The federal government's mounting scrutiny of orthopedic industry pricing practices for hip and knee replacement implants could convince Zimmer to more aggressively seek a presence in the artificial disc arena.

Wall Street insiders likely would look favorably upon a Zimmer acquisition in the emerging spinal disc space as such a move would decrease the firm's reliance on reconstructive hip and knee sales for top- and bottom-line growth.

Zimmer's stock slipped 5.8% to $77.81 on March 31 on news that the U.S. attorney's office in Newark, N.J. had issued the firm a subpoena requesting consulting contracts and certain other agreements between Zimmer sales reps and surgeons using its joint reconstruction products dating back to January 2002.

Orthopedics manufacturers Stryker, Smith & Nephew, Johnson & Johnson/DePuy and Biomet also received subpoenas from the U.S. Department of Justice on the issue on March 30-31 (¹ Also see "DoJ Probe Into Orthopedic Industry Could Rattle Upward Pricing Trend" - Medtech Insight, 4 April, 2005., p. 3).

The government probe appears to be an effort to alleviate pricing pressures on hospitals for orthopedic devices. Some analysts contend that surgeon loyalty to specific brands - achieved through consulting contracts - has enabled manufacturers to consistently raise prices of hip and knee replacement devices year-over-year.

The ongoing investigation could lead to prosecution under federal anti-kickback statutes and hefty fines. DoJ also could seek to create rules that significantly alter orthopedic firm/surgeon consulting arrangements going forward.

Substantive changes to reconstructive device pricing fundamentals could be particularly damaging to Zimmer, since hip and knee products accounted for approximately 78% of the firm's $2.96 bil. total revenue in 2004.

The firm is the leading player in the hip and knee implant markets, with about a 31% share in each space.

In a Jan. 31 earnings call, Zimmer reported quadrupling year-over-year Q4 earnings to $200 mil., partly due to continued strong pricing dynamics.

This performance helped buoy the firm's share price against the announcement of the DoJ investigation during the first quarter. Zimmer's stock slipped 2.9% in the three-month period (see chart: " ² 2005 M-D-D-I Index First Quarter Performance ").

Zimmer and its orthopedic competitors also could face an additional hurdle if the government decides to formally allow gainsharing arrangements between hospitals and physicians.

Gainsharing allows physicians to share in savings to hospitals that accrue as a result of increased clinical efficiencies, such as implanting less-expensive, high-quality orthopedic and cardiac devices.

In recent weeks, the HHS Office of Inspector General and Medicare Payment Advisory Commission separately came out with endorsements of "properly structured" gainsharing arrangements (³ Also see "OIG Okays Cath Lab Cost Savings Program Rewarding Physicians" - Medtech Insight, 28 February, 2005., p. 8).

HCA, the largest for-profit hospital group in the U.S., has said it plans to ask OIG to allow gainsharing with orthopedic surgeons as a way of inciting doctors to comply with the vendor list concentration purchasing practices it implemented in February.

Vendor list concentrations occur when a hospital or other purchaser decides to buy higher volumes of product exclusively from certain manufacturers in exchange for price concessions. Without gainsharing, previous attempts at vendor consolidation have resulted in surgeons looking for another employer allowing them more freedom of choice.

HCA plans to "save on hip and knee implant purchasing by concentrating buying to the three largest manufacturers (Zimmer, Johnson & Johnson and Stryker)," Credit Suisse First Boston analysts explain in a March 23 report.

Although gainsharing and vendor consolidation could negatively impact ortho firms' margins if the practices are widely implemented by buyers, Zimmer, J&J and Stryker may benefit from the new dynamics through increased volume and market share gains as smaller firms are excluded from hospitals' vendor lists.

Zimmer also could proactively resist pricing pressures on reconstructive devices by leveraging its work to spur profits for hospitals through physician adoption of its MIS 2-Incision hip and MIS Quad-Sparing knee procedures.

The Warsaw, Ind.-based firm plans to evaluate 1,000 surgeries conducted by surgeons at 10 sites to determine overall profitability per patient of its MIS procedures (⁴ Also see "Zimmer Aims To Sway Hospitals On MIS Cost-Savings, Dismisses Charité" - Medtech Insight, 13 December, 2004., p. 14).

