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Orthopedics: It's About Earnings BY JOHN MCCORMICK, DECEMBER 13, 2006

We are frequently asked this question: why do orthopedic medical device companies lose money in the initial stages of their development? The short answer is that it is a deliberate decision by management teams to grow their companies' revenues. The longer answer, discussed below, relates to the industry's sophisticated industrial economics. The ultimate takeaway is that orthopedic medical device companies have the capacity to deliver real earnings as they develop.

High Gross Margin
Historically, the industry has maintained a gross margin that typically ranges between 60% to 90% depending on the size of the company and the technology profile. By any measure, these are very high gross margins. What permits this to occur? In essence, the driver of these levels of profitability is innovation. Firstly, innovation has induced inventions, intellectual property, surgeon product co-development, product differentiation, regulatory approvals, know-how, branding and the like, which create barriers to price competition. And secondly, innovation allows the industry to maintain its pricing power to providers because implants represent only a very small percentage (5% - 10%) of the overall cost of orthopedic care. The return on investment to society is significant for implant innovation. And the high gross margin supports research and development, a sophisticated sales force and attracts capital.

Orthopedics: High Growth and High Gross Margin

EBITDA and Breakeven
The typical orthopedic start-up will often come to market with a surgeon-invented product or suite of products. Since the regulatory pathway to the market is shorter than for pharmaceuticals or in the cardiovascular industry, the company will be able to time its regulatory approvals closely to the product development cycle and will be able to begin selling is products in a relatively short period of time.

Such a company is going to need a management infrastructure, continuing research and development and - most importantly - a sales and distribution infrastructure. Typically, a company will utilize external, but more expensive, independent distributors to leverage their surgeon relationships and grow sales immediately. Sales commissions to independent distributors are normally in the 20% to 25% range. For this reason, the typical orthopedic medical device company will grow quite rapidly, but require cash until it reaches a self-sustainable revenue level, which can range from approximately $20 million to $50 million. Orthopedic medical device companies, at this revenue level, are not early stage companies. However, they can become extremely profitable, as they continue to grow.

Orthopedics: Profitable by Nature

Another option, less frequently used, is to hire and train a direct sales force. This will require greater investment, as the company grows, due to the fixed salaries of the sales force. As the company grows, it's operating leverage can increase, due to the lower sales commission (12% - 17%), which is typically paid to the direct sales representative. Kyphon (shown above) utilizes this technique and has achieved extraordinary sales growth.

Trading Revenue for EBITDA
Because of the high gross margins, orthopedic companies are often acquired or taken public at 5x to 10x multiples of revenue. Management and investors are fully aware of this and will often continually invest in both sales and distribution and the management infrastructure, in order to both accelerate revenue growth and create value more immediately.

An interesting case study from the industry is Kyphon, which has organically grown revenues from approximately $36 million in 2001, at the time it was seeking to go public, to over $400 million in revenues today. Notably, this impressive growth has been achieved organically. Kyphon, which consistently earns an 88% gross margin, has always understood that investing in a direct sales and distribution force, in order to capitalize on its intellectual property and create a barrier to entry to competitors through branding, is the key to success. The market has understood this and awarded Kyphon with a $1.5 billion market capitalization (3.7x revenue/20.0x EBITDA). Today, Kyphon is beginning to realize a return on its investment in sales and marketing through accelerating profitability.

Investing in Revenue Growth: Kyphon

Importantly, scaling back costs and achieving immediate earnings improvement remains an option for management. One notable example is St. Francis Medical, which capitalized on its differentiated spine product and recent FDA approval, started selling its product in earnest in 2005, recently reported nine month revenues of $36.5 million, 414.1% year-over-year organic revenue growth, and a 90.4% gross margin. The company earned $13.6 in EBITDA during this period - a 37.2% EBITDA margin.

Earnings Strategy: St. Francis Medical

Notably, Kyphon recently announced the purchase of St. Francis Medical for a total of $725 million. $525 upfront in cash and $200 in milestones. The total purchase price is approximately 18.0x trailing twelve month revenues.

Little Use of Leverage
Interestingly, the industry has had little need for leverage, due to the high earnings and return on equity, as companies grow. As companies reach the $100 million revenue level and above, they tend to generate strong cash flows and have very little need for outside financing. As companies mature, cash flows often become abundant and returns on book equity (earnings/equity) are highly compelling and often far in excess of long run stock market returns.