Orthopedic Report

Important Disclosures and Disclaimers can be Viewed at http://www.ssrp.com and on Page 67 of This Report.

Medical Technology — Orthopedics 2011 of 69 ©2011 Summer Street Research Partners. All rights reserved. Any unauthorized use, circulation or disclosure is strictly prohibited.

Medical Technology — Initiation of Coverage

Orthopedics 2011 January 19, 2011 Mark Landy 617-532-6428 [email protected]

Outlook

The orthopedic industry faces numerous hurdles, but they are well documented and current expectations are low. A hint that things are not as bad as believed could see orthopedic stocks trade higher. Data suggests that the current economic malaise is passing and 2011/12 orthopedic volume growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Putting industry fundamentals aside and looking at current valuations and expectations, a compelling case can be made against not owning orthopedic stocks in the first half of 2011. As current orthopedic expectations are low and a valuation floor may well be in place to support current price levels, the risk/reward to buying orthopedic stocks seems favorable given the current low expectations, lack of investor interest, and possible positive reaction to the slightest hint of good news. Historically, when expectations are low glimmers of hope lead to increased earnings expectations and short-term stock price appreciation. For this reason we recommend exposure to orthopedic stocks in early 2011.

Companies Cited

• Arthrex (Private)

• ArthroCare (ARTC-$27.85-NR)

• CONMED Corporation (CNMD-$26.05-BUY)

• Biomet, Inc. (Private)

• Exactech (EXAC-$17.80-BUY)

• Johnson & Johnson (JNJ-$62.10-NR)

• Orthofix (OFIX-$31.42-NR)

• Smith & Nephew (SNN-$56.83-BUY)

• Stryker (SYK-$58.39-BUY)

• Synthes (NR)

• Wright Medical Technology (WMGI-$16.78-NEUTRAL)

• Zimmer (ZMH-$56.16-BUY)

Highlights

• We are initiating coverage on the orthopedic industry with BUY ratings for CONMED (CNMD), Exactech (EXAC), Smith & Nephew (SNN), Stryker (SYK), and Zimmer (ZMH), and a NEUTRAL rating for Wright Medical (WMGI).

• 2011 could present trading opportunities in orthopedics. We recognize the significant and numerous hurdles the industry faces, but point out that they are well documented and current expectations are low. A hint that things are not as bad as believed could see orthopedic stocks trade higher. We like CNMD, EXAC, SNN, SYK, and ZMH.

• 2011 procedure growth could surprise. Data suggests the current economic malaise is passing, and 2011/12 volume growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. The first hint of increases in volume will drive orthopedic expectations and stock prices higher.

• Has historical mix benefit been underestimated? Recent trends seem to suggest that mix was a larger driver of last decade’s growth than thought, implying 1) volume growth has been overestimated and 2) pricing may perhaps be more stable that currently believed.

• Reimbursement mix shifts back to Medicare. The baby boomer generation begins to turn 65 in 2011, and we believe the bolus of Medicare patients that will begin to move through the system will be sufficiently large to start to skew payer mix back toward lower-paying Medicare.

• What about pricing, mix, the DOJ, the economy, the FDA, et al? Looking through 2012, the macro environment for orthopedic stocks remains difficult. It is our opinion that 1) not all companies are equally exposed and 2) the negative impact of possible regulatory changes and declining prices is not fully reflected in consensus forecasts. In our models in H2:11 we begin increasing R&D spending and lowering gross margin to reflect our position. We see sufficient wiggle room on the P&L statements of SNN, SYK, and ZMH to maintain 2011 and 2012 operating margins at current levels, despite industry headwinds.

• Looking ahead, a changing business environment could drive share shifts. In an era of higher volumes and lower prices, the industry will need to become leaner and more efficient. Changes must be made to the current distribution model and steps need to be taken to embrace a system rewarding efficiency and scale over profit per procedure. Opportunities may again present themselves for volume discounts, and those willing to risk price for volume could take share. We argue sufficient changes have occurred over the past 10 years and hospitals many now be empowered to enforce volume contracts, as they were not in the late 1990s.

• Valuation. Our DCF price targets for CNMD, EXAC, SNN, SYK, and ZMH are $43, $24, $72, $71, and $89, respectively.

January 19, 2011


INDUSTRY OVERVIEW

DISCUSSION The increasing global obesity rate and the aging populations in developed nations are only now hitting their stride as forceful drivers of orthopedic demand. Coupled with ongoing difficulties in finding solutions to regenerate cartilage and developing drug and biologic treatments to cure osteoarthritis, the profound impact these two headline demographic trends could have on global orthopedic demand over the next decade may well be underestimated. The flipside to exploding demand is the anticipated financial burden that musculoskeletal disease will begin to place on the global healthcare system. Current estimates of the future financial burden of musculoskeletal disease vary significantly and may well be overestimated for dramatic effect, but the fact that the current orthopedic business model will have to change to adapt to an era of increased volume, rising costs, and lower prices is unquestionable. We view access and reimbursement as the two levers available to payers to combat this growing financial exposure with reimbursement being the easier lever to pull. Over the next decade the orthopedic market will have to recalibrate profit expectations and will begin to embrace a system that rewards efficiency and scale over maximizing profit per procedure. Looking out over the next 12-18 months, we see continued chaos and confusion as investors weigh the impact of healthcare reform, regulatory reform, declining reimbursement, and increased government scrutiny on future procedure growth, pricing, and earnings. In light of the continuing well documented headwinds the industry is facing and the concurrent, almost certain potential for further declines in price and mix, 2011 expectations for orthopedics are muted with most investors choosing to stay away from the group and put their money elsewhere. Likewise, we see no compelling fundamental reason to buy or hold orthopedic stocks and find it difficult to forecast an orthopedic environment conducive to sustained margin expansion. We hold this view primarily for two reasons. First, we believe the industry’s cost exposure to healthcare reform and regulatory reform is underestimated, and second, we anticipate a reversal in the reimbursement mix shift back toward Medicare and a lower-than-expected blended reimbursement rate. These two issues will play out in the longer term, but their impact could gain increasing focus in 2011 as the leading edge of the baby boomer generation turns 65 and healthcare reform again becomes a major political issue when government returns in 2011. Republicans will certainly try to undo much of what the Democrats voted in, and they may be successful, but it is becoming increasingly difficult to ignore a US healthcare exposure that is now 17% of GDP and growing, and of which orthopedics is expected to be a large component. Putting industry fundamentals aside and looking at current valuations and expectations, a compelling case can be made for owning orthopedic stocks in the first half of 2011. Current orthopedic expectations are low and a valuation floor may well be in place to support current price levels. As such, the risk/reward to buying orthopedic stocks looks favorable, given the current low expectations, lack of investor interest, and possible positive reaction to the slightest hint of good news. Historically, when expectations are low, glimmers of hope lead to increased earnings expectations and short-term stock price appreciation. Despite orthopedic expectations being at a low following the surprise declines in volume in the second half of 2010, plus the corresponding earnings cuts, downgrades, and recent numerous neutral initiations, we do see the opportunity for improved sentiment and corresponding trading opportunities. We base this thesis on increasing signs that 2011 should see accelerating improvements in the global economy and continued growth in US employment. Signs of improving employment could increase volume and revenue expectations as organic procedure growth is augmented by patients returning to their orthopedic surgeons for treatments that were delayed during the economic downturn.

January 19, 2011


INVESTMENT THESIS We are initiating coverage of the orthopedic sector with BUY ratings for CONMED (CNMD), Exactech (EXAC), Smith & Nephew (SNN), Stryker (SYK), and Zimmer (ZMH), and a NEUTRAL rating for Wright Medical Group (WMGI). While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and the current expectation for earnings and orthopedic stock performance in 2011 and 2012 is low. With low expectations for performance, it can be argued that a valuation floor may well be in place to support current price levels and that the risk/reward to owning certain orthopedic stocks in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in procedure volume. In 2011 SYK and ZMH stand to benefit most from an upward revision in volume expectations. These companies also have the opportunity to take hip market share as Johnson & Johnson (JNJ-$62.10-NR), SNN, Biomet (Private), and WMGI battle a growing negative sentiment toward metal-on-metal articulation surface safety, and questions surround the safety and efficacy of hip resurfacing. At16x and 15x our 2011 and 2012 earnings forecasts, SNN stock is not as cheap as ZMH and SYK, and the company carries greater exposure to metal-on-metal and hip resurfacing than SYK and ZMH. That said, SNN has a strong and differentiated product pipeline in both hips and knees, and as one of the major orthopedic players its share price will benefit from increasing orthopedic sentiment and trade higher. CNMD, like SYK and SNN, is well positioned to benefit from the expected upgrades in efficiency operating room capacity that hospitals will have to make as they get ready to handle the increase in orthopedic procedure volume expected over the next two decades. Granted, the company is exposed to economic downtrends and reductions in hospital spending and patient volume, but it is less exposed to overall cost concerns and regulatory reform as the businesses it is in are smaller contributors to the overall financial orthopedic burden and will most likely fall into the proposed lower-regulated 510k bucket. EXAC and WMGI are building a nifty pipeline in orthopedics’ fastest growing segment — extremities. We estimate the 2010 extremities market approached $500MM with a five-year forward CAGR exceeding 10%. Extremities in 2011 will be the second-largest business units for EXAC and WMGI. We like the larger exposure both companies have to extremities and see extremities as one of the key drivers of future orthopedic earnings growth. For this reason we rate shares of EXAC BUY. However, WMGI in 2011 and 2012 carries a larger exposure to possible increases in regulatory costs, and is overexposed to metal-on-metal safety concerns and hip resurfacing issues. The company may see greater pushback on hip pricing given the high concentration of niche premium priced products in its hip portfolio. WMGI’s current valuation and the challenges it could face in 2011 and 2012 lead us to a more cautious stance and a NEUTRAL rating.

January 19, 2011


INVESTMENT THESIS RISKS The headline risk to our investment thesis for CNMD, EXAC, SNN, SYK, and ZMH in 2011 is continued economic malaise and increasing unemployment. Our BUY ratings are based on the expectation that improving volume trends in 2011 will be sufficient to temporarily offset concerns for continued declining reimbursement rates and increasing regulatory and approval costs. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks will underperform the broader markets, including CNMD, EXAC, SNN, SYK, and ZMH. The obvious risks to our NEUTRAL rating on WMGI are 1) a “rising tide floats all boats” and WMGI is able to produce financial results ahead of expectations driven by higher-than-anticipated overall demand and market growth, and 2) WMGI management is able to offset share losses in hips by switching surgeons to non metal-on-metal hip offerings in their product portfolios. Acquisition premium in SNN shares from recent speculation that the company is being bought is an investment risk that must be considered. If SNN is not bought, dissipation of the acquisition could lead to temporary underperformance. VALUATION From mid-1990 to 2005, the orthopedic sector benefited from a favorable macro environment, and in 2005 it traded at a 75% premium to the S&P 500, up from a 46% premium in 2003. Forward earnings multiples for the group peaked around 2005, when the group as a whole is traded at 30x 2006 estimated EPS over two times its forward earnings growth rate. From 2005 to 2010 valuations contracted, driven by government investigations into selling practices, declines in reimbursement, product failures, the near collapse of the US, and global economy and healthcare reform. The average and weighted average premium the group once enjoyed over the S&P 500 has shrunk to 17% and 5% respectively, and forward earnings multiples have contracted to the low to mid-teens from high twenties and low thirties. Price-to-growth multiples now average 1.4-1.5 times forward earnings growth rates down from 2 to 2.5 times seen in the go-go years of the mid 2000’s.

