Thursday, March 29, 2012

Rough Times Ahead for Health Care Stocks?

The Supreme Court yesterday ending three days of oral arguments discussing the constitutionality of President Obama's healthcare initiative passed by Congress a couple of years ago.

Here's how the Washington Post described the debate this morning:

The Supreme Court closed an extraordinary three-day review of President Obama’s health-care law Wednesday, with its conservative majority signaling that it may be on the brink of a redefinition of the federal government’s power.

Justices on the right of the deeply divided court appear at least open to declaring the heart of the overhaul unconstitutional, voiding the rest of the 2,700-page law and questioning the underpinnings of Medicaid, a federal-state partnership that has existed for nearly 50 years.

The Court will apparently not render a decision until June, but their ruling could change the way health care is delivered in this country.

However, the health care industry has already been undergoing significant changes in the past few years.

Health care stocks used to offer investors a "safe haven" due to their predictable revenue growth and fat profit margins.

However, as the pressures to slow the growth in healthcare expenses in this country have grown, the industry is under tremendous pressure to deliver the same kind of growth and profitability that investors have come to expect in the past.

I was reminded of these trends yesterday, when I had the chance to hear from management of Zimmer Holdings (ticker: ZMH).

Zimmer is one of the largest manufacturers of orthopedic implants (hips, knees, spine, trauma and dental) as well as related orthopedic products in the United States.

The company had been part of pharmaceutical giant Bristol Myers for many years before it was spun out in 2001.

Initially Zimmer was a stock market favorite.  Investors loved the fact that its products have a very favorable demographic tailwind as well as their ability to raise prices at a rate of +5% a year.  At the same time, operating margins at the company remained in the neighborhood of 25%, which allowed for a very steady growth in earnings per share.

For the first 6 years of its independent existence from Bristol, Zimmer stock was a home run, rising nearly +200% compared to a gain of just +24% for the S&P 500 during the same period.

But then reality, and the recession, hit.

Since its peak in the spring of 2007, Zimmer has fallen by nearly -30% vs. a loss of just -5% for the S&P 500.

The problem that the Zimmer has faced - as well as other orthopedic manufacturers - is that hospitals and doctors have become more cost conscious.  Hip replacement technology, for example, varies only in minor details between products, and often the more expensive solution is not necessarily the best for the patient.

The orthopedic device industry now face the prospect that Medicare - the largest purchaser of orthopedic devices - will now start posting prices that it will pay for products on the internet.

Although Zimmer yesterday downplayed the significance of this development - claiming that most hospitals already routinely share cost information - this will be another headwind the company will face in coming years.

And so in yesterday's meeting Zimmer management spoke mostly of cost-cutting. They are targeting cost saving of at least $400 million (roughly 6.5% of current expenses) between now and 2016.  Sales growth will come mostly from acquisition - the days of organic growth seem over for now, at least.

The investment case for Zimmer rests largely on your view of the economy.  When times are good, people are more likely to go for orthopedic procedures.

But if economic growth remains sluggish, Zimmer's stock could also struggle in this new world of American health care.