The Moat Show Ep. 2: Zimmer Biomet with Morningstar's Debbie Wang

On The Moat Show, we uncover the companies with economic moats, one stock at a time, by bringing on analysts from Morningstar to share their in-depth insights with you.

Visit VanEck.com/MOAT or VanEck.com/SMOT for the latest VanEck Morningstar Wide Moat ETF or VanEck Morningstar SMID Moat ETF holdings on the stock discussed in this episode.

The views and opinions expressed herein are those Debbie Wang of Morningstar as of 5/18/2023, and are not intended as financial advice, a recommendation to buy or sell any securities mentioned, or any call to action. Actual future performance of any securities mentioned is unknown. Certain statements may constitute forecasts, projections, or other forward-looking statements which are valid as of the recording date, for illustrative purposes only, subject to change without notice, and do not necessarily reflect those of VanEck or its employees.

Chelsea: It's episode two of The Moat Show, we're excited to have on senior Morningstar analyst Debbie Wang to discuss Zimmer Biomet. Welcome, Debbie.

Debbie: Oh, thank you so much for having me.

Chelsea: Debbie, for those who aren't familiar with Zimmer, could you briefly explain the history of Zimmer Biomet and elaborate on their present business activities?

Debbie: I would love to. Zimmer Biomet is one of the largest orthopedic implant makers, so these are the guys who make artificial knees and artificial hips. And their coming together is sort of interesting because Zimmer actually bought Biomet back in 2014-2015, and it was a little bit of a rocky transition for the two companies to come together and become integrated, partly because of regulatory issues. There were also snafus with inventory management and I.T. systems. But perhaps underlying all of that, one of the issues that turned out to be a bigger roadblock than you'd think was actually cultural, and that is because Biomet was born of Zimmer. A couple of the founders of Biomet were the ones who came up with the idea of a better way to do things and decided we're going to go down the street and open up our own shop and call it Biomet, and we're going to be different than Zimmer. If Zimmer was buttoned up in suit and coat and formalized procedures, we're going to be all about innovation and informality and blue jeans. So, when Zimmer decided to buy Biomet and bring the two pieces together again, you can imagine there were big feelings on both sides. And that turned out to be a really, really challenge, and big challenge for this company. But I would say that the difficulties that they had in 2015, 2016, 2017 only underscore the sense that this company has a pretty strong wide moat because it was able to come out of that period when it was really a basket case and it could get back on its feet.

Coulter: Well, that's really interesting. So it's almost as if Zimmer's kind of recently been this kind of comeback story, if you will. So, great, interesting background.

And since you kind of mentioned, I guess, leading into the next question: Debbie, you mentioned Zimmer's wide moat. I know Morningstar's economic moat rating plays a big role within your analysis of the company. So, can you talk a little bit about what makes Zimmer Biomet a wide moat company as well as kind of what competitive advantage do you see it exhibiting?

Debbie: Yes, well, of the five sources of Moat that we consider and look for, we think that Zimmer Biomet really benefits from two large ones. One is switching costs and then the second is intangible assets. And let me give you an illustration of that. So, the switching costs for Zimmer Biomet really lie with the orthopedic surgeon. You've probably seen this with mechanics, or when you do some home improvement and you go out and buy a set of craftsman tools, like wrenches, right? They're all standardized. So, whether you buy Craftsman, or whether you buy Ace Hardware, it's going to be a standard measurement in size. When it comes to orthopedic instrumentation, that is not the case. It's not standardized. Each company has its own proprietary instrumentation toolset. And so, what happens is in the process of training and becoming facile with a particular company's set of instruments and tools so that you get good at installing a knee or a hip. After a while, these orthopedic surgeons want to stick with the one that they've practiced on the most. So that's what gives rise to the switching cost. And the research out there suggests that orthopedic surgeons typically stay with their preferred vendor for 15 years and beyond. So, that's a pretty strong switching cost right there. And if they were to switch away, they'd have to relearn a whole system, practice on it. In the process of practicing, there may be situations where they can't get the preferred outcome for their patient. There may be a risk there. So that all plays into the switching costs.

