.

Conclusion

Life sciences companies can choose from a range of options when charting their differentiation strategies. Whatever mechanism for differentiating differently they ultimately adopt, companies need to assess and analyze not just the nature of changing purchasing habits in their core markets, but the implications of those changes for their products.

About the Author

John Babitt is a partner in the Life Sciences and Transaction Advisory Services Practice at Ernst & Young LLP. He has provided financial and accounting transaction advisory for Ernst & Young since 1995. Prior to rejoining E&Y’s Transaction Advisory Services Practice, John was CFO of a publicly traded medical technology company and was responsible for all financial and operational aspects, including capital raising and negotiating and structuring numerous collaborations and licensing arrangements. He has operations experience in combination products, biologics, cellular therapies, cardiac surgery and interventional cardiology. John received a bachelor’s in Accounting and an MBA in Finance from the University of Miami.

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