2023-08-12 05:20:20 ET
Summary
- Zimmer Biomet Holdings, Inc. has experienced a selloff alongside the healthcare sector in H2 FY'23.
- Despite the recent downturn, the company still represents compelling long-term value in my view.
- The company's Q2 numbers show growth in product revenues and strong cash flows, supporting a positive outlook for the future.
- Net-net, reiterate buy, eyeing $137 price objective.
Investment briefing
Investors have unloaded positions in Zimmer Biomet Holdings, Inc. (ZBH) amid a selloff in broad healthcare. The company's Q2 results haven't inspired any near-term confidence. ZBH had caught a reasonable bid in Q3 last year and rallied to highs of ~$145 last month. Its convergence on the S&P 500 healthcare sector was evident until that point [Figure 1].
Figure 1.
The basket of broad healthcare companies has repriced to the downside moving into August, with investors rotating out of the sector and many of the individual names within. You can see ZBH's divergence from peers since July in Figure 2.
Figure 2.
Net-net, for investors with the patience and intestinal fortitude, ZBH still represents compelling value for those positioned over the long-term. I've reiterated it a buy at $137/share valuation, eyeing this number over the coming 12 months. Reiterate buy.
Updates to critical investment facts
The bull thesis is corroborated by fundamental, sentimental and valuation findings. On earnings power and asset factors, ZBH is attractively priced on today's market values in my opinion. The case is outlined below.
1. Q2 numbers - knees the major growth lever
ZBH clipped quarterly product revenues of $1.87Bn, up 490bps YoY. Growth was powered by a 5% expansion in U.S. sales that surpassed the company's initial projections. Ex-U.S. turnover was up 7.2% led by its EMEA and APAC footprint. Underlining upsides in the quarter-ongoing recovery of elective procedures and the adoption of new product launches. It pulled this down to 19.3% operating margin and earnings of $1.82/share.
- Insights - pricing headwinds remain
Pricing growth continues to be a headwind for ZBH's top-line growth. This is not unique to the company, but a result of sustained pricing pressure in most countries in ZBH's footprint. Chiefly, this ties back to cost containment efforts from local healthcare systems and hospitals. And who can blame them- Kaufman Hall's national hospital flash report , released each month, shows national operating margins down 6% YoY in June, while revenues were up just 3% [note: this is a key resource for anyone following medical technology, medical instruments, and devices. Use it well] . This, despite discharges/day and operating room minutes/day up 8% and 2% YoY, respectively. Alas, hospital margins and profitability are strained, despite improving patient dynamics.
Net-net, ZBH's global selling prices resulted in a 100bps headwind in the quarter, 120bps for the YTD. An additional 1.5% pricing headwind is anticipated in H2 FY'23, as per management forecasts.
- Divisional breakdown of top-line
I rhapsodized in the last publication that ZBH's knees segment was the key growth, in my view. Its global knees division was up 10% YoY in Q1 and it grew another 10.5% YoY in Q2, up ~0.1% sequentially. Since 2018, looking at Q2 specifically, it has added another $68.4mm in revenues from the segment. Last quarter, growth was split with 9.8% from the U.S. and 11.4% in its international markets, pushed by adoption of the company's Rosa robotics system and its Persona portfolio.
Global hips were also up 490bps to $504mm and the sports medicine, extremities and trauma ("SET") business was up 2.7% to $442.7mm. Alas, reasonable contribution margin from each segment.
Figure 3.
Note: Q2 sales from 2018-2020 are adjusted for the dental and spinal segments, not recognized as of FY'21. (Data: Author, ZBH SEC Filings)
Critically, the observations from Q2 showed:
- ROSA penetration is rising, evidenced by the progress in the U.S. and core overseas markets.
- The introduction of Persona OsseoTi-the cementless knee replacement offering-has also garnered notable traction in the U.S. ZBH mentioned its goal to achieve 50% market penetration, up from the current 15%.
There are varying estimates on the growth of the cementless knee replacement market, also known as cementless total knee arthroplasty ("CTKA"). Some sources call for 22% CAGR into FY'27 to hit $2.4Bn, others project 6.5% geometric growth, whereas there are estimates of 26% compounding growth out there as well. Take the average-18.2% (median 22%)-this is quite attractive, in my view.
CTKA has several advantages over conventional TKA (given the latter inserts a spear/nail into the tibia in order to fix the prosthesis in place) and over cemented versions of the surgery, that use a 'cement' to fix the prosthesis. CTKA instead is moulded to allow a patient's natural bone to infiltrate and grow around the prosthesis. Advantages-shorter discharge times, less pain, and potentially few revisions. For surgeons and hospitals alike, these are attractive economic features.
All sources mentioned earlier value the current size of the market at ~$1.8-$2Bn, thus, 15% penetration today gets ZBH to $270mm in annual sales at the time of writing. Should 1) the CTKA market compound at the average of 18.2%, and 2) ZBH capture 50% of this by, say, 2028-then in my estimation, you'd be looking at a $4.6Bn market, with ZBH claiming $2.3Bn of this. At 30%, it is $1.385Bn. These are bullish numbers in my opinion.
