Conformis: The Short-Term Challenges Are Overshadowing Significant Long-Term Opportunities

Aug. 13, 2019 12:29 PM ETConformis, Inc. (CFMS)SNN, SYK, WMGI, ZBH13 Comments
Carolina Doc profile picture
Carolina Doc
150 Followers

Summary

  • The soon to be released total hip system is being undervalued by the market.
  • Potential of medicare approval for total knee replacement at surgery centers in 2020 is a huge opportunity.
  • The Aetna reimbursement issue will pass.
  • The White Diamond Research article (an editor's pick) is filled with inaccuracies.
  • I believe the company will be purchased for its technology by a larger orthopedic company.

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Carolina Doc is a Practicing Orthopedic Surgeon and Investor

Background

I am a fellowship-trained board-certified Orthopedic Surgeon who performs Hip, Knee, and Shoulder Replacements. I do not use Conformis's (CFMS) products (I don't like being a shareholder in products I use) but have a partner who does and has discussed the company's products at length with him. I have done a significant amount of research into the company, have evaluated the company's systems, and believe there is a tremendous amount of misinformation in the market about the company. A negative article about Conformis was recently published on Seeking Alpha and was filled with incorrect statements and observations. The article was even selected as an "Editors Pick".

I believe the company has a long runway ahead of it and is undergoing temporary correctable issues.

I will address the incorrect comments made in previous articles, recent challenges, and summarize the opportunities the company has in front of it. Ultimately, I believe the company will be purchased at a significant premium to current market prices.

Company Description on its Homepage

Conformis is a medical technology company that uses its proprietary iFit® Image-to-Implant® technology platform to develop, manufacture and sell joint replacement implants that are individually sized and shaped, or customized, to fit each patient's unique anatomy. ConforMIS offers a broad line of customized knee implants designed to restore the natural shape of a patient's knee. In recent clinical studies, iTotal® CR, ConforMIS' cruciate-retaining total knee replacement implant and best-selling product, demonstrated superior clinical outcomes, including better function and greater patient satisfaction compared to traditional, off-the-shelf implants. ConforMIS owns or exclusively in-licenses approximately 500 issued patents and pending patent applications that cover customized implants and patient-specific instrumentation for all major joints and other elements of the iFit® Image-to-Implant® technology platform. ConforMIS believes its iFit® Image-to-Implant® technology platform has application to other major joints in the worldwide market for joint replacement products."

In English

The Company sells Knee and soon Hip Replacements that are custom made based on a preoperative CT scan. The Conformis system comes with custom disposable guides for each patient for how much bone to remove surgically and at what angle. The implants are custom made for each patient "on demand" and turnaround time is approximately 5 weeks. The system has the possibility of allowing the surgeon to more precisely remove bone and align components during the surgery.

Company History

Conformis IPO'd in the summer of 2015 at a price of $15 with 9,000,000 shares outstanding. The company had a significant interest in its technology and went on to trade at a multiple of 19x sales temporarily. The recent years have not been kind, and the company currently trades at a multiple around 1.2x sales. The company's "message" was a perfectly fitting knee every time. When a traditional knee replacement is implanted, a "best fitting off the shelf knee size" is selected. That can leave overhang or underhang (see picture below). Too much of either has been shown to decrease patient satisfaction with their knee replacement. Unfortunately, growth has not been as good as advertised, and there has been a significant number of dilutive financings since the time of the IPO. Thankfully, the company is on better financial footing and has several developments coming that I believe will change its fortunes.

