2024-01-20 06:18:36 ET
Summary
- Zimmer Biomet is focusing on growth acceleration after spinning off divisions and refocusing on high-growth areas in the medical device market.
- The company's growth target is supported by investments in R&D for new product launches and strategic targeting of high-growth markets.
- Zimmer's ROSA system holds promise for accelerating growth in the Total Knee segment and tapping into an underpenetrated market with substantial growth potential.
Zimmer Biomet (ZBH) used to operate under a turnaround business, aiming to close the gap with its major competitor, Stryker (SYK). They spun off their spine and dental divisions and refocused on high-growth areas in knees, hips, extremities, and trauma markets. Zimmer appointed their new CEO, Ivan Tornos, in April 2023, and the management team is currently emphasizing growth acceleration. I am initiating coverage with a 'Buy' rating and a fair value of $140 per share.
Growth Acceleration is Highly Likely
The chart below illustrates that Zimmer has not achieved substantial real growth prior to the pandemic, with their group revenue only experiencing an average annual growth of 1.6% before FY20. The new management is now aiming for revenue growth that exceeds market growth by at least 100-200 basis points, with a corresponding increase in earnings and free cash flow surpassing the growth in revenue.
I believe their growth target is realistic and achievable for several reasons. Firstly, they are actively investing in R&D for new product launches, as revealed in their earnings call. They have outlined plans to introduce over 40 new products within the next 36 months. The current dollar value of their pipeline is twice that of 2018, underscoring the importance of this robust product pipeline for revenue acceleration and margin expansion.
Moreover, Zimmer Biomet is strategically targeting high-growth markets. They have indicated that 80% of their pipeline is in markets growing above 4%. By surpassing the market growth by 100-200 basis points, they anticipate achieving 5-6% organic growth from these new products.
As depicted in the above chart, their revenue growth has notably accelerated in FY21 and FY22. This acceleration aligns with their strategic shift towards higher-growth areas, coupled with increased resource allocation to hips, knees, extremities, and trauma markets. This data suggests a positive correlation between their strategic reallocation and the observed revenue growth.
Zimmer ROSA Vs. Stryker MAKO
In the past, Zimmer has experienced a loss of market share to Stryker, which is attributed to Stryker's superior management and the first-mover advantage gained by their MAKO robotic surgical system. The MAKO system received FDA approval in August 2015 and has since been expanded to include applications for knees, spine, and shoulders. This strategic move has proven highly successful for Stryker, contributing to the company's faster growth compared to Zimmer, as evident in the chart below. For additional details on Stryker, please refer to my recent article on the company.
As part of their catch-up strategy, Zimmer introduced the ROSA system, which received FDA approval in January 2019, marking a launch that occurred four and a half years after Stryker's MAKO system. The ROSA system is designed to assist in total knee replacements by providing support in bone resections. In Q3 FY23 , Zimmer's management reported robust growth for ROSA, noting strong adoption across the industry. This growth had a positive impact on their global knee business, resulting in a 7.3% increase in the U.S. and a 6.1% increase internationally, both driven by the utilization of the ROSA robotic systems.
Despite entering the robotic surgical system market later than Stryker, Zimmer has tapped into an underpenetrated market with substantial growth potential for all players involved. The late entry does not necessarily hinder Zimmer's prospects, particularly considering the significant room for expansion in the robotic surgery space. The ROSA system holds promise for accelerating Zimmer's growth in the Total Knee segment.
Stryker's Q3 FY23 earnings call revealed that, despite having around 300 MAKO systems in ambulatory surgery centers ((ASC)), there are approximately 12,000 ASCs in the U.S., indicating a sizable untapped market. Zimmer is actively working to sell more ROSA systems both within and outside ASC markets. In summary, there is a positive outlook for ROSA's growth in the coming years, and I share optimism about Zimmer's potential in this evolving landscape.
