Medtronic Spine Staggers

Bill Hawkins, CEO - MedtronicSurprised, confused and unexpected aren't terms surgeons, patients and investors like hearing from their medical device makers.

But those are some of the words Medtronic CEO Bill Hawkins used during a conference call with analysts on August 24 to describe the world's largest spine device maker's horrible quarter. Spine sales dropped over 9%.

This is a big admission from the ailing 800-pound Gorilla of spine.

Spine sales of $829 million for the quarter were down over 9%. Biologics, including InFuse, were down 5%. Spine hardware was down almost 7% and Kyphon, which Medtronic purchased for $4 billion a couple of years ago, was down over 20%. Overall, Medtronic's sales were down 4%.

Shifting Corporate Culture?

The fact that Medtronic is based in Minnesota, home of 10, 000 12-step recovery programs, may have something to do with Hawkins' admission of problems. Perhaps we are seeing a shift in the company's culture. In the past year Medtronic has become the first spine company to voluntarily disclose payments to surgeons. Senior executives have openly admitted to overpaying for Kyphon. Hawkins shuffled spine leadership and then stepped up to buy Osteotech at a good price.

These are things we might not have seen from Medtronic's spine division in Memphis a few years ago.

Fewer Jobs, Fewer Procedures and Price Squeezing

So what happened since the company met with analysts in March and painted a rosy picture for the future?

Hawkins pointed to a "challenging environment." He told analysts that a high unemployment rate and higher insurance costs have cut down on doctors' visits and hospitals have been squeezing manufacturers on pricing.

"I think that we are just in this kind of transition phase as we are trying to figure out what is going to happen long-term with the economy, " Hawkins told analysts. "I am confident that we will get through this and that people will return to going to see the doctor."

Declining Market Share

Wells Fargo analyst Mike Matson estimates Medtronic lost 4.7% of spine market share during the quarter, while the cheetah, NuVasive, gained 1.3%.

Hawkins said the biggest surprise for the company was the magnitude of the market slowdown and that slowdown escalated in late June and through July. The company saw per-procedure revenues decline driven by changes in product mix.

Refreshing Portfolio

"We remain focused on refreshing our entire [spinal] product portfolio. Solera, which is in its limited release phase, together with the recently launched TSRH 3Dx, are receiving very positive surgeon feedback.

"In biologics, we were encouraged by the positive FDA advisory panel recommendation for Amplify, and anticipate approval later this fiscal year.

"We continue to supplement our organic innovation and growth with tuck-in acquisitions that leverage our broad global footprint. Last week we announced our agreement to acquire Osteotech, which will enhance our strong portfolio of biologic products by adding best in class DBMs, consistent with our strategy of expanding our portfolio in the very attractive biologics market."

Matt Menze, PearlDiver Sr. AnalystWas this just "happy talk" from Hawkins and what are the challenges facing Medtronic as the company tries to stabilize spine sales?

Matt Menze, senior PearlDiver spine analyst told OTW that Medtronic is right to focus on new product launches and quantitatively showing how these products save on costs.

"However, during the call, " said Menze, "it was suggested that in order to save on costs, some hospitals are shifting back to titanium and away from PEEK. PEEK is part of some of the new products Medtronic is developing and for which it is hoping to receive premium pricing, The burden will be on Medtronic to show that the premiums are warranted."

Spine Surgery Pushback

Menze noted that Hawkins indicated that the company was seeing private payer pushback regarding indications for spine surgery as well.

"Indications such as 'lumbago' or 'low back pain' are drawing scrutiny from insurers, " said Menze.

PearlDiver Dissects the Codes

"We queried the PearlDiver private pay database and analyzed 7, 061 posterior lumbar fusions performed in 2009. We found that 'back pain' (as defined by ICD-9 diagnosis code 724.5) was coded in 2.5% (178 procedures) of the cases. Lumbago (as defined by ICD-9 diagnosis code 724.2) was coded for 12.5% (886 procedures) of the cases.

“'Back pain' was coded as the primary diagnosis (or the diagnosis most related to the procedure) in under 1% of the cases, while lumbago was coded as primary diagnosis in 196 procedures or 2.7% of the cases."

