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Last week, medical device maker Arthrocare (ARTC) purchased Discocare, an entity they refer to as a “third party billing company”. While analysts superficially cheered the move, Citron has decided to look deeper into this unholy alliance with a most nefarious business partner. Management has attempted to spin the story as acquiring a third party biller that possesses a special “algorithm” to get insurance approvals. Citron believes that Arthrocare purchased Discocare to cover up a relationship that is predicated on fraud and deception.

It is Citron’s belief that Discocare and Arthrocare have been “partners” by design: partners in a scheme to supply medical devices to doctors who prey on minorities and the financially disadvantaged, for the purpose of bilking money from insurance companies. Here is a brief description of the scheme (pdf warning). This will give an idea as to how Arthrocare is actually increasing their spine revenues and at whose expense.

Why is the “spine business” important?

Sell side analysts and the company can’t have it both ways. When your larger divisions are missing estimates and experiencing shrinking margins and your company is resting itself on the small yet highly growing and profitable spine products division …. it does matter.

The headline of Broadpoint’s research report states:

Spine offsets weak ENT Performance

Some other analyst comments:

Spine again led the way on a growth basis…..the negative surprises came from ENT and Sports Medicine.

While the expansion in the spine business and the recent gross margin surge are certainly positive we remain cautious due to the ongoing slowdown in ENT.

It is the opinion of Citron that the sell –side analysts have been reckless in their disregard of common sense and have performed insufficient independent due diligence of Arthrocare’s spine division operations.

And we give the award for most naïve analyst to Sean Lanvin of Oppenheimer, who wrote on Dec 17th:

Based on our research we believe that Discocare is a consultant to physicians that specializes in reimbursements.

Who is Discocare, and what is Arthrocare buying for its $25 million in cash?

In the conference call on January 3, 2008, Arthrocare discussed their acquisition of Discocare. In this call, management of Arthrocare described Discocare as a third party billing company. This is a sharp contrast to what Arthrocare employee Jackie Marsh who described them as a “third party distributor that handles Arthrocare Products.”

How they describe Discocare:The truth about Discocare :
A Third Party billing company with a “unique algorithm”The word “algorithm” was used 18 times in the conference call as though it is Discocare’s “secret sauce”. This is the first the investment public has heard of this. Nowhere in any analyst research, Discocare material or website, or legal testimony has anyone ever mentioned that Discocare has an algorithm.
A “special group of people” who have unique skills in reimbursementsDiscocare is the largest customer for Arthrocare PDD (spinal procedure) products. Nevertheless, Discocare does not have a Dun and Bradstreet Rating. (With no other material supplier relationships, and a special exclusive relationship with Arthrocare, Citron surmises that a rating was not a business necessity.)
A established billing company based out of Margate, Fl.Discocare is not headquartered out of Margate Fl. The address they give in Margate is actually that of Med-Plus Billing. Discocare is based out of the office of Palm Beach Lakes Surgical Center as evidenced by their only sign of existence, a listed phone number.

It is the opinion of Citron Research that Discocare is nothing more than a billing arm of the Palm Beach Lakes Surgical Center, where the billing is directed by convicted felon Mark Iszydore. Below is a link to a company that was incorporated with Dr. Cutler and Kugler, (owners of Discocare) with Mark Izydore, who provides as his address on this annual report the same address as the Discocare office (large pdf warning).

Citron believes that Isidor is the architect of the Arthrocare reimbursement scheme. Here is some interesting reading on Isidor.

7 Year Itch= Déjà vu?

It amazes Citron what type of short term memory Wall Street has. In 2000, Arthrocare was highly criticized for causing investor confusion in the frontloading of licensing revenues and royalty fees from multi-year deals. Due to the “gimmicky” accounting their sales doubled every year from the mid 90s. That allowed their stock to go from a low of $6 to $62. CEO Michael Baker unloaded shares to the tune of $10.6 million and the stock quickly retreated back to $18. For more detail on this, read the Forbes Magazine article from October of 2000 – which was highly critical of Arthrocare’s aggressive accounting policies (pdf warning).

Conference Call

On January 3, Arthrocare held a conference call that did more to add to the confusion that to clear up the already “shady” story. When asked about the EBIDTA and inventory of Discocare, CEO Baker refused to answer any questions. True, legally he might not have to answer, but for the sake of disclosure and clarity, not to mention just having put his company into debt for the acquisition, these questions demand reasonable answers.

But instead of facts, here is some of the astounding quotes management offered during the call:

Now, to the acquisition: we are happy to be with you today to announce that we’ve completed the acquisition of a key third-party billing and reimbursement service provider called DiscoCare.

