With the announcement that Zimmer (ZMH) plans to acquire Biomet, the competitive dynamics in the orthopedic implant market have shifted. In general, we expect the reduction in competition should help the large, top-tier firms, including Johnson & Johnson (JNJ), Zimmer, and Stryker (SYK). However, this dynamic will make it even more challenging for smaller midtier companies, such as Smith & Nephew (SNN) and MicroPort, to hang onto their hospital customers. We see this shift as the industry’s countermove to health-care provider consolidation and hospital efforts to reduce the number of vendors in return for greater volume discounts.
Some things have not changed, including the sources of economic moats for orthopedic implant makers. These moats remain grounded primarily in very high switching costs for surgeons, and secondarily in intangibles, such as intellectual property and close relationships with orthopedic surgeons. Zimmer’s acquisition of Biomet removes one midtier competitor from the mix, and we think this consolidation ultimately moves the orthopedic industry one step closer to the rational oligopoly that characterizes the highly consolidated cardiac device industry, where three rivals virtually control the entire market.
The economic backdrop for hospitals–the main customers for orthopedic implant makers–also remains the same. Hospitals are under increasing pressure to contain costs and raise quality standards, just as health-care reform has shifted more of the financial risk onto these health-care providers. While hospitals are experimenting with various approaches to cost-containment, the many attempts to specifically rein in implant costs–including installing materials managers, value analysis teams, and formulary models–have mostly failed. So far, hospital consolidation of vendors to take advantage of more attractive volume pricing has been more successful than other approaches, and we anticipate more hospitals will move in this direction–shrinking their orthopedic vendor lists from six or seven companies to two or three, for example. In this game of musical chairs, the largest implant makers will have a distinct advantage over the smaller ones, as hospitals seek to satisfy the greatest number of surgeons possible and minimize the number who will lose access to their favored device systems.
Finally, we expect pricing to remain under pressure as payers continue whittling away at reimbursement for joint reconstruction procedures. We would not be surprised to see Medicare cut reimbursement further as demand is expected to rise thanks to the first baby boomers reaching the key age window for knee replacement. Historically, the orthopedic firms have consistently seen 100-200 basis points of price pressure annually on older products, and we have not seen any precipitous drop related to the Affordable Care Act. We continue to expect rising volume to more than offset this pricing pressure.
Zimmer Is the Winner
Zimmer is the primary beneficiary of the consolidation. The firm still has a wide Morningstar Economic Moat Rating, and the addition of Biomet (which we had also rated as wide moat before it was taken private in 2007) will only reinforce that. Even though switching costs for individual surgeons will not necessarily rise with the addition of Biomet, Zimmer’s switching costs will spread laterally to encompass more of the trained surgeon base. In other words, Zimmer has captured a greater share of industry switching costs by combining its pool of surgeons with Biomet’s. We estimate Zimmer will enjoy approximately 35%-37% global market share in large joint reconstruction with this deal, which is also a reasonable surrogate for its share of the trained surgeon pool.
Considering the overlap in products between the two companies, we anticipate antitrust regulators will probably require Zimmer to divest itself of some of its competing products. Potential divestitures remain the wild card for Zimmer. In Zimmer’s 2003 purchase of Centerpulse, divestitures for antitrust purposes were extremely minor. At the time, Zimmer was only the number-three competitor in orthopedics, trailing Stryker and DePuy, while Centerpulse was a midtier company at number seven. Moreover, the product and geographic overlap between the firms was relatively limited. This time, regulators might see Zimmer’s situation differently. Before the announcement, Zimmer was already the leader in large joint reconstruction implants, and adding Biomet will allow Zimmer to widen that gap significantly. We think the most likely areas for divestiture will involve hips and knees, where there are more overlapping products and Zimmer’s estimated market presence could make regulators more nervous. We suspect regulators will need to examine the overlap product by product, as there are often slight differences between implants. At this point, we do not anticipate drastic divestitures in large joints. We also do not expect divestitures to affect the smaller product lines–including dental, trauma, spine, and sports medicine–where the combined Zimmer/Biomet would remain a smaller competitor. At this point, we anticipate some modest divestiture will be required for the deal to go through, which would still leave Zimmer in a strong leadership position in the orthopedic market.
