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Note From Edward Hemmelgarn

Now that the economy is moving into the more stable, mature phase of this economic expansion that began back in the fourth quarter of 2001, it will be important to be invested in companies that can grow faster than the economy for prolonged periods. Healthcare is a sector that should continue to grow faster than the overall economy, due to growth in spending in the U.S. as well as overseas. The healthcare sector currently represents the second largest concentration of investments in the portfolio. Our investments in this growing sector have ranged from bio-tech firms to pharmaceutical distributors to providers of software to the healthcare industry.

In this issue, we highlight one of the newest stocks in our portfolio, Integra LifeSciences Holding Corp. (NASDAQ: IART) with an interview with the company’s CEO, Stuart Essig. Integra is a specialty medical products company that provides a wide range of products to hospitals. Integra, an innovative company, supplies over 10,000 products including cutting edge technology to help patients with burns, head trauma, chronic wounds and other serious medical conditions. With the nation’s number one neurosurgical franchise and a growing plastic and re-constructive surgery sales force, Integra has the visibility in the hospital marketplace to effectively market their products to the surgeons who use them.

Karen Mroz-Bremner, Ph.D., one of our healthcare analysts, provides some insight into the drivers behind the growth in the healthcare industry with the accompanying article.

U.S. Healthcare Spending Continues to Grow
By Karen Mroz-Bremner, Ph.D. - Healthcare Analyst

As investment managers, we strive to invest in superior companies within growing segments of the economy — and few areas are growing more rapidly than healthcare. In 2003, healthcare expenditures increased by 7.4%, nearly twice the rate of overall GDP. Healthcare expenditures now account for over 15% of U.S. GDP, and that percentage is projected only to increase.

This growth is not simply a result of medical inflation. Yes, prices are rising and the nursing shortage has pushed up wages faster than that of the overall workforce; however, consumers also are accessing greater quantities of healthcare. Increasing utilization per capita comes not only as a direct result of an aging population, but as a result of advancing medical technology. For example, Anthem Inc. reports that since 1993 the average number of prescriptions per year has increased from 7.8 to over 11.5, a nearly 50% jump. Similar growth is occurring across the healthcare segment due to a number of factors, including: technology that improves the quality of life for people of all ages; patients becoming more proactive in their care; and increasing fear of litigation within the medical community, which has resulted in increasing use of diagnostic technology to rule out even diagnoses that are extremely remote.

Although this growing spending on healthcare creates investment opportunities in companies with unique proprietary products, many ideas also are being tried to control spiraling healthcare expenditures. Numerous “fixes” are being tried that seek to strike a delicate balance between providing the best overall healthcare and maintaining a reasonable overall cost. One such fix is Health Savings Accounts (HSA), which provide a tax benefit for using high deductible managed care plans. This gives individuals a better feel for the “true” cost of healthcare. Do patients change their usage patterns when they need to pay full cost rather than $10 or $20 to see a doctor or fill a prescription? Many believe that the answer is yes. Striking the right balance is not easy, however; a recent government study saw decreased usage of drugs for serious medical conditions resulting in significant complications as a result of increased co-pays for prescription medications.

The HSA plans may appeal to healthier individuals, but the majority of healthcare cost is incurred by a minority of the population. For example, approximately 20% of Medicare beneficiaries are living with five or more chronic diseases. This small proportion of seniors accounts for approximately 2/3 of Medicare expenditures. In younger populations, the skewing can be even more dramatic. Disease management programs have been designed to improve the health of these individuals and in the process save money. By providing personalized support programs and ensuring that patients’ diseases are being managed by following proven courses of treatment, the patients’ quality of life is improved and costly complications are avoided. Disease management programs are offered by almost all health insurers today and are soon to be available to some Medicare recipients through a pilot program.

Growth in healthcare utilization stems from a number of factors, including a growing and aging population. However, at Shaker Investments, we feel the most sustainable growth arises from the advent of new proprietary products that improve either physician efficiency, patient outcomes, patients’ quality of life, or cost effectiveness of treatment (i.e. medications that prevent future complications or disease).

