Zimmer Biomet Stock’s Valuation Offset By Lackluster Growth (ZBH)

Medical procedure volumes are gradually improving toward pre-pandemic levels, despite ongoing challenges with hospital staffing issues, and it’s time for Zimmer Biomet (NYSE:ZBH) to start delivering on the promises it has been making regarding leveraging R&D and improved go-to-market strategies to gain share in the ortho markets it serves and drive both attractive revenue growth and margin expansion.

I didn’t find a particularly compelling risk/reward opportunity with the shares when I last wrote about the company in early February of 2021, and with the shares down almost 25% since then (underperforming peers like Stryker (SYK) and the broader med-tech space), I don’t feel like I’ve missed out on much. While there have been signs of progress here and there, the reality is that the company’s performance in the ortho space on a two-year stack shows share loss in major joints.

I don’t think the valuation is particularly demanding if Zimmer can generate around 3% long-term revenue growth, mid-30%’s EBITDA margins, and high single-digit FCF growth. The real question, though, is whether or not the company can generate the sort of differentiated growth that will get investors to take a closer look – low-growth med-tech is a tough set-up for making money and I do have concerns that this could be a value trap.

Expectations Have Caught Up

Zimmer had put together a couple of quarters of better-than-expected numbers, driven by better ortho results, and while the ortho business has remained healthier than expected, overall results were no longer running ahead of expectations for the third quarter.

Revenue rose 5% in organic terms, missing expectations by about 1%, with good growth in the major joint business offset by weaker SET (the segment that includes sports medicine, extremities, trauma, and craniomaxillofacial and thoracic products) and “Other” results.

Gross margin declined 50bp yoy and 90bp qoq to 70.7%, beating by 20bp as the company continued to feel the pain from supply chain pressures. Operating income fell 8%, missing by 8%, with margin down 200bp yoy and 170bp qoq to 26.3% and missing by about 30bp.

The knee business posted a little better than 7% growth, beating by about 3%. Zimmer’s growth was about a point short of global knee growth, with Zimmer outperforming in the ex-U.S. market (7% growth versus 5% market growth) and underperforming in the U.S. market (7% versus 10% market growth). Stryker, Smith & Nephew (SNN), and Johnson & Johnson (JNJ) all outgrew the company in the U.S. market, but only Stryker outperformed in the international markets.

Zimmer’s hip business grew more than 10% in the quarter, beating by about 5%. Zimmer outperformed the global hip market by more than four points, with the company doing very well in the international markets (15.5% growth versus 4% market growth), but not so well in the U.S. market (roughly 5% growth versus 8% market growth). Stryker and J&J outperformed Zimmer in the U.S. market, but Zimmer was the growth leader outside the U.S.

SET revenue declined 2%, missing by about 2%. While markets like sports medicine, extremities, and trauma are generally healthy, Zimmer has been hit by value-based pricing for trauma products in China (the impact of which should roll off soon) and reimbursement changes for the Gel-One product.

Still Waiting For Real Momentum In Major Joints

A big part of the bull thesis on Zimmer Biomet has been built around the company leveraging new products and technologies, and particularly its Rosa robotic platform, to gain share in the major joint markets. Looking at the two-year stacks, that’s really not happening.

While Zimmer did modestly outgrow the global hip and knee market in the third quarter (8.5% growth versus 8% market growth), the two-year stack shows about 80bp of underperformance for Zimmer, with the company growing a little more than 5%, while JNJ grew more than 6% and Stryker grew more than 11%. The company has done better in international markets, but in U.S. knees the company was about 100bp below the market growth rate on the two-year stack (2% versus 3%), while Stryker grew more than 10%, and in U.S. hips Zimmer’s 6% contraction was worse than the 60bp market contraction (with Stryker grew about 2% and JNJ grew close to 4%).

Zimmer’s Rosa robotics system does seem to be driving some increased volumes, but penetration is still in the low teens and the company has been seeing more placements (versus outright sales) lately – something I would attribute to hospitals being cautious about their capital budgets. At this point, Zimmer has a long way to go to catch up to Stryker and its Mako robotics system (which has the advantage of many more years on the market), but Zimmer has been seeing some better placements in ambulatory surgical centers (about 30% of installations), and this should help shore up the company’s leverage to this important category.

Rosa should continue to be a positive driver for the company, but I don’t believe it has had the impact that the bulls had counted on, and the company continues to lose share to Stryker in knees. Installations seem to be progressing, though, and the company hasn’t mentioned staffing issues as an obstacle to near-term installations like Stryker has. I’d also note that the company is working on a shoulder implant for Rosa, and this could be a nice little driver in a couple of years.

Elsewhere, the Persona IQ (a smart knee implant that uses sensors to monitor motion) is technologically interesting but hasn’t really made a dent in the market. In hips, the company is pushing into direct anterior and direct posterior procedures, but I question whether the company can really generate exciting growth in this slower-growing market, particularly when Stryker seems to be picking up some momentum.

The Outlook

In the short term, supply chain issues are going to remain a headache, and although the company has secured key inputs out for a year (including titanium), inflationary pressures are still going to be evident in 2023. Making matters worse, unlike in many industrial markets, pricing power in the ortho space is limited – 200bp to 300bp of annual pricing declines are typical (though it’s been less severe this year), and Zimmer doesn’t seem to be getting quite the same lift from robotics as Stryker.

My revenue expectations for the next three years are a little higher than the Street’s, but I’m only looking for around 3% revenue growth and that isn’t going to stand out favorably in the med-tech sector. Comparisons to companies like Boston Scientific (BSX), Edwards Lifesciences (EW) and Intuitive Surgical (ISRG) may not be fair, but I still see Zimmer on the lower end of the spectrum for growth in the mid-cap and large-cap med-tech space. Likewise, long-term growth of around 3% isn’t particularly exciting, and Zimmer really needs to see its R&D investments translate into product launches that move the needle on revenue.

Margins are likely to remain under pressure again in 2023, but I expect some improvement from around 33% EBITDA margin in FY’21 to 34% this year and FY’23, and then start moving back toward 35% and into the high-30%’s in 2026 and beyond. The need for elevated inventory will weigh on free cash flow in the near term, but I do think Zimmer can get to 20%-plus FCF margin in FY’26 (versus a long-term average in the mid-teens) and improve toward the mid-20%’s over time. If they can achieve this, it will drive high single-digit FCF growth.

Discounted cash flow doesn’t suggest that Zimmer is priced all that attractively right now, with a mid-to-high single-digit total long-term annualized prospective return. Multiples in med-tech are often tied to revenue growth and margins (EBITDA margin, for instance), and looking at Zimmer that way, I believe a 4.5x revenue multiple is fair, supporting a $126 fair value, and if Zimmer can outperform on revenue growth and margin expansion a rerating to 5x is at least plausible.

The Bottom Line

Zimmer has had a better 2022 than analysts originally expected, but the reality is that the company still isn’t showing the share gains or revenue growth momentum that bulls have been calling for a couple of years now. That limits the appeal of the shares to me – while I don’t think the valuation is all that bad, I’m not really seeing evidence of momentum in the business and I’m not all that excited about a slow-growing established med-tech serving mature markets.