Figure 1: Orthopedic Valuation Table

January 19, 2011


ORTHOPEDIC MARKET OVERVIEW 2010 In 2010, orthopedic industry performance was a tale of two halves: outperformance in the first half and underperformance in the second half. Driven by increasing optimism in 2009 for an economic recovery in 2010, the first half of 2010 saw a pickup in procedure volume, stabilizing prices, and rebounding hospital spending. Reported results from Q4:09 and Q1:10 suggested an increase in demand for orthopedic products and hospital equipment. Expectations that the global economy would continue to strengthen through 2010 and the demand for orthopedic products and hospital equipment to continue to improve led orthopedic stocks to outperform the S&P 500. The expected improvements in the global economy did not materialize in the second half of 2010, and healthcare utilization and surgical volume slowed significantly. The exact reason continues to stymie investors and remains a mystery. Some speculate the contraction in volume can perhaps be linked to 1) European economic woes and corresponding decline in the US stock markets, forcing patients to again reign in spending, 2) the continued impact of lingering unemployment and inability of patients to meet both healthcare and living expenses, and 3) the passing of healthcare reform. The summer downturn in orthopedic volume took many industry executives and investors by surprise. Orthopedic stocks fell more than the S&P 500 in the summer selloff and lagged the fall recovery. In December, orthopedic stocks beat the S&P 500 as US employment showed signs of picking up. We estimate the worldwide orthopedic market in 2010 was approximately $38B, up 2% over the prior year. For the year, we calculate that hips grew 3% to $5.6B and knees grew 3% to $6.8B. Spine growth in 2010 at 2% was significantly below historical growth rates, and exiting the year showed no signs of rebounding. We calculate spine sales in 2010 were just over $7B, including stimulation and biologics. Trauma sales at $5.8B increased 7% in 2010 compared to 2009. We forecast equipment, endoscopy, and patient handling sales increased 4%to $7.7B and dental grew 3% to $3.0B. ORTHOPEDIC MARKET OUTLOOK FOR 2011 and 2012 Our outlook for 2011 and 2012 sees higher-than-expected volume growth offset by a continued decline in pricing and increases in R&D spending. Programs aimed at lowering distribution costs could begin to kick in as the industry begins to face an environment of higher volumes and reduced pricing driven by the baby boomer generation beginning to turn 65 and the corresponding reversal in the reimbursement trend back toward lower paying Medicare. For 2011 we forecast a 4% growth in hips and a 5% growth in knees, with pricing/mix down 1%. We anticipate spine growth to continue to be weak in the face of increasing government scrutiny into selling practices and new research continuing to show a lack of scientific evidence to support efficacy. We expect spine sales growth of 5% in 2011. In 2011 we look for trauma to grow 8% from 2010 levels, and equipment, endoscopy, and patient handling to pick up 200 basis points of growth over 2010. Hip market share shifts are possible in 2011 as JNJ, SNN, WMGI, and Biomet deal with increasing safety concerns surrounding ions released by metal-on-metal articulating surfaces and the safety and efficacy of hip resurfacing is questioned. While SNN and Biomet have deep enough product portfolios to maintain their physician base, WMGI may not, and JNJ faces a confidence and trust issue that could force some customers to jump ship. JNJ’s issue stems from the higher-than-expected failure rate of its hip resurfacing product and the alleged questionable manner in which the company brought this product to market. Ironically, SYK and ZMH stand to be the share gainers given their relative lack of exposure to metal-on-metal and hip resurfacing. Whether or not these share gains are sticky, both SYK and ZMH should see stabilization and possibly rebounds in their hip shares as the market reverts back to traditional tried and tested articulating surfaces. We see SYK and ZMH picking up a combined 2% market share in hip reconstruction in 2011 and 2012.

January 19, 2011


Figure 2: Global Orthopedic Market — 2009–2012E

Source: SSRP Research and company reports

January 19, 2011


INDUSTRY OVERVIEW The increasing global obesity rate and the aging populations in developed nations are only now hitting their stride as forceful drivers of orthopedic demand. Coupled with ongoing difficulties in finding solutions to regenerate cartilage and developing drug and biologic treatments to cure osteoarthritis, the profound impact these two headline demographic trends could have on global orthopedic demand over the next decade may well be underestimated. The flipside to the expected explosion in demand is the looming financial burden that musculoskeletal disease will place on the global healthcare system. As the developed nation’s population continues to age, the financial burden of musculoskeletal disease begins to shift toward the government — especially in the US where Medicare kicks in at age 65. The resulting reimbursement mix shift may well result in a reduction in the average reimbursement rate for orthopedic surgery, as government reimbursement is normally lower than that of the private health insurers. Increasing demand and lower reimbursement rates will force healthcare providers to become more and more efficient. They will continue to seek out ways to reduce the cost of delivering care and increase throughput as they face a steady climb in the number of patients they must treat. Providers, in turn, will look to industry to appropriately adjust their business models to better address the challenges they face. Discounts for volume contracts in orthopedics could be put on the table once again. In an era of lower reimbursement rates and corresponding declining prices, industry will need to streamline its business process and most likely readjust its distribution model so that its costs are more in line with prices paid. The cost of the current distribution model, which relies heavily on a sales representative/surgeon relationship, will have to be reduced or replaced by a more efficient, lower cost, real-time inventory management system. This will be difficult and disruptive as orthopedic surgeons have a strong sense of entitlement and take for granted the relationships they currently enjoy with their sales reps, in addition to the value provided by the sales rep and the benefits derived. In response to tightening reimbursement in the mid-1990s, many orthopedic companies agreed to offer discounts for volume programs. Orthopedic stocks were volatile, but investors ultimately took these contracts in stride as they hypothesized that the opportunity cost of losing an orthopedic surgeon to a competitor and the strength of the sales rep/surgeon relationship would maintain the status quo. Indeed, the hospitals were not able to drive the required volumes to achieve the agreed upon discounts. Hospitals blamed physician reluctance to use products from companies they did not support as the primary reason for not being able to deliver the required volumes. This was not surprising, as at that time many orthopedic surgeons were mostly self employed, plus orthopedic surgery and allied services were a strong source of hospital profits and hospitals did not want to rock the boat for fear of losing the surgeon to a competing hospital. Compared to the mid-1990s, many more of today’s physicians (including orthopedic surgeons) are employees of hospitals and hospital groups. As employees, their ability to push back and refuse products the hospital requires is greatly reduced. This opens the door to volume discounts and alternative distribution models. Further, as the surgeon is no longer the empowered decision maker and gate keeper, the requirement for industry to continue to pander to their needs and retain their loyalty is greatly reduced. The opportunity to downgrade the sales rep/surgeon relationship exists, and industry market share may well be up for grab to those companies who are willing to once again work with the providers on a price for volume basis. Our last observation regards mix shift as a driver of average selling prices and growth in the last decade. We believe the impact of mix shift to higher priced products driven by increasing number of surgeries in the younger population in the last decade was underestimated. The upshot going forward is that 1) pricing of mid- to lower-range product probably was and may be more stable than currently believed, and 2) the impact of volume growth was underestimated.

January 19, 2011


DEMOGRAPHICS AND OTHER AGE-RELATED TRENDS Non-surgical treatments for osteoarthritis remain elusive

Skeletal deterioration is fundamentally driven by the simple anatomical reality of joints wearing out and the increasing fragility of skeletal structures with age. Joint replacement surgery is and will remain for the next decade, at least, the only definitive therapy for the complete restoration of function and elimination of pain. Total joint surgery represents a tolerable procedure with a six-week recovery period and a 98% success rate. Total joint surgery is the most successful medical procedure performed today. Therapeutics agents are capable of managing the pain associated with deteriorating joints, but they do little to stop the progression of the osteoarthritis toward total joint destruction. Biologics, too, have had limited success in retarding joint degeneration over the long term, and the holy grail of regenerating cartilage to replace that which is lost over time remains elusive. Stem cell therapy has shown glimpses of promise, but harnessing their theoretical value remains an enigma that challenges researches. Other treatments (like hyaluronic acid injections into the joint cavity), while effective in the short term; do not halt the progression to an implant. For the foreseeable future, joint reconstructive surgery will remain the gold standard for patients whose joints are destroyed by osteoarthritis. While medication may be effective in the short term at controlling pain and restoring motion, all they do is delay the ultimate progression to surgery. The population continues to age and the baby boomers turn 65 The past 20 years have seen the orthopedic industry benefiting from demographics trends at both ends of the age spectrum — the very old and the aging. Market growth has been favorably influenced by the growth in revision procedures, as older patients outlive the useful life of their implants and have them replaced, and an increasing number of younger patients seek a cure earlier in the disease process. The demographic trends in Japan, Europe, and most other western economies are essentially the same (if not more favorable) than those in the US. Japan has the most rapidly aging population in the world, and in Europe the percentage of the population over age 65 is increasing in every country. Today, 14% of Europeans are over age 65 and the percentage is expected to increase 500 basis points over the next 20-30 years, placing another 40 million individuals in the 65-and-over age bracket. When World War II came to an end and soldiers returned home, an enormous number of babies were born. This population explosion, coined the baby boom by sociologists, lasted from 1946 to 1964. In the first year of the baby boom, there were 3.4 million recorded births, peaking in 1957 with 4.3 million recorded births. The number of births in 1957 is still the record year in the US. The baby boom ended in 1964 with 4.0 million recorded births. Of the total population of baby boomers, 51% are women. In 1964 baby boomers represented 40% of the US population. Today they make up 28%. In 2011 the baby boomer generation begins to turn 65 years old. This is a noteworthy occurrence, as the leading edge of the developed world’s most explosive population era reaches the average age of Medicare, marking an acceleration in the US government’s healthcare burden and ushering in a era of increasing volume and lower reimbursement. At age 65, the baby boomer generation reaches the “reconstruction age” Different diseases strike at certain ages. Cardiac disease typically occurs in the fourth and fifth decades of life, osteoarthritis in the six and seventh decades, and neurological degradation in the eighth and ninth decades. A US census birth rate chart and corresponding age chart (Figure 3) detailing the progression of the baby boomer generation through different disease states provides insight into how baby boomer healthcare needs change with age. Additionally, it suggests the positive impact on demand the baby boomers’ entry into a disease state may have. This analysis also highlights the corresponding decline in demand their departure may cause.

January 19, 2011


Figure 3. US Birth Rate Chart and Percentage of Population Over 65 in 1980, 2000, 2020

Source: U.S. Census Bureau

Looking at cardiology as an example, baby boomers entered their cardiac decades in 1986 and exited in 2006. Interestingly, this period corresponds to the beginning and end of the growth period for cardiac-focused medical device companies. Osteoarthritis and corresponding reconstructive surgery demand is traditionally a disease of the sixth and seventh decades. As noted by the American Academy of Orthopedic Surgery, the current average age for both hip and knee replacement surgery has been steadily declining over the years and is approaching 65. Extrapolating the cardiac experience to orthopedics, our charts show us to be entering an era marking the biggest growth in orthopedic demand and the beginning of a bolus of patients who will require orthopedic treatment covered by lower paying Medicare. Further extrapolation of US birth rate history offers greater anecdotal insights of the impact population growth and aging could have on healthcare utilization and orthopedics. The US birth rate picked up in 1939 as employment picked up after the great depression. This birth rate spike ended in 1942 when the US engaged in WWII and picked up again in 1946 when WWII ended, soldiers returned home, and the US economy prospered. Those born in 1939-1942 turned 65 and entered their musculoskeletal disease age in 2004 through 2007, and the birth rate lull attributable to WWI lasted from 1943-1945 with these folks reaching 65 from 2008 to 2010. The range from 1939-1945 represents the first meaningful boom and decline in US birth rate and corresponds exactly to the peak period in orthopedic growth from 2004-2007 and corresponding volume declines in 2008-2010. In 2011 the baby boomer generation turns 65, marking the beginning of the second and arguably the most impactful US birth rate spike on record. We expect the baby boomers to significantly impact orthopedic volume over the next decade.

January 19, 2011


Figure 4. Decreasing US Unemployment From 1939-1942 Drove a Birth Rate Spike From 1940-1943

Source: U.S. Census Bureau, Peace01234, SSRP

In 2011 orthopedic reimbursement mix begins to shift back to Medicare Over the past decade and a half, the average age of hip and knee recipients steadily declined toward 65, driven by patients in their early fifties looking to remain active by seeking a cure earlier on in the disease process. The impact on this trend was twofold. First, these patients were covered by private health insurance that paid significantly more for the procedure, and second, these patients required longer lasting premium product. The higher reimbursement rate and corresponding boost to hospital profits drove an increase in volume and a positive mix shift. While we continue to expect younger patients to seek surgery at an increasing rate, as the baby boomer generation begins to turn 65 in 2011, the bolus of Medicare patients that will begin to move through the system will be sufficiently large to start to skew the payer mix back toward lower paying Medicare. As the average reimbursement rate drops, one should expect a negative mix shift as hospital profits will no longer support the expanding use of premium product and everyday product at the current prices, and a larger portion of patients will get a mid-range product. One possible take away from the 2010 volume decline is the importance of private pay to orthopedics and how product mix may have skewed historical pricing assumptions and margin expansion. If this is indeed the case, orthopedic gross margins will be challenged in the years ahead as mix shifts back toward lower margin product that Medicare reimbursement rates and corresponding hospital profits can adequately cover. Beginning in 2012 we have begun to reduce gross margins slightly across the board to account for lower pricing and higher volume , as increases in manufacturing efficiency and reduction in COGS typically lag and declines in price can, in some cases, be instantaneous.

January 19, 2011


Figure 5. Analysis of the Baby Boomer Generation — Age and Corresponding Disease States

Source: SSRP estimates

US HEALTHCARE SPENDING HAS TO BE REIGNED IN

US healthcare spending dwarfs that in other developed countries and it may not be justified It is accepted that healthcare spending in the US is almost the same as that spent in all other developed countries combined. A metric commonly used when estimating the size of medical technology markets outside of the US is to double the US spending. Spending more on healthcare is not necessarily bad, but if the common expectation and assumption that the increased spending leads to better care, better outcomes, or improved quality of life is not fact, then the premium spent has to be questioned. A September 2009 written statement to the Senate Special Committee on Aging by Mark Pearson, head of the health division for the Organisation for Economic Co-operation and Development (OECD) points out that per capita healthcare spending in the US at $7,290 is two and a half times that of the OECD average of just under $3,000. At $4,763, Norway is the country with the next highest per capita healthcare spending. When this per capita spending is translated into using purchasing power parity, the US per capita spent is still far higher than other OECD countries. In his statement, Pearson notes that overall, health outcomes in the US are below average, but the US stands out as performing very well in the area of cancer care, achieving higher rates of screening and survival from different types of cancer than most other OECD countries. At the same time, many other countries, such as the United Kingdom and Canada, are doing much better than the US in providing good primary care to their populations, thereby reducing the need for costly hospital care for chronic conditions such as asthma or complications from diabetes, which should normally be managed outside hospitals. According to Mr. Pearson, the exact reason for US healthcare overspending is difficult to pinpoint, but it is likely due to a combination of significantly higher outpatient spending and the higher cost of health goods and services. He remarks, “It is notable that where there are payment structures that encourage cost-consciousness, the United States has a very efficient system: there are fewer physicians and hospital beds, and average length of stay in hospital is low. This is a sign that the structure of the health system determines expenditures.”

