Irhythm Technologies Inc (IRTC) Will Leave Investors Heartbroken – Kerrisdale

Kerrisdale Capital’s short report on Irhythm Technologies Inc (IRTC), titled, “Growth Reversal will Leave Investors Heartbroken.”

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We are short shares of iRhythm Technologies, a $2.3bn medical device company trading at over 15x sales despite facing multiple factors that will dramatically cut its revenue growth in the coming years. iRhythm’s Zio, developed over a decade ago and accounting for nearly all the company’s $150m in sales, is a one-lead heart rate monitor in patch form. This “extended Holter monitor” is worn by patients for up to 14 days, during which the device continuously records heart rhythm data. Each application of a Zio patch costs payors about two to four times what it would cost to use legacy monitoring modalities, but iRhythm claims that the Zio reduces costs for the healthcare system through increased effectiveness and better patient compliance.

A closer look at the circumstances surrounding the reimbursement treatment of the Zio Patch reveals that at the core of iRhythm’s revenue base is an exceedingly generous, but increasingly fragile, reimbursement regime. The Zio patch’s success in achieving unit-level revenues greater than any other cardiac monitoring method is a function of iRhythm’s subtle and skillful maneuvering around the arcane technicalities at the center of the American Medical Association’s reimbursement coding process. This has allowed iRhythm to essentially “name its own price” in the Medicare negotiation process, leading to unduly favorable reimbursement from commercial payors as well.

But the price gouging will inevitably be short-lived. The rapid increase in Zio patch utilization has now put a bullseye on its back, increasing the odds that both Medicare and commercial payors will both cut back on reimbursement levels and throttle utilization. In addition, the Zio patch is currently reimbursed under a temporary CPT tracking code that we expect will be transitioned into a permanent code for calendar year 2021. In the process, we anticipate reimbursement levels for the Zio patch will fall by over a third and potentially more than 50%.

Reimbursement cuts are not iRhythm’s only problem. Until recently, the Zio patch was the only product available in a category that it was responsible for creating. But the simplicity of the Zio and its commercial success have attracted competition, and new entrants have both superior devices and more diversified device portfolios. Up to now, iRhythm has successfully used favorable clinical studies and enterprise integration capabilities to win business. But competitors are now promoting the superiority of their own devices, backed by more recently published data that reflects much less favorably on iRhythm. They’re also offering more flexible solutions that appeal to a broader array of customers, such as larger enterprises. As a result, iRhythm will find it increasingly difficult to win business with large hospital systems and physician groups. In addition to market share losses, the specter of price competition from these peers looms large.

iRhythm has recently tried to diversify by extending its Zio patch into the real-time cardiac monitoring space with its Zio AT device. But the attempt appears to be too little, too late. Extensive discussions with industry participants and new disclosures in the company’s filings indicate that, contrary to iRhythm’s attestations in its most recent earnings call, iRhythm has pulled back on the AT. In fact, the product can no longer even be found on the company’s website. That leaves iRhythm as a one-hit wonder with a shrinking reimbursement revenue pool and a slew of superior competition. As the only single product company in the cardiac monitoring space, iRhythm has already missed the beat. The results could be fatal.

I. Investment Highlights

iRhythm faces reimbursement cuts of 30-60% in the near future. Close to all of iRhythm’s revenue is derived from its Zio XT Extended Holter patch, and the vast majority of that is not through the sale of the device to physicians and hospitals, but by billing third party payors for the scanning analysis and report, which are performed at an iRhythm Independent Diagnostic and Testing Facility (IDTF). The level of reimbursement for that step of the process, like any medical procedure, is dependent upon the Current Procedural Terminology (CPT) codes under which the procedure is reimbursed. CPT codes are overseen by the American Medical Association (AMA) and medical procedures can be associated with a few different types of CPT codes, depending on the level of recognition they receive from the AMA and the relevant specialty societies.

iRhythm generates almost all its revenue through billing third party payors for CPT code 0297T, the letter “T” indicating that the reimbursement code is a Category III tracking code. The AMA describes Category III codes as “temporary alphanumeric codes for new and developing technology, procedures and services,” a description that certainly fit the Zio patch when its temporary CPT code was first approved in July of 2011. But that was 8 years ago. The CPT system provides for automatic sunset of Category III reimbursement codes 5 years after implementation, whereupon they can expire, be renewed for a further five years if they are still “developing,” or be transitioned to Category I “permanent” codes if the underlying procedure has become more widespread and supported by literature.

