Orthopedic-Device Manufacturers: Aching Joints

Shares of the leading makers of artificial hips, knees and spinal implants came under pressure this week on the news that the U.S. government has subpoenaed the industry leaders, asking for information about their sales practices. Are the stocks cheap, or cheap for a reason?

Jog your memory and you'll recall that Biomet, Stryker and Zimmer are three stocks that essentially breezed through the 2000-02 bear market. Shares of each of these medical-device makers rose handsomely despite the dreadful market conditions. The performance resulted from relentless demand and high prices for hip and knee replacements, as well as the promise of breakthrough surgical remedies for spinal injuries and chronic back pain.

Analysts and fund managers have long admired the orthopedic industry for its demographic characteristics. Millions of people who get a new hip or knee, for example, are between 45 and 65 and have excellent health insurance or the money to pay for procedures to repair and rejuvenate their worn-out bodies. Some are replacing the replacements with lighter and more flexible second-generation versions. If you look back five or ten years, this sector has had some of the highest returns of any group in the stock market. Stryker (symbol SYK), the largest of the three, boasts an annualized return of 21% over the past ten years. Biomet (BMET) isn't far behind, with a 19% annualized return. Zimmer (ZMH), which Bristol-Myers spun off to the public in 2001, shows a compounded return of 14% over the past five years.

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But since 2003, the orthopedic sector has been causing pain rather than alleviating it. Each of the three stocks has trailed Standard Poor's 500-stock index. Growth rates have slowed and quarterly earnings have occasionally fallen short of analysts' expectations.

But now investors have to face something that is potentially even more troublesome: a federal antitrust investigation. Last Friday, the companies issued similar statements disclosing that the Department of Justice wants information about industry sales practices. The stocks fell 8% to 10% in three days.

This news isn't totally new. In March 2005, the government asked the industry for details about financial relationships involving surgeons, hospitals and the orthopedic-device makers. Since then, there have been no fines or settlements. It's unknown exactly what the government wants to scrutinize. But the risk to the industry's profits and to the value of the stocks is that the U.S. will find improper pricing agreements among the manufacturers, the doctors who select their favorite brand of implants and the hospitals where the operations take place. Because orthopedic-device makers' earnings growth has been greatly helped by regular and strong price increases, a settlement with the government could result in weaker pricing in the future. That would slow earnings prospects.

Although the stocks have fallen sharply since last Friday, analysts' reaction to news of the investigation has mainly been wait-and-see. Bank of America Securities did call this "one more overhang," downgraded Zimmer from buy to neutral and reduced its price target on the stock from $74 to $65. Zimmer's stock, $64 last week, closed Wednesday at $57. For now, most other analysts have left their ratings of the three companies unchanged.

Until the latest development, the general tone of the research on the industry has been one of restrained bullishness. Analysts have been writing that these stocks are unusually cheap but also that the glory days of rapid growth sparked by strong sales of hip and knee replacements are history. So, they say, this is a good time to buy these stocks at favorable prices if you can wait patiently for new products to kick into gear. At $42, Stryker trades for 21 times analysts' average 2006 earnings estimates. For a long time, Stryker carried a P/E in the 30s but its earnings always justified the high price. Zimmer and Biomet now sell for 16 times estimates, close to the value of the overall market. If the government's investigation turns out to be much ado about nothing, this could indeed be an excellent time to invest in orthopedics stocks.

Kosnett is the editor of Kiplinger Investing for Income and writes the "Cash in Hand" column for Kiplinger Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.