Zimmer Redux

Six months after a significant management change, Zimmer officials claim the orthopedics leader is back on track. But in today's environment, can even a successful orthopedics company please its drug-company parent?

In today's environment, can even a successful orthopedics company please its drug-company parent?

by David Cassak and Stephen Levin

• Long the undisputed orthopedics market leader, Zimmer has been going through difficult times. By contrast, Zimmer's parent, Bristol-Myers Squibb, is now the number one US pharmaceutical company.

• Judging by recent history, when pharma booms, Rx parents look to shed their device subsidiaries.

• However, Zimmer's new management believes it is the exception to that rule.

• Zimmer's strategy is going forward with a focus on sales efficiency, a more skeptical attitude toward national contracting, and an enhanced effort to get into new areas like biologics and spinal.

Uneasy lies the head that wears the crown, said Shakespeare. In business, market leadership is an enviable position—until things start going wrong. Then, it almost becomes a burden; market leaders have further to fall and less to gain in recovering their once-vaunted position. And then there's the psychological factor: having reached the top, even second place looks bad by comparison.

In orthopedics, the undisputed market leader through the late 1980s and early 1990s was Zimmer Inc., a wholly-owned subsidiary of Bristol-Myers Squibb Co. Riding the crest of the orthopedics industry's fast-paced growth, the company combined strong surgeon relationships, quick product development, and a powerful sales and distribution engine to soar to the top of the market.

But more recently, Zimmer has faced difficult times. Executives at Zimmer and knowledgeable outsiders note that the orthopedic giant is today and always has been strongly profitable. But over the last couple of years, the company has slowly but steadily been losing market share; from a high of around 24% a couple of years ago, Zimmer today has around 19% of the US reconstructive joint market—still number-one, but shrinking. Some financial analysts believe that within five years, Zimmer will lose its number one position to faster-growing competitors such as DePuy Inc.

To arrest its slide, Bristol-Myers Squibb cleaned house at Zimmer a year ago, announcing a change of leadership that saw a number of executives, including president Terence Furness, president/global products group Guy Mayer, and president/Europe Jeffrey Ashpitz relieved of their duties. While BMS searched for replacements, a new management team led by Peter R. Dolan, president of BMS's nutritionals and medical devices group, served in the interim. Within BMS, the tough but talented Dolan had earned a reputation as something of a turnaround specialist—he re-invigorated the company's declining OTC drug business and turned it into a winner. Now, he was asked to do the same with Zimmer.

While Dolan's assignment with Zimmer hardly requires the resuscitation he had to perform with BMS's OTC business, heading up a market leader in decline is not for the faint of heart. This is especially true when the struggling device subsidiary is part of a booming pharmaceutical parent, a situation that recent history tells us is not long on parental patience. By bringing in a new management team, Dolan may at least have bought himself some time with BMS to get Zimmer back on track. The real question is, however: will the bigger challenge for Zimmer's new leadership come from the economic and competitive pressures of the marketplace or from the high expectations of its parent?

A Special Challenge

Zimmer's new president, J. Raymond Elliott, an American Hospital Supply veteran who was most recently president and CEO of exercise and rehabilitation equipment manufacturer Cybex International Inc. , challenges the notion that Zimmer today is undergoing a turnaround. As noted, the company has always been profitable. "As far as I know, Zimmer has never been an underperformer" financially, says Elliott. "So, in that context, it's not really a turnaround." And Elliott refuses to talk about the management team that preceded the current one he's heading or why a change was needed. "That took place long before my time here," he says of Zimmer's firing of several senior executives last year.

Still, executives close to the company argue that Zimmer simply can't continue to operate as it has. "The business has to be run completely differently," says one. Ray Elliott notes, "I still think we're the best company in the orthopedics industry." But even he concedes that "the company got off track" and says there are several areas Zimmer must focus on over the short-term to hold its leading market position—improved sales efficiency, better management of what Elliott calls the supply chain, R&D productivity, and geographic market expansion.

More to the point, Elliott acknowledges that behind all of these issues, pretty standard fare for any device executive today, Zimmer faces a special challenge. "We've had a lot of success in recent years. But there's been a perception here that, all of a sudden, we weren't so successful. We were losing share, and if you went and talked to the people who work here every day, it's been a fairly depressed environment," he says.

