Turnaround Takes Hold at Zimmer

Zimmer Biomet ZBH, the undisputed king of hip and knee implants, enjoys the fruits of a wide economic moat. We expect favorable demographics, which include aging baby boomers and rising obesity, to fuel solid demand for large-joint replacement that should offset price declines. However, Zimmer has been plagued by pitfalls over the past three years, including integration issues, supply challenges, and quality concerns that caught the attention of the U.S. Food and Drug Administration. But new management has tackled these issues, and we’ve begun to see meaningful improvement.

Zimmer has benefited from close relationships with orthopedic surgeons who make the brand choice. High switching costs and high-touch service keep the surgeons closely tied to their primary vendor, and the surgeons bring in enough profitable procedures to keep hospital administrators at bay. These close relationships and vendor loyalty also explain why market share shifts in orthopedic implants are glacial, at best. As long as Zimmer can launch comparable technology within a few years of its rivals, it can remain in a strong competitive position. Nevertheless, we think surgeon influence will inevitably erode as the practice of medicine changes in response to healthcare reform. Over the long term, it will be more difficult for surgeons to run private practices profitably, and more of them will be open to employment at hospitals.

We think the growing emphasis by payers and hospitals on comparative effectiveness and cost-effectiveness will make conditions tougher for Zimmer and its rivals. By its nature, orthopedic innovation tends to be evolutionary rather than revolutionary. It is also less common for orthopedic innovation to tap into untreated patient pools with unmet needs, which is a strategy that cardiac device makers have pursued successfully. The difficulty and ethical issues surrounding randomized controlled trials for orthopedics also weaken Zimmer’s position when pressing for premium pricing. We think achieving meaningful innovation in orthopedic implants will be challenging.

Surgeon Loyalty and Intellectual Property Add to Moat Zimmer's wide economic moat stems from two major sources. First, there are substantial switching costs for orthopedic surgeons. The extensive instrumentation, or tool sets, used to prepare bones and install implants are specific to each company. The learning curve to become proficient in using one company's instrumentation is significant. Additionally, relative to other specialists, orthopedic surgeon skill and experience play an outsize role in the clinical outcome for the patient. These issues all leave surgeons reluctant to train and master multiple instrumentation systems, especially if procedure volume is too low to maintain high surgical facility with more than one system. Surgeons' preferences for certain vendors can stretch back to their days in residency training. Research has found surgeons stick with their preferred vendor and sales representative for 5-15 years and use that vendor for approximately 95% of their orthopedic procedures during that time. Switching to another instrumentation system would require taking time out for training, developing a relationship with new sales rep, and working less efficiently during the early period of mastering another vendor's tools, possibly raising risks for the patient and reducing the number of procedures (and income for the surgeon). This dynamic explains why market share among the six top orthopedic implant makers has remained remarkably steady.

Zimmer’s moat also involves intangible assets, including intellectual property that protects the product portfolio, which is characterized by evolutionary changes to technology, because new generations of products rely on intellectual property established by earlier iterations of those devices. Following changes to patent law introduced in 2012, the United States has switched to a first-inventor-to-file system, which had previously been a first-to-invent system. We think this change favors the moats of the larger orthopedic players like Zimmer. The new system encourages inventors to file an application as soon as possible. Inventors will also need to provide more detailed applications in order to head off competitors that may block improvement patents in future generations of products. The new law also mandates an opposition review after the patent has been granted. This will result in more challenges to patents. We think companies like Zimmer, which can support an extensive legal team, will be in a better position to take advantage of the new law by filing comprehensive patent applications on an accelerated timeline and mounting complex and time-consuming challenges to patents granted to competitors.

We think another intangible asset is the relationship between sales rep and surgeon. More so than with any other medical device or equipment, orthopedic sales reps play a critical role for the surgeons. The sales rep is present for every procedure, teaches the surgeon how to use each tool in the kit, and prepares selection of instrumentation in all the right sizes and sequence for the procedure according to individual surgeon preference. For most orthopedic surgeons, who may perform 30-40 hip replacements and 60-70 knee replacements in a year, the sales rep provides a valuable service. For the small group of high-volume surgeons, who may be performing five knee replacements in a day, there is less need for any training by the sales rep and the surgeon may wish to hire a nurse who can handle the procedure preparation.

FDA Issues Are Near-Term Risk Based on the average volatility of cash flows from the company's extensive orthopedic product portfolio, we rate Zimmer Biomet's uncertainty as medium.

Zimmer’s near-term risk is bound up in its regulatory infractions with the FDA, which has documented a number of quality control issues that are serious, from our perspective. If these issues are not resolved in a timely manner, other products may be at risk if the FDA decides to intervene and hold marketed products or pipeline candidates under regulatory review. Zimmer has taken steps to restore adequate inventory levels in order for the sales reps to effectively appeal to orthopedic surgeons, but any slip-ups here could slow down sales again.

The greatest longer-term strategic risk for Zimmer is if the management team does not come to grips with the changing orthopedic environment. Although the change is unfolding slowly, the writing is on the wall: Bundled payments, surgeons joining hospitals as employees, and further transparency in pricing are coming down the pike. If management does not formulate a new model for its orthopedic products, Zimmer could be left in the dust. In the meantime, the company is vulnerable to product recalls and related legal fees and inventory write-offs. With the regulatory and payer push for device registries, orthopedic companies may be subject to more frequent discoveries of product failures and subsequent recalls. Zimmer could also see greater exposure to consumer spending patterns, as increased cost-sharing requirements push more out-of-pocket expense onto individual patients.

Following the acquisition of Biomet, Zimmer has consistently been deleveraging and had paid down debt by more than $3 billion at the end of 2018. We anticipate substantial further deleveraging. As of December 2018, gross debt stood at $8.9 billion, or roughly 3 times trailing 12-month adjusted EBITDA. This is a considerable improvement since the acquisition of Biomet in 2015, which left the company with debt/adjusted EBITDA at 4.9 times. We expect Zimmer Biomet can hit net debt/adjusted EBITDA in the mid-2s by the end of the year. This would put leverage very close to management’s goal of gross debt/EBITDA of 2.5 times.