Whether it's on Main Street or Wall Street, the orthopedics industry has been become a focus of attention for both the relevant patient population seeking to improve its lifestyle as well as savvy investors hunting for lucrative opportunities. The US orthopedics industry is benefiting from robust demand for technologically advanced products that accommodate the increasingly active Baby Boomer lifestyle, as well as the sedentary lifestyle that accompanies the escalating levels of obesity in the US. We discuss these as well other underlying drivers.
The US orthopedics industry -- which covers hip, knee, spinal, shoulder, and trauma implants -- grew by 10.4% in 05 and is now valued at approximately $8.8B dollars. This market is expected to grow over 50% [CAGR 13%] over the next 5 years. Sales of spinal implants accounted for the lion’s share of the pie, approximately 39%. With its monolithic insurance system, the US accounted for over 70% of global orthopedic sales ($12.5B).
The major drivers of the orthopedics industry include robust demographics, pricing pressures, FDA regulation, and shortened product life cycles. EBIT margins at the top five firms in the orthopedic space hover around 30%, extremely attractive when coupled with the fact that these firms generate healthy cash flow, offer returns above and beyond their cost of capital, and manage their balance sheets exceptionally well.
The orthopedics industry itself falls under the medical devices umbrella. The medical devices and equipment group consists of companies that provide technology to hospitals, physicians, nursing facilities, and outpatient units. From needles to pacemakers to artificial discs, the industry generated over $148B in sales in 2004, a 14% increase from 2003. Thanks in part to the explosive growth of drug-eluting stents, industry revenues climbed 34% from 2001-2004. In the US, orthopedics account for nearly 19% of all medical device sales.
The Graying of America and the Delay of Morbidity
There are currently 77M Americans born between 1946 and 1964, also known as the Baby Boomer generation. This group accounts for 17% of the US population and is expected to climb ~ 700 bps by 2030. On a global scale, the number of people aged 60 or older is expected to grow to 2 billion by 2050. Whereas in 1900, people were expected to live to age 50, today people are expected to live until the age of 80. This delay in mortality has dramatically altered the medical landscape and driven up demand for cutting edge products.
The Baby Boomer population is at once incredibly active and paradoxically unhealthy. In the US, 80% of people over the age of 65% have at least one chronic condition. 60% have arthritis, which bodes well for manufacturers of reconstructive implants. Osteoarthritis, an inflammatory condition that afflicts over 50% of all people over the age of 65, leaves hips and other joints weak, which sparks procedure volumes. Arthritis risk has increased along with the obesity rates of the baby-boomers, and arthritis cases attributed to obesity rose from 3 percent to 18 percent between 1971 and 2002, according to researchers at Beth Israel Deaconess Medical Center [BIDMC].
Arthritis and obesity notwithstanding, Baby Boomers plan to lead active lifestyles well into their later years, according to the 2005 Del Webb Baby Boomer Survey, which discovered that 50% of Boomers ages 50-59 will buy new homes for their retirement. As long as Baby Boomers want to enjoy lifestyles that allow them to remain physically fit and socially active -- whether it be through exercise, dating, or working beyond retirement – the orthopedics industry will have a vast market to tap into.
The 3rd Party Payer System and the Big Pushback
With health care costs have outpacing inflation 16 of the last 17 years, the recurring question seems to be: who’s paying?
According to Ed Kroll, senior healthcare analyst at Cowen and Co., the US government will become a much larger payer of healthcare services over the next decade. In 2004, Medicare and Medcaid paid for 25% of the total US healthcare bill. (It is expected that by 2078, total Medicare costs will amount to twice the cost of Social Security. See Gold, et al for more details.) Currently, medical device companies are able to raise prices above inflation, which is a byproduct of a national health insurance system which bars employees from negotiating prices for medical supplies.
With government agencies such as Medicare and Medicaid fronting the bill, as it were, medical tech companies find themselves at will to hike prices and further improve their margin profiles, which Wall Street adores. Nevertheless, this pricing flexibility operates in cycles, and when times are tough, according to UBS analyst Ken Weakley, employers find themselves pushing a larger percentage of health care costs on to their employees, many of which are constrained to in-network HMOs. This “pushback,” as Weakley calls it, has put pressure on health care providers to lower costs. And whenever hospitals and other providers have to lower costs, they will negotiate on price, not quality. Thus, it not uncommon today to read about hospitals emphasizing “gain sharing” programs, which essentially reward doctors for saving hospitals money.