A Downsizing By Any Other Name

Adding to the somber mood at Zimmer: during the interim management period led by Peter Dolan, the company went through what Elliott calls "a fair amount of physical restructuring, with fewer people and all of the things that companies do in a so-called downsizing."

Elliott insists that Zimmer's restructuring was "less a downsizing than a refocusing," a refocusing on the company's core strengths in the US reconstructive (hip and knee) implant and, to a lesser degree, fracture markets. But strategic direction aside, the need to give Zimmer a new drive is one reason why Elliott says one of his chief aims is "to re-institute pride in the company and to reorganize how people, both internally and externally, view this company." As such, Elliott argues that his mandate as Zimmer's new CEO is less to fix the problems of the past than "to build a future for the company." He says, focusing on questions such as, in his words, "What's the strategic plan going forward? How are we going to execute it? What will it cost? And what's the output at the end?"

As noted, one of Elliott's top priorities was to improve what he calls Zimmer's "selling efficiency." Building on an initiative launched in February of 1997 by its SVP/US, Bruce Peterson, Zimmer began a major reorganization of its distribution network. (For more on this program, see "Zimmer Returns to its Roots,"IN VIVO February 1997.)

Under the new program, Zimmer streamlined its distribution network by reducing the number of distributors from 75 to around 27, including Alaska and Hawaii. And in Zimmer's five worst performing markets, markets where its share was lowest, it turned the business over to its five best distributors. "We simply asked them to move from geographies where they were doing very well and put them in tough geographies," says Elliott.

In the process, Zimmer created not just larger territories, but also higher, measurable standards for its distributors. "We went to contract by performance, not tenure," says Elliott, "and modified changes in commission structures that were much more performance oriented."

Zimmer also hopes to forge what Elliott calls "a much closer bond" with the distributors who remain. "We went to partnerships," he says, helping its distributors with everything from back office operations to things such as selection of employees and training. "We've gone to quarterly and in some cases monthly meetings with them, very intense meetings," he goes on. "We've gone to a system where we're working with them to find the products that will flow through and make them successful."

Zimmer's restructuring has gone as far as it will, at least in terms of reducing the number of distributors, says Elliott, who calls the results of the new distribution system "outstanding so far." But the restructuring was designed to address not just weaknesses in Zimmer's own distribution system, but new forces affecting the orthopedics industry over the past several years. Following a period of dynamic growth from the late 1980s to the early 1990s, the industry has seen both price constraints and shifts in utilization as managed care and other cost pressures have forced hospitals and surgeons to more carefully scrutinize implant use, focusing on lower cost products and deeper discounts from manufacturers.

Efforts to streamline distribution networks and, generally, to address what Elliott calls "the supply chain," are all part of the new reality for orthopedics companies. "The service part of the business is going to become huge in terms of complementing implant sales," predicts Elliott, service that embraces everything from clinical outcomes and residents' support to practice management, elements Elliott refers to as "the software side of the business."

The Orthopedic Iceberg

But complicating the current challenge for the orthopedics market is the fact that managed care pressures, while real to some degree, have been less acutely felt than many industry executives anticipated. In particular, many believe implant prices have begun to level off after an assault of several years, a view Ray Elliott shares. "I think pricing has somewhat stabilized and part of the reason is, customers are beginning to appreciate the level of benefit we provide," he says.

Elliott is betting that customers will begin to look at what he calls "the big picture," the overall cost of both orthopedic procedures and individual implants, rather than at the price of a particular product. He is banking as well on customers who will value both the clinical outcomes data derived from extensive testing to help reduce surgical costs, and the resident education support and other educational programs that Zimmer offers. In short, Elliott argues, if you unbundle all these related services Zimmer provides and add those to the price of the implant or instrument, "you're driving huge value."

Elliott believes customers are now coming around to that realization, based in no small part on the educational efforts of Zimmer and the other major orthopedics companies. In the process, the threat that customers would increasingly regard orthopedic implants as commodities has begun to wane. "If you see an orthopedic implant as simply a piece of metal, you can argue yourself into the position that it's a commodity and not worth more than a couple of dollars," he says. "But if you look at what really goes into that implant, and in particular the service levels that go with it, there's clearly huge value."

