Business Context and Reporting Period
Zimmer Holdings, Inc. reported its Form 10-K for the year ended December 31, 2013. The company designs, manufactures and markets orthopaedic reconstructive, trauma and spine devices, biologics, dental implants and related surgical products in more than 100 countries. Reportable segments were Americas, Europe and Asia Pacific. The filing predates the company’s later Zimmer Biomet name.
Direct channel accounts represented approximately 80% of 2013 net sales. The Americas contributed $2,619.8 million, Europe $1,212.6 million and Asia Pacific $791.0 million.
Financial Results and Key Metrics
| Metric | 2013 | 2012 | Change |
|---|---|---|---|
| Net sales | $4,623.4 million | $4,471.7 million | 3% |
| Gross profit | $3,337.3 million | $3,346.5 million | Down $9.2 million |
| Gross margin | 72.2% | 74.8% | Down 260 bps |
| Operating profit | $1,035.6 million | $1,047.4 million | Down $11.8 million |
| Operating margin | 22.4% | 23.4% | Down 100 bps |
| Net earnings attributable to Zimmer | $761.0 million | $755.0 million | Up 1% |
| Diluted EPS | $4.43 | $4.29 | Up 3% |
| Effective tax rate | 22.6% | 24.0% | Down 140 bps |
- Operating cash flow was $963.1 million, compared with $1,151.9 million in 2012, primarily reflecting higher inventory, the medical device excise tax and quality and operational excellence spending.
- Investing cash outflow was $282.5 million, including $192.9 million of instrument additions and $100.0 million of property, plant and equipment additions.
- Financing cash outflow was $467.3 million, including $719.0 million of share repurchases and $132.4 million of dividends paid.
- Cash and cash equivalents were $1,080.6 million; short- and long-term investments totaled $807.7 million.
- Total assets were $9,580.6 million and stockholders’ equity was $6,300.1 million.
- Long-term debt was $1,672.3 million, with only $0.5 million of short-term debt. The $1,350 million revolving credit facility had no borrowings outstanding at year-end.
- Debt consisted principally of senior notes due 2014, 2019, 2021 and 2039, plus a $112.4 million Japanese yen term loan. The company was in compliance with its credit facility covenants.
- Adjusted net earnings, a non-GAAP measure, were $988.4 million, or $5.75 adjusted diluted EPS, versus $932.5 million and $5.30, respectively, in 2012.
Material Changes Versus the Prior Comparable Period
- Sales growth accelerated to 3%, supported by new products including Persona The Personalized Knee System and Transposal Fluid Waste Management System, as well as stable or slightly improved joint replacement procedure volumes.
- Volume and mix contributed 7 percentage points of sales growth, while pricing and foreign exchange each reduced growth by approximately 2 percentage points.
- Americas sales increased 6%, Europe increased 3% and Asia Pacific declined 3%, principally due to foreign exchange effects and weakness in Japan.
- Knee sales increased 4%, extremities 11%, trauma 2%, dental 1% and surgical and other 18%. Hip sales declined 1% and spine sales declined 3%.
- Gross margin declined because of higher average unit costs, unfavorable product and geographic mix, excess and obsolete inventory charges, discontinued-product charges and quality-related inventory and manufacturing charges.
- Special items increased to $216.7 million from $155.4 million, primarily reflecting quality and operational excellence initiatives, integration activities, consulting, severance and certain litigation matters.
- Certain claims expense increased to $47.0 million from $15.0 million for estimated Durom Cup revision-surgery liabilities.
- No goodwill impairment was recorded in 2013, compared with a $96.0 million U.S. Spine impairment charge in 2012.
- Share repurchases increased to $719.0 million from $485.6 million. The company repurchased 9.1 million shares during 2013 and authorized a new $1.0 billion repurchase program effective January 1, 2014.
- Annual dividends declared increased to $0.80 per share from $0.54 per share.
Guidance, Outlook, Risks and Unusual Items
- Management projected 2014 net sales growth of 2.5% to 4.5%, assuming stable knee and hip procedure markets growing in the low- to mid-single digits.
- Expected 2014 pricing headwinds were 2% to 3% and expected foreign exchange headwinds were 0% to 1% based on December 31, 2013 rates.
- Management expected 2014 gross margin of 73% to 74%, R&D spending of 4% to 4.5% of sales and SG&A of 38.5% to 39% of sales.
- Management expected reported 2014 net earnings and diluted EPS to increase approximately 13% to 17%, but also expected approximately $250 million of quality, operational excellence and acquisition-integration expenses.
- The 2.3% U.S. medical device excise tax was expected to cost approximately $10 million per quarter in 2014, although the ultimate amount remained subject to discussions with the IRS regarding the tax base.
- Durom Cup liabilities totaled $379.0 million at year-end, including $50.0 million current and $329.0 million long term. The company also recorded a $218.0 million insurance receivable, subject to carrier coverage positions, and expected to pay most claims over five years.
- The IRS had proposed adjustments reallocating profits between U.S. and foreign subsidiaries for 2006–2009. Potential settlements or payments could materially affect future cash flows, tax expense and results.
- A patent infringement matter involving Stryker carried a trial-court award of up to $210.0 million plus interest and attorneys’ fees. Zimmer had appealed and had not accrued a liability because it did not consider a loss probable.
- An FDA warning letter concerning manufacturing and validation processes at the Ponce, Puerto Rico facility remained pending. Additional regulatory action, including seizure, injunctions, penalties or restrictions on approvals, was possible.
- Key continuing risks included pricing and reimbursement pressure, healthcare cost containment, regulatory compliance, product liability, foreign exchange, European government receivables, dependence on distributors and suppliers, intellectual property disputes, goodwill impairment and tax audits.
Most Important Facts to Verify
- Reconcile the reported GAAP earnings of $761.0 million with adjusted earnings of $988.4 million and assess whether excluded charges are recurring.
- Review the sustainability of the 2014 earnings guidance given the expected $250 million of special and integration expenses and ongoing medical device excise tax costs.
- Evaluate the adequacy of the $379.0 million Durom Cup liability and the collectability and coverage terms of the $218.0 million insurance receivable.
- Monitor the Stryker patent appeal and potential exposure of up to $210.0 million plus interest and attorneys’ fees.
- Assess the status and financial impact of the IRS profit-allocation dispute and other unrecognized tax benefits.
- Review FDA remediation progress at Ponce and other facilities and any resulting product, approval or manufacturing restrictions.
- Track inventory levels, excess and obsolete inventory charges, pricing pressure and foreign exchange effects on margins and cash conversion.
- Confirm refinancing plans for the $250.0 million senior notes due November 30, 2014 and continued compliance with credit facility covenants.