Zimmer - A Pure Play On A (Presently) Rotten Market
by Stephen D. Simpson, CFA
Waiting for a recovery in the orthopedics industry has been about as entertaining as watching paint dry, without the benefit of enjoying the fumes. Although it is certainly true that there are millions of Americans walking around on old knees and hips, and the number of 65+ year-old customers is on the increase, the reality is that a broadly favorable demographic push means nothing over the scale of a few years.
That makes Zimmer (ZMH) a tricky stock to assess. It certainly seems cheap relative to its likely future free cash flows, but the company's intense (70%-plus) exposure to hip and knee reconstruction is keeping a lid on enthusiasm in there here and now.
Fourth Quarter Results
Zimmer did alright in the fourth quarter. Relative to major rivals like Johnson & Johnson (JNJ) and Stryker (SYK), better than 2% organic growth in orthopedics was decent, particularly as the company saw a 4% increase in volume. Margins weren't so great, though, and it took a lower tax rate to offset a slightly weak gross margin and deliver a decent per-share outcome.
Looking For Signs Of Life In Reconstruction
Zimmer is no peripheral player in orthopedics. The company holds over one-quarter of the market for knees (making it #1 ahead of JNJ and Stryker) and almost one-quarter of the hip market (placing it a very close #2 behind JNJ and almost even with Stryker). Overall, its nearly 27% share of hip and knee implants puts it ahead of JNJ and Stryker, and roughly double the share of Smith & Nephew (SNN) and Biomet.
Unfortunately, though Zimmer has some positive things going for its reconstruction business, the company is swimming against a tough tide. Although Zimmer's new partial knee products are interesting, these procedures tend to be more elective than total knee replacements. Elsewhere, while the company was the only major player without major problems in custom products, its rivals have largely put those problems behind them. Much the same is true in the hip arena, where the company largely avoided the problems with metal-on-metal implants that troubled JNJ and Biomet.
Right now, the reconstruction market is under pressure on multiple fronts. Hospitals and payors have pushed back hard on reimbursement, while the economy has crimped elective procedures. DOJ investigations have forced companies to change their marketing practices, and the industry has been having to work through what was arguably a period of over-implantation.
Growth Markets Are Too Small
Zimmer does have exposure to faster-growing markets like extremities, dental, trauma and spine. Unfortunately, the company's exposure and market share aren't enough to really make a huge difference. ArthoCare (ARTC) and Tornier (TRNX) both have better leverage to extremities, and while Zimmer's Natural Nail system has certainly boosted its trauma business, they still have just single-digit share at a time when JNJ is about to become a more significant player with its Synthes acquisition.
The Patient Needs More Growth And Better Margins
Like almost any company, Zimmer is looking for ways of boosting growth and improving margins. On the growth front, the company may need to get more active on the M&A front. Zimmer has pretty good exposure to faster-growing OUS markets, but there's no free lunch in the offing here, as both pricing pressures and competition heat up.
On the M&A side, though, there are some options available to the company. ArthroCare and Tornier could make sense as targets for Zimmer, as could Integra Lifesciences (IART) if Zimmer management were interested in expanding outside of orthopedics. I would also be curious to know if Zimmer would think of approaching China Kanghui (KH) or Trauson as a way to accelerate its penetration of the Chinese market (Weigao is already involved in a JV with Medtronic (MDT).
As far as margins go, it seems like the entire sector got a little complacent during the good years. That gives Zimmer some opportunities to boost earnings simply by tightening up its operations and paying more attention to details like sourcing and distribution.
The Bottom Line
It's worth asking whether orthopedics can be an attractive growth market again. Though it's true that there are a lot of aging Americans who will not only need new hips, knees, and shoulders, but who will demand the more minimally invasive technologies where Zimmer is strong, it's not quite that simple. A lot of these hips and knees are going to get paid for through Medicare, and it is difficult to see how the federal budget can underwrite healthy reimbursement trends here. Orthopedics will remain a profitable business, but probably not as profitable as it used to be.
All of that said, Zimmer looks undervalued. Just mid-single digit free cash flow growth over the next decade is enough to power a mid-$70's price target for Zimmer, even with a slight penalty to its discount rate for its historically below-average return on capital. If Zimmer can find a way to drive leadership in emerging markets like China, expand its presence in faster-growing med-tech markets, and/or improve its margins and returns, even better performance could be possible.