Indeed, Elliott argues that customers, and in particular orthopedics surgeons, are beginning to realize that the price of the implant per serepresents a relatively minor component of cost, and that an exclusive focus on price misses the point for cost-conscious customers. It's what Elliott calls "the iceberg of orthopedics." "It's not the above the water services that'll kill you," he says, "it's the ones that disappear below the water that you didn't even know you were paying for." Threatened with the loss of certain services, Elliott claims that surgeons have been "pushing back more visibly in the last couple of years" to preserve these value-added items. The result, he notes, has been a stabilizing of prices that he believes will continue at least for the foreseeable future.

One large reason for the retreat in pricing pressures: the failure of large national hospital groups to enforce national contracts. After a period of several years when each of the leading national hospital alliances and systems, most notably Premier Inc., VHA Inc., and Columbia/HCA Healthcare Corp., all launched ambitious contracting efforts in orthopedic implants, all but the most optimistic of industry executives have come to conclude that these contracts have been disappointments. As these agreements sought significant price discounts but delivered little in the way of new business, executives throughout the orthopedics industry have begun to rethink the value and long-term impact of national contracting.

Ray Elliott believes managed care and national contracting will continue to grow at a modest rate, but he doesn't think they'll dominate the orthopedics industry, if only because there are too many other factors at play in the US health care system. Zimmer, "like everybody else, probably swung the pendulum too far in reaction to the whole [national contracting] situation," he acknowledges.

But Elliott implies at least that Zimmer will, like other orthopedics companies, begin to take a tougher line in negotiating future contracts. "I look at the compliance figures," he says, "and it becomes a game of incremental economics. We calculate at what point an incremental share of a high compliance contract at a low price is still a valuable earnings contribution. And we calculate the opposite." The result, according to Elliott, is that "there are some contracts out there that we simply will not participate heavily in because we don't believe the incremental economics are beneficial to Zimmer or BMS. It's just economics."

The refusal of market leaders like Zimmer to participate in national contracts has reverberations beyond Zimmer's own P&L statement. Indeed, high surgeon preference lines like orthopedic implants largely require market leadership participation because of the reluctance of surgeons to accept products that are unfamiliar or perceived to be of lower quality. Indeed, national contracting in such products is almost exclusively a game pitting big players against each other. Where such contracts have been successful, it is because hospitals and surgeons were offered a choice among leading brands; such agreements have proven almost powerless to improve the market share of smaller players(see "Wright Medical: Surviving as a Mid-Sized Device Company," IN VIVO, April 1996).

Ray Elliott insists that Zimmer has already walked away from contracts because the economics weren't there. About one negotiation with a leading group, he says, "They came to us interested in putting our product on contract. We told them they'd have to live by certain rules and when they said they couldn't, we just walked away." (Elliott won't say who the group is, but reports are it was Columbia, one of the few leading groups with whom Zimmer does not have an agreement.) Indeed, a truly new approach to national contracting by a market leader like Zimmer could more broadly affect the future of national contracting, especially as leading groups begin to revise their initial orthopedics programs—but only if Zimmer can maintain its reputation as a viable market leader.

Hips + Knees = Success

By late 1996, according to people who know Zimmer, the company was still extremely profitable, but had continued to lose market share. "Their knee business had stabilized, but the hip business was still deteriorating," says one industry executive. Ray Elliott acknowledges how important regaining dominance in the hip implant market is, particularly in the US. "The essential ingredient" to Zimmer's success, according to Elliott, "is to win the game in the US in hips and knees."

A more efficient sales and distribution organization and a more studied approach to national contracting will help. But perhaps an even greater challenge lies in Zimmer's product development. The product development strategy Zimmer relied on to drive its most successful growth is no longer viable. Working closely with large numbers of surgeons to produce a wide range of different designs was a great strategy when the market could and would pay for anything. But in a more cost-constrained market, dominated by more efficient purchasing styles, precisely the kind of supply chain issues Zimmer is focusing on, that doesn't work.

Ray Elliott argues that one of Zimmer's strengths is "one of the best corps of designing surgeons and surgeon relationships in the business." Still, Zimmer has paid a price for that closeness: says one industry executive, "The problem is, Zimmer has focused all of its attention on its inventing surgeons. As a result, they have an incredible array of products in hip replacement and a product development effort that is extremely complex."

In short, says this executive, "Zimmer has to become a more nimble hip and knee company than it was." Even Elliott acknowledges that, for example, the company's lack of hip revision implant products reveals "an obvious incompleteness" in Zimmer's R&D and product development efforts.

