Zimmer Holdings, Inc. — Form 10-Q Summary
Business Context and Reporting Period
Zimmer Holdings, Inc. designs, manufactures and markets orthopaedic reconstructive implants, biologics, dental and spinal implants, trauma products, surgical products and related services. The filing covers the unaudited three months ended March 31, 2014, with comparable results for the three months ended March 31, 2013. The filing predates the company’s subsequent merger-related name and business combination with Biomet.
Financial Performance and Position
| Metric | Q1 2014 | Q1 2013 | Change |
|---|---|---|---|
| Net sales | $1,161.5 million | $1,138.9 million | +2% |
| Gross profit | $856.1 million | $846.0 million | +1% |
| Gross margin | 73.7% | 74.3% | Down 0.6 percentage points |
| Operating profit | $298.4 million | $298.2 million | Flat |
| Operating margin | 25.7% | 26.2% | Down 0.5 percentage points |
| Net earnings attributable to Zimmer | $221.5 million | $218.6 million | +1% |
| Diluted EPS | $1.29 | $1.28 | +1% |
| Cash flow from operations | $188.8 million | $180.5 million | +5% |
Revenue growth reflected 5% volume and mix growth, offset by a 2% pricing decline and a 1% foreign-exchange headwind. Knee sales increased 4%, hips were flat, extremities increased 9%, dental increased 2%, trauma declined 3%, spine increased 1%, and surgical and other sales increased 1%.
Cash and cash equivalents were $882.7 million at March 31, 2014, compared with $1,080.6 million at December 31, 2013. Short-term investments were $705.4 million, and total short- and long-term investments had a fair value of $823.9 million. Total debt was $1,680.1 million, including $250.0 million of senior notes due November 2014. No borrowings were outstanding under the $1.35 billion revolving credit facility, and the company was in compliance with its covenants.
Financing activities used $290.7 million, including $400.5 million for repurchases of 4.2 million shares and $34.0 million of dividends. The quarterly dividend was increased to $0.22 per share. Inventory was $1,125.9 million, up from $1,074.5 million at year-end, and inventory days increased to 334.
Material Changes Versus the Prior Comparable Period
- Sales increased 2%, primarily from higher procedure volume, product mix and new products such as Persona The Personalized Knee System.
- Gross margin declined because of the medical device excise tax, pricing pressure and quality-related inventory and manufacturing charges. These effects were partly offset by foreign-currency hedge gains and lower excess and obsolete inventory charges.
- Operating profit was essentially unchanged because higher gross profit was offset by increased operating expenses and special items.
- Research and development expense declined to $47.5 million from $53.5 million, while selling, general and administrative expense increased modestly to $464.3 million.
- Special items increased to $45.9 million from $33.5 million, including asset impairment or disposal charges, consulting fees, dedicated project personnel, certain R&D agreements and accelerated software amortization.
- Interest expense declined to $15.0 million from $18.2 million, primarily because of fixed-to-variable interest-rate swaps entered into during the second half of 2013.
- The effective tax rate declined to 22.7% from 23.1%, partly because an international reorganization released a valuation allowance on foreign net operating loss carryforwards.
- Non-GAAP adjusted net earnings increased to $258.1 million from $240.8 million, and adjusted diluted EPS increased to $1.50 from $1.41.
Guidance, Outlook, Risks and Unusual Items
Management projected 2014 net sales growth of 2.5% to 4.5%, a gross margin of 73% to 74%, R&D expense of 4% to 4.5% of sales, and SG&A expense of 38.5% to 39% of sales. Reported net earnings and diluted EPS were expected to increase approximately 13% to 17% versus 2013. The outlook excluded anticipated Biomet merger and integration costs.
Management expected approximately $250 million of 2014 expenses related to quality and operational excellence initiatives and integration costs from recent acquisitions. The company also estimated the medical device excise tax would cost approximately $10 million per quarter. No further share repurchases were planned in 2014 because capital was being preserved for the pending Biomet transaction.
On April 24, 2014, after the quarter ended, Zimmer entered into a definitive agreement to acquire Biomet’s parent in a transaction valued at approximately $13.35 billion, comprising $10.35 billion of cash and 32.7 million Zimmer shares. The transaction was expected to close in the first quarter of 2015, subject to regulatory approvals and other conditions. Zimmer entered into a $7.66 billion 364-day bridge facility and expected to use existing cash, a new $3.0 billion term loan and senior notes to fund the transaction. The proposed transaction was expected to materially increase leverage, interest expense and integration risk.
- Durom Cup claims: remaining estimated liability of $372.3 million, including $50.0 million short-term and $322.3 million long-term; a $218.0 million insurance recovery receivable was recorded. Actual claims and insurance recoveries may differ materially.
- Stryker patent litigation: an adverse trial judgment could require payment of up to $210.0 million plus interest and attorneys’ fees; no liability was accrued because management did not believe a loss was probable.
- NexGen Knee System litigation remained unresolved, with no loss 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. Potential consequences included additional regulatory action, seizure, injunctions, penalties or delayed product approvals.
- The IRS had proposed profit-allocation adjustments for 2006–2009. The company disputed the adjustments, and final resolution could materially affect future tax expense, results and cash flows.
- Key ongoing risks included pricing pressure, healthcare cost containment, foreign-exchange movements, product liability, intellectual property claims, regulatory compliance, tax audits, Eurozone receivable collections and execution of the Biomet transaction.
Important Facts for Investors to Verify
- Whether the Biomet transaction closed on the expected terms, including regulatory approvals, financing, purchase price adjustments and resulting leverage.
- Actual 2014 merger, financing and integration costs compared with management’s expectations.
- Refinancing or repayment of the $250 million senior notes due November 2014.
- Changes in Durom Cup claim estimates and the collectability of the $218.0 million insurance receivable.
- Developments in the Stryker patent appeal and potential exposure of up to $210.0 million plus interest and attorneys’ fees.
- Resolution of the IRS tax matters and related cash payments or effective tax-rate effects.
- FDA remediation progress at the Ponce facility and any additional regulatory action.
- Whether pricing pressure, the medical device excise tax and foreign exchange offset expected volume and mix growth.
- Inventory levels, receivable collections in Greece, Italy, Portugal and Spain, and the company’s ability to fund the proposed transaction while maintaining liquidity and credit ratings.