Source: Conformis 10-K

Recent Developments from Medicare Could be Very Positive for the Company

Just this past week, CMS (The Medicare Governing Body) proposed that in 2020, Total Knee Replacement could be reimbursed in the Ambulatory Surgery Center (ASC) Setting. This could potentially lower costs for the government but also allow surgeons to profit from their Surgery Center Ownership. While this would not be an option for unhealthy Medicare patients, it would be a significant opportunity for Conformis as their implants are ideally suited to the Surgery Center Environment. The typical total knee system may have as many as six or seven trays (these are large and heavy) that contain trials, cutting guides, jigs, etc. In order to do the surgery at a surgery center, all the trays to perform the surgery have to be brought to the center and sterilized at that center in advance of the case. Additionally, the cost to sterilize a tray is typically $60. This is an ordeal as most surgery centers do not have the number or size of the sterilization machines of a hospital (my surgery center had to purchase a new sterilization machine when we started doing total knees at our center). Additionally, most surgery centers do not perform enough surgeries where an implant company is going to leave them at an ASC like they do at a busy hospital (trays are very expensive for a distributor and can cost over $20,000). Conformis has a "Total Knee in one tray" system that is ideally suited to this environment. Additionally, most ASC staffs aren't as familiar with Total Knee Replacements.

Below is a picture from the Operating Room of my Practice's Surgery Center

Source: Picture Taken August 2019 My Surgery Center

Our staff is fantastic, but they are new to the total joint arthroplasty and there is obviously concern about keeping up with the surgeon to the point our techs put the surgical technique for the current system up on the wall. Customized jigs in the Conformis system simplify the procedure for the staff. With the Conformis system, there are fewer cutting jigs to place and remove and no need to measure for which implants to select. Everything is pre-sized.

I am not sure when CMS will make the Ambulatory Surgery Center position official, but there are too much cost savings available for it not to. A recent study found that, on average, a total joint arthroplasty is 40% cheaper when performed at a Surgery Center. Additionally, demand for total knee and hip replacement is projected to rise exponentially in the future. This will be a tremendous burden on the healthcare system, and this is one area where cost savings can be easily achieved.

The company is somewhat late to market with an uncemented total knee replacement relative to some other companies, but it is in process for 2020/2021. The healthier patients who will have surgery at an ambulatory surgery center typically will have good enough quality bone to be a candidate for an uncemented total knee. Not cementing a knee further increases the speed of the procedure which will also be a benefit at a surgery center. I believe not having an uncemented knee to market is what has been keeping the company from making market share gains in the total knee market. The total joint surgeon in my group told me he would "use their system much more often if an uncemented CR knee was available." Personally, as an occasional total knee surgeon, I would also be much more interested in using the system when the uncemented knee option is available.

The New iTotal Hip System is a Game-Changer

I had the opportunity to see and demo the Conformis Total Hip at the American Academy of Orthopedic Surgeons conference in March of this year in Las Vegas. My attitude prior to seeing the hip system was "this company is wasting their cash on a total hip when they should be directing all their efforts towards an uncemented knee system." I was extremely impressed by their Total Hip and think it has the potential to be a game-changer in arthroplasty. The surgical technique for the hip system is found on the Conformis website.

I recently spoke to a total joint surgeon who is an attending surgeon at the hospital where I did my residency. I was asking him what he thought of a current resident my group was considering hiring. He responded, "he is an excellent surgeon and the only resident I have let due an acetabulum since I have been an Attending here." He meant this as a complement because most of the trouble in a total hip operation is on the acetabular component side (there are two parts to a hip replacement, the socket and the femoral component).

When a surgeon is placing a total hip acetabular component, bone is cleared out using a reamer. The Conformis Total Hip sets the angle of the reamer for proper orientation. It also has a depth stop, so a reamer cannot be "plunged" through the medial wall of the acetabulum which is a devastating and potentially life-threatening complication of the surgery. Additionally, when placing a cup in the pelvis, there are certain angles the surgeon is looking to implant the component at. The system has several holes in it which allow the surgeon to verify intra-operatively the acetabular component is being placed at the desired angle. Ideally, a surgeon is trying to place the acetabular component at a 40-degree angle as seen in the picture below. While this may seem easy, the patient may be obese, may have shifted during the surgery on the operating table, or the anatomy may not be like the textbook.