Executive Insights
Stuart Essig, President & CEO
Integra LifeSciences [NASDAQ: IART]

Q: At this point, neurosurgery is Integra’s largest market, while plastic and reconstructive surgery is your smallest. Will this relationship change in the next 5 to 10 years?
A: Plastic and reconstructive products is a relatively new business for us. We
started building its direct sales force in January, and expect to expand to 30 sales reps by the end of 2005. That will be less than a third of the size of the neuro sales team, but in time the two teams may be close to equal size. We are making a substantial investment in our plastic and reconstructive group, and expect it to become a significant leg of our company.

Q:What is Integra’s share of the neurosurgery segment?
A: Our share of the entire $1.5 billion segment is close to $150 million in annual sales. That makes us one of the larger players in the neurosurgery space, within hailing distance of Medtronic’s neurosurgery division. However, Integra’s products currently address only 40 – 50% of the neuro segment. Completing our neuro product line represents a major growth opportunity.

Q:If managed care continues to impact surgery, Stuart, how will that affect Integra LifeSciences’ growth?
A: Integra’s medical devices are principally used in neuro-trauma and neurosurgery, plastic and reconstructive surgery, and general surgery. In many cases, the patients treated with our life-saving devices are extremely ill, so this is not the first place a hospital looks to reduce costs. Nonetheless, as a company we are very sensitive to cost containment, utilization, and reimbursement issues.

Q:Does Integra’s broad line of more than 10,000 products make you vulnerable to competitors whose products might be more specialized?
A: We seek to provide customers with clinically relevant, cost-effective products across all of our device, instrument, implant and biomaterial lines. This compels us to constantly innovate, because there always will be competitors who seek to develop more advanced technology for a specific product. However, an innovative product is not necessarily a successful product if it isn’t effectively marketed. The breadth of our product lines enables us to bundle products that are used across a range of surgeries. That comprehensive approach is very attractive to hospitals and surgeons, who are less inclined to spend hours of valuable time considering narrow product offerings from some of our smaller competitors.

Q:Is it more advantageous to create a product specific to one type of procedure, like your new epilepsy line, or a product like the cranial access kit, which can be used in a broader array of surgeries?
A: Strictly from a sales standpoint, it’s generally preferable to have a product with multiple applications. Tools to map the brain prior to surgical procedures for epilepsy represent a small market, but by a number of other measures it is important to Integra. Epilepsy surgeons need tools that are specifically designed for their procedures, and our ability to provide those tools makes us very valuable to this particularly close-knit community.

Q:Integra has completed 20 acquisitions. Has that enabled you to achieve economies of scale?
A: Definitely. In approximately half of those acquisitions, a legacy company’s sales force numbered fewer than 10 reps. Our centralized sales force has close to 100 people calling on customers. This means that as soon as a small company is acquired by us, its marketplace reach can immediately increase by tenfold or
more. Also, we’ve closed nearly a dozen sites over the last five years, wherever there was duplication of effort. That has resulted in considerable savings.

Q:Considering Integra’s growth prospects, is there a sufficient pool of engineers and people with medical backgrounds to support your ambitious plans?
A: To-date, our ability to recruit talented people across engineering, marketing, sales or operations has not been an issue. The supply of recent grads has been ample, despite our steep growth curve. Also, keep in mind that our workforce is not limited to the U.S. We have approximately 1,100 employees, including about 360 in Europe.

Q:Do you have a presence in Asia?
A: Europe generates the lion’s share of our sales outside of the U.S. We have a relatively small presence in Asia. We don’t manufacture there, but sell into Japan, China, Thailand and South Korea. About 20% of our sales today are overseas, but we expect that percentage to grow across both Europe and Asia.

Q:Do you envision that Integra will become an attractive acquisition candidate for a large pharmaceutical or medical device company?
A: We’re not building the company to attract acquisition offers. Our goal is to construct an excellent franchise with competitive products and a strong P&L. A case can be made that the neurosurgery market today represents the same magnitude of opportunity as did the cardio market 10 years ago. We believe we are well-positioned as an independent company to exploit the growth of that market from every perspective: research, development, distribution and client service. There are strategic reasons why we may continue to be an acquirer, but there is no imperative for us to be acquired.