Justice Probe Hammers Stryker, Biomet

The government wants to take a look at some lucrative consulting arrangements.
By Melissa Davis ,

A long-expected government probe has brought fresh pain to makers of orthopedic implants.

This week, federal prosecutors officially subpoenaed at least three companies --

Stryker

(SYK) - Get Report

,

Biomet

(BMET)

and the DePuy unit of

Johnson & Johnson

(JNJ) - Get Report

-- about their relationships with orthopedic surgeons. The

Justice Department

is seeking "any and all consulting contracts, professional service agreements or remuneration agreements" with orthopedic surgeons dating back to January 2002, according to a press release issued Wednesday afternoon by Stryker.

The probe comes after a sharp rise in ortho implant prices that was already threatened by new "gain-sharing" agreements sought by hospitals to help bring costs back under control. Under the proposed deals, hospitals would split savings with surgeons who could be enjoying lucrative perks from the device makers right now.

Peter Young, a business consultant for HealthCare Strategic Issues, on Thursday called the government probe long overdue and called the legal exposure to implant makers substantial. He went on to say the makers have "seduced" nearly every large ortho group in the country through what could prove to be little more than a "sophisticated scheme" to buy market share.

"The financial catch is

that it is the hospital that pays for the implant -- not the physicians -- so implant prices skyrocketed," Young said. "Hospitals have said repeatedly, if the implant was a financial item on the physicians' business side, the absurd pricing of orthopedic implants would be moot."

Both Stryker and Biomet fell more than 7% on the news, dragging fellow device maker

Zimmer Holdings

(ZMH)

down with them. Johnson & Johnson, which derives only a small fraction of its sales from ortho implants, slipped 1.3% to $67.17.

Baird analyst Suey Wong wasted no time downgrading the pure-play device companies on Thursday.

He cut the two that fielded subpoenas, along with Wright Medical and Zimmer, from outperform to neutral, despite his continued faith in their fundamental business operations. He pointed out that similar probes have already led to significant fines for drug manufacturers. At the same time, however, he voiced some confidence that the device makers have managed to police themselves fairly well.

"Although each of our orthopedic companies do utilize (and compensate) orthopedic surgeons for various consulting, training and educational services, we believe each company has internally created rules and guidelines for how such relationships are established and monitored," Wong wrote. "Our field sources indicate many sales reps in the industry have previously been sent letters and other internal documents stressing the importance of these guidelines in recent years."

Still, Wong also acknowledged that the probe could prove long and unpredictable. Furthermore, he noted that it comes at a time when device stocks were already under pressure due to the looming gain-sharing agreements between hospitals and physicians. Thus, he recommended that investors "wait on the sidelines" for now.

Meanwhile, Wells Fargo analyst Ed Shenkan maintained his buy recommendation on Stryker despite his own concerns about the probe. He seemed less convinced that the companies had, in fact, been adequately policing themselves. As a result, he said, the government may decide to step up its own monitoring of the group. But he said any changes -- even a drop in consulting agreements -- should not hurt the solid growth rate of the sector.

Goldman Sachs analyst Lawrence Keusch expressed similar confidence about the group in general and about Stryker in particular.

"We suspect SYK has prepared for this for quite some time, having reviewed all of its consulting contracts in the past year, thereby insulating themselves more so than others from any potential adverse outcome related to this," wrote Keusch, who has an outperform rating on the stock. "Moreover, we suspect the smaller number of contracted consultants for SYK could further insulate the company from any unfavorable impact as compared to its larger peers, who maintain twice as many relationships or more with physicians."

In fact, Keusch said, Stryker has reportedly grown more conservative with its consulting deals -- and sacrificed some market share as a result -- in anticipation of the current government probe. Thus, he believes, the investigation might actually "level the playing field" for the company.

Natexis Bleichroeder analyst David Zimbalist suspects that the entire group saw the investigation coming. Now, he expects to wait up to three years as the government inquiry plays out.

Ultimately, he foresees more restrictions on consulting agreements and a weakening of the "very tight relationships" between device makers and orthopedic surgeons as a result.

SG Cowen analyst Dhulsini de Zoysa was already cautious on the industry -- save Zimmer -- even before the government took action. He noted that "talk of aggressive sales practices and cozy relationships with surgeons has been around for years." Even so, he said, the probe itself still comes as unwelcome news for the group.

Government investigations "can be long-lived and far-reaching," he warned. And "we expect the investigation of orthopedic companies to be no different."

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