Then the other source of Moat that we look at is intangible assets and for a lot of the medical devices and orthopedic device makers especially, it comes down to the sales rep. These people are highly trained, and they tend to be, they have very narrow, focused expertise just on the technology that the surgeon is using. So this may be a little bit disconcerting to lay people, but very typically, a sales rep is going to be in the room in the O.R. every time a procedure is being done. And they're there really sort of as backup help to the surgeon, especially if the surgeon only does, say, 20 knee replacements in a year. And while the sales rep sees them day in and day out, they're going to be much more familiar with the technology. So having a sales rep there and the role that that person plays is an intangible asset for Zimmer Biomet.

Chelsea: Debbie, can you clarify if the practice of having a sales rep in the procedure room, is that an industry standard or is that a differentiating factor for Zimmer Biomet? And if it is an industry standard, is there anything that you’ve looked into about potentially like the training or sales force that makes Zimmer sales reps more unique than the industry standard?

Debbie: Yeah, this is a standard operating procedure for the entire industry. All the orthopedic companies do this. What I would say is the research that's been done on that relationship between the orthopedic surgeon and the sales rep seems to indicate that it's very, very important to have a good rep who provides the appropriate level and the preferred level of support. So, what I mean by that is if you have a high-volume surgeon, they may feel like they've got everything under control, and so they may want that rep to be someone who's comfortable taking a back seat. On the other hand, if you've got a surgeon who who's not a high-volume surgeon is a low volume surgeon and probably needs more support or has more questions, you want that person, that rep in the room to be able to play more of an active role. Now, these reps do go through a lot of training. So, unlike the pharma sales reps that we're often more familiar with because they bring in pens and lunch and notepads to the doctors, these medical device sales reps spend a lot of their time going through the training before they're allowed to go out there and work with doctors. They also tend to work with the same doctors over time. So, for example, they may stick with the same doctor five, six years because they have an actual relationship there. And then any number of them just decide, you know, they're so intrigued by this work or and the technology that they end up going to medical school themselves and they flip onto the other side and become doctors. So, it's a little bit of a different professional path than some of the other sales reps that we see.

Coulter: Wow, that’s really interesting. So really, you had this kind of these two forces that are kind of, in a way, disincentivizing surgeons from moving away from Zimmer Biomet’s technology and their medical devices. You know, they have this committed capital of intellectual capital of years of training on and learning, you know, these devices. But then they also have these relationships with these sales reps where they see them probably every day or nearly every day, and they're in their in their operating room with them, helping them out and providing guidance. So, that's really interesting.

Kind of shifting a little bit, I guess I want to try and talk about what kind of greater themes are you seeing from Zimmer Biomet as well as the modern industry. So, what sort of trend are you watching that you think could potentially impact this space going forward?

Debbie: I think there are a couple that are on my radar screen. The first is post-pandemic. What is happening with the backlog? There is a backlog of patients out there who have decided to sit on the sidelines until the situation with the pandemic has receded enough that they feel comfortable coming back in and scheduling these procedures. So, these are patients who probably have had their condition worsen. In the meantime, they may be in more pain. They may be less able to walk as far. So that may set themselves up for a more challenging fix. Right. So, the procedure to put in a new knee may be more challenging. So that's one thing that I'm looking at.

The other thing, which is a factor that plays into how long it's going to take to work down this backlog has to do with hospital staffing. So, we know that we lost a lot of staff across the hospital during the pandemic. And in fact, we're now at the point where our nursing staff. So, the registered nurses that work in hospitals, we have not yet been able to recover to the pre-pandemic levels back in 2019. So, there is a bottleneck that's happening at the hospitals because they don't have enough staffing, and so if you're going to, call and make an appointment to have a hip replacement, it could very well be that you're going to be waiting longer than we would have been if we didn't have this issue with the labor.

