Much of the press has been about last week’s US$26.2 billion acquisition of LinkedIn by Microsoft as an example of the growing consolidation in the technology sector and the increasing valuations being paid to acquire user bases as well as the technology itself.
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In this case, LinkedIn provides Microsoft with a user base of over 433 million users and a social platform to market its existing software and cloud products to. However, using traditional valuation metrics, Microsoft is paying a steep price for LinkedIn – at US$196 per share, it was a 49.5% premium to share price prior to the announcement of the acquisition and represents a 2016 earnings multiple of 56 times and a 2016 operating cashflow multiple of 24 times (measured as earnings before interest, tax, depreciation and amortisation). Nonetheless, technology deals have boomed with Bloomberg data showing that for 2016 to date, technology deals have totalled US$230 billion globally.
However, the other sector experiencing significant M&A (“mergers and acquisitions”) activity is healthcare with over US$212 billion of global transactions announced in 2016 to date. Spurred by ongoing low interest rates and more drivers for growth and new products, the healthcare industry is in the midst of a consolidation wave.
With many mega-mergers failing to successfully complete such as Pfizer’s proposed acquisitions of AstraZeneca in 2014 for US$119 billion and Allergan for US$160 billion earlier this year, the focus is now on acquisitions of smaller companies focused on developing drugs to fight cancer and neurodegenerative diseases like Alzheimer’s as well as within the medical devices sector – growing areas as the global population ages.
AbbVie acquired Stemcentrx for US$5.8 billion to focus on drugs to target cancer stem cells; Sanofi is in a bidding war to acquire Medivation for about US$10 billion to access its research into treatments for various cancers; and St Jude Medical agreed to a US$30 billion takeover from Abbott Laboratories to combine with their heart-related medical devices businesses. The medical device industry alone has experienced US$187 billion of deals since 2014 according to Bloomberg.
Zimmer Biomet, a product of industry consolidation
Zimmer Biomet is a product of industry consolidation in the healthcare sector and is a company we own in our Splurging Baby Boomers Fund. The origins of Zimmer Biomet were established in 1927 to manufacture aluminium splints and more recently, it was spun off from Bristol-Myers Squibb listing on the New York Stock Exchange in 2001.
With a market capitalisation of US$23 billion, Zimmer Biomet was created when Zimmer acquired Biomet in 2015 for US$13.4 billion to create a leader in musculoskeletal products for the orthopaedic industry. This includes products for the hips, knees, spine and head areas that require replacement or reconstruction due to age, deterioration or external trauma. It has leading market shares of 37% and 30% respectively for the knee and hip replacement and reconstruction market, and these two areas make up about 60% of the company’s revenues. Zimmer Biomet estimates that the market size for knee and hip replacement and reconstruction is US$13.6 billion.
While the company services a wide range of patients, one of its core customer bases are those who are over 65 years of age, who represent a high portion of demand for hip and knee replacements. The United Nations estimates that this segment of the population globally will double to 16.2% by 2050 as humans continue living longer.
Zimmer Biomet is positioned to grow its business in a variety of ways from pure volume growth to expanding its exposure to other product segments such as spine and dental, where its market share is 5% and 11% respectively. Zimmer Biomet estimates that the market size for the spinal, dental, head and sports medicine and surgery markets is over US$25 billion, almost double the size of the knee and hip market. Cross-sell opportunities and increased bargaining power over pricing with its distributors will also drive growth.
LDR, their latest acquisition
In June 2016, Zimmer Biomet announced the US$1 billion acquisition of LDR, a manufacturer of spinal products including spinal disc replacements. The company believes the spinal market is worth US$10 billion a year and the acquisition gives it a combined 7% market share and the number 5 player behind market leader, Medtronic with a 31% share.
Prior to this acquisition, Zimmer Biomet had grown its own spinal and cranio-maxillofacial (head and face) revenues by 95% in 2015 and the LDR acquisition should continue to drive sales growth and also contribute to earnings per share from 2017 onwards (LDR currently earns over 83% gross margins on its sales). In fact, consensus analysts’ estimates show LDR revenues will increase by 80% from 2015 to 2019.
Most of this growth will be driven by LDR’s Mobi-C device, a metal-and-plastic disc that gives patients more freedom of movement when inserted in the spine than traditional fusion surgeries. It is also the only FDA-approved technology that can treat two adjacent discs in the spine although Medtronic is also seeking FDA for its own two-level disc. About 50 million people in the United States are insured for two-level cervical disc replacement surgery with a market size of US$820 million per year in the United States alone.
With the large market opportunity ahead of it, we believe Zimmer Biomet will continue to look for these smaller bolt-on acquisitions to add to its product suite, drive sales growth and incrementally add to earnings.
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