Zimmer Holdings (ZMH)

Zimmer Holdings, Inc. (ZMH), which was formed as a spin-off from Bristol-Myers Squibb in January 2001, is a global leader in the design, development, manufacture, and marketing of reconstructive and spinal implants, and trauma and related orthopedic surgical products. In 2003, through the acquisition of Centerpulse AG, the company added spinal and dental implants to its product mix. These products are offered to orthopedic surgeons, hospitals, and healthcare purchasing organizations or buying groups. Reconstructive implants, trauma, spine, and orthopedic surgical products contributed 84%, 5%, 5%, and 6%, respectively to total revenue in 2007. With operations in more than 25 countries, and products marketed in over 100 countries, operations are managed through 7,500 employees and three geographic regions: North and South America, Europe, and Asia/Pacific. In 2007, these three regions generated 58%, 28%, and 14%, respectively of ZMH's total revenue, respectively.

The orthopedics industry is benefiting from strong demographics, and the demand for improved, higher-value products. As such, the increased demand has spurred product technology advancements, leading to better pricing and higher margins. While the pricing environment, coming off several years of stronger price increases, appears more challenging, overall demographic demand continues to be strong and we expect growth of 7-10% going forward. The baby boomer generation, higher rates of obesity and diabetes continue to create demand.

After several years of steady price increases, pricing lately has been a nominal factor. Despite more recent concerns about pricing weakness, overall pricing pressure has not been as severe as expected.

Global Price Changes

Q1

Q2

Q3

Q4

2004

2%

2%

2%

2%

2005

1%

0.6%

0.5%

0.3%

2006

0.5%

(0.6%)

0.4%

0.4%

2007

0.2%

0%

0%

0%

2008

0%

0%

In 2006, 2007, and 2008, domestic price improvements were largely offset by international market price declines.

Pricing does remain under pressure internationally, particularly in Germany (-4.1% in Q407, -3.4% in Q307, -3.3% in Q207, -3.5% in Q107, -3.6% in Q406 and -3.1% in Q306), as reimbursement costs are being reigned in. However, several smaller European countries recorded flat or positive pricing. Overall, Europe experienced about a 1% price decline in both the third and fourth quarters of 2007, a price decline of 1.1% in Q207, -1% in Q107 and -1% in Q406. These results are an improvement from the third quarter 2006 negative 1.6% and consistent with the prior seven consecutive quarters of 1-1.6% price declines. In Asia (-1.8% in Q407), the company still expects pricing to decline annually for the next few years, due to scheduled price cuts in Japan. In the second quarter 2007, Japan experienced a price decline of 4.8%, 3.4% in the third quarter 2007 and 4.7% in the fourth quarter 2007. The company expects overall global pricing in 2008 to again be flat to slightly positive and stable, despite additional price cuts in Japan and elsewhere. In Q108, European markets showed aggregate price declines of 0.5%. During the same period, Asian markets showed a decline of 0.9%, led by Japanese reimbursement cuts of 2.8%. In Q208, pricing was flat, with price gains in the Americas offset by declines in Asian markets (-3.3%). Prices in Japan continue falling, down 5.2% year-over-year.

ZMH has generated operational synergies, including plant closures, which have improved gross margin for quite some time, with some of the improvement due to consolidating the 2003 Centerpulse acquisition. In fourth quarter 2006, adjusted gross margin increased 10 bps sequentially to 77.8% and, in first quarter 2007, adjusted gross margin increased to a record level of 78.3%. The company reported a second quarter adjusted gross margin of 77.7% and 77.9% for the third quarter 2007. However, in the first quarter 2008 and fourth quarter 2007, gross margin decreased 230 bps and 140 bps on a year-over-year basis, respectively. The declines were due to higher prices of chrome cobalt, an ingredient used in many of their products, a negative impact from foreign currency hedges and geographic sales mix, and inventory write-offs related to the Orthopaedic Surgery Products recall (below). Increasing manufacturing costs, expanding capacity, FX hedging losses and geographic mix will continue to depress gross margin during the remainder of 2008. Gross margin declines in the second quarter 2008 were primarily due to While gross margin is unlikely to go much higher in future quarters, the company believes they can maintain gross margin in the 76-77% range.

With a high gross margin, and consistent research and development spending, ZMH must continue to leverage SG&A expenses to generate bottom-line gains. ZMH management has largely met their 2005 goal of reducing SG&A expense by 200 basis points over time. However, missteps in the past two quarters related to Hips and the Orthopaedic Surgical Products (OSP) recall have erased such gains. During Q208, the company voluntarily suspended sales of the Durom Cup, a hip related product, after reports of the cup loosening and requiring revisions. The suspension is limited to the United States, the only geography experiencing the problem. After reviewing the problem, the company concluded it was due to the surgical technique used to implant the cup. The suspension will provide time to update the product's label and train surgeons. The product is available immediately to surgeons who complete training. The corresponding loss in sales is expected to be in the range of $20 - $30 million, or $0.06 to $0.09 in earnings per share. During April 2008, the company announced a voluntary product recalls of certain OSP products manufactured at the Dover, Ohio facility that the company has determined of not meeting internal quality standards. In addition, the company has voluntarily and temporarily suspended production and sales of certain OSP products manufactured at the Dover facility. The suspension of sales and recall are expected to add recurring expenses of $0.11 - $0.13 per share and one-time expenses of $0.07. However, management says the additional expenses will be offset by a change in capital structure increasing financial leverage and decreasing shares outstanding, and other one-time gains expected during the quarter. Management also alluded to the potential for certain product lines to be positioned to outperform current guidance.

