Arthrocare Billing Unit Draws Scrutiny

Its DRS division has some questionable math skills.
By Melissa Davis ,

OKLAHOMA CITY -- When it comes to sports medicine, critics say

Arthrocare

(ARTC)

likes to play by its own set of rules.

Arthrocare runs an obscure division, DRS, that offers assistance to surgery centers that use the company's sports medicine devices. Specifically, Arthrocare says, DRS bills insurers for its devices under "established carve-outs" so that surgeons won't have to seek reimbursement for the devices themselves. Surgeons simply bill for the actual operations instead.

"Carve-out billing is pretty straightforward," Arthrocare CEO Michael Baker told

TheStreet.com

earlier this month. "There's nothing the least bit unusual about what DRS does."

Yet some short-sellers who have placed huge bets against Arthrocare's stock, suspect the company of outright cheating. They say that the company appears to be "double-dipping" by billing for devices that are already covered under global fees paid to surgeons for the entire operations. They even supplied a damaging expert opinion as support for their claims.

Karen Zupko & Associates is a Chicago-based consulting firm that ranks as a premiere authority on healthcare reimbursement matters. In a recent letter to Endeavor Trading, Zupko stated that Arthrocare's disposable arthroscopic wands do not qualify as "durable medical equipment" that can be carved out for separate reimbursement. Moreover, Zupko indicated that Arthrocare may know as much but continues to seek additional reimbursement anyway.

"In our conversation with (Arthrocare's) independent distributor, we were directly told that by carving out wands, DRS is causing the reimbursement entity ... to effectively double-pay for the wand," Zupko stated. "In our opinion, when insurers discover this billing practice, two things are very likely to happen: they will issue requests for refunds and will scrutinize all further/future billing from Arthrocare and its subsidiaries."

To be fair, Zupko sent her negative opinion to a firm that has been known to short Arthrocare's stock. However, Endeavor reportedly sought an objective review -- never disclosing any financial interest in Arthrocare at all -- because it wanted to know for sure whether its suspicions were justified.

For its part, Arthrocare says that health insurers allow carve-outs payments for "new technology" in the sports medicine field all the time. But critics doubt that routine items, such as arthroscopic wands, actually qualify.

"We are not reimbursement experts," SIG Susquehanna analyst David Turkaly confessed in a recent report. "But we are not aware of any ARTC products that currently fall under an established device carve-out for separate reimbursement."

Earlier this month, Turkaly became the first mainstream analyst to actively steer investors away from Arthrocare's stock. He downgraded Arthrocare to "negative" even though his firm owns shares in the company itself. He fears that the stock, while up $1.60 to $45.73 on Friday, could set a new multi-year low of $32 a share down the road.

Amazing Comeback

Turkaly issued his downgrade just two weeks after Arthrocare reported blowout results for its sports medicine division.

Arthrocare has long depended on its core sports medicine business to generate most of its revenue. But the company competes against much larger rivals -- such as

Stryker

(SYK) - Get Report

,

Smith & Nephew

(SNN) - Get Report

and

Johnson & Johnson

(JNJ) - Get Report

-- in a market that's considered relatively mature. Thus, in recent years, the company has relied far more on its small spine unit to fuel its explosive growth.

Late last year, however, Arthrocare's core business began to take off just as its spine unit (

tainted by questions about its own billing subsidiary

) came under heavy fire. Last quarter, in a surprising reversal, sports medicine actually overtook spine as the company's fastest-growing business of all. It shifted attention away from the scandalized spine unit in the process.

Arthrocare touted the development, confidently proclaiming that its sports medicine business was "on a serious roll" that should continue for some time. The company has since credited new products, rather than higher prices, for that surge.

"It's all volume," Baker told

TheStreet.com

earlier this month. "We have seen no significant changes in our average selling prices."

Arthrocare has since conceded that the company, in fact, "updated the full price list" for its sports medicine products during 2007. Based on price lists obtained by

TheStreet.com

, those rate hikes were spectacular.

For example, an internal price list shows, Arthrocare charged $232 for one of its popular TurboVac arthroscopic wands in January of 2007. However, a follow-up list shows, the company was asking $363 for the same device just two months later. Together, the two lists reveal, the company adopted widespread rate increases -- with some sports medicine devices almost doubling in price -- during the first quarter of 2007 alone.

