The phones on the desks of hospital purchasing agents who buy hip and knee implants from Zimmer Holdings, Inc. and Biomet, Inc. are ringing right now.
On the other end of the line are investigators from the Federal Trade Commission (FTC). The investigators are asking the purchasing agents, among other things, if they believe the prices they pay for medical devices will go up if Zimmer is allowed to acquire Warsaw hometown rival Biomet.
According to Darren Tucker, the former FTC antitrust lawyer who handled the Johnson & Johnson/Synthes merger while working for the agency, if the answer is no, that’s pretty much the end of the story and the FTC will allow the Zimmer/Biomet deal to proceed. If the answer is maybe, the investigators will look for more data. If the answer is yes, the agency kicks into a high gear that could doom the deal.
Hart-Scott-Rodino Waiting Period
The Hart-Scott-Rodino (HSR) Act requires companies to file a premerger notification to both the FTC and the Department of Justice (DOJ). The agencies then agree who will review the case, but in ortho transactions it is usually the FTC. The premerger notification is full of information about each company’s business. The parties may not close the deal until a 30-day waiting period has passed, or the government has granted early termination of the waiting period.
Good Timing for Ortho
Tucker told investors during a Bank of America conference call hosted by analyst Bob Hopkins on June 19, 2014, that Zimmer is going to the FTC at a good time. The FTC staffers believe the marketplace in orthopedics is made up of highly sophisticated purchasers who have enough interchangeable products to choose from. Furthermore, going from five major suppliers to four does not set off antitrust alarm bells at the FTC.
Hospital mergers are the big deal at the agency at the moment with antitrust experts sitting on pretty good evidence that those mergers are driving up healthcare prices. Tucker also said that the agency, which looks for regulatory victories to tout to Congress and the media, will be unlikely to find them in orthopedics.
Tucker is surprised that since the deal was announced back in April, there has been no announcement from Zimmer. The HSR Act does not require the premerger notification to be filed at any particular time after a public announcement of intention to merge. A Zimmer spokesperson could not confirm or deny to us whether or not a premerger notification has been filed with the FTC.
The only public response to the merger so far has come from European regulators who put a halt to their review of the merger because Zimmer didn’t supply the needed information. Zimmer said it is responding aggressively to the request for more information.
“Pull and File”
Because the agency has 30 days to act and nothing has been made public, Tucker suspects Zimmer may have performed a “pull and refile” maneuver. After the company files the premerger notification documents, one of three things happens as the FTC looks at a deal.
First, says Tucker, the preliminary investigation with customers in the market might show that there is little fear of rising prices. In that case, the agency allows the HSR period to close and the deal proceeds.
Second, there may be some very limited questions on the minds of the investigators, but the company has a strong belief that the deal will be allowed to proceed. By “pulling and refiling, ” the company is giving agency another 30 days to settle their questions.
The Dreaded “Second Request”
Companies have a strong incentive to do that because if the staff questions are wide and deep enough, the agency will proceed to the third option: a “Second Request” order. Then all hell breaks loose as this sets up a massive roadblock which will extend the review period for many months. Only 4% of deals get a second request. Following the second request, there is a massive discovery request with depositions and subpoenas for documents from the parties as well as third parties. This can take as long as four to five months.
If a “Second Request” order is issued, there is a very heavy reliance on ordinary course of business documents to make the FTC case. That’s where investigators uncover, what Tucker called, “hot docs, ” where parties sometimes say things they really wish they hadn’t said. Investigators will dissect ordinary day-to-day documents which show things like who they view as their competitors including win/loss records, bidding records, marketing plans and strategies and strategic plans; all of which is designed to look at or to get at the idea of who is really competing against each other in the marketplace.
Search for Unilateral Effects
In the initial 30 or 60 day review period, Tucker says FTC lawyers and economists are looking for “unilateral effects.” That is, are the merging firms’ products particularly close to competitive products? Will a significant number of customers consider the Zimmer/Biomet products to be their first and second choices?
The investigators will want to know that if the merged company raises prices, are the purchasing agents going to continue to buy from the merged company and will they consider other competitors’ products to be very distant substitutes.
They’ll want to understand how customers actually purchase the products and how many suppliers they feel they need to maintain competitive pricing. Do they do things through RFPs (requests for proposals) or other types of formal bidding processes? Do hospitals limit it to two or three suppliers? They will want to talk to surgeons and other medical professionals to better understand to what extent the different suppliers in the market offer unique products or the extent to which, for example, Zimmer and Biomet’s products are unique in any way; this gets back to the idea of looking at the closeness of competition between the parties.
Product Differentiation
If there are a number of surgeons that state Zimmer and Biomet are offering the best products, that is potentially a concern. If, on the other hand, the surgeons say that they like all of the products on the market or if they weren’t able to turn to Zimmer, they would be happy with J&J’s or Stryker’s…hat would be very helpful for the transaction.
The FTC will also look at whether or not there are other companies that might replace the competition that would be lost from the merger. That new competition can come from two places. It could come from new entrants into a market, or it could come from an existing competitor. Agency investigators will ask if other players in the marketplace might reposition their products or might make other changes to make headway with customers that might be dissatisfied from the transaction.
In short, Zimmer and Biomet’s fate lies in the hands of their customers.
Five to Three and Market Share
That proposed consolidation will reduce the number of major U.S.-based hip and knee makers from four to three, with only Zimmer/Biomet, DePuy Synthes and Stryker remaining. Stryker has made it clear it is considering an acquisition of Smith & Nephew, which is based in England but makes its implants in Memphis, Tennessee.
Going from five to three major market competitors in a marketplace raises antitrust concerns. It was a consent agreement negotiated by Tucker that required DePuy to divest itself of its wrist trauma business before the FTC allowed the Synthes merger to proceed.
With JNJ/Synthes, Tucker said the FTC was concerned about the market for wrist fracture treatment systems and found that the merging parties would have over 70% share in that market. However, Tucker believes that non-industry outsiders often mistakenly place too much emphasis on overall market share statistics.
Market shares are not the only consideration. Yet, said Tucker, 70% is high and a merging party would have a hefty burden to convince the FTC that there is not a problem with the merged companies having a 70% share of most any market.
Dave Dvorak, Zimmer’s president and CEO, told analysts on April 24, 2014 that it was important to keep in mind that the orthopedics market is a $45 billion industry. He noted that Zimmer’s market share in knees is in the mid 20% range, while Biomet is in the lower teens. In hips, Zimmer is close to 20%, while Biomet has a similar share.
According to Tucker, the market shares in ortho are high with Zimmer/Biomet but certainly not showstoppers. With sophisticated customers doing everything they can to drive down costs, you typically don’t need to have five competitors for the customers to maintain competitive price levels. Four would certainly seem to be adequate and maybe even three, according to Tucker.
The other thing the FTC will look at is how many suppliers are needed to maintain competitive price levels, and this is very much an industry specific issue. There is no magic number of how many competitors you need in an industry to remain competitive. There have been some industries where the FTC has actually allowed deals to go from three to two, for example, without there being a problem because customers said they only need two suppliers because they can hammer the two against each other or play them off each other.
Clearance Expected
Tucker believes the FTC will want to clear the case quickly because he does not see the agency wanting to push to make a big case in ortho transactions right now. They are more interested in the hospitals for which the purchasing agents work. Maybe FTC staff is taking the opportunity to ask those purchasing agents some questions about their own competitors.
