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Medical-device firm Biomet, which will hopefully be more promising than AMD, makes artificial joints—mainly hips and knees—as well as a variety of other products used in orthopedic surgery, such as pins and screws for setting broken bones. The firm has been around for about 25 years, is still run by one of the founders, and competes "with a relatively small group of firms. (The top five firms in Biomet's main market control about 85 percent of sales.)

The orthopedic device industry is pretty attractive. Developed-country populations are aging, and better health care means that people are staying active longer—which increases the demand for artificial joints. Moreover, artificial joints became a mass-market product only during the 1980s and 1990s. Because joints typically have a 10- to 12-year life span, the number of revision procedures, which replace or repair a worn-out artificial joint, is just now starting to climb. Add these revisions to the demand for first-time procedures, and the market is growing at 7 percent to 10 percent. And because annual price hikes of 3 percent to 4 percent are pretty usual in the orthopedic industry, sales growth of 10 percent to 14 percent looks pretty doable for the average orthopedic device company. Companies that gradually gain market share or compete in the high-end segment of the market might be able to grow a touch faster, as well.

Margins are fat because the industry has high barriers to entry and high switching costs. Surgeons prefer products with long clinical track records, which means it would be tough for an upstart to quickly gain market share. In addition, this is a heavily research-dependent business, so having decades of product development experience and expertise helps keep incumbents ahead of potential new entrants. Finally, each company's products are slightly different, which means that orthopedic surgeons develop product preferences and are reluctant to take time off from surgery to get retrained on a competitor's product unless it offers a large potential benefit. Because artificial joint innovations tend to be incremental, rather than revolutionary, this isn't terribly likely, so market share in the industry stays fairly stable.

You can learn all of this information by reading Biomet's 10-K and those of a few of its competitors, as well as surfing a few industry-oriented Web sites. Let's see if the financials bear out what seems to be an attractive company.

Economic Moat

First, we need to look for evidence that the firm has an economic moat—what sounds good in words may not always show up in the numbers. As with AMD earlier in the chapter, we can do this by examining the trends in Biomet's free cash flow, margins, return on equity, and return on assets (see Figure 11.S).

These are the kinds of consistently excellent financial results that serious stock investors dream about—consistent and constantly increasing free cash flow, a free cash-to-sales ratio "well above 5 percent (and usually above 10 percent), and very consistent operating and net margins. There's little to quibble with here—any company that can convert more than 10 percent of sales into free cash flow for a decade Is doing something right.

Trends in ROA and ROE also look stellar, with high margins, decent asset turns, and modest financial leverage (see Figure 11.9). Asset efficiency

Figure 11.8 Biomet's historical free cash flow.

Figure 11.9 Biomet's profitability numbers.

has declined a bit since the early 1990s, but not to an alarming degree. The only black spot is 1999, when net margin suddenly dipped from 19 percent to about 15 percent. Even though it recovered promptly the next year, this is something we should investigate.

A quick glance at the financial results in Figure 11.10 shows that the lower margins in 1999 were likely due to the $55 million in "other" expenses that the company recorded that year. After digging into the footnotes of the 1999 IO-K filing, we find that the $55 million was a charge related to a legal dispute with a competitor, which claimed that Biomet competed with it unfairly. Although this is not a great development, the medical device industry is a litigious one, and adverse legal charges are a fact of life from time to time. Because this is the only sizeable problem during the past several years—and none of the legal disputes discussed in Biomet's 2OO2 IO-K sound particularly worrisome—it's not something I'm going to worry about too much. We should, however, make a mental note to pay extra-special attention to Biomet's balance sheet to make sure it has the resources to pay any more judgments that might come along.

Figure 11.10 Biomet's historical operating expenses.

Figure 11.11 Biomet's historical revenue growth.

Overall, it looks as though Biomet has a pretty sizeable economic moat. Returns on capital and free cash flow are consistently high, and there's not much year-to-year variation. Although we'll want to make sure we dig further into Biomet's competition—to make sure that these solid financial results are likely to persist in the future—Biomet has the financial hallmarks of a solid investment so far.