But a more critical threat to Zimmer's future success may come from the company's historical lack of investment in alternative strategies in adjacent markets which most industry observers believe represent the future of orthopedics. Elliott admits Zimmer is lagging and specifically cites tendons, ligaments, cartilage, bone growth, and biologics and biomaterials generally as areas to which the company has not paid enough R&D attention. "There's been no major work in the last few years on things outside of what I would call basic metals and polymers," he says, noting, "We've gotten away from being a business built on innovation." Not surprisingly, Elliott's plans call for re-allocating a significant portion of overall spending to R&D.

Tough To Crack Spinal Market

Zimmer's focus on its core hip and knee lines is a clear part of the company's "refocusing" as Elliott puts it. How far Zimmer will expand into other, newer orthopedics product lines, most notably spinal and biologics, remains to be seen.

The spinal market is particularly critical for Zimmer because this is the area currently driving growth in orthopedics. While traditional implant products are either flat or struggling to achieve low single digit growth, spinal products are booming at a rate approaching 15-20% annually. This is triggered in large part by new technologies such as interbody fusion cages (see "Reconnecting the Spinal Market," START-UP, April 1998). In looking at the future in orthopedics, Elliott says the question is "How do you grow dramatically without being in spine?"

This growth has also triggered a new interest by traditional orthopedics companies in an area they previously ignored because of litigation risks and a lack of synergy with existing orthopedics product lines. Along with this newfound interest in the spinal market has come a wave of acquisitions from which, to this point, Zimmer has been noticeably absent. Yet Elliott is adamant that, "We have to be in the spinal business. The only question is, how are we going to get into it?"

That question is critical because, unlike an area such as biologics or biomaterials which Zimmer will develop internally through its enhanced R&D spending, the spinal market is more difficult to grow from scratch. The research and product development curves are long and the spinal market requires a specialization, both in terms of R&D and customers, that differs from traditional orthopedics products. Elliott's answer is, "We will not build our spine business internally," listing licensing alliances, joint ventures, and acquisitions all as possible options.

Worldwide Challenges

Even Zimmer's one clear bright spot—its international operations—faces challenges. Ray Elliott contends that, of all its US-based orthopedics competitors, Zimmer has the highest ratio of ex-US to US sales, though he declines to release figures. (Other leading US orthopedics companies might dispute Zimmer's claim.)

Indeed, Zimmer's Japanese business is large—over $200 million a year in sales—and, in the words of one industry observer close to the Japanese market, "obscenely profitable." But the recent downturn in Asian economies and, in particular, the steady weakening of the yen against the dollar, suggests that even this one shining star may have faded a bit in the last year. Yet Elliott sees the Asian markets as being half full for Zimmer, with that region's current economic difficulties representing "just another stage in time." Zimmer is, he says, committed to Asia "for the long haul."

Zimmer is less strong in Europe—indeed in one of the largest markets, France, the company is no longer in the top three. Elliott acknowledges that market leadership is tougher in Europe, if only because of the strong presence of Swiss-based Sulzer Orthopedics Ltd. , a division of Sulzer Medica Ltd. , and DePuy, particularly in the hip market, though he draws sharp distinctions between the European hip and knee markets. While Zimmer is fast becoming the top knee company in Europe, he claims, "I think it will be a long time before anybody, including us, is number one in hips in Europe unless that market dramatically changes."

Living Up To Expectations

The ironic thing about Zimmer: despite all of the company's struggles, it still is the market leader. And Ray Elliott insists that in the last six months, the company has halted its slide in the very important US hip and knee market. For Elliott those markets are critical to Zimmer remaining the market leader. He notes, "It's tough to win a world battle if you can't win hips and knees in the US."

Still, some question whether this is enough. Talking about efforts at Zimmer to turn the company around a year ago, one executive close to the company notes, "It was a mammoth undertaking. Everything was taking much longer to do than they wanted. But the worst thing was that expectations at BMS were so high."

