Streetwise

Lauren Rudd

Sunday, August 22, 2010

Use Your Own Experience to Derive Investment Opportunities

Peter Lynch wrote in his 1989 best seller, “One Up on Wall Street,” that the Greeks used to sit around and debate how many teeth a horse has. Somehow they thought that was a better method than simply counting the teeth in a sampling of horses.

In a like manner, many investors sit around and debate whether a stock is going to rise in price, as if the financial muse is going to offer up an answer, as opposed to taking the time to delve into the company’s financials.

Lynch also made another important and timeless observation in his book. He pointed out that the most obvious investment opportunities are derived from your own experiences. Even if you are retired, live ten miles from the nearest traffic light, grow your own food and do not have a computer or television, you might one day have to visit a doctor. Hallelujah, welcome to the world of medical products and pharmaceuticals.

I mention this because having just had a full knee replacement this week; I am now the proud recipient of a product manufactured by the Zimmer Corporation, a company I wrote about less than a year ago. Unfortunately, Zimmer (ZMH) and Stryker (SYK), which shared the column, have not exactly set the world on fire in terms of share performance. Yet, I still like both companies.

To understand why, consider that the number of adults over 65 in the United States is expected to grow from 35 million in 2000, to 71 million by 2030. In developing countries the number is projected to reach 690 million.

Both Zimmer and Stryker are well positioned to take advantage of this trend. Zimmer manufactures orthopedic reconstructive implants, dental reconstructive implants and spinal implants. It also offers surgical products, including supplies and instruments.

Stryker is similar, operating in two business segments, orthopedic implants and medical and surgical equipment. The orthopedic division sells reconstructive implant systems, bone cement and the bone growth factor OP-1. The equipment division sells surgical equipment as well as patient handling and emergency medical equipment.

Zimmer recently reported second quarter ended June 30 results that included a 3.3 percent (constant currency) increase in revenue to $1.06 billion, led by its hip replacement products. Earnings were a less-than-stellar $0.82 per share, a decline of 16.3 percent due to one-time charges. If you exclude those charges, Zimmer earned $1.09 per share.

In its guidance going forward, Zimmer said it expects revenues to increase 3 to 5 percent on a constant-currency basis, with earnings of $4.15 to $4.35 per share. Zimmer has also agreed to acquire Beijing Montagne Medical Device to expand its presence in the rapidly growing Chinese orthopedic implant market.

Zimmer’s intrinsic value using a discounted earnings approach with a 9.9 percent growth rate and a 15 percent discount rate is $62 per share, while the more conservative discounted free cash flow to the firm approach yields an intrinsic value of $92. My earnings estimate for this year is $4.25 per share, with a 12 month target price of $57, for a 12 percent gain over the recent price of 51.31.

For its fiscal second quarter ended June 30, Stryker reported a 6.9 percent (constant currency) increase in net sales to $1,758 million and a 9.6 percent increase in net earnings to $0.80 per share. Orthopedic implant sales only increased by 1.4 percent, but that relatively slow growth was offset by a near 16 percent increase in medical equipment sales. Guidance for 2010 remains unchanged at a 5 to 8 percent increase in sales, while earnings are projected at $3.20 to $3.30 per share