Arthrocare raised its prices at a time when the growth rate for its big sports medicine division, hurt somewhat by a discontinued product line, had sunk into the single digits. Suddenly, however, the company started reporting a huge surge in that growth rate just a few quarters later.

Short-sellers feel certain that DRS, which surfaced in mid-2007, fueled that powerful comeback.

Without DRS, they say, Arthrocare might have struggled to sell its pricier devices to surgeons who collect lump sums for their operations. But thanks to DRS, they say, Arthrocare could offer to saddle health insurers with that cost instead.

Since those insurers never received separate bills for the devices in the past, they add, they would never notice - let alone protest - the gigantic rate increases.

In the end, many of those insurers may have never realized that they were conducting business with Arthrocare at all.

TheStreet.com

recently studied some official claims submitted by DRS. Notably, those claims offer no hints about DRS's ties to Arthrocare.

Indeed, to an outsider, DRS looks like a separate firm altogether. In one of the claims, for example, DRS requests $399 for a TurboVac wand. For support, DRS then includes an invoice showing that it paid Arthrocare $363 for the device. Together, those documents suggest that DRS is simply seeking a small mark-up on a device priced by an independent manufacturer rather than its own parent.

DRS even offers up a separate address. While DRS directs insurers to send their payments to a post office box in Texas - the state that Arthrocare calls home - it lists an actual street address in Florida. The company's official Web site does the same.

Yet Arthrocare itself knows better.

"The DRS people are located here in Austin," Arthrocare admitted to

TheStreet.com

this month. "They're not in Florida."

Keeping Score

Arthrocare has offered confusing reports about DRS's financial performance as well.

During Arthrocare's latest conference call, Baker told investors that DRS booked about $500,000 worth of sales in the fourth quarter of 2007 and about twice that amount in the following period. Compared to overall device sales, he has stressed, DRS "doesn't really add anything to revenue" at all. Arthrocare reported overall fourth-quarter revenue of $87.5 million.

"It's to help customers," Baker explained to

TheStreet.com

. And "frankly, we haven't done much of it so far."

Yet Arthrocare appears to be downplaying that contribution. In recent weeks,

TheStreet.com

has obtained two internal invoices detailing Arthrocare's sales to DRS. Both invoices, numbered as if seven transactions occurred between them, carry dates that fall within the fourth quarter of 2007.

Notably, just one of those claims comes to $1.37 million == almost as much as Arthrocare supposedly billed DRS during the past two quarters combined.

Perhaps Arthrocare itself can make the numbers work. After all, documents show, the company did choose two experienced accountants to help run its new billing firm.

Brian Simmons and Charles York officially work in Arthrocare's finance division, according to their resumes on the popular LinkedIn professional networking site. However, DRS filings show, they also double as the leaders of DRS. While their resumes indicate no particular expertise in medical billing -- or even healthcare in general -- they do show that both men previously worked together at Arthrocare's independent auditing firm.

Nevertheless, in promotional material, DRS markets itself as a top-notch reimbursement firm staffed with a team of accomplished experts in the field. It also boasts "over 10 years of experience as a national provider" of medical devices.

That claim looks like a stretch, however, since DRS never even filed incorporation papers until mid-2007.

When it did file, it listed John Raffle -- the head of Arthrocare's "strategic business units" -- as its sole executive. Interestingly, since then, Raffle has emerged as one of the most consistent inside sellers of Arthrocare's stock.

Raffle has cleared roughly $2 million from stock sales since last June alone. He executed his biggest transaction about a week before Arthrocare hit its all-time high. He followed up with another sale the very day that the shares reached their peak.

During that same timeframe, only Baker himself cashed in more.

Arthrocare's stock has fallen sharply since that selling spree, hurt by ongoing questions about the company's business practices. Baker claims that the shares no longer reflect the true value of the company. With the board now exploring "strategic alternatives," the company has essentially put itself up for sale as a result.

Still, Baker himself has invested no real money in Arthrocare despite its falling share price. For the most part, he seems to tout the company as an attractive investment for others instead.

"This is a great company with a great future," Baker proclaimed to

TheStreet.com

this month. "We're doing some amazing stuff here."

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