With Zimmer’s new heft and access to the largest pool of trained surgeons, virtually all hospitals will want to keep Zimmer/Biomet products on the shelf to keep a large swath of their surgeons happy. This more or less guarantees that Zimmer will remain on the vendor lists at the majority of hospitals and puts Zimmer in a stronger bargaining position than all other orthopedic implant competitors. Over time, as hospitals marginalize the smaller vendors and more surgeons choose to train on the systems from the top-tier competitors, Zimmer is likely to gain modest incremental market share, as should DePuy and Stryker. However, as with most trends in orthopedics, we think this will happen very slowly as surgeons trained on smaller systems retire or find that they can no longer access their preferred systems at their hospitals. The stickiness of surgeon preference remains very strong, and the process of cultivating more surgeons on Zimmer/Biomet systems will be slow.
Stryker and DePuy Getting Stronger Too
Further consolidation of the orthopedic industry also puts the remaining top-tier competitors–Stryker and DePuy–in a stronger position, as the chances of being left out of hospital contracts fall when the number of vendors declines. Before Zimmer’s announcement, many hospitals were likely to select some combination of two top-tier implant makers and one from the midtier to round out efforts to winnow down orthopedic vendors. It was very plausible for a hospital to contract with old Zimmer (with the largest pool of trained surgeons), DePuy (which offers a large pool of surgeons, along with the most extensive trauma portfolio thanks to the Synthes acquisition), and then Biomet to make a vocal minority of surgeons happy. Or, the combination of three could have easily been Stryker (and its broad portfolio of med-surgical equipment and neurovascular products), DePuy, and Smith & Nephew. No matter the combination, the point is that even the top-tier competitors faced the real possibility that they would be cut out of hospital contracts.
The probability of Stryker being left off the vendor lists has now fallen. We think hospitals will find the combination of Zimmer/Biomet, DePuy, and Stryker extremely attractive. This would allow a hospital to satisfy the majority of its orthopedic surgeons–roughly three fourths of them, by our estimates. This intense period of vendor consolidation has made conditions difficult for the entire orthopedic field, but we think the top-tier implant makers are the ones most likely to come through the process unscathed with wide moats intact. Over the longer term, we think simply staying on the vendor list at most hospitals will become a self-reinforcing moat mechanism. We anticipate a slow, gradual shift toward more hospital employment of orthopedic surgeons, compared with the majority who are in private practice today. These hospital-employee surgeons will want to adopt and become expert on implant systems that are widely used across different hospitals, which enhances their flexibility to leave for another hospital. As long as the top-tier firms, including Stryker, continue to sell implants to most hospitals, then more surgeons in training will choose to use those instrumentation systems, instead of specializing in Smith & Nephew’s systems, which will be available only in select hospitals.
Smith & Nephew Up for Sale?
As more hospitals seek to contract with the top-tier competitors, Smith & Nephew’s chances of securing more hospital customers have diminished. We expect the company will evolve gradually into a niche, peripheral brand among surgeons as fewer and fewer hospitals buy its products. The best chance for Smith & Nephew to survive this period of vendor consolidation is to pair up with another orthopedic implant maker, and we would not be surprised if the firm cobbled together a deal in the foreseeable future. We long thought a merger with Biomet would vault the two midtier companies into the top tier, where they could compete seriously with DePuy, Zimmer, and Stryker. In addition, considering the size of Smith & Nephew and Biomet, antitrust regulators would be unlikely to force divestitures.
With Biomet out of the picture, we now think Stryker may be the most likely partner for Smith & Nephew. Smith & Nephew’s orthopedic portfolio, which is geared toward meeting the needs of younger, more active patients, would complement Stryker’s hip and knee implants. The combination would also provide Stryker with a solid presence in the fast-growing sports medicine market, and Smith & Nephew’s sizable wound-care business could be folded into Stryker’s med-surgical portfolio. Importantly, Smith & Nephew’s footprint in emerging markets could be very attractive to Stryker, as the firm has been focused on strengthening its business in those geographic areas (and its infrastructure in India would nicely complement Stryker’s recent purchase of Trauson in China). As with the Zimmer/Biomet deal, some divestitures would probably be necessary to alleviate antitrust concerns. Stryker management has expressed interest in Smith & Nephew, but the U.K. Takeover Panel, under British rules, forced Stryker to declare its intentions last month, and Stryker backed off. This means any deal is off-limits to Stryker for another five months, though we think Stryker may pursue a deal after that. We think J&J could also be another partner for Smith & Nephew. For many of the reasons Stryker would find Smith & Nephew an attractive takeover target, we also believe DePuy would be interested in purchasing the firm. Smith & Nephew’s orthopedic and sports medicine portfolios would be complementary, though we speculate J&J may be less interested in the wound-care business, since it sold off its own wound unit in 2008.