Growth

Figure 11.11 indicates that revenue growth has been a little volatile, ranging from 8 percent to 20 percent, but a sales growth rate in the mid teens is about average. That's pretty good, and it's right in line with the industry growth rates we examined earlier in this section. That means Biomet is likely holding its own in terms of market share.

Now, let's see "whether earnings growth is similarly solid (see Figure 11.12). Aside from 1999, which was affected by that $55 million legal charge that we mentioned earlier, earnings growth has been excellent. It's tough to increase the bottom line at 15 percent annually for a decade, but that's what Biomet has done. In addition, it looks as though long-term earnings growth of 15.7 percent is right in line with long-term sales growth of 15.8 percent, which means Biomet probably hasn't had to play any accounting games to generate such solid results. The firm increased earnings the "way a great company should—by selling more products, year in and year out.

EPS Growth 93 94 95 96 97 98 99 00 01 02

Figure 11.12 Biomet's historical EPS growth.

Profitability

We've already given very high marks to Biomet for its solid free cash flow and high returns on capital, but as we did with AMD, let's dig deeper to find out what was driving the firm's profitability. Again, "we use a common size income statement as our tool (see Figure 11.13).

These are some very solid, steady results. Gross margins of 70 percent are high, and it looks as if they've been very gradually increasing over time, which means the firm has been able to maintain pricing power of the goods it sells and control costs of the materials used to make its products. Overhead (SG&A) costs have been very steady as a percentage of sales, which means Biomet isn't becoming more efficient as it grows. This is all right, though, because a big chunk of those SG&A costs are Bio met's payments to its salesforce— when salespeople sell more, they get paid more, which is as it should be.

Finally, it looks as though research and development has been declining as a percentage of sales. Although this could be positive, because it means higher overall margins as Biomet spreads R&D costs over a larger sales base, we need to be sure that Biomet hasn't pared back too far on research. Innovation is the lifeblood of a company such as Biomet, so we want to do some digging to make sure the company has plenty of new products in the pipeline. We can probably determine this by going through the company's recent press releases and annual report, and we can also compare how much Biomet is spending on research with its competitors to make sure it's in line.

Overall, though, there are few quibbles here. Biomet passes the profitability test with flying colors, and the results are as clean as can be, with very

Figure 11.13 Biomet's common size income statement, representing each line item as a percentage of revenue.

Financial Health

Biomet has no long-term debt, so that's one thing we won't have to worry about. The current ratio is around 4, "which is high for a company "with no debt to worry about, and the firm has consistently kept around 15 percent of total assets in cash.

One thing you want to watch with super-profitable companies such as Biomet is that they don't let too much cash pile up on the balance sheet. It's fine for a company to build a temporary war chest if it anticipates big investments sometime in the next few years, but cash that sits around on the balance sheet for a long time isn't being used efficiently. If you see cash as a percentage of total assets rising year after year for a firm that's already in fine financial health, try to find out why management isn't buying back stock, paying a dividend, or reinvesting it in the business. Any of the three are preferable to letting the cash account balloon.

The Bear Case

Creating a convincing bear case is especially crucial when evaluating com­panies like Biomet that score well on just about every front. Things that look too good to be true usually are, and every company has some warts that need to be taken into account.

First, we need to think about litigation risks. We mentioned earlier a re­cent $55 million charge related to an adverse legal settlement, and it's likely that the firm will be embroiled in other disputes from time to time. Therefore, we want to make sure that the firm has adequate insurance and that it's good about disclosing the status of "whatever litigation it's party to. (The "commitments and contingencies" section of the IO-K will help us do this.) Legal risks are largely unpredictable, so we should be prepared for some potential headline risk from Biomet.

