Zimmer Holdings (NYSE: ZMH) is the leading manufacturer of major joint (hip and knee) replacement and extremity (e.g., shoulder and elbow) implants. Zimmer’s growth has been negatively impacted over the past several years by a combination of product recalls; the fallout from the DOJ investigation into the orthopedic industry; poor execution; and the weakened global economy. Late last month, Zimmer reported 2Q12 revenue of $1,125 million (down 1.1%; up 1.8% in constant currency) that was light versus the consensus of $1,143 million and reconstructive sales of $843million (up 2% in constant currency) were below the consensus estimate of $859million, including Knee sales of $461 million (up 1% in constant currency) and Hip sales of $340million (up 2% in constant currency). I believe that Zimmer is over-exposed to the reconstructive market, which should experience sluggish volume growth over the next several quarters. Zimmer has few drivers to improve sentiment beyond current levels and limited earnings leverage suggesting limited earning upside.
Overall, U.S. hip market has seen accelerated growth from 1% in 1Q12 to 3% in 2Q12. (from the flat to negative market growth seen throughout 2011). Unfortunately, deceleration in international hip market growth (slowed from 2% constant currency growth in Q1 to 1% in 2Q) has washed-out the pickup within the U.S. Hip growth has been decelerating since 3Q11 outside the US and I expect at least one more quarter of sequential hip deceleration in Q3. Though U.S Hip market saw acceleration, Zimmer has been unable to tap the opportunity and lost 60 basis points of U.S hip share. On the other hand, its major rivals including Stryker (NYSE: SYK) is going strong in U.S and saw a revenue growth of 5% in the same segment. Although the company blamed underperforming territories within the U.S. and has made some resources and leadership changes, I don’t expect these changes to bring any significant upside at the top line.
Similarly, the U.S. knee market improved modestly from 2% growth in Q1 to 3% in Q2, Zimmer’s lost 80 bps of year/year knee share. In this segment also, Stryker appears to be the primary beneficiary of Zimmer’s U.S. knee share losses as Stryker’s knee segment sales grew 5% in 2Q. ZMH has consistently lost knee share in the U.S. every single quarter since 2008. In the near future also, Zimmer could further struggle to defend its already dislocated market share as Johnson & Johnson (NYSE: JNJ) is all set to release new products in Knee segment later this year and throughout 2013. Even the other business units were unable to offset the overall reconstructive softness. Strength in Trauma (+9%, led by nails and external fixation) and Other Surgical (+8%, led by power tools and blades) were offset by continued weakness in Dental (-5%) and Spine (-5%).
Zimmer is highly concentrated in Hip and Knee market (~70% of sales) and the population demographic appears unlikely to sustain anything more than 2-3% average hip and knee procedure growth. Although the percentage of total knee replacements and Hip implant conducted on patients over the age of 65 have been decreased considerably( by 8% in Knee and 12 % in Hip from 2000 to 2010), the 45-to-64 year-old age demographic has seen the most rapid growth in hip and knee replacements over the past 5 years. But the annual population growth of 65+ has been increasing while the 45-to-64 year-old age is seeing the deceleration in population growth. Overall, the picture implies that only ~2.5% annual procedure growth is possible in US Hip and Knee segment in the next 8 years.
Reconstructive market growth remains pressured by both structural and cyclical headwinds. Elevated unemployment continues to weigh on elective volume and hospital cost saving initiatives are increasing scrutiny on implant price. Although execution at Zimmer has improved, and the company is in the midst of new product launches, I do not foresee a pick-up in the near term. Further, I believe that fundamentals underlying the reconstructive industry remain weak with the current economic environment. Though many feel bullish with the recent lift of the preliminary injunction that was put in place against Gel-One in January 2012, I remain bearish, simply due to the relative size of the opportunity for Gel-One sales in comparison to Zimmer’s total revenue. It may even pinch a few pennies from Zimmer’s 2012 EPS as Zimmer ramps up inventory and marketing for a broader roll-out. Gel-One could be accretive in 2013, but I don’t see any major recovery at Zimmer anytime soon and recommend a sell on it.
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