Business Context and Reporting Period
Zimmer Holdings, Inc. filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2014. The company develops and sells orthopedic reconstructive implants, biologics, dental and spinal implants, trauma products, surgical products and related healthcare services across the Americas, Europe and Asia Pacific.
On April 24, 2014, Zimmer agreed to acquire Biomet’s parent in a cash-and-stock transaction valued at approximately $13.35 billion. Closing was expected in the first quarter of 2015, subject to regulatory approvals and other customary conditions.
Financial Results and Key Metrics
| Metric | Q2 2014 | Q2 2013 | Six Months 2014 | Six Months 2013 |
|---|---|---|---|---|
| Net sales | $1,182.9 million | $1,169.5 million | $2,344.4 million | $2,308.4 million |
| Gross profit | $849.7 million | $845.9 million | $1,705.8 million | $1,691.9 million |
| Operating profit | $259.3 million | $210.4 million | $557.7 million | $508.6 million |
| Net earnings attributable to Zimmer | $176.5 million | $152.1 million | $398.0 million | $370.7 million |
| Diluted EPS | $1.03 | $0.89 | $2.32 | $2.17 |
| Operating margin | 21.9% | 18.0% | 23.8% | 22.0% |
| Gross margin | 71.8% | 72.3% | 72.7% | 73.3% |
- Q2 sales increased 1%, while six-month sales increased 2%. Volume and mix contributed 4 and 5 percentage points, respectively, but pricing reduced growth by approximately 3 percentage points.
- Q2 operating profit increased 23%; six-month operating profit increased 10%. Lower claims expense, lower legal settlement expense and operating efficiencies were important contributors.
- Q2 net earnings attributable to Zimmer increased 16%; six-month earnings increased 7%. Diluted EPS increased 16% and 7%, respectively.
- Q2 net margin was approximately 14.9%, versus 13.0% in the prior-year quarter; six-month net margin was approximately 17.0%, versus 16.1%.
- Product trends included Q2 growth of 4% in knees, 1% in hips, 6% in extremities and 7% in trauma. Spine declined 4%, and surgical and other declined 10%.
- Europe sales increased 9% in Q2 and 8% for six months; Asia Pacific increased 3% and 2%, respectively. Americas sales declined 3% in Q2 and 1% for six months.
Cash Flow, Liquidity and Capital Structure
- Six-month operating cash flow was $442.9 million, compared with $370.2 million in 2013.
- Investing activities used $268.7 million, including $112.0 million for instruments, $63.4 million for other property and equipment, and net investment purchases of approximately $91.9 million.
- Financing activities used $291.1 million, including $400.5 million of share repurchases, $70.9 million of dividends and $47.7 million of debt issuance costs.
- Cash and cash equivalents were $968.7 million at June 30, 2014, compared with $1,080.6 million at December 31, 2013. Short-term investments were $729.3 million; total short- and long-term investments had fair value of $896.8 million.
- Long-term debt was $1.687 billion, compared with $1.672 billion at year-end 2013. No borrowings were outstanding under the $1.35 billion multicurrency revolving facility.
- Zimmer had committed financing for the Biomet transaction consisting of a $3.0 billion term loan and a $7.66 billion 364-day bridge facility. These facilities were subject to the merger closing and other conditions.
- The company classified $250 million of notes due November 2014 as long-term debt because it intended to refinance them through new notes or the Senior Credit Facility.
- At June 30, 2014, the company had $599.5 million remaining under its $1.0 billion share-repurchase authorization but did not plan additional repurchases because of the pending merger.
Material Changes, Guidance and Management Commentary
- Management’s 2014 outlook called for sales growth of 1.5% to 2.5%, gross margin of 72.5% to 73.5%, R&D expense of 4% to 4.5% of sales, and SG&A expense of 38.5% to 39.0% of sales.
- Reported net earnings and diluted EPS were expected to increase approximately 5% to 7% in 2014.
- Management expected approximately $250 million of 2014 expenses for quality and operational excellence initiatives and recent-acquisition integration, plus approximately $70 million related to the pending Biomet merger. Approximately $320 million of these costs were expected across special items, product costs and financing expense.
- The medical device excise tax was expected to cost approximately $10 million per quarter in 2014.
- Special items were $64.7 million in Q2 and $110.6 million for six months, including merger-related professional fees, restructuring and operational-excellence costs, asset charges and other items. A $7.2 million accelerated amortization charge resulted from reducing certain intangible assets’ useful lives to zero.
- Durom Cup claims expense was $21.8 million in Q2 and six months, versus $47.0 million in the comparable 2013 periods. The company estimated remaining Durom liabilities of $385.4 million and recorded a $218.0 million insurance receivable, subject to insurer rights and a 20% co-payment requirement.
- The IRS began an audit of U.S. federal returns for 2010–2012 and issued a statutory notice of deficiency for 2005–2007. The company intends to contest the notice; the ultimate tax impact could materially affect future earnings and cash flow.
Risks, Contingencies and Unusual Items
- The Biomet merger carried regulatory, financing, closing, integration, leverage, dilution and synergy-realization risks. S&P and Moody’s indicated potential downgrades if the merger closed.
- A Stryker patent case remained on appeal after a trial-court award that could require Zimmer to pay up to $210.0 million plus interest and attorneys’ fees. No liability was accrued because the company did not believe a loss was probable.
- NexGen knee product-liability cases were in discovery, with bellwether trials expected in the second quarter of 2015; no loss was accrued because the company did not believe a liability was probable or estimable.
- An FDA warning letter concerning manufacturing and validation processes at the Ponce, Puerto Rico facility remained pending. Additional regulatory action, including seizure, injunctions or civil penalties, was possible.
- Receivables in Greece, Italy, Portugal and Spain totaled $220.6 million gross, or $210.4 million net of allowances, exposing the company to government-budget and collection risks.
- U.S. Spine and U.S. Dental goodwill reporting units had limited excess fair value over carrying value in the 2013 impairment test, creating sensitivity to lower cash flows, weaker revenue or margin performance and higher discount rates.
Important Facts to Verify
- Whether the Biomet merger received all required regulatory approvals and closed on the expected timetable.
- The final financing mix, post-merger leverage, credit ratings and refinancing of the $250 million notes due November 2014.
- Actual 2014 sales, gross-margin and EPS performance against the stated guidance ranges.
- Changes in the estimated Durom Cup liability and collectability of the $218.0 million insurance receivable.
- Developments in the IRS tax disputes and their potential cash-tax consequences.
- Outcomes of the Stryker appeal, Durom and NexGen litigation, and the pending FDA warning-letter matters.
- Inventory levels, pricing pressure and performance of the Spine and surgical product categories, which declined year over year.