The growth story in the orthopedic-device sector is sounding a little creaky.

Outfits like Biomet ( BMET) and Zimmer ( ZMH) have been counting on aging, deep-pocketed baby boomers to drive huge earnings growth. But setbacks including a criminal probe of industry business practices have left investors feeling achy.

For years, joint makers have leaned on regular price increases, lucrative product upgrades and rising surgery volume. But the price hikes and upgrades have slowed, in part because hospitals have grown more demanding as their own finances have tightened. And some observers believe that even surgery growth could ebb, increasing the pressure on the group's already flailing shares.

More than a year ago, Bernstein analyst Bruce Nudell launched coverage with a cautious stance. Nudell was the rare analyst to question the staying power of the routine price increases that long boosted results. Now, his concerns are coming home to roost.

"From my point of view, this is just a tough space to invest in," says Nudell, who rates Biomet as underperform. "It will be interesting to see how all of this plays out." (Bernstein makes a market in Biomet.)

Biomet trades near the bottom of its 52-week range, while Zimmer -- the biggest pure-play orthopedics-device maker -- hovers near a three-year low. Even more diversified Stryker ( SYK) has been pounded.

Unhappy Turnaround

For now, at least, product pricing remains the biggest threat to the group.

Many blame an escalating government probe of the industry. In the spring of 2005, the Justice Department subpoenaed several big orthopedic-device makers about their financial arrangements with physicians.

For years, device makers had relied on notoriously brand-loyal surgeons -- including some with financial conflicts -- to insist on using their implants regardless of their costs. But government prosecutors, sniffing for possible fraud, have been investigating the financial arrangements between the makers and the surgeons who use their products.

Late last month, companies led by Zimmer revealed that they had received new subpoenas linked to a criminal probe. Now, industry sources say, the government has started asking companies about their arrangements with not only high-profile consultants and inventors, but also with less-prominent surgeons as well.

Biomet, Stryker, Zimmer and Johnson & Johnson's ( JNJ) DePuy failed to answer questions from Meanwhile, only Stryker has shared any real details with investors, saying in a recent conference call that investigators seem focused on possible antitrust violations involving specific products in specific regions of the country.

To be sure, orthopedic surgeons have started recognizing the gravity of the situation. This summer -- as the latest round of subpoenas went out -- The Journal of Bone and Joint Surgery published a lively debate about possible conflicts within the industry and how they should be handled.

Jorge Galante, a prominent surgeon on staff at at Zimmer's surgery training institute, acknowledged the potential for abuses under the current system, but nonetheless defended that system. In contrast, Sohail Mirza -- a University of Washington surgeon with industry ties of his own -- argued for some real changes, saying that even perceived conflicts can damage the public's trust.

Mirza cited possible weaknesses in orthopedics research, and the burdens that surgeons carry as a result, when making his case.

"The surgical literature, compared with that of other medical disciplines, lags in creating a strong evidence-based foundation for practice," he argued. "And much of the surgical care today depends on the experience and judgment of surgeons. In the face of uncertain science, patients largely trust this judgment, assuming that surgeons place the interests of patients first and foremost, beyond personal gain. ... Thus, orthopedic surgeons need to reevaluate their relationships with device manufacturers and address concerns about the influence of conflicts of interest."

Early Warning

While relatively new to orthopedics coverage, Nudell has performed some research that helps reveal how bone surgeons -- and the hospitals that rely on them -- tend to operate.

Last fall, shortly after initiating coverage of orthopedic stocks, Nudell published a telling report showing that just 20% of orthopedic surgeons perform some 70% of joint-replacement surgeries in this country. On a positive note, he said at the time, that metric suggests that these so-called battleground docs could push the adoption of premium implants manufactured by the companies they favor.

Since then, however, he has published new research -- finished just before the latest wave of subpoenas -- revealing that hospitals have long assumed that they were paying equitable prices for such implants and upon learning otherwise could start demanding lower prices as transparency increases in the wake of the current industry probe.

More specifically, Nudell found huge disparities in prices paid by hospitals for artificial joints that he views as unsustainable in the changing industry environment.

"The significant price dispersion that exists suggests a lack of price transparency and the insensitivity of surgeons to the cost of the implants that they ask to be purchased," he says. "Greater recognition of the true pricing environment on the part of hospitals will likely sour the relationship between manufacturers and providers, making it tougher to extract (price) increases for new products."

In a nutshell, then, Nudell foresees threats to not only standard implants, but to newer offerings -- such as gender-specific knees and hip-resurfacing systems -- as well.

Medicare Issues

To be fair, however, Nudell has yet to see real evidence of a third risk warned about by others.

So far, at least, device makers have been able to count on rising surgery volumes to boost their overall results. Even Nudell believes this trend can continue. At the same time, however, he has published research revealing unexpected -- and still largely unrecognized -- surgery declines in the past.

Between 1996 and 2000, Nudell notes, orthopedic surgeries remained flat, despite a surge in the senior population. Some, if not Nudell, now see the possibility of history repeating itself because of low Medicare payments.

Notably, just last month a major orthopedics journal featured an entire story about surgeons who have stopped treating Medicare patients because of poor reimbursement. Orthopedic surgeons -- even more than the hospitals where they operate -- have found themselves struggling to make decent profits on Medicare patients.

"The progressive erosion of Medicare payments vs. increased overhead has given new life to the question of opting in or out of the Medicare program," Denver spine surgeon David Wong wrote in Orthopedics Today. "Surveys performed by the North American Spine Society in 2001 and again in 2002 suggest that an increasing number of NASS members are opting out of Medicare or restricting access of Medicare patients to their practices. An American Medical Association survey revealed similar findings."

Spine surgeons, like those surveyed, often collect better payments than some orthopedic specialists. Thus, if joint-replacement surgeons follow their path -- as some have already done -- device makers could find volumes hurt, despite baby boomer-related opportunities.

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