PetBet Cart The Risk of Supply Cain Integration In July 2010, Mr Kevin Donald, CEO of the PetBet care, scribbled a few uotes about his latest meeting with a group of veterinarians, These were his customers, and they provided direct feedback on their latest experiences with PetBet’s diagnostic instruments for animal care. The feedback was always valuable, although on this visit, it was not entirely positive, ‘The customer feedback was fresh in Donald’s mind as he returned to the proposal; he had started reviewing that moming. It summarized the "make vs buy" analysis for Ovee cartridges condueted by his director of planning, Bob Smith. Smith recommended that PetBet build a cartidge fabrication unit ‘within its own plant rather then acquire GT corp., one of the company’s two current cartridge suppliers. The decision between in-house development and extemal acquisition was critically important PetBer's was growing fast averaging 17% annually since 2007-but it remained a small player with limited resources in a very competitive market, and Donald was determined to avoid a costly mistake He had to make a decision quickly. as the supply of the Ovee cartridges had been inconsistent in recent months. Indeed, the veterinary practice that Donald had just visited had recently been frustrated by @ temporary stock-out at their distributors. To maintain PetBet’s growl trajectory daliver on i promises. Furthermore, the contract with other cartridge supplier. Elore Plastics, would come for renegotiation in August 2010-a meet dhige WEES away. ‘Market overview: Evolution of Pet Diagnostics In 2010, veterinary spencing in the US was expected to be $13 billion, having grown at 79 10 88% per ‘year over the past decade (see Exhibit 1). Several factors drove this growth, First, pet ownership had increased steadily since the last 1980s, rising 6 points to ‘lds. Nearly 73 nillion households in the US. had one or more pets, and the average number of pets per household had increased. Collectively, these households accounted for over 86 milli and 78 million dogs, Seccd th eal of pt Sa Ee TSAO, More et nes ‘were empty-nesters, single, or childless. and increasingly they viewed their animals less as backyard inhabitants and more as family members. In fact, surveys showed that more than two-thirds of owners ‘thought of their pets as family or children. These owners were more invested ia the welfare of their animals, spending more on premium grooming services and organic pet food, for example. This rend also affected spending ou veterinary care, with the owner's willingness to spend more on screening. ‘wellness programs, and espensive procedures to prolong life. A third factor in the growth occurred on the supply side: an increase in the sophistication and the availability of veterinary care. Technology transfer from the lnuman side of the healthcare industry had gained momentum in the 1990s, This led to better equipment, a broader ranze of treatments and procedures, and more veterinary specialists to meet the demands of owners committed to the best possible care for their pets. Practices that offered a fuller range of veterinary services delivered better patient care and generated more revenue per client ‘The Market shift o In-clinte Diagnostic Equipment One aspect of the change in available veterinary eare was the adoption of in-house lab equipment. For decades, the veterinary market relied on outside reference labs to perform both routine and complex Page 1 of 5tests. The shift to in-house equipment was positive for customers, pets and vetesinarians alike. With inchouse fests, customers no longer had to wait a feve days for reslts and schedule follow-up visits to the veterinarian Point-of-care testing also enabled better patient care-restlts were available Blood. chemistry, and blood gas analyzers enabled veterinarians to conduct tests for a broad range of purposes, inchading preventative care, pre= aesthetic and geriatric screening, hypo- and hyperthyroidism, and critical care. For general screeninng—sich as for cholesterol, diabetes, or hyperthyroidism ~ the immediacy tended to lead to better compliance with prescribed care, and thus better patient outcomes—likewise, pre-anaesthetic tests armed veterinarians with more complete information before invasive surgery, The iiimedtiaey of ‘est results provided by it-house equipment was particularly important for critica. care situations. For example, a cat that had ingested toxic chemicals and faced kidney faire would rot have the time for a reference lab test: confisming its condition and beginning treatment had to take place atthe clini if ittwas to survive. For veterinarians, the business case for in-house lab equipment was also compelling. On average, veterinarians recommended diagnostic tests two to thuee times every day. Practices that could test on- site eapnured the full revenue from this service, rather than redirecting it (or mos of it) to an outside reference lab, In addition many veterinavians found that having equipment led te a higher volume of testing because customers were more aienable|toja test that would not requite a follow-up visit Adoption of in-house diaznosis had been somewhat slower at smaller veterinary practices. However. lager practices. such as . were increasingly likely to offer in- hhonse diagnosis, thereby making it more important for smaller and medinm practices to keep pace Donald was enthusiastic shout the opportunity ereated by these trends: The confluence of factors reshaping pet care has us very excited about our prospests, There was rising ddemaad from pet *parente” and vets devoted o beter patient outcomes and driving the growth oftheir own practices. The founders were confident about market growth. There were approximately 25 t0 SOK vetesinany practices the states, and research advises that approx. 