Undervalued by 30%, This High-Quality Stock Is a Buy

Zimmer Biomet ZBH is a leader in orthopedic reconstructive implants. A recently announced CEO change doesn’t alter our opinion of the wide-moat company: We expect that aging baby boomers and rising obesity rates will fuel demand for joint replacement, which will benefit Zimmer. This cheap stock is one of our analysts’ top 33 undervalued stocks for the third quarter; it’s also one of Morningstar chief U.S. market strategist Dave Sekera’s five wide-moat stocks to buy after earnings.

With the addition of Biomet, Zimmer is the undisputed king of large joint reconstruction. We expect favorable demographics, including aging baby boomers and rising obesity, to fuel solid demand for large joint replacement that should offset price declines. Zimmer’s strategy is two-pronged. First, it is focused on cultivating 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. Second, Zimmer aims to accelerate growth through innovative products and improved execution. The latter is critical, in our view, to realizing the company’s potential.

Key Morningstar Metrics for Zimmer Biomet

• Fair Value Estimate: $175
• Star Rating: 5 Stars
• Economic Moat Rating: Wide
• Uncertainty Rating: Medium

Economic Moat Rating

Zimmer’s wide economic moat stems from two major sources. First, there are substantial switching costs for orthopedic surgeons. The extensive instrumentation 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, an orthopedic surgeon’s 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. Second, there are intangible assets, including intellectual property that protects the product portfolio, and the relationship between sales representative and surgeon. The sales rep is present for every orthopedic procedure, teaches the surgeon how to use each tool in the kit, and prepares instrumentation in the right sizes and sequence for the procedure according to individual surgeon preference.

Read more about Zimmer Biomet’s moat rating.

Fair Value Estimate for Zimmer Biomet Stock

Our $175 fair value estimate reflects our expectation of more-normal procedure volume thanks to widespread vaccinations and some level of COVID-19 immunity acquired by extensive infection by previous variants. For 2023, we also assume additional pressure from China’s volume-based procurement program and an uptick in the cost of materials and transportation, which should be mitigated by the launch of the higher-margin redesigned Persona cementless knee. Over the longer term, we anticipate that the backlog of procedures that were delayed by the pandemic, more widespread adoption of Persona IQ, ongoing placement of Rosa robots, and associated product pull-through will be the main growth drivers. This translates into average annual top-line growth of 3% through 2026, which incorporates the roughly 250 basis points of price headwinds that have characterized large joints of late. The shedding of the dental and spine businesses in 2022 should boost gross margin, which we project will reach 72% by 2026. We assume operating margin will climb to 28% by the end of our explicit forecast period.

Read more about Zimmer Biomet’s fair value estimate.

Risk and Uncertainty

The most immediate near-term risk is constrained hospital capacity. We think surgeon reception of the Rosa robot is another near-term risk. The greatest longer-term strategic risk is if Zimmer 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. Without 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.

Read more about Zimmer Biomet’s risk and uncertainty.

Zimmer Biomet Bulls Say

• Orthopedic surgeons often resist efforts by hospitals or health systems to limit their autonomy and brand choice. This is a major factor in the consistent failure of most programs put forth by providers.
• Zimmer has amassed an impressive portfolio of patents; it owns or controls approximately 4,500 issued patents and applications worldwide.

Zimmer Biomet Bears Say

• The scarcity of high-quality comparative effectiveness research data makes it more difficult for orthopedic companies to secure premium pricing at the same time payers and hospitals are raising the bar for cost-effectiveness.
• While Zimmer’s Persona knee system offers opportunities for further customization, it also complicates inventory management. The company’s Rosa robot remains in a catch-up position and is unlikely to match Stryker’s installed base in the midterm.