Zimmer Shows Flexibility

The joint implant maker posts stronger-than-expected numbers.
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Zimmer

(ZMH)

, one of the nation's largest makers of joint implants, is showing off its speed.

The company grew both first-quarter sales and profits even faster than Wall Street had expected. Sales jumped 14% to $829 million, topping the consensus estimate by $17 million. Meanwhile, operating profits rocketed 34% to 75 cents a share. Analysts, on average, had been expecting a full 8 cents less.

Due to strength in its core orthopedic implant business -- and surprising growth in its smaller spine division -- the company raised its profit forecast for the full year. The company's guidance is now 8 cents ahead of the consensus estimate at $3 a share.

Zimmer was quick to celebrate its rapid growth in the quarter and its opportunities for the future.

"Zimmer is off to a good start in 2005, powered by the strength of our knee-replacement product sales, particularly in the Americas where we experienced a 22% increase, double-digit growth from our spine business for the first time since acquiring Centerpulse and record margins," said CEO Ray Elliott. "Education and innovation remain the keys to our success."

Zimmer's stock, already up 2.7% to $81 Tuesday on anticipation of good news, added 1% in after-hours trading.

Upside Surprise

Merrill Lynch analyst Katherine Martinelli had already predicted that Zimmer's booming orthopedics business would push the company's results beyond Wall Street expectations. But even she failed to predict such a large upside surprise.

Specifically, Martinelli figured that first-quarter revenue would jump 10% to $815 million, $3 million above the consensus estimate, despite two fewer billing days than a year ago. She also estimated that first-quarter profits would rocket by 21% to 68 cents a share and beat the average forecast by a penny.

Ultimately, Martinelli predicted that Zimmer's two orthopedic businesses -- which account for 90% of sales -- would fuel all of the company's revenue growth. She looked for double-digit sales growth from the company's implants, with knees selling even better than hips, and nearly 10% sales growth in orthopedic surgical products as well. The company exceeded her target in the first area but did fall short in the second.

In contrast, Martinelli simply expected sales of spinal and trauma products to remain at last year's levels. However, the company posted a surprising 14% jump in spinal sales instead.

Looking ahead, Martinelli was already predicting that both of those smaller divisions -- along with implants -- would post stronger growth going forward.

Hurdles Ahead

Still, Zimmer could face some challenges in its core orthopedics business. Notably, the company is banking much of its future on "minimally invasive surgery," or MIS, that has led to complications. Indeed, one analyst noted, problems with two-incision MIS -- just one technique promoted by Zimmer -- have caused MIS itself to become a sensitive topic.

Morgan Stanley analyst Glenn Reicin offered his view after attending the recent meeting of the American Academy of Orthopedic Surgeons, where MIS emerged as a major topic of debate this year. He acknowledged that MIS, as a new procedure, could lead to more complications at first. Nevertheless, he suggested that surgeons will grow more adept with experience and drive MIS success rates higher.

In the meantime, Zimmer itself continues to portray the MIS procedures as highly successful already.

"When compared with conventional hip replacement, the MIS two-incision technique -- as taught worldwide at Zimmer Institute facilities -- saved an average of 30% in costs while improving clinical outcomes by more than 30%," the company said. Going forward, "we will continue to pursue the marriage of improved patient quality of life and measurable economic value added to our health care system."

Reicin, for one, has seen no reason to change his favorable outlook on Zimmer even if others have reported less stellar results from the procedure.

"Just as we do not expect positive data on the use of MIS to drive adoption overnight, neither do we expect reports of complications to halt adoption or in any way affect Zimmer's position in this market -- especially since Zimmer now favors a variety of MIS approaches -- despite its previous decision to patent its two-incision approach," Reicin wrote last month. "As we see it, one way or another, this industry is moving toward treating most patients less evasively.

"As the most visible proponent of MIS, we believe that Zimmer stands to benefit on the margin from this shift."

Reicin also downplayed fears about new "gain-sharing" agreements which, some fear, could hurt the rocketing prices of implants. The agreements, which must be approved by the government, could reward surgeons for saving money by choosing less expensive implants. But Reicin, for one, sees a "very, very low" chance for gain-sharing to hit implant prices anytime soon.

Still, Reicin has grown more cautious on the industry -- and Zimmer in particular -- for an unrelated reason. Late last month, the federal government officially began investigating the marketing practices of orthopedic device makers. Specifically, the government is examining the financial relationships between industry salesmen and the orthopedic surgeons who select their companies' products.

Reicin, who immediately downgraded Zimmer from overweight to equal-weight on the news, had been fearing such a probe for some time.

"Perhaps the biggest risk to industry fundamentals relates to the potential of some sort of external shock to the industry if regulatory or legal bodies were to choose to redefine

the physician/sales rep relationship," Reicin wrote just weeks before the feds launched their probe. "We think that this close relationship is a primary source of the positive pricing environment for the industry. ...

So if action were to be taken, multiples for the entire orthopedics universe could come under pressure."