January 19, 2011


Figure 6. Healthcare Spending as Percentage of GDP (2006)

Source: OECD 2006 data

US healthcare burden is reaching unsustainable levels

The Office of the Actuary (OACT) of the Centers for Medicare and Medicaid Services, which publishes data on US healthcare spending, calculated that in 2007 the US spent $2.26 trillion on healthcare, or $7,439 per person, up from $2.1 trillion, or $7,026 per capita, in 2006. The OACT estimates that healthcare spending in 2006 represented 16% of GDP, an increase of 6.7% over 2004 spending, and that growth in healthcare spending is projected to average 6.7% annually over the period 2007 through 2017. For 2009, OACT calculated that US federal, state, and local governments, plus corporations and individuals, together spent $2.5 trillion, or $8,047 per person, on healthcare. This amount represented 17.3% of GDP, up from 16.2% in 2008. The Health and Human Services Department expects that the healthcare share of GDP will continue its historical upward trend, reaching 19.5% of GDP by 2017. When comparing the US to other OECD countries, OECD nations have more mechanisms in place to restrict expenditures than is the case in the US, even though most, if not all, people in these other countries are covered by a form of health insurance. This is done either by regulating quantities or prices or both, including the dissemination of new technologies, or by requiring a greater proportion of costs to be paid out of pocket. Regulating the price of inputs, such as doctors’ fees, hospital payments, and pharmaceutical and implant prices, is one way of constraining prices. Controlling volume is another, but it often requires measures that restrict choice. This may limit access to care, which someone insured under a typical US health plan would be able to access, or alternatively expose people to the risk of catastrophically high out-of-pocket payments, unless a safety net is in place. By paying such a price, the result is that other countries are able to afford universal health care at a lower cost than in the US. Rational thinking leads one to conclude that US healthcare costs have to be reigned in, and price and access will have to be better aligned as the US moves toward better control of healthcare spending. On March 1, 2010, Warren Buffett commented that the high costs paid by US companies for their employees’ health care put them at a competitive disadvantage. He compared the roughly 17% of GDP spent by the US on healthcare, with the 9% of GDP spent by much of the rest of the world, and noted that the US has fewer doctors and nurses per person, and concluded saying: “this kind of cost, compared with the rest of the world, is like a tapeworm eating at our economic body.”

January 19, 2011


Figure 7. The Impact Aging and “New Technologies” Have Had on US Healthcare Spending

Source: U.S. Census Bureau, OECD, SSRP

January 19, 2011


ORTHOPEDICS CONTRIBUTES TO US HEALTHCARE OVERSPENDING From 2000 to 2010 orthopedics costs rose faster than overall healthcare spending The demand for orthopedic implants has almost doubled since 2000. Over this period, driven by demographic trends and the growth in demand for implants by younger patients combined with innovation and the industry’s demand for premium pricing, US spending on orthopedics has grown at a higher rate than that for all US healthcare spending combined. During this period, the annual number of joint replacement surgeries in the US almost doubled, growing from 575,000 to over one million. Today, one in 30 Americans is walking around with at least one new joint. In 2000 that number was one in 60. This growth did not come without a price. Ten years ago, 54 cents out of every $100 the US spent on healthcare was spent on hip and knee implant surgeries. In 2008 the number increased to 78 cents. We estimate that the total cost for hip and knee replacement surgery grew annually at just over 10% from 2000 to 2010, with about 70% of the growth coming from procedure volume and 30% from procedure cost.

Figure 8. US Orthopedic Spending Versus Overall US Healthcare Spending Indexed


Joint replacement procedure cost inflation is not the problem Like many other US healthcare costs, this rate of growth and its corresponding financial burden is unsustainable. At first glance it may seem that the spending on hips and knees in the US is growing out of control, but on further investigation, this may not be the case. At 10% the annual growth rate in joint replacement surgery outpaces the overall annual healthcare spending growth rate by 200 basis points. However, with volume accounting for 70% of the growth, increased cost has only added 3% to the overall growth rate over the past 10 years. With healthcare inflation in the US running at just under 6%, orthopedic procedure cost inflation is not only reasonable, it is very much under control. Limiting access will not be easy, and joint replacement surgery reduces future healthcare needs Despite the increasing financial burden of orthopedic surgery and looming acceleration in demand, it seems morally wrong to ration access to a procedure with a demonstrated 98%+ success rate that restores normal function and mobility to patients. Further it is well documented that joint replacement surgery not only restores function and relieves pain but allows patients to live a more active and healthy lifestyle, reducing their future healthcare needs and financial burden on the healthcare system.

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Breaking down procedure costs: pricing is at risk and the distribution model must be fixed For 2009 we estimate that orthopedic implants accounted for 41% of the total annual procedure cost, with physician pay, hospital costs, and hospital profits accounting for 8%, 44%, and 8% of the total, respectively. From 2005 to 2009, implant costs rose at 4% annually versus 3% growth in hospital costs and a 2% decline in payments to orthopedic surgeons. The 4% annual growth in implant prices over the past five years is a significant moderation from past growth rates. Looking at the period from 2000 to 2009, implant costs grew annually at 6%, one point above healthcare cost inflation.

Figure 9. Breakdown of Costs for Joint Replacement Surgery in the US in 2009


Looking at the success rates of joint replacement surgery and moral hazard of limiting access, coupled with shrinking physician pay and hospital cost growth seemingly in line with inflation, implant pricing sticks out as the only reasonable lever available to control costs and limit financial exposure. Despite the fierce competition between five large companies, a commoditized core product and increasing procedure volumes, implant prices have risen almost 60% over the past 10 years. Simple economic theory tells us the status quo is not sustainable, and product pricing will have to decline as the volume demanded increases. The industry may argue that continued price inflation is justified and deserved, given the burden of ever increasing research, development and regulatory costs, and they may point out that implant gross margins are well below those of many drugs and other devices. This is true, and there is no arguing that research, development, and regulatory costs are a financial burden the orthopedic industry should be compensated for. But even as the orthopedic industry’s regulatory costs look set to rise, the industry will still spend far less than other industries do as a percentage of sales on research, development and regulatory requirements (6% versus an average 13%). When assessing R&D risk/reward, the risk associated with developing new orthopedic products is less than that associated with drugs, biologics, and other medical devices. Given similar gross margins, one can argue that the orthopedic industry is being overly compensated for the associated R&D risks. Another reason the industry may offer in support of current pricing is the need to service the end user. During implant surgeries, an industry sales representative is needed in the operating room to assist the surgeon with product selection and usage. Usually this help is in the form of suggesting the right sized product when asked or pointing out to the surgical assistants which instrument the surgeon needs next. In some cases, the sales representative assists the surgeon by using a laser pointer to help find the best incision points and placements for implants. This assistance is particularly helpful when new products are rolled out and are of questionable value during everyday surgery. The cost of keeping a sales

January 19, 2011


representative on call to assist with surgeries in every hospital the companies service is expensive. Orthopedic SG&A costs, as a percentage of sales, average 40%, far higher than the 30-35% seen in pharmaceutical, biotech, or other medical devices companies. While initially successful, the industry’s continued reliance on the sales representative/surgeon model is inherently flawed, especially in an era of declining reimbursement and increasing volume. The problem with the current approach to selling more implants by hiring more sales representatives is that the cost of employing the sales representative is simply too high. To perform, the sales representative needs to be adequately rewarded, with the reward increased each year, to prevent the representative from joining a competitor. This is an expensive cycle to maintain and its leverage is limited. The conclusion is obvious — orthopedic selling costs are simply too high, and the current model is not scalable. While some may view this as a problem, we view it as an opportunity. Sales and marketing inefficiencies more than outweigh the potential loss of gross margin from price declines. We recognize that breaking the sales representative/surgeon model will not be easy, but on average, 7% points of margin is available to offset the potential increase in regulatory costs and expected decline in prices.

DISTRIBUITION INEFFICIENCIES EXCEED COMBINED PRICE AND REGULTORY RISKS Increasing demand and lower reimbursement rates will force healthcare providers to become leaner and more efficient. They will continue to seek out ways to reduce the cost of delivering care and increase throughput as they face a steady climb in the number of patients they must treat. Providers, in turn, will look to the industry to appropriately adjust their business models to better address the challenges they face. Discounts for volume contracts in orthopedics could be put on the table once again. We calculate sufficient distribution inefficiencies that exist to offset both the price declines providers will look for and any increased regulatory costs. As surgeons become employees, changes in the distribution system become easier The cost of the current distribution model, which relies heavily on a sales representative/surgeon relationship, will have to be reduced or replaced by a more efficient, lower cost, real-time inventory management system. This will be difficult and disruptive as orthopedic surgeons have a strong sense of entitlement and take for granted the relationships they currently enjoy with their sales reps, in addition to the value provided by the sales rep and the benefits derived. In response to tightening reimbursement in the mid-1990s, many orthopedic companies agreed to offer discounts for volume programs. Orthopedic stocks were volatile, but investors ultimately took these contracts in stride as they hypothesized that the opportunity cost of losing an orthopedic surgeon to a competitor and the strength of the sales rep/surgeon relationship would maintain the status quo. Indeed, the hospitals were not able to drive the required volumes to achieve the agreed upon discounts. Hospitals blamed physician reluctance to use products from companies they did not support as the primary reason for not being able to deliver the required volumes. This was not surprising, as at that time many orthopedic surgeons were mostly self employed, plus orthopedic surgery and allied services were a strong source of hospital profits and hospitals did not want to rock the boat for fear of losing the surgeon to a competing hospital. Compared to the mid-1990s, many more of today’s physicians (including orthopedic surgeons) are employees of hospitals and hospital groups. As employees, their ability to push back and refuse products the hospital requires is greatly reduced. This opens the door to volume discounts and alternative distribution models. Further, as the surgeon is no longer the empowered decision maker and gate keeper, the requirement for industry to continue to pander to their needs and retain their loyalty is greatly reduced. The opportunity to downgrade the sales rep/surgeon relationship exists, and industry market share may well be up for grab to those companies who are willing to once again work with the providers on a price for volume basis. Manufacturing efficiencies exist but may be limited Significant improvements were made in manufacturing during the 2000-09 timeframe. The introduction of robots into the manufacturing process, the automation of the packaging process, and the implementation of ERP systems coupled with pricing increases lead strong growth in gross margins.

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Looking ahead, one of the opportunities for manufacturing efficiencies is a reduction in the cost of labor by moving manufacturing to the developing countries. While attractive, we point out that the savings on paper may not translate into real savings. Wage inflation in India and China is increasing as the labor pool better understands its value proposition and strives to join the middle class. The regulatory cost of ensuring compliance is significantly higher than in developed countries and adherence to standard operating procedures (SOPs) is not optimal. Often, raw materials are sourced from local vendors to reduce costs further and quality control is lacking, resulting in higher raw material costs. Currently little of the industry’s products are made in developing nations. Going forward, we see less opportunity for efficiencies in manufacturing than in sales and marketing. That said, there could be sufficient efficiencies left in manufacturing to offset increases in regulatory costs, which would be a net positive in our models as we offset increases in regulatory costs and pricing declines with improved distribution efficiencies. Innovation is now a survival tool and not an opportunity for price premium Over the years the orthopedic industry has brought many valuable new technologies to market. Some argue that not all of these new technologies were warranted or should have been used, but there is no argument that innovations such as highly cross-linked polyethylene, oxinium, instruments enabling a less invasive approach, navigation, and innovations in material and coatings have not added value to patients and reduced operating room and recovery time. As we look forward we see the most meaningful innovations being those that continue to make a joint replacement surgery easier and faster while decreasing recovery time and increasing speed to normal function. We see innovations in the devices being of lesser value and importance, as currently used products are very successful. It is hard to argue against a 98%+ procedure success rate with a product that has proven itself for over 20 years. Further strengthening this argument is the recent documented increased failure rate of the more modern concepts, such as hip resurfacing and nuisance squeak factor of ceramic-on-ceramic articulation surfaces.

INDUSTRY ANALYSIS AND EXPECTATIONS FOR 2011

The global market — 2011 We estimate the total global orthopedics marketplace will approach $40B in 2011, up 6% from 2010, with almost $24B or 59% generated domestically. We forecast US orthopedic market growth of ca. 5% in 2011, representing a return to historical growth levels after the growth spurt of the late 1990s to mid-2000 and dip in growth experienced over the past few years due to the recession of 2008. In 2011 we see the US and EMEA each losing a percentage point of market share to the Pacific region, as developing country utilization continues to pick up.