Acetabular Cup Abduction Angle

Source: Effect of acetabular cup abduction angle on wear of ultrahigh-molecular-weight polyethylene in hip simulator testing - Scientific Figure on ResearchGate

If the component is placed too vertical (the 70 degrees in the picture), the hip may become unstable or the plastic liner may wear out prematurely. If placed too flat or horizontal, the femoral component may impinge and lever the femoral head out of place causing a dislocation.

Additionally, a surgeon may desire to place an acetabular screw for additional fixation of the acetabular component. If a screw is not placed in a safe quadrant, a major blood vessel may be injured and may even result in patient death. The screws in this system are preset, and the operative plan provided to the surgeon tells he or she what length is safe if a screw is desired and the system presets where to place the screw.

To summarize, this system verifies that the acetabulum is reamed at the correct angle and to the correct depth, that the cup is oriented properly, and that screws that are placed are in the "safe zone". Essentially, this is the list of most of the things that could be done improperly on the acetabular component side of a hip.

Conformis has the opportunity to market this Total Hip System as "pre-navigated." Essentially, you have all the advantages of using a computer or "navigation" to help you place the system, but it is done ahead of time. Additionally, with Conformis, there is no expensive robot system that a hospital has to purchase for the surgeon (these can approach up-front costs of one million dollars). That potentially means no trackers that may get knocked off during surgery, no delays setting up the navigation computer in the operating room, and no pins in bones which can sometimes cause complications postoperatively. I have spoken with several busy surgeons who are hesitant to use navigation due to the additional time of surgery to set up computers and trackers to do the case.

When I was a resident, we were taught that the most common reason for an orthopedic surgeon to be sued was a leg length discrepancy after a total hip replacement. I believe the Conformis Total Hip may provide more precise leg length adjustment intraoperatively compared to current techniques. Currently, surgeons will template the case pre-operatively for what size components they are planning to use based on x-rays and will then verify leg length intraoperatively by feeling the patient's knees and heels. The Conformis preoperative plan allows surgeons to "fine tune" what they are planning on adding or taking away from leg length. Obviously, studies will be needed to prove this, but I believe it will likely be demonstrated in follow up studies.

I do not believe that a fellowship-trained orthopedic surgeon will feel that he or she has to use the Conformis Total Hip to properly place a cup and set leg lengths. I do, however, believe that the system will be ideally suited to the community surgeon (who are doing the majority of hip replacements in the United States today) who desires some intraoperative checks during surgery to make sure the components are properly positioned. I did my orthopedic training with the primary designer of the most used total knee system on the market. I remember him saying there is a "much greater need for navigation in the hip than the knee."

There is a Significant Opportunity in the Shoulder Market

I believe there is an additional opportunity for a "pre-navigated" shoulder. Although Conformis does not currently market a total or reverse shoulder, it is in excellent position to partner with an orthopedic company. Essentially, a small plastic jig would fit over the native glenoid. This would set the screw trajectory but not involve computers, sensors, and additional operative time (the part of navigation that drives surgeons crazy). The preoperative template would then advise what length of screw to use. I was recently at an industry sponsored event for a company who is a leader in shoulder surgery. While some surgeons in attendance did not have any issues using a computer/navigation for every case even if it added 10-15 minutes to each case, there were some very high-volume surgeons who did. This technology could be added very easily and would target the high-volume shoulder surgeon who would like a check on the glenoid side but does not want to add time to his or her case.

Aetna Reimbursement Issues are Temporary

On the most recent conference call, the management of Conformis provided a market update stating that they were seeing an increasing number of denials by Aetna for their total knee replacement. Additionally, Aetna had classified customized knee replacement as "experimental". Aetna is the third largest commercial payor in the United States. While Aetna is a small portion of the company's business, it did impact the company enough that they reduced their guidance. The policy is listed on the Aetna Webpage.

I have reviewed the studies cited by Aetna for its policy and it is rather confusing. They cite one study that actually found less blood loss in the Conformis Total Knee patients versus a standard implant. They also cite a study that states Conformis increased efficiency in the operating room due to fewer trays.