This trend has adversely impacted the economics and pricing profiles of med tech firms. The threat of reimbursement rate cuts, handled by Medicare, hounds orthopedic companies. According to Medical Device Link, an online information hub for the med tech industry, price cuts on high margin knee replacements, for example, could be as much as 5%. While disconcerting, this is nowhere nearly as bad as the catastrophic 15% declines witnessed in Asia. The price cuts are part of what S&P analyst Robert Gold calls the “trickle down effect”: when hospitals are left with squeezed margins, they naturally “pressure suppliers for better deals.” In sum, the cyclical and unpredictable nature of reimbursement rates to hospitals could impinge on the revenue and profitability profiles of the orthopedics industry. Pricing concerns notwithstanding, we believe the demand for medical devices and the disproportionately higher percentage of health care consumed by older citizens will more than offset such cost containment anxiety.
Innovate or Die: The Life Cycle of Medical Devices
High failure rates and rapid product cycles best characterize the medical device arena. There are a plethora of factors at play here, one of them being the allure of Wall Street itself: the rise in equity participation has spawned startup after startup led by doctors-cum-entrepreneurs hoping to dislocate the latest health technology. Equity ownership has encouraged scientific entrepreneurs to take on new risks in hopes of monetizing their intellectual property and hopping into the outstretched arms of VCs. But incumbent firms are not making it easy for them.
The Med Tech space, and by extension, the orthopedics industry, enjoys formidable barriers to entry. Beside large start up costs, new entrants must develop sustainable relationships with providers. According to Morningstar analyst Julie Stralow:
“Once comfortable with a vendor’s product set, surgeons have little incentive to switch to new suppliers since patient outcomes could suffer.”
Lacking durable customer relationships, new entrants will not last long. As price plays a larger and larger role in the dissemination of medical devices, the risk of commoditization threatens all the players, whose best defense is the set of solid relationships each maintains with medical practitioners, surgeons, and hospitals. Without these advantages, new entrants are destined to face slopes they can’t ski.
These manufacturers also scramble to maintain their technological edge through titanic investments in R&D, another barrier to entry. Typically, bigger is better: larger firms with economies of scale can hire the best scientists and produce at the lowest cost. Approximately 8-12% of medical device manufacturer sales are plowed back into R&D. (Large pharmaceutical companies spend, on average, 15% of their sales on R&D.) With the FDA approval process for medical devices less rigid than that for drugs, the rapid diffusion of innovation has made product exclusivity paramount among medical device manufacturers. As S&P analyst Robert Gold writes:
“Novel technologies that have little to no competition and clear cut clinical utility can command premium pricing.”
When those novel technologies are not readily available, medical device firms will go outside the firm and acquire development-stage businesses.
Legal and regulatory risk poses another hurdle. Since the early 1970s (stretching back to the Federal Food, Drug, and Cosmetic Act of 1938), the FDA has cracked down on the safety & efficacy of medical devices before granting marketing approval. In 2005, the DOJ subpoenaed a handful of firms for anticompetitive behavior and several widely used devices like implantable cardiovascular defibrillators (ICDs) were recalled off the market, as Guidant and Boston Scientific both found out. The one consolation a potential entrant might encounter is the low threat of substitutes across the industry: either patients undergo the necessary procedures, or they risk giving up the lifestyle they’re accustomed to and/or falling gravely ill. With Boomer disposable income at record highs, we believe the pendulum will swing in favor of the device manufacturers.
As much as these firms tend to differentiate themselves on quality, however, the current US healthcare system continues to push on price. If our currently dysfunctional healthcare system is to correct itself, it must once again begin to compete on value and innovation. Healthcare is not a commodity. We believe the firms far out on the innovation curve, with sticky vendor-physician/hospital relationships, will profit the most during the coming decade.
Meet the Players
Six firms control 70% of the orthopedics industry, a $22B pie. Zimmer Holdings (ZMH) is currently Stryker's (SYK) major competitor, arguably the leading global manufacturer of artificial knees and hips with a 30% market share. Johnson & Johnson's (JNJ) DePuy subsidiary and London-based Smith & Nephew (SNN) also contend aggressively. Biomet (BMET) (recently acquired by a private equity consortium) and Switzerland’s Synthes conclude the list.
In our opinion, diversified companies like Stryker and Johnson & Johnson (JNJ) – who are better insulated from cost containment pressures – will be rewarded with higher valuations in the market place. That higher market valuation is contingent, of course, on how these firms go about addressing the bevy of issues detailed in this report.
Disclosure: At the time of publication, the author and his family held a long position in shares of JNJ.