Description

Zimmer offers the chance to invest in the largest and most profitable supplier of orthopedic implants in the world with a very attractive risk/reward (down 20%; up 80%).  Despite having #1 market share, 30+% EBITDA margins for the past eight years, and an aggressive buy back program in place for their heavy free cash flow, Zimmer trades at only 7x 2009 EBITDA - near historic lows.

Background:  Zimmer is the largest manufacturer of knee and hip implants in the world.  Knees and hips represent 43% and 31% of revenues, respectively, while reconstructive products for extremities, dental, trauma, and spine represent 19% of revenues.  Zimmer was founded in 1926, eventually found its way into Bristol Myers, and was then spun out in 2001.  Over the years, ZMH has grown through organic growth (new product development) and acquisition (most notably the largely European Centerpulse acquisition in 2003).

Five companies, Zimmer, Stryker, DePuy (JNJ subsidiary), Smith & Nephew, and Biomet, control about 92% of the orthopedic implant market.  The U.S. market for hips and knees alone is approximately $5b, of which 55% is paid for indirectly by Medicare.  In the mid-2000s, the market was growing 8-12%/year as a result of the powerful trifecta of increasing volume due to demographic factors, new product development (which allows for higher pricing), and straight price increases.  The orthopedic companies valuations went to the moon - in 2004, Zimmer was valued at over 30x EBIT.

The high multiple could be partly explained by the stability of the business.  Over time, market share in the industry is extremely sticky for three main reasons.  First and most important is the physician's preference and training: once a surgeon knows how to implant a Zimmer hip, he is unlikely to comparison shop.  Furthermore, he's not the buyer anyway (more about that later).  Barriers to entry are very high because it is nearly impossible to get a physician to try a new device without significant investments in research, testing, and training.  Second, most surgeons rely heavily on sales reps, who are not typical sales reps - they actually stand in the operating room with the surgeon, often advising the surgeon on different approaches and assisting where necessary.  In some cases, the sales reps have more experience with these procedures than the surgeons do.  Finally, market share was sticky because of ethically questionable consulting agreements. 

This last reason got the industry into trouble.  In 2005, the Department of Justice began an investigation into the industry consulting practices.  In the end, the DOJ determined that it was probably a good idea to have orthopedic surgeons involved in the design of orthopedic implants.  However, certain industry practices crossed the line (i.e.: paying a surgeon $5,000 to fly first-class to Vail so he could speak for 15 minutes at an industry conference about a certain product).  Four of the five companies signed Deferred Prosecution Agreements (DPA) in September 2007, and accepted government overseers until March 2009.  Because industry sales and R&D are so intertwined with the physician community, the industry more or less froze during 2008.

Of course, Zimmer and its competitors were not immune to the other factors that impacted stocks in 2008.  The massive strengthening of the U.S. dollar in Q3 and Q4 last year flipped the optics of industry growth rates upside down.  Healthcare stocks sold off hard once Obama won (and especially once it became apparent in February that he wanted to take on health reform).  Multinationals were impacted by Obama's vague proposal on changing the tax deferral on foreign earnings.  And most surprisingly for orthopedic stock investors, it turned out that these procedures have a consumer discretionary element to them.  Younger, non-Medicare patients (45% of the U.S. procedures) became concerned about deductibles, co-pays, and even the time away from work required to rehab back to full health.  After banking on 10% growth every year, investors are now faced with 3-4% hip/knee growth.

Why does this opportunity exist? 

1)       The discretionary nature of hip and knee replacements have brought a "consumer" element to healthcare, which healthcare investors are not comfortable with.  (Incidentally, Zimmer stock and other similar stocks have not rallied with traditional consumer discretionary stocks.)

2)       Health reform is an overhang for all of healthcare, which has raised pricing concerns.

3)       ZMH has suffered market share losses in the past couple of years, though it is showing signs of stabilization.

4)       Minor timing issues:  2009 guidance is back-end weighted due to product launches; difficult currency comps through Q3 2009.

Investment Thesis

• Leading market share with a sticky customer base; share losses have stabilized: Zimmer is #1 in artificial hips (22% market share) and knees (27%), which together account for 74% of their revenues. As discussed above, physicians are reticent to change their implant supplier, but Zimmer gave some an opening last year. Zimmer, under the previous CEO, had been the most aggressive in signing consulting agreements to physicians. Under the DPA and their government overseer, who happened to be former Attorney General John Ashcroft, Zimmer shut down all communications with physicians, and some of the more aggressive (i.e.: pissed off) physicians took the opportunity to shift to competitors. However, starting in Q3 2008, Zimmer starting paying appropriate royalties again and began communication with physicians. As of now, the share losses have largely stopped because the vast majority of physicians make their implant decisions based on product quality and their own comfort level rather than kickbacks. In any case, Zimmer is now investing heavily in compliance, quality, and medical education and physician training.

