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Orthopedic tax pains

With U.S. sales to grow costlier, one company looks abroad

Deeter
Photos by Samuel Hoffman | The Journal Gazette
Tibia plates, top, and intramedullary nails are among products made by OrthoPediatrics in Warsaw.
OrthoPediatrics, which also makes sterilization cases for its devices, plans to pursue sales overseas.

Nick Deeter’s five-year-old company is growing, but he’s the one in pain.

The founder and chairman of OrthoPediatrics Corp. knows the financially responsible thing to do is market his products overseas. Not only do U.S. sales involve significant upfront costs, but they will soon be subject to a 2.3 percent medical device tax scheduled to take effect Jan. 1, 2013. International sales are exempt from the tax and upfront costs.

Across the medical devices industry, executives are bracing for a tax increase aimed at revenue – not profit – they say will unduly hurt new companies struggling to cover startup costs before they start turning a profit.

Strategies for dealing with the additional expense include cutting jobs and cutting back on research and innovation, they say.

The issue is critical in Kosciusko County, where the orthopedics industry employed 13,000 in 2009, according to a study by the Business Research Center at Indiana University. That was 43 percent of total county employment.

Jobs at risk?

A bill gaining traction in Congress would repeal the tax. The legislation, HR 436, has 225 co-sponsors, including Rep. Marlin Stutzman, R-3rd.

Stutzman worked with the bill’s author, Rep. Erik Paulsen of Minnesota, to gather support from fellow first-year representatives. Congressional leaders consider reaching 200 co-sponsors an important threshold, indicating about half of House members support a proposal, Stutzman said in a phone interview.

Once that criterion is met, a bill is much more likely to pass out of committee and come up for a vote before the full House, he said.

Stutzman, whose district includes Kosciusko County, called the measure one of his priorities. Warsaw, the county seat, is known as the orthopedics capital of the world despite its relatively modest population of 13,500.

“This is huge for our local economy,” he said. “This is going to cost jobs in the industry.”

Opponents of the tax point to a September study that estimated 43,000 U.S. jobs will be at risk if the tax goes into effect. Wages for those jobs – which could be sent overseas – total more than $3.5 billion.

The research was conducted by a former chief economist for the Labor Department and a former chief economist for the House Commerce Committee, lending credibility to the report released by the Hudson Institute, a conservative think tank in Washington.

The report was commissioned by the Advanced Medical Technology Association, also known as AdvaMed, an industry advocacy organization based in Washington.

Federal officials estimate the tax will generate $20 billion in revenue in its first seven years, the authors wrote. They concluded, however, that the tax would cause a “significantly higher” loss to the U.S. economy when lost jobs and production are calculated.

U.S. market growth?

The tax was included in the 2010 health care law, which was meant to increase insurance access for many Americans, including those who had trouble finding coverage because of pre-existing health conditions.

Supporters of the tax have argued that orthopedics companies and other medical device manufacturers will offset increased taxes with higher profits made from selling more products to a larger pool of people with health insurance.

Stutzman doesn’t buy it. The congressman isn’t convinced everyone will get access to health care insurance; he said he’s talked to business owners who would rather pay a penalty than tackle the cost of offering insurance coverage.

Some of his constituents vigorously agree.

Bill Kolter, Biomet Inc.’s spokesman, said in an emailed statement that the company believes the upcoming tax “is ill-conceived and counter-productive.”

“In an economy where the government is attempting to promote well-paying jobs in innovative industries, the tax threatens those very jobs in an industry where America still enjoys global leadership and a positive balance of trade,” said Kolter, whose official title is corporate vice president for government affairs, public affairs and corporate communication.

The U.S. will have among the highest effective tax rates on the medical device industry if the tax is implemented, Kolter said. He and others argue that northeast Indiana’s orthopedics companies already pay plenty in taxes.

Orthopedic devices makers in Kosciusko County alone paid a combined $114 million in state and local government taxes in 2009, according to the IU study.

Several major industry players in Warsaw declined to comment for this article: Zimmer Holdings Inc., DePuy Inc. and Symmetry Medical Inc. Minneapolis-based Medtronic, the world’s largest medical device maker, referred questions to AdvaMed.

David Floyd, CEO of OrthoWorx, which supports the orthopedics industry, spoke on behalf of the Warsaw-based non-profit’s members at a field forum in Indianapolis in October. Reps. Stutzman, Paulsen and Dan Burton, R-5th, also attended

Floyd testified that the pending tax levy “almost doubles the industry’s total taxes.” He described the medical device industry as “a shining example of American leadership in the world in innovation and technology.”

He went on to say, according to a transcript of his testimony: “It is unconscionable that our own government would take actions that will inflict significant damage to this asset, particularly in the area of employment.”

One manís response

OrthoPediatrics makes child-sized arm, leg and spine implants specially designed for children. We’re talking about kids with cerebral palsy and those who were in serious accidents.

“It’s products to help kids get back to being kids again,” Deeter said.

The company now sells only about 5 percent of its products overseas. Deeter would like to build that to 50 percent before the new tax takes effect in just over 12 months.

Shifting the customer mix will be challenging, but Deeter said the financial incentives are worth it. The pending tax is the latest blow in an industry where the deck already seems stacked against manufacturers. American hospitals can demand financial terms that aren’t available to customers outside the country, Deeter said.

OrthoPediatrics provides surgical instruments, sterilization trays and orthopedic devices at no cost to U.S. customers. The products can add up to about $125,000 – or more – for a set, which contains surgical instruments, a sterilization tray, and implantable devices in around 50 sizes.

Hospitals pay nothing until after a surgeon implants a device. Then, they pay only for that one device, which OrthoPediatrics immediately replaces. The instruments and trays are on a free, long-term loan.

It’s the same across the orthopedic device industry, said Deeter, who is also OrthoPediatrics’ managing director.

Kolter, of Biomet, confirmed that the orthopedics industry is so competitive, manufacturers “consign” devices, instruments and sterilizing equipment to customers without charge.

They pay for only those devices that are implanted. Symmetry Medical Inc. President and CEO Thomas Sullivan also confirmed the industry practice.

The business model is sustainable, Deeter said, because orthopedics suppliers roll the costs of research and regulatory approvals into the usual labor and raw materials.

As a result, a single stainless steel bone screw might sell to hospitals for $30, compared with a similar stainless steel screw that Home Depot might sell for 16 cents, Deeter said.

But the business model creates a significant hurdle to startups.

New orthopedic device companies need to invest millions in instruments and cases just to get their products into hospitals, he said.

International customers, who distribute products to hospitals in other countries, pay for the entire kit, which offsets higher marketing costs for overseas sales, Deeter said. Bottom line: Overseas sales generate more profit, he said.

The pending 2.3 percent tax on revenue from U.S. sales will just make it that much harder, Deeter said, for companies like his to grow.

After five years, the 50-employee business is just now starting to show a profit.

sslater@jg.net

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