Suddenly, the big orthopedic device makers are hurting.
Smith & Nephew
took a hit on Tuesday after warning that competition and Hurricane Katrina would cut into full-year results. Rival
fell almost as much.
Analysts from big research houses such as Deutsche Bank and Merrill Lynch quickly portrayed the market's reaction as overblown. But some investors,
fearing price cuts on orthopedic devices, have started to sense lasting problems for the group.
Indeed, they may have detected signs of trouble in recent presentations by none other than Zimmer's normally upbeat CEO.
To be sure, Zimmer CEO Raymond Elliott said something to worry investors during a Thomas Weisel Partners conference last week. Although Thomas Weisel itself remained optimistic about Zimmer -- loudly reiterating its outperform rating on the stock -- investors started to bail. Bernstein analyst Bruce Nudell may have pinpointed at least one reason why.
Last week, Nudell quickly circulated some notably cautious statements from Elliott's conference presentation.
"There is a psychology to the sales mind that always makes me nervous, because I can remember when we were growing at 17% or 18%," Nudell quoted Elliott as saying. "And I used to say to people, 'You do understand that it's 4% currency, 4% price and, underlying that, we're growing at 10%?' 'Yeah, isn't it great you're growing at 18%?' And I used to go, 'Oh, this is not going to work out well.'"
Now, the lift from currency has dwindled, with competitor Smith & Nephew saying that exchange-rate gains will contribute a mere 0.5% to this year's sales. Meanwhile, Elliott just this week disclosed that Zimmer's prices might decline for the first time that some people can remember. Of course, the industry will keep pushing its higher-end implants, but it could find fewer takers among hospitals that have stopped making money on joint-replacement surgeries for Medicare patients. Thus, the companies are now left to depend more on volume growth -- fueled by baby boomer demand -- to keep winning over investors.
Elliott focused on that particular strength when touting the orthopedic reconstructive business last week.
"That's what's nice about the industry," he said, according to Bernstein's recent note. "We'll get variations on other things like mix and price and U.S. dollar strength and weakness, but the underlying business, if people want to be in it that long -- it depends on what their investment strategy is -- but if you want to be in it, the underlying business is sound."
Obviously, some investors want more. In just one week, after two CEO presentations and an analyst downgrade, Zimmer's stock has dropped 12%. It slipped $1.15 Wednesday to $72.83.
So far, Smith & Nephew is the only player in the group to warn of a looming shortfall.
The company says that it now expects orthopedic sales to grow by 17%, rather than 18%, during 2005. Morgan Stanley analyst Glenn Reicin said market losses to
( BMET) and
Johnson & Johnson
will account for two-thirds of that shortfall, with Katrina causing the rest. He then went on to point out that the company had not blamed pricing pressures at all.
However, Reicin's note came out on the very day that Elliott -- head of the largest orthopedic device maker in the world -- was talking about just that. At a presentation Tuesday morning sponsored by Bear Stearns, Elliott said that Zimmer has been modeling three different scenarios for price: a 2% rise, a steady rate and a 2% decline. Elliott then essentially ruled out the first and then went on to say that prices "absolutely" could fall.
Many investors had expected prices to at least remain flat. But others had been looking for pricing pressures that, they believe, have only just now begun to show up. They expect cash-strapped hospitals to keep demanding price cuts on existing devices and, even worse, avoid the new products that tend to sell at a premium.
Nudell is especially focused on product mix. He notes that companies have relied on premium implants, rather than simple price hikes, to help fuel their growth. And he wonders whether hospitals will continue to buy those high-end devices -- absent some proof of their superiority -- for their break-even Medicare joint-replacement cases in the future.
Thus, Nudell plans to closely monitor overall supply costs for joint-replacement surgeries going forward. If those costs fail to climb by at least 3% or 4% in the U.S., he believes, the stocks will no doubt suffer.
Indeed, Nudell senses that Elliott himself may have been trying to warn people with his recent comments.
"I think he was preparing the Street for a much tougher price/mix environment," says Nudell, who has a market-perform rating on the sector. "The whole thesis on the group is that it just gets harder and harder. ... But where does it wind up? That's what we've been interested in."
Boom or Bust
To be fair, the industry still has the baby boomer volume story that has attracted so many investors in the past.
But Nudell sees possible risks even there. In a research note published late last month, Nudell portrayed volume as an unpredictable metric.
On the basis of available Medicare data, he found, hip and knee surgeries have been increasing by about 7% a year. That number, he said, has jumped to 9% or 10% in particularly good years. However, he added, it also dipped below 1% during an unusually sluggish 2000.
Going forward, many investors are counting on baby boomer growth that may very well materialize. But Nudell, for one, worries about what will happen if the industry runs into another unexpected slowdown.
"The data ... suggest that unit growth rates can be variable, which might result in noticeably low rates of U.S. revenue growth, especially if price and mix inflation moderates," he wrote. And "a dip in annual -- or even quarterly -- revenue growth rates could shake investor confidence."
Clearly, though, Elliott still has faith. Just this week, the Zimmer CEO portrayed hips and knees as the best ongoing business around. To stress his point, he even suggested that investors buy his competitors' stocks if they prefer.
Still, he did indicate that some things have in fact changed.
"Make no mistake. ... It's going to be a tougher price market out there for the next year or two," he said. So there is "more negative market psychology about whether the industry is a great growth industry" anymore.