Did an 8-year-old merger cause today’s ventilator shortage?

Will Rinehart
Apr 10, 2020 · 7 min read

Last week, President Trump invoked the Defense Production Act to order General Motors to produce badly needed ventilators in the fight against COVID-19. How bad has this shortage become? New York State, for example, alone needs 30,000 additional ventilators to respond to the crisis adequately.

According to a recent The New York Times report, a merger within the ventilator industry back in 2012 might be to blame. Before it was acquired by the company Covidien in May 2012, the small California-based Newport Medical contracted with the Department of Health and Human Services (HHS) to supply 10,000 units in a crisis. After they were acquired, however, Covidien pulled back from the deal to produce ventilators. Here’s the NYT’s take on the timing of the merger and the cancellation:

Government officials and executives at rival ventilator companies said they suspected that Covidien had acquired Newport to prevent it from building a cheaper product that would undermine Covidien’s profits from its existing ventilator business.

But a deeper dive into HHS’s original solicitation, which was never formally awarded, suggests a more mundane reading. At its inception, HHS was trying to hedge against high ventilator prices in the event of a pandemic by pre-purchasing ventilators at $2,000 each. As it turns out, this is a price that could never be met.

After this original solicitation closed, Newport and the government finally agreed to a deal for ventilators at $3,000 each. But, even at this higher unit cost, Newport failed to deliver. Ventilators are costly, complicated machines. The ventilators General Motors is supplying under President Trump’s order is coming in at $16,000 a unit. In hindsight, Newport wasn’t producing an innovative product that was taken off the market by a merger but was party to a poorly-specified government contract.

To many advocates, scholars, and policymakers, however, this wasn’t a case of a company getting out of a bad contract but instead is evidence of a company getting into an anticompetitive merger. As Matt Stoller noted in his newsletter, “The merger by any standard was a clear-cut antitrust violation.” As he continued, “Covidien bought Newport to take its competitive product out. That’s called a ‘killer acquisition,’ meaning that the goal is to undermine a potentially innovative or lower prices product line.”

Representative David Cicilline took to Twitter:

Sally Hubbard of the Open Markets Institute responded to the report, and said,

While the term has been floating around for some time, the most influential definition of a killer acquisition comes from a 2019 paper of the same name by Colleen Cunningham, Florian Ederer, and Song Ma. This paper argues incumbent firms may acquire innovative targets solely to discontinue the target’s disruptive products. These killer acquisitions preempt future competition, help to maintain or even raise prices, and finally rob consumers of an innovative product. As Ederer and Ma wrote in a follow up just last week, “there are some concerns that Covidien’s $108 million acquisition of Newport in 2012 was a killer acquisition that reduced the availability of ventilators.”

There are two critical moments in this story. In September 2010, Newport Medical entered into a $6.4 million contract with HHS to line up the production of $3,000 ventilators. As the Times reported, the price for a ventilator hovered around $10,000 at the time, and “getting the price down to $3,000 would be tough.” The direction of Newport shifted, however, when Covidien, a medical device manufacturer, acquired them. As the Times continued, “Covidien had demanded additional funding and a higher sales price for the ventilators.” In 2014, Covidien told HHS they wanted out of the contract, and soon they parted ways with the government. Had Newport not been acquired, some surmise, the innovative ventilator would have been produced, and the United States would have another 10,000 units in our stockpile.

But, the $3,000 price agreed to by Newport Medical and HHS exceeded the original price tag of $2,000. The initial request for proposals, which came out in 2008, put the price at “<$2000/fully kitted unit.” The White House’s 2009 budget, which is also cited in the NYT report, further confirms this, since the budget laid out a “next-generation ventilator. It included low cost ($1,000-$2,000), wide patient usage, user-friendliness, closed-loop circuit, portability, easy storage, universal interchangeable parts, internal oxygen source, and remote interface.”

Moreover, while the Times suggests that HHS “opted not to go with a large, established device maker,” the original award was never granted even though the agency expected to award “multiple contracts with incremental and performance-based funding.” In other words, what was agreed to by Newport and HHS cost 50 percent more on a per-unit basis than initially planned and was awarded to a single company instead of an army of suppliers.

