The sheer volume of big-name merger and acquisition activity, highlighted Thursday by rumours of a General Electric Co. bid for French energy and transportation giant Alstom SA, has attracted many investors' attentions away from the deal that interests me most, in the orthopedics sector.
Indiana-based Zimmer Holdings Inc. agreed Wednesday to acquire rival Biomet Inc. for $13.4-billion (U.S.). For investors, the deal highlights an industry where a number of powerful trends – notably demographics and the increasing prevalence of obesity – form an exceedingly bright outlook.
The growth story for orthopedics is focused on rising demand for hip and knee replacement surgery. The steadily-rising average age of developed world populations is expected to dramatically increase the incidence of osteoarthritis, the primary reason for joint replacement procedures.
The projections are startling. Dr. Steven M. Kurtz, Research Professor and director of the Implant Research Center at Drexel University's School of Biomedical Engineering, completed an exhaustive study that concluded:
"By 2030, the demand for primary total hip arthroplasties is estimated to grow by 174 per cent to 572,000. The demand for primary total knee arthroplasties is projected to grow by 673 per cent to 3.48 million procedures. Overall, total hip and total knee revisions are projected to grow by 137 per cent and 601 per cent, respectively."
There are relatively few companies poised to reap benefits from this trend: Johnson & Johnson, Zimmer Holdings, Stryker Corp. and Smith & Nephew Associated Cos. PLC.
Johnson & Johnson is the dominant player in the industry after acquiring Switzerland-based Synthes in 2012 for $20-billion. The company, however, is so large and diverse that orthopedic-related revenue forms less than 15 per cent of revenue. A great company, but JNJ may not be the best way to play the specific hip and knee replacement theme.
The valuation table indicates that Smith & Nephew, while recently cited as an eventual takeover candidate by Sanford C. Bernstein and Co analyst Lisa Bedell Clive, is struggling for profit growth. The company was forced to fund the replacement of almost 8,000 faulty hip devices beginning in 2012.
Stryker is the most attractively valued opportunity in the space based on forward earnings estimates. The company struggled through a loss in the past 12 months but analysts appear convinced of a turnaround.
Stryker's EBIT margin (earnings before interest and tax expenses divided by total sales – this is the most frequently used method of measuring profitability in this sector) is expected to double in the next year, to 23 per cent.
Zimmer has been the best performing company in recent quarters but, in the wake of its major acquisition this week, the short-term profit outlook for the company is difficult to discern.
The certainty of an aging population in the developed world means it's difficult to find a more dependable growth story than orthopedics. This doesn't mean there's no investment risk – regulation and new product cycles can affect short term results – but the backdrop of outsized future demand makes the sector an attractive option for long term investors.