Zimmer Hopes Are Hinged on Stellar Growth

But expectations are already sky-high for the big maker of orthopedic implants.
Author:
Publish date:

Some orthopedic device makers are starting to look a little more flexible than others.

Take

Stryker

(SYK) - Get Report

, for example. The giant implant maker last week delivered another powerful quarter, with sales in the core orthopedic implant business rising 13% on a constant-currency basis.

Just last month, however, rival

Biomet

(BMET)

rattled investors with a second-quarter profit warning. Although the company blamed the long-struggling Excellence by Innovation division, home to its spinal business, Biomet failed to meet high expectations for its crucial orthopedic reconstructive unit as well.

The market has grown concerned about reconstructive growth, which has fueled orthopedic stocks for years, because of potential pricing pressure. Makers of artificial hips and knees have long enjoyed close relationships with orthopedic surgeons who insist on using certain devices regardless of their prices.

After years of pricing hikes, however, the hospitals that actually pick up the tab for the implants have found themselves struggling to make money on Medicare patients who receive the bulk of U.S. joint-replacement surgeries. The hospitals have therefore stepped up attempts to win over orthopedic surgeons themselves and then use the doctors to help negotiate fairer implant prices from the device makers. Their efforts have likely been helped by a sweeping Justice Department probe that could threaten the lucrative financial deals between implant makers and the surgeons who faithfully use their products.

Indeed, news of successful price cuts recently caught the attention of at least one analyst.

"Although first reported by

TheStreet.com

early last month, our conversations with Aurora Health Care senior management confirmed that this has been the case at Aurora," Baird analyst Suey Wong wrote. "These price reductions at Aurora,

HCA

(HCA) - Get Report

and other hospital groups do raise our concern about moderating pricing trends going forward."

Leerink Swann analyst Jason Wittes, for one, sees major changes on the way.

"Longer term," he writes, "the subpoenas sent out by the Department of Justice investigating sales practices of the five major orthopedic companies is a significant development and one that we expect will lead to notable reforms to sales practices -- which will loosen the grip companies have on surgeons, further weakening their pricing power."

Indeed, Wittes expects to see clear signs of that power shift as early as this year.

"The second quarter should still be manageable for these companies," concedes Wittes, who has a market-perform rating on the orthopedic stocks. "We believe the impact will be more relevant in the second half. ... As such, any changes to guidance will be more telling than second-quarter performance."

Strut

For now, however, the market is still looking for the orthopedic companies to keep on strutting their stuff. Industry leader

Zimmer

(ZMH)

will take the stage next, when the company reports quarterly results on Wednesday. On average, analysts are looking for Zimmer to boost second-quarter revenue by 14% to $841 million. They expect the company to improve earnings by an even more impressive 36%, to 75 cents per share.

SG Cowen analyst Dhulsini de Zoysa, who calls Zimmer a core holding and "the premier orthopedics company in the world," is looking for more. She has predicted that Zimmer will beat the Street by a penny.

de Zoysa expresses particular optimism about Zimmer's huge orthopedic implant business -- which generates some 80% of sales -- forecasting an above-market growth rate fueled by strong American sales in particular. Specifically, de Zoysa believes that Zimmer will increase hip sales by 8% and knees sales by 21% to deliver an overall orthopedic implant growth rate of 15%.

Moreover, she is looking for Zimmer to boost its gross profit margin to a whopping 78% of sales -- up from 75% a year ago -- due in large part to the company's healthy reconstructive implant business. She believes that volume, pricing and product mix will all help out.

Still, de Zoysa acknowledges, orthopedic investors have already come to expect a lot.

"We fear that earnings growth may not be enough to drive meaningful share price appreciation through year-end," de Zoysa wrote about the group, which she considers fairly valued at current prices. "Case in point: When Zimmer reported 8 cents upside to the consensus EPS estimate for Q1, ZMH shares popped intraday -- up nearly 5% -- before closing down for the day."

Second String

Exactech

(EXAC)

, a much smaller player, is slated to report its own earnings the same day as Zimmer. Results from the two companies should differ vastly, however.

Unlike Zimmer -- and, in fact, most ortho device makers -- Exactech is set to report a dive in quarterly earnings, Wong reminds, due in part to "supply-related issues ... that are not expected to resolve until the second half of this year." Specifically, Wall Street is looking for Exactech's second-quarter profits to slide 3 cents to 13 cents a share.

Wong predicts that Exactech saw hip sales remain essentially flat and knee sales rise just 2% in the latest period. He is, therefore, looking elsewhere for expansion.

"While EXAC's 'other' category has traditionally generated less than 10% of the company's total sales and has received little focus on conference calls from management or investors, this category has generated significant growth for the company over the past 18 months," notes Wong, who has a neutral rating on the stock. "By 2006, we expect this category to represent nearly 15% of EXAC's sales, compared to less than 9% of sales last year."

Wright Medical

(WMGI) - Get Report

, a niche player in the field, will report earnings a day after Zimmer and Exactech. Like most in the group, Wright is expected to post quarterly increases in both revenue and earnings per share.

But Wittes, for one, still sees a difference between Wright and some of the rest.

"Wright did not receive a subpoena from the DOJ," Wittes says, "whereas the other four orthopedic companies did, which offers some -- though not complete -- comfort."

Still, Wittes has maintained his market-perform rating on the shares.

Smith & Nephew

(SNN) - Get Report

will end the sector's reporting season next month. The company, a European-based giant that's thinly traded in the States, is expected to post earnings of 54 cents a share -- up 8 cents from a year ago -- for the second quarter.