One Bond, Two Stock Ideas in Devices

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. We've recently launched credit ratings on two medical device companies and our credit analysts have found an interesting opportunity in one of their bonds. I'm here with senior analyst Julie Stralow to talk about Stryker and Zimmer, and see where that opportunity lies.

Julie, thanks for joining me today.

Julie Stralow: Nice to be here.

Glaser: So we did just launch ratings on Stryker and Zimmer. Can you talk a little bit about what those companies do and what you think of their credit quality?

Stralow: Sure. Well, both companies we rated AA+ which is very, very good. Both companies are top tier players in the orthopedic device industry, and we think that across the board, they look like very similar credits.

If we take a look at all their pillars, from their business risk to their solvency score, to their distance to default and their cash flow cushion, they're all in the upper echelon of the ratings on those basic metrics. And we think they look like similar credits.

Glaser: So they look very similar, but are their bonds trading at relatively similar spreads to treasuries?

Stralow: Actually they aren't. Zimmer looks like it's trading as a substantially wider spread than Stryker. So that's where we see the opportunity. For investors who are looking to have this exposure to the orthopedic industry, we think that they should take a look at Zimmer's bonds over Stryker's bonds right now.

Glaser: Why do you think the market thinks that Zimmer is a little bit of a riskier credit than Stryker?

Stralow: Well, I think that honestly the psychology of any investment is difficult to ascertain, but when you look at the different, the other rating agencies out there, we think investors might be anchoring on those ratings, which are a little bit lower for Zimmer.

We think that that has to do with a size bias that the rating agencies have for companies. Zimmer is a little bit smaller than Stryker in terms of total sales, but we think that their market share and their dominance of the industries that they're in and they play in, is just as strong, if not stronger than Stryker in some cases.

So we really think highly of both Zimmer and Stryker and we don't see the need to differentiate in terms of the credit quality between them at this point.

Glaser: Are there any particular maturities of Zimmer that you think look particularly attractive?

Stralow: Taking a look, the most comparable bonds that Stryker and Zimmer both have out there are about at a 10-year maturity. So the 2019 Zimmer bonds look like they're easily comparable to Stryker's bonds and they are trading at generally 30 basis points higher than we've seen recently.

So we think that that's a good opportunity for investors to go out and reach for a little bit more yield in a similarly credit worthy company.

Glaser: What are some of the risks to buying Zimmer's bonds?

Stralow: Honestly, when you get right down to it, they have a really, really low leverage position right now compared to their financial resources and their cash flow prospects. Right now, they would need probably a couple more quarters of free cash flow to have enough cash on their balance sheet to offset their entire debt outstanding.

So we really think that there's really limited risks in terms of being repaid. But of course, there are questions with any company about what they're going to go with future cash flow. And recently Zimmer has repurchasing shares. So that could funnel away cash flow for repayment. But in general we see very limited scenarios where these bondholders wouldn't be repaid in full.

Glaser: For investors who might be interested in investing in the equity, and are not as interested in the fixed income, do either of these stocks look attractively priced right now?

Stralow: Actually both of them look to be trading at significant discounts to our fair value estimate. So they're both in deep four-star territory. Zimmer looks a little bit more attractive on evaluation perspective, but both of them you should put on your watch list, and possibly consider them at current prices.

We really do think that recent share prices are discounting our most pessimistic scenarios for these companies. So, there's not a whole of down side risk in them in our opinion.

Glaser: That's great. Julie, thanks so much for talking with me today.

Stralow: OK. Thank you, Jeremy.

Glaser: For Morningstar.com, I'm Jeremy Glaser.