Notwithstanding at least some success on both the utilization and literature fronts in the 2013 to 2015 period, the temporary CPT codes associated with the Zio patch were renewed in February of 2016 and are currently slated to be reconsidered by the CPT Editorial Panel in early 2021. Given the recent explosion in the utilization of extended Holter monitors and the literature supporting their use, the relevant CPT codes will almost certainly be transitioned to Category I codes for use in the 2023 calendar year. Because Category I codes receive special scrutiny from the AMA’s Relative Value Scale Update Committee (RUC), reimbursement rates for procedures typically drop by about a third when they move from Category III to Category I, according to several former RUC members we’ve spoken with.

In the case of the 0297T code, we expect that the reimbursement rate cut will be even more draconian than average and is closer at hand than 2023. With respect to the magnitude of the reimbursement cut, we expect that the current $311 rate that CMS Contractor Novitas Solutions pays for 0297T in Houston (where iRhythm’s IDTF is not coincidentally located) will decline to the $150-200 range in a best case scenario, on par with the Category I reimbursement rate CMS confers upon cardiac Event Monitoring. Novitas accounts for the vast majority of iRhythm’s CMS revenue (in a classic case of contractor shopping, iRhythm originally located its diagnostic and testing facility in the region where it negotiated the most favorable reimbursement). In a worst-case scenario, iRhythm could see the reimbursement rate for 0297T fall to $45-50, similar to a Holter monitor reimbursement rate, which is what the vast majority of CMS contractors reimburse for the code at the current time. Commercial payor reimbursement rates, which are typically more generous than Medicare reimbursement rates, tend to use the CMS fee schedule as a reference, and a drop in Medicare reimbursement generally presages a similar magnitude decline in commercial payor reimbursement.

Regarding the timing of the transition to a Category I code, iRhythm competitor BioTelemetry Inc. has stated that it wants the extended Holter procedures transitioned to a permanent Category I code as soon as practicable. While there is some specialty society politics that BioTel has to navigate in the course of getting its application to the CPT Editorial Panel, we would expect a 2019 application to be easily approved by the Panel in the current year, implying a 2021 implementation of the newly transitioned code and the inevitable reimbursement reduction. BioTelemetry’s extended Holter accounts for less than 5% of its total revenue, and based on conversations with industry participants, management is pushing for a Category I code to exert pressure on iRhythm, its newest competitor. BioTel has also been on the receiving end of a massive reimbursement cut on its MCT monitoring in the past and would like to clarify the long-term pricing for the product in order to assess its own strategic direction in the new vertical.

Finally, even with no action from the AMA on CPT code changes, we expect that iRhythm’s extraordinary success in attaining coverage and favorable reimbursement rates from payors is in the process of backfiring. It’s worth noting that Category III codes are “contractor priced.” In other words, CMS does not set the price in its physician fee schedule, but each Medicare Administrative Contractor (MAC) sets or negotiates a price with the provider. iRhythm, with its IDTF in Houston performing all the scanning and reporting procedures, has benefited from the regional MAC – Novitas Solutions – generously reimbursing the Zio codes. No other MAC in the country reimburses for the procedure as generously, and most MACs have taken the view that not much differentiates the Zio from a traditional Holter monitor beyond the presence of some solid-state memory that can hold 14 days’ worth of heart rhythm data (~500MB). As such, in 39 of 50 states, 0297T would be reimbursed at rates 33-89% lower than $311.

While MACs don’t fiddle with pricing very much, we’ve found that large price changes tend to occur following abnormally large changes in procedure utilization. Our discussion with a former Novitas medical director who was involved in the original Zio reimbursement discussions confirmed that the MACs have analytics-based screens meant to flag procedures with abnormally large increases in utilization. Given the 300% cumulative increase in iRhythm’s revenues from CMS for the 3 years ending 2018 (3-year utilization changes being one of CMS’s primary triggers for review), we would expect that the alarm has already sounded at CMS or Novitas (or both) on a code that is being reimbursed disproportionately well compared to very similar procedures.

Any review of the code at the institutional level is likely to result in reimbursement coming down to a level closer to where the other MACs are. Additionally, Novitas’ contract for Jurisdiction H ends in June of this year. If any other contractor wins that contract, iRhythm is almost certain to lose its lush Medicare deal. And of course, commercial payors will follow.

The competition is already beating iRhythm at its own game. The Zio XT is actually a fairly simple device: a sensor that detects cardiac rhythm, some memory, and a patch. As a former iRhythm regional sales manager told us, “you could literally go and find the building blocks in your garage and build it yourself if you’re a bit handy.” Until the last twelve months, though, there was no real competition for the device, as it had yet to gain traction with physicians until two years ago. But recently, a slew of competitors have launched extended Holters that compete with the Zio, and for the most part, they’re making improvements around the Zio’s weaknesses, including patch placement, number of sensors, time-to-reporting and rhythm-recording clarity.