Another area of concern is that Biomet's foreign operations aren't in nearly as good a shape as its U.S. operations. If we look at the "segment data" section of Biomet's 2OO2 IO-K, we find that the firm does about 25 percent of its sales outside the United States, but only 12 percent of the firm's operating Income stems from ks foreign units. Because the foreign segment is a big portion of the overall company and it's only half as profitable—and it's not growing as quickly—we want to find out what Biomet's plans are for its foreign operations. Why are they so much less profitable and growing so much slower? How does Biomet plan to fix them? If Biomet can't get its foreign operations on track, does it plan to exit them altogether, or is there some larger strategic reason that the firm needs an international presence? We want to try to get answers to these questions so we know j ust how big a risk the firm's foreign operations are likely to be.

Biomet's size is also an issue, because digging into the orthopedic devices industry reveals that Biomet is not as large as some of its competitors. Biomet has about 7 percent of the worldwide orthopedic market, whereas its competitor Stryker has 15 percent and the DePuy division of Johnson & Johnson has about 14 percent. Firms with more market share can sometimes gain greater economies of scale—which would allow them to price their products lower—and may also be able to outmuscle smaller competitors by offering customers a more diverse product lineup. Because Biomet has been growing nicely for some time and there's no evidence yet of margin pressure, it looks as though the firm is holding its own against its larger peers. However, we want to keep in mind the risk that a larger competitor will try to squeeze Biomet.

Finally, we want to look into some big-picture industry risks. Biomet's large gross margins suggest that the firm has been able to charge premium prices for its products, and highly profitable health care industries tend to attract political pressure from time to time—just ask the large drug firms. A change in the rules for Medicare reimbursements or some other arcane regulatory issue could have a big impact on the whole orthopedic device industry. Like legal risks, regulatory changes are tough to predict, so we want to men­tally prepare ourselves for a potentially unpleasant shock.

Management

As with AMD, Biomet's proxy statement—which details executives' compen­sation—is a good first stop in assessing management. They're paid pretty reasonably: President and CEO Dane Miller pulled in less than $500,000 in salary and bonus, and other members of the executive team are in roughly the same range. One vice president even had a higher base salary than Miller in 2OO2. Salaries and bonuses have been moving up steadily over the past few years, but so have Biomet's profits. Finally, there's none of the "other compensation" frippery that executives at so many firms receive—no mention of loans, company cars, life insurance policies, special deferred retire-like-a-king accounts, and so on. Management is paid a healthy cash salary, some receive modest stock option grants, and that's that.

On the stock option front, neither Miller nor Chairman of the Board Niles Noblitt has received any stock options over the past three years, and some further digging into the proxy reveals that Miller has never received a stock option from the firm. Because Miller owns 3 percent of the outstanding shares and Noblitt owns I.S percent, this is entirely appropriate—both already have substantial ownership stakes that motivate them to act in shareholders' interests, and they see no need for greater ownership stakes. (Contrast this behavior with executives such as Larry Ellison of Oracle or Steve Jobs of Apple, each of whom has received substantial options grants in recent years despite already-large ownership stakes.)

For those executives who did receive option grants, the amounts look rea­sonable—over the past few years, no executive has received more than I percent of the total options granted in a given year, which means options are likely being widely distributed throughout the firm. Moreover, the total amount being granted each year is rarely above 1 percent of the total number of shares outstanding, and the firm's total number of shares has barely budged over the past decade. That tells me Biomet is using options responsibly to motivate em­ployees and executives without diluting shareholder value, which is exactly the kind of behavior you want to see in the management team of a firm.

Valuation

For a firm as high quality as Biomet, valuation is likely to be the Achilles' heel in the investment analysis process. Companies this good are rarely cheap, so we need to tread carefully as we decide what a reasonable value would be for Biomet's shares. Even though the firm's high growth rate and strong profitability mean that we should be willing to pay up for the shares, we can't pay too much, or "we'll be unlikely to receive a decent return on our investment.

Starting with the basic valuation multiples, we find that Biomet was trading at about 28 times the past year's earnings as of this writing. That's pricey—it's way above the market's price-to-earnings ratio of about 20—but it's substantially lower than the firm's average P/E of 38 over the past five years. Price-to-cash flow (P/CF) tells a similar story: The current P/CF ratio of 35 was higher than the market P/CF of 14, but lower than Biomet's historical average of 45.

