Description

The following is a short recommendation on Kyphon KYPH. The company is exceedingly expensive based on revenues and on earnings.

($ in millions)
FD Shrs 43 2003 2004E 2005E
Recent Price 24.5 EPS $0.20 $0.42 $0.59
Mcap 1053.5 PE 123 58 42
Cash 70 Revs 130 188 228
EV 983.5 EV/Sales 7.6 5.2 4.3

However, being expensive is just part of the story. This single product company enjoys a very high average selling price for its device (due to the largesse of Medicare) which I do not believe is sustainable over time and, until recently, enjoyed a monopoly position in the marketplace. In addition, insider selling has been regular and intense.

Kyphon is a medical device company that serves the vertebral compression fracture market. A vertebral compression fracture is a fracture of the vertebral body in the spine, typically occurring in elderly patients due to osteoporosis. Because of VCFs, many elderly people actually lose height and appear shorter than they did in their youth.

The traditional method of fixing vertebral fractures is to perform a vertebroblasty, which entails injecting the vertebral body with cement, thereby repairing the fracture. It is primarily regarded as a pain relief procedure and is performed typically by interventional radiologists. Reimbursement for vertebroplasty was recently increased by CMS (Medicare) from roughly $1300 to approximately $4000 in Ambulatory Surgery Center settings. The cost of materials for a vertebroplasty is ~$600.

Kyphon has taken the vertebroplasty procedure to the next level; instead of simply injecting cement into the collapsed vertebral body, Kyphon’s device entails the use of a saline filled balloon which expands within the vertebral body, creating sufficient space for the subsequent cement fill. A procedure that creates a space within the vertebral body is better known as a “kyphoplasty”. Advocates of the kyphoplasty procedure claim that the primary benefit of the balloon vs. no balloon is height restoration and fewer complications. Kyphon owns the intellectual property around its balloon technology and its balloon product accounts for virtually all of its revenues. Medicare shells out between $8000 and $13,000 for a kyphoplasty procedure (including the surgeon fee), which entails an overnight stay in the hospital. KYPH’s average revenue for its kits per case exceeds $3,900. KYPH is paid for its product by the hospital.

The billion dollar US market potential that some analysts refer to is derived by multiplying the number of VCFs potentially treated surgically by KYPH’s ASP of $3,900. It has been estimated that there are roughly 250,000 of such potential cases.

In 2003, there were approximately 60,000 VCF cases treated surgically; KYPH captured about half of those cases, while vertebroplasty captured the vast majority of the other half.

The bull case is highly flawed in that it rests on three dubious assumptions.
1. Reimbursement for kyphoplasty is sustainable.
2. Clinical value of kyphoplasty vs. vertebroplasty is measurable and significant.
3. KYPH’s intellectual property surrounding balloon technology would enable an environment free of competition.


QUESTIONABLE PREMISE #1
1. Reimbursement for kyphoplasty is sustainable.

Over 95% of KYPH’s procedure are reimbursed by Medicare. Importantly, there is no specific code for kyphoplasty. Spinal surgeons are able to use non-specific spinal codes 233 and 234 for fracture reduction and spinal fixation. Such coding can only be triggered if the patient stays overnight in the hospital. Do they need to stay overnight? Clearly not- as evidenced by the vast majority of vertebroplasty procedures being performed in an outpatient setting. A kyphoplasty procedure is no more invasive than a vertebroplasty. An early sign that Medicare is becoming aware of the relatively high cost of kyphoplasty is that it has tripled the global payment for a vertebroplasty procedure in the ambulatory surgery center to ~$4,000. Under the new reimbursement guidelines, doctors stand to make as much, if not more profit doing vertebroplasty as they would doing a kyphoplasty. This first step by Medicare is effectively removing economic incentives to prefer kyphplasty over vertebroplasty.

QUESTIONABLE PREMISE #2

2. Clinical value of kyphoplasty vs. vertebroplasty is measurable and significant.

Within the medical community the kyphoplasty procedure is highly controversial. Critics of the very expensive kyphoplasty procedure agree that it is a good pain relief procedure, but it is no better than the less expensive vertebroplasty. Critics have also complained that Kyphon has not proven that its procedure is superior to vertebroplasty in the form of head-to-head studies. Critics further indicate that as much height restoration can be achieved with vertebroplasty by positioning the patient properly on the table while performing the procedure. Ultimately, the failure of Kyphoplasty to prove itself superior to vertebroplasty could spell the demise of kyphoplasty’s generous reimbursement by Medicare.

QUESTIONABLE PREMISE #3

2. KYPH’s intellectual property surrounding balloon technology would enable it to maintain a monopoly situation for the foreseeable future.

Having received 510k approval in January of 2004, Disc-O-Tech, an Israeli start-up, is now the second competitor with an approved device specifically designed for performing kyphoplasty. Disc-O-Tech has cleverly sidestepped the KYPH patents in that its space- creating device does not use balloon technology, but uses a polymer material which unfurls at the tip of an injection device within the vertebral body. The SkyBone Expander as it is called, is not vulnerable to puncture (KYPH balloon’s puncture in 15% of cases) and is more capable of restoring height than the Kyphon balloon since it is not compressable as is the balloon. We understand that Disc-O-Tech is not interested in marketing the product themselves. Instead, they are seeking a partner with strong ties to the spinal surgeon market. Ultimately, the emergence of this competitor will likely result in lost unit market share and price competition for Kyphon.

Catalyst

· Kyphon competitor establishing distribution with large medical device company- ultimately a direct competitor will likely steal market share and compete on price.
· Doctors shifting volume back to vertebroplasty now that reimbursement for vertebroplasty has been substantially improved and relative clinical benefits of kyphoplasty vs. vertebroplasty remain unproven.
· Reduction in Medicare reimbursement for kyphoplasty due to demonstration of virtually equal clinical value of vertebroplasty. Vertebroplasty competitors are motivated to perform such studies. These competitors include Arthrocare, Interpore Cross and Cardinal Health.