|Shares Out. (in M):||214||P/E||12.1x||11.1x|
|Market Cap (in $M):||10,170||P/FCF||12.9x||11.8x|
|Net Debt (in $M):||376||EBIT||1,151||1,243|
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.
- 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.
- 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.
- 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.
- 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.
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).
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)
|Entry||09/21/2009 11:06 AM|
as someone who knows this idea better than me I was just wondering if you would explaining the disparity between CapEx requirements for ZMH and SYK. Specifically ZMH has a large amount usually devoted to "additions to instruments" but no such line item exists for Stryker. Since this number tends to be a big one (238m last year; 165m seen for this year), would you mind explaining it to ignorant? Me?
any help appreciated
|Subject||RE: instrument cost|
|Entry||09/24/2009 01:43 PM|
Stryker has a line item called "Loaner Instrumentation" which is the equivalent to Zimmer's "additions to instruments." Stryker amortizes their through SG&A (so it shows up in CFFO) vs. Zimmer amortizing through PP&E (and thus CFFI).
Hope this helps.