In my opening dialogue about the merits of healthcare, I discussed the long-term historical annual return of 11.3%. This was second highest of any major sector, just behind consumer staples. The healthcare sector also has the advantage of a lower than average beta for most stocks within the industry. Since 1986, the healthcare sector has only suffered five losing years (see table). This is the lowest number of negative return years of any of the major sectors within the S&P 500 stock index. Due to the impressive long-term returns along with strong defensive characteristics, I generally will maintain an above market weight in the sector versus the market.
Healthcare Sector: Losing Years since 1986
Within healthcare, several areas stand out. One of the most promising over the next decade is the medical supply and technology group. The market is bifurcated and includes several diverse mini-industries. Medical distributors are part of the industry, one which is dominated by three large firms including Cardinal Health (CAH), McKesson (MCK) and AmerisourceBergen (ABC). Medical technology product companies serve a specialized patient population and maintain much higher profit margins. The two-tier industry is dominated by a few leading manufacturers such as Boston Scientific (BSX), Baxter International (BAX), St. Jude Medical (STJ), Medtronic (MDT), Covidian (COV), and Becton Dickinson (BDX), which offer a comprehensive line of both conventional hospital supplies and healthcare technology products to a broad market segment. Further specialized are other niche players including orthopedic firms like Zimmer (ZMH), Stryker (SYK), Biomet (BMET), and Smith & Nephew (SNN).
Issues related to reimbursement rates is a large concern for U.S. medical device companies, as an adequate reimbursement rate usually determines whether a product will be viable in a given market. In the U.S. there are several players involved in establishing reimbursement rates. The Department of Health and Human Services' Center for Medical and Medicaid Services (HHS/CMS) is the central agent of control and change in the area of cost containment and reimbursement for Medicare and Medicaid. Other players in the U.S. market include HMOs, private health insurance companies and the Veterans' Administration. The U.S. market represents such a large percentage of the global market that a low reimbursement rate in the U.S. market may make a product uneconomical to produce globally. Reimbursement rates are considered so important that firms are advised to start working with CMS as early as possible in the product approval process. Notably, many medical device firms in the U.S. apply for and receive the CE mark (the regulatory approval process used in the European Union) before seeking FDA approval, or work on certifying their products in both systems concurrently. The new healthcare law will also bring a raft of changes to the medical device industry, including an excise tax on many medical devices, and the tax is causing a lot of consternation in healthcare circles. The medical device excise tax aims to raise $20 billion over 10 years when it goes into effect in 2013. The new law also states that medical device firms have 510(k) approval to market their products in the United States. This means that new devices must demonstrate that their products are "substantially equivalent" to anything already on the market. This will no doubt add to the cost of new medical device approvals.
Despite the concerns over reimbursement and the excise tax, many of these firms within the industry have impressive growth rates combined with moderate valuations. One of my favorite firms within the industry is Zimmer. Zimmer was founded in 1927 and has its headquarters in Warsaw, Indiana. The firm's primary market is orthopedic device production and marketing. Joint reconstruction is the largest portion of Zimmer's product mix. Knee and hip implants accounted for 71% of the firm's sales in 2011. The balance was generated from several orthopedic specialties including spine, trauma, surgical and dental.
In evaluating Zimmer, I have a screening list of key criteria that all equity selections must pass:
Key Selection Criteria
- A market capitalization over $10 billion.
- A leadership position within a growing industry.
- A dominant, or large, market share within its product mix.
- A strong position internationally.
- A strong balance sheet and high credit rating.
- A high free cash flow number.
- A low historical relative valuation as measured by price/sales and price/earnings ratios.
- A strong dividend growth rate.
- A catalyst of new revenue opportunities.
Zimmer meets my first criteria with a market capitalization of $11 billion. This small relative market cap gives plenty of room to grow while also providing the long-term stability of a large-cap company.
Zimmer also maintains a leadership position within its specialty industry and a large market share percentage in its two top products (knees & hips). Zimmer claims a leading market position in knee and hip implants and market share in this niche has been consistent over the past decade. Loyalty for hips and knees is proven as surgeons are generally trained and become comfortable with one primary supplier. The market also has future growth potential. The global orthopedic devices market for hips and knee replacement is expected to reach $57.9 billion by 2016, growing at a CAGR of 4.7% from 2011 to 2016. By 2030, the demand for primary total hip replacements is estimated to grow by 174% to 572,000. The demand for primary total knee replacements is projected to grow by 673% to 3.48 million procedures. Along with Stryker and DuPuy Inc, these three firms control 70% of total market share. Zimmer's share in knee and hip replacement is 27.7% and 24.3%, respectively. Zimmer also holds a top 3 position in the extremities business, which includes both shoulders and elbow implants. Its holds a 13% market share in extremities, a $1.2 billion market.
Zimmer generates 45% of its total sales from overseas markets, meeting my criteria of a higher-than-average international sales rate. International sales are also becoming a larger portion of Zimmer's total revenue percentage. In 2007, only 40% of total revenue came from outside the U.S. The benefits of adding foreign sales are evident in 2011's financial results. In 2011, European sales grew by 5% and Asia Pacific by 6% on a constant currency basis. Japan was the largest market in this region, accounting for roughly 52 percent of sales. Reliance on Japan's market should recede over the next five years as Zimmer is concentrating on Asia's other higher growth market like China. Zimmer's management team has set a goal of growing emerging market revenue ten fold to $10 billion by 2018.
