A Sleeping Giant About to Awaken

The going has gotten tough in the orthopedic sector, and many of the major players have responded by getting going. Johnson & Johnson (NYSE: JNJ  ) acquired Synthes to become the largest in trauma and the second-largest in spine, while Stryker (NYSE: SYK  ) acquired MAKO Surgical with an eye toward getting ahead of the evolution of the hip and knee markets. Smith & Nephew has diversified into wound care and arthroscopy, while Biomet is reportedly weighing its options, including a possible IPO. That leaves Zimmer Holdings (NYSE: ZMH  ) as the next major player to move.

Zimmer has already done what many of its rivals have found hard to do -- deliver real growth in a tough major joint recon market. Zimmer's knee sales were up 7% in the latest quarter, while hips were up 2%, and recent introductions like the Persona line have helped extend the company's lead in major joint reconstruction, with more than one-quarter market share (Johnson & Johnson is a few points behind, and Stryker is even further back). With a relatively clean balance sheet and some obvious areas to improve, though, Zimmer could have a trick up its sleeve to invigorate growth.

Hips and knees a good news, bad news situation
The good news for Zimmer is that its cornerstone franchise in major joint reconstruction (hips and knees) has been moving from strength to strength. Long a major player in the space, the company has made some investments in implant systems that allow surgeons to better personalize the procedure for the patient. With the Persona and Continuum lines, patients can get better long-term results including less pain, a better range of motion, and a more natural feel after the implant procedure. That's a powerful marketing angle for Zimmer, one that Stryker has found challenging to combat. Johnson & Johnson has also made strides on the personalization front.

The "but" is that Zimmer is getting stronger in a more challenging market. While a great deal of attention is paid to the graying of America and the prospect for millions of hip and knee replacements, pricing has gotten very tough. Gone are the days when ortho companies could look forward to solid pricing on new platforms and little pushback from hospitals or payors. Now, hospitals have gained scale and/or joined purchasing organizations and are pushing back hard on price -- often excluding OEMs that won't play ball with the prices. New and better products like Persona and Continuum do help (if a patient is asking for an implant by name, as they may go elsewhere to get it), but it's a challenging market all the same.

Weaker in more attractive areas
What hurts Zimmer relative to the likes of Johnson & Johnson and Stryker is that the company is quite strong in the slow-growing major joint recon market, but it is not as strong in areas like spine, trauma, dental, extremities, and non-ortho businesses.

Dental and spine have been sub-scale markets for Zimmer for some time now and relative underperformers. With less than a 10% share in dental and less than a 5% share in spine, Zimmer just doesn't have the market presence to compete effectively, and it is hard to see how the company can turn it around through organic growth.

An acquisition of a company like NuVasive or Globus could vault Zimmer back into relevance in spine, but the safer course may be to divest. Likewise in trauma, where the Natural Nail platform is a solid business, but not enough to give the company real scale next to Johnson & Johnson or Stryker.

Extremities are a different story. The company is the third-largest player in extremities, with a meaningful presence in the shoulder market. Zimmer isn't quite as strong in lower extremities, though, where Tornier and Wright Medical both have strong positions in feet and ankles and Stryker is strong in trauma. Given the recent pace of double-digit growth in extremities and the underpenetrated state of many extremities sub-markets, this has emerged as a real growth area in the orthopedics space.

What does Zimmer do now?
Zimmer has already acknowledged that acquisitions are on the mind of management. The acquisition of Dornoch has gone well (helped by a recall at Stryker), and management is looking for a deal that will bring in "hundreds of millions" of revenue, preferably with developing technology.

Ignoring that desire for emerging technology for a moment, I wouldn't rule out a deal for Biomet -- this would give the company impressive share in recon (nearly 40%), significant share in extremities, and fix some of the sub-scale issues in dental, trauma, and spine. At close to $3 billion in revenue, though, it would be a major undertaking for Zimmer. With that, I could see the company going smaller and acquiring the smaller, faster-growing Wright Medical, Tornier, or Globus.

I also wouldn't rule out another deal along the lines of Dornoch -- a deal that is outside of Zimmer's historical ortho space. While such a deal would offer some elevated execution risks, investors may appreciate the benefits such diversification would offer.

The bottom line
Absent a deal, I'm lukewarm on Zimmer. I believe the company does deserve some premium for its market share in major joints, but unless management can find a way to lift long-term revenue growth prospects to 5% or better, it's hard to argue paying a price above the low $90s. A deal for a company like Wright Medical, Tornier, or Globus could fit the bill, though, and the combination of an accelerated top line growth and deal-driven synergies could be a powerful one for this large med-tech player.

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