Zimmer Biomet Holdings, Inc. — Q2 2015 Form 10-Q Summary
Business context and reporting period
Unaudited quarterly report for the three and six months ended June 30, 2015. Zimmer completed its acquisition of Biomet on June 24, 2015 and changed its name from Zimmer Holdings, Inc. to Zimmer Biomet Holdings, Inc. Biomet contributed six days of results to the reported periods, so current-period consolidated results are not representative of the future combined company.
The company designs, manufactures and markets orthopedic reconstructive, sports medicine, trauma, spine, dental and related surgical products through the Americas, EMEA and Asia Pacific segments.
Financial performance and key metrics
| Metric | Three months ended June 30, 2015 | Three months ended June 30, 2014 | Six months ended June 30, 2015 | Six months ended June 30, 2014 |
|---|---|---|---|---|
| Net sales | $1,167.6 million | $1,182.9 million | $2,302.0 million | $2,344.4 million |
| Gross profit | $877.1 million | $851.3 million | $1,732.8 million | $1,709.1 million |
| Gross margin | 75.1% | 72.0% | 75.3% | 72.9% |
| Operating profit/(loss) | $(129.5) million | $260.9 million | $145.4 million | $561.0 million |
| Net earnings attributable to Zimmer Biomet | $(158.0) million | $176.5 million | $19.1 million | $398.0 million |
| Diluted EPS | $(0.91) | $1.03 | $0.11 | $2.32 |
| Adjusted net earnings | $278.7 million | $271.0 million | $551.5 million | $545.5 million |
| Adjusted diluted EPS | $1.59 | $1.58 | $3.17 | $3.18 |
Reported sales declined 1.3% in the quarter and 1.8% year to date. For Zimmer legacy operations, quarterly sales declined 6.4%, primarily because foreign exchange reduced sales by 7.1 percentage points. Volume and mix contributed 2.7 percentage points, while pricing reduced sales by 2.0 percentage points.
Special items were $469.4 million in the quarter and $556.4 million year to date, compared with $62.3 million and $98.9 million, respectively, in the prior-year periods. Major items included $164.1 million of merger consideration compensation expense, $73.0 million of Biomet retention expense, severance, contract termination costs and professional fees. These items drove the quarterly operating loss and sharply reduced GAAP earnings.
Operating expenses included research and development of $51.4 million in the quarter and $99.8 million year to date, SG&A of $445.1 million and $870.1 million, and intangible amortization of $33.0 million and $53.4 million, respectively. Interest expense increased to $82.7 million in the quarter and $105.8 million year to date, primarily because of debt issued to finance the merger.
Cash flow, liquidity and debt
- Operating cash flow was $278.3 million for the six months ended June 30, 2015, compared with $442.9 million in the prior-year period.
- Investing cash flow was $(7,720.7) million, including $(7,812.9) million for the Biomet acquisition.
- Financing cash flow was $7,799.7 million, reflecting $7,628.2 million of senior-note proceeds and $3.0 billion of term-loan proceeds, partly offset by $2.74 billion of debt redemptions and $74.7 million of dividends.
- Cash and cash equivalents were $1,424.6 million at June 30, 2015, compared with $1,083.3 million at December 31, 2014. Short-term investments were $459.0 million.
- Total debt was approximately $12.0 billion at June 30, 2015, compared with approximately $1.4 billion at year-end 2014. Long-term debt was $11,749.8 million and the current portion was $300.0 million.
- Debt consisted principally of $8.95 billion of senior notes, a $3.0 billion U.S. term loan and an approximately $94.4 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. The senior credit facility requires a consolidated indebtedness-to-EBITDA ratio no greater than 5.0 to 1.0 through June 24, 2016 and 4.5 to 1.0 thereafter.
- Management stated that operating cash flow, available borrowings and access to debt markets were sufficient for working capital, capital expenditures, debt service and dividends.
Material changes versus the prior comparable period
- The Biomet merger materially increased assets, liabilities, equity and future operating scale. Goodwill increased to $7,730.7 million and intangible assets to $9,941.5 million at June 30, 2015.
- Net sales decreased despite the six-day Biomet contribution, reflecting significant foreign-exchange pressure and ongoing pricing pressure. EMEA and Asia Pacific were particularly affected.
- Gross margin improved primarily because of higher foreign-currency hedge gains and geographic mix, partially offset by excess and obsolete inventory charges and lower average selling prices.
- GAAP profitability deteriorated because of merger and integration charges, higher amortization and substantially higher interest expense. Adjusted earnings remained broadly comparable with the prior year.
- Inventory increased to $2,441.4 million from $1,169.0 million, including $494.8 million of acquired Biomet inventory fair-value step-up.
- Accumulated other comprehensive income declined to $(40.5) million from $85.9 million, primarily due to foreign-currency translation effects.
Guidance, outlook, commentary and unusual items
Management expected Biomet to increase sales and related expenses significantly for the remainder of 2015. Integration plans are expected to continue through 2018. The company forecast approximately $250 million of integration-related cash outlays in 2015 and more than $500 million during the first three years after closing.
Management targeted net annual pre-tax operating synergies of $135 million in the first year and $350 million by the end of the third year after closing. It also expected continued special-item charges, acquired-inventory step-up costs and higher intangible amortization. R&D and SG&A as percentages of sales could remain elevated until synergies are realized.
Important unusual items and contingencies include a $333.1 million estimated remaining Durom Cup liability, $55.8 million of Biomet metal-on-metal hip claims, and $90.3 million paid in July 2015 to resolve the Stryker patent award, subject to remaining attorneys’ fees proceedings. Expected insurance recoveries related to Durom claims totaled $162.8 million at June 30, 2015, but insurers had reserved rights and could dispute coverage.
The company continued to face IRS tax disputes, FDA warning letters involving facilities in Puerto Rico and China, Biomet-related DOJ and SEC investigations under an extended Deferred Prosecution Agreement, product liability claims, patent litigation and other regulatory matters. Management stated that the outcomes and potential additional losses could not always be reasonably estimated.
Most important facts for investors to verify
- Whether Biomet integration produces the projected $135 million first-year and $350 million third-year operating synergies.
- The pace of debt reduction, covenant headroom, interest burden and the company’s ability to fund integration costs and dividends.
- Underlying organic sales growth excluding Biomet, foreign exchange and pricing effects, particularly in EMEA and Asia Pacific.
- The final purchase-price allocation, including goodwill, acquired intangible values, useful lives and related amortization.
- Actual cash payments and ultimate losses for Durom Cup, Biomet metal-on-metal, NexGen and other product-liability matters, including insurance recoveries.
- Potential financial consequences of IRS audits, DOJ and SEC investigations, FDA warning letters and other regulatory proceedings.
- Whether adjusted earnings remain representative after excluding recurring merger, integration, litigation, amortization and financing-related charges.