Description

Zimmer Biomet has a strong global musculoskeletal franchise with leading market share positions that should enable the company to sustainably grow revenue and EPS at a low single digit and high single digit rate respectively over the coming years.  Following Zimmer’s combination with Biomet in June 2015, the company has now had over 18 months to experience and take corrective action on the operational challenges (e.g., sales force harmonization and supply chain coordination) that tend to occur in this type of corporate combination.  We expect that Zimmer Biomet should now be able to take a more offensive/proactive stance in the marketplace, using its enhanced scale and market positions to grow revenues roughly in-line with its end markets.  Meanwhile, use of the company’s strong cash flow for deleveraging and capital returns should drive high single digit (or better) EPS growth.  We believe that if the company succeeds in achieving this and showing that it can be done on a repeatable, sustainable basis, then the ZBH forward P/E valuation could expand from approximately 13.5x now to 15x, resulting in an IRR of approximately 17% over three years.

Market structure

Over the past decade, the orthopedic implant market has gone through a period of consolidation, and now four companies control over 90% of the market: Zimmer Biotech (ZBH), Stryker (SYK), DePuy (Johnson & Johnson), and Smith & Nephew.

Demographic trends around the world are favorable for orthopedic implants. The world population 65 years and older is expected to grow 3%-plus over the next decade and reach almost 12% of the population by 2030 versus just 7.6% in 2010. Meanwhile, rising obesity levels, particularly in the US, will lead to higher utilization of orthopedic implants. Long-term sustainable growth will be driven by an aging population, growth in emerging markets, obesity, proven clinical benefits, new material technologies, advances in surgical techniques, and more active lifestyles.

As health care costs continue to increase around the world as a percentage of GDP, many countries are looking for ways to bring these costs down. The US Medicare system recently introduced a bundled payment program for joint reconstruction procedures, which could affect both volumes and pricing going forward. However, the incoming administration has opposed these measures and we expect this risk to be mitigated shortly after the Trump administration takes office. Please see the Risks section for a more detailed discussion of this development.

Zimmer has the #1 market share in knees and hips, with ~$4.7 billion in revenue. The global market for hips and knees is almost $14 billion and is growing 1-3% per year. This can further be broken down into 4-5% annual volume growth and 1-2% annual price declines. ~55% of the US market is paid for indirectly for Medicare.

Market share in orthopedic implants is extremely sticky for two main reasons:

• Physicians have preferences for and extensive training with a particular implant. It is nearly impossible to get a physician to switch brands without significant investment in research, testing, and training. Physicians are generally unwilling to endure lower outcomes while they get up to speed on new implants.

• Most surgeons rely heavily on sales reps, who actually stand in the operating room with the surgeon, advising on different approaches and assisting where necessary. These reps often have more experience with these procedures than the actual surgeons.

Stryker has recently gained approval for total knee arthroplasty on its MAKO surgical robot, which we anticipate will drive modest share gains for the company over the next few years. Please see the Risks section for a more detailed discussion of this development.

Company Overview

Zimmer Biomet (ZBH) is the largest and most profitable supplier of orthopedic implants in the world, with market leading positions in both hips and knees. Zimmer was founded in 1926, was owned at one point by Bristol Myers, and was spun out in 2001. Zimmer combined with competitor Biomet in 2015 for $13 billion. 60% of ZBH revenue comes from reconstructive surgery segments (hips & knees).

Business Segments

Zimmer operates in six product categories: knees, hips, SET (sports, extremities, trauma), dental, spine, and other.

Biomet Merger

In 2015, Zimmer bought Biomet for $13.4 billion and became Zimmer Biomet. The transaction was funded with a combination of cash on hand, a $3 billion term loan, and $3 billion of Zimmer equity.

The rationale for the deal was to shift the portfolio away from slower growth, more competitive hips and knees toward higher growth non-reconstruction trauma/extremities. The latter segments increased from 24% to 31% of company revenue following the acquisitions of Biomet and LDRH.

