An effective and efficient pathway to customers is important everywhere in orthopaedics, but perhaps nowhere is it more critical and complex than in China.
Traditionally, channel partners for orthopaedic manufacturers selling into mainland China have been the primary face of the brand for customers. They have driven local awareness through marketing and education initiatives, converted demand, taken orders, provided a critical element of the product logistics chain, created financing and collected payment from hospitals often renowned for long payment cycles.
To fulfill these varied roles across China’s geographically large and diverse market, a multi-tier distribution environment has emerged; three or more different layers of distribution might be involved in bringing a single product to a particular customer.
These critical business partners have also been the source of much angst for manufacturers: they have “owned” the customer, caused compliance concerns and they have often (in aggregate) taken a lion’s share of the end user price.
In China’s new medtech landscape, there is increasing focus from procurers, payors and patients on value for money, with price-based competition increasingly severe in many orthopaedic categories—even at the premium end of the market. End user prices are frequently ratcheting down from public tender to public tender, bringing the share of product value captured by manufacturers’ channel partners into stark relief.
The traditional channel model is becoming untenable, and adding fuel to this fire, China’s government has now issued regulation that directly regulates the route to market in ways that have not been seen before.
A lot, and rapidly. China’s regulators have pursued a systematic and significant tightening of regulation governing the sale and supply of medical technology products during the last five years. From new Good Supply Practice (GSP) standards and self-certification requirements, to formal licensing of third-party logistics (3PLs), to prosecutions against vertical market monopolies, such as that which made headlines against Medtronic in December 2016. These changes in regulation can be launched after limited consultation with industry, and with a highly ambitious timeframe for implementation.
The change generating most consternation in 2017, however, has been the introduction of a “Two Invoice” policy. In principle, China’s “Two Invoice” policy limits the channel to just one ”layer” (i.e., two changes of legal ownership, from manufacturer to distributor, and from distributor to hospital). That represents a huge change in a multi-layer channel, even with the various exceptions that can allow for additional invoices under certain specific circumstances.
First to note: medtech is escaping (relatively) lightly in the current wave of implementation. China’s central government has devolved a high degree of latitude to mainland China’s 31 provinces in how to interpret and implement this policy, and the main focus of initial regulation has been the pharmaceutical sector.
The argument has been well-made by medtech manufacturers and partners that the physical supply chain—particularly in orthopaedics—is more complex and integral to the clinical delivery of quality healthcare than physically supplying a box of pills, for example.
As a result, most of China’s policymakers are treading with caution in disrupting the structure of supply for orthopaedics…so far. While 26 of 31 provinces in China have now announced their plans to implement their versions of the Two Invoice policy, only three provinces—Fujian, Shaanxi, and Qinghai—have so far included any medical technologies in the scope of their initial Two Invoice implementation. As has been the pattern with pharma-focussed regulation in prior years, we expect that medtech will be progressively included under future updates to the policy framework.
What are China’s regulators actually trying to achieve?
The primary objective is to lower unit prices. We expect China’s healthcare spending to continue to increase at ~12% each year, with much of that going into external spending—drugs, equipment and devices, rather than salaries. Keeping a lid on healthcare inflation is paramount, even as underlying demand for and consumption of healthcare increases apace. Clamping down on costs is also politically popular, since approximately 30% of funding into China’s healthcare system is still directly paid out of pocket by patients and their families, who are typically charged directly for the non-reimbursable components of procedures, prescriptions and devices.
Enhancing transparency is a clear side benefit for policymakers in reducing the number of participants in the channel. Not only is it potentially easier to identify where there are systemic super-profits in the value chain, and potential to enable more effective market-based competition, there is also the potential to address China’s long held reputation for graft that adds to system costs and undermines public trust in healthcare professionals.
So what does that mean for manufacturers? (Distribution, finances, customer relationships)
For manufacturers reliant upon traditional channel arrangements, complying with the Two Invoice policy is a clear challenge on multiple fronts. Maintaining reliable product supply, sustaining visibility in the market and finding growth in new markets are all objectives challenged by channel disruption.
The new regulations also, however, represent an opportunity. By providing an industry-wide trigger for change, regulators have created an opportunity for manufacturers (and patients/payors) to capture more value, to reset the terms of trade and to secure new competitive advantage in the market as they re-construct capabilities that were previously the domain of their channel partners.
Another effect is channel consolidation. We’ve seen increasing deal volumes as distributors exit or merge, with 46 deals in medical device distribution (three orthopaedic related) across a variety of different therapeutic areas during 2016 as participants seek to deepen and extend their reach, and defend existing business from regulation-driven disruption. Cachet, for example, has built its business in ten key provinces by pursuing 28 deals during the last four years alone. Even the well-resourced Cardinal Health, itself a top ten distributor in China, is considering its strategic options there in the face of the continued investments of capital and resources that it sees as necessary to build out the business.
There is, nonetheless, plenty of room for consolidation before market concentration becomes a concern: estimates vary, but it’s widely accepted that China has more than 100,000 active medtech distributors.
How are companies responding in order to comply?
Orthopaedic and medtech manufacturers with operations in China are now navigating and negotiating complex questions of concern to executive teams, which typically include:
- How do we best extend reach to address new demand without adding distribution layers?
- How do we serve smaller, higher growth accounts cost effectively with fewer distributors, despite significant support requirements?
- How do we best capture more of the value of the product, whilst still ensuring suitable financial incentives for channel partners?
- Do the synergies of a simpler, unified approach to the channel outweigh the benefits of a tailored approach? How will that impact each product group or type of customer?
- What are the existing functions and capabilities that we must preserve in the transition? How do we achieve these in the face of regular regulatory intervention?
- How do we ”test & learn” in the subset of jurisdictions where regulation is first coming into force?
- What is the willingness at headquarters to invest to build capabilities in-house? What is the strategic and economic case supporting these investments?
In response, we have seen many of our larger clients increasing investment to build commercial and sales and marketing infrastructure, with intent to own a higher share of the value chain, and building optionality to dis-intermediate should that be required in future.
Manufacturers are also exploring their multi-layer channels from classic “distribution” arrangements to fee-based arrangements that do not involve change of legal ownership, but can maintain the participation of most current parties in the short term.
There is also an ongoing fundamental re-appraisal and fragmentation of roles previously supplied on an ”integrated” basis by distributors. For example, we’re seeing more exploration of the feasibility of greater use of 3PLs and Contract Sales Organizations (CSOs).
For some smaller medtechs, we’ve seen moves to ”outsourcing the problem” by leveraging a single major channel partner, such as Sinopharm, DKSH, China Resources or Cardinal Health which have been actively building their medtech distribution capabilities.
L.E.K.’s medtech clients have taken a wide variety of approaches appropriate to their own individual markets, capabilities, risk and investment appetites. Medtech manufacturers ultimately have the good fortune that there is opportunity to use early implementer provinces as test beds for a national model that may soon be needed.