Recent Results and FY24 Preview
Their revenue growth has accelerated after the pandemic, driven by the launch of their ROSA systems and a refocus on core businesses following the divestitures of the Spine and Dental segments. Their debt level is slightly higher compared to their peers, with a net debt leverage of 3.3x in FY22. Concerning free cash flow, they are allocating funds to dividend payments and some stock repurchases.
In Q3 FY23 , they achieved a 4.7% constant revenue growth and a 5.5% growth in adjusted operating profit. The robust growth in knees was notable, propelled by widespread adoption of the ROSA system. However, challenges in China, marked by tough comparisons, and headwinds in Russia resulted in a 0.6% year-over-year decline in their hips business.
For the full-year guidance, they accounted for the foreign exchange impact on revenue through adjustments but made no changes to the adjusted EPS growth.
They are set to report their Q4 FY23 earnings on February 8th before the market opens. I don't anticipate any surprises in their Q4 actual results. During the Q3 FY23 earnings call, they stated that there would be little change for the upcoming quarter. Looking at the FY24 full-year outlook, I am optimistic that they can achieve above 6% organic revenue growth with margin expansion. They possess a robust new product pipeline as discussed earlier, and these launches are expected to generate growth tailwinds and contribute to margin expansion in the next fiscal year.
The company has provided an initial guidance of mid-single-digit constant revenue growth in FY24, but I believe they are being conservative at this point. Based on their FY23 guidance, they are projected to deliver an average annual revenue growth of 7.8% in constant currency over the past three years. Therefore, a 6% constant revenue growth in FY24 seems reasonable.
On the margin side, the company is concentrating on controlling SG&A spending. Initiatives in this regard began in the second half of this fiscal year and are expected to extend into the new fiscal year, contributing to cost control and margin expansion. They acknowledged foreign exchange headwinds in FY24, which might exert some pressure on gross margin. Despite this, the company is positioned to continue its path of margin expansion in FY24.
Valuation
My assumptions for FY23 align with their full-year guidance. As discussed earlier, I anticipate they can achieve at least 6% revenue growth over time. Additionally, considering their historical track record, tuck-in acquisitions are expected to contribute another 60 basis points to revenue growth. I identify two primary growth drivers for their future expansion: ROSA and GLP-1.
ROSA is poised to accelerate growth in their Total Knee business. Given that the knees business constitutes 40% of group revenue, a high-single-digit growth, similar to what Stryker has achieved, could translate to 3-4% of topline growth for this division.
As highlighted in their Q3 FY23 earnings call, obesity currently poses a challenge to joint surgery, as many surgeons are hesitant to operate on obese patients. The GLP-1 drugs are anticipated to act as a tailwind for orthopedics. While it is challenging to precisely quantify the financial impact, GLP-1 is expected to provide a growth tailwind for Zimmer, contributing to their overall expansion.
Their margin expansion is driven by operating leverage, new product offerings, as well as SG&A cost controls, and I calculate that their operating margin will expand to 22% by FY32. The model is using a 10% WACC, the same discount rate I use for all models. The terminal growth is assumed to be 4%, as I believe they can sustain slightly above GDP growth. The fair value is estimated to be $140 per share, based on my estimates.
Key Risks
Hips Business in Russia : The Russia market has created approximately a 50bps growth headwind in the latter half of FY23. However, their overall exposure is relatively limited, with net sales in Russia and Ukraine accounting for less than 1 percent of their consolidated net sales in 2022.
High Debt Level : As of December 31, 2022, their total debt stands at $5.7 billion, with $850 million due in 2024. In the near term, I expect the company to persist in paying off their debt and reducing their debt leverage. Investors should not anticipate any significant increase in dividends or share repurchases in the immediate future.
Conclusion
Zimmer has successfully executed a turnaround of their business portfolios and strategy. With ROSA expected to drive their Knees growth in the near future, and the potential growth tailwinds from GLP-1, the company appears poised for positive developments. Considering the current undervaluation of the stock, I am initiating coverage with a 'Buy' rating and a fair value of $140 per share.
For further details see:
Zimmer Biomet: Growth Acceleration Is Likely Driven By ROSA; Initiate With 'Buy'