Pre-Announcement Blues
BY EDITOR, OCTOBER 8, 2003
Two major allograft suppliers, Regeneration Technologies and Osteotech, pre-announced 3rd quarter results last week and, as a result, endured fairly severe sell-offs. While the reasons given by each firm were different, the fact that it was these two suppliers caused some observers to wonder about the vitality of the allograft industry. In this week's HealthpointCapital Fact Sheet we review allograft, its brief history and its outlook.
Allograft is a generic term for processed, donated human tissue (bone, skin, heart valves or other soft tissues) which is then supplied to surgeons for implant. The industry has grown up and is today characterized by large-scale, pharma grade, high volume processors.
What drove the industry's growth was a potent combination of product innovation and the growing realization that cellular implants – like allograft – perform better in patients.
The two milestone innovations for the industry were, we believe, Grafton® and RTI's engineered bone dowel. Grafton® represented a distinctly surgeon-friendly material with a measurable amount of growth factor proteins. Within a very short period of time, Grafton® captured a dominating share of the bone graft market. Its principal market was spinal fusion surgery as an adjunct to, or occasionally, a replacement for the painful, expensive second operation of harvesting from the iliac crest bone.
In the decade since Grafton® was introduced, every supplier of orthopedic implants has added an allograft based bone void fill similar to Grafton®. Grafton® has been losing share for some several quarters. Its manufacturer, Osteotech, has been diversifying and improving sales incentives for Grafton® sales people. Sales for the September quarter are going to be $19 million, according to management. That's better than we'd expected. But the incremental earnings from those revenues are less than management had expected. Osteotech's international diversification into a broad array of engineered allograft products – all of which sustained the top line – hurt the bottom line. Earnings, said management, would likely miss previous estimates and come in closer to $0.03-0.05 per share, not the $0.12 per share previously hoped for. Osteotech lost $70 million in value with the news.
Thinking about human bone as a raw material is an innovative and valuable idea. Human bone works as an implant. Its proteins, porous structure, collagen and calcium are like comfort food for the body. When implanted, human bone incorporates into the healing process, allowing the body to work unimpeded to heal and regenerate new bone, vessels and, sometimes, cartilage. Regeneration's great invention was to carve ('engineer') and shape bone into a spinal implant. Within three years of the bone dowel's introduction, it had exceeded the other popular intervertebral implant (the spine cage) in unit sales. From the bone dowel came all manner of bone hardware – spacers, pins, screws, etc. – a virtual catalogue of shaped and carved bone implants.
In the six years since Regeneration introduced the bone dowel, virtually every allograft supplier has engineered allograft of some form or another.
For the third quarter Regeneration announced that it would miss its revenue target for the quarter by about $2 million, or roughly 10%, because its largest customer – Sofamor Danek – had over inventoried its engineered allograft and bone void fill. A little over a year ago, Regeneration had changed its relationship with Sofamor Danek, transferring responsibility for inventorying the product, billing the customer, managing receivables, etc. to SDG. This is the first time such a glitch has surfaced publicly. And, considering that it cut Regeneration's value in half, it was a doozy.
This year, we expect, sales of biologic product will clear $1 billion, of which allograft products will account for roughly $405 million or 40% of the total. Both RTI and OSTE are leaders in this market. Sales for Osteotech this year, we expect, will rise 10% to $92 million. Regeneration, we expect, will post $86 million of net sales, up 25%. Over the course of the next three years, as the European market opens up and as an entire new generation of biologic and allograft materials come to market, revenue growth should accelerate. Osteotech, we think, will be the largest and most significant player in Europe. Regeneration certainly has the capabilities to be a prolific innovator of biologic/allograft products and, with its Sofamor Danek, Stryker and Exactech distribution agreements, to also move product to the market.
Furthermore, both companies, we think, are growing more rapidly than their reported sales indicate. In Osteotech's case, international sales are rising at triple digit rates and a new relationship at JNJ's AcroMed subsidiary creates the conditions for upside revenue surprise. With regards to Grafton, stemming the loss of market share will require a new and improved, perhaps even market segmented product.
At Regeneration, this quarter's 10% growth rate belies an underlying demand that, we estimate, is closer to double that rate. First, spine surgeries continue to rise as a result of such basic structural factors as demographics (this is the one clearly baby boom driven market since most back pain occurs between the ages of 45 and 65), the U.S. and Europe population's weight gain, rising cases of diabetes and continually improving patient success rates. Second, RTI's principal customer, Sofamor Danek is itself reporting 30-40% rates of revenue growth. Finally, surgeons have accepted allograft and are increasingly choosing cellular, resorbable technologies over metal in their practice.
The one dark cloud is InFuse®. One shot of $5,000 InFuse® into a collagen sponge and no bone graft is required. At least that was the view of one surgeon we talked to last week. What is InFuse® doing to sales of allograft based bone void fill? Stay tuned.
Last week's sell-off of allograft companies misses, we think, the fundamental and increasingly important role of allograft in orthopedics. The message from all managements who market allograft to surgeons, including SDG, is that demand, indeed need for allograft continues to grow. And the core rationale for allograft – better patient tolerance for the implant, less morbidity – is solidly in tact. We believe that revenues, while still rising in the normally soft third quarter, will, from all accounts in the field, rise at double digit rates in the fourth quarter and accelerate in the first four to five months of 2004.
Longer term, allograft products are, we think, the transition technology to broader use of all manner of biologic products by surgeons. Allograft products are, for example, excellent carriers for stem cells, growth factors, peptides, chemotherapies, anti-biotics and the myriad of other biologic and small molecule drugs that could re-grow damaged cartilage, eradicate a tumor, speed healing in diabetic patients, eliminate post-surgical infection and so forth. In other words, regenerate and heal... not cut and replace. As we make clear in the table at the end of the HealthpointCapital Weekly, biologics is a 190,000 procedure market today... growing to over 2 million procedures in 10 years and $3.3 billion in revenues.
