Is This Tax Good for Business?

There is a plan working its way through the Senate that proposes to tax device manufacturers $4 billion to pay for increased insurance coverage in America. AdvaMed and the large manufacturers are against it.

Source:  RRY Publications, LLC

We ran the numbers. Not so fast, AdvaMed. To us, Senator Baucus (D-Montana), the Chairman of the Senate Finance Committee, is proposing a government-funded program to increase the demand for all medical devices. Orthopedic companies sold about $30 billion in devices last year. The top 10 device companies sold about $100 million of products in 2008 (see attached table); add in the other couple hundred public medical device companies, and the medical device industry probably sells about $200 billion – $300 billion of products annually.

So this $4 billion tax sounds like a 2% tax.

There are 35 million to 40 million uninsured people in the United States (we saw numbers as high as 47 million, but if you exclude non-citizens the number drops). If Sen. Baucus’ plan is half way successful and 15 million new, insured patients come into the healthcare system, orthopedic companies will sell 8% more implants. That’s $2.4 billion of incremental revenue, about $1.8 billion in incremental gross profits and, very likely, $1.2 billion in incremental operating profit. If that costs these companies, say, 2% in new taxes, what’s the problem?

Last year, on average, the top six orthopedic companies earned 26% on every sale―at the operating income line (that’s after paying for making the products, all R&D, selling, marketing, and administrative costs. The only things missing are taxes and interest expense).

So, let’s break this down. The tax is, let’s say, 2%. On $30 billion in industry sales (last year’s numbers), that’s a tax of about $600 million annually. Nothing to sneeze at, for sure.

That tax is supposed to be used to pay for new insurance programs for under or uninsured people. What if it insures 15 million people who are not currently insured? How many will become customers for orthopedic companies?

Here’s a quick way to calculate that. There are 177 million insured people in the United States (source: U.S. Census Bureau). Let’s assume virtually all orthopedic patients are in that number. If the number of newly insured people is 15 million, then that is an 8.5% increase. So, 8.5% more orthopedic patients. If our industry is serving 4 million patients annually, then we’d be adding 300, 000 new patients with this 2% tax.

But, really, this isn’t a 2% tax. It’s a flat dollar amount based on market share. Our theoretical $600 million tax would be 2% based on last year’s sales, but with 300, 000 new patients and almost $2 billion in new revenues, that tax would fall to 1.9% and continue to decline as a percentage of revenues as more insured patients come into the system.

Would orthopedic companies pay 2% of revenues in exchange for 4x that in incremental revenue? Why not? Isn’t that what marketing is supposed to do? What percentage of sales is that marketing and sales budget? Which major orthopedic CEO wouldn’t invest 2% in the form of marketing and sales expenses to get an 8% bump in sales?

Probably the biggest risk for orthopedic manufacturers is if the number of insured patients does NOT appreciably increase. That, we think, is the real bottom line here. Both orthopedic manufacturers and President Obama have a common objective―more customers for orthopedic treatment. What is really interesting is that Congress appears to be working hard to create and fund a program which would almost guarantee millions of new patients each year (of which hundreds of thousands would be new orthopedic product customers each year).

In our calculations, if the number of new insured patients does not reach 6.5 million, then the industry loses money. More than 6.5 million new insured patients and the incremental profits are greater than the tax.

Why AdvaMed doesn’t like this deal.

AdvaMed’s President, Stephen J. Ubl, issued the following statement on September 9 in response to Senator Baucus’ draft healthcare reform proposal.

“AdvaMed supports broad-based health care reform that will ensure all Americans have access to quality, affordable health care. From the outset we have worked with congressional leaders and the White House to help achieve this important goal for our nation. However, our industry will vigorously oppose the proposed $40 billion tax ($4 billion over ten years) on medical devices and diagnostics that is included in the draft reform proposal.”

We read a September 8 draft of Baucus’ “Framework for Comprehensive Health Care Reform” and we saw $4 billion. Here’s the language:

Medical Device Manufacturers Fee. Under this proposal, an annual fee of $4 billion would be imposed on the medical devices manufacturing sector beginning in 2010. The fee would be allocated by market share.

But Mr. Ubl objected to this tax for the following reasons:

• The tax will fall most heavily on small companies.
• Device manufacturers will have to share the pain from Medicare cuts as it is.
• It will stifle innovation. We’re not sure why the 2% tax would come out of the R&D budget instead of marketing…but Mr. Ubl is positioning AdvaMed’s opposition on that conclusion. Apparently, in order to maintain those 26% profit margins, Mr. Ubl thinks that companies will cut R&D.

Steer, Don’t Fight

The U.S. government is creating a government-funded program to significantly increase customers for orthopedic products. Not surprisingly, it is working up a tax on device companies to partially pay for the program. If orthopedic manufacturers decide to fight this, they will appear to be reactionary. If they recognize that a program is coming together which increases demand for their products, then they should endorse it in principle and then work to steer it so that it becomes a win-win for industry, patients and physicians.