This article is part of our Rising Star Portfolios series.
I'll be the first to admit: I can't measure the environmental consequence of an acidic raindrop halfway across the world. Likewise, as newspapers blare headlines of unprecedented domestic health care reform, a still jobless recovery muddles on, and record budget deficits plague our nation, I'll be the first to acknowledge that a considerable uncertainty surrounds health care stocks.
I can say one thing: At around 13 times free cash flow, Zimmer Holdings
Zimmer is just what the doctor ordered, on this count. I'm starting an $800 position, or 4.7% of my Rising Star Portfolio's first year capital.
The business
Zimmer's business is a simple one: It makes replacements for knees, hips, extremities (shoulders and elbows, teeth, and spines worn thin by life's wear and tear. About three-quarters of revenue derives from knees and hips, where Zimmer maintains the No. 1 and 2 market positions, respectively, based on full-year 2009 results.
This is a great business, not least because replacing knees and hips isn't exactly trash collection: These procedures are very complex. And because surgeons typically learn knee- and hip-replacements on a specific brand -- whether it's Zimmer or competitors Biomet, Stryker
The result: A beautifully oligopoly-esque business, where market leaders keep relatively stable market shares and produce continuously high returns on equity. That coupled with an aging, obese, and (somewhat oxymoronically) increasingly active younger population have contributed to a stable growth outlook.
With a moat like this, how can you lose?
Truth is, Zimmer's stumbled in recent years. Some of the trouble's its own doing, and some the result of externalities. Health care legislation threatens to reduce Medicare reimbursement rates, and a significant proportion of Zimmer's revenue is tied to it. Meanwhile, unemployment rates remain staggeringly high by historical standards, which equates to fewer insured, and fewer procedures for Zimmer.
Take that, and add Zimmer's fouls. It has lost market share as rivals led the way on product launches. A notable product recall in 2008 contributed to its troubles. These factors, coupled with high unemployment, kept a lid on pricing increases for the past two years.
Perhaps I should I be concerned. But I'm not. Instead, I'm buying the controversy. I think the fundamentals of Zimmer's moat remain intact, and an increasingly plump, old American populace will feed its returns. Why? Read on.
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We're healthy. Or not. And getting older: As a population, Americans are one of two things, and little in between: They're healthy and active, or not. The healthy, active sorts are wearing their precious joints thin on 5K races, marathons, and the new black: triathlons. The obese suffer a similar fate, for the stress their bodies place upon them. These trends, coupled with an aging population, should provide consistent and growing demand for Zimmer's wares.
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Health-care legislation doesn't matter: Lower Medicare reimbursements -- a stipulation of the recently passed legislation, and in the long run, a possible consequence of the U.S.'s chronic budget deficits -- are no joke. They could impact on Zimmer's ability to pass price increases. But I don't think it matters.
Truth is, Zimmer's payments are only indirectly tied to Medicare reimbursements. Zimmer gets paid by hospitals (or whoever the medical provider is), and hospitals are reimbursed by Medicare. The recently passed health care legislation requires that individuals carry insurance, and as a result, hospitals' uncollected accounts will dramatically decline, and profitability will accordingly improve. That's a big bone to hospitals, which collectively operate on razor-thin margins, and that's if they're lucky.
So while lower Medicare reimbursements from legislation are a net negative, I'd wager that's counteracted by improved profitability from higher insured counts in hospitals. Then consider: The knee and hip replacement industry dynamics -- effectively an oligopoly, where hospitals are pretty fragmented -- favor the device makers. I don't think it's too wild-eyed to believe that pricing pressure will ease, albeit at a measured pace.
Long run, industry and Zimmer-specific factors look favorable. First, an aging population, obesity, and active lifestyles that stress joints should contribute to long-term industry growth in mid- to high-single-digit rates, which help should offset the impact of declining gross margins. Second, Zimmer's operating efficiency is near-legendary: Its manufacturing processes are almost entirely automated, and by its report, a 10% increase in raw materials costs would not materially affect results. -
High unemployment: While budget deficits, concerns over inflation, and lagging business confidence threaten the recovery's long-term prospects, it appears that a tentative recovery has taken hold. Companies are, at long last, raising money in the bond markets and replenishing inventories. The 2008-2009 period was hardly a garden-variety recession, but in the past, these factors presaged an employment recovery. Most importantly, an employment recovery means more people with health insurance. For Zimmer, that means more procedures, higher sales, and better profitability.
- Product launches, recalls, and R&D: Zimmer's missed the boat on a few product launches, and in 2008, suffered a product recall. It's been a tough, uphill slog, as the company's lost market share to competitors and pricing's been pressured. But given a longer-term view, I'm not too concerned.
Given customer loyalty, unless Zimmer falls dramatically behind the technology curve, or experiences chronic quality issues, I expect that market share fluctuations should only occur at the margin over the longer term. And Zimmer's consistently devoted funds to R&D, and recently brought a suite of new product launches to the market. The past quarter's results affirm as much, as management cited strengthening demand from launches and market share gains.
Valuation
Now for the kicker: Even with these concerns, I still think we're getting Zimmer shares at a song. At 13 times cash flow, the market's assuming some combination of a consistent loss of market share, pricing pressure from botched product launches and health care reform, and resulting margin compression. Could all that happen? Sure. But I'd wager otherwise.
On the strength (or weakness, as it may be) of demographic and economic trends, I expect Zimmer's top-line to grow approximately 6% to 7% in coming years. I also anticipate operating margin expansion to the 30% range on increased scale, reduced pricing pressure, and operating efficiencies. Couple that with ongoing share repurchases, and I peg the shares' intrinsic value at $82 a stub.
Risks
The biggest to my thesis are those I've already discussed: technology and regulation. Though Zimmer's moat affords some protection, the company cannot rest on its laurels. There's no indication it has, but consistent loss of market share would prove concerning.
On the regulatory front, there are two things to watch. Health care reform is one, but the second is pending Food and Drug Administration guidelines surrounding medical device approvals, which could substantially increase costs for device-makers. Tentative indications are that the government intends to play nice, but it's anyone guess.
The bottom line
Regulation or not, Zimmer, as the market leader, stands ready to plug into the powerful demographic trends that are favoring the industry. Yet Zimmer's shares are priced as if the company won't, despite its staggering moat.
I'm willing to bet otherwise, and so I'm committing $800, or 4.7% of my Rising Star Portfolio's first year's capital, to Zimmer shares. Join me at my discussion board to chat it up, or comment below.
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