40% have accepted in-house lab equipment. As penetation increases the fim was thinking to caprure shave, particularly with products and pricing that work well for small and medivin practices. Industry analysts piojested § f2 x the next five years Company Background: PetBet Care and Ovee Founded in 2001 and tased in Parsippany. New Jersey. PetBet developed. manufactured. and ‘marketed in-house diagnostic equipment, focusing on household pets. The company’s first product ‘was the Henta, an automated cell counter that delivered a complete blood count in just minutes. In 2004, the company also added a line of disposable test kits for rapid diagnosis of diseases such as heartworm. giardiasis and Lyme disease. The most important milestone came in mid-2006 when PetBet introduced Ovee, a diagnostic instrument that provided chemistry; electrolyte, imammeassay. and blood gas analysis (see Exhibits 2 and 3) ‘The Ovee instrument was used at the point of care in a veterinary clinic, enabling veterinarians to run 1a wide range of tests on their animal patients. The veterinarians would take a sample of blood or serum and place it into a "est cartridge, which was then inserted into the Ovee for analysis, Cartridges ‘were proprietary to PetBet System, and cartridges were designed for specific animals and tests Results were available in less than 10 minutes, allowing the veterinarian to provice a diagnosis and, if necessary, make a treatment decision. Page 2of 5Ove delivered highly necurate test results and was simple to use. In smaller clinies, the veterinarians ‘themselves processed the results; many larger clinics employed lab technicians, who handle Ovee ‘with ease after minimal trining. Ovee’s small physical footprint (it sat om a tabletop and occupied just fone square foot) and the competitive pricing of both the instrument (average price af $9,500) and its test cartridges (average ptice of $9.25) made it very attractive, particularly to simall and medium-sized ‘veterinary practices. PetSet had sold over 750 Ovee analyzers in its first 12 months and had significantly increased its analyzers sales in each of the following years. The projected size of the installed base by the end of 2010 was 7.00 analyzers in the veterinary practices across North America PetBet’s research and. nent team continued to work toward new innovations, The nest prodiiet Ss sae eo hr mai nich could be aighte, sealed instrument that worked with smaller cartridges. A segment of veterinarians offered house calls, and s product would enable them to conduct diagnostic tests during visits PeBet had a small dest Caesar aoe ‘bat it primarily marketed its product through a network of veterinary Gistbotors tat ypically amied abroad range of equipment and supplies for practices Pethet versus the competion Petit vied with three major competitors in the veterinary diagnostic instrament market, Yedexo Laboratories, Inc., was the industry leader and boasted the largest product line, the best-established distribution network and sales force. and a strong brand name. It had the vas installed base, and its wide-ranging, cohesive suite of diagnostic tools and veterinary practice software made the difference in tenms of customer satisfaction. Its Catalyst De chemistry analyzer. lnnched in late 2008. provided accuracy comparable to reference labs and could rm multiple patient samples simultancously, making it particulanly well suited for MiGKEVOIMR practise. Caxix, Inc. was Yedexx’x primary competitor. ‘vith prodvets that delivered comparable cesuls but were slightly more cost-effective and considered easier to use, particulaly compared with prior generations of diagnostic struments. Abaxis introduced its VS2 in 2008. and its ease of use meant there was reducing overhead for veterinary practices. Teska Corporation offered a similar set of products a5 those ofits larger compettors, as well as alin of pet vaccines and pharmaceuticals, Its products were cncrally considered! lower end in quality and Iss innovative tha of its eompetiters. PeiBet System’s Ovee product offered practitioners the same level of “reference lab” — quality and accuracy. It was extremely user-fiiendly, requiring virtually no training, an¢ its small physical footprint made it convenient for practices with space limitation. Furthermore, it featured self calibration capabilities, and its quality control had been recognized for its accuracy and flagsing compromised patient samples veterinarians a lower cost-per-use. This had helped PetBet Care gain taction among Veterinarians adopting