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Could Implant Makers Lose Their Crutch?

Justin Ferayorni

There are very few markets in which multiple competitors selling similar goods can enjoy high margins and good pricing power while maintaining the ability to introduce slightly improved but relatively untested products at still higher price premiums. Now, imagine this happening without corporate collusion.

Orthopedic implant manufacturers have coexisted in such a dreamlike market, but I believe the dream is going to end.

My thesis is based on the argument that all their products are basically the same: It's all just metal. It comes in different shapes and sizes, different metals, and it may have different coatings, but in general, if I lined up all the products in front of an objective eye, there is a paucity of differentiation across the product lines.

While competition is certainly intense, it's not based on price. There are three interesting aspects of this market that have insulated it from normal price competition.

Whether replacing a hip or a knee, an orthopedic surgeon generally uses manufacturer-specific instruments to perform the procedure. This surgeon has been trained on a particular manufacturer's instruments by his mentor during residency, naturally establishing a high switching cost that is very difficult to overcome. Surgeons are loath to go through a retraining process, which means essentially that implant manufacturers win clients for life. The surgeon is the central element of the pricing paradox.

Hospitals have tried for years to force their surgeons to consolidate purchasing to a few select manufacturers to get an edge on pricing. This has repeatedly failed, as most recently demonstrated by HCA's mea culpa in February. There is a feedback mechanism in place to short-circuit the process.

The root of that mechanism is surgeons' feet and hospitals' goal to tie up market share. If a hospital demands that an orthopedic surgeon use a different manufacturer's implants and he refuses because he is unwilling to learn to use new instruments, the surgeon can leave that hospital and join another, taking his patients with him. The hospital would lose much more in profit than it would gain had it been successful in consolidating purchasing. Status quo maintained.

Intertwined with this are plain old profits on a procedural basis. The bulk of the patients who receive orthopedic implants are Medicare beneficiaries. The way Medicare reimbursement works is that each patient case is categorized into a diagnosis-related group (DRG). Medicare then pays hospitals a set rate for that patient, no matter the number of procedures, based on the average resources used to treat patients in that patient's DRG.

The hospital essentially gets a flat rate and is expected to be able to generate a reasonable profit after materials and labor. The DRG system closes the vicious circle. Price competition on the implant portion of the procedure is not incentivized by this system, as no one has much to gain by encouraging it -- except perhaps the American taxpayer, who picks up the bill.

But the taxpayers' employees in Washington may be about to make some changes. In the next few months, the Centers for Medicare and Medicaid Services (CMS) will release a proposal for reweighting the DRGs that, if it follows the recommendations of the Medicare Payment Advisory Committee, will be based on the actual cost of providing care. It's highly possible that the CMS will try to change the pricing or incentive structure with regard to orthopedic implants. I can by no means guess how much this would help or hurt any specific company, and whatever is initially proposed will likely look very different from whatever is finally put in place.

At the end of the day, what this comes down to is basic economics. Many competitors and essentially one buyer, Medicare, are in the equation -- let's find the market price based on supply and demand. To me, this is starting to look a lot like what is ailing Big Pharma, though without the pesky generic competition problem.

So who are the players and what will happen to them over time?

Stryker (SYK Quote - Cramer on SYK - Stock Picks), Johnson & Johnson's (JNJ Quote - Cramer on JNJ - Stock Picks) Depuy division and Zimmer (ZMH Quote - Cramer on ZMH - Stock Picks) are the big three -- together they command the largest chunk of market share. Biomet (BMET Quote - Cramer on BMET - Stock Picks) and Smith & Nephew (SNN Quote - Cramer on SNN - Stock Picks) fall into the next tier. They also have diversified businesses, R&D and sales and marketing infrastructure that can be scaled appropriately, if necessary. Smaller competitors, including Exactech (EXAC Quote - Cramer on EXAC - Stock Picks) and Encore Medical (ENMC Quote - Cramer on ENMC - Stock Picks), face different challenges, as scale is not on their side.

I believe that over time, an appropriate incentive structure on orthopedic surgery pricing and reimbursement will reduce revenues and gross margins for all the players. Operating margins may stay flat, though, as I believe a lot of fat could be trimmed from their marketing machines. This probably just means fewer dinners at The Palm and less Caribbean fishing trips for surgeons.

Biomet has reportedly hired Morgan Stanley to explore alternatives. I believe it will be very hard to find a natural buyer in the face of the looming changes that I've discussed. I believe these undercurrents are the reason why the company's founder and CEO, Dane Miller, stepped down recently. The writing has been on the proverbial wall for quite some time.

Smith & Nephew has often been rumored to be a likely suitor, especially since it lost a takeover battle for Centerplus to Zimmer. But as Smith & Nephew CEO Christopher O'Donnell told me, the Centerplus acquisition wasn't about buying market share; it was about strategic distribution footprint. Centerplus had a distribution footprint that didn't overlap Smith & Nephew's. Biomet does.

The future is far from clear, but hopefully this article can help when considering these companies' prospects over the next few years. There will be relative winners and losers, certainly -- so proceed with caution.

With respect to Biomet, think long and hard about what type of premium a buyer would pay to get into a business with this set of dynamics. On the other hand, if a premium buyer shows up, train an eagle eye on its business -- its house may be in worse shape.