Figure 10. 2011 Geographic Breakdown and Market Composition

Source: SSRP

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Joint arthroplasty The vast majority of the reconstruction market still consists of hip and knee procedures, with shoulder procedures making up most of the difference. Devices exist to treat other joints in the body, such as the finger, ankle, wrist, and elbow, but sales are insignificant when compared to hips and knees. We estimate the global reconstruction market in 2010 was $12.7B, up 3% over 2009. This rate significantly lags the 8% growth over the past decade. We estimate the reconstruction market will grow in the mid-single digits over the next several years, with volume contributing about 5% and mix and pricing taking 1-2% points away. For 2011 we estimate that the worldwide market for reconstruction products will approach $13.3B (+4%). We forecast the major players in reconstructive market shares for 2011 (versus 2010) as follows: ZMH at 25%, (+1%), SYK at 20%, (+1%), JNJ at 21%, (-1%), Biomet at 12% (flat), and SNN at 11% (flat). The remaining 12% (-1%) is made up a number of smaller players, including WMGI and EXAC. We expect the global hip market in 2011 to approximate $5.8B with growth of 4% over 2010. In 2011 we see the global hip market remaining dynamic, with possible share shift as the safety of metal-on-metal and the efficacy and long-term durability of resurfacing continues to be questioned. Hip market share over the past five years has seen shifts driven by the introduction of new products and technologies, most notably ceramic-on-ceramic and hip resurfacing. ZMH and Biomet were most affected, as they lagged in the development of both products and saw share erosion. SYK, SNN, JNJ, and WMGI saw share increases as they brought these new products to market, specifically SNN in resurfacing and SYK and JNJ in ceramic-on-ceramic. Looking to 2011 and the possible fallout from metal-on-metal ion safety issues, we see Biomet, SNN, WMGI, and JNJ as being particularly exposed, given their broad exposure to the metal-on-metal articulating surfaces either through the traditional implant or resurfacing. We estimate that metal-on-metal represented roughly 20% of the US market in 2010, down from 25% in 2009 with JNJ and Biomet being the market leaders with shares of 60% and 30%, respectively. In 2011 we forecast resurfacing to make up 5% of the US market, down fr0m 8% in 2010. SNN, SYK, WMGI, and JNJ are all exposed, with SNN carrying the largest exposure with over 80% US resurfacing share and resurfacing contributing about 15% to hip sales.

Figure 11. Global Constant Currency Quarterly Hip and Knee Growth Q1:05-Q4:10E

Source: SSRP

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Figure 12. Global Constant Currency Annual Hip and Knee Growth 2000-2010E

Source: SSRP

The market for extremities is small, with sales in 2010 around $500MM, but it is growing rapidly in excess of 20%. The law of small numbers must be remembered, but extremities is an area for innovation. Not too long ago implants represented pieces of plastic that could be bent in one plane only. We forecast the 2011 extremity market at $585MM, up 17% over 2010. Market leaders include JNJ and ZMH, with WMGI and EXAC making inroads into the market. At an annualized $30MM in sales, extremities is now EXACs second-largest business behind knees and its fastest-growing segment at around 30% growth over 2009. WMGI also has a strong extremities business with 2010 sales forecasted at just under $120MM, up 12% over 2009. Extremities is WNGI’s third largest business, just behind knees, and in 2011 should leapfrog knees to become WMGI’s second-largest and fastest-growing business unit. While we like EXAC and WMGI’s exposure to extremities, their contribution is not yet large enough to offset the impact of the challenges they face as smaller players in hips and knees — a market where size and increased regulatory costs matter, given the relative sizes of their biologics businesses compared to overall sales. Trauma and fixation The fixation (or trauma) segment of the orthopedic market refers to the rods, plates, screws, and other hardware used to stabilize bones until they can heal. We estimate global revenue in this segment in 2010 was $5.8B, up 7% over 2009, with about 55% of sales being made in the US. The major trauma players and their market shares include: Synthes at 41%, SYK at 17%, SNN at 8%, JNJ at 5%, Biomet at 3%, ZMH at 4%, and others, including OFIX at 22%. We view the trauma and fixation segment as relatively mature, with future growth relatively stable at around 6-8%. Fixation devices are generally grouped into two buckets, either internal or external, with the majority of the market being internal. In either case, the objective is to reposition the broken bone and to secure it in the correct anatomical position so that it may heal properly and restore normal function. Whereas external devices utilize a metal frame outside the body to help fixate a break, internal fixation products are placed internally and generally require invasive surgery. While the increase of accident-related fractures is generally a function of simple population growth, the segment is also benefiting from an increasing rate of osteoporosis, which causes a thinning of bone density and, consequently, a greater susceptibility to fracturing. Osteoporosis currently affects more than 25 million Americans (mostly post-menopausal women) and is a contributing factor in approximately 2 million fractures annually. We estimate the potential number of worldwide cases of osteoporosis could be as high as 100 million by the year 2025. We currently estimate that hip fracture repair and stabilization make up just over 25% of the total trauma market. Advances in bio-resorbable products and

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continued developments in osteobiologics will be the drivers of future growth. One negative to keep in mind is the impact of OSHA and improvements in US workplace safety. Emergency room visits for workplace-related accidents have been steadily declining over the past few years and should continue to do so in the future. Also, as the US moves heavy manufacturing abroad and construction — especially housing construction — remains under pressure, the trauma market could experience slight erosions in growth until GDP growth is fully restored and housing starts pick up.

Endoscopy We estimate the arthroscopy/sports medicine sales in 2010 were just under $3.3B, up 1% over 2009. We forecast the 2011 arthroscopy market will be roughly $3.5B, up 7%. The major players and their market shares in 2010 include SNN (24%), JNJ (20%), Arthrex (23%), SYK (12%), ARTC 7%, and CNMD (6%). The remaining 8% is made up of a number of smaller players. Endoscopy systems are composed of scopes, cameras, instruments, repair kits, and other devices designed to allow surgeons to practice minimally invasive surgery (MIS). In contrast to open surgery, MIS can produce equal outcomes with less expense and quicker patient recovery. The market tends to be more lifestyle-driven (rather than age-driven), as active people generally have a greater probability of being injured. Arthroscopy is increasingly practiced in an office-based setting, rather than hospital-based. Spine With 2010 sales at $7.0B, the market for products used in spine surgery represents the largest orthopedic market segment. Outside of SYK and EXAC, the spinal products market is a market segment that our covered companies carry little exposure to. Granted, at the margin the spine market could influence reported earnings from SNN and ZMH by a percent or two, but on the whole they are not meaningful. We forecast the spinal market in 2011 at $7.4B, up 5% over 2010. The US currently accounts for over 70% of the worldwide spinal surgery products market. In 2010 the major spine players were Medtronic (MDT) at 36%, JNJ at 15% and Synthes at 14%.

Figure 13. Global Spine Market Shares and Product Lines — 2010 Source: SSRP

Over the past two years spine market growth has contracted dramatically from mid-teens to being flat to slightly down. Many have highlighted the recession and price competition as the major cause for the growth collapse and anticipate a rebound when employment picks up and health insurance is restored.

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We are not so optimistic and do not expect a complete rebound in spine surgery. We point out the increasing number of articles being written questioning the value of spine surgery. The first of these papers hit in 2004 and its findings were quickly said by the industry to be biased against surgery with inadequately matched patient subsets. Contrary to the industry’s absolute dismissal of the paper’s findings, the medical community must have seen something and began to look into the true value of spinal surgery. Judging by the number of articles written over the past five years on the subject, there must be some concern among the scientific community as to the true value of spine surgery. Further, the DOJ inquiry into selling practices and the emerging reports of excessive use of spinal products by physicians reporting receipts of legitimate payments from spine companies is concerning. As 1) more data on physician payments and selling practices is made available, 2) physicians have to start disclosing income from companies whose products they use, and 3) the potential backlash from patients who had what they believe to be inappropriate surgery takes hold, it is our opinion that market growth could be negatively impacted for some time to come. Going forward, we no longer view spine as a must-have for our covered companies. This is a reversal from our previously held belief that orthopedic companies should get into the spine market as its superior margins and strong long-term growth potential would be accretive to their overall growth rates. Today we believe the opposite, and that it is highly likely that historical spine growth was due more to aggressive selling than appropriate diagnosing and that the long term organic growth rate might actually be below the orthopedic average and be a drag on company sales growth. Orthobiologics We estimate the worldwide market for osteobiologics in 2010 at just under $3.0MM (+0%), with 65% of sales in the US. MDT is by far the market leader with a 37% market share. InFUSE, MDT’s recombinant bone morphogenic protein growth factor, is by far the dominant product, with 34% market share. Synthes, JNJ, and SNN are the notable players, with 7%, 3%, and 3% market shares, respectively. Other companies, including WMGI, SYK, EXAC, and Biomet, make up the remaining 47% of the market. The most notable market development in orthobiologics came in the summer of 2002 when the FDA approved MDT’s InFUSE, a recombinant bone morphogenic protein designed to facilitate spinal fusion. InFUSE was developed jointly by WYE and MDT and was the first recombinant protein to be approved for use in orthopedic surgery. InFUSE adoption was quick, and annual sales are approaching $1B. OP-1, developed by SYK and WYE, is approved for humanitarian use in treating long bone fractures. In 2010 SYK sold its OP-1 business, exiting the rhBMP market. After blood transfusions, bone is the most frequently implanted substance in humans, with somewhere between 550,000 and 600,000 graft procedures done in the US annually. Bone grafts have numerous uses, including spinal fusion (about half of all grafts) and the repair of structures damaged by trauma, infections, and surgery. Bone grafting is a basic component of skeletal surgery involving the placement of a graft between two pieces of broken bone. The most common use of a bone graft is to stimulate the healing of bone. The main reason for using a bone graft is to stimulate new bone formation and speed up healing. A second reason for bone grafting is the maintenance of skeletal integrity when larger pieces of bone are used to fill a void or voids between two the broken bones. Orthopedic surgery, maxillofacial surgery, plastic surgery, periodontal surgery, and orthodontic surgery are the leading users of bone grafts. Bone grafts can be either autologous, allograft, or synthetic. Autologous bone grafts are taken directly from the patient. The primary drawback to an autologous graft is that it generally necessitates an additional procedure to obtain the graft, which in turn creates added expense and increased pain and recovery time. Still, autologous grafts account for more than 50% of total graft volume. The primary reasons are that they are osteoconductive, osteoinductive, and osteogenic, meaning they cause cellar differentiation and induce new bone growth both at the placement site and in the graft itself, creating a very strong union. Allografts, currently the second most commonly used bone grafts, are taken from human cadavers and processed by either bone banks or commercial firms. While allografts typically undergo extensive sterilization, they still carry a slight risk of transmitting pathogens and can also cause immune system reactions. Allografts are both osteoconductive and osteoinductive, although their inductive properties may be somewhat compromised in the sterilization process. An obvious advantage to allografts is the fact that a second harvesting operation is not required. Synthetic grafts are derived from numerous materials, including polymers, bovine collagen and coral. While competition is high, the synthetic graft manufacturers have yet to deliver an artificial material exhibiting reasonable osteogenic properties.

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Figure 14. Global Orthobiologics Product Market — 2010

Source: SSRP

Demineralized bone matrix (DBM) is a manufactured product consisting of the proteins from demineralized bone mixed with a substrate (e.g., glycerol or a polymer) to form a paste or putty. DBM is mostly an osteoinductive product, but lacks sufficient osteoinductive powers to be used on its own. It is almost always used as a bone graft extender (not as a substitute) and is intended to be used to achieve a higher fusion rate. Growth factors and stem cells include rhBMPs and blood-derived growth factors. Blood-derived growth factors are generated in the operating room by spinning patient blood down in a centrifuge to separate the blood cells from plasma. Recombinant bone morphogenetic proteins (rhBMP) are a family of proteins that have been shown to induce cellular differentiation and bone growth. Both BMP-7 (OP-1, SYK) and BMP-2 (InFUSE, MDT) have been isolated and produced by recombinant DNA techniques, a method by which human proteins are grown outside of the body. The produced protein is turned into a powder which is either reconstituted at operating site and delivered via a collagen plug or mixed into a putty from which is eluted. Gene therapy is also being investigated. LIM mineralization protein-1 (LMP-1) was discovered in 1997 and is thought to turn on bone formation very early on during bone development and healing. LMP-1 is an internal signaling molecule that helps turn on the production of a number of different proteins within bone cells, which are then secreted into the surrounding fluid to attract other cells needed for bone formation. The LMP-1 gene is delivered via an adenoviral vector into a sample of blood drawn from the patient. The blood sample is then placed on a matrix, such as a piece of collagen or a sponge, and is implanted into the surgical site to allow bone to form. LMP-1 therapy is in early clinical trials and will probably not come to market in the near future.

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CONMED Corporation, Inc. (CNMD) January 19, 2011

Initiation of Coverage Recommendation: BUY Price Target: $43.00

Mark Landy 617-532-6428 [email protected]

Source: StockCharts.com

Stock Data – (NASDAQ: CNMD) Price: $26.05 52-week high: $16.75 52-week low: $27.05 Shares out: 28.12MM Shares short: 1.71MM Average volume (10-day): 157K

Valuation Metrics Market cap: $746MM Enterprise value: $922MM Book value/share: $20.62

Financial Highlights (September:2010) Cash/equivalents: $16.5MM Debt: $214.3MM

10A Q1:11E 11E 12E Revs $720M $181M $746M $781M Prior NM NM NM NM EPS $1.30 $0.34 $1.44 $1.61 Prior NM NM NM NM P/E 20 NM 18 16

Company Description CONMED Corporation provides surgical devices and equipment for minimally invasive procedures and monitoring. The company’s products serve the arthroscopy, powered surgical instruments, electrosurgery, cardiac monitoring disposables, endosurgery, and endoscopic technologies. The company operates primarily in the US, Canada, the UK, Japan, and Australia. It was founded in 1970 and is headquartered in Utica, New York.

