Zimmer Biomet Holdings, Inc. — Q1 2018 Form 10-Q Summary
Business context and reporting period
Zimmer Biomet designs, manufactures and markets orthopedic reconstructive, sports medicine, trauma, spine, craniomaxillofacial, dental and related surgical products. This unaudited report covers the three months ended March 31, 2018, compared with the three months ended March 31, 2017. Results are affected by foreign currency movements, pricing pressure, supply and quality remediation issues, and ongoing integration of the Biomet acquisition.
Key financial metrics
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Net sales | $2,017.6 million | $1,972.4 million | 2.3% increase |
| Operating profit | $305.0 million | $348.1 million | 12.4% decrease |
| Operating margin | 15.1% | 17.7% | Down 2.6 points |
| Net earnings attributable to Zimmer Biomet | $174.7 million | $299.4 million | 41.6% decrease |
| Diluted EPS | $0.85 | $1.47 | 42.2% decrease |
| Adjusted net earnings | $390.9 million | $433.4 million | 9.8% decrease |
| Adjusted diluted EPS | $1.91 | $2.13 | 10.3% decrease |
| Cash flow from operations | $490.5 million | $275.4 million | 78.1% increase |
- Sales growth consisted of 1.1% volume/mix growth, a 2.6% unfavorable pricing effect and a 3.8% favorable foreign-exchange effect.
- Geographic sales were $1,208.1 million in the Americas, $496.5 million in EMEA and $313.0 million in Asia Pacific. EMEA and Asia Pacific grew 9.6% and 8.2%, respectively, while Americas sales declined 1.8%.
- Product-category sales included Knees of $713.3 million, Hips of $492.0 million and S.E.T. of $442.3 million. Dental and Spine & CMF sales declined year over year.
- Cost of products sold increased to 28.5% of sales from 26.0%, primarily because of Warsaw North Campus production and inventory costs, higher excess and obsolete inventory charges, lower pricing and unfavorable hedge effects.
- Cash and cash equivalents were $1,765.4 million at March 31, 2018, versus $524.4 million at December 31, 2017. The quarter-end balance was temporarily elevated by debt refinancing activity completed before the April 2 maturity payment.
- Investing cash outflows were $101.7 million, including $60.4 million for instruments and $26.7 million for property, plant and equipment. Financing cash inflows were $841.8 million.
- Total debt was approximately $11.1 billion, comprising $1,625.0 million of current debt and $9,486.9 million of long-term debt. The company had $400.0 million drawn under its $1.5 billion multicurrency revolving facility and was in compliance with financial covenants.
- The company declared a quarterly dividend of $0.24 per share. A previously authorized $1.0 billion share repurchase program remained entirely available.
Material changes versus the prior comparable period
- Operating profit and reported earnings declined despite modest sales growth. The principal drivers were higher manufacturing and inventory costs, quality remediation, pricing pressure and the absence of significant prior-year tax benefits.
- Q1 2017 included a $69.7 million tax benefit from an internal tax restructuring and $21.8 million of benefits from resolving tax matters. Q1 2018 recorded a $47.2 million tax provision and had an effective tax rate of 21.1%.
- Operating cash flow improved substantially, aided by increased receivables factoring and the absence of significant 2017 cash payments related to the Durom Cup settlement and FCPA resolution.
- In March 2018, the company issued $450.0 million of floating-rate senior notes due 2021 and $300.0 million of 3.700% senior notes due 2023, receiving net proceeds of $749.5 million. These proceeds, revolving-facility borrowings and cash were used to repay the $1.15 billion of senior notes due April 1, 2018; repayment occurred on April 2.
- The company early adopted revenue-recognition, pension-presentation and hedging standards. Revenue recognition timing did not change materially, but certain cost and balance-sheet classifications were revised. It also reclassified $42.9 million from accumulated other comprehensive income to retained earnings under ASU 2018-02.
Guidance, outlook, commentary and risks
- Management forecast 2018 sales growth of 1.5% to 3.5%, including an estimated 2.0% to 3.0% benefit from foreign currency. Volume/mix growth is expected to strengthen in the second half as supply constraints improve.
- Management expects higher 2018 product costs, with Warsaw North Campus costs continuing to affect cost of sales into 2019. R&D and SG&A are expected to rise as tax savings are reinvested in the business.
- Acquisition, quality remediation and other expense in each of the last three quarters was expected to remain consistent with Q1 levels. Full-year interest expense was estimated at approximately $300 million.
- Key operational risks include supply constraints, quality and remediation issues at the legacy Biomet Warsaw facility, FDA warning letters and inspection observations, pricing pressure, distributor integration problems in Spine and stabilization initiatives in Dental.
- Material contingencies include an estimated $151.3 million remaining liability for Durom Cup claims, $32.5 million for Biomet metal-on-metal hip claims, and potential additional exposure of up to $165.0 million in the Stryker patent litigation. The company also faces pending Heraeus litigation, a securities class action and an OIG subpoena investigation.
- The company remains subject to a three-year DOJ Deferred Prosecution Agreement relating to legacy Biomet FCPA matters. Noncompliance could result in prosecution, penalties or exclusion from federal healthcare programs.
- U.S. tax audits for 2010–2015 include proposed profit-allocation adjustments for earlier years. Management estimated that unrecognized tax benefits could change within the next twelve months by between a $115 million decrease and a $25 million increase.
- Management stated that operating cash flow and available revolving capacity should be sufficient for working capital, capital expenditures, debt service, dividends and potential share repurchases, but future dividends remain subject to board approval and debt restrictions.
Important facts for investors to verify
- Whether Warsaw North Campus remediation resolves supply constraints and reduces elevated manufacturing, inventory and quality costs.
- Whether reported sales growth becomes less dependent on favorable foreign currency movements and whether volume/mix growth improves as projected.
- The timing and cost of remaining debt maturities, refinancing activity and expected deleveraging.
- Updates on FDA warning letters, Form 483 observations, the DOJ Deferred Prosecution Agreement and the OIG investigation.
- Changes in estimates for Durom Cup, metal-on-metal hip, Stryker, Heraeus and other litigation contingencies.
- Final accounting effects of the 2017 Tax Act, including GILTI, transition-tax estimates and unresolved tax audits.
- The sustainability of operating cash flow, including the extent to which receivables factoring contributes to reported cash generation.