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Great Expectations: What Wall Street Wants from Orthopaedics Companies

Published: April 15, 2010
By: Robert C. Dunne
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Investors seek companies with solid technology and consistent growth.

Orthopaedic science is based on the need to relieve pain and keep people moving. As baby boomers grow older, they become subject to the aches and pains of an aging body and a gradual loss of mobility. The current generation does not easily accept the consequences of aging and looks to orthopaedic and musculoskeletal physicians for help. 
 
In recent years, orthopaedics has emerged from being a modest subsector of the medical device industry to a $43 billion worldwide market, according to industry estimates. With a range of treatment areas, it is now the single largest segment of the medical device industry (see Figure 1). 
 
 
The Scandinavian Total Ankle Replacement is manufactured by a company that received the third largest venture capital funding in 2009. Photo courtesy of Small Bone Innovations Inc.
Most investors in orthopaedics stocks are seeking consistent performance, with advancing sales, steady  earnings growth, and minimal disruptions from changes in economic conditions. The aging population drives demand for orthopaedic products, because older people are more vulnerable to deteriorating bones and joints. The orthopaedics industry also benefits from new technologies that offer better therapy or that provide surgeons with more treatment options. 
 
Many investors associate orthopaedics with large, well-established companies such as Johnson & Johnson, Zimmer Holdings, and Stryker. However, large manufacturers aren’t the only prospects. The industry provides opportunities for more aggressive investors to seek out smaller companies with significant new technologies. These investors may focus on the new issue market or invest in privately held venture capital situations. 
 
The Industry, the Players
Although seven large companies account for more than 60% of the orthopaedics industry, more than 70 publicly-traded companies participate in this market. When taking into account the small, privately owned businesses, more than 1700 companies are involved in orthopaedics. Larger companies such as Johnson & Johnson and Medtronic, both of which have a broad range of products in healthcare, have a significant stake in the orthopaedics industry as well. Johnson & Johnson’s DePuy unit has market strength in hips, knees, and extremities, but also participates in virtually all areas of orthopaedics. Medtronic Sofamor Danek focuses entirely on the spine and remains the market leader in this area. Stryker, Smith & Nephew, Synthes, and Zimmer are the largest publicly traded companies that derive the majority of sales from orthopaedics markets. 
 
Small to medium-sized companies ($100 million to $1 billion in sales) include Alphatec Spine, ArthroCare, Exactech, Integra Orthopedics, NuVasive, Orthofix International, and Wright Medical. Most of these companies concentrate on market niches rather than attempting to compete across the board with the industry giants. Some companies are still in an investment phase and have yet to reach their optimal level of profitability. As a group, they may offer greater potential than companies with more capital but also involve greater risks.
 
Orthopaedics stocks performed well in the late 1990s and early 2000s but have struggled somewhat in recent years. Growth from 1999–2004 reflected solid gains in procedures, combined with price increases that averaged 5 to 6%. New technologies such as materials, biologic products for orthopaedic surgery, and new products for spine surgery contributed to industry growth during this period. 
 
 
Figure 1. Orthopaedics is the largest sector of the medical device industry. Click on pie chart for larger view. Source: Viscogliosi Bros. LLC (New York City).
However, since 2004, the industry has faced more difficult times. Pricing flexibility has eroded, and the major orthopaedics companies were forced to reach settlements with the U.S. Department of Justice that have been on costly and burdensome terms. In 2008, orthopaedics stocks declined with the market but experienced a sharp rebound last year.  
The financial results of orthopaedics companies are not greatly influenced by changes in the economy, but they can still have an effect. Patients who have suffered fractures or are in severe pain must be treated. However, some elective procedures, such as knee replacements or arthroscopic surgery, can be postponed. Patients who have lost insurance coverage or are in fear of losing their jobs may also avoid elective surgery. During the current recession, knee surgeries, especially on younger patients, have been affected by the bad economy.  
 
Overall, worldwide orthopaedics industry growth was estimated in the 4 to 5% range in 2009, which is down from the typical 10% growth. Sales were weakest in the first quarter but showed an improving trend in the latter part of the year. For 2010, the industry is expected to experience growth between 7 and 8%.
 
Making an Investment
Customer loyalty is key to success in orthopaedics markets. Typically, a surgeon will use one or two suppliers. A company sales representative is present in the operating room and develops a close relationship with the surgeon. Ideas for new products often come from surgeons, who find ways to complete surgeies more easily and more effectively. As a result, surgeons develop close relationships with their device suppliers, and changes in market share are infrequent.
 
Investors in orthopaedics stocks are primarily looking for steady and reliable performers rather than high beta investments with volatile earnings and rapidly fluctuating stock prices. Although investors are concerned about potential product price declines, orthopaedic products are generally not sold on the basis of price. In many hospitals, surgeons control the purchasing decision but are not heavily involved in price negotiations. Nonetheless, hospitals that have a high volume of orthopaedic procedures are seeking—and often getting—low pricing. Generally, hospitals that buy in large volumes can negotiate lower prices from suppliers. In orthopaedics, these discounts are generally modest. 
 