• We are initiating coverage of CONMED Corporation (CNMD) with a BUY rating and $43 price target. The orthopedic industry faces numerous hurdles, but we believe they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher with CNMD participating.

• 2011 procedure growth may surprise. Data suggests that the current economic malaise is passing, and procedure growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Given the low expectations for procedure volumes, any hint of upside in procedure growth will drive consensus estimates and CNMD’s stock price higher.

• An improving economy will drive increases in hospital spending. Hospitals have to upgrade orthopedic capacity given the expected increases in orthopedic volumes. If expected improvements in the economy materialize in 2011, hospital spending could accelerate above current muted expectations.

• CNMD is well positioned to benefit from increasing volume trends. CNMD is well positioned to benefit from an expected upgrade cycle in operating room capacity and efficiency as hospitals prepare for a significant step up in orthopedic demand driven by aging and obesity.

• CNMD is underexposed to potential increases in regulatory cost and overexposed to hospital spending. As equipment sales meaningfully outweigh sales of therapeutic products, CNMD is overexposed to reductions in hospital spending and procedure volume and underexposed to regulatory reform and potential increases in R&D spending. If expected improvements in the economy materialize in 2011, hospital spending could accelerate above currently muted expectations.

• Altrus not yet in our models and could provide 2011 upside. The Altrus thermal-energy-based tissue fusion system was approved in December 2010. While management forecasts 2011 sales between $5MM and $10MM, we have elected to not yet include Altrus sales in our models until we have greater clarity on rollout dynamics and acceptance.

• 2011 estimates. We forecast 2011 EPS at $1.44, on revenues of $746MM (+4%). For 2012 we are expecting total sales to grow 5% to $781MM and EPS of $1.61.

• Valuation. On a 10-year discounted cash flow basis we value CNMD shares at $43. Our DCF forecasts include a WACC of 9.3%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 6.9.

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INVESTMENT SUMMARY We are initiating coverage of CONMED Corporation, Inc., with a BUY rating and $43 price target. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning CNMD in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. CNMD is well positioned to benefit from increasing volume trends and expected upgrade cycles in operating room capacity and efficiency as hospitals get ready to handle the increase in orthopedic procedure volume over the next two decades. With Altrus sales not yet in our models and CNMD’s lower exposure to potential increases in regulatory costs and higher scrutiny of overall orthopedic costs, we see potential upside to current earnings expectations. In a period of improving orthopedic sentiment, CNMD shares will likely trade higher.

Figure 1. Exposure to Industry Trends

Source: SSRP

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INVESTMENT POSITIVES 1. Lower exposure to increases in regulatory costs. As equipment sales meaningfully outweigh sales of therapeutic products, CNMD is overexposed to reductions in hospital spending and procedure volume and underexposed to regulatory reform and potential increases in R&D spending.

2. Altrus not yet in our models and could provide upside. The Altrus thermal-energy-based tissue fusion system was approved in early December 2010. While management forecasts 2011 sales between $5MM and $10MM, we have elected to not yet include Altrus sales in our models until we have greater clarity on rollout dynamics and acceptance.

3. An improving economy will drive increases in hospital spending. Hospitals have to upgrade orthopedic capacity and improve efficiency given the expected increases in orthopedic volumes. Hospitals reigned in spending during the economic downturn, with the exception of the back end of 2009. If expected improvements in the economy materialize in 2011, hospital spending could accelerate in 2011 above currently muted expectations.

INVESTMENT RISKS 1. Continued economic malaise. The headline risk to our CNMD investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, especially CNMD, will underperform.

2. Transitions in manufacturing and consolidation. Disruptions in manufacturing and quality control are always possible when right sizing and realigning manufacturing. In the long run, the benefits strongly outweigh risks, but when things go wrong they typically take longer than expected to fix and the impact is greater than expected.

3. Product acceptance and quality perceptions. As CNMD rolls out Altrus and other new products, risk exists related to acceptance. For this reason we elect not to include Altrus in our models.

4. A difficult macro environment. Until the long-term impact of the increased unemployment rate, the DOJ investigation regarding selling practices, healthcare and regulatory reform, the impact of the housing collapse, European austerity measures, and the looming musculoskeletal financial burden are all fully appreciated, orthopedic industry headwinds will remain as depressors of valuation premium.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $43 valuation of CNMD shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 9.3%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 6.9. CNMD is currently trading at 18 times our 2011 EPS forecast of $1.44 and 16 times our 2012 EPS forecast of $1.61, slightly ahead of the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. CNMD is currently trading at less than one times our 2011 and 2012 sales forecasts, a discount to the group’s 1.9 and 1.8 times sales multiples for 2011 and 2012. At 1.4 times the 2012 PEG ratio, CNMD is trading at a premium to its growth rate but well below historical PEG ratios seen in the mid-2000s.

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Figure 2. Orthopedic Valuation Table

Figure 3. CNMD 10-Year Discounted Cash Flow Model

Source: SSRP

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FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 1. Revenue outlook: We forecast sales of $745MM (+4%) and $781MM (+5%) in 2011 and 2012. Our revenue forecasts do not include a contribution from recently approved Altrus tissue sealing.

2. Gross margins: We expect gross margins of CNMD to increase 100 basis points in 2011 and 2012 to 52.8% and 53.6%, respectively.

3. Operating expense outlook: For 2011 and 2012 we forecast SG&A at $310MM and $338MM, respectively, equating to 38.5% and 38.3% of sales, respectively. Our forecast reflects lowered selling and distribution costs as the company improves distribution efficiencies. For 2011 and 2012 we move R&D up to 4.6% and 5.0% of sales.

4. Tax rate and share count: We forecast a stable tax rate in 2011 and 2012 at 36% and increase the fully diluted share count to 28.7MM and 29MM, respectively.

5. EPS outlook: Our 2011 EPS forecast of $1.44 is up 11% over EPS in 2010. For 2012 we estimate EPS will grow 12% to $1.61.

6. Balance sheet and free cash flow: CNMD closed 2010 with just over $10MM in cash and marketable securities and $186MM in debt. We estimate that CNMD generates just over $40MM in free cash flow a year.

Figure 4. CNMD Quarterly Revenue Statement

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Figure 5. CNMD Quarterly Income Statement

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Figure 6. CNMD Annual Balance Sheet and Financial Ratios

January 19, 2011



Exactech, Inc. (EXAC) January 19, 2011




Stock Data – (NASDAQ: EXAC) Price: $17.80 52-week high: $22.34 52-week low: $14.03 Shares out: 12.92MM Shares short: 243.56K Average volume (10-day): 37.9K


Financial Highlights (September:2010) Cash/equivalents: $2.5MM Debt: $34MM

10A Q1:11E 11E 12E Revs $188.9 $52.1 $203.9 $221.1 Prior NM NM NM NM EPS $ $ $ $ Prior $0.88 $.025 $1.02 $1.16 P/E 20 NM 18 16

Company Description Exactech, Inc. develops, manufactures, markets, distributes, and sells orthopedic implant devices, related surgical instrumentation, and biologic services to hospitals and physicians in the US and internationally. The company has a strategic partnership with Genzyme Biosurgery to develop polymer-based synthetic biomaterials. Exactech, Inc. was founded in 1985 and is headquartered in Gainesville, Florida.

• We are initiating coverage of Exactech, Inc. (EXAC) with a BUY rating and $24 price target. We recognize the numerous hurdles the orthopedic industry faces, but point out that they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher. With little exposure to premium priced hips and knees and overexposure to the fast growing extremities segment, we believe EXAC is set to benefit from an improving 2011 orthopedic market.

• EXAC is an emerging force in the fast-growing extremities market. EXAC is an emerging presence in the $500MM extremities market. At 16% of sales and at an average 20% over the next two years, extremities is set to overtake hips as EXAC’s second-largest business unit. We forecast extremities to be 26% of sales in 2016.

• Resolution of DOJ investigation removes overhang. EXAC will pay a $3MM fine without admitting or denying guilt. An independent monitor will be in place for a year to observe compliance. While widely expected, this resolution resolves the “how much” question. Monitoring costs in 2011 are still an unknown dynamic.

• Extremity growth could provide P&L leverage. The forecasted increase in revenue growth driven primarily by US extremity sales in 2011 and 2012 should be sufficient to offset required investments in distribution and R&D.

• With spine/biologics contributing 15% of sales, EXAC may be exposed to proposed upgrades in the 510k process. We believe the 510k regulatory process will be upgraded, increasing approval costs for many orthopedic devices. As a human-derived orthopedic implant was the genesis for the review of the 510k process, it is likely that biologics will be more highly regulated in the future. EXAC R&D costs may be disproportionately increased given its above-average exposure to spine/biologics.

• 2011 estimates. Our 2011 sales and earnings forecasts are $204MM (+8%) and $1.02. In 2012 we forecast sales of $221MM (+8%) and earnings of $1.16.

• Valuation. On a 10-year discounted cash flow basis we value EXAC shares at $24. Our DCF forecasts include a WACC of 10.7%, terminal sales growth rate of 7%, and terminal P/EBITDA multiple of 5.7.

January 19, 2011


INVESTMENT SUMMARY We are initiating coverage of Exactech, Inc. with a BUY rating and $24 price target. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning specific orthopedic stocks in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. With little exposure to premium priced hips and knees and overexposure to the fast-growing extremities segment, we believe EXAC is set to benefit from an improving 2011 orthopedic market and improved sentiment. We therefore rate shares of EXAC BUY with a $24 price target.


Source: SSRP

January 19, 2011


INVESTMENT POSITIVES 1. EXAC is an emerging force in extremities. EXAC is an emerging presence in the $500MM extremities market. At 16% of sales and at an average 20% over the next two years, extremities is set to overtake hips as EXAC’s second-largest business unit. We forecast extremities to be 26% of sales in 2016.

2. Lower exposure to hip and knee price declines. We believe EXAC is less exposed to price declines in hips and knees, as it does not participate in the premium market segments. We further believe that mix shift over the past decade has been underestimated and that pricing of mid- and lower-market product segments is more stable than currently believed.

3. Resolution of DOJ investigation removes overhang. EXAC will pay a $3MM fine without admitting or denying guilt. An independent monitor will be in place for a year to observe compliance. While widely expected, this resolution resolves the “how much” question. Monitoring costs in 2011 are still an unknown dynamic but should not exceed the forecasted $3MM.

4. Better control over European distribution. EXAC recently converted its Spanish distribution network to a direct distributor. Direct distribution provides greater control and margin benefits as longer-term increases in sales margin meaningfully offset short-term increases in SG&A. We expect EXAC to be opportunistic in converting more of its OUS sales network to direct distribution.

INVESTMENT THESIS RISKS 5. Continued economic malaise. The headline risk to our EXAC investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, including EXAC, will underperform.

6. Management is not able to limit the potential R&D earnings drag. If management is not able to minimize the potential R&D earnings drag and invest in sales and marketing at the same time, revenue and earnings growth could disappoint.

7. Product acceptance. There is always acceptance risk when new products are rolled out. These risks apply to EXAC as it grows its extremities and spine product pipelines.

8. Impact of DOJ settlement. EXAC recently settled with the DOJ and will be under the scrutiny of a monitor in 2011.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $24 valuation of EXAC shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 10.7%, terminal sales growth rate of 7%, and terminal P/EBITDA multiple of 5.7. EXAC is currently trading at 18 times our 2011 EPS forecast of $1.02 and 16 times our 2012 EPS forecast of $1.16 — barely ahead of the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. EXAC is currently trading at less than 1.2 and 1.1 times our 2011 and 2012 sales forecasts, a discount to the group’s 1.9 and 1.8 times sales multiples for 2011 and 2012. At 1.2 times its 2012 PEG ratio, EXAC is also attractively valued relative to historical PEG ratios.

January 19, 2011



Figure 3. EXAC 10-Year Discounted Cash Flow Model

Source: SSRP

January 19, 2011


FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 7. Revenue outlook: Our 2011 revenue estimate is $204MM, up 8% from $189MM in 2010. In 2012 we forecast revenues of $221MM, up 8% from 2011. Our 2011 and 2012 revenue estimates are at the low end of guidance for growth of 8% to 12%.

8. Gross margins: We expect gross margin to be flat in 2011, and at 65.5% growing to 65.7% in 2012 driven by increasing US extremities sales and benefits from direct sales in Europe.

9. Operating expense outlook: For 2011 we forecast SG&A spending at 43.5% of sales, up 70 basis points from 2010 as distribution of extremities is broadened and the transition to direct sales in Spain hits the P&L. We are giving management the benefit that they will be able to grow extremities distribution and at the same time drive efficiencies in SG&A and forecast 2012 SG&A at 42.5% of sales down 100 basis points. We are increasing 2011 R&D spending to 7.4% of sales (from 7.3%) to reflect increased regulatory costs from anticipated upgrades to the medical device regulatory and approval systems. In 2012 we increase R&D spending to 7.8% of sales. Our forecasted operating margin for 2011 at 10.5% is 50 basis points higher than 2010, increasing to 11.2% in 2012.

10. Tax rate and share count: We forecast a stable tax rate in 2011 and 2012 at 38% and increase fully diluted share count to 13.1MM and 13.2MM, respectively.

11. EPS outlook: Our 2011 and 2012 EPS forecasts of $1.02 and $1.16 are based our assumptions of one time charges as management’s EPS guidance is for GAAP EPS.

