Zimmer ( ZMH) is testing its flexibility even sooner than some people had anticipated. The giant orthopedic device maker proved on Wednesday that it can weather a slowdown in sales growth and still beat the high profit targets set by Wall Street. The company posted third-quarter sales of $763 million -- up just 9% from a year ago -- that clearly fell short of the $779 million consensus estimate. But operating profits of 70 cents a share beat expectations by 3 cents. "Similar to the market overall, sales results were mixed, with hip and knee sales delivering slower growth, offset by solid performances in spine, dental and trauma," Zimmer CEO Ray Elliott stated. "Our highly leveraged earnings performance demonstrates the strength of Zimmer's business model, which is designed to capitalize on our position as the low-cost producer and distributor while delivering quality earnings on every new sales dollar under a variety of market conditions." Still, many had anticipated that Zimmer's double-digit sales growth would at least hold up a little longer. Instead, pricing pressures on the company's core orthopedic division -- where sales grew just 10% in the quarter -- went ahead and dragged the top line down. Even so, Zimmer sees no real hit to the company's bottom line for now. It reaffirmed full-year guidance of $3.07 a share, exactly in line with Wall Street expectations. It also issued new 2006 guidance of between $3.58 and $3.65, against the $3.64 consensus estimate. Skittish orthopedic investors reacted with relief. After pressuring the stock for weeks, they pushed it up 1.9% to $65 a share in after-hours trading.
Given widespread pricing pressures on orthopedic implants, however, Wong questioned whether Zimmer could keep on delivering that kind of improvement going forward. "We believe ZMH's ability to rapidly expand margins longer-term could come under pressure, should pricing pressure in the U.S. build or should the Japanese government institute further price cuts," explained Wong, who has a neutral rating on the stock. Zimmer relies heavily on sales in the crucial U.S. market, where hospitals have started fighting off regular price hikes for orthopedic implants and demanding big discounts instead. Zimmer itself has already begun modeling for domestic price cuts of up to 2% next year. The company also depends more than most on Japan, Wong noted, where it generates up to 10% of its sales and ranks as the largest player in the reconstructive group. There, he said, the company has predicted that prices could fall by as much as 8%. Wong warned of price cuts in the German market as well. As a result, he said, orthopedic stocks like Zimmer -- which is particularly exposed to the implant business -- will continue to face pressure.
By now, however, SG Cowen analyst Dhulsini de Zoysa has already slashed her own targets for the company. She now projects that Zimmer will go on to post revenue of $3.6 billion -- up just 8.2% -- and profits of $3.50 a share next year. Wall Street is still forecasting revenue of $3.7 billion and profits of $3.64 instead. Yet de Zoysa believes that other analysts will soon lower the bar as well. She foresees a possible buying opportunity if that happens. She considers the stock attractive in the low to mid $60s and believes that it could go on to outperform the broader market -- by as much as 20% -- in the coming year. "ZMH shares, once the highflier in ortho, have taken a beating in recent weeks," confessed de Zoysa, who recommends buying the stock although she remains cautious on the group overall. "But we believe that ZMH shares will break out of this funk over the next 12 months ...
when we expect the company and the ortho industry more broadly to get past certain macro issues." Of course, the industry must get past a lot. It must continue to address pricing, which many believe will get worse before it gets better. It must also grapple with so-called "gain sharing," which could push doctors to select cheaper implants and seems to be gathering steam. And last but not least, it must overcome a sweeping government probe that could threaten the cozy ties between device makers and surgeons that have helped make the companies so profitable in the first place. So many experts, including Wittes, prefer to exercise caution right now. "Since our downgrade in early February of 2005, valuations and multiples have come down and are approaching our targets," Wittes wrote this month. "But we remain cautious on the orthopedic group ... particularly as we are still in the early innings of a changing environment" that could pressure the stocks going forward.