Zimmer Biomet 2Q17 Earnings: Risks are to the Downside

Zimmer Biomet announced second quarter earnings Thursday morning and we took the opportunity to look through the 1H17 results and compare our projections from December of last year to the company’s actual results.

We have written several reports on Zimmer and one on a small cap company in the same industry, and also have a full Guided Tear Sheet covering Zimmer as well.

Revenues

The firm generated $3.9 billion during the first half of 2017, compared to $3.8 billion during the first half of last year – an increase of 2%. In addition, the firm provided upward guidance for full-year 2017 revenues of between $7.8 billion and $7.9 billion. In contrast, our model originally forecast a range of $7.9 billion to $8.2 billion; we have since brought down and tightened our forecast range to equal the firm’s guidance. The new forecast range implies revenue growth of between 1.5% and 2.5% during 2017.

The best- and worst-case forecasts in our original model (built before the release of 2016 actuals) were quite close to actual since we built our projections on three quarters of actual results.

From the firm’s guidance, we tightened our overall revenue growth assumptions, pulling down our worst-case average growth to 2% per year (from 3% in our last model) and our best-case average growth to 5% per year (from 7% in our last model). We believe this makes sense considering the large amount of consolidation in the industry and pricing pressure from government insurance schemes and competition.

Profits

Zimmer provides a complete Statement of Cash Flows, so it is possible to calculate 1H17 Owners’ Cash Profit (OCP) for the company as we usually do. According to our calculations, the company generated $174 million of profit and an OCP margin of a paltry 4%. Our original forecast for 2017 OCP was $1.0 billion in the worst-case and $1.4 billion in the best, but because of the variability of working capital accounts, we’re not particularly surprised or concerned about the shortfall.

Regarding our 2016 forecasts, again, our forecasts bounded the actual results, though actuals were closer to the best-case scenario.

Profits were at the high end of our range due to add-backs of non-cash charges that arose from the Biomet acquisition (“inventory step-up” for those of you interested in the accounting details). Even with this odd one-off, we were happy to see that profit fell between our forecasted range.

While looking through our original model, we realized that we were probably short shrifting Zimmer’s best-case OCP margin assumptions. Our original model had best-case OCP margins of 17%, which was the two highest five-year average OCP margin going back to 2009. However, before that, while the medical device market was booming, the profit margin averaged even higher – 19%. We have thus increased our best-case OCP margin estimates to 19%, to represent the return of a booming medical device demand environment (during which time the 5-year rolling growth rate maxed at 5%).

For 2017, our new OCP range is from $1.0 billion in the worst-case to $1.5 billion in the best.

Investments

 

No company provides enough disclosure in its earnings announcement to accurately calculate Framework’s measure of investment spending: Net Expansionary Cash Flow.

The information Zimmer gives us shows that the company has cut way back on its capital spending after the Biomet purchase. We think that a relatively low level of investment spending is likely for the next few years, followed by a return to a more normal level (before the Biomet purchase, Zimmer spent an average of around 17% of its OCP on investments). We are estimating two years’ worth of Net ECF to OCP of 5%, followed by three years of 10%. This level is lower than our previous projections because we realized that with the high degree of industry consolidation, there was probably little necessity for such high levels of capital spending in the future. If we are wrong about this and the company goes back to spending more, the valuation will skew lower.

Because 1H17 Net ECF is an “inflow” (i.e., our assumption for maintenance capex is higher than what the company is spending to buy new equipment), its Free Cash Flow to Owners (FCFO) margin is 11.5% – much higher than the 4.4% OCP margin.

We know that these flows will likely change over time, and think our the levels of FCFO forecast by our model are reasonable.

Average FCFO from the years 2006-2014 were $638 million. In our best-case scenario, we see the firm generating 133% more FCFO – $1.4 billion on average. In our worst-case scenario, we see the firm generating 49% more FCFO on average over the next five years than the historical time period mentioned above (which excludes the misleading 2015-2016 period).

Looking at long-term FCFO trends was instructive to me. Over the past 10 years, FCFO did not expand at all – on the contrary, it trended downward.

Seeing this, we decided that we would change our assumption for medium-term FCFO growth to 2% in the worst-case and 5% in the best.

Valuation

After making changes to our assumptions, our valuation range shifted a bit, but stayed roughly the same. At present, there is only a single valuation scenario above the current price, suggesting that risk is to the downside for investors in Zimmer Biomet. We are still not keen to invest in this company, but a speculative Out-of-the-Money put might be worth considering, especially for those who want bearish exposure to the US healthcare environment.