Health-Care Stock Set to Outperform

Following stock recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

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Zimmer Holdings
Moat: Wide | Risk: Below Avg | Price/Fair Value Ratio*: 0.79 | Three-Year Expected Annual Return*: 18.7%

What It Does: Zimmer (ZMH) is a leading provider of orthopedic medical devices. The firm focuses primarily on joint reconstruction, where it leads key niches including knee and hip implants. Reconstructive implants accounted for 83% of the firm's sales in 2006. The balance was generated from related surgical tools, devices to treat traumatic injuries, and spinal column treatments. Zimmer's core operational activities include device development, manufacturing, and marketing.

What Gives It an Edge:Morningstar analyst Julie Stralow assigns Zimmer a wide moat, as the orthopedic implant business is highly concentrated in the top five providers, and market shares tend to be very sticky from year to year. Stralow believes the stickiness stems from several factors. First, switching to a competitor's implant would require the surgeon to undergo extensive training on the other set, with uncertain outcomes for the surgeon's reputation and for patients. Second, switching to another supplier's tools for an incremental, evolutionary change usually doesn't make sense, especially since the surgeon's current supplier may have a similar offering in the works. Third, customer service matters in this business, too. Surgeons depend on their supplier's reps to get them the correct implant at a moment's notice. Switching to another supplier would mean cultivating another relationship with a sales rep, which takes time.

What the Risks Are: Zimmer must stay near the top of the innovation curve to maintain physician loyalty for its devices. If it doesn't, or if a competitor introduces game-changing technology, Zimmer's financial results would suffer. Surgeon loyalty may also be tested by financial gain-sharing arrangements being tested at some hospitals. Reimbursement-rate risk looms, too, because third parties determine how much hospitals get paid to perform orthopedic procedures. If these payers slash reimbursement rates enough, hospitals could demand price declines on devices.

What the Market Is Missing: Stralow attributes recent stock weakness to the firm's weaker-than-expected fourth-quarter outlook. The firm's earnings forecast was substantially lower than expected, due to a slew of one-time items and weaker-than-expected sales guidance. The market is also concerned that a revolutionary offering from Zimmer in knees (gender-specific product) won't take as much share from competitors as expected. Furthermore, investors speculate that an offering from a competitor (hip resurfacing) may have a stronger-than-anticipated impact on Zimmer's hip products. However, Stralow asserts that even when taking these factors into consideration, Zimmer's shares look attractive.