ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q1 FY2011

Zimmer Holdings, Inc. — Form 10-Q Summary

Reporting period: Three months ended March 31, 2011. The filing is by Zimmer Holdings, Inc. and its subsidiaries, the predecessor name reflected in the source filing for the company identified in the request as Zimmer Biomet Holdings, Inc. Financial statements are unaudited.

Business Context and Reporting Period

Zimmer designs, manufactures and markets orthopedic reconstructive implants, dental and spinal implants, trauma products, surgical products and related services. Reportable geographic segments are the Americas, Europe and Asia Pacific.

Shares outstanding at April 25, 2011: 191.96 million.
Sales growth was supported by volume and mix, foreign exchange and growth in hips, extremities, dental, trauma and surgical products.
Knee sales were flat and spine sales declined, reflecting procedure, reimbursement and operational challenges.

Key Financial Metrics

Metric	Q1 2011	Q1 2010	Change
Net sales	$1,115.6 million	$1,062.8 million	+5%
Gross profit	$836.6 million	$794.4 million	+5%
Gross margin	74.9%	74.8%	Approximately flat
Operating profit	$297.2 million	$294.1 million	+1%
Operating margin	26.6%	27.7%	Down 110 basis points
Net earnings	$208.9 million	$205.4 million	+2%
Diluted EPS	$1.08	$1.01	+7%
Operating cash flow	$182.2 million	$259.5 million	Down $77.3 million

Research and development expense increased to $55.6 million from $50.5 million, while selling, general and administrative expense increased to $458.3 million from $447.2 million. Special items increased materially to $25.5 million from $2.6 million. The effective tax rate was 27.0%, compared with 26.5%.

Non-GAAP adjusted net earnings were $230.9 million, compared with $207.4 million, and adjusted diluted EPS was $1.19, compared with $1.02. These measures exclude inventory step-up charges, special items and related tax effects.

Cash Flow, Liquidity and Capital Structure

Cash and cash equivalents were $575.6 million at March 31, 2011, down from $668.9 million at December 31, 2010.
Short-term and long-term investments had a fair value of $397.4 million. Cash, investments and available credit provided substantial liquidity, although the filing states that $792.4 million of cash and investments held outside the United States was expected to remain indefinitely reinvested; the cited disclosure is presented in the filing in the context of March 31, 2010.
Operating cash flow declined primarily because of lower receivable collections, inventory investment, increased pension funding and product liability payments.
Investing cash flow used $66.9 million, including $46.3 million for instruments, $17.1 million for other property, plant and equipment, and $13.2 million for other assets, partly offset by $75.0 million of investment sales.
Financing cash flow used $216.5 million, principally because of $236.1 million of share repurchases.
Long-term debt was $1,140.2 million, including $500 million of senior notes due 2019, $500 million due 2039 and $143.0 million outstanding under the senior credit facility. There was no short-term debt.
The $1,350 million revolving credit facility had $1,207.0 million of availability at March 31, 2011. Additional uncommitted credit facilities totaled $52.8 million.
The company repurchased 4.2 million shares at an average price of $55.83 per share. Approximately $1.0 billion remained authorized under the $1.5 billion repurchase program.

Material Changes Versus the Prior Comparable Period

Sales increased 5%, with volume and mix contributing 4 percentage points and foreign exchange contributing 2 percentage points; pricing reduced growth by 1 percentage point.
Asia Pacific sales increased 16%, Europe increased 5% and the Americas increased 2%.
Product-category sales changes included dental +21%, trauma +16%, extremities +12%, surgical and other +10%, hips +7%, reconstructive products overall +3%, knees flat and spine down 5%.
Operating margin declined despite improved manufacturing efficiency and lower SG&A as a percentage of sales, primarily because special items rose by $22.9 million and R&D spending increased.
Interest expense declined to $11.0 million from $14.6 million, partly due to interest-rate swaps and higher interest income.
Weighted-average diluted shares declined to 193.8 million from 204.2 million, supporting the 7% increase in diluted EPS despite only 2% net earnings growth.
Comprehensive income increased to $297.6 million from $151.7 million, primarily reflecting favorable foreign-currency translation and other comprehensive-income movements.

Guidance, Outlook, Risks and Unusual Items

Management forecast full-year 2011 sales growth of 5% to 7%, assuming low-single-digit knee and hip procedure growth, pricing pressure of approximately 1% to 2% and a positive foreign-exchange effect of approximately 3% at March 31 rates.
Expected 2011 gross margin was approximately 75%; R&D was expected at 5% to 6% of sales and SG&A at 40% to 41% of sales, excluding specified restructuring and integration expenses.
Management expected $75 million to $80 million of global restructuring and transformation expenses and an additional $15 million to $20 million of acquisition integration costs during 2011.
The March 2011 earthquake and tsunami were expected to reduce Japan’s full-year sales by up to 10% versus prior expectations, implying an estimated approximately 1% reduction in consolidated sales relative to pre-disaster expectations.
Special items included $16.2 million of employee severance and retention costs associated with changes to the organizational structure affecting approximately 450 employees. Most related payments were expected by year-end 2011.
Estimated remaining Durom Cup-related liability was $124.4 million at March 31, 2011, including $42.5 million short-term and $81.9 million long-term. The company expected to pay most claims within three years, but actual claims and payments could differ materially.
A jury awarded $27.6 million in a product-related case involving the Polett matter. The company had not accrued a charge because post-trial relief and appeal arguments were pending and management did not consider a loss probable; a future charge could materially affect results.
The company received a subpoena from the SEC concerning business activities in substantially all Asia Pacific countries in connection with an ongoing Foreign Corrupt Practices Act investigation. The outcome was not predictable.
The company remained subject to tax audits, including an IRS proposed adjustment involving intercompany pricing for 2006 and 2007. The ultimate tax impact could be material, but the amount was not reasonably estimable.
Other risks included pricing and reimbursement pressure, healthcare reform and a scheduled 2.3% U.S. medical-device excise tax beginning in 2013, product liability, intellectual-property claims, regulatory compliance, foreign exchange, acquisitions, supplier concentration and compliance with the Corporate Integrity Agreement through 2012.

Important Facts for Investors to Verify

Reconcile GAAP earnings growth with the substantially higher adjusted earnings growth and assess the recurring versus nonrecurring nature of the $25.5 million of special items.
Monitor operating cash conversion, receivables and inventory: days sales outstanding rose to 66 and inventory days rose to 312.
Assess the sustainability of share repurchases and their effect on EPS relative to underlying net earnings growth.
Track the Durom Cup claims reserve, the Polett litigation and other product-liability matters for potential changes in accrued liabilities or earnings.
Follow developments in the SEC/DOJ FCPA investigation, the IRS intercompany-pricing matter and compliance with the Corporate Integrity Agreement.
Compare actual 2011 sales, margins, restructuring costs and Japan results with management’s stated outlook.
Evaluate the effect of foreign-exchange hedges, including the reported $72.5 million net unrealized loss deferred in accumulated other comprehensive income and the $39.5 million expected to be reclassified to earnings over the next twelve months.