Balance Sheet/Free Cash Flow
Zimmer has a credit rating of A- from Standard & Poor's. Zimmer exited 2011 with cash and cash equivalents of $768.3 million compared with $668.9 million as of December 2010. Zimmer has maintained free cash flow per share of $4.84 Zimmer's free cash flow yield based upon a price of $62 is 7.8%. Zimmer has shown consistent growth in FCF, despite the heavy buyback of stock over the preceding five years.
As for relative valuation, Zimmer is trading toward its lower range in history. Zimmer has traded at a price/sales ratio range of 2.1 to 5.1 over the preceding five years. The highest price/sales ratio in the past decade occurred in March of 2007, when Zimmer traded at a 5.6 price/sales ratio.
Price /Sales Ratio
|Sales Per Share|
|Sept. 1, 2012||2.48||26.30|
|Sept. 30, 2011||2.31||25.01|
|Sept. 30, 2010||2.51||21.58|
|Sept. 30, 2009||2.85||20.06|
|Sept. 30, 2008||3.49||18.43|
|Sept. 30, 2007||5.09||16.73|
The average price/sales ratio of Zimmer has been 3.1, thus Zimmer is trading at a below average historical level at today's stock price level. Consolidated net sales for the last quarter (6/2012) were $1,125,000,000, an increase of 1.8% year over year. Over the previous five years, based upon sales per share growth, Zimmer has advanced SPS by a compound rate of 9% per year. This was aided no doubt by the sizable annual buybacks accomplished by Zimmer each year. If buybacks continue on the historical pace, and net sales can increase by 4% per year (see commentary below), Zimmer's stock price could reach over $100 a share with a conservative 7.5% SPS growth rate.
|2015 SPS Projected||32.67|
Dividends, and more importantly dividend growth is a important component of total return. Historically, those firms that pay and grow dividends over time outperform those firms that do not. For any investment candidate, I require a dividend not only be paid, but for the growth rate in future dividends be above the market. Zimmer has become a candidate for selection due to the fact the firm recently instituted a dividend. Zimmer Holdings declared its first quarterly dividend of $0.18 per share earlier in 2012, marking the first time the company has elected to return cash to its shareholders. Given that Zimmer is expected to earn $5.22 per share in earnings in 2013, the yearly dividend represents a payout ratio of 13.8%. Zimmer maintains over $5 a share in cash on the balance sheet, more than enough to support future dividend increases. In its statement to investors, the management team of Zimmer estimated that it will return two-thirds of its net income to shareholders through repurchases and now dividends. This would generate solid double-digit growth in annual dividends through the decade. A new share repurchase program was also put in place this year, which authorizes purchases of up to $1.5 billion of the company's common stock through December 31, 2014.
For Zimmer to reach a price of $100 + plus per share by 2015, overall sales growth must improve from the 2% annual rate of the previous year. The knock on Zimmer and many of its competitors is sales growth has been anemic since the Great Recession started. Share buybacks have contributed to about two-thirds of Zimmer's earnings per share growth since 2007. Buybacks and dividends can improve shareholder returns, however ZMH's top line must begin to advance beyond current estimates to generate higher valuations based upon price/sales and price/earnings. I feel that Zimmer has several lines of new incremental growth over the next few years. Two niche areas that Zimmer can add revenue from are hyaluronic acid and power tools.
Zimmer's entry into the $700mm hyaluronic acid HA market this year is one area of new growth. On August 3, a ruling came that the Gel-One product made by Tokyo-based Seikagaku and distributed by Zimmer doesn't infringe a Genzyme patent for a method to treat arthritic pain in the knee. Genzyme will continue to dominate this market in the future, however it looks likely that Zimmer can take market share. This should result in incremental revenue gains of $100 to $200 million by 2015.
Zimmer's second area of new growth is its re-entry into the $1 billion power tools market. It has already acquired Sodem Diffusion S.A., the manufacturer of SoPlus Orthopaedic Surgical Power Tools in 2010. The company was since re-named Zimmer Surgical, S.A.. Zimmer also acquired Reno, Nevada-based Synvasive Technology, Inc., enhancing the power tools portfolio through the addition of Synvasive's STABLECUT® surgical saw blades, as well as the eLIBRA® Dynamic Knee Balancing System™ for soft tissue balancing. The power tool market is currently dominated by competitor Stryker. Gaining a 10% market share in power tools by the end of 2015 could result in Zimmer gaining an additional $100 million plus in revenue.
Additionally, Zimmer's new system Persona should allow the company to maintain or improve its market-share lead in knees. Overall, I project that Zimmer can return to growth in sales of 4% per year, up from the 2% level. This also does not take into account a more favorable economic environment, which would improve both hip and knee replacement based on the industry's high correlation with GDP growth. Despite the economy, growth should come from the two new niche areas discussed, surgical and HA, along with high single-digit growth rates in extremities and its smaller dental division. Combined with solid free cash flow generation and double-digit dividend growth, I feel Zimmer is one of the best positioned "value" stocks within the medical device industry.