A Barron’s article a week ago was titled, “Shares of Hip-Replacement Giant Could Gain 25%.” With a long-term view of investing, this report may bring some opportunity (source).
Some article highlights included:
- Zimmer Biomet (ZBH, Financial), the nation’s leading hip- and knee-replacement maker, is trading at a steep discount.
- Zimmer Biomet has substantially completed the integration of its sales force (after Zimmer acquired Biomet in 2015) — appointing team leaders, setting clear compensation plans, conducting product training and allowing different teams to cross-sell products, according to the company.
- The company, which has a market value of about $20 billion, recently authorized a $1 billion share buyback.
- In addition, the company has consistently beaten analysts’ earnings estimates.
Everything in the article seems appetizing so I took some time trying to figure a little more about its industry trends and Zimmer Biomet’s management.
Industry trends
Falls can cause trauma to an individual’s skin, organs and bones. If the fall or any other external impact is severe, excessive stress given to a bone causes a fracture.
Hip fractures are commonly associated with a fall (source). According to the Centers for Disease Control, as the U.S. population ages, the number of hip fractures is likely to go up (source).
The medical device business is important in long-term health care. Many elderly patients are prone to falling, regardless of their home situations. Statistics claim that every 13 seconds, an older adult is treated in the emergency room for a fall; every 20 minutes, an older adult dies from a fall (source). These are hard facts, but there is a reason why most elderly are provided wheelchairs for functional mobility especially when they have other ongoing medical complications.
Acquisition
The acquisition of Biomet by Zimmer was not just the first big acquisition that occurred among the artificial devicemakers. Johnson & Johnson (JNJ, Financial), a strong medical device competitor, also had a major acquisition deal in 2011. Johnson & Johnson spent $21.3 billion that year to acquire a Swiss company named Synthes Inc. The Johnson & Johnson-Synthes acquisition was secondary to the former company’s desire to be more cost efficient in the face of increasing price pressure from the hospital it serves (source). Johnson & Johnson also purchased an orthopedic company, DePuy Inc., in 1998 for $3.5 billion.
Comparison
(Zimmer-Biomet and Johnson & Johnson hip and knee sales per companies’ 10-Ks)
No doubt, Zimmer-Biomet leads Johnson & Johnson in terms of hip and knee orthopedic sales in spite of the $21 billion purchase of Synthes by Johnson & Johnson in 2011. The hips and knees medical device business contributed 67% in Zimmer-Biomet’s total sales for the past three years.
As quoted in the Wall Street Journal, "DePuy and Synthes together will create the most innovative and comprehensive orthopedics business in the world and enable us to better serve clinicians and patients worldwide," said Bill Weldon, former chairman and chief executive of Johnson & Johnson (source).
Hips and knees market share
(Recent Smith & Nephew annual report)
Zimmer-Biomet is not only engaged in the hip and knee medical device business. According to Standard & Poor’s, the company does business in three more categories, which are spine, dental and a newly created S.E.T. (surgical, sports medicine, foot and ankle, extremities and trauma) category. These additional segments are to account for 20% of Zimmer-Biomet’s total sales.
Management
David Dvorak, 52, has been CEO since 2007. A $10,000 investment starting at the beginning of former CEO Ray Elliot’s tenure until his retirement would have returned, including dividends, 198% compared to Standard & Poor's 500’s 41%. On the other hand, a $10,000 investment since Dvorak’s appointment as CEO would have produced a total return of only 25% compared to the S&P 500’s 67%, an underperformance in either (S&P 500 or previous CEO) comparison.
Dvorak has been with Zimmer since 2001 and began as a senior vice president of Corporate Affairs and general counsel. Dvorak has the experience to drive results for the company. According to Reuters, Dvorak also began his career practicing corporate law with focus on mergers and acquisitions and on securities law. After almost a decade, Dvorak and Zimmer made their biggest acquisition yet, $13.35 billion for crosstown rival Biomet in April 2014.
This was not the first acquisition by Zimmer under Dvorak. During the time of the Great Recession and market panic, Zimmer acquired ORTHOsoft Inc. in 2007 for C$50 million and Abbott Spine in 2008 for $360 million (source). These two acquisitions showed how conservative Dvorak could be when it comes to acquisitions and mergers.
Net shareholder return
Zimmer-Biomet only initiated its dividend in 2012 but has been buying back its shares for the past decade.
In the graph, it appears that Zimmer-Biomet provided steady profits or cash flow on average as shareholder return, which was primarily through buybacks for the last decade. The company also recorded an average three-year dividend growth of 20%.
Other numbers
The merger-acquisition deal appears to have made sense as it made Zimmer-Biomet the country’s leading company by revenue in the $45 billion global market for artificial knees, hips and other orthopedic and bone-mending implants.
Nevertheless, the deal made Zimmer-Biomet’s balance sheet unappetizing to conservative investors. The new company’s combined net debt rose from -$221 million (more cash than debt) in the first quarter of 2015 to $10 billion in the second quarter.
Zimmer expects to realize annual cost synergies of $270 million by the third year after closing or in 2018. Zimmer completed its acquisition of Biomet in June 2015 (source). In the context of mergers, cost synergy is the savings in operating costs expected after two companies that compliment each other's strengths join (Investopedia).
Other risks
The hip and knee medical device business can experience serious liability costs. In 2013, Johnson & Johnson paid $2.5 billion to settle defective hip implants in 8,000 patients. And the company still faces thousands of other lawsuits concerning hip implants (source).
Conclusion
I can easily calculate Zimmer-Biomet’s intrinsic value in several different ways or just rely on several distinguished analysts’ target prices for the company. According to the Barron’s article above, the company is undervalued. Nevertheless, dissecting some of Zimmer-Biomet’s business operations clearly provided some additional details but failed to prompt my fingers to enter any limit orders for its shares, primarily because of its current massive debt pile.
Happy Investing!
Mark
