Friday, October 13, 2006

Calls of Note Part 2

Wachovia previewing Zimmer Holdings (NYSE:ZMH) ahead of 3Q06 results. ZMH is counting on its recently launched hip products to provide an acceleration in revenue growth, most notably its new ceramic-on-ceramic hip and large head metal-on-metal hips. In firm's view, the quarter hinges primarily on how much penetration ZMH was able to achieve with these products in what they continue to view as a "mix-adverse" hospital market.

Firm evaluated the sensitivity of ZMH's revenue to hard bearing penetration. At 10%, 20%, and 30% hard bearing penetration of ZMH's U.S. hip sales, hip growth would be 7%, 9%, and 12%, respectively, and total revenue would be $816MM (firm's current estimate), $822MM, and $829MM, respectively. Since consensus calls for $830MM, they believe it implies around 30% hard bearing penetration. Given that competitors have seen hard bearing penetration peak in the 30-50% range after having these products on the market for several years, reaching 30% in one quarter seems challenging to the firm.

Firm expects continued weakness in ZMH's knee category and forecast 7% growth in Q3 2006, up from 4.5% growth in H1 2006 due to currency tailwinds and an easier comp. In addition to facing SYK's Triathlon and BMET's Vanguard knees, ZMH must now fend off Smith & Nephew's new Journey knee with its decade-old NexGen knee. ZMH's Gender Solutions knee should help eventually but likely will not be out until Q4 2006.

Given the recent run-up in ZMH shares, firm believes investors will be disappointed by anything less than stellar Q3 2006 results. In their view, a revenue miss as small as $5MM might be enough to send the stock down sharply and even an in-line quarter might not drive the stock meaningfully higher. With their lingering concern about a revenue miss, firm recommends that investors take some profits before ZMH reports its third quarter results.

Firm has Underperform rating on the stock with $55-$59 valuation range.

Notablecalls: With the Underperform rating Wachovia is expected to be negative. However, they do make some good points and the stock is due for some profit taking. Would be looking to short this one after the open.

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