U.S. orthopaedic device prices were estimated to be nearly flat last year. There is still some modest benefit in mix upgrades, which generally offset price reductions on older products. Mix upgrades occur when newer products with differentiating features replace older products. Most orthopaedics companies are able to realize higher prices for new products. 
 
Near term, when price increases in orthopaedics will be harder to come by, nothing worse than low single-digit price erosion is likely to occur, as long as current business practices persist. However, a shift in decision making from the surgeon to the hospital or the payer could change the business environment. 
 
Where the Challenges Are
The regulatory environment for product approvals is becoming more challenging, and PMA applications are receiving close scrutiny. It is anticipated that FDA will try to limit use of the 510(k) procedure, which shortens product review time and does not usually require clinical trials. The 510(k) process was intended for products that are substantially equivalent to those already on the market, but this concept has been stretched considerably. The vast majority of orthopaedic products being sold today have been approved under the 510(k) process.   
 
Reimbursement is another issue that is generating controversy in the industry. Until recently, products or procedures with FDA approval were routinely reimbursed, but this is no longer the case. CMS as well as insurance companies are taking a hard line on payment. Products with 510(k) approvals, but no formal clinical trials, have sometimes been deemed investigational and thus not eligible for reimbursement. Some examples of this situation in the orthopaedics industry include two-piece ankle implants and new approaches for spinal fusion.  
 
Going Public  
Typically, privately held companies that choose to go public have at least modest revenues and the potential for profitability during the next two or three years. In addition, the need to go public could arise because the business requires more capital for expansion, or the owners want to diversify their assets. 
 
Investors in initial public offerings (IPOs) are willing to take risks for higher growth. The investors who have short-term horizons are hoping for a hot issue (new stock issue that rises to a premium once the offering is completed) that quickly moves to a premium over the offering price. In orthopaedics, there have been successful offerings, but they haven’t occurred recently. 
Unique technology can be critically important in launching a successful IPO. Examples of orthopaedics IPOs that have performed well include NuVasive, which developed a less-invasive system for spine surgery, and Kyphon, which invented a unique way to treat vertebral compression fractures. Kyphon was acquired in 2007 for $3.9 billion by Medtronic for a hefty premium over its issue price.
 
Going public can be challenging. The company must select a reputable underwriting firm that understands the business and is capable of selling the stock to the public. Documents providing more information than the company disclosed as a private entity must be submitted to the U.S. Securities and Exchange Commision and must be made available to investors. 
Attorneys and accountants are also deeply involved in the process. During the final stage of the process, company management and investment bankers pitch the stock to investors.    
 
The last two years have been difficult for IPOs, but positive trends in the stock market could change this in 2010.  Selling the business to a larger company is another alternative in a market that is not receptive to IPOs. Although larger orthopaedics manufacturers have extensive R&D capabilities, they often look to acquire smaller companies for game-changing product ideas.  
 
Venture Capital
Venture capitalists (VCs) have pools of money that are aggressively invested in start-ups or early-stage growth companies that are not yet profitable. The VCs typically take companies through the development stage and fund operations until they are ready to go public or to be sold to a larger company. Since this is a high-risk business, VCs generally seek high returns of five to seven times the invested capital. For example, in the late 1990s and early 2000s, VCs invested heavily in Internet-related technology. Investment in this area has declined in recent years, and life sciences has increased as a percentage of total VC investments. 
 
Funding for medical device companies was down 27% for 2009  amounting to $2.5 billion for 309 deals. Trends in Q4 2009 were more encouraging, as medical device funding increased 13% sequentially, with  $719 million going into 87 deals. This trend bodes well for a stronger medical device VC market in 2010 and beyond. For example, in 2009, the third largest VC funding was for Small Bone Innovations Inc. It raised $108 million, which is more than the $100 million each raised by Twitter and Facebook during the same period. 
 
Conclusion
Analysts believe that orthopaedics will be a vigorous, growing market in the years ahead. Established products should show steady growth, while emerging markets such as foot and ankle implants and minimally invasive surgical techniques offer the potential for incremental industry gains.
 
The industry has challenges but nonetheless remains an attractive area for investors seeking steady returns. Innovation will be critical for growth, and although no single new product will contribute dramatically to sales in a specific year, it is important to have a steady flow of new and improved products. Ultimately, new products drive growth by addressing unmet medical needs and allowing surgeons to treat a broader range of orthopaedic and musculoskeletal conditions. 
 
Robert Dunne is the portfolio manager for Orthopedic Investment Partners Fund LP (New York City). 

Published in Orthotec, Spring 2010, Volume 1, No. 1


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