Orthopedic device makers like

Zimmer

(ZMH)

and

Biomet

( BMET) just got a lucky break.

The Centers for Medicare and Medicaid Services this week decided to increase payments for joint-replacement surgeries next year. CMS previously laid out plans to keep reimbursement flat, making it hard for device makers to seek high prices from hospitals that make little -- if any -- money replacing joints for senior citizens. But the agency, pressured hard by industry lobbyists, has now agreed to raise payments for joint replacements by 4% to 5% instead.

"This could be a watershed event for the entire medical-device space," declared Wachovia analyst Michael Matson, whose firm hopes to secure investment banking business from Biomet and

Stryker

(SYK) - Get Report

over the next three months. "Within orthopedics, the FY 2007

Medicare increases are significantly larger than in recent years and should give the companies more pricing and mix breathing room."

Matson predicted that orthopedic stocks would "be up sharply" in response. They did increase some, though perhaps not as much as Matson had anticipated. Zimmer, the largest orthopedics player of all, jumped 3% to $66.14 on Wednesday. Meanwhile, smaller Biomet climbed 2.8% to $34.39. And Stryker, a more diversified company, rose 2.3% to $46.80.

Of course, the stocks had been advancing strongly ahead of the CMS news. They began their recent climb last week, when investors learned that government officials had narrowed an antitrust probe of the industry. The shares then maintained that momentum this week, with experts forecasting some rate relief as well.

"Recent buzz from Washington analysts, which has been supported by industry sources with whom we have spoken, suggests that the net reimbursement adjustment for major joint replacement could instead increase by 3% to 6% in FY 2007," Bernstein analyst Bruce Nudell wrote ahead of the formal CMS announcement. "It would not be shocking to us if CMS slightly loosened its historical stance towards orthopedics. ... If this is true, it could continue to provide a lift to the stocks as investors come to believe that reimbursement and concomitant pricing pressure will lessen" for the group.

Yet Nudell himself remains cautious on the story. He continues to maintain an underperform rating on Biomet, along with market-perform ratings on both Stryker and Zimmer, in anticipation of more tough times ahead. His firm makes a market in Biomet securities.

Harsh Landscape

Quite simply, Nudell believes that the sector still faces price-related challenges. To be sure, he found little reason for hope in recent quarterly updates.

"Performance announced in the second quarter confirmed our view that (price) inflation, achieved both through mix and price, continues to be difficult to generate, Nudell wrote on Tuesday. "In any case, the torrid (price increases) seen in 2003 and 2004 -- 10%-plus for hips and 6%-plus for knees -- are now distant memories."

Clearly, Nudell feels, the industry landscape has changed.

In the past, he says, hospitals made enough money on commercial joint-replacement cases to keep them from pushing surgeons -- who are notoriously brand-loyal -- into using cheaper implants that might make their Medicare cases more lucrative as well. But over time, he says, those hospitals have started questioning the prices they pay for orthopedic devices as joint-replacement surgeries have become less and less profitable.

As a result, Nudell says, hospitals have grown increasingly sophisticated and pricing has taken on a new transparency that threatens future rate hikes. Indeed, he predicts, knee prices could remain flat and hip prices could fall by 1.5% annually beginning next year.

To be fair, however, Nudell also admits that things could go a bit better.

"Given hospital emphasis on demand matching (premium implants restricted to younger, private-pay patients) and the elimination of the most flagrant pricing disparities, we continue to believe that a 0% (price) inflation assumption is the most that can be justified at this time but that investor sentiment towards the stocks should be boosted if CMS loosens their stance, as we suspect that they might in the final FY 2007 rule," Nudell wrote on Tuesday. "If CMS loosens a bit and if private payers continue to reimburse generously, we believe it's not unreasonable to hold a slightly more optimistic view of the industry's prospects."

In fact, Nudell went ahead and raised his price targets -- if not his ratings -- on the three major orthopedic stocks in anticipation of good news. Even so, he still views Biomet as overvalued and sees little room for appreciation in the shares of Stryker or Zimmer.