Growing pains in the Medtronic-Kyphon merger

When Medtronic Inc. announced in July 2007 that it was buying a competitor called Kyphon Inc. for $4.2 billion, executives described the deal as a coming-together of complementary technologies for spine surgery to help more patients with crippling back pain.

On paper, the merger of a fast-growing and entrepreneurial firm with a muscular market leader seemed to make solid business sense.

But the potential rewards of the deal -- one of the biggest in Medtronic's history -- have yet to be fully realized for the Fridley-based medical technology giant. As Medtronic CEO Bill Hawkins said in a February conference call with Wall Street analysts: "Kyphon, very candidly, has been a bit of a disappointment for us."

Medtronic is integrating California-based Kyphon into its fold at a time when its $3 billion spine business is under pressure from federal regulators, the Department of Justice and an embarrassing whistle-blower lawsuit, not to mention competitors, some of which are small physician-owned companies that analysts call "ankle nippers."

In the third quarter, revenue from the spine division -- Medtronic's second-largest and historically a high-flyer for the company -- grew 4 percent to $832 million. Kyphon's sales were $148 million, up 3 percent from the previous year.

"When you're integrating the culture of one organization into another, there are always challenges and issues that you have to deal with that you hadn't counted on," Gary Ellis, Medtronic's chief financial officer, said last week.

Medtronic's Memphis-based spine division typically has focused on marketing devices that treat younger patients, such as those suffering from scoliosis -- an abnormal curvature of the spine -- and degenerative disc disease in the neck and lower back. Kyphon's devices, on the other hand, skew towards an older demographic -- patients with spine fractures and stenosis.

Analyst Christopher Warren of Caris & Co. in New York, said a key misstep has been the integration of the companies' sales teams.

"From what I understand, the Kyphon people would sell the product in a way where it was like a missionary sale: 'Here's a better mouse trap,'" he said. Medtronic "reps are used to saying to customers, 'Here's another product in our portfolio.' This has been causing some hiccups in the marketplace and disillusionment among the two sales forces."

But Medtronic's Ellis discounts that notion. "Actually, it's worked very, very well. Typically, when you take a very large sales force like Kyphon had and what we have at Medtronic and merge them, you lose people, but we've lost very few people."

Shakeup slowed integration

One of the challenges for the sales staff, and the entire business, was a management shakeup last April when spine division President Pete Wehrly left. He was replaced by Steve LaNeve, who headed Medtronic's operations in Japan. Ellis said turnover in the executive suite "resulted in delays in how we were integrating."

"Some of the Kyphon products were not ready for prime time," said analyst Tim Nelson with FAF Advisors in Minneapolis. "The [X-Stop] product fell flat."

Retrain, refocus

Ellis admitted X-Stop, while promising, had to be "relaunched. ... We felt the training of physicians and education about who the best patients are for this product had to be dealt with. We had to go back and retrain and refocus our organization."

Ellis said he is confident Medtronic has handled the bulk of integration issues with Kyphon. And not a moment too soon for the spine business.

Last July, the Food and Drug Administration warned doctors about use of Medtronic's popular bone-growth product, Infuse, in ways not approved by regulators, dampening its sales. In addition, the Department of Justice is probing "off-label" use of the spine surgery product.

Kyphon hasn't escaped federal scrutiny either. Last May, Medtronic announced that Kyphon had agreed to pay $75 million to settle a Justice Department investigation involving allegations that the company had submitted fraudulent claims to Medicare. Still, the settlement amount had been reserved on Kyphon's books before the acquisition closed, so Medtronic did not take any related charges on its financial statement.