This, according to Menze, means that 1-3% of posterior lumbar spine fusions are “at risk” for private payer pushback due to back pain being the diagnosis, while about 12% are at risk due to a diagnosis of lumbago. Overall, Menze said these account for the minority of cases.

"However, lumbar degenerative disc disease (as defined by ICD-9 diagnosis code 722.52) was coded in 58% or 4, 088 cases. It would seem that the larger threat would be if private insurers began requiring something more than DDD [degenerative disc disease] as a diagnosis, such as spinal instability since DDD comprises the majority of posterior lumbar spine fusion cases, " concluded Menze.

Hawkins told analysts that lower back pain is the second most common reason people go to see a physician and the number of people who are actually getting instrumented through fusions or having a surgical operation is still a very small percent. "I think as the technology continues to evolve, as we advance more minimally invasive approaches, whether it's the direct lateral approach or whether using some of the navigation technologies that we have, I believe we're going to be able to continue to grow the overall market."

New Targeted Products

Hawkins believes new products, beginning with Solera, the TSRH 3Dx, Vertex Select and whole series of products are "targeted right at where the market is going, so we're optimistic over the long run, but we're in a period now that is a bit uncertain."

Gary Ellis, Medtronic's CFO told analysts that netting out the effect of the market slowdown during the quarter, Medtronic performed about where management expected relative to the market "as we continue to progress toward returning the business to market growth by the end of FY11."

"However, based on current market conditions, we believe that it is more reasonable to model flat FY11 revenue growth for our spinal business, which includes the negative impact of the extra week last year and assumes spine market growth for the remainder of our fiscal year of 3% to 4%.

Flat, Negative 2010

PearlDiver's Menze was not as optimistic. Menze said he anticipates flat to slightly negative revenue growth for calendar year 2010.

He estimates third quarter revenues will decline 3.7% resulting in $830 million in sales. He expects calendar year 2010 revenues to decline 1.9% to $3.434 billion.

"After including Medtronic results into our overall market model, we estimate that overall spine market growth was slightly negative for the quarter. We do not anticipate that there will be a reversal of the negative trends affecting the spine market by year end.

“There are also macroeconomic signs indicating that the economic recovery (if there is one) may not be as robust as previously thought. High unemployment resulting in a loss of benefits is key, as 70% of spine fusions are covered by private insurers and the majority of patients that are privately insured receive their health insurance through their employers. The industry faces sever macroeconomic headwinds and industry specific challenges.”

Reducing Spine Exposure

Menze observed, "Management indicated that the company is working to develop an overall portfolio that is less leveraged to spine (22% of Medtronic’s total revenue is spine related). This indicates that the company does not view spine as making the strong contribution to overall company revenue growth as it did in the past."

Perhaps this is another sign of a culture shift at Medtronic. Is this quarter the handwriting on the wall that Medtronic is accepting a loss of market share to competitors? Could it be a sign of Lukianov’s revenge?

Hawkins didn’t appear to reflect that sentiment.

Navigating a Mega Trend

Hawkins described a “mega trend” with hospitals purchasing more physician practices. The hospitals are working to get their physicians to look at ways to reduce those costs without compromising patient care.

Photo courtesy: Anthony Huff“That puts the onus back on us to be able to clearly demonstrate that when we bring out PEEK materials there is very clear evidence to support the clinical benefit of using a different material versus, say, a titanium.

“We're investing a lot in clinical evidence. The number of clinical studies we have across the enterprise, I think, is unparalleled in the industry.”

The company is on pace to spend over $1.2 billion in R&D alone this fiscal year.

China, India, Brazil

Hawkins is also looking overseas.

“Four or five years ago, ” said Hawkins, “we invested in China. I was there two weeks ago and I couldn't be more enthusiastic about the long-term prospects for where China is. It's close to a half a billion dollars run rate right now and growing at 20% plus a quarter.

“So we're making those investments and we have been in the other markets like India and Brazil. We're confident that these are going to be strong markets over the long run.

Will the Gorilla recover and finds his legs and hold off the Cheetah?