Looking at this, industrial consultant Jason Crawford asked, “For a critical strategic resource, why did the HHS rely on a single, small supplier?” The answer lies in the original contract and the accompanying documents.

While the contact between the federal government and Newport could have differed, the original RFP didn’t stipulate that 10,000 units would be bought. Instead, it required that,

The Contractor and subcomponent contractors/suppliers/vendors shall have available raw materials/subcomponent supplies and/or accessories in domestic inventory during a pandemic influenza outbreak to ensure the likelihood that 10,000 fully kitted ventilators can be manufactured within six (6) months to assure that Government contracts may be honored.

As initially imagined, these ventilators weren’t intended to be held within the strategic reserve. Rather, they were to be a guaranteed stream of ventilators when demand was high. In response to feedback from bidders, BARDA answered a set of questions on February 2, 2009, that clearly spelled this out. “It is highly unlikely that the government will not need ventilators,” they said. Still, when pressed, the organization made no promises to follow up the contract with a purchase order for 10,000 units. As they further noted, “Materials and the storage [of parts] is the responsibility of the manufacturer.”

The specifics of the deal has all the hallmarks of a call option, a type of financial contract that has existed since Ancient Greece to hedge against price volatility. In a call option, the buyer has the right, but not the obligation, to purchase a product or multiples of that product from the seller at a certain time for a certain price. Airlines have used these for years to reduce their exposure to rising fuel prices since the call keeps costs at a specific level even if market price increases. The federal government was hoping to do the same with ventilators, which have increased in cost by over 150 percent in this crisis. To the federal government, the most innovative part of this project was the contractual terms.

Some read this story and see Newport as having an innovative ventilator project that was taken off the market through a merger. But it is more likely that Newport was trying to create low-cost ventilators and failed. Ventilators are costly because they require high-quality materials, need to perform a range of actions, and have to meet specific medical guidelines set by the Food and Drug Administration.

Low-cost ventilators typically arrive at their price by stripping out features, which makes them harder to get approved in the United States. Last year, for example, the MIT Sloan Healthcare Innovations Prize was awarded to the Umbulizer team, which created a $2,000 ventilator. As team presenter Shaheer Piracha explained, machine ventilators are typically designed to perform 15 different functions, many of which are rarely needed to save a life. His team was able to keep costs down by focusing on the four most common functions that doctors in Pakistan needed and building around those requirements.

Newport sold high-quality products. Indeed, Medtronic, which bought Covidien in 2015, continues to sell upgraded versions of Newport’s ventilators, including the e360 and the HT70. But the ventilator that came from the government contract never got approval for use in neonatal populations, which was required. It makes sense that Covidien asked for more money per unit toward the end of the contract. The high cost of ventilators reflects the demands and requirements of the device. As Medtronic said in a statement, “They were not able to deliver a product close to the target cost of manufacture required by the contract specifications.” In other words, it wasn’t an innovative ventilator as much as it was an overspecified government contract.

There’s more, as Geoffrey Manne and Dirk Auer point out in their detailed post on this topic:

  • There was little overlap between Covidien’s and Newport’s ventilators;
  • Even today, the mechanical ventilator market remains highly competitive, and fractured, with at least eleven different producers; and finally
  • If the deal was truly a killer acquisition and it would have the effect of boosting Covidien’s profits, the value should have been larger than $108 million since “an acquisition value out of line with current revenues may be an indicator of the significance.”

Given the facts, it is hard to claim this was a killer acquisition. The more likely story is that the federal government tried to low-ball a project, got a bite from Newport, and that project ultimately failed when Newport realized they were taking a loss on every single product.

The New York Times is right that “the collapse of the project helps explain America’s acute shortage.” HHS should have recognized what they were doing with the contract. They were trying to guarantee a price in the event of a pandemic when prices were sure to rise. Rather they should’ve been ready to purchase ventilators as a call option, just like airlines buy fuel hedges and farmers buy insurance.

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