12. Balance sheet and free cash flow: EXAC closed 2010 with just under $3MM in cash and marketable securities and $13MM in debt. We estimate that EXAC will have $7MM in free cash flow in 2011 and with capital spending reduced in 2012 to $14MM.


January 19, 2011


Figure 5. EXAC Quarterly Revenue Statement

Figure 6. EXAC Quarterly Income Statement

January 19, 2011


Figure 7. EXAC Annual Balance Sheet and Financial Ratios

January 19, 2011



Smith & Nephew, plc (SNN) January 19, 2011




Stock Data – (NYSE: SNN) Price: $56.83 52-week high: $57.24 52-week low: $41.61 Shares out: 177.4MM Shares short: 1.13MM Average volume (10-day): 635K

Valuation Metrics Market cap: $10.91B Enterprise value: $11.87B Book value/share: $13.97

Financial Highlights (October:2010) Cash/equivalents: $490MM Debt: $1.09B

10A Q1:11E 11E 12E Revs $3.94B $1.00B $4.10B $4.31B Prior NM NM NM NM EPS $3.11 $0.79 $3.32 $3.54 Prior NM NM NM NM P/E 17 NM 16 15

Company Description Smith & Nephew is a global company engaging in the development, manufacture, marketing, and sale of medical devices in orthopedics, endoscopy, and advanced wound management. The company operates through three independent business units: orthopedics, endoscopy, and advanced wound management. The company was founded in 1856 and is headquartered in London, the United Kingdom.

• We are initiating coverage of Smith & Nephew (SNN) with a BUY rating and $72 price target. We recognize the numerous hurdles the orthopedic industry faces, but point out that they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher.

• 2011 procedure growth may surprise. Data suggests that the current economic malaise is passing and procedure growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Given the low expectations for procedure volumes, any hint of upside in procedure growth will drive consensus estimates and SNN’s stock price higher.

• SNN has a higher risk profile but should also benefit from improving sentiment. SNN carries greater exposure to metal-on-metal and resurfacing than its peers, and patent risk exists in wound management. However, as one of the major orthopedic players SNN shares should also benefit from increasing sentiment and trade higher.

• Acquisition premium. Acquisition speculation has driven SNN shares higher in December and early January. If SNN is not bought, downside risk exists as acquisition premium dissipates.

• Balance sheet not quite there yet; earnings growth could lag. SNN does not have the same financial leverage as Stryker (SYK-$58.39-BUY) and Zimmer Holdings (ZMH-$56.16-BUY). With approximately $200MM in cash and generating around $120MM in free cash flow per quarter, SNN cannot afford to be acquisitive and buy back shares. As the company already pays a dividend, at current valuation we expect management to focus more on revenue growth and the product pipeline than on reducing share count. We forecast SNN average earnings growth of 6% through 2014, below that of its peers.

• Wound management legal issues ease; trauma could be a wild card in 2011. Patent litigation with Kinetic Concepts (KCI-$45.77-NR) in negative pressure wound therapy (NPWT) will continue as new actions are brought and current decisions move through appeal. Generally, outcomes have favored SNN and we do not expect any litigation impact in 2011/12. At 10% of sales, trauma influences growth and has been a drag on earnings. With a relatively complete product line, a small turnaround in trauma will relieve some P&L pressure. We are forecasting market share gains in trauma in 2011 and 2012.

• 2011 estimates. We forecast 2011 and 2012 EPS at $3.32 and $3.54, respectively.

• Valuation. On a 10-year discounted cash flow basis we value SNN shares at $72. Our DCF forecasts include a WACC of 8.8%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 7.8.

January 19, 2011


INVESTMENT SUMMARY We are initiating coverage Smith & Nephew with a BUY rating and $72 price target. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that the current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning specific orthopedic stocks in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Despite SNN’s greater exposure to metal-on-metal and resurfacing than its peers, as one of the major orthopedic players its share price will benefit from increasing orthopedic sentiment and trade higher.


Source: SSRP

January 19, 2011


INVESTMENT POSITIVES

5. Strong hip product portfolio. SNN has a strong hip product portfolio with numerous best-in-class offerings. Oxinium is one example, and its wear characteristics are simply superb. While we forecast hip share erosion in 2011 from declines in resurfacing, we forecast hip share stabilizing in 2012 as usage of other SNN hip products increases.

6. Diversification provides cross-selling opportunities. SNN’s broad product platform provides the opportunity to implement cross-selling programs to reduce selling and marketing costs.

7. Litigation overhangs gone for now. SNN has managed to overturn and win most of the patent infringement suits brought by KCI in NPWT. New cases may arise and appeals will continue, but in 2011 we see no material litigation risk.

8. Trauma upside is possible. At 10% of sales, trauma strongly impacts overall sales growth. Trauma sales have underperformed and been a drag on earnings for some time. With a relatively complete product line we expect a renewed effort in trauma, and a small turnaround could provide welcome earnings leverage.

INVESTMENT RISKS 9. Continued economic malaise. The headline risk to our SNN investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, including SNN, will underperform.

10. High exposure to metal-on-metal and hip resurfacing. As the market share leader, SNN is highly exposed to the growing negative sentiment toward hip resurfacing and metal-on-metal. Management has commented that resurfacing accounts for 15% of global hips sales and 20% of hips sales in the US.

11. Manufacturing shift to developing countries. Opportunities for reducing labor costs by moving manufacturing to the developing countries, while attractive on paper, may not translate into real savings. Wage inflation is increasing as the labor pool better understands its value proposition and strives to join the middle class. The regulatory cost of ensuring compliance is significantly higher, and adherence to standard operating procedures is not optimal. Often raw material sourced from local vendors to further reduce costs is lacking in quality, pushing quality control costs and raw material costs higher. The chance of regulatory actions and corresponding supply constraints increases significantly.

12. Acquisition premium. Acquisition speculation has driven SNN shares higher in December and early January. If SNN is not bought downside risk exists as acquisition dissipates.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $72 valuation of SNN shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 8.8%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 7.8. SNN is currently trading at 16 times our 2011 EPS forecast of $3.32 and 15 times our 2012 EPS forecast of $3.54 — slightly below the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. SNN is currently trading at less than 2.5 and 2.3 times our 2011 and 2012 sales forecasts, in line with its larger-cap peers. At 2.4 times its 2012 PEG ratio, SNN is the most expensive stock in the group and is trading above the historical PEG ratios seen during the mid-2000s orthopedic boom.

January 19, 2011



Figure 3. SNN 10-Year Discounted Cash Flow Model

Source: SSRP

ACQUISITION SPECULATION SNN valuation has been boosted by commentary in the press that it is a likely acquisition target. M&A speculation in medical devices is nothing new, and SNN is as good a target as any of the other orthopedic players. In our opinion, Biomet (Private) and ZMH, given their higher exposure to pure orthopedics, are better targets for an already diversified conglomerate looking to enter the orthopedic market. That said, SNN’s diversified business and product mix does provide instant diversification to an orthopedic player overexposed to large joint reconstruction.

January 19, 2011


FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 13. Revenue outlook: We expect SNN revenues to be $4.1B (+4%) in 2011, and $4.3B (+5%) in 2012. For 2011 we are forecasting $2.2B in orthopedic sales (+3%), $902MM in endoscopy sales (+6%), and $967MM (+6%) in wound management sales.

14. Gross margins: We expect gross margins to expand to 73.8% in 2011 from 74.2% in 2011, driven by EIP benefits including manufacturing consolidation.

15. Operating expense outlook: For 2011 we forecast SG&A spending as a percentage of sales to drop 100 basis points from 2010 levels to 45.9%.We are increasing R&D spending to 4.3% of sales (from 3.9%) to reflect increased regulatory costs from anticipated upgrades to the medical device regulatory and approval systems. Our forecasted operating margin for 2011 is 22.8%, up from 22.4% in 2010.

16. Tax rate and share count: The 2011 tax rate remains 31.4%, and average annual ADR count increases to 192MM from 190MM.

17. EPS outlook: Our 2011 EPS forecast is $3.32, up 7% over EPS in 2010. For 2012 we estimate EPS will grow 7% to $3.54.

18. Balance sheet and free cash flow: We estimate SNN closed 2010 with approximately $200MM in cash and marketable securities, and just over $1B in debt. We estimate that SNN generates about $125MM in free cash flow each quarter.


January 19, 2011


Figure 5. SNN Quarterly Revenue Statement

January 19, 2011


Figure 6. SNN Quarterly Income Statement

January 19, 2011


Figure 7. SNN Annual Balance Sheet and Financial Ratios

January 19, 2011



Stryker Corporation (SYK) January 19, 2011




Stock Data – (NYSE: SYK) Price: $58.39 52-week high: $59.72 52-week low: $42.74 Shares out: 397MM Shares short: 15.77MM Average volume (10-day): 2.47MM


Financial Highlights (September:2010) Cash/equivalents: $4.51B Debt: $1.02B

10A Q1:11E 11E 12E Revs $7.32B $1.96B $8.19B $8.68B Prior NM NM NM NM EPS $3.32 $0.90 $3.73 $4.13 Prior NM NM NM NM P/E 17 NM 16 14

Company Description Stryker is a broadly based global leader in medical technology and one of the largest players in the $40B worldwide orthopedic market. The company’s business is separated into three units: implants, medical surgery equipment and neurovascular. Stryker was incorporated in Michigan in 1946 and employs approximately 13,000 employees worldwide.

• We are initiating coverage of Stryker Corporation (SYK) with a BUY rating and $71 price target. We recognize the numerous hurdles the orthopedic industry faces, but point out that they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher. SYK is well positioned to outperform.

• 2011 procedure growth may surprise. Data suggests that the current economic malaise is passing, and procedure growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Given the low expectations for procedure volumes, any hint of upside in procedure growth will drive consensus estimates and SYK’s stock price higher.

• Hip share is up for grabs. Hip market share is up for grabs as Johnson & Johnson (JNJ-$62.10-NR), Smith & Nephew (SNN-$56.83-BUY), Biomet (Private) and Wright Medical Group (WMGI-$16.78-NEUTRAL) battle a growing negative sentiment toward metal-on-metal articulating surfaces and the longer-term value proposition of hip resurfacing is questioned. SYK’s exposure to these concerns is low and it is well positioned to take share.

• Acquisition integration and balance sheet leverage provides earnings wiggle room. SYK is an excellent integrator of acquisitions and should deliver meaningful operating leverage from the acquisitions closed in 2010. We have included a net $340MM in 2011 sales from acquisitions (Neuro +344, Gaymar +54, OP1 -58). We expect SYK to remain acquisitive in 2011 and continue to use its balance sheet to support earnings growth. We estimate over $800MM remains in SYK’s share repurchase program.

• MedSurg growth is a wild card in 2011. Hospital capital spending rebounded in 2010, driving medical surgery equipment organic growth to 10%. While acquisitions will help the 2011 growth rate through the anniversary of Gaymar in September, historical growth is closer to 7%. We conservatively forecast MedSurg sales, including Gaymar, at 7% noting there is likely upside to our number.

• 2011 estimates. We forecast 2011 EPS at $3.73, at the high end of guidance, and revenues of $8.2B. For 2011 we are expecting total sales to grow 12%, boosted by $340MM in net acquisition/divestitures, with implants growing 6% and MedSurg growing 7%.

• Valuation. On a 10-year discounted cash flow basis we value SYK shares at $71. Our DCF forecasts include a WACC of 9.1%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 7.9.

January 19, 2011


INVESTMENT SUMMARY We are initiating coverage of Stryker Corporation with a BUY rating and $71 price target. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning SYK in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. We note that a rising tide floats all boats, but compared to its peers SYK carries less exposure to metal-on-metal articulating surfaces and is in a position to benefit from the fallout. With new hip and knee products rolling out this year, the opportunity for SYK to expand its business exists and we see the company benefiting more from a rebounding economy and orthopedic demand than many of its competitors.


Source: SSRP

January 19, 2011


INVESTMENT POSITIVES 9. Low exposure to metal-on-metal. SYK carries less exposure to metal-on-metal articulating surfaces than many of its competitors and could benefit as the market shifts back toward traditional polyethylene liners and increases its use of ceramic-on-ceramic in younger patients.

10. Shape-Match knee launch. SYK is awaiting approval of the Shape-Match knee for its entry into the custom fit total knee market. We anticipate approval in early 2011 and expect a controlled rollout through 2011.

11. Margin expansion. SYK’s entry into the neurovascular market brings a product line with higher gross and net income margins than the corporate average. Looking forward, we like SYK’s broad product platform and ability to implement cross-selling programs to reduce selling and marketing costs.

12. Balance sheet leverage. SYK will exit 2010 with just under $3.5B in cash and marketable securities, generating almost $350MM in cash a quarter. The company has significant financial flexibility to boost earnings and grow revenues.

INVESTMENT RISKS 13. Continued economic malaise. The headline risk to our SYK investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, including SYK, will underperform.

14. Diversification outside a comfort zone is risky. SYK’s entry into the neurovascular market makes sense, but it is an area the company has little experience in. Yes, the company sells to trauma surgeons, neurosurgeons, and others who work in and around the brain, but interventional neurovascular is a tough business with nuances SYK may be unfamiliar with, and the learning curve may be steeper than anticipated. We expect SYK to continue to diversify its business and see integration and leverage become harder and more risky.