So those are two issues that are out there. Then the third is we start looking at, well, how can technology potentially make up the gap and help us? And that gets me to a third trend in orthopedics that is really large right now and is a big driver of growth, which is the use of robotics. So, we're talking about robots that help the surgeon put a knee in or put a hip in. That's a big area of growth, and a lot of surgeons want to be able to learn how to use one and become good at using one so they can offer that to their patients.

Chelsea: Debbie, I read that you previously identified a long-term strategic risk for Zimmer Biomet is the shift from surgeons to hospital employees. So, I'm just curious if you could dive into that a little bit and why this transition is occurring.

Debbie: Yeah, thank you for asking that question, because I think it's something that we as patients and consumers of health care don't really think about. But it really comes down to financial incentives that that spur choices. The way it has typically worked is most orthopedic surgeons have been in private practice, and most of them have been sole practitioners. So these are folks who like to work by themselves in a lot of cases, and they will work on a piecemeal basis. So each time they do a hip replacement, they get paid for that. What we have in our country is a triangulated system where the surgeon is the one that makes the choice on which kind of knee to put into the patient. And then you've got the hospital that has to negotiate a contract with Zimmer Biomet, for example, to buy those knees. And then you have a third-party payer out there that actually pays for the whole thing. So that would be, for example, Medicare. So, what happens is everybody has their own agenda, but those agendas may not overlap. Right? The doctor's going to be looking for what he or she thinks is the best option for this patient. The hospital's going to be looking for the best deal that they can strike with the manufacturer. And then you've got the payer that just wants to pay less but has very little control over any of it. So, by having an orthopedic surgeon become an employee of the hospital, it starts to bring their financial incentives into alignment, because whatever they choose to put into this patient, if it's good for the hospital, it will ultimately also be good for the surgeon since the surgeon gets paid by the hospital. So, that that is a very long-term trend that we've been keeping our eye on, because we think over time it may diminish the surgeon's primacy in making that brand choice right now. So, but like I said, this is a very long-term trend because it's generational. So, what we're seeing is a lot of the older orthopedic surgeons who have been accustomed to practicing in private practice, a private practice setting, they will continue that until they retire, whereas the new surgeons that are coming out of the training programs, through the residencies and the fellowships, they are the ones who are more inclined to sign up and be an employee of the hospital. So this is a very long term turnover story.

Chelsea: Got it. So I guess, because it's so long-term, Zimmer has time to plan for this shift happening and potentially they could target maybe more of the hospital administrators or the insurance companies, to make up that influence gap a little bit.

Debbie: Yeah, that's exactly right. That's exactly right. Although we still think, to some extent there's going to be protection in the switching costs that I talked about earlier. Right. If a doctor has spent ten years using Zimmer Biomet’s toolset, it will take a lot to convince that person to switch over to a different competitive toolset.

Chelsea: Interesting. Okay, Debbie, we saved the best question for last. This question is about your background. We know prior to your role at Morningstar, you spent some time as a brand strategist at a big ad agency. So, we're both really curious to hear what inspired your career shift to equity research, and if you can draw any parallels between your experiences in these seemingly very different roles.

Debbie: I have always had a Jones for investing. I like the idea of being a very small owner of a larger company, having a very small slice of ownership, but having a vested interest in that company in the business that underlies it. I love that concept. And it took me a while to sort of learn how to use the tools to be able to assess that. But I do think it's fair to say there's a fair amount of overlap between the two areas of marketing strategy and equity research, in that it's all about taking a look at a company, understanding its strengths and weaknesses. And then from there, being able to develop some sense of whether this company has a competitive advantage. And how do you leverage that? And I think that that really does play into the way that I look at a company and try to sort out what's going on here and whether it's going to succeed over the long term.

Chelsea: Fascinating. All right. Thanks so much for your time, Debbie.

Coulter: Yeah, really appreciate it. Interesting stuff.

Debbie: Thank you so much.