Suddenly, the big orthopedic device makers are hurting. Smith & Nephew ( SNN) took a hit on Tuesday after warning that competition and Hurricane Katrina would cut into full-year results. Rival Zimmer ( ZMH) 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.
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."