ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q3 FY2015

Zimmer Biomet Holdings, Inc. — Form 10-Q Summary

Business context and reporting period

Unaudited results cover the three and nine months ended September 30, 2015, compared with the corresponding 2014 periods. Zimmer completed its acquisition of Biomet on June 24, 2015; therefore, Biomet results are included only from the closing date in reported 2015 results. The company provides orthopedic reconstructive, sports medicine, extremities and trauma, spine, dental, biologics, and related surgical products across the Americas, EMEA, and Asia Pacific.

Key financial metrics

Metric	Q3 2015	Q3 2014	9M 2015	9M 2014
Net sales	$1,762.2 million	$1,106.0 million	$4,064.2 million	$3,450.4 million
Operating profit	$116.0 million	$255.2 million	$253.8 million	$811.0 million
Operating margin	6.6%	23.1%	6.2%	23.5%
Net earnings attributable to Zimmer Biomet	$22.2 million	$173.1 million	$20.0 million	$566.5 million
Diluted EPS	$0.11	$1.01	$0.11	$3.30
Operating cash flow	Not separately provided	Not separately provided	$429.6 million	$698.6 million

Reported third-quarter sales increased 59.3%, primarily from the Biomet acquisition. On a pro forma basis, including Biomet as if acquired at the beginning of 2014, third-quarter sales declined 6.7% and nine-month sales declined 5.5%, reflecting foreign exchange, divestitures, and pricing pressure. Volume and mix were positive, while foreign exchange reduced reported third-quarter sales by 6.7 percentage points and pricing reduced sales by 2.2 percentage points.

Net earnings and margins declined sharply because of merger-related costs, acquired inventory step-up, higher intangible amortization, increased SG&A and R&D, and materially higher interest expense. Non-GAAP adjusted net earnings were $338.4 million in the third quarter and $882.2 million for nine months, compared with $249.7 million and $790.3 million, respectively, in the prior-year periods. Adjusted diluted EPS was $1.64 and $4.78, compared with $1.45 and $4.61.

Liquidity, balance sheet, and debt

Cash and cash equivalents were $1,466.9 million at September 30, 2015, compared with $1,083.3 million at December 31, 2014. Short-term investments were $343.3 million; total short- and long-term investments had a fair value of $466.5 million.
Total assets were $26.7 billion, including $7.7 billion of goodwill and $9.8 billion of intangible assets, largely reflecting the Biomet acquisition.
Total debt was approximately $11.9 billion, consisting principally of $8.95 billion of senior notes and $2.85 billion outstanding under the U.S. term loan. Interest expense was $90.8 million in the third quarter and $196.6 million for nine months.
The company had a $1.35 billion undrawn multicurrency revolving facility and reported compliance with its debt covenants. The principal leverage covenant was no greater than 5.0-to-1.0 through June 24, 2016 and 4.5-to-1.0 thereafter.
Nine-month investing cash outflow was $7.68 billion, including $7.81 billion for the Biomet acquisition. Financing cash inflow was $7.66 billion, primarily from $7.63 billion of senior notes and $3.0 billion of term-loan proceeds, partially offset by debt repayments and issuance costs.
Capital allocation included $112.3 million of dividends paid during the first nine months. The company reinstated its share repurchase program, with $599.5 million remaining authorized, but stated that available cash would be used primarily for debt repayment and dividends.

Material changes, outlook, and unusual items

The Biomet merger produced $742.8 million of third-quarter sales and $802.7 million of nine-month sales, but contributed operating losses of $28.3 million and $316.5 million, respectively, due to acquisition and integration charges, inventory step-up, amortization, and related costs.
Special items were $195.9 million in the third quarter and $751.9 million for nine months, including merger consideration compensation expense, retention plans, severance, contract terminations, consulting fees, and integration costs.
Acquired Biomet inventory included a $368.3 million fair-value step-up. Management expects significant remaining inventory step-up expense and intangible amortization for the rest of 2015.
Integration plans are expected to continue through 2018. Management expects approximately $250 million of integration cash outlays in 2015 and more than $500 million in the first two years after closing. Targeted annual pretax operating synergies were $155 million in the first year and $350 million by the end of the third year after closing.
Management expected pricing pressure and unfavorable foreign exchange to continue. R&D and SG&A as percentages of sales were expected to remain elevated until synergies are realized.
The company revised prior-period financial statements for accounts payable accrual errors, accounting for a Biomet divestiture, and other immaterial out-of-period adjustments. Management concluded the prior errors were not material to previously issued statements but that cumulative correction in the current quarter would have been material.
A material weakness was identified in internal control over financial reporting relating to accounting for non-routine, complex transactions after the Biomet merger. Disclosure controls were therefore deemed ineffective at a reasonable assurance level. Remediation includes additional accounting resources and enhanced review processes.

Risks, contingencies, and other investor considerations

Durom Cup product-liability claims had an accrued remaining liability of $322.9 million and a $95.3 million receivable for estimated insurance recoveries. Insurance coverage remains subject to carrier rights, a 20% co-payment, and a cap.
Biomet metal-on-metal hip claims had an accrued liability of $39.3 million; ultimate settlement payments remain uncertain.
The Stryker patent matter resulted in a $90.3 million payment in July 2015. Following a U.S. Supreme Court grant of certiorari, the company stated that it could potentially record an additional charge of up to $140.0 million.
NexGen knee litigation, Durom Cup litigation, Heraeus trade-secret proceedings, FDA warning letters, and various government investigations remain unresolved. Potential losses or outcomes are not fully estimable in several matters.
Biomet’s Deferred Prosecution Agreement and related compliance-monitor arrangements were extended through March 2016, while DOJ and SEC investigations regarding alleged conduct in Brazil and Mexico continued.
Tax audits and disputed IRS profit-allocation adjustments could materially affect future taxes, cash flows, and earnings. The nine-month effective tax rate was unusually low at 2.7%, compared with 30.2% for the third quarter, partly because of the geographic mix and tax treatment of special items.
Foreign exchange, healthcare cost containment, reimbursement pressure, regulatory compliance, product liability, intellectual property, integration execution, leverage, and collection risk in certain European countries remain significant risks.

Important facts for investors to verify

Whether Biomet integration milestones and the projected $155 million and $350 million synergy targets are achieved on schedule.
The pace of debt repayment, leverage relative to covenant thresholds, and the effect of approximately $11.9 billion of debt on future interest expense.
The final purchase-price allocation for Biomet, including goodwill, intangible values, amortization periods, deferred taxes, and inventory step-up.
Progress in remediating the material weakness and whether subsequent filings report effective internal controls.
Actual cash payments and insurance recoveries for Durom Cup and other product-liability matters.
Developments in the Stryker, NexGen, Heraeus, FDA, DOJ, SEC, and IRS matters, including any additional accruals or penalties.
Underlying organic and pro forma sales trends after separating acquisition effects from foreign exchange, pricing, divestitures, and volume or mix.