ZBH experienced disynergies following its merger with Biomet. Sales disruptions are common following medtech mergers as the salesforce is rationalized during the integration, and sales growth slowed dramatically in the second half of 2015. Sales growth had begun to accelerate in the first half of 2016, before experiencing a hiccup in 3Q16 related to inventory mismanagement. Preliminary results for 4Q16 show a reacceleration of sales growth due to cross-selling and the more specialized sales forces.

The Biomet merger was expected to be double digit accretive to EPS in Year 1 and 1.5x accretive to operating cash flow. The company expected to achieve $135 million of cost synergies in Year 1, but actually realized $155 million ($225 million through 1.5 years). Zimmer expects to achieve an additional $125 million of cost synergies by mid-2018.

2020 Plan

Following the Biomet merger, the company has laid out the following financial goals for 2020:

Capital Allocation

Over the past decade, ZBH has returned ~$4.8 billion to shareholders through share repurchases. The company implemented a dividend in 2012 and has paid ~$725 million of cumulative dividends to shareholders. Share repurchases will slow over the next two years, as management has committed to bringing leverage down to 2.5x by 2018 and a large majority of cash will go to debt paydown. Beginning in 2019, we forecast that management will be able to return upwards of $1.5 billion per year to shareholders in the form of share repurchases and dividends.

Forecasts

We forecast revenue growth of 3.1% per annum over the forecast period, which compares to the company’s recent trend of 2.6% growth per annum. The large joints market is growing volumes 4-5% per annum but faces steady price pressure of 1-2% per annum. We assume that the introduction of total knee arthroplasty to Stryker’s MAKO robot will also lead to share losses for Zimmer. As such, we forecast Zimmer’s knee revenue to grow 2.5% per annum vs. 3.0% market growth. However, we have ample reason to believe that MAKO will not take any share at all, and that the combined market-leading ZBH portfolio will be able to grow at above-market rates. If we assume that knees grow at 3.5%, our IRR increases by 150 bps.

In markets where ZBH is a smaller player (spine, SET, dental), there is great potential for cross-selling and sales force specialization to drive above-market growth. As part of the Biomet integration, Zimmer separated out the sales forces for large joints and SET, and the increased focus should help accelerate growth to at or above market rates. They are taking the same approach in spine and have a differentiated portfolio of products following the LDR acquisition.

We forecast gross margin to be flat at 75.1% during the forecast period, which is in line with the long-term average. Through a combination of operating leverage and merger synergies, we forecast EBITDA margin expansion of ~200 bps over the forecast period.

To date, the company has realized $225 million of an expected $350 million of synergies from the Biomet merger. In Year 1, the company achieved $155 million versus an expected $135 million. The company expects to achieve the remainder of the synergies by mid-2018. We forecast the remaining $125 million of synergies to be spread evenly over 2017 and 2018.

The company expects to achieve $2 billion of free cash flow by 2020, and we are in line with this forecast. We expect the company to generate a cumulative $5.5 billion of FCF over the forecast period. We model $1.75 billion of debt repayment, to bring the company in line with its leverage target, and $2.3 billion of share repurchases. We forecast the company to maintain a dividend payout ratio of ~12.5%, resulting in ~$730 million of cumulative dividends over the forecast period.

Zimmer’s effective tax rate is significantly above those of its medtech peers, at ~24%. The company is undergoing a tax optimization initiative and implementing the same sort of structures outside the US as peers over the next several years. We forecast the tax rate to decline to 20% by 2018. Stryker embarked on a similar initiative in 2013 and was able to lower their tax rate by 500 bps in 2015. We do not believe this tax optimization is included in Street estimates. Meanwhile, there could be further upside to our estimates if the incoming Trump administration follows through on its plan to lower the US corporate tax rate to 15-20%. A 15% tax rate beginning in 2018 would increase our IRR by 200 bps.

Peer group valuation

ZBH currently trades at a significant discount to peers on a PER basis, at 13.5 vs. 17.1. It also trades at a discounted EV/EBITDA multiple of 11.0 vs. 12.4. We believe there are three main reasons for this discount:

• Zimmer has a relatively larger market share in slower growth segments like hips and knees. However, ZBH is in the process of becoming more like SYK. Following the Biomet merger, they are now bigger in the faster-growing SET market, with a dedicated salesforce to drive growth (similar to SYK). The company is taking the same approach to spine with the recent acquisition of LDRH.