I would expect the Conformis Total Knee to be allowed again at some point in the future with Aetna. A similar situation occurred to the company with Cigna (CI) a few years ago. It was resolved, and Cigna is currently approving the Conformis product. Importantly, there is not a published article I am aware of that shows customized total knee replacement to be inferior to conventional total knee replacement. I also believe the impact to stock has been out of proportion. The proposed loss of sales from Aetna is approximately 4 million dollars of sales for the rest of the year. This is about 5% of annual sales. The stock was down 40% on Thursday 8/1/2019.

There is Value in the Company's Patents

It is very difficult to analyze the value of a company's patents. I believe the most practical way to evaluate a portfolio is to evaluate licensing fees from other competitors. In September of 2018, Conformis entered into a patent settlement with Smith & Nephew (SNN) for $10,500,000 to license Conformis technology for off-the-shelf component use for the knee. Conformis has over 300 patents relating to patient-specific arthroplasty, and I do believe this settlement shows there is value in the company's patent portfolio. Additionally, the above settlement was only for knees, and there could be licensing opportunities with other companies for other joints.

Cash Burn is Slowing

One of my concerns with my investment in Conformis was the rate of cash burn the company was experiencing. I expected some kind of dilutive financing would be required if the rate did not slowdown in calendar 2019. On June 25 of this year, the company announced what I would call a very shareholder-friendly debt restructuring. Innovatus Capital purchased 3 million shares at then market prices (3.87) and Conformis was given $30,000,000 in debt financing to refinance its debt outstanding. This structure brought minimal dilution to current shareholders.

The company had approximately $21,000,000 of cash on hand as of June 31, 2019. Additionally, the company decreased its cash burn to approximately $4,000,000 last quarter. At the current burn rate, the company has 5 quarters of cash on hand and is projecting an increase in gross margin as we enter the second half of the year which could further reduce the burn rate.

There is a Margin of Safety at Today's Valuation

In 2013, Wright Medical sold their arthroplasty line to MicroPort Orthopedics when they focused on becoming an extremity company. This was an arthroplasty line I would call "commoditized." I am not aware of any differentiating features of the line other than perhaps the medial pivot knee replacement. The transaction took place at 1.1x sales. Conformis has significant intellectual property and a unique approach to the arthroplasty market. My worst-case scenario which could involve a poor hip launch, product recalls, FDA delays, etc. is, therefore, 1.1x sales. That valuation is approximately 10% less than today's valuation. I believe there is a substantial margin of safety at today's price.

Addressing the Bear Thesis

The article that was published was filled with incorrect statements. When discussing the total hip system, the authors actually cite a physical therapist's opinion of the Conformis system. Physical therapists don't perform arthroplasty surgery and would be the wrong profession to evaluate this system. A physical therapist, who happens to have total hip replacements, will know nothing about the "safe zone" to place an acetabular screw, how much bone to remove, what causes a component to loosen, disadvantages of different bearing surfaces, and a multitude of other details of how the surgery is performed. A physical therapist's "job description" is to help patient's rehab after a surgery - not perform it.

Several counterpoints to the article are made below.

1) "Clinical studies have failed to prove customizable implant clinical benefits."

There are situations where a computerized system has to be used (previous fracture, retained hardware) and there are clear benefits to using these types of systems.

Source: Indian Journal of Orthopedics Jan-Feb 2013. Total knee arthroplasty in extra articular deformities: A series of 36 knees

In the above case with femoral deformity, traditional femoral referencing techniques cannot be used. When performing a total knee replacement, a surgeon makes a hole at the end of the femur and then inserts a long metal rod to align the cuts that will be made. Clearly, with a crooked bone or hardware in the way, this is not possible. The above case has to be either performed navigated with a computer or "prenavigated" with Conformis.

While the above case is somewhat rare, it is clearly an example of when a patient-specific system like Conformis is beneficial to the patient. Additionally, if the Conformis system is equivalent in long-term outcome (I suspect it is) but easier to use for the operative team with fewer trays that is a benefit. Conformis is the only knee system I am aware of that comes in one tray.

