Zimmer Biomet Holdings, Inc. — Q3 2019 Form 10-Q Summary
Business context and reporting period
Zimmer Biomet designs, manufactures and markets orthopedic reconstructive products, sports medicine, biologics, extremities and trauma products, spine, craniomaxillofacial and thoracic products, dental implants and related surgical products. This unaudited Form 10-Q covers the three and nine months ended September 30, 2019, compared with the corresponding 2018 periods.
Key financial metrics
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net sales | $1,892.4 million | $1,836.7 million | $5,856.5 million | $5,861.9 million |
| Operating profit | $245.8 million | $223.3 million | $800.7 million | $824.3 million |
| Operating margin | 13.0% | 12.2% | 13.7% | 14.1% |
| Net earnings attributable to Zimmer Biomet | $431.1 million | $162.2 million | $810.9 million | $521.9 million |
| Diluted EPS | $2.08 | $0.79 | $3.93 | $2.55 |
| Cash flow from operations | Not separately provided | Not separately provided | $1,162.5 million | $1,367.9 million |
Q3 sales increased 3.0%, while nine-month sales declined 0.1%. Volume and mix increased sales by 6.8% in Q3 and 4.6% year to date, offset by pricing declines of 2.9% and 2.7%, respectively, and foreign-exchange headwinds of 0.9% and 2.0%.
Q3 operating margin improved despite higher research and development and selling, general and administrative expenses. The nine-month margin declined because of higher litigation, research and development, other charges and a $70.1 million in-process research and development impairment charge.
Reported earnings benefited substantially from a provisional $263.8 million net tax benefit related to Swiss tax reform. Excluding specified items, adjusted diluted EPS was $1.77 in Q3 2019 versus $1.63 in Q3 2018, and $5.57 for the first nine months versus $5.45 in the prior-year period.
Liquidity, cash flow and debt
- Cash and cash equivalents were $512.5 million at September 30, 2019, compared with $542.8 million at December 31, 2018.
- Operating cash flow was $1,162.5 million, investing cash flow was $(591.3) million and financing cash flow was $(597.2) million for the first nine months.
- Investing outflows included $239.5 million for instruments, $155.3 million for property and equipment, and $197.6 million to acquire intellectual-property rights.
- Total debt was approximately $8.3 billion, including $2.0 billion classified as current and $6.35 billion classified as long term. Debt service obligations for the next 12 months were estimated at $2.2 billion.
- Debt maturities included $500.0 million of notes due November 30, 2019 and $1.5 billion of notes due April 1, 2020. Management stated that these obligations could be met through operating cash flow, refinancing or the revolving facility.
- On November 1, 2019, the company entered into a new five-year, $1.5 billion unsecured multicurrency revolving facility maturing November 1, 2024, replacing the prior facility. No borrowings were outstanding under either facility as of September 30, 2019.
- The company paid $147.3 million of dividends during the first nine months and declared quarterly dividends of $0.24 per share. The $1.0 billion share-repurchase authorization remained unused.
Material changes versus the prior comparable period
- Q3 sales growth was driven by improved volume and mix in Knees, Hips and S.E.T.; year-to-date performance remained approximately flat because of foreign-exchange pressure and weaker EMEA sales.
- Q3 net earnings increased primarily because of the Swiss tax reform benefit, lower interest expense, lower quality-remediation costs and lower acquisition-related costs.
- Interest expense declined to $56.8 million in Q3 and $174.5 million year to date, from $67.5 million and $220.8 million, respectively, due to lower debt levels and hedging benefits.
- Research and development expense rose to 6.0% of sales in Q3 from 5.2%, while SG&A rose to 43.9% from 42.9%. Nine-month SG&A increased to 42.1% from 40.6%.
- The company paid $192.5 million to buy out certain licensing arrangements, replacing variable royalties through 2029; the payment was capitalized as an intangible asset.
- The company recognized a $70.1 million impairment charge on terminated IPR&D projects and a $20.8 million charge for terminating a raw-material supply agreement.
- Quality-remediation expense declined to $20.7 million in Q3 and $63.1 million year to date, compared with $32.2 million and $112.3 million in the prior-year periods.
Guidance, outlook, commentary and risks
Management estimated full-year 2019 sales growth of flat to positive 0.5%, including a 1.25% to 1.75% negative foreign-exchange effect. Management expected net earnings to increase significantly from 2018, when goodwill and intangible-asset impairments and litigation charges contributed to a net loss, and expected interest expense, acquisition costs and quality-remediation costs to decline.
Key operating risks include pricing pressure, foreign-exchange volatility, healthcare cost containment, product development and launch execution, supply constraints, regulatory compliance and product liability litigation. The company continued to address FDA warning letters relating to its Warsaw, Indiana and Ponce, Puerto Rico facilities; the Montreal warning letter was cleared in August 2019. The filing states that adverse FDA action could restrict manufacturing, marketing or sales.
Heraeus-related trade-secret litigation and an ongoing U.S. International Trade Commission investigation could result in damages, injunctions or exclusion orders. The ITC evidentiary hearing was scheduled for January 2020. Other material matters include Durom Cup claims with an estimated remaining liability of $63.8 million, Biomet metal-on-metal hip claims with an estimated liability of $65.7 million, and a putative securities class action and derivative actions.
The company was subject to a Deferred Prosecution Agreement and independent compliance monitoring related to legacy FCPA matters. The filing also identifies uncertainty regarding IRS proposed adjustments for 2005–2012 tax years, future tax-law changes, and the phase-out or replacement of LIBOR, EURIBOR and TIBOR.
Important facts for investors to verify
- Whether the provisional $263.8 million Swiss tax benefit is adjusted as additional cantonal provisions are enacted and whether future cash-tax savings are realized.
- How the company refinances or repays the $500.0 million and $1.5 billion near-term debt maturities.
- Progress in resolving the Warsaw and Ponce FDA warning letters and related quality-remediation requirements.
- Potential additional exposure from Heraeus litigation, the ITC investigation, product-liability claims and the securities class action.
- Whether full-year sales achieve the stated flat-to-0.5% growth outlook after pricing and foreign-exchange effects.
- Whether operating cash flow improves after litigation payments, licensing expenditures and working-capital needs.
- Future goodwill impairment risk, particularly for the EMEA reporting unit and the Dental reporting unit, whose estimated fair value had limited cushion over carrying value.