Zimmer Holdings, Inc. — Q1 2015 Form 10-Q Summary
Business context and reporting period
Zimmer Holdings designs, manufactures and markets orthopedic reconstructive implants, biologics, dental and spinal implants, trauma products, surgical products and related healthcare services. This unaudited filing covers the three months ended March 31, 2015, compared with the same period in 2014.
The company changed its quarter-end closing convention for most international subsidiaries. The 2015 period therefore includes up to four additional billing days, although management states the effect is not material to consolidated comparisons.
Financial performance and liquidity
| Metric | Q1 2015 | Q1 2014 | Change |
|---|---|---|---|
| Net sales | $1,134.4 million | $1,161.5 million | Down 2% |
| Gross profit | $855.7 million | $857.8 million | Down 0.2% |
| Gross margin | 75.4% | 73.9% | Up 1.5 percentage points |
| Operating profit | $274.9 million | $300.1 million | Down 8% |
| Operating margin | 24.2% | 25.8% | Down 1.6 percentage points |
| Net earnings attributable to Zimmer | $177.1 million | $221.5 million | Down 20% |
| Diluted EPS | $1.02 | $1.29 | Down 21% |
| Operating cash flow | $91.5 million | $188.8 million | Down $97.3 million |
Cost of products sold declined to 24.6% of sales from 26.1%, primarily because of higher foreign-currency hedge gains. Research and development expense was $48.4 million, or 4.3% of sales, and SG&A expense was $425.0 million, or 37.5% of sales. Special items increased to $87.0 million from $36.6 million, mainly due to Biomet merger-related professional fees and operational excellence initiatives.
Cash and cash equivalents were $8.79 billion at March 31, 2015, compared with $1.08 billion at December 31, 2014. Total current assets were $11.92 billion, including $488.4 million of short-term investments. Inventory was $1.22 billion, and management reported 389 days of inventory on hand, up 55 days from the prior-year quarter.
Long-term debt increased to $9.06 billion from $1.43 billion at December 31, 2014. The increase primarily reflects the March 2015 issuance of $7.65 billion of senior notes to finance the proposed Biomet transaction. The company also had a $3.0 billion Biomet term loan facility and a $1.35 billion multicurrency revolving facility; no revolving borrowings were outstanding at quarter-end. The company was in compliance with applicable debt covenants.
Financing activities provided $7.57 billion, principally from the senior-note issuance. Capital expenditures were $34.4 million, and dividends paid were $37.3 million. The quarterly dividend declared was $0.22 per share.
Material changes versus the prior comparable period
- Sales declined 2%, with volume and mix contributing 7 percentage points, pricing reducing growth by 2 percentage points and foreign exchange reducing growth by 7 percentage points.
- Americas sales increased 1% to $645.2 million; Europe declined 9% to $298.9 million; and Asia Pacific declined 3% to $190.3 million.
- Product-category sales decreased 6% for hips and 9% for dental; knee, extremity and trauma sales were approximately flat; spine sales increased 3%.
- Net earnings declined substantially because of higher special items, merger-financing costs and increased interest expense, despite improved gross margin and lower SG&A.
- Interest expense increased to $23.1 million from $15.0 million, and other expense increased to $22.6 million from $1.7 million, primarily reflecting merger-financing activities.
- Adjusted net earnings, a non-GAAP measure, were $272.8 million versus $274.5 million, while adjusted diluted EPS was $1.58 versus $1.60.
- Operating cash flow decreased partly because of a $97.6 million loss on forward-starting interest-rate swaps settled in connection with the senior-note issuance and higher merger-related expenses.
Guidance, outlook, risks and unusual items
The proposed $13.35 billion Biomet merger, expected to close in May 2015, was not reflected in the filing’s standalone operating guidance. Management did not provide 2015 guidance for the combined company. The transaction was expected to be funded with existing cash, the $7.65 billion senior-note offering and a planned $3.0 billion term-loan draw. Management expects continued foreign-exchange headwinds, ongoing pricing pressure and volume/mix growth from a stable joint-replacement market and new products. Standalone R&D spending was projected at 4% to 4.5% of sales, and full-year pricing pressure was expected to reduce sales growth by 2% to 3%.
If the merger is not completed by July 23, 2015, or the agreement is terminated earlier, the merger notes must generally be redeemed at 101% of principal plus accrued interest. Following the merger and expected term-loan borrowing, combined debt was anticipated to be approximately $12.1 billion. Credit-rating agencies had placed Zimmer’s ratings under review or on negative watch, with expected downgrades upon completion.
Material contingencies include Durom Cup product-liability claims, for which the company estimated remaining liability of $348.3 million and recorded a $170.3 million receivable for expected insurance recoveries. NexGen Knee System litigation remained unresolved, with bellwether trials expected in the third quarter of 2015 and no loss accrued. A $70.0 million Stryker patent-related loss had been accrued in the fourth quarter of 2014.
The FDA warning letter concerning manufacturing and validation processes at the Ponce, Puerto Rico facility remained pending. Potential consequences include additional regulatory action, product seizure, injunctions, civil penalties and delays in certain approvals. The company also faces unresolved IRS matters that could materially affect future tax expense and cash flows.
Important facts for investors to verify
- Completion of the Biomet merger, required regulatory approvals and any conditions imposed by regulators.
- Use of the $7.65 billion merger-note proceeds, the timing and terms of the $3.0 billion term-loan draw, and the resulting leverage and interest burden.
- Whether merger-related synergies and integration benefits offset the expected increase in debt service and operating complexity.
- Future foreign-exchange effects, pricing pressure and the sustainability of reported hedge gains.
- Inventory levels, days on hand and potential excess or obsolete inventory charges.
- Resolution and cash impact of Durom Cup, NexGen, Stryker and other litigation, including the collectability of the $170.3 million insurance receivable.
- Progress in resolving FDA warning-letter and inspectional-observation matters at the Ponce facility.
- Outcomes of IRS audits and disputed tax matters, for which the filing does not provide a clear estimate of potential future payments.