What’s a joint like this, doing in a nice girl like you?

Barrons loves Zimmer Holdings and so do I. Here’s their take and my own.

Saturday, June 14, 2008

Knee-Deep in Profits
By JAY PALMER

Zimmer is the global leader in knee and hip replacements, with profit margins that are among the industry’s best. And it’s about to get a flood of new customers, as the oldest baby boomers approach 67 — the average age for implant. Our reporter’s notes from the operating table.

Like legions of my fellow boomers, I know a thing or two about creaky knees. Mine developed after six decades of punishment, including sport-parachuting at high school in England. Much later, arthritis settled in, followed a few years ago by an ankle injury that left me with an awkward gait. The fact that I am, as my doctor politely puts it, "large," hasn’t helped matters. By last year, the creaking of my knees was accompanied by true groaning. It was time to go bionic.

Masterfile, Inset: Courtesy of Zimmer
Next Best thing: An artificial knee functions, in many ways, just like a normal real one.
I paid a call on Tom Gutowski of Princeton, N.J., an orthopedic surgeon near my home who performs some 300 joint replacements every year, two-thirds of them knees. He concluded with X-rays that both my knees would benefit from the procedure, especially the right one. He proposed that we start there, replacing the bum joint with a metal-and-plastic device made by Zimmer Holdings. Specifically, he chose that company’s NexGen LPS-Flex Fixed Bearing Knee, which offers a higher-than-normal 155 degrees of motion.

Today, four months after the operation, I am firmly on the mend. The pain has mostly subsided and I am getting around with greater and greater ease. I have come to like my new body part. I also have come to like Zimmer and its stock (ticker: ZMH). The company, with a market value around $16 billion, is the global leader in knee and hip replacements — the fastest-growing segments of the worldwide, $30 billion orthopedic market. And Zimmer’s stock, down nearly 20% in the past 12 months, looks attractively priced.

Make no mistake, aging baby boomers will be buying knees and hips for years to come. The average age for an implant is about 67, says Jim Crines, Zimmer’s chief financial officer — and the oldest of the 75 million boomers is only 62. So a big bulge in demand lies ahead.

It’s not just that boomers are getting older. Like me, many are well-fed, putting heavy strains on their joints. At the same time, boomers are determined to remain physically active for longer than their parents and grandparents did. That will require plenty of spare parts.

In all, the U.S. market for hip and knee replacements, which hit about $5.5 billion last year, should grow at a compound annual rate of 7%-8% a year through 2013, according to research firm Frost & Sullivan. Zimmer, for its part, is poised to keep grabbing market share, boosting hip and knee sales by closer to 10% a year.

The stocks of Zimmer and its rivals, such as Stryker (SYK), Johnson & Johnson’s (JNJ) DePuy division and Britain’s Smith & Nephew (SNN), all have been enjoying long-term ascents. Between 2002 and 2004, Zimmer’s share price more than doubled; the rally continued, albeit at a slower pace, right up to last fall.

At that point, the Justice Department accused the industry of using phony consulting contracts to pay off surgeons using its products. Zimmer and its peers settled, paid a fine and agreed to have external monitors oversee surgeon contracts. (Gutowski, my surgeon in Princeton, says he has no financial interest in Zimmer.)

Zimmer shares, which had traded as high as 91 before the controversy, tumbled to 64. Now, with the scandal diminished, the shares are back up to about 70 — and demographics still favor long-term growth. The stock could well keep climbing: The consensus among analysts is that it will rise about 20% over the next 12 months, to 85 — and some bulls figure it will top 90.

JIM CRINES, THE CFO, points out that there is considerable pent-up demand for Zimmer’s wares. Many people who haven’t had hip or knee replacements are candidates, but are putting off operations out of fear, he says. "We are working to lessen the trauma of surgery," which could attract the fence sitters, he predicts.

My own experience shows that a knee replacement isn’t as scary as it might seem. I was struck more by the sheer ingenuity of the engineering. The operation started with a spinal anesthetic and six-inch incision down the front of my knee. After the muscles, nerves, blood vessels and knee cap were carefully pushed aside, Gutowski leveled off the top of my tibia (shin bone) and, using a special cement, inserted a flat metal plate with a plug going down the center of the bone.

