Cost of Medical Devices Chafes
HEARD ON THE STREET
Hospitals Fight Back, Demand Orthopedic Firms Lower Prices
By LEILA ABBOUD and PAUL DAVIES
Staff Reporters of THE WALL STREET JOURNAL
May 13, 2005; Page C4
Medical-device makers have flourished in recent years as more people from the aging "baby boom" generation undergo hip and knee replacements. Now, a backlash by the device makers' biggest buyers -- hospitals -- is complicating the outlook for these companies.
After years of absorbing steady price increases of 4% to 5% annually, some U.S. hospitals are fighting to contain spending on orthopedic devices from such makers as Medtronic Inc., Stryker Corp., Biomet Inc., Zimmer Holdings Inc., Smith & Nephew PLC and Johnson & Johnson's DePuy unit. Rising device costs squeeze hospitals because reimbursements from insurers and government health-care providers have remained flat.
Historically, hospitals -- which pay for the devices -- haven't been able to control costs of orthopedic devices because the manufacturers spend hundreds of millions of dollars on marketing to surgeons, who choose which devices to use. Sales representatives are often present in operating rooms during surgeries, and companies offer lucrative consulting arrangements to "high volume" surgeons.
Now some hospitals are driving harder bargains with orthopedic companies and trying to convince doctors to use less-expensive devices. Their effort to weaken the close ties between device makers and doctors has gotten a boost from a continuing Justice Department investigation into the device industry's marketing practices. In March, Stryker, Biomet, Zimmer, DePuy and Smith & Nephew disclosed that they had been subpoenaed.
Some investors expect a tougher pricing environment to slow the 15% to 30% growth rates at orthopedic-device makers, and put pressure on share prices. Although the medical-device group has outpaced the S&P 500 by as much as nearly threefold in the past five years, the stocks have been less zippy in the past six months. While Stryker is up about 10% during the period, Zimmer is flat and Biomet's share price is down 20%.
Jason Wittes, an analyst with Leerink Swann & Co., downgraded the group to "market perform" and cut earnings estimates in February because of pricing-pressure concerns. Mr. Wittes doesn't own shares of orthopedic-device makers. Hospitals are challenging "the traditional ties between the orthopedic companies and the orthopedic surgeons," Mr. Wittes wrote in a March report. Leerink has conducted nonsecurities and nonbanking-related business with Stryker.
David Illingworth, president of Smith & Nephew's orthopedic division, echoed that view at an investors' conference last week: "Surgeons have power today -- that will probably change over time."
The opaque and fragmented nature of the market makes it hard for hospitals to get good prices. Device makers keep prices closely guarded, and often charge vastly different prices for the same product.
Last year, orthopedic suppliers hit HCA Inc., the U.S.'s biggest hospital chain, with a 20% price increase. This year, HCA has reduced the number of device makers it bought from, and demanded discounts in exchange for higher volume. Biomet refused to go along and was dropped as a supplier. Johnson & Johnson's DePuy, Stryker and Zimmer agreed. Leerink's Mr. Wittes says HCA won price reductions of 15% to 20% on average.
Other hospitals are taking similar steps. Cedars-Sinai Medical Center in Los Angeles is nearing the end of six-month negotiations to lower orthopedic-device prices. [5/3]
HCA and smaller hospital groups like Pinnacle Health System in Harrisburg, Pa., and Providence Hospital in Columbia, S.C., are offering doctors incentives to use preferred devices. Under the approach, known as gain sharing, the hospital gives doctors a portion of the money saved from using cheaper devices. Gain sharing is controversial; critics worry that any plan where doctors and hospitals share profits could lead to unnecessary surgeries or compromise patient care.
Similar cost-containment efforts failed in the past. Orthopedic-device firms have 60% to 70% gross profit margins and still expect rising demand from aging baby boomers, which could mean higher stock prices.
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