Zimmer Biomet Stock: Ortho Performance Encouraging (NYSE:ZBH)

Writing about Zimmer Biomet (NYSE:ZBH) (“Zimmer”) in late November, I thought that the shares looked undervalued, but that the company would need to show more ability to separate itself from the pack in terms of growth and margin performance, particularly in its core Hip and Knee segments. Since then, the shares have modestly outperformed a strong med-tech sector, but have lagged Stryker (SYK), though Zimmer did come through with better growth in the fourth quarter.

I do see room for Zimmer stock to head higher, as the margins should support a fair value in the $140s. The biggest concern I have at this point is whether med-tech as a sector can continue to outperform – the large-cap portion of the sector has climbed back up to its peak relative valuation to the S&P 500. And if there is a broader rotation away from med-tech in search of bargains elsewhere, Zimmer could face some headwinds that have little to do with its own particular merits.

Higher Opex, But A Strong Quarter All Around

Zimmer posted a very good all-around quarter, as the company beat at every revenue line, outgrew its rivals in some categories, and beat on gross margin, while offering guidance that was consistent with expectations. The only flaw was some overspending (relative to expectations) on SG&A and R&D.

Revenue rose about 3% as reported, a little more than 8% in constant currency, and about 10% in organic terms when adjusting for different selling days. That was more than 3% ahead of sell-side expectations, with each segment beating by at least 2%.

Knees grew more than 10%, beating by more than 5%, while Hips grew more than 8% and beat by about 2%. The Sports Medicine, Extremities, & Trauma (or SET) segment grew almost 8%, beating by more than 4%, while “Other” grew about 1% and beat by 2%.

Gross margin improved two points from the year-ago quarter and a point from the prior quarter to 71.7%, and supply challenges seem less limiting at this point. Operating income rose more than 3%, beating by 3%, while operating margin rose 20bp yoy and 200bp qoq to 28.3%, missing by 20bp on higher SG&A and R&D spending.

Major Joints Looking Better, And Rosa Can Drive More Growth

The global hip and knee market grew about 11% in the fourth quarter, an unsustainable pace boosted by recovering procedure volumes as staffing shortages improve. Zimmer grew more than 11%, comfortably ahead of Johnson & Johnson’s (JNJ) 6% and a bit above Stryker’s (SYK) 10%.

Knees drove the strength, with U.S. knees up almost 13%, beating JNJ’s 11% and Stryker’s 7.5%. Management cited procedure volume recoveries around the world, as well as improved sales driven by new products (including Persona cementless knees) and pull-through from the Rosa robot platform. Management doesn’t consistently provide details on Rosa, but Rosa accounted for a “low teens” percentage of Zimmer’s knee procedures this quarter versus 10% a year ago. To frame the opportunity, consider that Stryker’s MAKO robot drives more than half of its knee volumes.

The hip business saw almost 8% growth in the U.S., and Zimmer continues to lag Stryker (up 11%) and JNJ (up 9%) here, but did still perform better relative to its main rivals than in the prior quarter. The story here is largely the same as for knees – procedure volume recoveries, new products, and Rosa pull-through, but there’s even more room for Rosa to drive this business (and MAKO accounts for about a third of Stryker’s hip implant volumes).

Work To Do Elsewhere

Zimmer’s performance in SET wasn’t quite as impressive, with close to 8% growth coming up short of the 12% growth that Stryker reported in its U.S. trauma and extremities business. This isn’t a fair comparison or really a fair presentation of Zimmer’s performance, though, as the craniomaxillofacial, sports medicine, and upper extremities businesses were all strong, but held back by reimbursement pressures in the restorative therapies business.

Shoulder continues to be a very significant opportunity within this business, and the company is progressing with its shoulder application for the Rosa robot. I expect to hear some sort of update at the upcoming AAOS meeting, but it looks like Zimmer at least has a chance of getting to market ahead of Stryker’s MAKO iteration for shoulders (expected in the second half of 2024).

As far as “work to do”, I would also expect further tuck-in M&A. The company recently acquired Embody, a manufacturer of collagen-based therapies for soft tissue injuries (particularly tendon and ligament injuries). Zimmer paid $275M (including milestones) for a business serving markets growing close to 20%, and while I historically haven’t had a lot of love for companies like Embody (reimbursement and sustained revenue growth always seem more challenging than expected), I do find their BIOSPIN technology interesting. I would estimate that Zimmer probably paid around 10x revenue upfront ($150 million, suggesting $15 million in revenue), with the remainder tied to sales and/or FDA milestones.

Even with my reservations about soft tissue technology companies, this is the sort of deal I expect and want to see more of – I don’t think there’s much in the $1B-plus M&A world for Zimmer, but I think adding differentiated technology-driven niche products makes a lot of sense, and there are a lot of niche companies addressing sports medicine, trauma, and extremities, as well as robotics technology that Zimmer could consider.

The Outlook

I expect further normalization in procedures as staffing issues and other bottlenecks fade. On the more negative side, I also expect the industry to return to its typical annual price erosion; management indicated it will be on the lower end of the typical range (200bp-300bp) this year, but it’s still a challenging given ongoing inflation.

I’ve modestly boosted my numbers for Zimmer, but I’m still looking for long-term core growth in the neighborhood of 3.5%. That’s not particularly compelling, and that is a concern of mine, but I do see the opportunity to exceed my revenue targets, particularly if Rosa catches on and really drives meaningful pull-through.

On margins, I expect ongoing improvement, with EBITDA margins climbing from around 33% in FY’22 to 35% in FY’25 and 36% in FY’27. I expect this to drive meaningful improvement in free cash flow margins – from the mid/high-teens to the 20%s and then toward the mid-20%s over time, driving long-term FCF growth around 7%.

Discounted cash flow doesn’t suggest a lot of undervaluation, but given where the sector is now, that doesn’t really surprise me. Looking at margin-driven valuation, mid-30%s EBITDA margins can support a forward multiple of 5x on revenue (EV/revenue), giving me a fair value in the mid-$140s.

The Bottom Line

I’d like to see Zimmer follow up this performance with more quarters of share gains in major joints, not to mention strong performance in sports medicine and extremities. The potential is there and I expect that the company will continue to push its new products and Rosa as invaluable growth drivers. My biggest issue today is relative/sector valuation – med-tech is looking fairly richly-valued now, and while I think Zimmer has more room to run, sector rotation out of med-tech would be an unwelcome headwind.