By The Valuentum Team
Zimmer's Investment Considerations
• Zimmer Biomet (NYSE:ZBH) produces orthopedic reconstructive devices, spinal and trauma devices, biologics, dental implants, and related surgical products in the Americas, Europe, and Asia Pacific. The firm has been around for more than 85 years and is headquartered in northern Indiana. It was formed as a result of the merger of Zimmer and Biomet in 2015.
• Zimmer's deal for Biomet was a big one. The combined entity offers one of the most comprehensive and diversified musculoskeletal portfolios. Operational synergies are also expected, and pricing power will be enhanced across areas of overlap.
• Zimmer's adjusted earnings per share have expanded steadily from the $3.94 mark in 2009. The company has demographic trends in its favor, and the firm's global position as a leader in musculoskeletal health is only strengthening. The Biomet deal is expected to be accretive to earnings immediately. Both companies have been dedicated to R&D spending, and an innovative leader will be the result.
• The Zimmer-Biomet merger was completed mid-2015, and the company is now a leading innovator in the $45 billion musculoskeletal industry, backed by a more comprehensive and diversified portfolio with impressive market share and solid cross-selling opportunities.
• 2015 was a transformational year for Zimmer Biomet, but the firm was able to report top-line growth that was supported in part by sequential improvement in its joint reconstructive business. Adjusted earnings per share growth was solid despite GAAP results being severely impacted by the integration of the recent acquisition.
• The integration of Biomet has been substantially completed, which, when combined with the company's broad musculoskeletal portfolio, should help the firm accelerate growth as it progresses through 2016. Reported revenue growth will be impacted by currency headwinds, and management expects revenue to be approximately flat for the year.
• Zimmer's extremities portfolio currently includes a range of options for shoulder and elbow replacement. The company has a #3 position in this market, which is expected to grow at a 12% CAGR across the globe. The division is much smaller than knees and hips, however.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Zimmer's three-year historical return on invested capital (without goodwill) is 33.3%, which is above the estimate of its cost of capital of 8.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Zimmer's free cash flow margin has averaged about 16.5% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Zimmer, cash flow from operations decreased about 9% from levels registered two years ago while capital expenditures expanded about 29% over the same time period.
In fiscal 2015, Zimmer reported net cash from operations of ~$817 million and capital expenditures of ~$168 million, resulting in free cash flow of ~$649 million, representing a ~29% decrease from fiscal 2014.
This is the most important portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares:
Our discounted cash flow model indicates that Zimmer's shares are worth between $92 and $138 each. Shares are currently trading at ~$108, in the lower half of our fair value range. This indicates we feel there is more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $115 per share represents a price-to-earnings (P/E) ratio of about 27.4 times last year's earnings and an implied EV/EBITDA multiple of about 18.8 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 12.7% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 1.6%. Our model reflects a five-year projected average operating margin of 30.4%, which is above Zimmer's trailing three-year average.
Beyond year five, we assume free cash flow will grow at an annual rate of 4.2% for the next 15 years and 3% in perpetuity. For Zimmer, we use an 8.5% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $115 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Zimmer. We think the firm is attractive below $92 per share (the green line), but quite expensive above $138 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Zimmer's fair value at this point in time to be about $115 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Zimmer's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $153 per share in Year 3 represents our existing fair value per share of $115 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Zimmer's merger with Biomet in mid-2015 has positioned the combined entity as a leader in musculoskeletal health. The company expects the deal to be accretive to earnings immediately, cash flow from operations to increase by 50%, and net annual synergies of ~$350 million by Year 3. Zimmer has a #3 position in the shoulder and elbow replacement market, which is expected to grow at a 12% CAGR globally, but is still much smaller than the firm's knees and hips division.
After a transitional 2015, management expects to accelerate growth throughout 2016. The company's low-yielding dividend is still fairly young, but strong free cash flow generation should lead to material dividend growth moving forward. The company's Dividend Cushion ratio is fantastic, for example. Its dividend report can be downloaded here. Though we admire the company's growth prospects, we'd like to see it trading at a larger discount to our fair value estimate before initiating a position. Zimmer currently registers a 4 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.