• Medical devices seem like a great business, but Zimmer management has done a poor job of creating value for its owners for years.

Selling artificial knees and hips – Zimmer Biomet’s strongest product lines – should be a great business. Demographic tailwinds, network effects, and high barriers for new competitive entrants should mean the kind of business that an intelligent investor would want to own. However, Zimmer’s profit growth has lagged nominal GDP for nearly every year in the past ten, and a lack of pricing power since 2009 has proved a headwind to Zimmer’s top-line.

The future of orthopedic devices may look different from the past, but judging by history, Zimmer’s business does not look very compelling.

  • Zimmer spent 20% more on its 2015 acquisition of Biomet than it had generated in total profits since its 2001 IPO.

One of the main trends in the industry is consolidation. Zimmer acquired Biomet as a way to break out of a close, competitive pack and now holds an overall market share that is a close second to Johnson & Johnson’s (JNJ) DePuy / Synthes unit (itself created through consolidation). The price Zimmer’s owners paid to play in this game was a high one, however.

The cash portion of the cash and stock Biomet transaction used up $7.8 billion – 84% of all the Owners’ Cash Profits (OCP) generated by the firm since its IPO – and the stock portion had a dilutive effect equal to more than six average years’ worth of profits since 2001. Profits have markedly dropped since the acquisition, and it is still too early to know where “normalized” profit levels will end up at the company. Politics may have as much to do with the answer to this question as commercial considerations.

  • The consolidating industry may improve Zimmer’s prospects, but considering the political uncertainties regarding public health policy, we think risks may be tilted to the downside.

Zimmer’s products were selling like hot cakes and had good pricing power before the Financial Crisis. Since that time, volumes have been generally weak and the firm has had to discount to retain its industry position. We think this may be due to the growing unwillingness of insurers or employers to approve the expensive procedures that are “elective” in many cases. Changes in public health policy – the repeal of the Affordable Care Act and potential drastic changes to Medicare – would likely harm Zimmer’s business materially. On the other hand, Zimmer’s strong position in a consolidating industry may allow it to operate in a cozy oligopoly if drastic changes in the payment environment do not occur.