Zimmer Holdings, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2011; filed November 2, 2011. Financial statements are unaudited. The filing identifies the registrant as Zimmer Holdings, Inc. (the company now known as Zimmer Biomet).
Business Context and Reporting Period
The company designs, manufactures and markets orthopedic reconstructive implants, dental and spinal implants, trauma products, surgical products and related services. Reportable segments are the Americas, Europe and Asia Pacific. During the quarter, Zimmer acquired a controlling, non-exclusive interest in Zfx GmbH to expand its digital dentistry presence; the acquisition was not material to reported results.
Financial Performance
| Metric | Q3 2011 | Q3 2010 | 9M 2011 | 9M 2010 |
|---|---|---|---|---|
| Net sales | $1,031.5 million | $965.0 million | $3,284.5 million | $3,085.5 million |
| Gross profit | $779.6 million | $745.9 million | $2,465.7 million | $2,347.4 million |
| Operating profit | $266.6 million | $271.6 million | $822.9 million | $793.8 million |
| Net earnings attributable to Zimmer | $191.5 million | $191.1 million | $604.2 million | $562.0 million |
| Diluted EPS | $1.01 | $0.96 | $3.15 | $2.78 |
- Q3 sales increased 7%, driven by 3% volume/mix growth and a 5% favorable foreign-exchange effect, partly offset by 1% pricing pressure. Nine-month sales increased 6%.
- Gross margin was approximately 75.6% in Q3 and 75.1% for the first nine months, versus 77.3% and 76.1%, respectively, in the prior-year periods.
- Operating margin was approximately 25.8% in Q3 and 25.1% year to date, down from 28.1% and 25.7%. Foreign-currency hedge losses, higher unit costs, restructuring charges and inventory step-up costs pressured margins.
- Q3 net earnings were essentially flat, while nine-month net earnings increased 8%. Reduced share count from repurchases lifted diluted EPS by 5% in Q3 and 13% year to date.
- Non-GAAP adjusted diluted EPS was $1.04 in Q3 and $3.44 for nine months, compared with $0.96 and $3.07, respectively, in 2010.
Revenue and Operating Trends
| Segment | Q3 2011 Sales | Q3 Change | 9M 2011 Sales | 9M Change |
|---|---|---|---|---|
| Americas | $582.1 million | Flat | $1,820.4 million | 1% |
| Europe | $252.5 million | 17% | $876.4 million | 13% |
| Asia Pacific | $196.9 million | 19% | $587.7 million | 18% |
- Strongest product-category growth was in trauma, dental and surgical products. Hip sales increased 10% in Q3, while spine sales declined 2%.
- Americas demand remained pressured by unemployment, lower consumer confidence and reconstructive procedure volumes below historical utilization rates.
- Management cited continued demand for premium products and long-term growth drivers including aging populations, obesity, emerging markets and advances in surgical technology.
Cash Flow, Liquidity and Capital Structure
- Operating cash flow was $783.8 million for the first nine months, down from $852.5 million. Lower collections, inventory investment, pension funding and product-liability payments contributed to the decline.
- Investing cash outflow was $411.1 million, including $403.8 million of investment purchases and $67.8 million of property, plant and equipment additions.
- Financing cash outflow was $493.3 million, including $906.5 million of share repurchases, partly offset by $375.2 million of revolving-credit borrowings.
- Cash and cash equivalents were $553.0 million at September 30, 2011, compared with $668.9 million at year-end 2010. Short-term investments were $424.9 million, and total investment securities had a fair value of $586.1 million.
- Long-term debt was $1,543.5 million, including $1,000 million of senior notes and $518.0 million drawn under the Senior Credit Facility. The facility had $832.0 million of remaining availability and matures November 30, 2012.
- The company had $1,008.7 million of cash and investments held outside the United States and expected to be indefinitely reinvested abroad.
- Zimmer repurchased 16.2 million shares for $906.5 million during the first nine months and had approximately $0.3 billion remaining under its $1.5 billion authorization.
Material Changes and Unusual Items
- Special items increased to $8.0 million in Q3 and $47.0 million for nine months, principally reflecting severance, restructuring, consulting, contract termination and acquisition-related costs. Approximately 500 employees were affected by organizational changes.
- The company recorded $50.0 million of additional Durom Cup-related claims expense in the second quarter of 2011; cumulative provisions for the relevant pre-July 22, 2008 surgeries totaled $271.7 million, with an estimated remaining liability of $142.6 million at September 30, 2011.
- Interest expense declined to $11.7 million in Q3 and $32.5 million for nine months, versus $14.2 million and $43.1 million, respectively, primarily due to interest-rate swaps and higher investment income.
- The effective tax rate was 25.0% in Q3 and 23.6% for nine months. Tax audits and unresolved tax matters could materially affect future tax expense and cash flows.
- Accumulated other comprehensive income included significant currency and hedge-related volatility. The company reported a $77.4 million other comprehensive loss in Q3, largely from foreign-currency translation.
Guidance, Outlook and Risks
- Management forecast full-year 2011 sales growth of 4.8% to 5.2%, assuming global knee and hip procedure markets are flat to slightly positive.
- Expected 2011 pricing effect is approximately negative 1%, while foreign exchange was expected to contribute approximately 2.5% based on September 30 rates.
- Management expected approximately 75% gross margin, R&D expense of 5.0% to 5.5% of sales and SG&A expense of approximately 41% of sales.
- Expected 2011 restructuring and transformation costs were $55 million to $60 million, with an additional $15 million to $20 million of acquisition integration costs.
- Key risks include weak procedure volumes, pricing and reimbursement pressure, foreign-exchange volatility, product liability, regulatory compliance, healthcare reform, tax audits, competition and acquisition integration.
- The FDA issued a Form 483 after a July 2011 inspection of the Warsaw manufacturing facility, identifying quality-system observations. A future reinspection and possible additional FDA action could affect approvals, operations, reputation and financial results.
- The company was defending an SEC/DOJ Foreign Corrupt Practices Act investigation, with an SEC subpoena received in 2011 concerning Asia Pacific activities. The outcome and potential financial impact were not estimable.
- A $20.3 million judgment in the Polett litigation was under appeal and had not been accrued because management did not believe a liability was probable. An adverse outcome could materially affect a future period.
- The Corporate Integrity Agreement with the U.S. Department of Health and Human Services remains in effect through 2012; a material breach could result in exclusion from federal healthcare programs.
Investor Verification Items
- Verify whether the 4.8% to 5.2% 2011 sales outlook and approximately 75% gross-margin outlook were achieved.
- Track Durom Cup claims, payments and any increase above the $142.6 million estimated remaining liability.
- Monitor the Warsaw FDA Form 483 response, reinspection and any warning letter or other regulatory action.
- Review the SEC/DOJ FCPA investigation and related potential penalties or remediation requirements.
- Assess refinancing and liquidity needs before the November 2012 Senior Credit Facility maturity.
- Evaluate cash conversion, receivables and inventory levels, including 71 days of sales outstanding and 348 days of inventory on hand at quarter-end.
- Reconcile reported GAAP results with management’s non-GAAP measures and the exclusion of claims, inventory step-up and special items.