In mid-December I wrote that there was at least some chance that ortho giant Zimmer (UNKNOWN:ZMH.DL) would make a bid for Biomet and become the dominant company in hip and knee implants, as well as leverage stronger share in areas like extremities, dental, trauma, and spine. That speculation has come to pass, as Zimmer has announced a $13.35 billion bid for Biomet. Assuming the deal passes regulatory scrunity, Zimmer is likely to see meaningful cost synergy, but there are risks involved in devoting such a large amount of capital to a market with some growth challenges.
The deal to be
Zimmer announced on April 24 that it had reached an agreement to acquire Biomet for $13.4 billion in cash and stock. Of the total, $10.35 billion will come in the form of cash and the company will issue close to 33 million shares for the stock component, resulting in Zimmer shareholders owning 84% of the combined company.
Zimmer management believes that the deal will add $1.10 to $1.30 to earnings per share in 2015 (versus a prior average estimate of $6.79), with potentially $270 million in synergies by 2017.
Becoming a strong #2
Combined, Zimmer and Biomet will hold about 17% of the orthopedic market, trailing only Johnson & Johnson (NYSE:JNJ) at 21% share and leaping ahead of Stryker at around 13% share. Together, the two companies will hold almost 40% share of global hip implant market and about one-third of the knee implant market. Johnson & Johnson and Stryker will both still be very viable competitors with more than 20% share each and in each market, but Smith & Nephew may find it increasingly difficult to subsist on approximately 10% market share.
The benefits of becoming the leader in major joint recon may have been the prime motivation for the deal, but this combination adds scale in other markets as well. The two companies will hold about one-quarter of the fast-growing extremities market, with more than a third of the shoulder market. That may create considerable pressure on Johnson & Johnson and Tornier, but the combination will not be all that significant in the lower extremity (foot/ankle) market. Given Stryker's weaker positioning in the extremities market, it seems at least plausible that Zimmer's move will prompt a response to acquire its way into this faster-growing sub-market.
The deal also adds some scale to the combined spine, trauma, and dental businesses, but will not vault them into leadership or strong #2 positions.
A bold move
Zimmer is paying about 4.2 times Biomet's annualized trailing nine-month sales, not a particularly unreasonable figure. Johnson & Johnson paid almost 5x revenue for Synthes, but spine care and trauma were more highly regarded at the time. On the other hand, Zimmer appears to be paying considerably more on an EV/EBTIDA basis – around 17x versus around 11x in the JNJ-Synthes deal.
Cost synergies are going to be key to making this deal a winner, but the strong overlap should facilitate rationalizing R&D, marketing, and manufacturing efforts (the two companies are literally headquartered in the same city in Indiana). With this deal, management can pick and choose between the most promising products and programs and reduce redundant or overlapping administrative, marketing efforts.
There are a lot of common sense positives to this deal, but it is not without risk. First, there is a chance that regulatory bodies will object to the share that the companies will hold in particular markets and they may demand divestitures.
There is also the market itself to consider. Major joints seem to be recovering from a prolonged slump, but reimbursement pressure and price sensitivity have become significant factors in the market and the FDA has tightened up its standards for new approvals. The aging of North America and Western Europe, as well as the modernization of the health care systems in countries like China, should provide could underlying volume, but there is nevertheless the risk that Zimmer has made a very large deal to expand a slow-growing business.
The bottom line
Back in December I thought that a deal could spur a significant move in Zimmer's shares, and the stock was up more than 10% on the Biomet deal news as of midday Thursday. That seems like a pretty fair reaction, and I would say that the shares remain priced to deliver mid-to-high single-digit returns, with potential upside from better synergies in the Biomet deal.