The DOJ Goes Fishing for Orthopedics

Well, it finally happened.

After being rumored and whispered about by industry-watchers for quite some time, the U.S. Department of Justice (through the U.S. Attorney's Office in Newark) has finally launched an investigation of the orthopedics industry.

Stryker (NYSE: SYK  ) , Johnson & Johnson (NYSE: JNJ  ) , Biomet (Nasdaq: BMET  ) , and Smith & Nephew (NYSE: SNN  ) all received subpoenas yesterday. While orthopedics giant Zimmer (NYSE: ZMH  ) is notable for not being on that list (at press time), it may be only a matter of time before it too is included.

According to the various press releases, the investigations seem to be essentially identical. The government appears to be requesting documents pertaining to consulting, professional service, and remuneration agreements between the companies and physicians going back to 2002.

As I mentioned about two weeks ago in a piece on Biomet, this investigation was seen to be coming eventually -- particularly in the wake of the government's investigation of Medtronic's (NYSE: MDT  ) practices in its Sofamor Danek spine business.

So what, exactly, is the government looking for?

This investigation was likely prompted by a mix of concerns. Sales of orthopedic implant prices (particularly hip and knee) have risen markedly over the past years, and there have been accusations that the industry is engaging in aggressive selling practices and certain incentive-based arrangements to boost sales.

In particular, consulting agreements with physicians and surgeons are likely to bear the brunt of the scrutiny. Orthopedic companies routinely sign doctors to "consulting agreements" that can pay the doctor upwards of $50,000 a year. Although the companies are normally tight-lipped about these arrangements, it's something of an open secret in the industry, and upwards of 1,000 such agreements are likely outstanding.

While some of these arrangements are entirely legitimate (the doctors can help provide feedback on subjects ranging from product design to sales training), some observers have alleged that the agreements are often thinly veiled schemes to pay physicians to recommend and/or use a specific company's products.

Similarly, while companies are not eager to disclose a lot of information about these practices, it is generally thought that Zimmer and Johnson & Johnson are more aggressive (in terms of the number of contracts outstanding) and Stryker and Biomet are less so. In fact, Stryker recently reviewed all of its contracts and reduced the total number of contracted consultants.

So what will happen to the industry?

Probably not a whole lot. Investigations like these take years to complete (a similar investigation of the dialysis industry took about six years to resolve), and the likely consequence will be a wrist-slapping fine. By way of comparison, when the dialysis industry investigation was complete, it resulted in fines of $351 million for Gambro and $486 million for Fresenius (NYSE: FMS  ) .

Although it may seem as though I'm prematurely presuming guilt on the part of these companies, I've seen a lot of these government "fishing trips," and when they look long enough, they almost always find something for which they can levy fines.

In any event, any fines to be levied won't come for years, and they'll most likely be easily digestible for the companies involved. What's more, even if this investigation alters the industry's sales practices (say, by tightly restricting consulting arrangements), it doesn't alter the fundamental economics of the business -- more people are aging and need the artificial hips and knees.

Consequently, I'd suggest that investors keep a close eye on the stock prices of the companies involved. If the stocks really sell off, investors should consider using the opportunity to pick up some shares in quality growth companies at sale prices.

For more on the world of orthopedics, check out some related Foolishness:

Fool contributor Stephen Simpson owns shares of Johnson & Johnson. The Motley Fool has a disclosure policy.


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