This Medical Supply Company Sourced 35% of Its Products From China. Here’s What Happened When Trump’s Tariffs Changed Everything

October 17, 2019, 11:30 AM UTC

Michael Einhorn is describing how the trade war is upending the life of successful, mid-sized American medical products supplier. His account is a case study in how tariffs virtually overnight made its biggest supplier uncompetitive, and the challenges of spinning the globe to find new lifelines to serve hospital and clinics.

Many U.S. companies, from wearable-device maker FitBit to toy purveyor Hasbro to footwear giant Nike are shifting production from China. But practically none of the famous players grappling with disruption are talking much about where they’ll be transferring production of those gadgets, playthings, or sneakers, or how much extra they’ll pay to make to make them outside of China.

The details of how the trade conflict is forcing companies to shoulder much higher costs are as crucially important as they are hard to get. That’s because a phenomenon called “deadweight costs” that’s imposing a heavy burden on the U.S. economy. Every extra million dollars that U.S. companies spend making the same products in Malaysia, Canada or the U.S., that they used to produce from China causes a dollar-for-dollar hit to national income––that’s the “deadweight” damage. That burden also include the extra cost to consumers for sneakers or appliances made by foreign producers in third countries that they used to buy cheaper from China. Based on the deadweight costs calculated for 2018 by economists from Princeton, Columbia and the New York Federal Reserve, the heavy tariffs slapped on China could in 2020 raise costs to our manufacturers by $160 billion. That extra penalty would drag what would have been almost 3% growth in the absence of the trade tiff to under 2%.

Einhorn couldn’t be more frank about where he’s moving production, how much more it’s costing his company, and most of all, the realization that the new trade regime means downgrading China from his dominant supplier to a relatively minor role. “I’ve come to realize in just the last months that these tariffs aren’t going away,” he told Fortune in an exclusive interview. “Xi Jinping is no pushover. Our business has 25% margins, so how can we afford 25% tariffs? Our take is that we want to move as much production as we can away from China. I’m just not risking our future on China.”

Einhorn is president of Dealmed, a privately-held manufacturer and distributor that’s one of the industry’s top two suppliers in its home market, the New York-Connecticut-New Jersey tri-state region, and among the largest half-dozen in the nation. Besides distributing pharmaceuticals for major drugmakers, Dealmed sells 320 mostly-disposable medical products such as gauze, face masks, gowns, dressings, gloves, and basic testing products to hospitals, physicians’ offices, surgery and dialysis centers, health care systems, and urgent care facilities.

Dealmed manufactures products that account for around 20% of its sales. “That’s tens of millions of dollars,” says Einhorn, who declines to disclose total revenues. The vast bulk of the wares Dealmed makes under its own brand it’s long outsourced to Chinese manufacturers. Einhorn also imports another group of products that it purchases from Chinese manufacturers, and distributes in its sales territory. Those goods account for an additional 15% or so of sales, raising the share of made-in-China goods that it markets to around 35%.

Einhorn recounts that the shift in production to China was growing continuously until the trade war caused a sudden reversal. “Fifteen years ago, we sourced maybe 15% of our products from China,” he says. “China made mainly lower-end, cheap products. If you wanted a cheap adhesive strip [known by the J&J brand BandAid] you’d go to China.”

Cutting out the middleman

Over the years, he says, the quality of its leading export nation’s products improved, and Dealmed turned to China for more sophisticated gear such as on-site testing devices for urine samples and strep throat. “The Chinese then began making the same products as U.S. manufacturers but at lower cost, such as face masks, wash cloths, and eventually testing equipment,” he recalls. He says that in the first phase, Dealmed would buy the Chinese-made goods from importers who worked as middlemen.

“But then we realized we could make those products under our own brand by doing contract manufacturing in China,” says Einhorn. He adds that in the past four or five years, the Chinese producers aggressively lobbied Dealmed and other U.S. distributors to form those outsourcing partnerships. “The manufacturers would cut out the middlemen and lobby us directly, saying ‘We can make it a lot cheaper in China for you under your own label.'”

Dealmed’s imports from China peaked early last year at around 40% of its sales, and Einhorn expected the share to keep growing––even when the first waves of tariffs hit. “When we first started hearing about tariffs in the summer of 2018, we yawned,” he says. “We thought the tariff threats were just talk.” Even at the end of September last year, when the U.S. slapped 10% duties on $200 billion in Chinese exports, Einhorn wasn’t worried. “For the first few months it was business as usual,” he says.

The reason was two-fold: The initial 10% duties weren’t catastrophic, and many medical products were exempted. “In the first half of this year, the U.S. removed almost 100 products from the tariff list, including sutures and needles,” he says. “I thought that health care products would mostly continue to be exempt. We in the industry also thought tariffs were mainly being used as a threat, and would go away after a couple of months.” Even if the duties remained, he reasoned, the Administration, would make an exception for health care since disrupting Chinese imports could cause shortages of staple products crucial to hospitals and clinics. “Our supply chains are fragile,” he says. “We don’t have warehouses packed with gauze and testing equipment. We depend on just-in-time delivery.”

