Big Bucks from New Knees and Hips

10/18/2010 10:40 am EST

Focus: STOCKS

Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, equities strategist and editor of Morningstar StockInvestor, and analyst Julie Stralow say a leading medical device maker should profit from boomers’ aging joints.

Zimmer (NYSE: ZMH) claims a leading market position in reconstructive devices, where it excels in knee and hip implants.

Zimmer’s core operational activities include orthopedic device development, manufacturing, and marketing. The firm focuses primarily on joint reconstruction, where it remains a key leader in knee and hip implants, [which] accounted for 73% of the firm’s sales in 2009.

Market share in this niche is typically quite sticky, because with patient outcomes dependent on skills developed with a particular manufacturer’s devices, surgeons have little incentive to switch once [they’re] comfortable with a supplier’s product set for a particular procedure.

Long-term growth trends look promising, too. Joint replacements are typically preceded by years of wear and tear on the body. Aging and osteoarthritis can lead to the painful breakdown of hips and knees. With baby boomers entering their later years, procedure volume should increase at a healthy pace in the long run.

Two conflicting factors also should lead to healthy procedure growth: more active lifestyles and expanding waistlines. Many boomers expect to pursue higher-intensity activities for a longer time than previous generations. These activities can place additional stress on joints and lead to more replacements.

On the other hand, joints are taking a beating under heavier bodies as the obesity epidemic takes its toll. These trends suggest procedure growth will accelerate over the long run.

However, worries persist about society’s ability to pay for this volume growth and about Zimmer’s position in the industry. The vast majority of industry sales are paid for by government entities, such as Medicare, [who] might have to cut reimbursement rates for procedures, which would pressure profits of hospitals and could trickle down to device makers in the form of lower prices.

Also, in the wake of a Justice Department investigation, Zimmer disrupted interactions with high-volume knee and hip surgeon consultants, which appears to have driven some of them to other suppliers and cut Zimmer’s market share. Although we think Zimmer will return to Industry-like growth in 2010 and beyond, near-term underperformance has weighed on the stock.

Despite those headwinds, we think the fundamental attractiveness of the industry remains intact, and Zimmer should continue reaping the benefits of its top-tier position in the orthopedic business.

The stock trades at enough of a discount to our fair value estimate of $78 per share to attain a five-star rating. (Zimmer closed above $51 Friday—Editor.)

After several years of disappointing results, we think Zimmer looks set to get back on track in 2010 and beyond, returning to market growth rates near 7%. We think operating margins will likely remain around 28% during the foreseeable future, as any potential margin expansion will likely be eaten up by the US device tax expected in 2013.

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