Buy Zimmer Biomet

| About: Zimmer Biomet (ZBH)

Summary

Weak earnings a product of nonrecurring merger-related expenses.

Fundamentally sound business with economic moat and strong long-term growth prospects.

Undervalued by 6% based on 1-year price target, but poised for long-term returns.

Investment Summary

Zimmer Biomet (NYSE:ZBH), formerly Zimmer, manufactures and sells products used for treating disorders and injuries to bones, joints, and tissues. The company acquired competitor Biomet in June 2015, and the stock has steadily declined since. It currently trades at a forward multiple of 11.4. The newly consolidated company's EPS fell from $4.26 to $0.78 in 2015 due to significant merger-related expenses, the majority of which are nonrecurring. We believe this is an excellent opportunity to buy a business with important competitive advantages in an industry with stable long-term growth prospects. Based on our 1-year price target of $110.52, shares are undervalued by 6%.

Business Description

Zimmer Biomet is a leading orthopedic device maker. The company sells knee and hip reconstructive products, as well as a variety of other products that repair knee, shoulder, and spinal injuries, preserve joints, treat arthritis and extremity fractures, and stabilize broken bones. In addition Zimmer provides dental, face, skull, and chest reconstruction products. The company's primary customers include surgeons, hospitals, stocking distributors, healthcare dealers, and dentists. Zimmer generates approximately 60% of its revenue in the Americas region, 25% in EMEA, and 15% in the Asia Pacific.

Industry Outlook and Competitive Position

We maintain a positive outlook for the global orthopedic device industry. We expect that aging populations, rising obesity, more active lifestyles, and technological innovation will drive long-term demand for joint replacement products. While lower reimbursements from third party payers will create pricing pressures, industry revenues should outpace global GDP growth over the next five years.

The orthopedic device market is concentrated among a relatively small number of firms who enjoy a degree of pricing power. Competition is primarily based on technological innovation, quality, brand reputation, and customer relationships. Firms typically have bargaining power over customers due to high switch costs: significant product differentiation means that the process of learning how to implement a new device is a time-consuming one. Rather than learn a new system and work less productively, surgeons prefer to specialize in a single product and will often retain the same vendor and sales rep for many years. These deeply entrenched relationships keep market share stable and raise barriers to entry.

Zimmer is the industry leader in knee and hip reconstruction, and the acquisition of Biomet, a competitor, only strengthened the firm's position. According to Becker's Spine Review, the company's market shares in knees and hips are expected to reach 40% and 32% respectively as a result of the merger. ZBH has a considerable economic moat thanks to key competitive advantages. First, the company has a large sales force with strong customer relationships, and can leverage its bargaining power over customers to mitigate the efforts of third party payers and hospitals to cut costs. Furthermore, no single customer accounts for more than 1% of Zimmer's sales. Zimmer's intellectual property provides another advantage. The company owns or controls over 7000 patents. In an industry that depends on technological change for growth, patent protection is essential for the development of future products that build off the intellectual property of earlier generations.

Zimmer-Biomet's main competitors include DePuy Synthes of Johnson & Johnson (NYSE:JNJ), Stryker (NYSE:SYK), Wright Medical Group (NASDAQ:WMGI), Smith & Nephew (NYSE:SNN), Medtronic (NYSE:MDT), and Nobel Biocare of Danaher (NYSE:DHR). The high profit margins that Zimmer and its rivals generate compared to the industry average are a testament to their strong competitive positions (Figure 1).

Figure 1: Peer Group (Market Cap in Millions)

