Inside Wall Street: A Standout Play in Hip and Knee Implants

A major force in medical orthopedic devices, Zimmer Holdings' (ZMH) dominance in reconstructive implants such as hips and knees is attracting renewed investor attention. The fresh interest is due to favorable prospects in the business in which it has a 25% market share, a stock that's been depressed and an industry that's consolidating. Plus, Zimmer is viewed as buyout prey by some pros.

Zimmer has a "very strong business franchise in orthopedics, which is experiencing very favorable long-term demographic trends with the aging baby boomer population worldwide," says David A. Katz, chief investment officer of Matrix Asset Advisors, which has accumulated shares. He notes that the average age of an implant patient is 67 years old, and the first baby boomers, he adds, are turning 63-64 this year. So he expects demand to pick up, enhanced by the rising need for implants in emerging markets, including China and countries in Latin America.

A Big Pharma Might Be Interested

Zimmer has solid financials. With a "pristine balance sheet, strong cash flow and essentially zero net debt, the stock is very cheap at 11 times earnings 2010 estimate of $4.32 a share," says Katz. The stock, currently trading at $49, traditionally sells at 15 to 20 times earnings, he notes. On Jan. 19, 2010, it hit a 52-week high of $64.

In addition to its favorable prospects as a stand-alone company, Zimmer is an "attractive takeover candidate for a large health care company (domestic or foreign) that may want to diversify its revenue base at a time when major pharmaceutical companies face patent expirations," says Katz. Zimmer's franchise is "very stable," adds Katz, and has "zero patent risk -- and currently trades at inexpensive levels." Its market cap of $9.9 billion would be "a very manageable size" for a large pharmaceutical company seeking an acquisition in reconstructive implants, says Katz, who puts the value of Zimmer at $75 a share.

The big challenge to Zimmer is fierce competition and a short product life cycle that requires coming up with new products to keep or boost its market share and profit margins. Zimmer has spent the past two years updating its product lines and sales force, notes Katz, leading to renewed market share gains. That has enabled the company to outperform the industry in the past quarter, which Katz expects will continue over the next two years as Zimmer tries to regain some market-share loss from previous product recalls and regulatory actions.

A Bigger Market?

Analyst Phillip M. Seligman of Standard & Poor's notes that "the long-term global demand drivers for Zimmer's orthopedic implants remain intact, given an aging population and the rise of obesity levels." Another positive: eventual insurance coverage for up to 32 million additional Americans via the new health care reform legislation. That may expand Zimmer's potential market down the road, says Seligman, who rates the stock a buy.

Although the global hip- and knee-replacement markets have slowed because of the economic downturn, Seligman expects the company to shortly return to market growth rates based on new products. "We see a seasonal pickup in the 2010 fourth quarter," says the analyst. Prospects remain strong in Asia-Pacific, "where we are positive on Zimmer's planned acquisition of a Chinese firm," says Seligman.

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He expects revenues will climb some 3.6% in 2010 to more than $4.2 billion, including knee implant sales of more than $1.8 billion and $1.3 billion in hip implants. Seligman sees earnings jumping to $4.32 a share in 2010, up from 2009's $3.32. For 2011, Seligman expects profits to rise to $4.75.

Although Zimmer isn't highly favored by Wall Street analysts, some large institutional investors are big stakeholders, including State Street Global Advisors, which has accumulated a 3.6% stake; Vanguard Group, also with a 3.6% interest; and Fidelity Management with 2.3%.

For individual investors seeking to strengthen their portfolios by getting a slice of an improving health care market, Zimmer could help build up their holdings.