Business Context and Reporting Period
Zimmer Biomet Holdings, Inc. filed this unaudited Form 10-Q for the three months ended March 31, 2016. The company designs, manufactures and markets orthopedic reconstructive, sports medicine, biologics, extremities, trauma, spine, bone healing, craniomaxillofacial, thoracic, dental and related surgical products.
Results include Biomet only from the June 24, 2015 acquisition. Accordingly, reported year-over-year comparisons are not fully comparable; management also provides supplemental pro forma comparisons assuming the merger occurred on January 1, 2015.
Financial Performance and Position
| Metric | Q1 2016 | Q1 2015 | Change or comment |
|---|---|---|---|
| Net sales | $1,904.0 million | $1,134.4 million | Increased 67.8%, primarily from the Biomet merger |
| Operating profit | $245.5 million | $269.9 million | Operating margin declined to 12.9% from 23.8% |
| Net earnings attributable to Zimmer Biomet | $105.9 million | $171.4 million | Net margin declined to approximately 5.6% from 15.1% |
| Diluted EPS | $0.52 | $0.99 | Declined due primarily to merger-related costs, amortization, inventory step-up and higher interest expense |
| Adjusted net earnings | $404.3 million | $266.9 million | Non-GAAP measure excluding specified acquisition, amortization, inventory and other items |
| Adjusted diluted EPS | $2.00 | $1.54 | Non-GAAP measure |
| Cash flow from operations | $265.2 million | $91.5 million | Improved primarily from merger-related effects and lower inventory investment |
Cost of products sold excluding amortization was 33.4% of sales versus 25.1% in the prior-year quarter, including $153.7 million of acquired Biomet inventory step-up expense. Intangible amortization was $126.6 million versus $20.4 million. Special items were $94.1 million versus $86.8 million.
At March 31, 2016, cash and cash equivalents were $996.8 million, short-term investments were $13.4 million, and total current assets were $5.1 billion. Long-term debt was $11.1 billion, including $8.95 billion of senior notes, $2.1 billion of U.S. term-loan borrowings and an approximately $103.2 million Japan term loan. No borrowings were outstanding under the $1.35 billion multicurrency revolving facility. The company was in compliance with its debt covenants.
Financing cash outflows were $825.3 million, including a $400.0 million term-loan repayment, $415.5 million of share repurchases and $44.6 million of dividends. The quarterly dividend declared was $0.24 per share.
Material Changes Versus the Prior Comparable Period
- Reported sales increased substantially because the Biomet business was included for the full quarter in 2016 but not in the comparable 2015 reported period.
- On a pro forma basis, sales declined 1.9%, reflecting 2.1% volume/mix growth offset by pricing pressure of 0.9%, product-line divestitures of 1.5% and foreign-exchange headwinds of 1.6%.
- Pro forma sales declined in all major product categories: Knees by 1.0%, Hips by 1.3%, S.E.T. by 1.7%, Dental by 7.4%, Spine and CMF by 1.7% and Other by 7.3%.
- Net earnings and GAAP EPS declined despite higher revenue because of acquisition-related inventory step-up, increased intangible amortization, higher interest expense and integration costs.
- Operating cash flow increased by $173.7 million year over year, while financing cash flow changed from a $7.6 billion inflow in Q1 2015, when merger notes were issued, to an $825.3 million outflow in Q1 2016.
- The company repurchased 4.2 million shares for $415.5 million and authorized a new $1.0 billion repurchase program effective March 1, 2016.
Guidance, Outlook, Commentary and Risks
Management expects 2016 pro forma revenue growth of 0% to 1%. The outlook assumes approximately 1% foreign-exchange pressure, 2% pricing pressure, 1% impact from product-line divestitures and 4% to 5% volume/mix growth. Management expects growth to improve in the second half as the sales force stabilizes, cross-selling opportunities develop and merger-related dissynergies anniversary.
Management expects 2016 R&D expense of 4.5% to 5.0% of sales, SG&A of approximately 37% of sales, significant but lower special-items expense than in 2015, higher interest expense and continued acquired-inventory step-up and intangible-amortization charges. Integration cash outlays are expected to be approximately $290 million in 2016, supporting a target of $350 million in annual pretax operating synergies by the end of the third year after closing.
- Integration execution, sales-force disruption and the realization and timing of Biomet synergies remain important risks.
- Pricing pressure, healthcare cost containment, reimbursement changes, foreign-exchange volatility and weak international markets may affect revenue and margins.
- FDA warning letters relating to facilities in Ponce, Puerto Rico and Zhejiang, China remained unresolved; further regulatory action could include seizures, injunctions, penalties or delayed product approvals.
- Biomet-related DOJ and SEC investigations concerning the Foreign Corrupt Practices Act remained ongoing after the Deferred Prosecution Agreement’s extended term.
- Material legal contingencies include Durom Cup claims, Biomet metal-on-metal hip claims, NexGen knee litigation, Heraeus trade-secret litigation and Stryker patent litigation.
- The remaining accrued Durom Cup liability was $309.2 million, with a $95.3 million insurance-recovery receivable; insurers could ultimately dispute coverage.
- The company had $4.575 billion of unremitted foreign earnings intended for repatriation and recorded a $1.552 billion estimated tax liability related to that repatriation.
- On April 25, 2016, the company announced an agreement to acquire Cayenne Medical, expected to close in Q2 2016 and not expected to materially affect financial results.
Important Facts for Investors to Verify
- Reconcile reported results with pro forma results because the Biomet acquisition materially affects all year-over-year comparisons.
- Assess the sustainability of adjusted earnings after excluding $172.9 million of inventory and manufacturing charges, $126.6 million of amortization and $94.1 million of special items.
- Monitor debt reduction, upcoming senior-note maturities, floating-rate exposure and compliance with the 4.5-to-1.0 consolidated indebtedness-to-EBITDA covenant applicable after June 24, 2016.
- Track whether pro forma revenue growth reaches the 0% to 1% 2016 outlook and whether volume/mix gains offset pricing, divestiture and currency headwinds.
- Verify progress toward integration milestones, approximately $290 million of 2016 integration cash outlays and the $350 million annual synergy target.
- Review developments in FDA remediation, DOJ and SEC investigations, product-liability claims, intellectual-property litigation and related insurance recoveries.
- Evaluate liquidity after dividends, share repurchases, debt repayments, litigation payments, tax obligations and potential acquisitions.