To investors, iRhythm has defended its competitive position as unassailable given that the Zio is “better, proven, and complete.” But the literature it uses to show that the Zio is better than other monitoring modalities has now been replaced by literature employing the same testing methodologies but showing that competitors such as Bardy Diagnostics’ CAM patch are superior to the Zio on the same endpoints. And though iRhythm claims that its underlying AI tools perform better than expert cardiologists, a careful read of the clinical studies it promotes shows that the Zio’s diagnostic capabilities are in certain ways inferior to even the “low-tech” traditional Holter monitor that has been around since 1962.

Finally, discussions with doctors at large hospital networks suggest that iRhythm’s one-size-fits-all “complete” enterprise solution can be a competitive disadvantage. Zio customers are forced to use iRhythm’s IDTF for scanning and reporting, but many hospitals already employ their own ECG technicians, which makes paying for iRhythm’s scanning and analysis service inefficient and costly. New entrants such as Bardy have exploited this weakness by offering more accommodating software tools that allow larger institutions to have their already-employed technicians read and analyze the rhythm recordings. This has the added advantage much faster turnaround time, which aids both physician and hospital workflow.

The Zio AT is a failure, leaving iRhythm as a single-product company with a TAM much smaller than it describes to investors. iRhythm’s portrayal of its current addressable market is a cardiac monitoring market encompassing approximately 4.5 million monitoring procedures annually, all of which can be addressed by either the Zio XT or the newer Zio AT. iRhythm, with just a “low double digit” percentage of that market at recent year-end, has a long way to go before its penetration will start to slow, or so iRhythm claims.

This narrative is misleading. The market for cardiac monitoring, excluding iRhythm, is trifurcated along approximately the following lines:

Irhythm Technologies

Traditional Holter monitors occupy the low end of pricing but almost two thirds of volumes. Event Monitors are in the middle with ~20-25% of the volume. Meanwhile, mobile cardiac telemetry (MCT), the most expensive monitoring procedure, makes up ~10-15% of volumes. As we heard from several electrophysiologists, the Zio XT cannot reasonably compete with most Event Monitoring procedures and MCT, which make up about a third of the market. These procedures are typically prescribed by electrophysiologists who require real-time attended monitoring, high levels of rhythm-recording clarity, and/or minimal time-to-diagnosis. The Zio XT has no real-time capabilities and takes 3-4 weeks from the start of monitoring to get its report to the doctor. Due to its miniaturized design, it also necessarily skimps on recording clarity. As a result, we believe that at least a third, and potentially up to a half, of iRhythm’s claimed TAM is actually off-limits to the Zio XT.

To address the inability of the XT to perform real-time monitoring, iRhythm introduced the Zio AT in mid-2017. The AT was originally billed by iRhythm as “our version of Mobile Cardiac Telemetry” meant to “serve patients who have more critical symptoms such as syncope, pre-syncope and ventricular tachycardia.” 1 But the AT has not lived up to iRhythm’s initial expectations, which foresaw a timeline of “3 to 4 quarters in order to get full AT contracts.” We were unable to find any physicians, at large hospital groups or otherwise, that were using the AT, while multiple competitors indicated that they were under the impression that iRhythm had pulled the product from the market. At the current time, the AT has been pulled from the company’s website entirely, leaving iRhythm as a single product company.

Even more potentially concerning is that the presentation of the product was clearly misleading – the Zio AT was apparently never able to provide actual real time monitoring, and the recently filed iRhythm 10-K has noticeably backed away from this claim. In fact, the 510K device application to the FDA specifically states that the device “is not intended for use on critical care patients,” who are ostensibly to be treated with actual MCT devices. It’s unclear, then, why iRhythm would claim to investors that the AT was a “version of MCT” and intended to compete in that arena.

In a separate attempt at “TAM expansion,” iRhythm has been confidently suggesting to investors that the 4.5 million annual monitoring procedures will double over the next few years as monitoring guidelines are rewritten to recommend monitoring asymptomatic but “high-risk” populations. But the actual literature and studies that iRhythm cites, as well as some important literature they ignore, seem to imply the precise opposite. Such an explosion in the monitoring market is nowhere on the horizon, partly because devices like the Zio are simply way too expensive, but also because they’re not very effective.

II. Company Overview

Irhythm Technologies

iRhythm was founded in 2006 by electrophysiologist Uday Kumar to fill a void he identified in the available cardiac monitoring methods that were used to diagnose problematic arrhythmias. Physicians would normally try to diagnose an arrhythmia through a 12-lead ECG (electrocardiogram) or a 24-48 hour-portable Holter monitor, the latter which Kumar considered cumbersome, and which could only monitor for up to 48 hours.