According to CSFB analysts Adam Galeon, David DeMartino and Christopher Pasquale, Zimmer's MIS 2-Incision surgery is used in roughly 8% of the firm's hip procedures. They add it could address up to 25% of procedures as hospitals urge surgeons to adopt the technique, which can result in savings of about $3,000 per procedure.

Artificial Disc Liability May Seem Less Risky

Still, with uncertainty swirling about future pricing and margin trends for hip and knee implants, Zimmer might assuage investor fears by diversifying its product portfolio with the purchase of an artificial disc firm.

The company has been reluctant to throw itself into the emerging spinal disc space in the past due to the crowded marketplace and liability concerns.

However, at a First Albany Capital conference in December, CEO Raymond Elliot said Zimmer could be enticed to acquire "second-generation surgical discs and nucleus replacements, particularly when getting into hydrogels and a little softer set of materials" (⁵ Also see "Zimmer Aims To Sway Hospitals On MIS Cost-Savings, Dismisses Charité" - Medtech Insight, 13 December, 2004., p. 14).

Several smaller firms, such as Disc Dynamics and Raymedica, which manufacture Dascor and PDN-Solo nucleus replacements, respectively, as well as LDR Spine, developer of the second-generation Mobidisc artificial lumbar disc, could represent attractive options.

Zimmer's presence in the spinal category is limited to interbody fusion, cervical, thoracolumbar, non-fusion and biologic applications acquired through its 2003 Centerpulse purchase.

Stryker also might seek one or more "tuck-in" acquisitions in the near future to achieve its $6 bil. revenue goal in 2006.

In their recent report, CSFB analysts observe, "Stryker's balance sheet is debt-free, and there is little doubt that management will pursue acquisitions of complementary technology."

Stryker's stock fell 7.5% to $44.61 in Q1, with a 5.9% loss coinciding with the company's announcement about the DoJ investigation on March 31.

The full-scale launch of Stryker's Triathlon posterior stabilized total knee system, which began in early 2005, should help the firm continue its 20% earnings growth in the immediate future - a mark Stryker has met for the past 25 years, excluding a brief period of dilution from the 1998 Howmedica acquisition.

DJ Orthopedics' stock rose 16.9% to $25.05 in the first quarter, as the firm avoided a subpoena and reported Q4 revenue of $68.1 mil., up 24.7%. Besides outperforming its larger orthopedic peers, the issue also led all firms on "The Gray Sheet" quarterly index of 32 NYSE/AMEX-traded device and diagnostic stocks.

The composite crept ahead 0.6% in the period, following a 15% increase last year. Comparatively, both the S&P 500 and Dow Jones Industrial Average slipped 2.6% in the first quarter.

Boston Scientific Stock Takes A Tumble In Q1

Investors reacted warily to Boston Scientific's plans - announced in a Feb. 1 presentation - to accelerate R&D spending in its endosurgery and neuromodulation units. The company's issue fell 17.6% to $29.29 in Q1.

The firm hopes to accelerate development of newer devices, such as the Precision spinal cord stimulation system and partner Therus' SoundSeal noninvasive hemostasis system, in anticipation of escalating competition and ebbing revenue from the Taxus paclitaxel-eluting stent over the next few years.

The cash-rich manufacturer also might opt to bolster its cardiac rhythm management franchise through an acquisition. Presently, Boston Scientific is banking on its Cameron Health investment to provide an entry into the ICD market (⁶ [A#01310060007], p. 9).

The firm faces litigation exposure from separate breach-of-contract and patent suits with Medinol and J&J, respectively (⁷ 'The Gray Sheet' Jan. 24, 2005, In Brief). In a March 31 report, CIBC World Markets analyst John Calcagnini pegs the related financial risk at $1 bil., adding: "We believe a judgment of this magnitude is already in the company's stock price."

New to "The Gray Sheet" index in 2005 are Hospira (-3.7% to $32.27 in Q1), Ivax Diagnostics (-6.9% to $4.05) and Kinetic Concepts (-21.8% to $59.65). Pall and PLC Systems were dropped from the index.

Ortho Firms Feel DoJ Probe Price As Stocks Fall In Q1; Will Zimmer Diversify?

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