The Shifting Outlook for Orthopedics

Pricing, reimbursement, and spending pressures have become aural wallpaper for our industry. The effects of that insistent refrain from Wall Street analysts and anonymous bloggers (too numerous to mention) has begun to oxidize the infrastructure of orthopedic company valuations.

From an economic perspective, the business of manufacturing orthopedic products is about 0.2% of U.S. Gross Domestic Product (GDP) which is too small to have much macroeconomic impact. But when lost work time is factored in the impact is 8% of U.S. GDP and when patient impact (assuming roughly 75 million patients see their doctors for an orthopedic complaint each year) is considered, the effect rises to 21% of the U.S. population.

From a valuation perspective, the business of manufacturing orthopedic products is about 0.17% of all equity valuations that trade on the U.S. market which is close to its actual economic impact. Over the past 18 months the value of the orthopedic industry has declined to a point where, by most traditional valuation measures, the industry is either inexpensive or prospects for orthopedic sales and profits are worse than published estimates would indicate.

The debate about whether this industry is in for a difficult short term versus a more favorable long term because of demographically driven demand changes is an important one, which we will examine more in a moment. For now though, the thing that strikes us most is the remarkable 180-degree change in consensus outlook for the largest sector in orthopedics: spine surgery.

The Changing Outlook for Spine Surgery

Six years ago the consensus of most industry observers and investors was that spine surgery was the top investment choice for hospitals, manufacturers, private equity firms and generally speaking, Wall Street. It was then the most profitable service sector in orthopedics with high-dollar procedures, a payer mix weighted toward private payer (as opposed to Medicare) patients, favorable reimbursement updates from Medicare and the perceived long-term trend of increasing per capita utilization. In addition, new technologies (treatments for vertebral compression fractures and motion preserving implants) were expected to be the engine for sustained growth over the next several years.

What happened? While spine continued to be the most profitable service sector in most hospitals, changing attitudes at the FDA and CMS (Centers for Medicare and Medicaid Services) effectively mugged new spine technologies between 2004 and 2009 and set in motion, we think, an institutional bias against higher reimbursements for spine surgery. Today the consensus view is this:

• Motion preservation technologies will not replace fusion surgery

Demand Drivers  and Variables

Making projections is particularly dangerous at the peak and trough of a cycle. In 2004, the sales and earnings outlook for orthopedics looked sunny as new procedures (intervertebral implants, extremity replacements, MIS) were starting to roll out, Medicare reimbursement was rising, suppliers were reporting strong cash flows and new capital flowed in. So projections reflected those rosy days.

Today we are at the other end of the cycle, which should make us wary of predictions of imminent procedure or profit declines.

Then, there always is the “Stuff Happens” wild card. Last March U.S. Health Reform passed and with it comes a series of initiatives and changes which will affect every corner of U.S. healthcare. These changes  are scheduled to roll out in phases over the next 36 months.

It’s going to be another very interesting few years.

Here is how we analyze the factors that have been put in play and how, we think, they will likely shift trend lines in 2011 and beyond.

Long Term Outlook for Orthopedics Industry

Demographic Baseline

Aging populations in the U.S., Canada and Europe form the core of demand curve shift long term. Medicare forecasts as well as census data indicate that this is fundamentally an inelastic curve. Pain knows no economic limitations. As a result, we forecast that demand for orthopedic interventions will accelerate between now and 2040.

Utilization Rates

Per-capita utilization rates of orthopedic interventions have and will continue, we think, to shift the basic demand curve upwards. Increased Medicare or other insurance coverage, lifestyle decision making, new information sources (like the Internet) and increased availability of orthopedic services globally will, we think, keep utilization rates rising.

Technology’s Effect

Technology can increase utilization rates for orthopedic procedures and diagnoses that lead to procedures. Between 1995 and 2005, surgeons and engineers did, in fact, innovate significant numbers of products. Changing 510(k) and CMS reimbursement policies however, increase the risk that product innovation will stop contributing to per capita utilization rates.

Source: Robin Young Consulting

The core demand for orthopedic products and services is driven by the incidence of several disease states that are clearly age-related: arthritis, osteoporosis, back pain, and soft tissue (ligament, tendon, disc tissue) deterioration. The numbers of people in the U.S. that are 65 years of age or older (the prime age for orthopedic interventions) form a baseline of increasing demand. Per-capita utilization rates, which are lower than might otherwise be expected, are affected, we think, by three factors:

• Increased rates of health care coverage—whether from Medicare or government mandated private insurance programs
• Continued lifestyle decision making
• New information sources like the internet which provides consumers with cost, quality and availability information.

So per capita utilization rates for orthopedic interventions will, we expect, continue to increase.

Technology, however, is the canary in the coal mine and has already, in our view, been hit with a blast of methane gas by the FDA and CMS. We think that the U.S. is no longer a leader in medical technology and the momentum has shifted to other countries like Israel, Europe and China. As a result, we are forecasting that the role of innovation in the United States will diminish in importance as a driver of utilization rates.

Industry Report Card

Change Drivers

Spine

Sports Medicine

Large Joint Replacement

Extremities

Trauma

New Procedures

C

A-

C

B

C

Implant Innovation

C

C

C

C

C

Biologic Innovation

A

A

B

A

B

Implant Pricing

C-

B+

C

B

C

Outpatient Procedures

B-

B+

D

B-

C-

Private-Pay Reimbursement

C-

C+

B

B

B

Medicare Reimbursement

C

C

B+

C+

B

Demographics

B+

B

A

B+

B-

Lifestyle Factors

B

B+

A

B

C

New Points of Care

C

B+

B

B

C

Growth Capital

C+

B

C

B

C

Expected Grade

C

B

C

B

C

Source: Robin Young Consulting

The greatest growth driver is new procedures that solve heretofore unmet clinical problems. With the changing tenor at the FDA and CMS, this driver is not expected to affect volumes significantly. The highest future grades, we think, will come in sports medicine, extremities and biologic innovation. No sector managed to grade higher than a “B.” Concerns regarding reimbursement rates and implant innovation prevented any sector from scoring higher. In fact, three of the five major orthopedic sectors did not rise above a “C.”

Sports Medicine and Extremities

Sports medicine and extremity repair have several of the most powerful growth drivers operating:

• New points of care like ambulatory surgery centers and independent and more entrepreneurial clinics. These points of care have the ability to build awareness of new treatments.

Biologics

Allograft stem cell products are now a routine biologic alternative and by this time next year, the first FDA-approved stem cell drug will be on the market. Furthermore, new trophic and biologic transplant implants are moving into the market which will expand the range of therapies for orthopedic patients. Cartilage repair technologies took a blow when Regen Biologics ran afoul of the FDA, but progress is coming on several fronts. By 2020, two or more regenerative treatments are likely to be on the market.

Conclusion: External Factors Hurting

Bottom line, the industry is earning a “C.” External factors have made the operating environment for orthopedic companies more difficult. It doesn’t have to be. Spine surgery will continue to be the largest single revenue producer in orthopedics and likely the most profitable sector for hospitals. Furthermore, if ever there was a time to accelerate the pace of innovation, it is now. Innovation in all areas including manufacturing and distribution can keep cash flows and profit margins strong for suppliers. Demand for orthopedic interventions, we expect, will rise significantly due to both demographic and utilization factors.

Hospitals, however, are hitting a personnel wall which will strain operating room capacities and drive administrators to reduce length of stays while also narrowing surgeon flexibilities. Spine is no longer the top investment choice for hospitals or Wall Street. But sports medicine and extremities have the potential to become the industry’s centers of innovation, particularly with respect to new procedures, points of care and biologic treatments.