in-house equipmert for the frst time. Production Process: Parsippany Plant ‘Manufacturing at PetBet Care was divided into 2 distinet phases: instrument production and cartridge ‘manufacturing. The first phase dealt with assembling and testing of the Hema and Ovee diagnostic cate, whereas the later piase, produced the single-use cartridge for each test. The operations were physical sere an sated i fe same pan Page 3 of 5Production of the Hema and vee instrument was an assembly-line operation, PetBet eare designed or specified all key components and sonsced them from a range of third-party contract manufacturers. Creal components ncled Becmuse total unit vohime was modest ands etter invesmest oe eeeee? Ul) oaiae nr Tougtern, single souce supliers Components and stb- ‘Semis tt te oe ant potion opened on nile Silt ach nished unit was put through extensive quality testing to ensure that it met product specifications. Although the instruments were produced for use with animals, rather than humans, PetBet Care adhered to FDA regulatioas for Good manufacturing Practices required for medical devices, Cartridges Production Each test for the Ovee required a single-use cartridge designed for a specific animal and a specific panel of tests, stch as albumin, creatinine, glucose, and many more. The cartridge consisted of two injection-moulded plastic pieces- a base and a cover. Once assembled, the base and cover created a series of chambers into which the blood sample flowed. Within each chamber was a specific chemical reagent that would initiate a reaction with the blood, which the Ovee could then analyze. Cartridge ‘production took place in a sterile clean room where the chemical reagents were prepared. placed in separate chambers, and eeze~dried to remove all moisture. The lyophilization, or freeze-drying, process placed the reagents in a stable state. The base and cover plastic components were then welded together, and the cartridge was sealed in an individual foil package, PetBet Care sourced its reagents from over dozen tip chen sei, most of them, located inthe ulded plastic parts came frou: two suppliers - GT == vided approximately three-quarters, ers ize needs, While Elore Plastics, based in Lowell, Massachusetts, provided the rest. Decision: Backward Integration Opportunity Since 2008, PetBet had been exploring the opportunity to begin its own profuction of cartridge components, Backward integration could potentially solve the supply issues that had plagued the Company. Plastic suppliers such as GT and Elore Plastics faced 9 very competitive, fagmented market with low margins. Most suppliers had little buying power and depended on the petrochemicals asa key input and were us vulnerable tool prices and supplies. The Noltlity adleiges for the industry. Furthermore, the uncertain economie envionment following the finan erss of 2008 had made demand forecasting difiul for plates suplirs and thie customers. Cait Cows for GT and Elor Plastics made it dificult fo respond to unexpected demand spike, adng fo oscasional prodution delays, Such supplier the company to early 2010, simultancot plastic part suppliers led to a shortage of the comprehensive wellness test cartridge. Thus, the ability to fully control the supply of plastic components had obvious appeal. If the company pursued this strategy, it needed 10 decide whether to ‘buy or build this new capability 10 optimize its cartridge production, leading Page 4of 5“Buy” opportunity Relations between PetBet and GT had always been very friendly. When Donald broached the possibilty of merger, le found a receptive audience, as the GT Founder and owaer was intrested ia retirement. For a purchase price of $15.75 million, PetBet would acquire § moulding presses, each quipped with 10 cavity moulds (each mould produced 10 cartridges bases or covers ata time) and operating with 7S-seconck cycle time. An experienced labor force, including supervisors and machine operators, would come wp With acquisition. Bob Smith's analysis suggested dat with 90% uptime over 3 shifis and a S-day working week, 4 modling presses could mest PetBet's current c: needs, He estimated that PetBet System's business already accomuted for approximately reventic, and the remaining molding presses ‘ed for outside business, some of which GT had a long-term contractual basis. “Build” opportunity As an altemative, Smith had also stulied the possibility of making the plastic components in-house at the Parsippany plant. PetBet would require only 4 molding presses to meet its needs, rather than & offered by GT. Another advantage of this option was the company could acquire newer machinery ‘with shorter 70-second cycle time. slightly move efficient use of raw materials, and machine uptime of 95%, The initial set up would require time for installation and testing of the ecuipment, as well as Minne lng of ical ttl Once vp scape Sed tt pn wl ET eS Way SETS ‘months Donald pondered Smith's proposal to build the cartridge components production in-house (See Exhibit 4), The issues with supply and backward integration lad already snatched bis sleep in last few days. Was Smith’s case considerable? Will this step counter the SC risk? Page Sof 5