• Following the Biomet merger, Zimmer experienced disynergies as the sales force was rationalized which caused topline growth to slow dramatically. Just as revenue growth was beginning to reaccelerate, the company had an inventory-related misstep in 3Q16 which again caused revenue growth to slow dramatically. These events have caused investors to take a wait-and-see approach until sustainable growth from the combined companies is steadier and more visible.

• As mentioned previously, ZBH has lower returns on invested capital than some of its medtech peers despite relatively higher margins. We believe this is due to inefficient working capital management, particularly with respect to inventory. We believe some of the inventory management tools being implemented by the company could free up significant working capital and increase returns on capital more in line with peers.

IRR

Using an exit multiple of 15x EPS, we forecast a three-year rolling IRR of 17.0% for an investment in ZBH.

Risks

1.       Market share losses. Market share in hips/knees has historically been stable due to the markets being dominated by a few large players with little differentiation among products, in terms of clinical outcomes. However, Stryker has recently gained approval for total knee arthroplasty on its robotic MAKO system and we believe this has the potential to shift some share in knees slightly to SYK. SYK’s MAKO robot provides feedback to the user aimed at reducing the variability of implant placement versus traditional surgery. Both MAKO and patient-specific implants (another potential competitive threat) aim to reduce the likelihood of the need for revision surgery and also potentially improve patient function/flexibility. However, there is no long-term clinical data to support either hypothesis, meaning that any physician defections will likely be from those already trained on, and extensive users of, the MAKO system for other procedures. Moreover, Zimmer already offers patient-specific instruments and Biomet brought patient-specific implants to the portfolio, which should help ZBH hold off competitive threats. ZBH recently acquired a spine robot (Rosa) and could in the future adapt the robot technology for knees.

Other factors protecting market share from a shift to MAKO are the added cost and procedure time associated with the robot purchase and procedure; lack of long-term data demonstrating outcome improvements with robotic placement; the likelihood that MAKO disproportionately cannibalizes SYK share versus converting competitive users; and physician preferences for ZBH implants may prevent them from switching to SYK implants just to gain access to robotics.

2.       Reimbursement pressures. The Comprehensive Care for Joint Replacement (CJR) model was implemented by the Centers for Medicare and Medicaid Services (CMS) on April 1, 2016. The model essentially bundles payment to the hospital for an entire CJR episode from procedure through post-acute care. This theoretically encourages the hospital to cut the cost of care, including the cost of implants.

We feel that the risk from CJR is overblown for a number of reasons. The US only accounts for 62% of ZBH’s revenue, and US hips/knees are only 35% of total revenue. Meanwhile, there has never been direct reimbursement to the ortho companies. Hospitals have always been paid based on a diagnosis/procedure basis and it is the hospital’s job to manage costs. As a result, hospitals have always had a significant incentive to lower ortho implant costs, and the industry has been facing ~2% annual pricing pressure for some time now. However, the power of the ortho surgeons has and will continue to be significant because while an individual joint replacement is not very profitable, the sum of all the business that the ortho surgeon brings to the hospital is very profitable.

Hospitals are having a relatively easy time staying under the CJR-mandated cost thresholds by sending more patients home and fewer to costly post-acute care facilities. 40-60% of the cost of orthopedic care comes from post-acute care, so this is where cuts are happening under the bundled payments. Implants have not yet been a focus of cost cuts. It is challenging to squeeze out price reductions from the implant manufacturers and surgeon resistance to switching implant and instrumentation brands does not help hospitals succeed in this endeavor. For the hospital, reconstructive surgery is a profit center and cost cutting is more focused on areas that lose money like ER/ICU. Clawbacks to reimbursements won’t start happening until mid-2018, and will not be impactful to volumes until then. Meanwhile, ZBH is focused on developing pre-op/intra-op instruments and personalized implants, which should reduce OR times and repeat procedures.

