Jonathan Waldstreicher is an equity research analyst at Bear Stearns, an $11 billion investment banking firm in New York.
In recent years, the rise in health care supply costs has been staggering, especially in orthopedics. Not only have vendors been pricing new products at a 40 percent premium to legacy devices, but they also have been raising prices on the older-generation products.
As a result, such companies as Biomet, J&J Depuy, Raynham, Mass.; Smith & Nephew, Memphis, Tenn.; Stryker, Kalamazoo, Mich.; and Zimmer, Warsaw, Ind., have been growing revenue at rates in excess of 13 percent year after year.
Due to these excellent operating and financial results, Wall Street analysts and investors following these stocks have certainly rewarded them with high returns: Zimmer stock is up 92 percent, Smith & Nephew 67 percent, Stryker 31 percent and Biomet 25 percent, all since January 2003.
Those who work in the equity research department at Bear Stearns, New York, try to value each segment of a company's businesses to determine if the stocks should rise further or begin to fall. The three revenue growth components, i.e., increases in procedural volumes, upcharge on legacy products and premium pricing on new products, represent approximately 6 percent to 7 percent, 2 percent and 4 percent to 5 percent, respectively.
Glancing at price increases, 2 percent on old products does not seem high. However, this component is measured on an international basis; U.S. device price increases have been approximately 4 percent to 6 percent each year while those outside the United States have remained flat. Since pricing is the revenue component that remains at greatest risk to the 13 percent growth, Bear Stearns coldcalled hospital materials managers to ask about their sentiment regarding the direction of pricing in the coming years.
In total, 20 materials managers representing 46 hospitals and 433 orthopedic surgeons, roughly 2 percent of all U.S. orthopedic surgeons were surveyed. The materials manager sample was geographically diverse and varied in the number of surgeons per system, ranging from one to 100 surgeons with a mean of 22.
The sample group was divided into two, defining a large health care system as a purchaser of reconstructive implants for 10 or more orthopedic surgeons, and a small hospital as a purchaser for nine or fewer orthopedic surgeons. Of the 20 materials managers, 12 cover large hospital systems with an average of 32 surgeons per health care system, and eight cover small systems, with an average of six surgeons per hospital. Grouping the hospitals by size sheds light on differences in surgeon behavior, contract structures with device companies, and bargaining power on pricing.
Ortho in the red
Only two of the 20 hospital systems surveyed are profitable in orthopedic reconstructive surgery, as opposed to five years ago when these cases had attractive profit margins. As the prices of reconstructive implants have increased as well as labor costs, profit margins on orthopedic surgery nearly have been eliminated. The larger health care systems have been combating 3 percent to 5 percent annual increases on existing devices, while smaller hospitals are experiencing up to a 10 percent price increase.
Thus far, many hospitals have been able to sustain their orthopedic surgery services by subsidizing the near losses on Medicare patients with the profits generated by private-pay insurance. In other hospitals, orthopedic surgery is in the red and must be cross-subsidized by more profitable branches of the hospital. Despite pressures to regain profitability, hospitals must continue to offer orthopedics, even if they are losing money on it, to maintain comprehensive, specialty medical care.
Traditionally, materials managers have not been successful in convincing orthopedic surgeons to switch implant vendors because of better pricing on products. Most surgeons are trained on a specific set of instrumentation during their residencies and refuse to switch companies, either because it takes time to switch or they enjoy the service they receive from the vendor sales reps. These factors have led to extremely sticky market shares in the orthopedics industry (even though one company may have a superior technology over another), preventing materials managers from offering volume-for-price discounts to a certain vendor and bargaining on price when negotiating a purchasing contract.
Recently though, materials managers have attempted to control costs through two standardization measures: price and products. Within standardization of price, capitated pricing refers to the price that purchasing managers are willing to pay for a given joint implant irrespective of technology, i.e., hospitals will pay the same amount for a high-tech hip implant as a basic hip, while shelf pricing refers to the price that purchasing managers are willing to pay for a specific type of joint implant. Typically, a purchasing manager's target price is $200 to $300 below the level of Medicare reimbursement for a given procedure so that a hospital can, at minimum, break even on Medicare patients while generating a profit on private-pay patients. Price standardization, in effect, leads to direct competition for purchasing contracts at some hospitals. At other hospitals which employ a capitated structure, the burden effectively is placed on vendors to meet a hospital's terms.
