The rumors of a takeover of orthopedic artificial joint maker Smith & Nephew (NYSE:SNN) are so strong that the company felt compelled to make a public statement last week. This statement went against the company's policy of only making public statements when there is material information related to the operations of the company and not on market speculation.

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The company stated that "it is not engaged in any discussions which could lead to a merger or a takeover involving the company", yet speculation remains high. And on Sunday, the news media reported that rival Johnson & Johnson (NYSE:JNJ) is considering making a formal offer for the company. This offer follows a reported tentative offer from JNJ which was rejected last year. At the heart of the market speculation lies an industry that has several strong players and many barriers to entry, but one that also faces significant headline and regulatory risk related to changes to reimbursement.

The Players and the Market

The orthopedic technology market consists of makers of artificial joints, such as knees and hips. The largest players in are Zimmer Holdings (NYSE:ZMH), Stryker (NYSE:SYK), JNJ, Biomet and SNN. These companies have faced many challenges in the past, from lawsuits related to their relationship with physicians to reimbursement cuts in Medicare to the latest economic downturn.

The economic environment hit these companies hard because the products manufactured by these companies are used in elective surgeries. Customers have been putting off these surgeries for various reasons such as fear of missing work and losing their jobs, or due to loss of jobs and insurance coverage. As a result, these companies have come under increasing pressure to achieve more profitable economies of scale, increase share and broaden product suites.

As hospitals continue to narrow their suppliers in order to rein in costs, companies with the most expansive product line-up will likely be the ones chosen. As such, orthopedic companies are feeling increasing pressure to consolidate to achieve scale. The stocks have come under similar pressure and have yet to return to the pricing levels of March 2008. SNN, despite the recent run-up associated with the merger talks, is still selling 15% lower than its highs two years ago. Similarly, larger peers, those considered the acquirers like ZMH are selling at 40% below 2007 highs and SYK down over 25%.

The Bottom Line

The U.S. healthcare industry continues to be in upheaval and the economic climate remains challenged. Consumer confidence measures, while improving, do not register the impact of the elasticity of demand on healthcare choices. As such, orthopedic companies need to ensure that they will be the choice when the demand picks up. (To learn more, see Investing In The Healthcare Sector.)

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