Additional pricing pressure on implants could lead to further industry consolidation, and ZBH would be in position to consolidate smaller players who would struggle disproportionately. ZBH could be a target itself from MDT, who doesn’t participate in reconstruction but wants to.

Finally, the selection of Rep. Tom Price to head the Department of Health and Human Services (HHS) likely ensures that the current bundled payments program will be significantly diluted. Price, who is an orthopedic surgeon by trade and a ZBH shareholder, wrote a letter to CMS three months ago in an effort to have current and future planned mandatory initiatives related to CJR eliminated. Once he is confirmed, he can unilaterally undo the programs immediately.

3.       Inventory problems. As previously mentioned, the company experienced inventory issues in hips/knees during 3Q16 which prevented them from fulfilling certain orders, causing revenue growth to fall well short of guidance and expectations. ZBH underestimated the demand for certain key cross-sell brands in the existing customer base, leading to a depletion of safety stock, and affecting its ability to capitalize on new customer opportunities. We believe that much of the issue stemmed from the integration of Biomet, as management under-estimated the mix shift toward the Persona Knee and Biomet Hip portfolio. Just weeks before the end of the quarter, management was extremely confident about hitting guidance. The lack of visibility into the largest part of the business is somewhat alarming, but the company is deploying new demand planning and production tools which upon full implementation will better ensure ZBH’s ability to forecast and satisfy demand in the future. The company recently reported 4Q16 sales results which showed a reacceleration of revenue growth and was the best growth quarter for the company since the Biomet acquisition closed.

4.       Economic downturn. While healthcare spending is often recession-resistant, the last US recession highlighted that these orthopedic procedures actually have a consumer discretionary element to them. Younger, non-Medicare patients (~45% of US procedures) became concerned about deductibles, co-pays, and even the time away from work required to rehab back to full health. Revenue growth decelerated from 11.5% in 2007 to (1%) in 2009, introducing a “consumer” element to healthcare, which some healthcare investors are not entirely comfortable with. On the flip side, hip and knee implants last anywhere from six to ten years, depending on activity level, so there is a recurring revenue element depending on the age of the patient.

5.       Obamacare repeal/reform. We do not believe that repeal/reform of the Affordable Care Act (ACA) will have a material impact on Zimmer’s business or our forecasts going forward. Management believes that ACA only provided “tens of basis points” of volume growth in recent years. We believe this is accurate as orthopedic utilization rates for Medicaid patients, who are overrepresented in the incremental ACA population, is significantly lower than other patient populations.

6.       ZBH has received a Form 483 from the FDA. Zimmer disclosed recently that it has received a Form 483 from the FDA regarding a legacy Biomet plant in Indiana. This will likely lead to a warning letter from the agency. However, the impact of a warning letter is likely to be benign, as a warning letter does not prevent the approval or sale of the types of products that ZBH produces. Remediation will cost money (likely a rounding error for a company of ZBH’s size) as well as consume management’s time. If they do not fix the problems in the next 12-18 months, the next step would be a consent decree and an injunction, which we believe is very low probability.

Catalyst

Zimmer Biomet has a strong global musculoskeletal franchise with leading market share positions that should enable the company to sustainably grow revenue and EPS at a low single digit and high single digit rate respectively over the coming years.  Following Zimmer’s combination with Biomet in June 2015, the company has now had over 18 months to experience and take corrective action on the operational challenges (e.g., sales force harmonization and supply chain coordination) that tend to occur in this type of corporate combination.  We expect that Zimmer Biomet should now be able to take a more offensive/proactive stance in the marketplace, using its enhanced scale and market positions to grow revenues roughly in-line with its end markets.  Meanwhile, use of the company’s strong cash flow for deleveraging and capital returns should drive high single digit (or better) EPS growth.  We believe that if the company succeeds in achieving this and showing that it can be done on a repeatable, sustainable basis, then the ZBH forward P/E valuation could expand from approximately 13.5x now to 15x, resulting in an IRR of approximately 17% over three years.