On average, this is a savings of $300-400 a case and does not include the ability to "turn over" a room faster for the next surgery.

2) "Lack of established clinical benefits result in denial of extra reimbursement required for the customizable implant."

There is a net cost savings with this system due to having fewer trays to perform the surgery. It saves several hundred dollars per case in sterilization costs which is about the additional cost the implant commands in the market. Additionally, the potential for less blood loss decreases the transfusion rate which is very expensive and comes out of the total reimbursement for a hospital (DRG). There has been a recently released study showing decreased costs of total hospital stay when a Conformis implant is used.

3) "Other companies came up with similar customizable products."

I am not aware of any orthopedic company with the combination of BOTH custom-made implants and jigs in use in the total knee or hip market today. There are patient-specific jigs available with other systems, but custom off-the-shelf implants are then implanted at the time of surgery.

4) "Reviews from a Chatroom are Very Negative"

The author posts one review of a patient who is unsatisfied because their Conformis Total Knee is "draining" like it is a smoking gun. A draining total knee is infected until proven otherwise and has nothing to do with the type of implant chosen. The risk of infection in a joint replacement is one in a hundred, on average, and not dependent on the brand of total knee. Risk factors for an infection are things like obesity, smoking, long surgical time, and diabetes. I would challenge the author to find a study that correlates brand of implant to infection risk.

Acquisition-Friendly Orthopedic Environment

There has been a tremendous amount of consolidation in the orthopedic space. Some of the prices I see being paid for niche products is mind-blowing.

In March of this year, Stryker purchased a balloon spacer for implantation in shoulders. This product addresses the tiniest sliver of the shoulder arthroplasty market - patients who are too sick to undergo a reverse shoulder arthroplasty. It sold for $220,000,000 including milestones.

Conformis addresses the 7 billion dollars total hip market and the 8 billion dollars total knee market. I believe, ultimately, the company will be purchased by one of the major players to fold its technology into their existing lines.

Summary

In my opinion, Conformis has two opportunities in front of it which could be significant developments in the total joint market. If it succeeds on just one of the two, I believe the company will be worth multiple times more than its current valuation.

The first opportunity is the release of an "uncemented total knee in one box" which would be ideally suited to the surgery center environment. Going forward, more total joints are going to be performed in the surgery center setting. Most centers are not going to purchase navigation machines (they can cost several hundred thousand dollars) and this is the best alternative. Additionally, I believe there will be additional uptake in the hospital setting when an uncemented option is available. In the aforementioned scenario of an FDA approved uncemented knee in a Pro-Surgery Center Medicare environment, I would place a multiple of 4 times sales on the company and would anticipate significant sales growth from today's levels. 4 times annual sales of $100,000,000 would be a $400,000,000 market capitalization based on only the knee side of the business.

The second is the opportunity for the Conformis Total Hip system to capture significant market share for the orthopedic surgeon who is looking to place the acetabular component more accurately without having to use intraoperative navigation. The total hip market is estimated to be almost 7 billion dollars annually worldwide. I can easily see Conformis capturing several percent of the market with their new system with a successful launch. If one were to project a 2 percent market share (I believe this is very conservative) at a valuation multiple of 4 times sales, we will be looking at a $560,000,000 market capitalization on only the total hip side of the business. This is more than quadruple the current market capitalization.

If both opportunities are achieved, I believe this is a billion-dollar orthopedic company.

This article was written by

Carolina Doc profile picture
150 Followers
Carolina Doc is a Fellowship-Trained Orthopedic Surgeon as well as a Real Estate, Stock, and Private Equity Investor. He has a special interest in the medical and technology space and has served as a sub-investigator for several FDA approved products. He is among the busiest Orthopedic Surgeons in a large metro area and specializes in Sports Medicine, Joint Replacement, Arthroscopy, and Fracture Care.

Disclosure: I am/we are long CFMS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: Carolina Doc and his immediate family own stock in Conformis.

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