Company

Market Cap

5-Yr CAGR

Med EBIT Margin

D/E

Forward P/E

P/B

P/S

Dividend Yield

Danaher Corp

65,169

10.4%

17.1%

0.5

17.7

2.8

3.3

0.6%

Johnson & Johnson

299,390

2.6%

25.8%

0.2

15.7

4.2

4.4

2.8%

Medtronic

134,177

5.1%

23.6%

0.7

15.6

2.6

3.7

2.0%

Smith & Nephew

14,766

3.2%

18.6%

0.4

16.2

3.7

3.1

1.9%

Stryker

39,383

6.3%

18.7%

0.4

17.0

4.6

4

1.3%

Wright Medical Group

1,698

12.8%

-33.5%

0.5

N/A

1.6

2.6

NA

Zimmer-Biomet

20,764

7.3%

23.0%

1.2

11.9

2.2

3.5

0.8%

Industry Average

2,625

5.8%

9.5%

0.6

N/A

3.7

3.9

1.3%

Financial Analysis and Valuation

Zimmer's acquisition of Biomet saw the company grow revenues by 28% in 2015. However, EPS declined from $4.26 to $0.78 primarily due to special items associated with the merger. Stock-based compensation and retention bonuses paid to Biomet employees, as well as severance expenses, contract terminations, and other integration charges caused "Other Operating Expenses" as a percentage of sales to increase to 19.5%, compared to a five-year average of 5%. Consequently, operating margin fell from its stable average of 23% to just 7.8%. These non-recurring expenses should gradually revert to their historical levels over the coming years. We also expect that SG&A synergies from the merger will partially offset higher COGS and amortization expenses that resulted from fair value adjustments to inventory and intangible assets when Zimmer consolidated Biomet's financials.

The Biomet acquisition left ZBH with a significant amount of debt on its books and interest expense will exceed historical averages over the forecast period. Long-term debt increased by $10 billion, pushing D/E from 0.2 to 1.2. Rising interest expenses are largely responsible for Zimmer's falling net profit margin over the last five years, and with interest coverage at just 1.6, shareholders are exposed to a downturn in demand. But assuming the amount of debt stays constant, high financial leverage benefits equity holders when sales are growing, and we believe the catalysts are in place to support long-term growth and drive margin expansion.

Based on the firm's 3-year average P/E ratio of 21.2, shares are undervalued by 6.1%. Our 1-year price target of $110.52 implies that revenues will grow 25% thanks to the full-year impact of the Biomet merger, with, volume growth of 4% offset by pricing pressures from health care curtailments and currency headwinds. We expect COGS and amortization to remain well above pre-merger levels as a result of fair-value adjustments, and that R&D will account for 4.75% of sales. We project SG&A as a percentage of sales to fall from 38.2% to 37% thanks to cost synergies, and expect special items to decrease by approximately 50%. As a result, operating margin should increase from 7.8% to 21.25% in 2016, a number that is still below historical averages, but one that should continue to improve in the following years as special items decrease.

Our EPS estimate of $5.21 also takes into account the impact of the board's recently authorized $1B share repurchase program. We expect the company to repurchase roughly 10 million shares, and that the combination of fewer shares outstanding and higher profitability restoring investor sentiment will drive price multiple expansion up closer to historical levels.

The biggest risks to the price target relate to the company's ability to integrate Biomet, increased cost-cutting measures from third party payers, and higher interest rates. It is too early to judge the success of the merger, but on the surface the acquisition makes sense: the companies sell comparable products and the consolidation will allow ZBH to expand into faster-growing markets such as sports and extremities. Despite increased pricing pressures we like the outlook for organic growth. The company typically grows volumes at a rate two-to-three times the absolute percentage decline in pricing, and Zimmer's strong bargaining power limits the degree to which prices will fall. Finally, while the company's high debt levels are a potential concern, we do not anticipate interest rates to increase any time soon. The economy is too weak for the Fed to raise rates multiple times in 2016, particularly in an election year when Chair Yellen's future at the Fed depends on a Democrat retaining the presidency

Conclusion

The combination of strong long-term demand drivers and a sizeable economic moat make Zimmer-Biomet an attractive option, particularly against the backdrop of a weak and uncertain economic climate. At $103.74, shares trade at a miserly forward multiple of 11.9. With profitability set to rebound as one-time items normalize, one has to wonder why the stock is cheap. Insiders and institutional investors have been dumping shares over the last few months at prices close to the current price. We typically refrain from basing investment decisions on the actions of insiders because their reasons for buying or selling are often unrelated to their views of the business. In this case, we think it provides an excellent opportunity to purchase a fundamentally undervalued business.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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