The sides and bottom of my femur (thigh bone) were then shaved to specific angles using precision instruments and, again, cemented to a kind of metal cap. This fits to — and rotates on — a polyethylene surface attached to the top of the tibia plate. In a decade or so, this by-then worn insert can be easily replaced with minor surgery, thus avoiding a complete new operation.

Because the operation leaves the muscles and nerves uncut, recovery is relatively swift and I was walking with a crutch the evening of the surgery. Pain was occasionally acute, but easily alleviated by medication. Now, after a series of admittedly tough sessions with my physical therapist, I am walking a couple of miles a day without pain. Stairs, especially coming down, remain a challenge, but this is sure to get easier with time. I have every confidence in my NexGen LPS-Flex Fixed Bearing Knee.

Of course, Zimmer has other knees in its pipeline. It plans to soon introduce the NexGen Flex Mobile knee, which is said to allow more natural joint rotation, and the Gender Solutions joint system, a knee implant specifically tailored to a woman’s smaller joint. Innovations like those help explain why Zimmer has been posting double-digit growth in knee sales, which account for 42% of the company’s total revenue.

Frost & Sullivan, Thomson Reuters
Three at the top: Zimmer, Stryker and DePuy have more than two-thirds of the artificial hip and knee markets, which are growing as boomers age.
THE OUTLOOK FOR HIPS, while generally upbeat, is a bit less certain. This business, which accounts for 31% of company sales, increased 10% in the most recent quarter, and that pace is expected to continue in the immediate future. Sales should be helped by new gender-specific hip system (about 60% of hip-replacement patients are women), plus a new hip-stem implant that promises to conserve more bone than existing offerings.

But there is a problem. Zimmer, unlike rivals Smith & Nephew and Stryker, has yet to offer a product for hip-resurfacing, a less-than-total replacement operation. Resurfacings are increasingly popular among younger, more active patients and may end up accounting for 8%-to-10% of hip operations. Zimmer’s resurfacing product isn’t scheduled to launch before 2011, a couple of years behind early expectations.

Though knees and hips remain Zimmer’s main growth drivers, the company also makes dental and spinal implants. But all these products face one major challenge: society’s ability to pay for the procedures. Medicare and top insurance companies are pushing to cut reimbursement rates, which will pressure profits of hospitals and eventually trickle down to the manufacturers in the form of lower prices. A knee replacement often runs $35,000, while hips go for about $40,000.

ZIMMER, HOWEVER, IS in a strong position to take on this challenge. Thanks in part to leading-edge manufacturing technology, its operating profit margins are now among the industry’s best, at close to 30%, and could be headed significantly higher.

Ever since it was spun off from Bristol-Myers Squibb in 2001, Zimmer has generated strong cash flows, equal to about 20% of sales. Those have financed a slew of acquisitions, most recently last year of ORTHOsoft, a Canadian company that designs and markets top medical software, instruments and computerized systems to help orthopedic surgeons increase accuracy in hip, knee and spine implant surgery.

Zimmer also bought Endius, a company that has developed breakthrough, minimally invasive spine-surgery products, implants and techniques to treat spine disease.

The Bottom Line:

Zimmer’s shares, knocked down by an industry faux pas, could climb by more than 25%, as demand builds and the company launches innovative products.Now, with the pace of acquisitions slowed, the company is using its cash to buy back stock at a higher rate, a move that clearly reflects management’s view that the company is trading at a discount to what it is really worth.

At its recent price around 70, Zimmer stock was changing hands at 16.5 times estimated ’08 earnings of $4.20 a share and about 14.5 times ’09 projections of around $4.77 a share. Both multiples are well below its historic peaks in the high 20s. Given the continued longer-term growth prospects, the company’s high margins and its position in the industry, this valuation seems on the low side.

Certainly, the company can count on selling at least one more knee. When Gutowski visited me immediately after my surgery, the first thing he mentioned was that the damage to my right knee was far worse than he’d expected. On that basis, he forecast that my left knee would need replacing within 24 months.