2023-05-26 10:14:10 ET
Summary
- ZBH exceeded expectations with significantly higher organic sales growth and an EPS of $1.89.
- I am positive about management's decision to raise full-year guidance to 6-7% ex-FX, as I believe it indicates underlying strength and improved macro dynamics.
- While ZBH is addressing pricing pressure and anticipating a smaller impact, caution should be exercised regarding FY24 gross margin.
Overview
Organic sales growth for Zimmer Biomet ( ZBH ) came in significantly higher than expected in 1Q23 , contributing to the company's impressive 1Q23 results. With the help of recovery tailwinds from ongoing procedures, product sales momentum, and on-point execution despite supply headwinds, the company's top line increased by about 10%, reaching $1.83 billion. The higher-than-expected revenue led directly to an EPS of $1.89. There is, in my opinion, very little for bears to criticize in 1Q23 performance. Moreover, management increased guidance on the strength of underlying trends and the stabilization of macro dynamics. The new Knee releases coming soon should help maintain this upward trend (Knee grew 18% in the US which is a strong sign of recovery and pent-up demand). With positive developments across the board, I would not be surprised to see an increase in revenue and EPS forecasts in the coming quarters. So long as ZBH can maintain consistent top-line growth and improve margins, I am sticking to my recommende d buy rating.
Guidance/Outlook
Management raised full-year guidance to 6-7% ex-FX, which I believe the market received favorably at the time, as evidenced by the stock's jump to a high of $149 following the earnings release. Top-line growth in the latest quarter is responsible for 170bps of the increase in guidance, with the rest of the improvement attributable to structural growth. When compared to management's earlier guidance of 4% growth at the mid-point, I believe the new midpoint of 6.5% underlying growth in the revised guidance is very promising (literally to grow 50% faster than expected). The updated guidance was astounding, but I found that the accompanying comments were the real sources of optimism. In the 1Q23 earnings, ZBH also mentioned that the effects of inflation, supply chain problems, and staffing shortages have stabilized and are improving, which is great news in my opinion. Looking at the entire FY23, I expect 1Q23 to be the strongest performing quarter for the year. I say that because 1Q23 enjoyed a more favorable year-over-year comparisons due to Omicron last year, as such, making the growth in 1Q23 is disproportionately large compared to growth in subsequent quarters. That's why I wouldn't project this year's or the next few years' continued robust expansion on its current trajectory. Considering the difficult recovery comps in 2022 and the selling day headwind of 100bps, I expect 2Q23 to post lower growth than 3Q23. Finally, I believe 4Q23 will be the next highest growth quarter thanks to a combination of factors including an uptick in supply and contribution from new products and a selling day tailwind of around 100bps.
Pricing & Margin
Management noted that despite the stabilization and improvement of inflation and supply chain headwinds, ZBH still faces the pricing pressure that began in FY22. Albeit, ZBH is working to improve their price competitiveness in response to this price erosion, and they are having some success. Going forward, management anticipates a smaller price impact of less than 200 bps; however, they still anticipate pricing pressures in the market, which they believe may intensify over time. Therefore, despite the optimistic forecast for the year, I would take a more cautionary stance on FY24 gross margin. While overall commentary was light, it was made clear by management that a gross margin in the vicinity of FY22 levels plus operational improvement in FY23 should be used as a benchmark for 2024. In my opinion, the use of FY22 as a baseline instead of FY23 gives the impression that management is being extremely cautious in order to properly set market expectations regarding the degree of pricing pressure that will be experienced.
Valuation
With the company's growth momentum and solid execution this quarter, I believe the market is becoming more optimistic about the company and its stock. While the stock has fallen from its high following the earnings, I believe this is due to profit-taking rather than fundamentals. In my opinion, the stock is fairly valued at $149 based on my model, but at $128 today, it represents a 20% upside. The assumption that would be challenged is whether the stock can continue to trade at 18x forward PE, which is higher than its 10-year average of 15x. In my opinion, the current growth momentum should continue this year, and if the macro environment improves in FY24, growth should continue.
Own model
Own model
Risks
I think the risk to ZBH stock is more on the pricing side, which is still pretty ambiguous as prices remain competitive in the industry. It is hard to be very confident that management is able to combat this price erosion with continuous success. This is especially when management mentioned they expect continuous pricing pressure, and may intensify over time. If management calculations are wrong, it might lead to consensus further revising their estimates downwards.
Conclusion
ZBH delivered impressive 1Q23 results, with higher-than-expected organic sales growth and an EPS of $1.89. The company's strong performance was driven by recovery tailwinds, product sales momentum, and effective execution despite supply headwinds. Management's decision to raise full-year guidance to 6-7% ex-FX was positive in my opinion as it reflects underlying strength and improved macro dynamics. However, it is important to note that the strong growth in 1Q23 may not be sustainable throughout the year, with subsequent quarters likely to face more challenging comparisons and selling day headwinds. Also, pricing pressure remains a concern, although management is working on price competitiveness. Overall, with consistent top-line growth and improved margins, I recommend a buy rating on ZBH.
For further details see:
Zimmer Biomet: Expect Growth Momentum To Continue