ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q3 FY2018

Zimmer Biomet Holdings, Inc. — Form 10-Q Summary

Reporting period: Three and nine months ended September 30, 2018. The financial statements are unaudited and compare with the corresponding 2017 periods. Zimmer Biomet designs, manufactures and markets orthopedic reconstructive, sports medicine, trauma, spine, CMF, dental and related surgical products.

Financial performance and liquidity

Metric	Q3 2018	Q3 2017	9M 2018	9M 2017
Net sales	$1,836.7 million	$1,813.1 million	$5,861.9 million	$5,735.0 million
Operating profit	$223.3 million	$211.2 million	$824.3 million	$839.4 million
Operating margin	12.2%	11.6%	14.1%	14.6%
Net earnings attributable to Zimmer Biomet	$162.2 million	$98.8 million	$521.9 million	$582.4 million
Diluted EPS	$0.79	$0.48	$2.55	$2.86
Operating cash flow	Not separately provided	Not separately provided	$1,367.9 million	$1,179.4 million

Q3 sales increased 1.3%, driven by volume and mix growth, particularly in Knees, Hips, Asia Pacific, Americas capital equipment and EMEA customer tenders. Nine-month sales increased 2.2%.
Q3 net earnings rose primarily because of lower acquisition, integration, impairment and quality-remediation costs, as well as a tax benefit. Nine-month earnings declined because the 2017 period included significant tax benefits from tax restructuring and tax matter resolutions.
Pricing reduced sales by 2.4% in Q3 and 2.5% for the first nine months. Volume/mix contributed 4.7% and 3.0%, respectively; foreign exchange reduced Q3 sales by 1.0% but increased nine-month sales by 1.7%.
Cash and cash equivalents were $524.6 million at September 30, 2018, essentially unchanged from $524.4 million at December 31, 2017. Current assets were $4.5 billion versus current liabilities of $2.4 billion.
Investing cash outflows were $334.2 million, primarily for instruments and property, plant and equipment. Financing cash outflows were $1,026.7 million, including debt repayments and $146.2 million of dividends.
Total debt was approximately $9.2 billion, comprising $600.0 million of current debt and $8,597.4 million of long-term debt. The company had no borrowings under its $1.5 billion multicurrency revolving facility and was in compliance with applicable financial covenants.
Dividends declared were $0.24 per common share in each quarter of 2018 through the reporting date. A $1.0 billion share-repurchase authorization remained unused.

Material changes versus the prior comparable period

Cost of products sold excluding amortization increased to 28.8% of sales from 27.6% in Q3 and to 28.8% from 26.9% for the nine-month period, reflecting Warsaw North Campus manufacturing and supply issues, excess and obsolete inventory charges, lower pricing and unfavorable hedging effects.
SG&A increased to 42.9% of sales in Q3 from 39.3% and to 40.6% for nine months from 39.1%, driven by specialized sales-force investments, compliance costs, incentive compensation and business-transformation spending.
Acquisition, integration and related expense declined to $17.4 million in Q3 and $113.9 million for nine months, compared with $61.6 million and $192.3 million, respectively.
Quality-remediation expense declined to $32.2 million in Q3 and $112.3 million for nine months, compared with $51.1 million and $135.4 million, respectively, although remediation remains ongoing.
Interest expense declined to $68.3 million in Q3 and $223.1 million for nine months, compared with $82.3 million and $247.5 million, primarily because of lower average debt.
The company issued $750.0 million of senior notes in March 2018 and used the proceeds, revolving-facility borrowings and cash to repay $1.15 billion of senior notes due in April 2018.
Revenue recognition under ASC 606 was adopted retrospectively. It did not change the timing of revenue recognition, but reclassified certain costs from SG&A to sales and changed certain balance-sheet classifications.

Guidance, outlook and management commentary

Management estimated 2018 sales growth of 1.0% to 2.5% over 2017, including a foreign-exchange benefit of slightly less than 1.0%.
Termination of a U.S. bone-cement distribution agreement was expected to reduce Other product-category revenue by approximately $10 million to $15 million per quarter beginning in Q4 2018.
Management expected higher 2018 product costs because of Warsaw North Campus manufacturing costs, with effects potentially continuing into 2019.
R&D and SG&A were expected to increase as tax savings were reinvested in the business; acquisition and integration expenses were expected to decline.
Management expected lower interest expense and generally stable quality-remediation expense for 2018.
The company continued to refine provisional accounting for the 2017 Tax Act. The measurement period was expected to end in Q4 2018, and final effects could differ materially from current estimates.

Risks, contingencies and unusual items

FDA warning letters relating to facilities in Warsaw, Montreal and Ponce remained pending as of November 1, 2018. Potential consequences include operating restrictions, product or approval delays, export-certificate restrictions, penalties or other regulatory action.
The company recorded $112.3 million of remaining Durom Cup-related liabilities and $62.1 million related to Biomet metal-on-metal hip claims. Estimates depend on litigation developments and expected claim volumes and payments.
A securities class action alleging misleading statements regarding FDA compliance and revenue growth survived the company defendants’ motion to dismiss; further proceedings were pending.
Heraeus trade-secret litigation remained active in multiple jurisdictions. The company had accrued an estimated loss related to the Frankfurt Decision but had not accrued losses for other related matters where liability was not considered probable or estimable.
A Stryker patent matter could require a future charge of up to $170.0 million; an appeal was scheduled for December 2018.
An OIG subpoena concerning healthcare-professional consulting arrangements remained under review, and the outcome could not be predicted.
The company was subject to a Deferred Prosecution Agreement and independent compliance monitoring relating to pre-acquisition Biomet FCPA matters. Noncompliance could lead to prosecution, exclusion from federal healthcare programs and material adverse effects.
Dental goodwill of $389.1 million was tested for impairment and exceeded carrying value by less than 5%; future underperformance could result in impairment charges.
Other significant exposures include pricing pressure, foreign-currency volatility, healthcare cost containment, product liability, regulatory compliance, tax audits and integration or supply-chain execution.

Important facts for investors to verify

Whether the company achieved its 2018 sales-growth guidance and quantified the actual impact of the bone-cement distribution termination.
Progress and costs associated with Warsaw North Campus remediation and resolution of the outstanding FDA warning letters.
Debt maturities, refinancing plans and compliance with credit-facility covenants, particularly the $600.0 million U.S. Term Loan B due September 2019.
Final accounting effects of the 2017 Tax Act and the status of IRS proposed adjustments for 2005–2012.
Changes in Durom Cup, Biomet metal-on-metal, Heraeus, Stryker and securities-litigation liabilities and cash payments.
Whether Dental reporting-unit performance improves sufficiently to avoid a goodwill impairment charge.
Sustainability of operating cash flow after factoring activity, remediation spending, litigation payments, capital expenditures and dividends.