Buy Zimmer-Biomet Holdings (ZBH, $109-115, Mkt Cap: $23.0B)
Company Description: Zimmer-Biomet Holdings designs, develops, manufactures, and markets orthopedic implants. In 2015, the Zimmer-Biomet merger created the #2 largest orthopedic company in the world by merging the #3 and #5 players. This includes hips, knees, spine, trauma, and dental. ZBH is viewed as a global leader in the orthopedic space with a focus on hips and knees as well as the surgical toolkits and prep associated with various orthopedic procedures.
ZBH Investment Summary: We believe that Zimmer-Biomet is poised to accelerate earnings after three difficult years of merger integration between Zimmer and Biomet. The new CEO Bryan Hanson has the ability to unlock material value from ZBH. We look at peer Stryker (SYK), which trades at a full 9-10x P/E turns (6x on EBITDA) above ZBH, as an example of that value. Over the next 12 months, we believe the stock could break out of its 3 year trading range if the new CEO can address the following issues: 1) Supply Chain issues are fixed. 2). FDA observations/concerns in Warsaw manufacturing facility are adequately addressed. 3). Product launches meet timelines and ramp. Many have launched and are market testing. 4). Margins rebound back to prior levels and could trend higher on scale post-merger.
Key Metrics to Watch:
Revenue growth in-line or better than cons...driving a return to market growth
Margin expansion in-line or better than cons
Pipeline Development on track:
Persona Partial knee (launched, in market testing)
Persona Revision knee (launches 2H18)
Cementless knee (launched, in market testing)
Rosa Robotics platform launches 2H18 or early 2019
Supply Chain resolutions/recovery for 2H18 on track
Quality remediation: FDA lifts observations from Warsaw facility
M&A/Portfolio Mgt: New CEO does portfolio management to drive faster growth
ZBH Detailed Investment Thesis: We believe that Zimmer-Biomet is poised to accelerate earnings after three difficult years of merger integration between Zimmer and Biomet. We think the new CEO Bryan Hanson has the ability to unlock material value from ZBH. We look at peer Stryker (SYK), which trades at a full 9-10x P/E turns (6x on EBITDA) above ZBH, as an example of that value. ZBH generates solid FCF and holds market leading positions across key orthopedic markets with favorable demographic tailwinds. The stock continues to trade at a significant 7x '18E P/E discount to large-cap MedTech peers reflecting the ongoing operational issues.
Over the next 12 months, we believe the stock could break out of its 3 year trading range if the new CEO can address the following issues: 1) Supply Chain issues are fixed resulting in normalized supply levels. 2). FDA observations/concerns in Warsaw manufacturing facility are adequately addressed. 3). Product launches meet timelines and ramp. We will be looking for updates on the Persona knee, Cementless knee, and Rosa Robotics platform launches. These are key products that close the gap to competitors, especially SYK. 4). Margins rebound back to prior levels and could trend higher on scale post merger.
New CEO Meeting: In 4Q17 ZBH appointed Bryan Hanson as President and CEO, who was a protégé under BAX's Joe Alimeda when both were at Covidien. We know Hanson from his prior strong track records at Medtronic and Covidien. ZBH also appointed a new head of investor relations, Coleman Lannum, who is also well regarded by investors and analysts. We recently met new CEO Hanson. He is acutely focused on the ZBH turnaround, both the supply chain remediation and FDA issues at the Warsaw facility. Both issues were more complex than expected, resulting in a longer turn-around by late 2019. He re-affirmed his conviction in getting supply back on the market in 2H18. He also remained committed to many product launch timelines in 2H18 that should help close the gap to competition in the ortho market. He hopes for mid-single digit revenue growth by 2H19, continued debt pay down to below 3x, and then active portfolio management through bolt-on M&A to accelerate revenue growth. These will drive margin expansion in 2H19 as well.
Operating Margin expansion from Better Scale/Leverage: Pre-merger, operating margins at Biomet were in the 26-27% range, which compares to Zimmer in the 31% range. We see substantial opportunity for ZMH to increase Biomet margins over the next few years. We see margins bottoming in 2018 and then improving through 2022.
Pre-Tax Margin Expansion from Debt Paydown: Biomet's pre-tax margins were in the 20% range, much lower than ZMH's pre-tax margins in the 30% range. We believe Biomet's debt load was a drag on margins due to higher interest expense from leverage associated with the private equity ownership and capital structure. We see pre-tax margins benefiting from debt pay-down. ZBH is on track to get debt to 3x by the end of 2018 and 2.5x by 2019. This would allow for portfolio management through bolt-on acquisitions into faster growth adjacencies. We model trough EBT margins in 2018 and improvement to 29-30% by 2022 or earlier.