Arrhythmias (abnormal heart rhythms) occur when the electrical impulses that coordinate a person’s heartbeats aren’t working properly, causing the heart to beat too fast, too slow, or irregularly. An arrhythmia could be a symptom of Atrial Fibrillation, a condition that the CDC estimates affects anywhere between 3 and 6 million people in the United States, and which can be a precursor to stroke. It could also signal more acute and potentially fatal conditions in the case of ventricular tachycardia or ventricular fibrillation (rhythms with dysfunctional electrical impulses originating in the ventricles).

Diagnosing arrhythmias can be tricky. Even in a symptomatic patient, they can occur multiple times a day, but they can also occur less frequently – sometimes just a few times over the course of a month. Before the Zio, physicians had three cardiac monitoring options:

  • 24-48 Hour Traditional Holter monitor – A technology that first became available in 1962, a modern Holter typically has 2-5 leads (wires) that are connected to electrodes, which are attached to the patient’s chest in strategic locations so as to maximize the precision and clarity of the reading. The leads are attached on the other end to a recorder, which saves the recording onto flash memory. After 24-48 hours, the recording is analyzed by a technician and physician, with the aid of software that eliminates the majority of the dataset made up of “normal” heart rhythms.
  • Cardiac Event Monitors – Event Monitors (EM) have at least two leads connected to a recording device similar to a Holter. EMs differ from a Holter in their duration and purpose – they can be worn by patients for up to 30 days, and only offer episodic, rather than continuous, monitoring. If the device senses an arrhythmia, or the patient signals the occurrence of symptoms (by pressing the appropriate button), the rhythm data from the episode is saved and transmitted to a scanning facility. A technician, or the patient’s doctor, is immediately able to analyze the episode in close to real time.
  • Mobile Cardiac Telemetry – MCT takes all the capabilities of Holters and Event Monitors, and combines them. An MCT device records continuously for up to 30 days, and there’s always a technician at a scanning facility watching the patient’s heart rhythm in real time.

Irhythm Technologies

All of the monitors were assemblies of wires, electrodes, and external recorders, which required the patient to unhook and then reconnect the device when showering or exercising. Holter monitors were inconsistent in diagnosing infrequent arrhythmias. Event Monitors recorded arrhythmias only episodically, which could have resulted in missed events. MCT was mostly overkill for patients without potentially life-threatening symptoms, and the constant monitoring was expensive, leading to reimbursement difficulties.

Into that void stepped the Zio patch, a water-resistant device in which all the monitoring components – sensor, lead, recorder – are combined into a small device and attached, on a patch, to the patient’s chest slightly above their heart. The device records the patient’s heart rhythm continuously for up to 14 days and saves all of it. At the end of the monitoring period, the patient mails the assemblage to an iRhythm Independent Diagnostic and Testing Facility (IDTF), where an iRhythm technician scans the data and generates a report, with the help of iRhythm’s proprietary software. The report is then sent to the physician, whose responsibility it is to review and interpret the report, and then treat the patient appropriately.

The Zio has some significant drawbacks. The turnaround time from the day the patch is applied to when the doctor would review results with the patient is about 4 weeks (which is still a major obstacle to physician acceptance). The Zio also has no ability to transmit rhythm data in real time. Perhaps most significantly, both the patch placement at the top of the chest, and the presence of only one lead, result in rhythm data quality that’s inferior to that of any “legacy” monitoring system.

But, in iRhythm’s telling, what the Zio lacked in these respects it made up for with simplicity for the patient, workflow enhancement for the doctor, and length of continuous recording. The latter, in particular, is at the heart of the clinical evidence employed by the company to “prove” that the Zio is the ideal monitoring modality with the best record of diagnosing arrhythmias. iRhythm has very effectively parlayed this argument into broad payor coverage for the Zio with generous reimbursement.

But, as we describe in more detail below, a careful study of the evidence reveals that it’s much weaker than iRhythm really lets on. That’s allowed new competitors, with devices that correct for the Zio’s flaws, to design and promote new studies that paint the Zio patch in a more pedestrian light. Those competitors can also successfully claim the same benefits iRhythm does in comparison to other monitoring systems. More ominously, though, a thorough examination of the reimbursement paradigm that underlies the Zio reveals a very precarious foundation for iRhythm’s business model that’s all but certain to soon change for the worse.

Disclosure: Kerrisdale Capital is short shares of iRhythm Technologies, Inc.

Article by Kerrisdale Capital

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