• Valuation is attractive for an extraordinarily profitable business: Zimmer is trading at 7.1x 2009 EBITDA - near historic lows - more attractive than their peers. They are aggressively buying back stock (and still have authorization to buy back 9.5% of company). 35+% EBITDA margins have been sustained for the past eight years - even in the latest challenging quarter.

• Healthcare reform fear is overblown. First of all, the U.S. represents only 57% of their revenues. Secondly, there is no direct reimbursement to the orthopedic companies from the government. Hospitals are paid based on a diagnosis/procedure basis, and it's the hospital's responsibility to manage its costs. As a result, hospitals have had a significant incentive to lower orthopedic implant costs for a long time. However, the power of the orthopedics surgeons has and will continue to prevail because while the profitability of an individual joint replacement surgery might not be so profitable, the sum of all the business that the orthopedist brings with him is very profitability. Finally, Obama's hospital proposals only slow the rate of hospital payment increases - but are often portrayed as cuts (that's government accounting for you).

• Potential for upside recovery from a number of areas:

1. Demographics: In the US, currently only 54% (hips) and 57% (knees) are paid for by Medicare. This is likely to increase as the Medicare population begins to grow by 3% per year between 2010 and 2020 (vs. 1.4% between 2000 and 2010). In addition, the rising level of obesity in the world will lead to higher utilization rates.
2. Pent-up demand once the economy improves. The economy has likely pushed off a large number of procedures, but potential patients' pain has not gone away. A solid hospital contact has indicated to me that procedure volumes have already started to increase.
3. Fat: A business with 35% EBITDA margins should have better returns on capital than 12-15%. There is likely a lot of fat in the business, at least from a working capital perspective.
4. Integration activities: Zimmer is currently experiencing an expected earnings setback from the integration of ABT's spine business (closed in October 2008). Spine represents 6% of overall revenues.

• Expectations are low and the focus is on the wrong issue: Zimmer and the whole orthopedic space has few fans now. I believe that the overriding focus is on pricing (which is starting to come down slowly). I fully concede that pricing will come down - they products are way too profitable and the health system is too strained for them not to. However, as long as the prices come down in a controlled manner, the industry will do great, since the demographic trends will overwhelm the price declines. According to my U.S. market models, assuming that (a) U.S. hip and knee implant prices begin declining by 3.5% per year, (b) there is no change in the joint replacement rate (it is likely to increase), and (c) there is no further change in ZMH's market share - the decline in ZMH's EBITDA would be only 4% over the next three years.

Incidentally, the concern over prices only applies to the United States.  Zimmer, as the largest international supplier of artificial implants, has been dealing with all sorts of price environments for many years.  Their international business is nearly as profitable as the U.S. business (though off a smaller base).

Risks:

• Pricing pressure becomes more pronounced (with or without healthcare reform)
• Market share losses continue
• Working capital cannot be improved for structural reasons.
• Health reform reduces procedure volumes (through rationing of care). (For example, a mandate to attempt physical therapy prior to hip or knee surgery.)

Valuation:

• I believe that Zimmer is worth $80. Even if Zimmer grows at only 3%/year for the next three years with flat margin expansion it would be generating almost $1.7b of EBITDA. Applying an 8x EBITDA multiple and adjusting for all the cash the company would generate over that period of time results in an $80 stock price. If this happens, 8x EBITDA is likely conservative.

• On the downside, if their revenues are flat, compressing their EBITDA margins to 34% (margins have not been that low since they acquired the Centerpulse business), Zimmer will still generate over $1.4b of EBITDA and over $700m of cash per year. Even with a 5x EBITDA multiple, Zimmer stock would be worth around $40. Since Blackstone, KKR, TPG, and Goldman Sachs paid 19x EBITDA for Biomet in 2007, I don't think Zimmer would stick around too long at that valuation, regardless of the credit markets.

• In valuation, it's worth considering the levers that Zimmer has to pull. Just in the short run, Zimmer can expect the following:

a. Higher volume of new products, which typically have better margins

b. Lower SG&A costs, especially related to ramping up global compliance initiatives

c. Improved consumer discretionary trends (patients can only defer surgery for so long)

d. Improvements in spine business after fully integrating Abbott's spine business (completed Oct. 2008)

e. Lower inventory levels

f.  Lower share count each quarter as ZMH presumably buys back shares (they actually drew on the revolver to buy shares in Q1)

Catalyst

• Procedure volumes pick up with the economy
• Zimmer new product introductions in hip, trauma, and knee do well
• Government compliance issue from one of its competitors that shift share back to Zimmer.