Will Obamacare Derail Zimmer Holdings, Inc.?

Zimmer's hip and knee replacement products offer potential upside, offsetting fear over higher taxes.

Feb 26, 2014 at 6:30PM

One of the most surprising trends for health care investors may be the rally in medical appliance companies including hip and knee leader Zimmer Holdings (NYSE:ZMH).

In the wake of Obamacare, investors were warned companies would face a profit cliff that would unhinge earnings and crater share prices. Yet, Zimmer's shares have marched 16% higher since health care.gov went live last fall, and shares of Zimmer's primary competitor, Stryker (NYSE:SYK) are trading at new highs too. Let's see if that optimism is warranted.

ZMH Chart

ZMH data by YCharts

Improving procedure markets
The recession took a toll on discretionary orthopedic surgery as cost conscious patients moved to the sidelines, and higher unemployment reduced work and recreation related injuries. But signs suggest improving employment and consumer confidence are jump starting procedure demand.

The number of total knee procedures climbed from 543,000 in 2007 to 719,000 in 2010. Similarly, the number of hip replacements has grown from 230,000 to 332,000 in the same period. That's good news for Zimmer, a leader in replacement knees, hips, shoulders, and elbows.

With a market share of 26% in knee replacement, Zimmer is the largest in the business, outpacing competitors Johnson & Johnson's ((NYSE:JNJ) Depuy Synthes and Stryker. Zimmer's knee sales have grown by nearly 8% to $1.9 billion between 2009 and 2013 thanks to the rebound in the number of procedures, and knee revenue grew roughly 10% year-over-year in the fourth quarter. That growth pop last quarter came thanks to a 12% jump in volume, which more than offset a 2.4% drop in prices.

Zimmer's 21% share in the hip replacement market puts it slightly behind Johnson's Depuy. However, rebounding procedure demand is lifting Zimmer's hip revenue too. Between 2009 and 2013, hip sales are up about 8% to $1.33 billion. In the most recent quarter, sales for hip products grew 2.9% year-over-year as volume improved 5%, more than offsetting price pressures.

Better days may be ahead
Zimmer's smaller businesses are growing quickly too. Its extremities segment sales are up 43% since 2009, reaching $194 million last year thanks to 11% growth in demand for shoulder and elbow products. That's an impressive advance, but more impressive is the 55% growth in Zimmer's surgical product sales, which climbed to $432 million in 2013.  Sales of Zimmer's trauma and dental products are also up double digits since 2009,   and improvement across all these businesses more than makes up for the 20% drop in spine revenue during the period.

Procedure demand may soon be swelling thanks to aging baby boomers. Active, longer-living boomers who want to maintain their lifestyle and avoid years of arthritic pain are increasingly turning to replacement surgery. A CMS study showing that between 1999 and 2007 the number of hip and knee replacements grew a statistically significant 21% and 65% among Medicare patients backs up that assertion.

Since more than 10,000 baby boomers turn 65 every day, the rising need for procedures has industry watchers expecting the hip replacement market will hit $7.1 billion by 2019, up from $6.2 billion in 2012. The global market for knee replacement is expected to grow too, increasing to $10.9 billion in 2017 from $6.9 billion in 2010.

That presents an opportunity for profit growth at Zimmer -- and its competitors -- given industry operating margin may have found its footing in the fourth quarter. If so, rising demand will be leveraged for a bigger bottom line.

ZMH Operating Margin (TTM) Chart

ZMH Operating Margin (TTM) data by YCharts

Fool-worthy final thoughts
Zimmer's sales grew more than 3% in 2013, generating adjusted earnings per share of $5.75, up 8.5% from 2012.  

Buybacks reduced  the company's share count by 1.7 million shares during 2013, yet after paying for share repurchases and dividends, Zimmer's cash hoard finished the year north of $1 billion, up from $884 million in 2012. Short term debt fell to $0.5 million from $100 million, and long term debt dropped to $1.67 billion from $1.72 billion during the year.

The balance sheet should improve even more this year given the company is guiding for 3% to 5% sales growth and earnings per share of between $6.10 and $6.30. If the procedures head higher, it Zimmer's sales growth will more than offset the medical device tax headwind, in which case recent enthusiasm isn't misplaced.

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Todd Campbell has no position in any stocks mentioned. Todd owns E.B. Capital Markets, LLC.  E.B. Capital's clients may or may not own shares in the companies mentioned. Todd also owns Gundalow Advisor's, LLC. Gundalow's clients do not have positions in the companies mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and Zimmer Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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