Zimmer Fans on Edge

The latest sales shortfall raises some eyebrows on Wall Street.
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Zimmer

(ZMH)

has tripped up again.

The orthopedic-device maker

fell short of top-line expectations for the first quarter but still issued ambitious bottom-line guidance for the rest of the year. The company needs an outstanding third quarter -- and an even better fourth -- in order to hit its targets now.

Meanwhile, the company reported that sales grew just 4% (or 7% constant currency) to $860 million in the latest quarter. On a brighter note, net income jumped 18% to $206 million and earnings per share of 82 cents came in a penny ahead of the consensus estimate.

Still, the company's future guidance clearly bothered some. Looking ahead, Zimmer expects to report a weaker second quarter than Wall Street had anticipated and then seriously step up its performance in the latter half of the year.

To achieve its goals, Zimmer must increase profit growth to as much as 22% in the third quarter and 29% in the fourth. But the company sounded confident.

First-quarter "constant currency sales were a little light at 7% growth vs. our expectation of 8%," Zimmer CEO Ray Elliott admitted. "However, the interest shown by surgeons at the (recent industry) meeting and our progress towards launching an unprecedented number of major new products throughout the second half of this year confirms our optimism. We believe we have the right strategy for innovation, and our position as the low-cost orthopedic manufacturer and distributor should enable us to continue generating unmatched operating leverage and operating cash flow."

Investors didn't buy the story. They pushed shares of Zimmer down 4.4% to $63.25 following Wednesday's update.

Vote of Confidence

Stifel Nicolaus analyst Gregory Simpson expected mixed results from the company.

He predicted that sales growth had slowed to 5.4% in the first quarter -- still short of expectations -- but could be headed for a strong rebound in the second half of the year. In the meantime, he figured that profits had increased nearly three times as much.

"Last quarter, for example, ZMH dropped a remarkable 90% of incremental sales to the operating-income line -- well beyond the company's 50% target," Simpson reminded on Tuesday. Still, "we expect the Street to focus on incremental information that could serve to boost confidence in Zimmer's expected second-half 2006 acceleration. If ZMH management can accomplish this, we think investors will be increasingly willing to look a little more forward rather than remaining mired in the uncertainties of the present industry environment."

Simpson has cast his own vote of confidence. He reiterated his buy rating and $80 price target on Zimmer's stock just ahead of the company's latest results.

The New Deal

Baird analyst Suey Wong sounded more restrained when discussing Zimmer's new supply deal with hospital giant

HCA

(HCA) - Get Report

on that same day.

To be fair, Wong portrayed the arrangement as a "win/win" for both parties involved. Zimmer has once again promised HCA discounts in order to secure more of the company's business. However, Wong suspects, Zimmer probably gave away less than it did under a similar agreement last year.

HCA failed to meet its obligations -- triggering a rare public dispute -- under that particular deal. Even so, Wong feels, the hospital chain seemed to make some very important progress that opened the door for the new arrangement with Zimmer.

Such deals "have failed in past years -- and appeared to be failing throughout much of 2005 at HCA -- as most surgeons simply continued to use whatever products they desired," Wong wrote on Tuesday. But "given our conversations with local hospitals, we believe HCA's success in driving surgeon compliance with its vendor-reduction program has led other, smaller hospitals systems to initiate or more aggressively pursue similar programs."

Wong sees ongoing risks for orthopedic players, including Zimmer, as a result. In the past, he points out, orthopedic-device makers managed to raise their prices by 3% to 5% a year. However, he says, those pricing gains began to moderate in 2005 and could hit multiyear lows in 2006. Ultimately, he sees pricing pressures continuing through this year and possibly beyond.

Multiple Threats

Wong mentions other threats as well. Perhaps most notably, he points out that the Justice Department continues to investigate the close relationships between orthopedic companies and the surgeons who use their devices.

"In general," Wong says, "our primary concerns regarding the DOJ investigations is that potential sanctions could force changes in the surgeon/manufacturer relationships -- potentially leading to less surgeon loyalty and increased market-share volatility throughout the industry."

He worries about reimbursement issues, too. Recently, he notes, Medicare proposed flat reimbursement levels for hip and knee replacements. In contrast, he says, the agency usually offers modest hikes instead.

Still, Wong sees plenty to like about Zimmer and the industry as a whole. Wong, whose firm plans to seek investment banking business from Zimmer over the next three months, portrays the company as a leader in a sector that faces outstanding growth opportunities down the road.

Nevertheless, he stops short of recommending the stock even at its seemingly low price.

"We continue to believe multiples established in recent years are somewhat irrelevant," Wong explains, "given current industry issues that include near-term pricing pressures, declining mix benefits, the ongoing DOJ investigations and the potential for further negative news."