Arthrocare Unit's Revenue Razzle-Dazzle
OKLAHOMA CITY -- No wonder
Arthrocare
(ARTC)
has been reporting explosive demand for its sports medicine devices.
"Basically, we provide the devices to them (customers) at no charge," Arthrocare Vice President David Applegate told
TheStreet.com
in a recent interview.
While Arthrocare CEO Michael Baker rushed to deny this activity, which could inflate reported sales, Applegate should know best. After all, Applegate oversees DRS -- the very billing division that's in charge of the alleged giveaway program.
Through this program, Arthrocare appears to be booking revenue that it hopes to recover from health insurers down the road. "Our revenue recognition procedures for sales generated by DRS are very straightforward," Arthrocare stated in a recent email to
TheStreet.com
. "When a surgeon orders a device through DRS, we agree on a contracted sales price. We recognize revenue at that contracted sales price when the device is shipped to the surgery center."
But Arthrocare never mentions actual money changing hands. Rather, the company implies that DRS simply earns the right to pursue reimbursement from health insurers instead. However, with insurers known to demand steep discounts -- and even reject entire claims -- the company may never see some of that money at all.
In fact, Arthrocare could face stiffer resistance than most. Critics say the company is seeking "carve-out" payments for devices that are normally covered under global surgery fees paid to physicians instead. Moreover, they add, Arthrocare is using DRS as a well-disguised front to request jacked-up rates for its supplies.
While Arthrocare denies any wrongdoing, the company's own documents help support its critics' claims.
During the first quarter of 2007, internal price lists show that Arthrocare dramatically raised the rates for its sports medicine supplies. Normally, surgeons might seek out cheaper alternatives offered by rivals like
Stryker
(SYK) - Get Report
,
Smith & Nephew
(SNN) - Get Report
and
Johnson & Johnson
(JNJ) - Get Report
. However, thanks to brand-new DRS, surgeons could suddenly choose to pass the device cost on to health insurers instead.
That strategy appears to be working. Just months after DRS surfaced, Arthrocare began reporting explosive growth in its sports medicine division. The unit's growth rate literally doubled between the third and fourth quarters of 2007, then further expanded in the first quarter of this year.
Still, Arthrocare's balance sheet has suffered in the process. Last quarter, Arthrocare saw its inventories decline as it shipped out more and more devices. But the company found itself waiting longer and longer for payments as well.
Notably, during that short 90-day period, Arthrocare watched its receivables balloon by $10.6 million -- growing three times faster than actual sales -- as the company sat on an ever-growing stack of unpaid bills. The company's cash balance plunged by 23% in the meantime.
Arthrocare claimed that the company, tied up with other matters, simply spent too little time on collections. But experts seemed troubled nonetheless.
"That's just a big jump," Canaccord Adams analyst William Plovanic declared during the company's first-quarter conference call. And "it's hard to kind of see that just not having people focusing on collections would cause that big of a change sequentially.
"Is there something else at play here?," Plovanic asked.
Some observers point straight at DRS. They feel certain that Arthrocare has been using DRS to report huge chunks of revenue that the company will probably never realize in the end.
Arthrocare has downplayed its dependence on DRS, however. For starters, the company claims that DRS caters primarily to small surgery practices that need help with their billing. However, DRS's own marketing materials specifically list "ARTC high-volume surgery centers" -- which tend to place big orders -- as a prime target instead.
Arthrocare could be minimizing DRS' impact on its financial results as well. In an email to
TheStreet.com
, Arthrocare portrayed DRS's "incremental contribution to revenue" as insignificant. The company pegged the exact contribution at $500,000 - or "approximately six-tenths of 1%" of total company revenue - in the fourth quarter and $1 million in the quarter since.
Yet documents obtained by
TheStreet.com
suggest that Arthrocare relies on DRS far more. A single invoice issued during the fourth quarter of 2007 -- when DRS supposedly contributed just $500,000 to Arthrocare's sales -- shows DRS ordering almost $1.37 million worth of Arthrocare supplies.
Arthrocare appears to be counting only small DRS markups on its sports medicine devices instead. Specifically, in its recent email, Arthrocare described DRS' contribution as "the incremental revenue received from an insurance company over our normal contractual price."
The difference between small mark-ups and actual device charges can be vast. In claims reviewed by
TheStreet.com
, those mark-ups accounted for less than 10% of DRS' overall bills to insurers.
If those claims are typical, the evidence suggests, Arthrocare could be relying on DRS for almost 20% of its sports medicine sales. In other words, the company could be leaning on DRS for nearly all of the division's recent growth.
If so, Arthrocare still needs to collect a lot of money just to account for the sales that it has already reported. At the same time, the company has promised big future gains as well. With its receivables skyrocketing already -- and its future growth targets set high -- the company could be poised for a fall.
SIG Susquehanna analyst David Turkaly sees clear reason for alarm. While other analysts have continued to embrace Arthrocare, despite concerns about the company's business practices, Turkaly has grown increasingly bearish on the name.
Following his latest downgrade, issued on May 5, Turkaly now has a full-blown "negative" rating on Arthrocare even though his firm owns stock in the company itself.
"While we have not encountered a 'smoking gun,' per se, we have observed, read and listened to many data points concerning this story that all seem to point in the same direction -- and still strike us as very odd," Turkaly wrote in early May. "Nothing in the four months since our initial downgrade has convinced us that the likelihood of future reimbursement scrutiny and/or potential investigations is any less likely.
"In fact," he added, "we have really only seen information that could still potentially be damaging" in the end.