BW 50: A Test Of Zimmer's Agility

The artificial joint maker has the lead in a hot business. But it faces a Justice probe and price pressures

In Warsaw, Ind., where Zimmer Holdings Inc. (ZMH ) is headquartered, there's an old farm expression: Make hay while the sun shines. "We're baling hay as quickly as we can," quips J. Raymond Elliott, chairman and chief executive of the orthopedic-products company. Since it was spun off from Bristol-Myers Squibb Co. (BMY ) in 2001, Zimmer has boosted sales by 37% a year on average. Net income has surged at a 54% annual clip over the same span, while Zimmer's gross margin swelled to a record 77.3% in this year's first quarter.

That bounty stems in part from simply being in the right place at the right time with the right product. Zimmer is the world's No. 1 manufacturer of artificial knees and hips, with a 30% market share. Nearly 900,000 Americans underwent joint-replacement surgery in 2004. That's 2 1/2 times the number in 1999. Demand for prostheses is only likely to grow as the elderly population expands in wealthy economies such as the U.S., and as these metal-and-ceramic devices become longer-lasting, making implants an option even for people in their 40s.

Zimmer has secured an enviable position in that booming market with a two-pronged strategy. First, it has built pioneering devices for minimally invasive surgery -- the latest thing in the operating room. And Zimmer has run thousands of surgeons through its own training program, turning them into loyal customers. A veteran salesman turned corporate restructurer, the 55-year-old Elliott also has been unapologetically aggressive in hiking prices and cutting costs, relocating factories, for instance, to shrink the company's tax rate to as low as 3%. No wonder, then, that Zimmer has graduated from BusinessWeek's 2003 class of Hot Growth companies to No. 38 on this year's BusinessWeek 50 ranking of the best performers in Corporate America.

GRUMBLING

After nothing but blue skies, however, a few clouds are moving in. The U.S. Justice Dept. is investigating the five major orthopedics companies' payments to surgeons for consulting work. While the price of most medical equipment drops every year, Zimmer and its competitors routinely have jacked up prostheses prices 4% to 5% a year. The suspicion is that surgeons don't question the hikes, which are charged to hospitals and clinics, as a payback for their consultants' fees.

Hospitals are grumbling about the runup in implant costs, too. HCA Inc. (HCA ), the largest hospital operator in the U.S., is asking the government to waive a rule to allow the hospital chain to team up with surgeons to reduce outlays on orthopedic devices and then split the savings with them. Cost-sharing schemes generally are banned today to prevent kickbacks to physicians.

Figuring that Zimmer is losing pricing power, a few equity analysts recently lowered their stock recommendations to neutral, from outperform. One of them, Jason Wittes, with New York-based Leerink Swann & Co., adds that Stryker Corp. (SYK ), which vies with Johnson & Johnson (JNJ ) for second place in artificial knees and hips, is a better buy because it is only half as dependent on the joint-replacement market as Zimmer is.

Zimmer's once-soaring stock price is feeling the pinch from anxious investors. Back in July, Zimmer shares had more than tripled in price since they began trading in August, 2001, hitting a high of $89.44 and making the initial public offering one of the smartest plays of the past few years. After the Justice Dept. subpoenas were disclosed on Mar. 31, however, Zimmer's share price skidded 9.2% in two days, slashing $1.96 billion from its market capitalization. The stock has yet to recover and traded in mid-May near $78. Lawrence E. Eakin Jr., senior director of growth equities for National City Corp.'s (NCC ) Armada Funds, bought 60,000 Zimmer shares last year. Earlier this year he began selling as he saw growth rates slowing. Says Eakin: "I do worry."

Not Elliott. He insists he's unfazed by the Justice Dept. inquiry or HCA's effort to turn surgeons against Zimmer. The company has hundreds of doctors on its payroll, with some pulling in $100,000 a year in fees. Dr. Richard A. Berger, for one, an orthopedic surgeon at Rush University Medical Center in Chicago, says he billed Zimmer for more than 1,000 hours of work in 2004, helping the company design, test, and modify its implants and surgical tools. Berger does more than 750 minimally invasive knee or hip replacements a year -- and always uses Zimmer implants. But he says there's no quid pro quo; he simply knows Zimmer's products best since he had a hand in creating them. Elliott, too, says the company's relationships are all above board and that Zimmer is fully cooperating with the government. Nor does Elliott see any reason to alter Zimmer's relationships with its physician-consultants.

As for HCA, Elliott says Zimmer hopes to wrap up a contract by June 1 in which it would give the Nashville-based company price breaks on basic products in exchange for greater sales volume at HCA's hospitals and surgical centers, particularly high-margin artificial knees used in minimally invasive surgery. "I believe this is a win-win," he says.

RUNNING 24/7

Elliott does acknowledge that Zimmer no longer can bank on raising prices across the board every year. Still, the CEO forecasts that earnings will increase by 24% in 2005, to $670 million, with sales growing 12%, to $3.33 billion. And net income will go up at least 25% in 2006, he says. Meanwhile, the company, which borrowed $1 billion in 2003 to buy Swiss orthopedic-products maker Centerpulse in a hostile $3.1 billion deal, will be debt-free by 2006, Elliott says. That means he'll be able to start building a new stash to go shopping again, to decrease Zimmer's reliance on knees and hips and supersize its numbers. "It's nice to have great pricing power," he says, "but we believe we've got a successful strategy that goes on for several years."

In the meantime, though, how can Elliot meet his profit pledge? Synergy, he answers. Following the Centerpulse takeover, the CEO has been restructuring Zimmer's global manufacturing operation. Like most orthopedics outfits, Centerpulse had bought a lot of components from outside suppliers. Elliott is insourcing this work, which means Zimmer's highly automated facilities now can run 24/7. Zimmer is also closing a Centerpulse plant in Austin, Tex., and shifting production to the company's hometown and to Switzerland. Because the company brought more factory work to Switzerland, its tax rate there was halved, to 12%. At the same time, the company is doubling its output in Puerto Rico, where its tax rate has just been cut to 3%. All told, Elliott says, maneuvers like these will add $100 million to the bottom line in 2006.

Zimmer also is introducing new devices, which typically sell for higher prices. Elliott counts 177 products in development today. The company is moving into new markets, too. Through Centerpulse, Zimmer now makes implants for spinal and dental repair. And it continues to woo surgeons. In 2004 some 1,400 of them went through courses at Zimmer's 21 training sites around the U.S. and Europe to learn, hands on, how to perform joint replacements through incisions only a few inches long. This year, Elliott says, enrollment could top 2,000. Although prostheses may seem similar, surgeons typically stay with the brand they know.

Thus, the all-expenses-paid training should help keep Zimmer devices in demand, no matter what happens to prices. For now, Zimmer's outlook isn't all sunshine. The Justice Dept. isn't expected to say what its subpoenas and investigators have found for at least a year. But if Zimmer is cleared, as Elliott believes it will be, he could be making a lot more hay for many more years.

By Michael Arndt in Chicago

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