ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q2 FY2017

Business Context and Reporting Period

Zimmer Biomet Holdings, Inc. designs, manufactures and markets orthopedic reconstructive, sports medicine, trauma, spine, craniomaxillofacial, dental and related surgical products. This unaudited Form 10-Q covers the three and six months ended June 30, 2017, compared with the corresponding 2016 periods.

Financial Performance and Liquidity

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Net sales	$1,954.4 million	$1,934.0 million	$3,931.7 million	$3,838.0 million
Operating profit	$282.3 million	$201.6 million	$632.7 million	$447.1 million
Operating margin	14.4%	10.4%	16.1%	11.6%
Net earnings attributable to Zimmer Biomet	$184.2 million	$(31.3) million	$483.6 million	$77.5 million
Diluted EPS	$0.90	$(0.16)	$2.38	$0.38
Operating cash flow	Not separately provided	Not separately provided	$715.9 million	$652.4 million

Sales increased 1.1% in the quarter and 2.4% year to date. Growth reflected the LDR acquisition and strong Asia Pacific performance, partly offset by supply delays, pricing pressure and unfavorable foreign exchange.
Net earnings benefited from lower inventory step-up charges, favorable tax items and operating leverage. The company recognized a $69.7 million tax benefit from restructuring deferred tax liabilities and tax benefits of $67.0 million in the quarter and $88.8 million year to date from resolving tax matters.
Adjusted net earnings were $424.6 million in the quarter and $858.0 million year to date, compared with $407.1 million and $814.3 million, respectively, in the prior-year periods. Adjusted diluted EPS was $2.08 and $4.22, compared with $2.02 and $4.03.
Cash and cash equivalents were $450.0 million at June 30, 2017, down from $634.1 million at December 31, 2016. Investing cash outflows were $262.1 million and financing cash outflows were $656.9 million for the first six months.
At June 30, 2017, current assets were $4.4 billion and current liabilities were $3.0 billion. Debt consisted of $1.329 billion current debt and $9.354 billion long-term debt on the balance sheet. No borrowings were outstanding under the $1.5 billion multicurrency revolving facility, and the company was in compliance with its debt covenants.
The company paid $96.5 million of dividends during the first six months and declared quarterly dividends of $0.24 per share. The $1.0 billion share repurchase authorization remained unused.

Material Changes Versus the Prior Comparable Period

Revenue growth was modest, with volume and mix contributing 4.7% in the quarter and 5.7% year to date, but price reductions and foreign exchange reduced growth by 2.6% and 1.0% in the quarter, respectively.
Spine and CMF sales increased 33.0% in the quarter and 32.5% year to date, primarily due to LDR. Knee sales declined 2.4% in the quarter and 1.3% year to date; dental sales declined 6.4% and 3.7%, respectively.
Cost of products sold excluding amortization fell to 27.0% of sales from 33.1% in the quarter and to 26.5% from 33.4% year to date, mainly because Biomet inventory step-up charges substantially declined. This benefit was partly offset by manufacturing inefficiencies, lower hedge gains and pricing pressure.
Special items increased to $158.6 million in the quarter and $268.7 million year to date, including quality remediation, integration, consulting and impairment costs. Intangible amortization also increased due to LDR and other 2016 acquisitions.
Operating cash flow improved, partly because the company sold $582.7 million of receivables for $582.3 million of cash proceeds and estimated approximately $210 million of incremental operating cash inflows from receivables programs.
Debt reduction continued: the company redeemed $500.0 million of senior notes and paid $150.0 million on the U.S. Term Loan A during the first six months.

Guidance, Outlook, Risks and Unusual Items

Management forecast 2017 sales growth of 1.5% to 2.4%, assuming approximately 0.3% foreign exchange pressure, approximately 2% pricing pressure and approximately 1.2% benefit from LDR for the full year.
Management expects lower 2017 cost of products sold due to reduced inventory step-up, excess and obsolete inventory and medical device excise tax costs, but expects continued pressure from pricing, lower hedge gains and incremental manufacturing costs.
Management expects R&D expense of approximately 4.5% of sales, SG&A of approximately 37.5% of sales, lower special items than in 2016 but still significant, and lower interest expense from debt repayment.
Supply constraints related to quality enhancement and remediation at the legacy Biomet Warsaw facility continued to affect key brands. Management expected to reduce backorders through the third quarter and early fourth quarter and restore sufficient safety stock by year-end 2017.
Biomet integration plans are expected to continue through 2018. Cumulative employee termination and contract termination costs were $158.4 million and $134.9 million, respectively, at June 30, 2017; management expects total costs of approximately $170 million and $140 million.
Significant contingencies include estimated remaining Durom Cup liabilities of $224.2 million, Biomet metal-on-metal hip liabilities of $36.4 million, and potential additional Stryker litigation charges of up to $165.0 million. Durom-related insurance recoveries included a $95.3 million receivable, but insurers reserved their rights to deny coverage.
Pending FDA warning letters related to facilities in Ponce, Puerto Rico and Montreal, Canada, remediation of FDA inspection observations, and a June 2017 OIG subpoena concerning healthcare professional consulting arrangements could result in regulatory, financial or operational consequences.
The company entered into a three-year DOJ Deferred Prosecution Agreement in January 2017 concerning legacy Biomet FCPA matters. Noncompliance could result in prosecution and possible exclusion from federal healthcare programs.
Disclosure controls were deemed ineffective as of June 30, 2017 because of a continuing material weakness in income-tax accounting controls. Management added tax and intercompany accounting resources and implemented a remediation plan, but the weakness had not been remediated.
After quarter-end, the CEO resigned effective July 11, 2017 and the CFO became Interim CEO. A senior business-unit executive also announced a September 2017 resignation, creating additional management-transition risk.

Important Facts for Investors to Verify

Whether Warsaw remediation achieves sustained production throughput, clears backorders and restores safety stocks as projected.
The sustainability of reported earnings after unusually favorable tax benefits, lower inventory step-up charges and other adjustments.
Progress toward reducing leverage and meeting near-term debt maturities, including the $1.150 billion of 2.000% senior notes due April 2018.
The ultimate cost and insurance recoveries associated with Durom Cup, Biomet metal-on-metal and other product-liability matters.
The outcome of FDA matters, the OIG investigation and compliance with the FCPA Deferred Prosecution Agreement.
Whether the tax-accounting material weakness is remediated and whether additional out-of-period tax adjustments arise.
Execution of the CEO succession process, retention of key executives and achievement of the forecast 2017 sales and cost targets.