ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q1 FY2012

Zimmer Holdings, Inc. — Form 10-Q Summary

Business Context and Reporting Period

Zimmer Holdings, Inc. filed an unaudited Form 10-Q for the quarter ended March 31, 2012. The company designs, manufactures and markets orthopedic reconstructive implants, biologics, dental and spine implants, trauma products, surgical products and related healthcare services. Reportable segments are the Americas, Europe and Asia Pacific.

International subsidiary results primarily cover periods ending March 25, 2012. Interim results are not necessarily indicative of full-year performance.

Financial Performance and Position

Metric	Q1 2012	Q1 2011	Change
Net sales	$1,140.7 million	$1,115.6 million	2.2% increase
Gross profit	$852.0 million	$836.6 million	1.8% increase
Gross margin	74.7%	75.0%	Down 0.3 percentage points
Operating profit	$295.6 million	$297.2 million	0.5% decrease
Operating margin	25.9%	26.6%	Down 0.7 percentage points
Net earnings attributable to Zimmer	$209.6 million	$208.9 million	0.3% increase
Diluted EPS	$1.17	$1.08	8.3% increase
Operating cash flow	$207.4 million	$182.2 million	13.8% increase

Sales growth was driven by 5 percentage points of volume and mix, offset by 2 percentage points of pricing pressure and 1 percentage point of foreign-exchange impact. Segment sales were $634.4 million in the Americas, $300.8 million in Europe and $205.5 million in Asia Pacific. Asia Pacific grew 10%, while the Americas and Europe each grew 1%.

Product trends included reconstructive sales growth of 2%, trauma growth of 8% and surgical and other growth of 10%. Dental declined 3% and spine declined 7%. Knee and hip sales each increased 2%.

Research and development expense increased to $59.6 million, or 5.2% of sales, from 5.0% of sales. SG&A increased in dollars but declined to 40.6% of sales from 41.1%. Special items increased to $33.5 million from $25.5 million, primarily reflecting consulting and professional fees, litigation matters, transformation activities and severance.

At March 31, 2012, cash and cash equivalents were $674.0 million and short-term investments were $555.1 million. Total available-for-sale investments, including long-term investments, had a fair value of $752.0 million. Accounts receivable were $895.0 million and inventories were $937.0 million.

Total debt was approximately $1.72 billion, consisting of $144.6 million of short-term debt and $1.57 billion of long-term debt. The company had $141.8 million outstanding under its $1.35 billion revolving Senior Credit Facility, leaving $1.21 billion available. The facility was scheduled to mature November 30, 2012, and management expected to replace it during the second quarter.

Cash Flow, Capital Allocation and Liquidity

Investing cash outflows were $164.2 million, including $255.6 million of investment purchases, $28.8 million of instrument additions, $19.5 million of property and equipment additions, and $34.9 million invested in other assets.
Financing cash outflows were $129.1 million, including $141.6 million for repurchase of 2.3 million shares at an average price of $61.03.
Approximately $1.4 billion remained available under the $1.5 billion share repurchase authorization, which expires December 31, 2014.
The company declared a quarterly dividend of $0.18 per share, totaling approximately $31.7 million, payable in April 2012.
Management stated that operating cash flow and available borrowings were sufficient for working capital, capital expenditures, dividends and debt service.
Cash, cash equivalents and investments held outside the United States totaled $1.21 billion and were expected to remain indefinitely reinvested abroad.

Material Changes Versus the Prior Comparable Period

Revenue increased modestly, but operating profit declined because of higher unit costs, lower average selling prices and increased special items.
Net earnings were broadly flat, while diluted EPS increased primarily because share repurchases reduced the weighted-average diluted share count to 178.5 million from 193.8 million.
Operating cash flow improved by $25.2 million, primarily because of the timing of tax payments, partly offset by increased product-liability payments.
Cash declined by $94.3 million during the quarter as operating cash flow was more than offset by investing and financing outflows.
The company announced plans to outsource its Warsaw, Indiana distribution center and other organizational changes affecting approximately 140 employees.
The January 2012 acquisition of Synvasive Technology contributed to growth in surgical and other sales.
The cross-currency interest-rate swaps related to a Japanese subsidiary matured during the quarter, and the related U.S. dollar debt was repaid with yen-denominated debt.

Guidance, Outlook, Commentary and Risks

Management forecast 2012 sales growth of 0% to 2.5%, assuming low-single-digit knee and hip procedure growth, modest economic growth and relatively stable employment.
Foreign currency was expected to reduce 2012 sales by approximately 1.5% to 2.0% at March 31 exchange rates, with a projected 2.5% revenue reduction in the second quarter from translation.
The Japan price adjustment effective April 1 was greater than expected and added pressure to the full-year pricing outlook, previously negative 2%.
Expected 2012 gross margin was approximately 75%; R&D expense was expected at 5% to 6% of sales; and SG&A was expected at 39.5% to 40.5% of sales.
Management expected approximately $110 million of restructuring and transformation costs and approximately $15 million of acquisition, integration and other costs during 2012, with most recorded as special items.
Expected 2012 net interest expense was approximately $60 million, higher primarily because of the $550 million senior-notes offering completed in November 2011.
The FDA began a re-inspection in April 2012 of the Warsaw manufacturing facility following a July 2011 Form 483 concerning quality systems. Additional regulatory action could affect revenue, operations, cash flow and reputation.
The company had accrued $388.2 million for Durom Cup-related claims but could not estimate additional potential losses. NexGen knee lawsuits remained pending without an accrued loss.
A Pennsylvania product-liability matter involving the Poletts had resulted in a $20.3 million judgment against Zimmer and another defendant; Zimmer had appealed and had not accrued a loss.
An SEC and DOJ investigation concerning potential FCPA violations remained unresolved. The company could face monetary penalties or remedial actions.
The IRS had assessed reallocations of profits among U.S. and foreign subsidiaries for 2005–2007; additional tax audits and unresolved tax positions could materially affect future results.
Credit exposure to European public hospitals was significant. Receivables in Greece, Italy, Portugal and Spain totaled $242.1 million, with Italy and Spain representing $229.8 million; deterioration in government funding could result in material bad-debt expense.
The company expected the 2.3% U.S. medical-device excise tax scheduled for 2013 to affect earnings, although it expected transformation savings to offset the impact.

Important Facts for Investors to Verify

Whether the FDA re-inspection leads to a warning letter, additional remediation or restrictions affecting the Warsaw facility.
The ultimate cost and timing of Durom Cup claims, NexGen claims, the Polett appeal and other litigation.
The outcome and potential financial impact of the FCPA investigation and IRS tax matters.
Whether the company completes replacement of the $1.35 billion revolving credit facility before its November 2012 maturity.
Progress toward the projected $125 million of 2012 restructuring, transformation and acquisition-related costs.
The effect of Japan pricing actions, continuing reimbursement pressure, foreign exchange and European hospital-credit conditions on sales and margins.
Execution of the distribution-center outsourcing, finance-function centralization and global financial-reporting software implementation.