Investors in the big orthopedic device makers are keeping an eye on a pricing standoff with a big customer.
and the DePuy unit of
Johnson & Johnson
the bulk of its business in return for price cuts on their artificial hips and knees. The hospital operator is struggling to bring skyrocketing implant prices under control.
HCA has been fighting an uphill battle to win over notoriously brand-loyal orthopedic surgeons and make the arrangement work. But salespeople for competing device makers such as
( BMET) and
Smith & Nephew
, which were left out of the company's deal, indicate the big hospital chain may be making some progress.
"We used to have 70% to 80% of the market share at HCA's hospitals in Houston," says a Smith & Nephew representative in the area. "Now it's basically zero."
Clearly, some HCA surgeons who once used Smith & Nephew implants have begun using so-called compliant devices -- ones that are covered under the HCA pact -- instead. Other surgeons -- including some especially busy ones -- have simply taken their business elsewhere. HCA has paid a price as a result.
But investors are increasingly concerned that the device makers could suffer from the deal as well. They'll get an update on that notion when Stryker posts fourth-quarter numbers after the close Thursday.
After all, three of them have already given HCA big price breaks in order to win the company's business. With other device makers left out, those chosen vendors fully expected higher volumes in return. But HCA -- as the largest hospital chain in America -- could spark an unwelcome trend if it actually managed to pull this deal off: It could make other hospital operators start demanding big price cuts of their own.
Stryker CEO Stephen MacMillan acknowledged this very threat during an investor presentation early last month. But he dismissed the possibility just after that -- and some Wall Street experts have since followed suit.
"In the U.S., HCA appears to have been unsuccessful in their attempt to drive lasting price reductions through increased volume to preferred vendors," William Blair analyst Ben Andrew wrote in a Stryker earnings preview just last week. "As a result, we believe that pricing at HCA should return to the previous higher levels and that this will serve as an important precedent that will limit the ability of other hospital groups to arrange similar deals."
Investors may have more reason for hope.
"MacMillan last week at the J.P. Morgan health care conference indicated that (orthopedic device) growth could begin to improve as we move through 2006," J.P. Morgan analyst Michael Weinstein wrote on Jan. 18. Indeed, "both MacMillan and Zimmer CEO Ray Elliott hinted at a slightly more favorable outlook than third-quarter commentary implied."
For now, at least, Weinstein is looking for more of the same from Stryker. Indeed, he called for a "replay" of Stryker's disappointing third quarter, when the company releases its latest results on Thursday afternoon. Specifically, he predicted flat hip sales and below-market knee growth for the company.
To be fair, however, Weinstein called for solid contributions from Stryker's other business lines. He also expressed comfort in the company's 20% growth target overall.
"While we don't see much if any upside to this target," he wrote, "we also believe that Stryker management isn't scratching its way to 20% but instead views the benchmark as a very achievable goal for 2006 while still investing meaningfully in the business."
J.P. Morgan, which helped with a public offering of Stryker securities over the past 12 months, currently has an overweight rating on the company's shares.
Andrew likes Stryker, too, even if he feels somewhat less confident in the company's guidance.
"We are looking for comfort that this 20% growth target is reflective of actual business trends and not merely the reiteration of the company's long-term growth mantra," wrote Andrew, who has an outperform rating on the company's stock. "In fact, our model assumes just 17.3%
earnings per share growth for 2006."
Still, Stryker's stock rose 1.2% to $44.59 on Thursday ahead of the company's earnings report. Zimmer, which is set to release its own update on Monday, jumped an even stronger 2.1% to $68.49.
Harris Nesbitt analyst Joanne Wuensch has outperform ratings on Stryker and Zimmer alike. However, she has an underperform rating on one orthopedic device maker -- Biomet -- that has been excluded from the HCA deal.
Some experts believe that Biomet looks far more vulnerable than its larger peers. Biomet has refused to slash its own prices and lost some business as a result. The company has always counted on physician loyalty to win out over hospital mandates in the end. It has won that war before and, to be fair, continues to win some battles even now.
For example, one high-volume orthopedics group in Richmond recently abandoned HCA because it could continue using Biomet joints at a competing facility 25 miles down the road.
"We did 61% of their (orthopedics) business," Richard Worland, the high-profile surgeon who leads that group, told
last month. "The hospital is in serious trouble. ... But I don't think hospitals need to be practicing medicine, and they have no right to tell surgeons which implants to use."
Tom Chambers, an orthopedic surgeon who recently left an HCA-owned hospital in South Carolina, feels much the same. Indeed, he has even considered suing HCA for forcing surgeons to stop using certain devices -- which he considers an antitrust violation -- and failing to help cover any liabilities that may result.
Chambers portrays orthopedic surgeons as "carpenters, basically," who grow comfortable using certain tools and face a learning curve when they change. Chambers himself has chosen to switch hospitals, requiring a new 90-minute round-trip commute, rather than give up the devices he has been using for years.
But he worries that others -- notably patients -- could still suffer under arrangements like HCA's.
"The big three (device makers) haven't come up with anything innovative in the last two to three decades," Chambers insists. "It has always been the smaller companies that they have purchased. But small companies won't be around if they have no access to hospitals."
In the end, some believe, HCA could be hurting itself. They claim that HCA turned its back on discounts offered by non-contract vendors -- particularly Smith & Nephew -- that would have kept their prices down and their orthopedic referrals in place. But instead, they say, the company has taken extraordinary steps to enforce a contract that could bring no clear winners at all.
"I think that HCA has discovered that the contract isn't as good as they thought it was," says one Smith & Nephew representative. "And the contracted vendors aren't happy with the contract, either. They would just as soon see it go away."