One Health-Care Pick, and One for Your Radar

Jason Stipp: I'm Jason Stipp for Morningstar. It's Ideas Week on Morningstar.com, and I'm here with our core stock specialist, Morningstar's Paul Larson, editor of StockInvestor newsletter. He recently made a new purchase for the Hare Portfolio in StockInvestor. He's here to tell us a little about that company and the case behind it.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So, this is the company in the health-care sector. It's one that you've been looking at for a little while. You pulled the trigger on it recently. What is the company? What does it do? And let's start from there?

Larson: Sure. The company is Zimmer, ticker ZMH, and they are an orthopedic device firm, primarily making artificial hips and knees.

Stipp: Okay. And I know the companies you look for, you look for wide moats. This is also a wide-moat company. What gives its competitive advantages?

Larson: You are right, this company does have a wide economic moat, and there are two main reasons for this. One, they have intellectual property similar to lot of other medical device firms, namely patents on the technology that they have. More importantly, this is a company that has switching costs. They do provide these hips and knees to surgeons who chose the devices for their patients.

Once a surgeon is comfortable and proficient on a given platform installing it in the patients, they tend not to switch. Because when a surgeon does try to pick up a new skill set, patient outcomes tend to be quite negative during that learning-curve period. So, there are some quite significant switching costs across the entire industry that Zimmer definitely benefits from.

Stipp: So, lots of incentive for doctors to stick with the devices that they are comfortable with.

So, it sounds like some good defensive position there. What's the growth story look like for Zimmer, and the growth story in sales for these devices?

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Larson: Well there is both secular growth, as well as cyclical growth. Looking at the secular growth: One, we have an ageing population--more people are going to need hips and knees as they get older. Two, we have a more active population; people expect to stay physically active well longer into their life spans than previous generations. and third, we have expanding waistlines; as people are heavier, it's more wear and tear on hips and knees, and this is definitely benefiting the volumes for these particular companies.

Stipp: You mentioned cyclical growth as well. So, I know a lot of industries and companies faced some slowdowns during the downturn. What's the cyclical story here then? Usually health care doesn't tend to be quite as cyclical. What's the story on that one?

Larson: Well, you are right, but artificial hips and knees, they actually did see a slowdown during the recession, because a bum knee is not going to kill you. So, there is a little bit of a discretionary aspect to these particular surgeries.

But if you had a bad knee three years ago, it's not going to be any better today. So, I think a lot of the demand was simply put off during the recession, and this is a company that is going to be a beneficiary of that deferred demand.

Stipp: Paul, I know that you don't invest in stocks unless the price looks good. So the fundamental story sounds pretty good. What's the price look like? Why was the valuation compelling?

Larson: Well the valuation is quite compelling. When you look at the forward earnings, the company trades at just a little bit more than 10 times forward earnings. When you look at the cash flow, their free cash yield is right around 11% today. The balance sheet is quite clean, with essentially no debt on the balance sheet. So, looking at the valuation, the expectations priced into the stock are quite low today.

Stipp: So why does the stock look so compelling from a valuation perspective? Is there a cloud over it or some concerns that might be overblown. Why is it that people have beaten it down a little bit?

Larson: Well, there are two things. One, you have some concern about the company's market share. When you look at the most recent quarters, their growth has been slightly below some of the other competitors in the industries. When I say slightly, I'm talking about 1% or 2% revenue decline versus 1% or 2% revenue increases for the competitor.

So, a little bit of lost market share, but I think this is a just a normal ebb and flow of a relatively small group of competitors within the industry.

The bigger concern I think is the regulatory reform and what that is going to mean as it gets implemented. Zimmer is going to be one of the companies that is going to have to pay the medical device tax. There is some concern that that's going to cause reduced demand and then, of course, the government is going to have more of its thumb on pricing, greater pressures on pricing, and this doesn't just relate to the medical device companies, it's across all health-care services that is going to have this pricing pressure.

But we think that regulatory reform is actually going to be a mild positive, because we are going to have a greater cohort of people that are going to have a medical coverage. So, whatever they lose in taxes and pricing, they are going to more than makeup in increased volumes in the years to come.

Stipp: Likely that piece of the story might be one that not a lot of people watching the stock have really taken fully into account?

Larson: I think people see a lot of uncertainty surrounding this reform, and we all know how the market hates uncertainty.

Stipp: So sounds like certainly a good opportunity on Zimmer right now. Are there any stocks on your radar that may be aren't quite cheap enough to buy right now, but are certainly worth keeping a close eye on?

Larson: Sure. One stock in the same sector that I actually used to own and sold it earlier this year is a company called Intuitive Surgical. I think that this company, it's not a stretch to say, has the widest moat in the health-care sector. And the reason for this is they are a robotic surgery company. They provide the robotically assisted devices for the operating rooms. This company essentially has a monopoly, and I don't know of many other companies that have a monopoly, with no other competitors in the space whatsoever, and just a massive lead in terms of intellectual property.

Stipp: So, that stock looking about fairly valued right now, but certainly, one to keep on the watch list.

Larson: Yes. It was dropping a couple of weeks ago, and I was keeping my fingers crossed it would keep going to drop into buy range; it didn't quite get there. But who knows what will happen in the future?

Stipp: All right. Well, Paul sounds like two interesting ideas. Thanks so much for joining me today.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.