Finally, Biomet's earnings yield and cash return of 3.0 percent and 2.1 percent, respectively, didn't exactly scream "undervalued." We could get better returns in risk-free treasuries, and given Biomet's higher risk than a T-bond, "we should demand a higher cash return and earnings yield from its shares.

However, bond payments are fixed, whereas Biomet's earnings and cash flow should grow substantially over time. Moreover, Biomet's business has been consistent over the past several years, which means we can forecast the firm's future with more confidence than we could, for example, AMD's future. Sounds to me like Biomet is a perfect candidate for a discounted cash flow analysis.

Biomet's free cash flow has increased pretty steadily over the past several years, so let's use $180 million as our estimated amount for 2004. (Biomet's historical free cash flows are shown in Figure 11,8,)

If we increase free cash flow at 15 percent over the next five years and conservatively assume that Biomet starts to lose market share and grow more slowly after five years, we see that the present value of the free cash that Biomet will generate over the next 10 years is about $2 billion. (I used a relatively low discount rate of 9 percent—versus a market average of 10.5 percent—because Biomet Is a very financially stable company.) Add In our perpetuity value of about S3.5 billion, and Biomet is worth $5.5 billion, or about $21 per share (Figure 11.14 runs through these calculations for you).

With the stock trading at about $28 as of this writing, Biomet doesn't look like much of a value under this set of assumptions. However, maybe we're being too conservative by forecasting that a competitor will start eating Bio­met's lunch in just five years. Moreover, it might not be reasonable to assume that a firm in an industry as young and robust as orthopedic devices will be growing at just 3 percent after a decade. That's a really low growth rate—in line with the overall economy—and it's entirely possible that Biomet will still be growing at an above-average rate in 10 years' time. Therefore, let's try another scenario. We'll assume Biomet can grow faster starting in year six, and

we'll push our forecast horizon out to 15 years, at which time we assume that Biomet's growth rate declines to a steady state of 3 percent (see Figure 11.15).

This set of assumptions results in an estimated intrinsic value per share of about $30, which is right around where the shares are trading as of this writing. Assuming this is a reasonable scenario, I'd start getting interested in the stock at around $24, which would be a 20 percent discount to my estimated intrinsic value. I'm not looking for much of a margin of safety because Biomet's strong balance sheet, excellent industry prospects, and solid profitability all make it less likely that something will go horribly wrong with my assumptions.

However, this process has taught us something very important: For us to believe that Biomet's shares are worth $30, rather than $20, we have to believe that the firm can hold off its competition and grow at an above-average rate for a long period of time. Companies that can increase free cash flow at an average annual rate of 12 percent for a lengthy period of time—which is what our second scenario assumes—are few and far between, after all.

This is the key benefit of a discounted cash flow approach to valuation. Having thought through a couple of possible scenarios for Biomet, we now know exactly what assumptions are incorporated in our estimated intrinsic value of $30 per share. Armed with that knowledge, we can make a more informed investment decision—we wouldn't know as much about the assumptions needed to believe that the stock is reasonably valued if we'd just looked at the current P/E relative to the historical average P/E. For example, we should probably pay very close attention to Biomet's competitive position relative to other firms in the industry, as well as to any signs that the long-term demand for orthopedic devices might be slowing, because those two factors are what moved our value estimate from $20 to $30.

Conclusion

There you have it—real-world application of the tools of fundamental analy­sis, in a simplified form, is exactly what we do at Morningstar every day.

This is some pretty painstaking stuff, and it's not reasonable to do a super-thorough analysis of every single company you investigate. In the real world, time is short, so even the pros use shortcuts to help separate the companies that really are worth a great deal of analytical time from the ones that are unlikely to be good investments. In the next chapter, I show you exactly how to sepa­rate the wheat from the chaff when you're trying to narrow down a list of in­vestment candidates to the ones that are really worth a thorough investigation.

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