Why not mention that they are also your largest customer for spine products and owned by the largest end user of the product?

The DiscoCare model for ArthroCare’s Plasma Disc Decompression procedure is actually a highly disciplined treatment algorithm that we believe is the key to successful authorizations.

Is this algorithm patented and why haven’t we heard anything about this in the past, also why hasn’t anyone told Discocare management about this?

DiscoCare does not guarantee payments to a physician or a facility.

Funny, on the Discocare website it directly states, “Discocare includes a service package with each device such as authorization for procedures and facility reimbursement guarantees.”

So, it’s not clear that this is going to cause any increase in the revenue that we see.

How can a third party billing company/distributor of your fastest growing division not add anything to the top line? Have they being doing this for free?

We are going to now be absorbing DiscoCare’s entire cost structure and adding to it as we go through the year to build this capability out. So, I think that’s all we are prepared to say about that right now.

What is the cost structure? You have no office and no staff that can be verified.

And, remember Bill when we gave guidance for next year, we were already well along on our thinking about this — about doing this acquisition. So, this is not — that’s one of the reasons why we are reaffirming our 2008 guidance. We will not — it’s not incremental to what we were thinking about in ‘08 when at the time we gave the guidance.

You gave guidance on just “thinking about an acquisition”? Is there anything else you are thinking about?

And it was our judgment that we could not build up our internal capability as rapidly as we can see to take advantage of the opportunity.

How much and how long did the company spend to duplicate the Discocare model? If Baker wants us to believe that he couldn’t create a third party biller than he is either incompetent or lying…which one?

The Rosetta Stone

The tell tale sign to this whole scheme is the testimonies of Michael Denker, the director of Discocare, and Jackie Marsh, the sales manager at Arthrocare. This testimony is all less than 6 months old and shows the cover-up that is occurring at Arthrocare.

Former Arthrocare employee Michael Denker now runs Discocare. Discocare sells 1 product that they buy from only 1 vendor…it just can’t get any simpler than that. But look at what happens when Denker has to explain the Arthrocare/Discocare relationship under oath:

Q:How do they know—well, does the contract between Arthrocare and Discocare set forth a price for each convenience pack

A:That’s between Arthrocare and Discocare

Q:Do you have any knowledge as to the terms of the contract?

A: No

Q:Who with Arthrocare knows the terms of that contract?

A: Don’t know

Jackie Marsh is the territory representative for spine sales for Arthrocare. She is the rep for the largest growing product in its most concentrated region of South Florida. She should be responsible for more spine sales than anyone else in the company. This testimony was in August of 2007, not more than 5 months ago. She was questioned in great detail about the relationship between Arthrocare/Discocare (for sake of brevity we have excluded attorney objections):

Q:The sales price for the Arthrocare wand and needle is $7500

A:Yes

Q:For what period of time has it been priced at $7500

A: I don’t know

Q: Was it priced at anything other than $7,500 since you have worked for Arthrocare?

A: Yes

Q: When was the change

A: I don’t know

Q:Why was there a change

A: I have no idea

Q: And you don’t know what it was priced at before $7,500?

A: I don’t recall
(after being shown an invoice to the Palm Beach Lakes Surgical Center we get our answer)

Q: And the indicated amount for that unit is what?

A: $1,300

Arthrocare’s officers and analysts expect investors to believe that in an industry where no one except Arthrocare can get insurance reimbursement for their spinal PDD products, Arthrocare, through the magic of Discocare, can jack up their product’s price 500% and still grow the business by leaps and bounds. Where is the common sense here? How do the analysts read these testimonies of the two people closest to Arthrocare’s spinal products and Discocare, and are still unable to figure out that a “cover-up” is occurring? This also forces us to ask if Arthrocare is actually selling more wands or just selling them at higher prices and what is the true quality of the earnings.

Conclusion

Citron understands the severity of the charges we have made in this report against Arthrocare. We are prepared to defend everything we have written in a court of law. If Arthrocare elects to sue us, we welcome the lawsuit and look forward to discovery to bring light to what we believe is the company’s profit model having architected an intentionally predatory practice of medicine … However, we believe the insurance companies will get to them long beforehand.

Meanwhile, here is a list of questions that it would be most illuminating to have answered by management at Arthrocare’s presentation at the Needham conference this week (pdf warning). They probably won’t be answered anyway, but they certainly won’t be answered if they aren’t asked – and judging by the quality of existing research on the company, investors can’t count on the cheerleader analysts to ask the tough questions.

Disclosure: Author has a short position in ARTC

Source: Arthrocare's Acquisition of Discocare: Trying Put the Genie Back in the Bottle