ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q3 FY2016

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

Reporting period: Three and nine months ended September 30, 2016; filed November 8, 2016. The financial statements are unaudited. Comparisons are affected by the June 24, 2015 Biomet merger, whose results were included only from the acquisition date in the 2015 period.

Business context

Zimmer Biomet designs, manufactures and markets orthopedic reconstructive, sports medicine, biologics, extremities, trauma, spine, craniomaxillofacial, dental and related surgical products. The company completed the LDR acquisition on July 13, 2016 and also completed several smaller acquisitions, including Cayenne Medical, CTC, CD Diagnostics and MedTech.

Financial performance

Metric	Q3 2016	Q3 2015	9M 2016	9M 2015
Net sales	$1,832.8 million	$1,762.2 million	$5,670.8 million	$4,064.2 million
Operating profit	$195.5 million	$116.0 million	$642.6 million	$253.8 million
Operating margin	10.7%	6.6%	11.3%	6.2%
Net earnings attributable to Zimmer Biomet	$158.8 million	$22.2 million	$236.3 million	$20.0 million
Diluted EPS	$0.78	$0.11	$1.17	$0.11
Cash dividends declared per share	$0.24	$0.22	$0.72	$0.66

Q3 sales increased 4.0%; nine-month sales increased 39.5%, primarily because 2016 included Biomet for the full period.
Q3 operating margin improved by 4.1 percentage points, while nine-month margin improved by 5.1 percentage points.
Q3 and nine-month results benefited from lower merger-related expenses than in 2015. Q3 also benefited from the absence of Biomet inventory step-up expense.
Adjusted net earnings were $362.4 million, or adjusted diluted EPS of $1.79, in Q3 2016, compared with $338.4 million and $1.64, respectively, in Q3 2015. For the nine months, adjusted net earnings were $1,176.7 million and adjusted diluted EPS was $5.82.

Sales trends and margins

Q3 geographic sales were $1,175.9 million in the Americas, $368.8 million in EMEA and $288.1 million in Asia Pacific.
Q3 product-category sales included knees of $631.3 million, hips of $440.6 million, S.E.T. of $402.1 million, dental of $95.9 million and spine and CMF of $183.6 million.
Q3 volume and mix contributed 5.4 percentage points of sales growth, while pricing reduced growth by 1.9 percentage points and foreign exchange contributed 0.6 percentage points.
Q3 knee sales declined 0.1% because of supply issues; dental sales declined 7.3%. Spine and CMF sales increased 24.3%, partly due to LDR, and S.E.T. sales increased 8.5%.
Q3 cost of products sold excluding intangible amortization was 26.2% of sales versus 31.3% in the prior-year quarter. Intangible amortization was 9.0% of sales versus 7.0%, and special items were 9.3% versus 11.1%.

Cash flow, balance sheet and liquidity

Nine-month operating cash flow was $1,005.0 million, compared with $387.3 million in 2015.
Investing cash outflow was $1,544.7 million, including $1,021.1 million for LDR and $421.9 million for other business combination investments.
Financing cash outflow was $434.1 million, including $700.0 million of term-loan repayments, $140.3 million of dividends and $415.5 million of share repurchases.
Cash and cash equivalents declined to $475.3 million at September 30, 2016 from $1,459.3 million at December 31, 2015. Short-term investments were $13.4 million.
Total debt was approximately $11.6 billion, consisting of $575.8 million current debt and $11,006.2 million long-term debt. Senior notes had aggregate principal of $8.95 billion, and term-loan principal totaled $2.666 billion.
The company entered into a new $750.0 million Term Loan B and a $1.5 billion multicurrency revolving facility. No borrowings were outstanding under the revolving facility at quarter-end. The company was in compliance with its debt covenants.
Total assets were $27.0365 billion and total stockholders’ equity was $9.7462 billion at September 30, 2016.
Management stated that operating cash flow and available revolving credit were sufficient for working capital, capital expenditures, debt service, dividends and share repurchases.

Material changes and unusual items

Special items were $170.4 million in Q3 and $397.0 million for the nine months, versus $195.9 million and $751.9 million, respectively, in the prior-year periods. These primarily included Biomet integration, consulting, termination, contract and acquisition-related costs.
The company recognized a $28.0 million impairment of Biomet in-process research and development assets during the nine months.
A $25.1 million deferred tax benefit related to finalizing Biomet tax accounts was recognized in Q3. Out-of-period adjustments included a $25.1 million deferred tax benefit and $12.0 million of pretax operating expenses; management concluded they were not material.
Biomet integration plans are expected to continue through 2018. Total expected costs include approximately $170 million of employee termination benefits and $130 million of contract termination expenses. The company expected approximately $330 million of integration-related cash outlays in 2016 and targeted $350 million of annual pretax synergies by the end of the third year after closing.
At September 30, 2016, the company had incurred cumulative integration costs of $115.3 million for employee termination benefits and $123.8 million for contract termination expenses.

Guidance and management outlook

Management reduced its fourth-quarter 2016 sales outlook, expecting growth below market rates versus its previous expectation of at-or-above-market growth.
The revision reflected temporary product supply disruptions caused by operational process enhancements, shipment delays, manufacturing forecasting constraints and ongoing supply-chain integration.
Management expected lower Biomet inventory step-up expense in Q4, which should improve gross profit, partly offset by lower hedge gains.
Full-year R&D expense was expected to remain between 4.5% and 5.0% of sales; SG&A expense was expected to approximate 38% of sales. Special items were expected to remain significant, and interest expense was expected to increase because of LDR acquisition financing.

Risks, contingencies and other matters

Durom Cup liabilities were estimated at $299.8 million, including $75.0 million short-term and $224.8 million long-term. The company had recognized $479.4 million of related expense since 2008 and reported a $95.3 million insurance-recovery receivable; insurers could deny some or all coverage.
Remaining liability for Biomet metal-on-metal hip implant claims was estimated at $60.7 million.
The Stryker litigation could require a future charge of up to $165.0 million following appellate proceedings concerning willfulness and damages.
FDA warning letters remained pending for facilities in Ponce, Puerto Rico; Zhejiang, China; and Montreal, Quebec. Potential consequences include additional regulatory action, seizure, injunctions, civil penalties and delays in product approvals or certificates.
Biomet’s former Deferred Prosecution Agreement and related SEC and DOJ investigations remained unresolved. The DOJ had notified Biomet that it believed a breach occurred; additional liabilities were considered probable, but the ultimate resolution and terms were uncertain.
IRS audits and proposed adjustments for 2005–2009 could result in significant future tax payments. The company could not reasonably estimate changes in unrecognized tax benefits.
European healthcare budget constraints exposed the company to collection risk. Net receivables in Greece, Italy, Portugal and Spain were $221.0 million after allowances, representing 15% of consolidated net trade receivables.
Additional risks include acquisition integration, pricing pressure, product liability and intellectual property litigation, FDA compliance, foreign exchange and interest-rate volatility, dependence on suppliers, healthcare cost containment and realization of anticipated synergies.

Most important facts to verify

Whether supply-chain remediation restores product availability and supports fourth-quarter and 2017 sales growth.
Progress toward the targeted $350 million of annual Biomet synergies and the remaining integration cash costs.
Debt reduction, upcoming maturities, covenant headroom and the effect of LDR financing on interest expense.
Resolution and cash exposure from Durom Cup, metal-on-metal hip, Stryker and Heraeus matters.
Outcomes of the DOJ and SEC investigations and the pending FDA warning-letter remediation.
Actual tax payments and liabilities arising from IRS audits, Biomet tax-account finalization and planned repatriation of $4.6856 billion of unremitted foreign earnings.