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Will body-parts makers saunter or stumble?
Boomers' swelling need for hip and knee replacements has propelled makers of orthopedic devices. But new regulation and competition may hobble them.
By Michael Brush
Companies that make replacement body parts for baby boomers have been the darlings of investors for years now, rewarding shareholders with gains of 100% and more since the start of the decade.
Its no secret why. There are some powerful demographic trends behind the rapid earnings growth of orthopedic-device makers such as Zimmer Holdings (ZMH, news, msgs), Stryker (SYK, news, msgs) and Biomet (BMET, news, msgs).
Baby boomers simply need more and more hip and knee joint replacements as they get older. Rising obesity levels are good for business, too, since heavier people put more wear and tear on their joints.
With those pieces in place, and with the stocks down 5% to 10% from recent highs, it would appear those stocks offer a good buying opportunity for long-term investors.
Regulators clear the way for competition
But there are reasons for investors to be cautious.
Federal regulators currently are looking into potential conflicts of interest in the way the equipment makers pay consulting fees to doctors who use their products. Such arrangements, critics say, have helped put the kibosh on competition.
And health-care regulators are allowing new ways for hospitals to share with doctors whatever savings can be generated when those doctors use cheaper orthopedic devices, provided the devices are of equal quality. That could hurt the device makers' pricing power.
Both developments could encourage competition and drive down the profit margins of the large device makers by giving hospitals more control in choosing orthopedic devices. The bottom line: Hospital companies like HCA Inc. (HCA, news, msgs) have been searching for ways to rein in the cost of orthopedic gadgets, and these developments may give them an opening.
Flat prices, stumbling stocks
To be sure, these orthopedic-device makers aren't in immediate danger of losing business, says Jason Wittes, an analyst with Leerink Swan & Co., a boutique health-care sector research firm. They already have contracts in place for 2005. But Wittes thinks healthy annual price hikes that have averaged 4% to 5% in recent years may begin to shrink in 2006 and perhaps turn into outright price declines a year or two later.
If so, that could reduce price-earnings multiples on device-maker stocks by some five points, says Wittes, meaning the stocks could see price declines of 20% to 25%. The stocks could fall this year, since the stock market takes predicted events into account well before they happen.
A spokesman for Zimmer says its a mistake for investors to jump to any dire conclusions about pricing. He says its too early to know how plans designed to split savings between hospitals and doctors will work in the real world.
Consulting services under scrutiny
One of the more immediate concerns for investors is federal scrutiny of practices that may have helped keep device-maker margins artificially high.
In recent public comments, Lewis Morris, chief counsel for the Department of Health and Human Services' Office of Inspector General, has alluded to ongoing investigations of consulting agreements between doctors and the device makers. To be sure, these are high-tech products, so device makers need to hire doctors to help design and test them. But some industry observers think consulting contracts are made overly generous and are part of a bigger plan to cement physician loyalty.
The Zimmer spokesman says all consulting agreements his company has with doctors are above-board and in compliance with strict codes of conduct established by the device makers' trade group. Brad Tandy, the compliance officer for Biomet, says his company follows the same codes, and has had guidelines in place since 1999. Representatives of Stryker declined to be interviewed for this story.
Giving doctors the OK to save money
Another move by regulators -- this time loosening some rules -- may also hurt the stocks. Federal anti-kickback rules set strict limits on the types of payments hospitals can make to doctors, because of concerns that hospitals may pay doctors for making money-saving decisions like discharging patients early.
But the OIG may be carving out exceptions. In a series of advisory opinions released in the last four weeks, the OIG has allowed hospitals to do two things to get a grip on the cost of orthopedic devices. First, it has expanded a 2001 opinion that hospitals are allowed to share savings with doctors who opt for cheaper supplies -- known as "gain-sharing arrangements."
Interchangeable body parts
Second, the OIG has approved hospital plans to set up committees to decide which kinds of devices are essentially interchangeable, because studies show they work equally well.
This second change, called standardization, is the real breakthrough, says Wittes. It means hospitals can now decide which products from an array of suppliers do just about the same thing. Doing so, big urban hospital groups like HCA and Tenet Healthcare (THC, news, msgs) can run more orders through one or two suppliers, and demand discounts for volume.
OIG advisory opinions arent broad regulations that apply to everyone. Strictly speaking, they only address issues raised by the specific industry player writing in for guidance. But the health-care industry watches these advisory opinions closely, to get a feel for what the OIG thinks is kosher.
There is clearly a change in the governments attitude to gain sharing and standardization of suppliers, says Wittes. One casualty will be pricing power of the orthopedic suppliers.
Zimmer -- the biggest orthopedic device maker -- doesnt seem too concerned about what is going on. We think it too early say whether gain sharing will have any long-term impact on prices, says Brad Bishop, a spokesman for Zimmer. Given that hospitals will have to have arrangements approved and get surgeon compliance, it is hard to speculate how much this will influence product pricing.
Jan Wald, an analyst with A.G. Edwards & Sons, points out that a continuing flow of innovative products commanding higher prices may help save the day. Zimmer, which has 26% of the orthopedic implant market and gets 75% of its revenue form hip and knee implants, rolled out 40 new products last year. They accounted for 18% of sales, says Wald.
Risky valuations
Meanwhile, the stocks trade at rich valuations that dont afford much room for surprise.
"All of these companies have been aggressive in raising prices in the last 5 years, and there is a strong relationship between their high valuations and expectations that they will continue to be able to raise prices," says John LaForge, a money manager with SRQ Capital in Sarasota, Fla. LaForge has short positions in Zimmer, Stryker and Biomet.
From a valuation perspective, Zimmer looks the most vulnerable. At $86 a share, Zimmer trades at 29.5 times 2005 projected earnings of $2.91 per share. On average it has sold for 24 times forward earnings in the past three years. Its trading at the high end of its historic range of 19.7 to 32 times forward earnings.
With forward price-earnings multiples of 29.3 and 25, Stryker and Biomet trade in line with their five-year average price-earnings multiples. But Strykers historic range is 19 to 41 times forward earnings, and Biomets range is 16 to 35.4. This suggests theres plenty of room for downside for each.
Insiders certainly seem cautious. Since November, insiders at Stryker and Biomet have sold $115 million worth of stock, according to Thomson Financial. In February alone, Zimmer insiders dumped $37.7 million worth of stock.
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