5 Orthopedic Stocks to Watch

 |  Includes: JNJ, MDT, SNN, SYK, ZBH
by: Morningstar
By Julie Stralow

With worries continuing about a potential double-dip recession that could delay some procedures in the short term, the market appears to be giving investors an opportunity to pick up shares of orthopedic firms at a big discount to what we think they're worth. For those willing to endure the current economic uncertainty, major orthopedic players may make good investment options due to their relative safety in economic downturns, solid long-term prospects, and significant discounts to our fair value estimates.

Even in the worst economic downturn since the Great Depression, orthopedic implant sales still managed to grow in the mid-single digits in 2009, as higher-growth niches like spine and trauma pulled up low-single-digit growth from knees and hips, according to company reports. Overall, orthopedic firms typically enjoy resilient revenue streams even in tough economic times, in stark contrast to many other innovation-driven companies. Part of this resilience is based on its payor base, as many government entities that support elderly care in the U.S. and general care throughout the rest of the world have been unwilling to significantly cut spending on these procedures even during budget crises. So while we have seen some procedure delays among relatively young patients worried about disrupting work schedules to have surgery and rehab in a weak employment environment, those delays weren't enough to cause a sales contraction in the industry during the 2009 recession. Obtaining the pain relief and increased mobility that usually comes after orthopedic surgery appears to still motivate most potential patients even in weak economic environments.

Adding to these recession-resistant demand characteristics, most orthopedic firms enjoy very healthy financial conditions as well, so we wouldn't expect them to be caught in a financial jam if credit markets tighten again. Top orthopedic players enjoy high marks in our credit rating system. We give Johnson & Johnson (NYSE:JNJ) a AAA rating, Stryker (NYSE:SYK) and Zimmer (ZMH) a AA+ rating and Medtronic (NYSE:MDT) a AA rating. With reasonable leverage and solid cash flow prospects, we don't see many realistic scenarios where another recession or tough credit market would hurt their viability.

Looking to long-term industry prospects, we expect growth rates to accelerate to the high single digits in the next five years, as several key trends should drive growth in the long run. Orthopedic procedures are typically preceded by years of wear and tear on the body. With baby boomers entering their later years, procedure volumes should increase at a healthy pace for the foreseeable future. Also, many boomers expect to pursue higher-intensity activities for a longer period of time than previous generations, which will likely lead to more potential patients seeking procedures to regain mobility than in the past. Joints are also increasingly taking a beating under heavier bodies, as the obesity epidemic takes its toll. These demographic and lifestyle trends support our view that industry growth will accelerate from recent lows in the long run.

While we remain optimistic about the industry's prospects, we recognize that several factors beyond short-term economic concerns are threatening industry profits, including increasing taxes, pricing pressure, and regulatory standards. However, recent share prices at orthopedic firms appear to be discounting scenarios more dire than even our worst-case scenarios would suggest. For example, our worst-case scenario for Zimmer values the firm at $57 per share, similar to recent share prices. Our major assumptions in our worst-case scenario consist of sales only growing 3% compounded annually through 2014 and operating margins falling to 24% (from 29% excluding charges in 2009) during the next five years. Other orthopedic company shares appear to be discounting similarly weak scenarios, and overall we see limited downside risks at current prices given the firms' long-term prospects. Beyond the downside protection we see at current prices, we believe investors could be richly rewarded if orthopedic firms can reaccelerate top-line growth and use cost-control efforts to stave off big profitability cuts, which are generally reflected in our base-case valuations.

Below are five orthopedic companies trading at significant discounts to our fair value estimates.

Johnson & Johnson
Price/Fair Value = 77%
As one of most diversified health-care companies in the world, it shouldn't come as a surprise that J&J is a top-tier supplier of orthopedic devices too. Its DePuy unit, which accounted for about 9% of J&J's sales in 2009, holds top-tier positions in knee, hip, spine, and sports medicine (endoscopy) niches. J&J has been benefiting from solid orthopedic growth in recent years, and we'd expect more of the same from this giant going forward.

Price/Fair Value = 77%
Medtronic is the top provider of spinal implants in the world, with about 36% market share in 2009. Spine devices accounted for about 22% of the firm's sales in fiscal 2010. While Medtronic's spinal segment only grew 3% last year during a weak product cycle (versus low-double-digit growth for the worldwide spinal market in 2009), this segment's growth could accelerate in the near future as it launches next-generation fusion products.

Smith & Nephew (NYSE:SNN)
Price/Fair Value = 76%
Smith & Nephew is focused on treating active, relatively young patients and on internal efficiency initiatives. In recent quarters, rising economic tides and cost controls appear to have offset some weakness associated with a key hip product on Smith & Nephew's bottom line. Going forward, however, the firm's results will be particularly sensitive to the employment market, due to its targeting of younger patients in the orthopedic spectrum. Shares may rally or falter depending on employment trends.

Price/Fair Value = 73%
With about 60% of its sales coming from orthopedic implants and the balance coming from medical equipment, of which many are utilized in orthopedic procedures, Stryker offers a unique investment opportunity in this niche. Much of its medical equipment sales come from hospital capital budgets, which makes Stryker's financial results particularly sensitive to the economic health of hospitals. In the most recent recession, hospitals cut their capital spending dramatically, causing declines in Stryker's medical equipment business. Going forward, that segment could provide a key catalyst for growth at Stryker whenever the economic tide turns positive.

Price/Fair Value = 72%
Zimmer offers the most pure exposure to the top-tier orthopedic implant niche available in the public markets. As a leading provider of knees and hips, Zimmer should be able to generate similar results as the overall industry. We think the firm could have some momentum behind it too; after several tough years, Zimmer could get back on offense in the second half of 2010 with new knee and hip offerings expected to accelerate growth.

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