ZIMMER BIOMET HOLDINGS, INC. quarterly report, Q3 FY2020

Zimmer Biomet Holdings, Inc. — Q3 2020 Form 10-Q Summary

Business context and reporting period

Zimmer Biomet designs, manufactures and markets orthopedic reconstructive products, sports medicine, biologics, extremities and trauma products, spine, CMFT, office-based technologies, dental implants and related surgical products. This unaudited filing covers the three and nine months ended September 30, 2020, compared with the corresponding 2019 periods.

Results were materially affected by the COVID-19 pandemic, which deferred elective surgical procedures. The company reports three operating segments: Americas and Global Businesses, EMEA, and Asia Pacific.

Financial performance and liquidity

Metric	Q3 2020	Q3 2019	9M 2020	9M 2019
Net sales	$1,929.3 million	$1,892.4 million	$4,939.2 million	$5,856.5 million
Operating profit (loss)	$299.2 million	$245.8 million	$(328.5) million	$800.7 million
Net earnings (loss) attributable to Zimmer Biomet	$242.5 million	$431.1 million	$(472.6) million	$810.9 million
Diluted EPS	$1.16	$2.08	$(2.29)	$3.93
Operating margin	15.5%	13.0%	(6.7)%	13.7%
Net margin	12.6%	22.8%	(9.6)%	13.8%

Q3 sales increased 2.0% year over year, driven by recovery in elective procedures, particularly in the U.S. and parts of Asia Pacific. Nine-month sales declined 15.7% because of substantial procedure deferrals in the first and second quarters.

Q3 sales by geography: Americas $1,216.5 million, EMEA $366.2 million and Asia Pacific $346.6 million.
Q3 sales by product category: Knees $648.7 million, Hips $484.1 million, S.E.T. $359.9 million, Dental, Spine & CMFT $295.5 million and Other $141.1 million.
Q3 gross margin, based on reported sales and cost of products sold excluding amortization, was approximately 70.5%, compared with approximately 71.7% in the prior-year quarter. The decline reflected lower selling prices, production limitations and fixed manufacturing costs.
Research and development expense declined to $85.9 million in Q3 from $114.4 million; SG&A declined to $790.0 million from $826.4 million.
Cash provided by operating activities was $779.4 million for the first nine months, compared with $1,162.5 million in 2019.
Cash used in investing activities was $297.9 million, and cash used in financing activities was $135.5 million.
Cash and cash equivalents were $967.3 million at September 30, 2020, compared with $617.9 million at December 31, 2019.

Debt and liquidity

Total current and non-current debt was approximately $8.3 billion at September 30, 2020, including $450.0 million of current debt and $7,840.2 million of long-term debt.
The company issued $600.0 million of 3.050% senior notes due 2026 and $900.0 million of 3.550% senior notes due 2030. Proceeds and cash on hand funded repayment of $1.5 billion of senior notes due April 2020.
No borrowings were outstanding under the $1.5 billion 2019 Multicurrency Revolving Facility or the new $1.0 billion September 2020 Revolving Facility.
Management stated that operating cash flow, cash on hand and available revolver capacity should meet ongoing liquidity requirements for at least the next twelve months, although COVID-19 could change that assessment.
The company was in compliance with applicable debt covenants at September 30, 2020. Temporary covenant relief permits a maximum consolidated leverage ratio of 5.75x for certain periods ending through December 31, 2020, stepping down thereafter.

Material changes versus the prior comparable period

Q3 revenue recovered to modest growth, but nine-month revenue remained materially below 2019 because of pandemic-related procedure deferrals.
Nine-month operating results shifted from an $800.7 million profit in 2019 to a $328.5 million loss in 2020.
The company recorded $645.0 million of goodwill and intangible asset impairment charges in the first nine months of 2020, including $470.0 million for EMEA, $142.0 million for Dental and $33.0 million of in-process research and development impairments.
Nine-month restructuring and other cost-reduction charges increased to $89.2 million from $17.0 million. The 2019 Restructuring Plan is expected to generate total pre-tax charges of approximately $350 million to $400 million and reduce annual operating expenses by approximately $200 million to $300 million by the end of 2023.
Nine-month litigation-related charges increased to $100.4 million from $48.0 million, while 2019 included a $23.5 million litigation settlement gain.
Q3 2020 net earnings were lower than the prior year primarily because Q3 2019 included a $263.8 million provisional Swiss tax reform benefit.
Q3 operating margin improved despite lower gross margin, reflecting cost reductions, restructuring benefits and lower selected SG&A expenses. Nine-month segment margins declined because fixed costs did not fall proportionally with lower sales.

Outlook, commentary, risks and unusual items

Management described the COVID-19 recovery as uneven and highly uncertain. The recovery curve flattened late in Q3, and management could not predict whether Q4 would show further recovery, continued flattening or contraction.
Risks include renewed virus outbreaks, government restrictions, patient reluctance, economic weakness, delayed elective procedures, pricing pressure, collection risk and supply-chain disruption.
Management expects less than a 1% positive full-year 2020 sales effect from foreign exchange if recent currency rates persist. No formal full-year revenue or earnings guidance is provided in the filing.
Goodwill remains exposed to further impairment. The Americas CMFT reporting unit had estimated fair value less than 5% above carrying value, and further impairments could result if cash flows decline, recovery is delayed or discount rates increase.
Pending tax matters include a draft IRS notice proposing approximately $600 million of additional tax for 2013, subject to interest and penalties. The company disputes the position and has not accrued additional reserves for it.
The company expects a fourth-quarter 2020 net tax benefit of approximately $50 million to $80 million from an IRS agreement covering 2006–2012 and approximately $30 million related to Swiss tax reform matters.
Estimated remaining liabilities include $52.9 million for Durom Cup claims, $58.2 million for Metal Reaction claims and $58.6 million for Biomet metal-on-metal hip claims, including estimated legal fees.
FDA warning letters relating to the Warsaw North Campus and Ponce facilities remained pending. The company continues remediation and remains subject to potential operating restrictions or other regulatory action.
The FCPA monitorship ended in August 2020. The company expects the related deferred prosecution agreement and criminal information to conclude around February 7, 2021, subject to continued compliance.
Subsequent to quarter-end, one of two planned acquisitions closed and the other remained subject to regulatory approval. Assuming approval, aggregate initial consideration is approximately $225 million in Q4 2020, with approximately $145 million of deferred payments in 2021.

Most important facts for investors to verify

Whether elective procedure volumes continue to recover or are reduced by subsequent COVID-19 waves and related restrictions.
The sustainability of Q3 revenue recovery and the effect of pricing pressure and unfavorable product or geographic mix.
Future goodwill and intangible asset impairment exposure, particularly in EMEA, Dental and Americas CMFT.
Debt maturities, covenant headroom and the company’s ability to refinance or repay approximately $750 million of debt due in 2021 and additional maturities thereafter.
Progress and total cost of the 2019 Restructuring Plan, including whether targeted annual savings of $200 million to $300 million are achieved.
Resolution and cash-flow impact of the IRS transfer-pricing dispute and other tax audits.
Potential outcomes and additional costs from product liability, Heraeus trade-secret litigation, the ITC investigation and FDA remediation.
Whether the expected tax benefits and planned acquisitions are completed on the terms and timing described in the filing.