ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q3 FY2017

Zimmer Biomet Holdings, Inc. — 2017 Q3 Form 10-Q

Reporting period: Quarterly and nine-month periods ended September 30, 2017; filed November 6, 2017. The unaudited results cover the global design, manufacture and marketing of orthopedic reconstructive, sports medicine, trauma, spine, CMF, dental and related surgical products.

Financial performance and condition

Metric	Q3 2017	Q3 2016	9M 2017	9M 2016
Net sales	$1,818.1 million	$1,832.8 million	$5,749.8 million	$5,670.8 million
Operating profit	$213.4 million	$195.5 million	$846.1 million	$642.6 million
Operating margin	11.7%	10.7%	14.7%	11.3%
Net earnings attributable to Zimmer Biomet	$98.8 million	$158.8 million	$582.4 million	$236.3 million
Diluted EPS	$0.48	$0.78	$2.86	$1.17
Adjusted diluted EPS	$1.72	$1.79	$5.93	$5.82

Q3 sales declined 0.8%; nine-month sales increased 1.4%. Volume and mix contributed 0.9% in Q3 and 4.1% year to date, while pricing reduced sales by 2.1% and 2.3%, respectively.
Q3 net earnings declined 37.8%, primarily because of a $32.7 million goodwill impairment and favorable tax items recorded in the prior-year quarter. Nine-month net earnings increased 146.5%, aided by lower inventory step-up costs and significant tax benefits.
Q3 cost of products sold was 27.5% of sales versus 26.2% a year earlier, mainly because of hedge losses, lower average selling prices, higher manufacturing costs and unfavorable mix. Nine-month cost of products sold improved to 26.8% from 31.0%.
Special items were $165.4 million in Q3 and $434.1 million for the nine months, including merger integration, quality remediation, consulting, litigation and impairment charges.
Operating cash flow was $1,179.4 million for the nine months versus $1,005.0 million in 2016. The increase included approximately $273 million of incremental cash inflows from receivables sales.
Investing cash use was $382.6 million, including $255.7 million for instruments and $109.8 million for property, plant and equipment. Financing cash use was $977.6 million, primarily reflecting debt repayments, a $500.0 million senior-note redemption and $145.0 million of dividends.
Cash and equivalents were $480.8 million at September 30, 2017, compared with $634.1 million at year-end 2016. Current assets were $4.43 billion and current liabilities were $3.01 billion.
Total debt carrying value was approximately $10.42 billion, comprising $1.23 billion current debt and $9.20 billion long-term debt. The company had no borrowings under its $1.5 billion multicurrency revolving facility and was in compliance with financial covenants.

Material changes versus the prior comparable period

Production constraints at the legacy Biomet Warsaw facility, low inventory levels, one fewer billing day, hurricane-related surgery delays and an India-wide knee price reduction pressured Q3 revenue, particularly in the Americas and in the Knee and Hip categories.
Nine-month Spine and CMF sales rose 20.1%, primarily because of the LDR acquisition and strong thoracic sales. Nine-month S.E.T. sales increased 3.3%, while Knees, Hips, Dental and Other declined.
The company recognized a $32.7 million goodwill impairment for the Office Based Technologies reporting unit, eliminating that unit’s remaining goodwill. The impairment reflected continued revenue declines, integration issues, management turnover and poor execution.
Interest expense declined to $82.3 million in Q3 and $247.5 million for the nine months, reflecting lower average debt and refinancing with lower-rate Euro Notes.
Foreign-currency translation generated $367.9 million of other comprehensive income for the nine months, while cash-flow hedge losses were $79.4 million, producing total other comprehensive income of $274.1 million.
The company early adopted the simplified goodwill impairment standard and the intra-entity asset transfer tax standard. The latter reduced beginning 2017 retained earnings by $72.7 million.

Guidance, outlook, commentary and risks

Management projected 2017 sales growth of 1.0% to 1.5%, including approximately 0.1% benefit from foreign exchange, a roughly 2% pricing headwind and a 1.2% contribution from LDR.
Management expected 2017 R&D expense at approximately 4.5% of sales and SG&A at approximately 37.5% of sales. Interest expense was expected to decline because of planned debt repayments.
The company expected to restore safety-stock levels across its full portfolio during the first half of 2018. Biomet integration activities were expected to continue through mid-2018, with total employee termination and contract termination costs expected to reach approximately $170 million and $140 million, respectively.
Material risks include continued manufacturing and quality remediation problems, FDA warning letters and inspection observations, pricing pressure, reimbursement and healthcare cost containment, foreign exchange, tax audits, supply constraints, product liability claims, intellectual-property litigation, and the ability to achieve acquisition synergies.
Durom Cup liabilities totaled $218.3 million at September 30, 2017, partly offset by a $95.3 million receivable for expected insurance recoveries. The company stated that actual claims and payments could differ materially from estimates.
The company could be required to record up to $165.0 million related to the Stryker litigation if its appeal is unsuccessful. Other significant contingencies include Biomet metal-on-metal hip claims, Heraeus cement litigation, the Polett lawsuit and a putative securities class action.
The FDA warning letters relating to Ponce, Puerto Rico and Montreal remained pending. Potential regulatory actions could restrict manufacturing, marketing or sales.
The company entered a three-year Deferred Prosecution Agreement related to legacy Biomet FCPA matters and paid approximately $30.5 million in January 2017. An independent compliance monitor was appointed in July 2017. An OIG subpoena concerning healthcare professional consulting arrangements remained under review.
Disclosure controls were not effective as of September 30, 2017 because of an unresolved material weakness in income-tax accounting controls. Management had added tax resources and begun remediation, but the weakness had not yet been remediated.
The 2.3% U.S. medical device excise tax was scheduled to resume January 1, 2018 absent further legislative action, potentially affecting earnings and cash flow.

Investor verification points

Verify whether production and inventory constraints were resolved in the first half of 2018 and whether customer demand recovered.
Assess the sustainability of reported earnings excluding tax benefits, acquisition-related costs, amortization, special items and other adjustments.
Review debt maturities, refinancing requirements and covenant capacity, particularly the $1.15 billion of senior notes due in April 2018 and term-loan maturities.
Monitor FDA remediation, the Deferred Prosecution Agreement, the OIG investigation and the status of the income-tax control weakness.
Reassess product-liability, intellectual-property and other litigation reserves, including insurance recoveries and the potential Stryker exposure.
Confirm the effect of pricing pressure, the potential medical device excise tax reinstatement, foreign exchange and healthcare reimbursement changes on future margins.