While the company recorded a 60 bps improvement in 2007 SG&A, the trend reversed in Q108 with SG&A increasing 120 bps to 39.2% y-o-y. The increase was due to DOJ monitoring fees and higher instrument costs. A one-time change in accounting for stock options to reflect the actual forfeiture rate experienced to date helped offset the decline by 50 bps. Excluding this benefit, SG&A would have increased by 170 bps. Given investments the company needs to make, we expect an increase in 2008 SG&A expense levels to 39-40% of sales as the company continues to spend on IT infrastructure, sales force expansion, ORTHOsoft dilution and product launches. The DOJ settlement-related monitoring expenses (about $0.06 - $0.09 per share for the remainder of 2008) will also make it more difficult to show SG&A improvement. Overall, the company expects about $100 million in incremental spending in 2008. We do note that about half (the DOJ monitoring costs) will likely go away in 2009.

During the quarter, the company announced that the Department of Justice ended its antitrust investigation that has weighed on Zimmer and the orthopedics companies. In June 2006, the DOJ issued subpoenas to the major orthopedic companies, including Zimmer, focused on investigations into possible criminal industry pricing (anti-trust) issues. According to ZMH in its Q206 call, in the fall of 2005, a single hospital conducted a bid process for orthopedic in-plant pricing. As part of that process a representative of the hospital (we believe HCA) sent an e-mail containing the hospital's proposal to the local representatives of various orthopedic companies including Zimmer's local independent distributor. Upon receipt of that e-mail, a representative of one of Zimmer's competitors sent an unsolicited message to the recipients of the original hospital message. The competitor's e-mail proposed that the orthopedic companies adopt a uniform pricing strategy in response to the hospital's proposal. When Zimmer learned of its competitors' proposal, the company advised its local independent distributor to reject it on behalf of both the distributor and Zimmer, which the distributor did. In writing, the rejections stated emphatically that neither Zimmer nor its distributors would participate in pricing discussions with competitors. Zimmer's policies insist upon full compliance with the Antitrust Laws. The company complied with the investigation. While ZMH admitted no wrongdoing in the DOJ settlement, Zimmer entered into a Deferred Prosecution Agreement, will pay a civil settlement amount of $169.5 million (by far the largest of the major ortho manufacturers) and will be subject to oversight by a federal monitor (expected to cost $30-$40 million) appointed by the U.S. Department of Justice for 18 months.

New products tend to drive top-line gains and Zimmer continues to launch product advances. In particular, Gender Solutions knee implants, receiving 510(k) clearance in 2006, are specifically designed for women, who make up approximately 60% of knee implants, as a means of addressing the specific anatomical differences typically seen in women. The company believes that it is the first company to address this gender difference and first quarter 2007 sales exceeded company projections, although subsequent results in the second and third quarters of 2007 didn't show substantial market gains, partially due to production issues. The Gender Solutions knee (GSK) implant is based on Zimmer's NexGen Knee platform. In addition, the company has experienced some cannibalization pressure and competitive countermeasures on its Natural Knee line from the Gender Solutions knee introduction. However, as an offset to this pressure, the company started a full release of its Natural Knee Flex in the fourth quarter of 2007, after a limited release in Q307. After receiving the FDA approval in December 2007, the company also introduced the NexGen LPS-Flex Mobile Bearing Knee, to match competitive offerings, with a limited release in January 2008, and full U.S. availability by mid-2008. On the hip side, the company released its first gender-specific hip replacement system, the Gender Solutions M/L Taper Stem with Kinectiv Technology in the fourth quarter 2007. Management also expects to introduce the Gender Solutions Epoch Stem, another gender-specific hip replacement system, by 2H08. Nonetheless, ZMH faces hip growth challenges since the company has been unable to gain market share or improve overall mix and competitors have been able to offer a hip resurfacing product. Zimmer won't be able to offer a competitive U.S. hip resurfacing product for about two years, but does expect to file for international market approval in 2008.

Also, in November 2007, management acquired ORTHOsoft, Inc., a leading provider of computer navigation systems for orthopedic surgery, for roughly $47 million cash. The deal, however, was dilutive to 2007 EPS and is expected to be $0.03 dilutive to 2008 EPS but accretive beyond 2008. The acquisition moves ZMH firmly into the emerging surgical navigation market. The company earlier had a partnership with Medtronic.

Part of the 2005, 2006, and 2007 earnings increase achieved by management came from planned tax efficiencies, not top-line or operational efficiencies. Further tax help to the bottom-line doesn't appear likely going forward. The company now expects the 2008 tax rate to be up to about 28.5% from the 27.5% rate reported in 2007, the 28.2% rate reported in 2006 and the 29.6% rate reported in 2005.

Summary: Zimmer's second quarter results and forward guidance suggests a lower top-line relative to its competitors given weaknesses in trauma, some holes in its product portfolio (like hip resurfacing) and lack of market share or mix shift gains in the Gender Solutions line. The company will find it more difficult to expand operating margin while supporting new product development, marketing, infrastructure investments and monitoring costs. The new management team has lowered 2008 EPS and revenue guidance by $0.15 to $4. 50-$4.10 and 1.5% - 2.0% to 8.5%-9.0%, respectively. The company continues to use stock repurchases to a large extent to generate bottom-line EPS. The company purchased 6.9 million shares during the second quarter 2008, extinguishing a $1.0 billion repurchase agreement and initiating another worth $1.25 billion. In-line with the group 2008 P/E/G average, our target price moves to $80, and is roughly equivalent to 19x our revised 2008 EPS.

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