Zimmer Holdings (ZMH) has been approaching a very attractive entry price over the past several trading days. In a previous article, factors coincident with future outperformance were described - Zimmer seems to meet most if not all of these criteria.
Zimmer was spun off from Bristol-Myers Squibb (BMY) in 2001. They specialize in reconstructive implants to restore lost function in limbs due to disease or trauma (75% of sales). In a highly competitive industry, Zimmer continues to spend on research and development to the tune of $239M in 2011 (5.4% of sales). They have steadily increased R&D spending over the past 10 years from $52M in 2000, a very favorable trend. Over the past three-year period Zimmer has averaged a compound annual sales growth rate of about 5% and an EPS growth rate of approximately 9%. This does not represent the kind of growth that gets the animal spirits of Wall Street excited, but it represents good growth at a reasonable price.
Discounted cash flow analysis of Zimmer was performed based on the slow but steady growth rate demonstrated since 2004. Zimmer has grown free cash flow at an average rate of 3% per year. To be conservative a lower 2.5% growth rate and a cost of capital of 10% were assumed. From current free cash flow of $1,177M in 2011 this would indicate an intrinsic value of $13.8B over 50 years at which point discounted cash flows become relatively insignificant. This indicates a margin of safety of 25% from the present level of valuation. Below is a chart of the free cash flow yield of Zimmer over the past ten years.
Earnings held up quite well even during the dark days of the great recession. In 2009 EPS declined to 3.33 from 3.73 the previous year. While selling pressure on the stock was considerable during the 2008-2009 bear market, Zimmer's performance held up quite well under very difficult economic conditions.
A pessimist might say that the price has been relatively stagnant since 2004. Two things should be noted, first the price has netted a nearly 107% return since Zimmer was spun off in 2001 (92% greater than the S&P 500), second the free cash flow yield has massively outpaced the share price performance over that time. This trend simply cannot continue; sooner or later the price must go up if the free cash flow yield continues to increase.
Other Valuation Considerations
Other metrics of valuation indicate that Zimmer is compelling at the present time:
- Price to Sales = 2.30.
- Price to Book = 1.80.
- EV/EBITDA = 6.89.
- Trailing 12 month P/E = 13.8, minimum ratio was 12 in 2011 or 9 in 2009.
- Forward P/E = 11.2.
- Return on Equity = 13.1%.
- PEG ratio = 1.19.
- Debt/EBIDTA = 1.1.
- Beta vs. S&P 500 = 0.94.
- Volatility was 86% compared to the S&P 500 over the past 90 days.
These metrics are all favorable compared to the S&P 500 as a whole, or compared to competitors within Zimmer's sub-sector.
One way to think about the value of Zimmer as a company is to consider the cost of building a competitor company. Book value tends to be predictive of future returns because it represents a barrier to entry. When a company trades on the open market for less than the sum of its parts there will be few new competitive entries. Zimmer has a book value of $5.5B, $1.2B of which is in cash and about $3B of which is intangible assets from acquisitions. As prior acquisitions have led to the current earning power of the company, I let them stand at full value.
Furthermore, to build a competitive company years of R&D spending would be required. Zimmer's R&D spending over the past ten years depreciated at 10% per annum would represent a value of an additional $1.3B. So nearly 70% of the purchase price represents cost of entry. If the share price declines another 10% the capital of a buyer will have a great deal of protection.
A very important part of any holding is a demonstrated history of shareholder friendly behavior. Over the past ten years Zimmer has generated $6.736B in net income. Over the same time period the company has spent $4.049B to repurchase stock, which has dramatically lowered the number of shares outstanding. This means that 60% of net income has been returned directly to shareholders. A dividend was also recently instated yielding 1.2% and $1.5B in buybacks are authorized through the end of 2014. Thus over the next 17 months shareholder remuneration will average north of 10% per annum. Considering how overbought many dividend paying stocks are at the present time, a company like Zimmer that has flown under the radar looks very attractive.