15. A difficult macro environment. Until the long-term impact of the increased unemployment rate, the DOJ investigation into selling practices, healthcare and regulatory reform, the impact of the housing collapse, European austerity measures, and the looming musculoskeletal financial burden are all fully appreciated, orthopedic industry headwinds will remain as depressors of valuation premium.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $71 valuation of SYK shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 9.1%, terminal sales growth rate of 5% and terminal P/EBITDA multiple of 7.9. SYK is currently trading at 16 times our 2011 EPS forecast of $3.73 and 14 times our 2012 EPS forecast of $4.13 — slightly below the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. SYK is currently trading at 2.7 and 2.6 times our 2011 and 2012 sales forecasts — a premium to the group’s average 1.9 and 1.8 times sales multiples for 2011 and 2012. At 1.3 times its 2012 PEG ratio, SYK is trading at a premium to its growth rate but well below the group average 1.5 and historical PEG ratios seen in the mid-2000s.

January 19, 2011



Figure 3. SYK 10-Year Discounted Cash Flow Model

Source: SSRP

January 19, 2011


FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 19. Revenue outlook: We expect SYK revenue growth to continue to pick up in 2011 from no growth in 2009 and 8% growth in 2010. We forecast 2011 sales at just over $8.1B, up 12% over 2010 with acquisitions and divestitures adding a net $340MM. For 2011 we are forecasting $4.6B in implant sales (+6%), $3.2B in MedSurg sales (+7%), and $380MM in neurovascular sales. Our revenue assumptions on hips and knees assume organic growth and do not include the Shape-Match launch and any hip market share gains.

20. Gross margins: We expect gross margins of SYK to expand in 2011 from 68.8% to 69.8%, driven mainly by neurovascular sales and by improvements in manufacturing efficiencies.

21. Operating expense outlook: For 2011 we forecast SG&A spending as a percentage of sales to essentially be flat, with 2010 at 37.1%. We are increasing R&D spending to 6.3% of sales, from 5.5%, to reflect higher neurovascular R&D costs and increased regulatory costs from anticipated upgrades to the medical device regulatory and approval systems. Our forecasted operating margin for 2011 at 25.4% is up 20 basis points from 2010.

22. Tax rate and share count: We have reduced the 2011 tax rate slightly to 28% and reduced the average annual share count to 387MM from 399MM. In 2012 we reduce the tax rate to 27.5% and reduce share count to 384MM.

23. EPS outlook: Our 2011 EPS forecast of $3.73 is at the high end of guidance, up 12% over EPS in 2010. For 2012 we estimate EPS will grow 11% to $4.13.

24. Balance sheet and free cash flow: SYK closed 2010 with $3.4B in cash and marketable securities and almost $1B in debt. We estimate that SYK generates almost $350MM in cash each quarter.


January 19, 2011


Figure 5. SYK Quarterly Revenue Statement

January 19, 2011


Figure 6. SYK Quarterly Income Statement

January 19, 2011


Figure 7. SYK Annual Balance Sheet and Financial Ratios

January 19, 2011



Wright Medical Group, Inc. (WMGI) January 19, 2011

Initiation of Coverage Recommendation: NEUTRAL Price Target: NA



Stock Data – (NASDAQ: WMGI) Price: $16.78 52-week high: $19.61 52-week low: $13.43 Shares out: 39.19MM Shares short: 2.09MM Average volume (10-day): 304K


Financial Highlights (September:2010) Cash/equivalents: $157MM Debt: $201MM

10A Q1:11E 11E 12E Revs $511M $135M $538M $574M Prior NM NM NM NM EPS $0.66 $0.21 $0.75 $0.82 Prior NM NM NM NM P/E 24 NM 22 20

Company Description Wright Medical Group specializes in reconstructive joint devices and bio-orthopedic materials, focusing on the higher-growth sectors of advanced knee implants, bone-conserving hip implants, revision replacement implants, and extremity implants. Wright has been in business for over fifty years and is located in Arlington, Tennessee. In 1999, Warburg Pincus Equity Partners recapitalized WMGI and today has no controlling interests.

• We are initiating coverage of Wright Medical Group, Inc. (WMGI) with a NEUTRAL rating. We recognize the numerous hurdles the orthopedic industry faces, but point out they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher. However, in 2011 WMGI faces numerous company-specific issues that could limit its participation in any industry upside.

• Significant metal-on-metal exposure puts WMGI’s biggest business segment at risk. Metal-on-metal articulating surfaces are a large part of WMGI’s hip franchise. Management noted on its Q1:10 earnings call that metal-on-metal was 50% of mix, down fr0m 58% the prior year. Exiting 2010, it is likely that metal-on-metal mix may still exceed 30-35%, and further market share losses are likely.

• With biologics contributing 16% of sales, WMGI is exposed to proposed upgrades in the 510k regulatory process. We believe the 510k regulatory process will be upgraded, increasing approval costs for many orthopedic devices. As a human-derived orthopedic implant was the genesis for the review of the 510k process, it is likely that biologics will be more highly regulated in the future. WMGI R&D costs will disproportionately increase, given its above average exposure to biologics.

• WMGI is an emerging force in the fast-growing extremities market. WMGI has assembled an enviable product portfolio in the $500MM extremities market. At 24% of sales and growing in the mid-teens, extremities are set to overtake knees as WMGI’s second-largest business unit. While we like this business, it is currently not large enough to offset share loss in hips, pending increased R&D spending, and pushback on price premiums for niche products.

• 2011 estimates. Our 2011 sales and earnings forecasts of $538MM and $0.75 are both below consensus. Our 2012 forecasts are $574MM and $0.82, respectively.

• Valuation. On a 10-year discounted cash flow basis we value WMGI shares at $16. Our DCF forecasts include a WACC of 8.6%, terminal sales growth rate of 6%, and terminal P/EBITDA multiple of 7.6.

January 19, 2011


INVESTMENT SUMMARY We are initiating coverage of Wright Medical Group, Inc. with a NEUTRAL rating. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning specific orthopedic stocks in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. We note that a rising tide floats all boats, but in 2011 WMGI faces a number of company-specific issues that could limit its participation in any industry upside. Specifically, we are concerned with the potential for continued market share losses in hips, given WMGI’s large exposure to metal-on-metal articulating surfaces and increased R&D costs due to the company’s larger-than-average exposure to biologics. We are also concerned with continued pushback on premium prices asked for niche and higher end products, a meaninful portion of WMGI’s hip product portfolio.


Source: SSRP

January 19, 2011


INVESTMENT THESIS RISKS 16. Continued economic malaise. The headline risk to our WMGI investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, including WMGI, will underperform

17. Limited hip market share losses. If management is able to stem share loss by either switching customers to alternative products or convincing them that metal-on-metal articulations do not place patients’ lives at risk, hip market share loss will be contained and WMGI will trade higher.

18. Product acceptance. There is always acceptance risk when new products are rolled out. These risks apply to WMGI as it grows its extremities product pipeline.

19. Changes to the 510K process are less onerous than expected. The medical device industry has a powerful and effective lobbying presence in DC and has time and time again managed to reverse potentially difficult situations. AdvaMed has already publically stated its opposition to the suggested changes in the 510k process. If the industry is able to soften much of the expected impact on regulatory costs, WMGI will benefit and trade higher.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $16 valuation of WMGI shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 8.6%, terminal sales growth rate of 6%, and terminal P/EBITDA multiple of 7.6. WMGI is currently trading at 21 times our 2011 EPS forecast of $0.75 and 19 times our 2012 EPS forecast of $0.82 — ahead of the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. WMGI is currently trading at 1.3 and 1.2 times our 2011 and 2012 sales forecasts — a discount to the group’s 1.9 and 1.8 times sales multiples for 2011 and 2012. At 2.1 times its 2012 PEG ratio, WMGI is trading at a significant premium t0 its growth rate and at the group’s historical high.


January 19, 2011


Figure 3. WMGI 10-Year Discounted Cash Flow Model

Source: SSRP

FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 25. Revenue outlook: Contrary to consensus and in line with our expectations for continued erosion in hip share, we forecast flat revenue growth in 2011 versus 2010. Our 2011 revenue estimate is $538MM, up 5% from $511MM in 2010 (+ 5% over 2009). In 2012 we see hip share stabilizing at 2011 levels and forecast revenues of $574MM, up 7% from 2011. For 2011 we are forecasting $175MM in hip sales (+0%) which is below our market growth expectation for 4%, $129MM in knee sales (+3%), again below market, and $140MM in extremity sales (+17%).

26. Gross margins: We expect gross margin to increase 10 basis points in 2011 to 69.7% (from 69.6%), driven mainly by declining average hip prices. We expect it to be down 30 basis points in 2012, at 69.4%, as pricing pressure in its hip franchise continues.

27. Operating expense outlook: For 2011 we forecast SG&A spending at 51.5% of sales, down from 52.1% in 2010, as costs are removed from the distribution system. We forecast 2012 SG&A at 50.3% of sales. We are increasing 2011 R&D spending to 7.5% of sales (from 7.2% in 2010) to reflect increased regulatory costs from anticipated upgrades to the medical device regulatory and approval systems. In 2012 we increase R&D spending to 7.8% of sales. Our forecasted operating margin for 2011 is essentially flat at 10.1%, from the 9.8% operating margin in 2010. For 2012, operating margins are set to increase to 10.2%, driven by cost reductions in sales and marketing offsetting R&D increases and declines in gross margin.

28. Tax rate and share count: We forecast a stable tax rate in 2011 and 2012 at 35% and increase fully diluted share count to 44.35MM and 44.6MM, respectively

29. EPS outlook: Our 2011 EPS forecast is $o.75, up 13% over EPS in 2010. For 2012 we estimate EPS will grow 9% to $0.82.

30. Balance sheet and free cash flow: WMGI closed 2010 with just over $120MM in cash and marketable securities and $200MM in debt. We estimate that WMGI will generated $28MM in free cash flow in 2010 and forecast it will generate $14MM of free cash flow in 2011.

January 19, 2011


Figure 4. WMGI Quarterly Revenue Statement

January 19, 2011


Figure 5. WMGI Quarterly Income Statement

January 19, 2011


Figure 6. WMGI Annual Balance Sheet and Financial Ratios

January 19, 2011



Zimmer Holdings, Inc. (ZMH) January 19, 2011




Stock Data – (NYSE: ZMH) Price: $56.16 52-week high: $64.77 52-week low: $46.27 Shares out: 197.44MM Shares short: 8.25MM Average volume (10-day): 2.3 MM


Financial Highlights (September:2010) Cash/equivalents: $981.6MM Debt: $1.14B

10A Q1:10E 11E 12E Revs $4.12B $1.09B $4.39 $4.64 Prior NM NM NM NM EPS $4.26 $1.13 $4.69 $5.25 Prior NM NM NM NM P/E 13 NM 12 11

Company Description Zimmer Holdings, Inc. is a large global orthopedic manufacturer that was founded in 1927, acquired by Bristol-Myers in 1972, and spun off in a tax-free distribution to shareholders in 2001. Through its subsidiaries Zimmer designs, develops, makes, and markets orthopedic, dental and spine implants, trauma products, and operating room supplies in the Americas, Europe, and the Asia Pacific Region.

• We are initiating coverage of Zimmer Holdings (ZMH) with a BUY rating and $89 price target. We recognize the numerous hurdles the orthopedic industry faces, but point out that they are well documented and current expectations are low. A hint that things are not as bad as expected could see upward earnings revision and orthopedic stocks trade higher. ZMH is well positioned to outperform.

• ZMH is the most levered to fluctuations in orthopedic volume. With knees and hips accounting for 73% of sales, ZMH is the least diversified of the larger orthopedic players. At 11.5x and 10.5x our estimated 2011 and 2012 earnings forecasts, it is, not surprisingly, the cheapest stock in the group given the current outlook and low expectations. In a rebounding market, ZMH has the best risk/reward profile of the group and we recommend some exposure to ZMH.

• 2011 procedure growth may surprise. Data suggests that the current economic malaise is passing, and procedure growth could surprise as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. Given the low expectations for procedure volumes, any hint of upside in procedure growth will drive consensus estimates and ZMH’s stock price higher.

• Hip share is up for grabs. Hip market share is up for grabs as Johnson & Johnson (JNJ-$62.10-NR), Smith & Nephew (SNN-$56.83-BUY), Biomet (Private) and Wright Medical Group (WMGI-$16.78-NEUTRAL) battle a growing negative sentiment toward metal-on-metal articulating surfaces and the longer-term value proposition of hip resurfacing is questioned. ZMH’s exposure to these concerns is very low and it is well positioned to reverse share losses and begin taking share.

• Strong balance sheet provides flexibility. ZMH generates roughly $1B in annual free cash flow and over the past three years has returned over $2B to shareholders through share repurchases. As we look toward 2011 we see ZMH becoming more acquisitive to bolster revenue growth and diversify the business. We would not discount the opportunity for a dividend but view this as unlikely in 2011, given the increasing number of smaller companies battling to survive in the current economic environment and corresponding depressed values.

• 2011 estimates. We forecast 2011 EPS at $4.69, 4 cents ahead of consensus on revenues of $4.4B. For 2011 we are expecting total sales to grow 5%, excluding any benefit from recently announced and closed acquisitions.

• Valuation. On a 10-year discounted cash flow basis we value ZMH shares at $89. Our DCF forecasts include a WACC of 9.6%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 7.5.