As vendors have been more aggressive on annual price increases, some purchasing managers have used standardized pricing to negotiate with them. According to Bear Stearns' analysis, seven of 12 of the large health care systems surveyed employ price standardization, as opposed to just one out of eight of the smaller hospitals. On pricing, the larger hospitals have a significant advantage because they negotiate higher volume contracts for a greater number of surgeons.
Product standardization is the other main cost control measure. Purchasing managers limit vendor choice in devices used by surgeons, giving higher volume contracts to fewer vendors in return for better discounts. In contrast to price standardization, at which larger hospitals are more successful, several of both the large and the small hospitals surveyed have standardized their products.
Intuitively, it should be more difficult for smaller hospitals to standardize by product. Large facilities can more forcefully persuade the surgical staff to switch to a certain product to contain costs, even if it translates into a few physicians leaving the facility. However, small hospitals are not as willing to lose a greater percentage of their revenue with every surgeon that departs. But, not one surgeon has left any of the 46 hospitals surveyed because of the cost-cutting initiatives. The hospitals that have indicated a product shift point to Zimmer as the share winner because of the aggressive sales force and knowledge of the pricing environment.
In fact, Zimmer and Stryker have a significant presence in 16 of the 20 hospital systems surveyed, and J&J DePuy follows with nine.
Smaller hospitals have increased their orthopedic surgery staffs in the last few years and it is nearly impossible to lure new surgeons without providing them with the implants to which they are accustomed. Thus, hospitals that are expanding their orthopedic services likely will have little negotiating leverage.
Several purchasing managers also mentioned pricing discounts from Zimmer and Synthes if they guaranteed the companies a certain percentage of their share. The companies each requested 80 percent share from two small hospitals to be eligible for this discount, while two large hospitals were informed of discount eligibility with 50 percent Zimmer share.
Oh, the options
When asked about the future of U.S. pricing, responses varied from down to flat to up. Three of the four purchasing managers at hospitals that already have standardized by price and product predict that prices of reconstructive implants will continue to increase.
This could suggest that standardization is the last option in cutting implant costs; if this fails, hospitals may have little further leverage. If all vendors simultaneously increase prices, as has been the case over the last few years, prices will inevitably rise, even if purchasing managers can negotiate among the lowest of the increasingly expensive vendors.
Over the last five years, most purchasing managers surveyed have experienced a 3 percent to 5 percent annual price increase on reconstructive implants, while a few claim that prices have risen as high as 10 percent annually. These increases often have led to directives from health care administrators to examine costs related to orthopedic surgery. Before taking large, immediate cost-cutting measures, institutions first have been educating their surgeons on cost issues.
Executives and purchasing managers have been compiling benchmarking data for surgeons to compare patient outcomes and costs. When this data is combined with statistics on patient outcomes, which are nearly identical across orthopedic device producers, some administrators have convinced surgeons that cutting costs is their responsibility. Also, surgeons realize that responsible spending could help preserve the level of ancillary services that help facilitate patient care.
Surgeon cooperation with hospital management seems to be a new phenomenon, but varies with hospital size. Large facilities have been successful in relying on their surgeons to cut costs by switching implant companies. Materials managers issue an ultimatum to surgeons: use cheaper implants or forfeit privileges to operate at a hospital.
This ultimatum has been more prevalent in large facilities because they can afford to lose a surgeon occasionally, as opposed to a small hospital where each surgeon generates a greater percentage of revenue. Surgeons from larger facilities also are cooperating with hospital management when determining which patients receive premium implants, priced anywhere from 5 percent to 40 percent more expensive than regular implants. Such premium products are used for more active, younger patients.
Physicians at larger facilities tend to use premium-priced devices more often because they are exposed to larger patient populations and practice in tertiary care facilities that specialize in orthopedic surgery, in contrast to the community hospitals.