Zimmer was "trying to get the company turned around in a flat market," this executive goes on, "and the problem was BMS wanted the business to grow 15% a year, like its drug business was. It just wasn't going to happen." More to the point, BMS brought Peter Dolan on in the hopes that he would be able to recreate the magic he performed in his current capacity as head of BMS's nutritional business, Mead Johnson Nutritional Group, where he reportedly drove $100 million in savings to the bottom line, half of which he reinvested in the business, half of which turned over to BMS. The problem is, says one company observer, "he did it all in productivity gains. And at Mead Johnson there were incredible productivity opportunities. Zimmer doesn't have those." Zimmer contends that while each division in BMS's portfolio is responsible for productivity savings, the parent company's primary directive is that each division maintains one of the top two positions its respective business area.

Ray Elliott says he doesn't feel the burden of unrealistically high expectations from BMS senior managers, claiming that the only pressure is to maximize shareholder return. "I don't have to prove to be any better than [BMS's] US pharma or Mead Johnson," he asserts. "I've got to prove that I'm better than everybody else in the orthopedics industry."

But executives at other device companies that are owned by drug companies have, in the past, often complained that managing a device company to live up to the high margin expectations of drug companies is tough. Over the past two decades, the pharmaceutical industry has followed a for-the-most-part consistent pattern: when business turns down in pharmaceuticals, invest in medical devices for the steady returns and diversification opportunities. But when the drug business gets healthy again, get rid of the device businesses.

Thus, over the past decade, a number of drug companies have divested their medical device businesses. To name just three prominent examples: Warner-Lambert Co. , which sold its Imed business; Eli Lilly & Co. , which in 1994 successfully spun off its devices businesses into cardiovascular giant Guidant Corp. [See Deal].

Most recently, Pfizer Inc. , riding one of the most successful drug businesses in history—also announced its intention of divesting its Shiley Inc. cardiovascular, Howmedica Inc. orthopedics, and American Medical Systems urological device businesses, after earlier selling its very successful Valleylab Inc. electrocautery business to United States Surgical Corp. [See Deal]. (Pfizer's reported plans: a spin-off into separate public companies of its various businesses, hoping to copy the success of Guidant, whose shareholder value has increased astronomically since its IPO.

Pfizer's announcement combined with BMS's own recent success in drugs has left many industry executives wondering over the similarities between Pfizer's device businesses and that of Bristol and speculating that BMS will try a similar divestiture. For one thing, like Pfizer's, BMS's drug business is soaring: diabetes drug Glucophagehas earned blockbuster status; its oncology franchise is the world leader at a time when excitement about new treatment options in cancer are at a fever pitch; and, as if to confirm BMS's success in hard figures, last year BMS became the number-one drug company in US sales, according to IMS America.

In addition, Pfizer's orthopedics business and Zimmer's have experienced similar fates over the past couple of years: both are market leaders (Howmedica was, until recently, number-two in the US) that have seen steady market share declines. And finally, just as Pfizer foreshadowed its announcement to exit medical devices altogether with the sale of ValleyLab, BMS last year divested to Conmed Corp. two other major device businesses, its Linvatec and Hall Surgical product lines [See Deal].

Of course, BMS has officially made no announcement of any intention to sell Zimmer or exit medical devices altogether; Linvatec and Hall were ostensibly sold because they no longer fit the company's business. But then, Pfizer initially denied that the ValleyLab sale was part of a larger effort to exit medical devices, claiming ValleyLab no longer fit a medical device business that would be built around a cardiovascular and orthopedic clinical focus. The similarities thus ring loudly for many watching both companies. "If Bristol doesn't intend to sell Zimmer as well, that [i.e., selling Linvatec and Hall] was a big mistake," says one industry executive.

But Ray Elliott insists that BMS is not positioning Zimmer for a sale, and he argues that "the starting points and end points" between BMS and Pfizer are quite different. "The big difference is Pfizer is a drug company that only wanted to be a drug company and now is one," Elliott argues. "BMS wants to be a diversified health and personal care company that relishes diversity. We feel it gives us better value, providing offsets for other markets' ups and downs," he goes on.

Elliott acknowledges that industry rumors surrounding BMS exiting the device world have already hurt Zimmer in the marketplace. He responds to those rumors by stating, "To the best of my knowledge, we will be a part of BMS for the foreseeable future based upon one thing. BMS, more so now than ever, is a performance based company and in order to remain a player, you have to perform."

Elliott was brought in to orchestrate Zimmer's improved performance. With his honeymoon period over, the curtain has gone up. A demanding market and an equally demanding parent will determine how long a run it will be.