Zimmer Biomet Holdings, Inc. — Q1 2017 Form 10-Q Summary
Business context and reporting period
Zimmer Biomet designs, manufactures and markets orthopedic reconstructive, sports medicine, biologics, extremities and trauma, spine, craniomaxillofacial, dental and related surgical products. This unaudited report covers the three months ended March 31, 2017, compared with the same period in 2016.
Growth included a full quarter contribution from the July 2016 LDR acquisition, while temporary supply delays at the legacy Biomet Warsaw facility constrained availability of certain knee, hip, upper-extremity, sports-medicine and trauma products.
Financial performance and liquidity
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Net sales | $1,977.3 million | $1,904.0 million | 3.8% increase |
| Operating profit | $350.4 million | $245.5 million | 42.7% increase |
| Operating margin | 17.7% | 12.9% | 480 basis-point expansion |
| Net earnings attributable to Zimmer Biomet | $299.4 million | $108.8 million | Increase of $190.6 million |
| Diluted EPS | $1.47 | $0.54 | Increase of $0.93 |
| Operating cash flow | $275.4 million | $272.8 million | Increase of $2.6 million |
Net margin was approximately 15.1% in Q1 2017 versus 5.7% in Q1 2016. The improvement primarily reflected a $139.1 million reduction in inventory step-up expense, a $69.7 million tax benefit from restructuring deferred tax liabilities, a $21.8 million tax benefit from resolved tax matters and operating leverage.
- Sales growth consisted of 6.8% volume/mix growth, offset by 2.3% pricing pressure and a 0.7% unfavorable foreign-exchange effect. Excluding LDR, reported sales growth was 1.6%.
- By product category, Spine and CMF sales increased 32.0%, S.E.T. increased 6.0%, hips increased 1.7%, knees declined 0.2%, dental declined 0.7% and other products declined 1.8%.
- Cost of products sold excluding intangible amortization declined to 25.9% of sales from 33.6%, primarily because Biomet inventory step-up charges were substantially completed by June 30, 2016. Intangible amortization increased to 7.7% of sales from 6.6%.
- Special items increased to $110.1 million from $88.7 million, including $37.0 million of Biomet merger-related items and $73.1 million of other items, principally quality enhancement, remediation and consulting costs.
- Cash and cash equivalents were $1,039.5 million at March 31, 2017, compared with $634.1 million at December 31, 2016. Cash included $378.0 million held outside the United States.
- Investing activities used $133.1 million, primarily for instruments and property, plant and equipment. Financing activities provided $256.1 million, including $400.0 million drawn under the multicurrency revolving facility and $150.0 million of term-loan repayment.
- Total debt was approximately $11.5 billion, comprising $975.0 million classified as current debt and $10,537.8 million of long-term debt. The company was in compliance with its debt covenants at March 31, 2017.
- The quarterly dividend remained $0.24 per common share. A $1.0 billion share-repurchase authorization remained available, with no repurchases during the quarter.
Material changes versus the prior comparable period
- Profitability improved substantially because inventory step-up expense fell by $139.1 million and tax benefits materially reduced the reported tax provision. The company reported a $34.1 million tax benefit in Q1 2017 versus a $46.1 million tax provision in Q1 2016.
- Operating cash flow was broadly stable despite product-liability payments and FCPA settlement payments; sales of receivables provided approximately $50 million of incremental operating cash inflow.
- Debt composition changed as the company drew $400.0 million on its revolving facility, repaid $150.0 million of Term Loan A and prepared to fund the $500.0 million senior-note maturity due April 1, 2017.
- SG&A increased to 38.5% of sales from 37.7%, while R&D increased modestly to 4.6% from 4.5%, reflecting acquired businesses, expedited freight and investment in sales and medical education.
- The company early adopted ASU 2016-16 effective January 1, 2017, reducing retained earnings by $72.7 million on adoption and providing a $1.8 million favorable tax effect in Q1.
- Disclosure controls and procedures remained ineffective because of an unremediated material weakness in income-tax accounting controls. Management added tax resources and engaged an outside firm, but remediation had not been completed.
Guidance, outlook, commentary and risks
- Management projected 2017 sales growth of 2.0% to 3.0%, assuming approximately 1.2% unfavorable foreign exchange, 2.0% pricing pressure and 1.2% growth from including LDR for the full year.
- Management expects supply constraints to improve during 2017, with restored inventory levels supporting stronger volume and mix growth in the second half. It expects R&D of approximately 4.5% of sales and SG&A of approximately 37.5% of sales.
- Management expects 2017 special items to remain significant but below 2016 levels, integration cash outlays of approximately $310 million and net annual pretax synergies of $350 million by mid-2018.
- Integration plans are expected to continue through 2018. Estimated remaining integration costs were approximately $26.2 million for employee termination benefits and $5.1 million for contract terminations, based on cumulative incurred amounts and stated program estimates.
- Durom Cup claims had an estimated remaining liability of $233.3 million, including $75.0 million current and $158.3 million long term, partially offset by a $95.3 million insurance-recovery receivable. Actual losses and insurance recoveries may differ materially.
- Other material contingencies include Biomet metal-on-metal hip claims of $46.2 million, potential additional Stryker litigation charges of up to $165.0 million, unresolved Heraeus trade-secret proceedings and tax audits, including proposed IRS adjustments for 2005–2009.
- FDA warning letters and inspection observations remained pending at facilities in Ponce, Zhejiang and Montreal, with potential operating, marketing and regulatory consequences.
- The company entered into a three-year Deferred Prosecution Agreement related to legacy Biomet FCPA matters, paid approximately $30.5 million in January 2017 and remains subject to an independent compliance monitor.
- Key operating risks include continued supply disruptions, quality remediation, pricing pressure, foreign-exchange volatility, healthcare cost containment, regulatory actions, litigation, tax uncertainty, integration execution and collection risk in certain European countries.
Most important facts for investors to verify
- Whether Warsaw production and inventory availability improve sufficiently to support the projected second-half volume recovery.
- Whether reported earnings growth persists after excluding tax benefits, lower inventory step-up expense and other special items; adjusted diluted EPS was $2.13 versus $2.01.
- Progress toward debt repayment, including repayment of the $400.0 million revolving-facility borrowing and upcoming maturities.
- Execution of the integration plan, the approximately $310 million of expected 2017 cash outlays and the targeted $350 million of annual pretax synergies.
- Resolution and cash impact of Durom Cup, Stryker, Heraeus, metal-on-metal hip, tax and other legal contingencies.
- Remediation of the material weakness in income-tax controls and restoration of effective disclosure controls.
- Compliance with the FCPA Deferred Prosecution Agreement and the status of FDA warning letters and manufacturing remediation.