It should also be noted that over time, there advantages to repurchase driven share price appreciation when the shares are held in a taxable account. Dividends must be paid in cash, however, repurchases concentrate your shares free of taxes until the shares are sold. This tax advantage will be particularly important if taxes on dividend paying stocks are raised with expiration of the Bush tax cuts. I
t should also be noted that shareholder equity has been rising or constant over the past five years. Thus, share repurchases are not being aggressively pursued via debt financing. The trend of outstanding shares is shown below. Since 2006 25% of the float has been retired, even as the price has declined from 80 to 58 and free-cash-flow has increased by about 10%. Put those three together and the valuation of Zimmer is twice as attractive as it was in 2007.
(click to enlarge)
The buying and holding decisions of insiders are always very telling. David C. Dvorak is the current CEO of Zimmer Holdings. His total compensation in the previous fiscal year was $2.87M and $6.49M over the past three years. Mr. Dvorak currently holds 120,000 shares with a market value of $7.35M or a concentrated holding representing nearly six years after-tax income. Mr. Dvorak knows the business of Zimmer better than anyone. The fact that he has staked a large portion of his net worth in common stock demonstrates that his decisions will be aligned with the best interest of shareholders and that he believes in the future of his company.
Analysis of Prior Valuation Metrics Against 1-Year Forward Return
Analysis of several valuation data sets was performed (P/B, P/E, EV/EBITDA, P/S). The best fit against forward return was the price/sales ratio. Data prior to 2005 were excluded, as multiple expansion was the driving force for price appreciation at that time. A shareholder in 2004 would have been forced to conclude that the run-up in price was unsustainable as it was driven by P/E multiple expansion from 20x in 2003 to nearly 90x in 2004.
From 2005 to last year, 1 year forward returns are plotted against the price/sales ratio below. The minimum price/book and price/sales in the first quarter of 2009 were: 1.46 and 2.00 respectively. Remarkably, a further 10% correction in the price would correspond to a valuation nearing the 2009 lows.
The current price/book and price to sales are: 1.81 and 2.29 respectively. The first represents a 23% premium to 2009, while the second represents only a 14% premium. A further 5-10% correction in Zimmer's share-price would seem to indicate that risk to reward is very favorable. Buying in the range where the current price/sales ratio rests has been associated with good returns within one calendar year.
Further Growth Considerations - Demographic Trends
From the 2010 fiscal year net sales in the Americas represented 58% of total sales, versus 26% for Europe with the remaining 16% from the Asia Pacific region. For the long term, demographic shifts in these regions toward an older population base should be favorable. In 1950, the number of U.S. citizens older than 65 represented 8.1% of the 152M population or 12M. By 2000 senior citizens accounted for 12.4% of 282M persons, expanding by nearly three fold to 35M. By 2050 it is projected that 20% of the anticipated 439M inhabitants of the United States will be elderly or 87M a 150% increase from the present level. Thus the fairly conservative growth outlined above seems to be a very likely possibility.
Zimmer Holdings' current price is nearing buy territory. The last quarterly report was in-line with analyst's estimates; however, the street has not been impressed. The share price has already declined from a high of nearly 65 to the present price of 58 and violated support and the 200-day moving average. This may foreshadow additional selling pressure leading to an excellent entry point for a long-term investment. A limit order in the 51 region has a good chance of being filled, alternatively investors interested in options strategies could sell a December 22nd put with a strike price of 50 dollars per share. The current asking price is 1.00 per contract, representing a return of 2% over five months or 4.8% annualized. I certainly would not buy a put with a breakeven price of 49, thus selling such a put seems attractive, if the shares are assigned you get the stock for a cost basis of 49 + fees, if not you get a return nearly twice the current risk-free rate.
Zimmer Share Price Since 2008
In an efficient market place sellers of Zimmer would realize that accepting a price at least 25% below fair value because of an earnings report that only meet expectations is illogical. However, in an inefficient marketplace where price movement is self-fulfilling an intelligent investor may soon have the opportunity to purchase Zimmer at a very steep discount.