Zimmer, HCA Clash Over Discounts

A joint implant-pricing deal isn't going smoothly.
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Updated from 1:36 p.m.

Zimmer

(ZMH)

has just won a very public battle with

HCA

(HCA) - Get Report

- the nation's largest hospital chain - over pricing for its artificial joints.

Prompted by a threat from Zimmer, HCA announced Tuesday afternoon that the company was "in error" when it told investors last week that it would continue to enjoy discounts from Zimmer and two other vendors throughout 2006. HCA said that the company had, in fact, failed to meet requirements set forth by all three of those vendors that would have allowed the price cuts to continue.

"I regret any incorrect statements we have inadvertently made," HCA CEO Jack Bovender stated on Tuesday. "We will continue to pursue our orthopedic program with our vendors, and I am hopeful we can resume negotiations to revitalize the long and positive relationship between HCA and Zimmer."

HCA's stock fell 2.4% to $47.91 during Tuesday's controversy. Meanwhile, Zimmer bounced a little less than 1% to $67.26 at the end of Tuesday's session.

The stakes are high. In recent quarters, orthopedic device makers have found themselves fielding demands for discounted implants from hospitals that claim they no longer make money on many joint-replacement surgeries. Three device makers -- Zimmer,

Stryker

(SYK) - Get Report

and

Johnson &

Johnson's

(JNJ) - Get Report

DePuy -- answered HCA's call last year by giving the hospital chain price breaks in return for 95% of its business.

The deal, which relies on the cooperation of notoriously brand-loyal surgeons, has been closely watched by both sides of the industry. The outcome, some felt, would help signal which party would hold the upper hand in pricing negotiations going forward. Zimmer's latest disclosures have now left some experts feeling that device makers could win out in the end.

"We view this as significant," wrote Deutsche Bank analyst Tao Levy, "as it demonstrates that the orthopedic companies will continue to vigorously defend pricing proactively and not simply be at the mercy of customers, large or small."

Deutsche Bank has a buy recommendation on Zimmer's stock. The firm does, and seeks to do, business with the companies it covers in its reports.

Zimmer's letter, made public just ahead of a company presentation on Tuesday, helped push its shares up 1.6% to $67.78. Shares of other orthopedic device makers gained some ground as well.

Behind the Scenes

To be sure, many found Zimmer's letter enlightening.

"The letter ... sheds remarkable light on the behind-the-scenes discussions between Zimmer and HCA," JPMorgan analyst Michael Weinstein wrote on Tuesday. It "highlights a series of 'non-contractual attempts to achieve the appearance of compliance.'"

Over the past 30 days, Zimmer claims, HCA has taken three deliberate steps -- never approved by Zimmer itself -- in an effort to meet its goals. First, Zimmer says, HCA asked for permission to deliver 90%, rather than 95%, of its business to those involved in the contract. Second, the company says, HCA asked for Zimmer to grant an "exemption" for 23 of its 170 domestic hospitals. Third, it says, HCA asked if certain of its divisions could simply fall short of the requirements.

Notably, Zimmer claims, HCA made its third request a day after telling its investors that it had already met its targets and expected its discounts to continue.

By then, Zimmer says that it had already taken several steps to restore its former prices. Indeed, Zimmer says that it actually started to increase its prices -- albeit not yet to original levels -- after HCA first failed to meet its compliance targets last fall. Moreover, Zimmer adds, "you acknowledged these September-announced price increases by paying numerous invoices thereafter based on the revised pricing."

Then, in late November, Zimmer says that it formally denied HCA's request for a one-year extension of the pricing discounts. Finally, on Jan. 1, Zimmer says that it reinstated its old prices.

To be fair, HCA acknowledged that it had not reached compliance by the end of 2005. The company instead told investors last week that it had since met its targets and, therefore, anticipated ongoing discounts for 2006.

However, Zimmer clearly believes that HCA wound up misleading investors in the end.

"Various statements made during the HCA call have caused confusion by their implication that somehow HCA would still be entitled to 2005 pricing, when communications among Zimmer, HPG (HCA's purchasing group) and HCA establish that this is simply not the case," Zimmer wrote. "HCA's public statements on these issues have caused damage to Zimmer -- to our credibility and otherwise. Be advised that we reserve the right to take any steps that are necessary to clarify any confusion based on the HCA call."

Even when apologizing on Tuesday, HCA suggested that it felt it was telling the truth.

"At the time of the conference call, HCA was in active negotiations with representatives of Zimmer to reduce its compliance commitment from 95% to 90%, and HCA believed it would be able to obtain that change," HCA said. "Having reviewed the latter from Zimmer filed with the Form 8-K, we conclude we were wrong in that belief."

Weinstein, for one, sees fresh reason for hope.

"After 12 months of taking it on the chin from HCA, with its public attacks at investor conferences and on earnings calls, one of the three major orthopedic companies finally fired back," wrote Weinstein, whose firm counts both HCA and Zimmer as clients and owns at least 1% of HCA's shares. "We believe Zimmer's letter both highlights the fact that surgeon preference still prevails in orthopedic implants and sets the tone for future contract negotiations for the orthopedic industry as a whole. (These are) two important positives for the ortho industry, in our view -- and a much better start to 2006."