Regulating these procedures has provided some additional cost control with the assistance of physicians.
The age of evolution
Vendors agree that product standardization is an opportunity for the strongest players in the market to increase device volume, although they must be more competitive on price.
Zimmer has been very aggressive at capturing new contracts in hospitals where purchasing managers are consolidating vendors. Also, new contract structures are different from their historical format.
In the past, reconstructive hip and knee implants were priced similarly across companies while vendors offered large discounts on their premium-priced products. Yet, Zimmer is capturing new purchasing contracts by offering significant discounts on the more frequently used, undifferentiated products while they are pricing products specific to Zimmer close to their list prices.
The company's day-to-day products represent 80 percent to 85 percent of all units and 60 percent to 70 percent of reconstructive device revenue.
Products offered by a single company represent 4 percent to 6 percent of listed products, which Zimmer is trying to increase to the 12 percent to 18 percent range. After it becomes the primary or secondary vendor at a given hospital, Zimmer could have less competition and more access to physicians to promote their individual products.
Zimmer also is actively driving longer contract terms, which has been confirmed in conversations with hospital purchasing managers.
By signing two- to three-year contracts, as opposed to the usual one-year term, Zimmer is locking down the hospitals so that they could take advantage of near exclusivity.
Hospitals are more likely to agree to lengthier contracts if they receive better undifferentiated product discounts.
In contrast to hospital purchasing managers, Zimmer claims that capitated and shelf pricing have not been successful thus far. Zimmer expects reconstructive device price increases to continue in the three to four percent range.
However, Stryker has a more decentralized operating structure. Although it also has marked up prices on reconstructive devices in the past several years, company management believes price increases will level off to match inflation.
Gain sharing thoughts
Since Feb. 4, the Office of the Inspector General of the Department of Health and Human Services has issued seven advisory opinions relating to gain-sharing agreements. Gain sharing is a cost-cutting system in which physicians receive 50 percent of hospital cost savings from using less costly devices, fewer suture kits, noncross-matched blood and other clinically equivalent, but less expensive supplies. Thus far, all of the gain-sharing approvals have covered cardiac surgeons or cardiologists, although investors are concerned that this system also can be applied to orthopedics.
If it is, there is great potential for market share shifts as physicians are motivated to switch from one vendor to another after being loyal to a vendor since residency. If more hospitals can move to a volume-for-discount contract with vendors, there can be even more pressure on price.
Despite Wall Street's concerns it isn't likely that gain sharing will penetrate orthopedics. Cardiologists always have been less loyal to a particular vendor than orthopedic surgeons and more willing to try new devices.
It is highly unlikely that an orthopedic surgeon will spend time learning to use new instruments in exchange for a few thousand dollars of divided savings.
This value probably will not come close to replacing the service that a surgeon receives from a sales rep. Therefore, even though gain sharing may be a big trend in orthopedics and allow the cardiac catheterization labs to negotiate better pricing, it probably won't affect orthopedics.
Under investigation
On March 30, major implant vendors received subpoenas for documents relating to orthopedic surgeon consulting contracts from the Department of Justice.
Anyone involved in the orthopedics industry knows of such contracts in which physicians are compensated for their time teaching others, working with engineers on developing new products or performing research for vendors. Regardless of whether the consulting contracts were legitimate, there probably will not be much change in the environment. Many Wall Street analysts say that the previously impossible market share shifts now may come about because of less loyalty to the vendors.
However, it is estimated that only 5 percent of surgeons have been compensated by companies and that surgeons likely will remain with the same vendor they have used throughout their careers.
Additional proof for this conjecture lies in the United Kingdom orthopedics market. Even though there are rare cases of consulting contracts, market shares are still extremely sticky.
An overall theme from the survey is that price increases will moderate from 4 percent to 6 percent to the 2 percent to 3 percent range. It seems as though hospitals are becoming increasingly powerful as they share information with each other and as they convince surgeons that their cooperation can make a difference.
Materials managers now know that Wall Street investors analyze the market in which they operate, merely on a more objective, wider scale.
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