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Merrill turns bearish on Orthopedics while Stephens puts its money into a sparkling Gem of a spine center. Guess who we think is the smarter investor! BY EDITOR, APRIL 7, 2003

Merrill Lynch's ratings downgrade of, in effect, the entire Orthopedics industry will rank, we think, with Business Week's infamous "Death of Equities" cover story - which coincided with the beginning of the greatest bull market in history - as one of the great examples of premature bearishness by a Wall Street analyst.

Merrill's basic thesis is as follows:

• Moderating Medicare reimbursement will cause manufacturer price increases to also moderate.
• Recon product mix derived price increases will also slow down.
• Reconstructive implants (hip/knee) are the core of orthopedics and as they go, so goes the industry.
• Recon revenues will grow 15% in 2003, but slow to 10% in 2004.
• Slower orthopedic sales growth will minimize upside EPS surprises.

Ummm, we disagree.

To date, Medicare appears to have had no effect on list price increases. As Table 2 (at the end of this section) illustrates, Medicare has lowered the reimbursement rate for DRG #209 (large joint reconstruction) in six of the past eleven years. It didn't matter vis a vis large joint reconstruction ASP list prices. In 1999, for example, Medicare reimbursement for DRG 209 declined 2.0%, list prices for devices used in that procedure rose 7.1%. The next year (2000), Medicare lowered DRG 209 reimbursement by another 2.1%. The large joint recon ASP rose 8.7%. And so forth.

We don't see any trends, current or prospective, which would indicate that the connection between Medicare and orthopedic list prices will draw closer. The industry, for example, is moving to younger, more active patients. Products increasingly stretch the continuum of care, moving ever earlier in the disease process with smaller, incremental modes of therapy. If anything, Medicare patients will decline  as a percent of the total number of orthopedic patients. If the past is any guide to the future, then it is no exaggeration to say that Medicare reimbursement change is very likely to remain disconnected from prospective list price increases.

The better issue, it seems to us, is what will hospitals do? Will they pushback on future price increases? Given the negotiated nature of most hospital pricing, we'd guess there is some pushback going on, and have forecast a modest 2% rate of future pricing increase.

Pricing is the least important factor determining future orthopedic revenue growth. Revenue growth for ALL of orthopedics will, we expect average a 16% annual rate of growth of which price changes will amount to just 2% of the total. As the following table illustrates, unit growth combined with technological innovation will be the principal drivers of revenue growth in the coming decade. Not pricing. Pricing, in fact, will be the least  important factor - even smaller than geographic expansion.

Demographic changes, lifestyle changes will drive, we forecast, an average annual 5% rate of unit procedural increases. Technology driven therapies will allow surgeons to address such large and underserved markets as osteoporosis (44 million patients), MIS hip, knee and spinal treatments (50 million patients) and begin to more frequently regenerate tissues with innovative biologic solutions.

Orthopedics is more than reconstructive implants. One of the surprises is that Recon has delivered such exceptional revenue growth these past couple of years. Indeed, one of the reasons Orthopedics has traditionally been a research back water is because Wall Street has historically considered Recon to be a mature, slow growing product category. In fact, over the past two years, Recon revenue growth has accelerated. And that occurred with really minimal impact from the 65 million aging baby boomers.

While reconstruction implants have delivered double-digit revenue growth, three other large Orthopedic sectors are growing even faster - spine, biologics and sports medicine. Spinal implants are now $2 billion in annual sales and are delivering 25-30% rates of annual growth to such firms as Medtronic (MDT:NYSE) and Johnson and Johnson (JNJ:NYSE). Only biologics products are growing faster and at $800 million in revenues, biologics is increasingly a key driver of industry revenue growth.

The top three industry growth sectors (spine, biologics and sports medicine) represent $3.8 billion in annual revenues and are growing between 20-25% annually. Reconstruction represents, we estimate, $5.1 billion in annual revenues and is growing 13% annually (Merrill's Recon numbers are $5.7 billion, growing 9-11%). The top three growth sectors are now 75% the size of Recon, but growing almost twice as fast. How could Merrill ignore spine, biologics and sports medicine when evaluating the prospects for future industry revenue growth?

Orthopedic Innovation is very strong and will drive continued product mix change. Whether it's the uni-compartmental knee, ceramic-on-ceramic hip, vertebroplasty, growth factors, or MIS hip, knee or spine, technology is pushing treatments up and down the continuum of care. Innovation is delivering the kind of lifestyle based outcomes that will, we believe, drive further penetration of existing markets. Our shorthand for this phenomenon is the Pepsi Generation becomes the Orthopedic Generation and that, we believe, will be essentially synonymous with innovation. This is a very significant phenomenon. We haven't seen its full impact. We see no sign that product mix changes have peaked. Further, given the nature of today and tomorrow's orthopedic patient, we can't imagine that orthopedic products won't continue to evolve into higher value-added, high performance products and that will affect revenue growth.

In the above table, we list the change in Medicare reimbursement for DRG 209, large joint reconstruction, from 1992 to 2002. As it shows, Medicare decreased the rate of reimbursement in six of eleven years. We also list, for the same years, the list price increase from manufacturers for DRG 209. As the table shows, list prices rose at varying rates every year between 1992 and 2002. The direction and magnitude of those changes were completely independent of the changes in Medicare reimbursement. Statistically, there was no connection.