An growing wave of tariffs

But between May and September of this year, the Trump administration in three waves raised tariffs from 10% to 25% on $200 billion in Chinese imports, hit another $300 billion with 10% duties, and then raised that round of tariffs to 15%. “All of a sudden, the the U.S. was taking products off the exempt list, including gloves and cotton-based products like gauze, dressings, and bandages. In a few months, we went from 10% tariffs on a small percentage of our products to 25% tariffs on close to half of our products.”

By September, Einhorn concluded that the new tariff regime not only wasn’t going away, it would probably get worse. In the last few months, Dealmed has already shifted 5% of its dollar volume of manufacturing and purchasing from China to other nations––at generally higher cost. It’s already switched production of paper products such as surgical gowns and operating table coverings, to the U.S., and expects to source 100% of that line stateside by year end. “The cost of those disposable paper products in the Midwest is around 15% higher than the costs of making those same products in China,” says Einhorn, noting that the quality in the U.S. is superior.

He’s also moving production of all Dealmed’s point-of-care testing devices, including swabs for strep throat, to the U.S. “The costs at a plant in the northeast where we transferred the business are about the same,” he notes. “The manufacturer lowered its prices to get the business we used to do in China.”

Glove production is shifting to Malaysia. Dealmed sells eight different types of medical gloves made from three materials, nitrile (the best-seller), latex, and vinyl. Einhorn is moving fast. He’s has already shifted the majority of glove production to Malaysia, and plans to relocate all of it by year end, so that China will go from sole supplier on gloves to zero. “Malaysian companies are selling hard to take advantage of this opportunity,” says Einhorn. In Malaysia, he’s paying 5% more latex supplies, and 10% more for nitrile and vinyl than the costs in China, assuming the same prices for the raw materials, which do fluctuate. But since the U.S. slaps 25% tariffs on gloves imported from China, Dealmed is still saving 20% on latex and 15% on nitrile and vinyl. The rub is that hospitals, clinics and urgent care facilities, and eventually patients and taxpayers, will pay a lot more for the health care system’s most basic products. Einhorn confirms that eventually, all of these these cost increases will result in higher prices.

On the other hand, Einhorn finds it tough to source good alternatives for cotton-based products, from gauze to dressings. “We looked at Turkey,” he says. “But their prices are 35% higher than China’s. We’re also in talks with a factory in Mexico. They’re at high-single digits more. So right now, we have no choice but to keep buying from China.”

Leaving China entirely

Still, Einhorn’s goal is to pull all of Dealmed’s production out of China. He’s troubled not just by the heavy duties––which he now foresees as permanent––but also because of uncertainty caused by the administration’s vacillating policies. “Items get taken off the exempt list, then put back on, then taken off again,” he says. “Shipments from China are held up in ports for two weeks with no explanation. We don’t know what’s going on. It’s the wild west.”

The Dealmed example shows that at best, the Trump tariffs are only achieving part of their goal to bring exports made in China back to U.S. plants. Even that objective is of questionable benefit, because the big duties on Chinese goods provide an umbrella of protection that allows less-efficient U.S. manufacturers to fill the void by making the same goods at higher costs, rendering our manufacturing less lean and productive than before Trump tied ankle weights to Chinese rivals. It’s true that the U.S. collects taxes on those imports that partly offset the damage. But as Dealmed’s maneuvers show, U.S. companies are replacing a big share of the products they used to buy in China with costlier substitutes from Japan or Canada––think of Dealmed’s pricier gloves from Malaysia. The business that jumps to third countries not only provides no benefit to the U.S. economy, it exacts the deadweight costs that are already a substantial drag on our growth.

All told, the Dealmed experience is a primer in how rapidly a nimble manufacturer can shift business from the nation that’s long been by far its dominant supplier. Remaking its global network, however, comes at a big cost. “The new tariff regime will change the landscape in health care,” says Einhorn. “China did a good job manufacturing, but they also cut corners wherever they can. There may be some benefits to the switch in terms of quality. But it will come at a cost.” The trade war should be a pocket book issue. And nothing better summarizes what it means for America than making our hospitals, patients and taxpayers pay more for gloves from Malaysia and testing gear or gauze from Mexico.

More must-read stories from Fortune:

Trump’s tax bill has cost homeowners a trillion dollars
—Inside JP Morgan, moving on from WeWork is proving to be a messy proposition
What is Oyo? Behind Softbank’s latest high-growth, high-valuation bet
—Why the next recession may feel very different than 2008
—Trump’s tariffs were supposed to ding China, but the U.S. economy is getting hit 2.5x harder
Don’t miss the daily Term Sheet, Fortune’s newsletter on deals and dealmakers.

Read More

CryptocurrencyInvestingBanksReal Estate