We have launched coverage of Osteotech and Orthologic and we briefly examine why Medicare Reimbursement is such a minor influence on orthopedic pricing.
BY EDITOR, MAY 19, 2003
Osteotech is in the midst of a significant turn-around year with sales expected to reach or exceed $96 million and for cash flow (defined as EBITDA) to clear $23 million. This stands in contrast to last year's $83 million in sales and $1.6 million in EBITDA. Osteotech's sales growth rate at 16% is in line with overall orthopedic and spinal implant industry averages - but its cash flow rebound is truly significant.
The company's stock has responded and at the current $230 million market cap is at the highest level since August, 2000 - two and half years ago.
The causes for Osteotech's recovery are really two-fold. First; the absence of either production delays or lawsuits. Both significantly distracted management's time and resources over the course of the past three years. Second; a new tissue processing arrangement with LifeNet (one of the country's largest tissue banks) to supply the DePuy / Acromed division of JNJ with allograft bone fill. DePuy Acromed is the second largest supplier of spinal implants after Medtronic's Sofamor Danek subsidiary with about $250 million in spinal hardware revenue for 2002. Allograft bone graft is typically used primarily in spine implant surgery and DePuy/Acromed is the second largest supplier in this nearly $500 million spinal material market. We think this is significantly good news for Osteotech.
We are forecasting that sales will rise to $96 million for 2003 and that reported earnings will reach $0.48 per share - less than management's guidance but reasonable given the rocky past. With EBIDTA likely to reach $1.10 per share - we think reported EPS is of lesser fundamental importance.
The full Osteotech launch comment including sales and earnings forecasts through 2006 are available at:
www.HealthpointCapital.com.
OrthoLogic is the leading tissue healing company nobody has heard of. Its electromagnetic stimulation products hold the #3 market position behind Biomet's EBI subsidiary and Orthofix (sold via Stryker) and we estimate will generate $46 million in sales in 2003, up 20% from last year's levels. OrthoLogic's bone stimulation products are expected to kick out an impressive 85% gross margin this year.
But it is Chrysalin', OrthoLogic's small molecule product, that could revolutionize the tissue healing and regeneration industry.
Chrysalin is a peptide that, in animal and clinical trials, has shown to significantly speed healing and may be able to re-grow cartilage in articulating joints. It is also cheap and versatile. Unlike the currently FDA approved tissue healing compounds - the recombinant bone morphogenic proteins like OP-1 (Stryker) or RhBMP-2 (Medtronic/Sofamor Danek).
By this time next year, Chrysalin will be in three potentially revolutionary clinical studies; a Phase III fresh fracture study, a Phase I/II spinal repair study and a Phase I/II cartilage repair study. Preliminary studies show that Chrysalin heals distal radius fractures 25% faster than a control group.
We forecast that OrthoLogic's bone stimulation revenues will rise 20% this year to $46 million but that earnings will in fact turn to an operating loss of over $600,000 (offset by the company's sizeable interest income arising from the company's $28 million in cash). The loss is due to the cost of Chrysalin's clinical trials.
What is the potential for Chrysalin? A 1% share of the fresh fracture market plus a 1% share of the non-union fracture market (which would be an off-label use), plus a 1% share of the spinal implant market plus, finally, a 1% share of the potential cartilage repair market adds up to, we estimate, revenues of over $70 million.
We think Chrysalin's earliest potential FDA approval is in 2006. During the intervening years we are modeling for double digit electromagnetic revenue growth and losses to pay for Chrysalin's clinical trial work.
Medicare: The Paper Tiger
Medicare has lowered the reimbursement rate for DRG 209 (the principal code for large joint reconstruction) in six of the past eleven years. But manufacturer list prices for DRG 209 implants have risen all eleven years and have not changed in any way that could be considered to be statistically correlated to Medicare reimbursement change.
The obvious question is why haven't Medicare reimbursement rates had an impact on list prices for implants?
Four reasons, we believe, explain this phenomenon;
- Medicare pays only 50-55% of DRG 209
- a. Supplemental insurance pays 15%
- b. Patients pay 18%
- c. Medicaid pays 12%
- Orthopedic implants represent from 4-10% of the procedure cost. Labor and professional fees represent 66% of the procedure cost, pharmaceuticals are 5%, services like telephone, and TV, etc. are 11% of costs and so on. (data from Centers for Medicare and Medicaid Services, U.S. Government.)
- Medicare's DRG 209 reimbursement covers the entirety of the large joint procedure cost - of which, as we pointed out above, the implant is often less than 10% of the cost. In fact, according to Medicare's own data, instruments and devices tend to amount to only 3% of total hospital expenses.
- Manufacturer's more expensive, minimally invasive; lifestyle implants are targeted to younger, non- Medicare patient populations. Therefore, at the margin, list price increases and revenue increases are disproportionately influenced by such non-Medicare implants and patients.
Bottom line: Medicare is too small a reimbursement factor (paying for only about half the procedure cost) and implants are too small a cost factor (amounting to less than 10% of a total procedure cost) to sway pricing decisions at the manufacturer level.
Going forward, we expect Medicare's reimbursement rates for DRG 209 to fall and rise at pretty much the same rates they have for the past decade - and net, net be a non-factor with regards to manufacturer list price strategies. Of more importance, we believe, will be the hospital negotiating power and their increasing willingness to pushback at manufacturers - asking for and in some cases demanding 30, 40% discounts to those list price tables. We've therefore concluded that orthopedic implant price increases are destined to moderate over the coming decade and we are forecasting that the rate of growth will average 3% on an annual basis.