2. Cash flows, profitability remains strong
ZBH has been recycling cash back into its knees business and adding capacity to this segment. From Q2 in printed $1.5Bn in trailing post-tax earnings, the company's owners were treated to $1.38Bn in cash flow after all reinvestments accounted for.
This is down on FY'22 and FY'21 but consider the following:
- The reinvestment rate from ZBH's earnings increased from 90bps to 7.5% last quarter on these figures.
- It deployed $111.6mm in cash towards new capital commitments last period (on TTM figures), up from $13mm last year, and from the ZimVie divestiture the year prior.
- It produced $348mm in quarterly OCF on FCF of $165mm to the firm which are strong numbers of 18.6% of turnover, in my view.
Looking at things in first principles, the company now holds a $17.9Bn capital charge, down from ~$20Bn 2 years ago, yet quarterly sales and operating income are both up ~$100mm from that time. Hence, $2.4Bn less capital produces ~$100mm more in pre-tax income. Quite constructive, and talks to the company's operating leverage.
Figure 4.
On the talk of operating leverage, you can see this is a positive data point for ZBH. Since December last year, it has realized ~1-3x operating leverage from its sales growth. In other words, each turn in revenue has produced 1 to 3 turns in operating income. With the pricing dynamics outlined earlier, this bodes in well for investors. Earnings growth (notwithstanding the company's dividend of $0.96/share) is therefore, one catalyst to appreciate investor capital into the coming years, in my view.
Figure 5.
3. Valuation - asset factors, earnings power
Investors are selling their ZBH stock at 16.6x forward earnings and 12.7x forward EBITDA. The company has created $2 in net asset value for every $1 in market value. At 15.3x cash flow gets you 6.5% cash flow yield and the dividend offers a 0.77% forward yield as well. ZBH is also priced at a relative discount to the sector at each of these multiples/yields.
Those are the relative valuations; thus, managers mandated to a benchmark may find relative value in these depressed prices. Moreover, valuations in the sector are correlated to sales growth along with profitability. You'll note ZBH has produced a series of economic losses for its shareholders when factoring a 12% discount rate (long-term market averages) since 2020 as it hasn't beaten this hurdle rate with its return on existing capital.
Imagine benchmarking yourself, an investor, against ZBH, a fellow 'investor'. You would have outperformed ZBH by just riding the benchmark ( SPY ) over these few years, and that's the reason why. Alas, the performance of its equity since 2020 is well explained from these numbers since.
Figure 6. ZBH returns on existing capital deployed and at risk
Based on a 12% hurdle rate, and the current market cap of $26.09Bn, the market is expecting the following:
- For ZBH to produce $3.125Bn in pre-tax earnings (3,125/0.12 = $26,009) out into the future as the terminal value.
- From the TTM pre-tax income of $1.965Bn, this calls for 16.8% growth per year in earnings over the coming 3 years to (1,965x(1+0.168)^3/0.12 = $26,009).
- From FY'22 numbers this gets me to $2.29Bn pre-tax for FY'23.
The question is whether there's reason to think differently from the market's view. Management has revised guidance down by ~100bps to 6% growth at the top line this year, calling to $7.4Bn in revenue. Wall Street looks to $7.4Bn as well, stretching to $7.72Bn the year after, on $8.00 in earnings. The market projects 30% pre-tax margin for FY'23 (2.29/7.4 = 0.3) and this is above the 2-year rolling average. Critically, the Street's analysts have updated their sales and earnings forecast 24 times and 22 times in the last 3 months. One might say this is a bullish outlook, and I would agree.
Assessing ZBH's ability to compound intrinsic value lies on its ability to reinvest at the return on its capital deployed. Performing this calculus since 2020, you can see blow the company's market value has followed this calculus well. I had opined ZBH was tremendously undervalued in 2020 given the value gaps, but this has since tightened. Looking forward, I've got the company reinvesting ~3-5% of earnings at c.10-11% return on capital, getting me to $28.8Bn in implied market value, or $137/share, by this time FY'24. To me this supports a buy rating, and warrants patience and keeping a long-term view in the investment debate.
Figure 7.
Note: The orange market cap line is retrieved from Seeking Alpha. and superimposed over the implied valuation line. Hence the slightly faded image. (Data: Author, Seeking Alpha)
In short
Net-net, a recent selloff in broad healthcare and pricing headwinds across its core segments haven't been conducive to ZBH's equity stock re-rating to the upside. However, peeling back the layers, the economics of the situation are still relatively attractive. Make no mistake-ZBH is a slow compounder that offers relative value at its current multiples. I've also got the company at an implied market value of $28.8Bn or $137/share into the coming periods, backed by solid FCF conversion and ZBH recycling capital back into its knees business to grow the franchise. These factors support a buy rating in my view. In short, reiterate buy.
Appendix 1.
Data: Author, ZBH SEC Filings
For further details see:
Zimmer Biomet: Knees The Key Growth Lever, Reiterate Buy On Long-Term Value