Hanger Orthopedic Group (HGR)

The Bethesda, MD-based Hanger Orthopedic Group, Inc. (HGR) provides orthotic and prosthetic (O&P) patient care services in 46 states in the U.S. and the District of Columbia through its 636 patient care centers. Orthotics comprises custom design, fabrication, and fitting of braces and supports for treating musculoskeletal conditions. Prosthetics deals in custom design, fabrication, and fitting of artificial limbs required by patients suffering from loss of a limb at birth, vascular diseases, diabetes, cancer, or trauma. The company operates in four business segments: Patient-Care centers, Distribution, Linkia and Innovative Neurotronics. Patient-Care centers, which generated about 90% of 2007 revenue, provide O&P devices to the patients, and operate fabrication centers for O&P components. Additionally, the Patient-care center segment runs a national managed care agent for O&P services and a patient referral-clearing house called OPNET. The Distribution business segment (10% of 2007 revenue) supplies O&P products and components to the O&P industry, including the company's own Patient-care centers. Linkia is a provider network management company for the orthotics and prosthetics industry. Innovative Neurotronics develops emerging neuromuscular technologies like WalkAide.

As the market leader, HGR has economies of scale unmatched by other competitors. To further drive awareness and market share in a 1-2% volume growth market, the company's field force provides extensive education to physicians. To build relationships, the company is attempting to become a one-stop shop by offering a comprehensive total care package to patients that physicians can rely upon.

Linkia was established early in 2004 to bridge the gap between payors and O&P practitioners. It is the first managed care organization dedicated solely to the O&P market. Hanger Orthopedic believes this strategy will help gain market share and rationalize pricing in a highly fragmented market. During the first year of operation, Linkia signed an agreement with United HealthCare (UHC) where Linkia would provide O&P services to UHC. Despite the increased spending and focus by management, Linkia took much longer to produce any substantial revenue, contributing only $4 million during 2005. In September 2005, Linkia announced it had obtained a contract with CIGNA Healthcare, which became effective October 17, 2005. It is one of the two contracts that the company had originally planned to sign in the third quarter 2005. The company also signed a contract with Great-West Healthcare, effective August 1, 2006. Excluding the Great-West and CIGNA contracts, the Linkia initiative was up 9% to $32 million for the first nine months of 2006, added about $20 million in the fourth quarter 2006 for an annual 2006 base business of $52 million. The company has been able to obtain scheduled price increases from the three payors given the 2007 CMS rate increase. Linkia contract-related revenues increased 16%, 8.2%, and 16% year-over-year during the three quarters ending Q208. Linkia has contributed between 0.5% and 1.3% to same-center revenue growth.

Medicare makes up about 28% of Hanger's revenues and many managed care contracts are tied to the Medicare fee schedule. However, the competitive bidding program CMS is attempting to institute may weaken HGR's position with managed care contract negotiations. As of July 2008, the program was put on hold until September 2009. There has been a history of commercial payors pushing down prices in line with the fee schedules. The Medicare fee schedule was frozen on October 1, 2003 with no inflationary adjustments. Hanger initially walked away from re-signing several contracts that would have drastically reduced pricing but the action lowered same-store volumes. Even with the Linkia initiative begun in 2005, some negotiations largely stalled over pricing. In some instances, management believed the soft volume growth was related to lower employment levels and/or changes in plan benefits. Overall, the company saw lower volumes as patients extended the life usage of their prosthetic devices to avoid paying higher co-pays and/or deductibles. On the positive side, Medicare readjusted the 2008 fee schedule with a 2.7%, 10 bps under our target, having a positive impact on roughly 35% of the business in the first year. Combined with the 4.3% increase seen in 2007, the impact on same-center growth in Q208 was 2.0%. We believe the Linkia initiative, which increases volume through discounting, may mitigate these price gains somewhat.

Same-center sales growth

Volume growth

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

2006

3.9%

0.1%

1.6%

(7.0%)

2007

2.6%

4.2%

5.1%

8.0%

1.0%

3.2%

3.7%

6.5%

2008

4.2%

8.9%

2.2%

N/A

* Same-center sales were adversely impact from hurricane weather. Excluding this impact, the company estimated third quarter same-center sales increased 0.5%.

The company continues restructuring its heavy debt burden. In May 2008, the company entered into swap contracts, fixing 37% of total debt ($406 million) to LIBOR at a rate of 3.4% for a three-year period. During Q208, the company's stock reached a price that triggered the acceleration of all preferred stock dividends through May 2011. The preferred shareholders elected to convert their shares into common stock, adding 700,000 new shares to shares outstanding. As a result of strong performance in Q208, the company's debt-to-EBITDA ratio fell below 4x for the first time in a long time. At year end 2007, HGR carried over $400 million in total debt, a 68% debt/capital ratio, which does reduce the company's ability to seek larger acquisitions and keeps the expense structure fairly limiting.

Innovative Neurotronics developed WalkAide, an electrical stimulation device to treat stroke-related "drop foot". WalkAide received FDA clearance in 2005 with the product officially marketed in May 2006. There are approximately 500,000 annual U.S. stroke patients but the device has been off to a slow introduction given lack of Medicare coverage and reimbursement. Based on peer-reviewed clinical trial data, HGR expects to make a submission in late Q308, with an answer from the FDA by the end of 2008 or early 2009. The company has already received a preliminary Medicare Code, indicating a functional use, rather than therapeutic. The product lists for about $4,500. WalkAide received European CE Mark approval in November 2006. In July 2007, the company signed a commercialization agreement with Teijin Limited to gain approval and market the WalkAide in Japan. In Q208, WalkAide achieved $3.0 million in sales. Management also noted a growing interest on the part of insurance companies to adopt newer technologies, such as WalkAide, which proves to be more functional than therapeutic.

The company makes small tuck-in acquisitions based upon geography, quality of practitioner, and product and service mix. Due to the scale of administrative and regulatory headaches smaller practitioners face, practitioners often approach the company requesting to be bought out. In July 2007, the company acquired SureFit, a manufacturer and distributor of therapeutic footwear for diabetic patients in the podiatric market. SureFit produced about $9 million in revenue for the 12 months ended May 31, 2007. The deal is expected to be accretive in 2008, but had no overall impact to 2007 results given initial integration activities. Hanger acquired three patient-care firms in November 2007: Stagner Orthopedic Services in Tennessee, Specialized Prosthetic & Orthotic Technologies, Inc. in Utah, and MHC Prosthetics LLC in Maryland. Collectively, the three acquisitions generated about $3.5 million in revenues and are expected to be immediately accretive to earnings. The Utah acquisition opens up a new market in Salt Lake City for Hanger.

In the first quarter of 2008, Hanger Orthopedic Group acquired Colorado Professional Medical, Inc., Beverly Hills Prosthetics-Orthotics, Inc., Orthotic-Prosthetic Center, Inc., Precision Orthotics of Tuscon, Inc., and Compton-Jones Orthotics, LLC. These acquisitions provide Hanger with an enhanced presence in Colorado, California, Florida, Arizona and West Virginia, respectively, and they add a net total of nine additional patient care facilities.

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