January 19, 2011


INVESTMENT SUMMARY We are initiating coverage of Zimmer Holdings with a BUY rating and $89 price target. While we concur with the general thesis that the outlook for the orthopedics industry will remain challenging over the next 12-18 months, we point out that the industry’s problems are well documented and that current orthopedic expectations are low. With the low expectations for orthopedic performance, it can be argued that a valuation floor may well be in place to support current orthopedic stock price levels. It is our opinion, therefore, that the risk/reward to owning ZMH in the first half of 2011 is compelling, as expectations may have to be set higher given the likelihood of a pickup in employment and procedure volume. Many point to the increase in unemployment over the past few years and corresponding loss of healthcare insurance as the root cause of the collapse in 2010 procedure volume. So, if current data is suggesting that the economic malaise is passing and that employment is picking up, we argue that volume growth should therefore pick up and surprise to the upside as organic growth is bolstered by patients returning for surgeries delayed during the economic downturn. With knees and hips accounting for 73% of sales, as the least diversified of the larger orthopedic players, not surprisingly, ZMH is also the cheapest stock in the group at 12x and 11x our estimated 2011 and 2012 earnings forecasts. Given the current orthopedic outlook and low expectations in a rebounding market, ZMH currently has the best risk/reward profile of the group and we recommend some exposure to ZMH. We note that a rising tide floats all boats, but compared to its peers ZMH is the most leveraged to a rebound in volume and carries the lowest exposure to metal-on-metal articulating surfaces. ZMH is well positioned to benefit from the metal-on-metal fallout, and with new hip and knee products rolling out in 2011 the opportunity exists for ZMH to stem market share losses of the past few years and begin expanding its business once again.


Source: SSRP

January 19, 2011


INVESTMENT POSITIVES 13. Lowest exposure to metal-on-metal. Of the larger players, ZMH has the least exposure to metal-on-metal articulating surfaces and could benefit as the market shifts back toward traditional polyethylene liners and increasing use of modular systems, especially in revision surgeries.

14. Reversal of share loss should accelerate in 2011. DOJ settlement, field actions, and quality issues combined with underexposure to new hip and knee technologies have resulted in meaningful market share losses over the past few years. ZMH has rejuvenated its hip and knee product lines and is well positioned to benefit from the metal-on-metal fallout and recapture share from momentum of products rolled out in 2010 and new products to be rolled out in 2011.

15. Balance sheet leverage. ZMH will exit 2010 with just over $1B in cash. A large portion is restricted as it is held off shore. The company generates over $200MM in free cash each quarter and has significant financial flexibility to boost earnings and grow revenues. We anticipate ZMH will use much of its fire power in 2011 to make smaller acquisitions to bolster its product pipeline.

16. If SNN is a takeout candidate, why isn’t ZMH? Recent reports suggest that SNN may be a takeout target. We point out that ZMH’s concentrated business and low valuation may make it a more attractive asset to a large diversified group looking to gain or bolster healthcare exposure. As strategic business decisions are on the horizon for ZMH, selling the company must be a consideration.

INVESTMENT RISKS 20. Continued economic malaise. The headline risk to our ZMH investment thesis is continued economic malaise and increasing unemployment. If global economic woes persist in 2011 and US unemployment continues to pick up, orthopedic volumes will continue to decline and orthopedic stocks, especially ZMH, will underperform.

21. Strategic business decisions loom and diversification outside of a comfort zone is risky. ZMH needs to begin to diversify its business and reduce exposure to hips and knees. The company needs to begin adding complementary products to its sales bag to increase cross-selling opportunities and reduce sales and marketing margins. Diversification outside of areas of core expertise is always risky.

22. Product acceptance and quality perceptions. As ZMH rolls out new products, given the very public quality issues the company faced in 2008, product acceptance risks remain. While early, initial acceptance is in line with management’s expectations.

23. A difficult macro environment. Until the long-term impact of the DOJ investigation into selling practices, healthcare and regulatory reform, the impact of the housing collapse, the increased unemployment rate, European austerity measures, and the looming musculoskeletal financial burden are all fully appreciated, orthopedic industry headwinds will remain as depressors of valuation premium.

VALUATION Given the macro changes in the overall healthcare environment and ongoing changes in the medical device industry, traditional valuation methodologies based on earnings multiples, sales multiples, PEG ratios, and relative performance may be misleading. In an environment where valuation premiums are being resent and growth is rapidly slowing, we prefer a discounted cash flow model. Our $89 valuation of ZMH shares is based on a 10-year discounted cash flow model. Assumption inputs include a WACC of 9.6%, terminal sales growth rate of 5%, and terminal P/EBITDA multiple of 7.5. ZMH is currently trading at 12 times our 2011 EPS forecast of $4.69 and 11 times our 2012 EPS forecast of $5.15 — well below the group average for 2011 and 2012 of 17 and 15 times our 2011 and 2012 EPS forecasts. ZMH is currently trading at 2.5 and 2.3 our 2011 and 2012 sales forecasts — ahead of the group average of 1.9 and 1.8 times sales multiples for 2011 and 2012. At 1.1 times its 2012 PEG ratio, ZMH is trading at a very small premium to its growth rate and well below the group average and the historical PEG ratios seen in mid-2000s.

January 19, 2011



Figure 3. ZMH 10-Year Discounted Cash Flow Model

Source: SSRP

January 19, 2011


FINANCIAL DISCUSSION AND MODEL ASSUMPTIONS 31. Revenue outlook: We expect ZMH revenue growth to continue to pick up in 2011 from 1% growth in 2009 and 2% in 2010. We forecast 2011 sales at just under $4.4B, up 5% over 2010 with recent acquisition not included. For 2011 we are forecasting $1.3B in hip sales (+5%) and $1.8B in knee sales (+5%). Our revenue assumptions on hips and knees assume organic growth and do not include market share gains or impact of yet-to-be-launched products. For 2012 we forecast revenues to grow 6% to $4.6B.

32. Gross margins: We expect gross margins at ZMH to be down 20 basis points in 2011 at 76.2%, driven mainly by manufacturing efficiencies being offset by pricing declines. In 2012 we forecast further pricing pressure will reduce gross margin by 20 basis points to 76%.

33. Operating expense outlook: For 2011 we forecast SG&A spending as a percentage of sales to essentially be down 30 basis points from 2010 at 41.3%. We are increasing R&D spending to 5.1% of sales (from 5.0%) to reflect increased regulatory costs from anticipated upgrades to the medical device regulatory and approval systems. Our forecasted operating margin for 2011 at 29.8% is up from 28.9% in 2010. For 2012 we forecast a decline in SG&A to 40.7% of sales, with R&D increasing to 5.8% of sales — in line with our thesis that SG&A costs will be reduced to offset increased R&D spending. We have 2012 0perating margins declining slightly to 29.5%.

34. Tax rate and share count: We forecast a stable tax rate in 2011 and 2012 at 26.5% and reduce the fully diluted share count to 195MM and 189MM, respectively.

35. EPS outlook: Our 2011 EPS forecast of $4.69 is 4 cents ahead of consensus and up 10% over EPS in 2010. For 2012 we estimate EPS will grow 10% to $5.15.

36. Balance sheet and free cash flow: ZMH closed 2010 with just over $1B in cash and marketable securities and $1.1B in debt. We estimate that ZMH generates just over $2o0MM in free cash flow each quarter.

Figure 4. ZMH Quarterly Revenue Statement

January 19, 2011


Figure 5. ZMH Quarterly Income Statement

January 19, 2011


Figure 6. ZMH Annual Balance Sheet and Financial Ratios

January 19, 2011


Important Disclosures and Disclaimers

Analyst Certification: Each research analyst who authored the attached research report certifies the following: 1) All of the views expressed in this research report reflect my personal opinions about the subject company or any company mentioned in this research report; 2) I have not and will not receive compensation in exchange for the recommendation or views in this research report; and 3) Neither I nor the firm that employs me believes or have reason to believe that I have any material conflicts of interest with regard to the subject company or any company mentioned in this research report at the time of its publication. Analyst/Firm Financial Interest/Control: Neither the analyst nor any members of his/her household has a financial interest in the covered company, or companies mentioned in this research report, including the ownership of shares, warrants, or options on the subject company's securities. In addition, neither the analyst nor any member of his/her family is an officer, director or advisory board member of the subject company. At the end of the month immediately preceding the publication of this research report, the firm and/or its affiliates did not beneficially own 1% or more of any class of common equity securities of the subject company, nor any company mentioned in this research report. Summer Street Research Partners ("SSRP" or "the Company") does not make markets in any securities, including those of the subject companies in this research report. The research analysts’ compensation is not directly related to the specific recommendations or views expressed in this research report. Research Analyst(s) compensation is however based upon various factors including SSRP's total revenues, a portion of which may in the future be generated by investment-banking related activities. Investment Banking and Other Services: SSRP has not provided investment-banking, advisory or other similar services to the subject companies described in this research report, nor are they clients of the SSRP. Further, the firm and its affiliates have not managed or co-managed a public/private offering of securities for the subject companies in this research report, and have not received compensation for investment-banking services from the subject companies in this research report. We expect to receive or intend to seek compensation from the subject companies for investment-banking related services in three months from the date of this research report. The firm has not received investment-banking revenues or participated in a public/private offering of securities as a manager or co-manager of the subject company's securities in the past 12 month from the date of this research report. Nor has the firm or its research analysts received compensation from the subject company or any company mentioned in this research report for products and services in the past 12 months. In addition, no research analyst, employee or affiliate of SSRP with the ability to influence the substance of this research report has received any compensation for products and service in the past 12 months. Definition of SSRP's Stock Rating System as used in this Research Report: BUY – We believe the stock’s total return will significantly outperform its peer group; NEUTRAL – We believe the stock’s total return will not be significantly different than its peer group; SELL – We believe the stock’s total return will significantly under perform its peer group. General Disclaimers: The information contained herein is intended for distribution to institutional investors and is for informational purposes only. SSRP's research reports should be considered as only a single factor in making an investment decision. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness and it should not be relied upon as such. Additional information is available by contacting SSRP. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer to buy or sell any securities. The data contained herein is intended for the sole and exclusive use of clients of SSRP. No reproduction, transmission or replication of any of the information or data contained within this document may be done without the expressed written consent of SSRP. Medical Consulting Research Inc. (MCRI) is a division of SSRP. Investment Rating Distribution for the Period 10/1/10 through 12/31/10:

Rating Count Percentage

BUY 14 58%

NEUTRAL 9 38%

SELL 1 4%

Companies under coverage at 12/31/10 24 100%

We have assigned an investment rating for at least one year for the following subject companies mentioned in this report: CNMD


Ratings History Date Rating Share Price Price Target 1/19/11 BUY $26.05 $43.00 CNMD Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and CNMD will underperform.

• Manufacturing/Consolidation: Disruptions in manufacturing and quality control are possible as manufacturing consolidation continues.

• Product Acceptance: Acceptance of new products is always a risk Valuation Method for Price Target: 10-year DCF

January 19, 2011


EXAC


Ratings History Date Rating Share Price Price Target 1/19/11 BUY $17.80 $24.00 EXAC Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and EXAC will underperform.

• Management is not able to limit the potential R&D earnings drag: If management is not able to minimize the potential R&D earnings drag and invest in sales and marketing at the same time, revenue and earnings growth could disappoint.

• Product acceptance: There is always acceptance risk when new products are rolled out.

• Impact of DOJ settlement: EXAC recently settled with the DOJ and will be under the scrutiny of a monitor in 2011.

Valuation Method for Price Target: 10-year DCF

SNN


Ratings History Date Rating Share Price Price Target 1/19/11 BUY $56.83 $72.00 SNN Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and SNN will underperform.

• High Exposure to Metal-on-Metal and Hip Resurfacing: SNN is market share leader and is exposed to negative sentiment toward hip resurfacing and metal-on-metal.

• Manufacturing: Shift in manufacturing to developing countries may not translate to expected savings.

• Acquisition Premium: If SNN is not bought downside risk exists as acquisition dissipates.


SYK


Ratings History Date Rating Share Price Price Target 1/19/11 BUY $58.39 $71.00 SYK Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and SYK will underperform.

• Product acceptance: There is always acceptance risk when new products are rolled out.

• Diversification outside of comfort zone: SYK has little experience in the neurovascular market increasing acquisition risk.

• Macro Enviornment: Orthopedic industry headwinds will remain as depressors of valuation premium.


January 19, 2011


WMGI


Ratings History Date Rating Share Price Price Target 1/19/11 NEUTRAL $16.78 NA WMGI Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and WMGI will underperform.

• Market Share Losses: Management must stem share loss by switching customers to alternative products or convincing them that metal-on-metal articulations do not place patients’ lives at risk.

• Product Acceptance: Risks apply as WMGI roll rolls out new products in 2011 and 2012.

• Changes to 510K Process: WMGI may be overexposed to proposed changes in the 510k process and corresponding increase in R&D requirements.

Valuation Method for Price Target: NA

ZMH


Ratings History Date Rating Share Price Price Target 1/19/11 BUY $56.16 $89.00 ZMH Investment Risks

• Global Economy: If global economic woes persist, orthopedic volumes will decline and ZMH will underperform.

• Diversification Strategy: ZMH needs to begin to diversify outside its comfort zone and reduce exposure to hips and knees.

• Product Acceptance: Risks apply as ZMH rolls out new products. • Macro Enviornment: Orthopedic industry headwinds will remain as depressors of valuation premium.


Orthopedic Report

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