The Fog of Allograft Innovation
BY ROBIN R. YOUNG CFA, FEBRUARY 9, 2004
Last week Regeneration Technologies (RTI), the third largest supplier of allograft products, reported that sales of allograft products to Medtronic Sofamor Danek (MSD) dropped 61% in the 4th quarter to $5.1 million. MSD is Regeneration's largest customer accounting for 60% of total sales. Last year, the number for Q4 sales to MSD was $13 million. Huge drop. No analyst saw it coming. Management didn't either.
Even though sales to MSD had also been weak in the 3rd quarter, management kept production running through the first weeks of the 4th quarter. Through October and into November, inventories grew. Then it became increasingly clear that MSD's orders weren't going to materialize. By the end of 2003, unsold inventories had risen to $41.7 million – a 16% increase from the third quarter's $35.9 million and up 46% from last year's $28.6 million. This was even with stopped production for a part of the quarter.
Unfortunately, receivables fell even more precipitously than inventories grew in Q4. Receivables fell 66% from the same period a year earlier to $5.9 million. As the following chart illustrates, these twin trends (rising inventories and falling receivables) have been in place for a year.
In its quarterly conference call to analysts and investors, management assured listeners that shipments to MSD were recovering and that allograft sales to MSD in the first quarter would be in line with previous quarters (not the 4th, before that). Indeed, Brian Hutchison said that he expected overall revenues would return to $21-23 million quarterly levels in the March quarter. Essentially, where they were mid-year, last year.
What happened? In a nutshell, RTI processed and shipped more spinal allograft than Medtronic Sofamor Danek could sell. MSD had too much inventory in the 3rd quarter, supplied its surgeons from that inventory in the 4th quarter and, presumably, will be resuming its order patterns in the 1st quarter.
But what if something is going on in the market for spinal allograft products? Is there an overabundance of allograft or allograft substitute products? Is product differentiation gone? Do sales people, to say nothing of surgeons, care about brand names anymore?
As it turns out, two allograft companies, RTI and CryoLife (CRY), have reported numbers for the 2003 fourth quarter and both reported sharp drops in their core allograft product lines. While we don't see a connection between RTI and CRY, but we do see a common lesson.
Approximately 22 years ago CryoLife became the first company to accept a supply of donated human tissue, process it and then return it to the surgeon. Typically, the tissues came from the same hospital system as the surgeon-user. And CryoLife's revenues came from processing the tissues for surgeon use.
It would be more than ten years before another company would emerge to supply surgeons with a unique, processed allograft product. That was Osteotech and the product was a demineralized bone putty (DBM) called Grafton'. Along with its partner, MTF Foundation, Osteotech created the first viable alternative to autograft bone harvesting for spinal fusion, trauma and other orthopedic applications.
At its peak, Osteotech was afforded a $600 million market cap by Wall Street. Other innovators followed. CryoLife pioneered vascular and cartilage allograft. LifeCell perfected acellular soft tissue for a variety of surgical needs including skin and gastro-intestinal procedures. And Regeneration Technologies pioneered the carved or engineered allograft implant.
Today, all of these products (excepting LifeCell's soft tissues) are available from numerous sources. The original pioneers now contend with both direct competitors and functional substitutes. Indeed the pace of product obsolescence is much faster than, we suspect, most managers in the allograft industry realize. Otherwise, why would allograft companies spend comparatively little on R&D?
The average public allograft company spends 4% of sales on R&D. The average public large joint replacement company spends 5% of sales on R&D. Medtronic and Johnson and Johnson spend, respectively, 9% and 11% of sales on R&D.
Today, Regeneration's Osteofil' bone graft fill and Osteotech's Grafton' are facing serious competition from the second generation bone void fills that incorporate nearly twice the amount of DBM and, theoretically, bone growth factors, per unit than their product. And these products were not developed by the market leaders. RTI's bone dowels face a myriad of substitutes including peak plastic implants, MacroPore's spacers and bone spacers from several non-profit and for-profit suppliers.
CryoLife, which has been battling everything from patient lawsuits to a virtual FDA shut down of its orthopedic allograft sales, has had constraints on its ability to innovate since 2001. The result has been opportunistic competition from LifeNet, RTI and the American Red Cross and precipitous declines in CryoLife's allograft revenues in the 2003 4th quarter.
What lesson do we see? Both RTI and CRY, we believe, are paying the price for lack of innovation. RTI is addressing this issue with s sharp increase in R&D spending. For the just ended quarter, RTI's R&D spending rose 22% from the prior year to $773,000. At 6% of sales, this is double RTI's historic rate but still below the more typical rates for such leaders as Medtronic, Zimmer or JNJ. CryoLife's ability to innovate certainly has improved with its recent financing and (providing the FDA allows it) should pick up in the coming quarters.
Will RTI recover? Management thinks so. We aren't so sanguine. The issue is new products, not simple refinements. We think the market is waiting for serious value added modifications if not game changing products. Innovation must go further than refinements of existing products to keep RTI (or CryoLife or Osteotech or any other allograft supplier) from slipping further. Medtronic, which spent $2.7 billion on R&D in 2003, is flooding its sales force with significant new products. How does RTI compete with R&D at 6% of sales? It's tough. So the solution is to find new markets and new partners – which, in essence, is what management alerted its investors that it plans to do, evolutionarily, by the way.
Last year, the biologics market grew, we estimate, 19% to $1.011 billion in sales. For 2004, on the basis of such new products as Infuse', new forms of DBM, new glues and hemostats and the re-emergence of anti-adhesive products (led by Wright Medical, a classic metal hip and knee company with some of the most innovative biologics products on the market today), biologics sales will likely grow 17% to $1.2 billion. Longer term, the market for biologic implants instead of metal or plastic implants will grow to become the predominate form of implant. Who will lead this market? Only one company, LifeCell, is devoting significant resources to R&D (16% of sales) and, not surprisingly, is putting up consistently strong revenue growth results and finding new applications for its innovative line of soft tissue implants. Other than Paul Thomas's LifeCell, frankly, it is hard to see the which of the remaining crop of small companies will make the grade.