Despite Smith & Nephew management’s consistent commitment over the past several years to staying independent, we suspect the firm may be revisiting this issue following the Zimmer/Biomet news. This is actually the second time Zimmer has won a target that Smith & Nephew has bid for. In 2003, Smith & Nephew offered to buy Centerpulse, just before Zimmer swept in with a more generous offer. In 2006, Smith & Nephew bid for Biomet, but found itself outbid by the private equity consortium that took Biomet private. Based on these occasional attempts at combining with other firms, we think Smith & Nephew’s previous management team actively sought out opportunities to bolster its competitive position via acquisition. Historically, M&A has been the favored strategy for orthopedic implant makers to enlarge their trained surgeon pools, primarily because it is so difficult to entice enough individual surgeons switch implant and instrumentation systems. It is much easier to simply purchase the target company and get all its surgeons that way.
Compared with the top-tier competitors, Smith & Nephew has successfully closed far fewer deals. In early 2011, shortly before Olivier Bohuon became CEO, the firm was at the center of much acquisition attention. Both J&J and Biomet had approached Smith & Nephew about a potential purchase, and Stryker was rumored to have done so as well. We speculate the current Smith & Nephew management team seems to have thrown in the towel on strengthening its peripheral position in the developed markets and has set its sights firmly on trying to win in the emerging markets where there are not as many orthopedic surgeons entrenched with competitive systems. With the competitive field consolidating, we think Smith & Nephew’s best opportunity to remain competitive in the developed markets will be to sell itself to a larger rival.
Based on bids for Smith & Nephew in 2011 as well as Biomet’s most recent transactions, we think Smith & Nephew could secure a price of 3-5 times sales. This would put the price range at $15.6 billion-$22.3 billion. However, in light of Zimmer’s purchase of Biomet and the increasing likelihood that Smith & Nephew will become marginalized by hospitals, we surmise Smith & Nephew may need to settle for the lower end of this price range. Although it has an attractive product portfolio and formidable innovation abilities, the challenge of finding customers is rising. The firm is running out of strategic options, in our opinion. It will be a matter of when, not if, Smith & Nephew pairs up with a larger rival. Considering that the shares are currently trading 45% above our intrinsic value of $61, we think the market has already priced in an acquisition premium, anticipating that a deal will emerge.
Orthopedic Evolution Toward Another Source of Moat
Ongoing consolidation leaves the orthopedic implant market looking more like the cardiac device market, where three major competitors control an estimated 90% of the market. We think this is a favorable shift from an investment viewpoint. With switching costs lower in cardiac rhythm management devices, the three CRM makers–Medtronic, St. Jude Medical, and Boston Scientific–derive much of their moatiness from efficient scale and operate in a rational oligopoly. In this situation, the finite market is well served by the existing competitors. We think the orthopedic industry is moving in this direction.
If Smith & Nephew is acquired by a top-tier rival, that would leave close to 90% of the orthopedic implant market controlled by three major competitors, which we think would only enhance the wide moats in the orthopedic business. Without the threat of serious new entrants, we are reassured that the three remaining major competitors are likely to stick with disciplined pricing practices. If any small new entrants were to arrive with potentially disruptive technology, it would be very easy for the established top-tier rivals to purchase the upstarts. Conversely, it would become that much more difficult for new firms with meaningful technology to gain traction with hospitals and eventually dig an economic moat. For these emerging firms, we expect acquisition by the large companies will become the preferred exit strategy. This paves the way for Zimmer, Stryker, and DePuy to strengthen their wide moats as they add to their intellectual property over time.
We thinks the risk that hospitals may consolidate all orthopedic purchases with one vendor applies to only a minority of hospitals. Most are likely to contract with two or three vendors because that is one way for health-care providers to spread their clinical risk. Medical device recalls or product failures crop up on a regular basis, and hospitals try to avoid putting all their eggs in one vendor’s basket. The recent recall of DePuy metal-on-metal hips underscores what could happen if a hospital is unlucky in picking the one vendor with a product recall. We expect hospitals will generally want to contract with several vendors–enough to take advantage of the better pricing that higher volume brings, and also to diversify exposure to potential recalls.