Orthopedic-device makers continue to bounce back. The companies have been hurt in the past by pricing pressures on their artificial joints and government investigations of their business practices. Now, however, some experts sense relief on the way -- and, in fact, believe that the companies could be poised for their strongest performance in years. Wachovia analyst Michael Matson kicked off 2007 with an upgrade of the entire sector -- and a special endorsement of industry leader Zimmer ( ZMH) -- in anticipation of that rally. "We expect 2007 to be a better year for the orthopedics firms, particularly the larger ones, given stable pricing and mix, less reimbursement uncertainty, an improved product cycle and favorable exchange rates," Matson wrote on Wednesday. Meanwhile, "we believe it is possible but unlikely that (industry probes) will be resolved during 2007. A resolution of the cases could be a positive catalyst since it would remove a major overhang" on the group. Matson says prices for reconstructive joints -- pressured downward last year -- could actually rise by as much as 3% in 2007. For starters, he says, Medicare has stepped up its payments for joint-replacement surgeries this year. Before, he notes, Medicare offered more modest increases that failed to offset the rising cost of joint implants used in the operations. Thus, he adds, hospitals started to lose money on some Medicare joint-replacements and pressured device makers to lower their prices as a result.
But by now, Matson says, many larger hospital systems have already implemented cost-control programs -- widely criticized by orthopedic surgeons -- that will probably not be repeated going forward. Still, he adds, smaller hospital companies have started testing similar programs that could pressure, but not worsen, orthopedic prices this year. Matson looks for product mix, boosted by a string of new and pricier offerings, to help the industry out. He highlights hip-resurfacing systems, which offer an alternative to total hip replacements, as the biggest driver. But "not all companies will have hip-resurfacing products during 2007," he adds. "And those that do not may see slower growth in their hip business." Smith & Nephew ( SNN) introduced the first hip-resurfacing system to the U.S. market last year. Wright Medical ( WMGI) hopes to follow up with its own hip resurfacing system very soon. Matson recommends Wright, his favorite small-cap pick, as a turnaround story with potential upside from its new offering. His firm owns at least 1% of Wright's shares itself and hopes to secure investment banking business from the company going forward. This week, Matson started recommending industry giant Zimmer as well. He notes that Zimmer will soon start touting an important new product of its own. "Zimmer plans to launch a massive direct-to-consumer (DTC) ad campaign around its Gender Solutions knee in early 2007," Mason wrote when upgrading the company's stock from neutral to overweight on Wednesday. "We view this as a bullish sign for the entire industry since past orthopedic DTC campaigns have tended to drive increased growth across the industry."
Matson offers other reasons for his "change of heart" about Zimmer's outlook as well. First, he says, the looming takeout of smaller Biomet ( BMET) has renewed investor confidence in the sector. Moreover, he says, that transaction -- coupled with a stock-options scandal -- could disrupt operations at Biomet and lead to share gains for Zimmer in the near term. Looking ahead, he adds, Zimmer could go on to beat its guidance for the full year. To be fair, Matson still sees some possible risks. For starters, he says, Zimmer could deliver its third straight revenue miss when it reports fourth-quarter results. Nevertheless, he says, the company should continue to meet profit expectations. Still, Matson worries about the departure of longtime Zimmer CEO Ray Elliott. "Elliott has done an excellent job running Zimmer and will be tough to replace," Matson writes. "We believe, however, that this risk is minimal since Elliott is to stay on as chairman for a year. ... Zimmer is an aggressively and effectively run leader in a rebounding industry, in our view." Matson looks for Zimmer's stock to climb as high as $97 a share in the coming year. The stock rose 70 cents to $77.80 on his upgrade, leaving it near the top of its wide 52-week range. Matson's firm has no business relationship with the company.