Zimmer Biomet Q4: Expect Volume to Rise As Covid Impact And Labour Stabilizes (ZBH)

Overview

Zimmer Biomet Holdings (NYSE:ZBH) has made significant operational and portfolio revitalization with new product advances to reclaim its footing and market share. As the effects of the COVID virus begin to fade and nurse staffing levels off, I anticipate an increase in the volume of the Orthopaedic market going forward. ZBH stands to gain market share in this sector on the back of its robust implant portfolio and the enthusiasm shown by surgeons for Rosa robotics. If ZBH can maintain consistent top-line growth and improve margins, I believe the stock price has further room to rise.

Earnings update

In 4Q22, ZBH posted strong revenue growth, with each underlying segment performing exceptionally well, especially Knees. ZBH reported $1.83 billion in revenue, an organic increase of 10% despite a 5.6% headwind from FX. Revenue growth and stronger-than-expected gross margins drove ZBH’s 4Q22 EPS to $1.88. But the positive effect of the higher gross margin on the EBIT margin was neutralized by the slightly higher OPEX, which led to a 28.3% EBIT margin.

Segment update

Overall, the results for the Large Joints were positive, with Knees particularly strong due to improved recovery after surgery in most areas, simpler comps, the attraction of Persona, and deeper ROSA penetration and greater pull-through. The hips market also performed well, due to the improvement in international procedures, favorable comparison to prior international results, popularity of products such as G7 revision and Avenir Complete primary hip, as well as the Rosa pull-through procedure, particularly in the United States.

Also successful was SET, where growth in CMFT, Sports Medicine, and Upper Extremities more than counteracted the negative effects of reimbursement shifts in Restorative Therapies, which are expected to weigh on 1H23 as well. Last but not least, Other did exceptionally well, with Rosa installations beating Zimmer’s annual 300 installation goal in 2022.

Pricing headwinds

The pricing headwind that has historically ranged from 2 to 3 percentage points per year is expected to return to the lower end of that range next year, according to management, but I don’t anticipate any additional benefit beyond that. Over the past few years, pricing headwinds have been partially mitigated thanks to management’s efforts to improve analytics and governance. But I don’t think those factors alone would reduce the benefits to below 2 points. The reason I say this is because a normalized volume of procedures in 2023 should result in more standard volume-based discounting, which was a major factor in the price benefit in 2022.

FCF/M&A

As a result of a lower FCF conversion rate, ZBH’s FCF for FY22 was $910 million. For FY23, management has guided to a range of $925 million to $1.025 billion in FCF, with the mid-point implying a conversion rate of 65%. Considering this set of projections and ZBG current net-debt to EBITDA ratio, I believe ZBH has a lot more leeway to pursue strategic M&A, and the company’s management has indicated that it is still open to diversifying into markets outside of Orthopaedics and elective procedures. A rudimentary calculation, assuming ZBH increase leverage to 3x, would imply additional 2 to 3 billion in dry powder for acquisitions.

Pipeline

According to management, the first procedures using the new cementless Knee from Persona have been completed since receiving FDA approval, and the product is expected to fully launch in mid FY23. Management did not give any specifics about the robotic shoulder opportunity, but they did say it would happen around the time Stryker hits the market.

Guidance

In 2023, the first and fourth quarters will have easier comps and enjoy 100 bps of growth due to more selling days, as such these quarters are expected to be stronger than 3/4Q. FX wise, management did not provide any explicit guidance; however, given that the EUR/USD is now higher than it was a year ago, there is likely some cushion to FY23 FX guidance.

Moving down the P&L, management guided 1H gross margin to be better than 2H due to favorable mix effects and the timing of FX hedge gain, and that EBIT margin will exhibit seasonality that is consistent with revenue performance. My analysis indicates that the guidance does point to an increase in EBIT margin in 2023. EPS wise, management guided EPS in the range of $6.95 and $7.15 for the year. The guidance assumes supply chain headwinds will persist throughout FY23, with some relief coming in the second half of the year. Given the higher revenue growth and better FX rate, I believe that the guided EPS may be too conservative, leaving room for earnings surprise.

Valuation

Management believes that in FY23, macro pressures will persist but stabilize, providing a favorable environment for ZBH’s growth. While inflation, supply chain, and labor issues are still present, they appear to be getting better in ZBH. To sum up, I think ZBH will be able to meet its targets, and its margins should keep growing at a modest rate. With these assumptions and the current market valuation on ZBH, I see a 14% upside to the current share price.

Conclusion

In conclusion, the performance of ZBH in 4Q22 was strong, with revenue organic growth of 10% and earnings per share of $1.88. I expect the Orthopaedic market volume to rise in the near future as we get over the covid impact and labour stabilizes. I believe there is more room for ZBH stock to rise if the company can sustain consistent top-line growth and improve margins.