Zimmer Holdings, Inc. — Form 10-Q Summary
Business context and reporting period
Unaudited quarterly report for the three and nine months ended September 30, 2014. Zimmer designs, manufactures and markets orthopedic reconstructive implants, biologics, dental and spinal implants, trauma products, surgical products and related healthcare services through the Americas, Europe and Asia Pacific segments. The filing predates completion of the proposed Biomet transaction; the merger was expected to close in the first quarter of 2015.
Financial performance and position
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Net sales | $1,106.0 million | $1,074.3 million | $3,450.4 million | $3,382.7 million |
| Gross profit | $807.7 million | $745.5 million | $2,513.5 million | $2,437.4 million |
| Operating profit | $251.2 million | $211.7 million | $808.9 million | $720.3 million |
| Net earnings attributable to Zimmer | $165.5 million | $154.4 million | $563.5 million | $525.1 million |
| Diluted EPS | $0.96 | $0.90 | $3.29 | $3.07 |
| Operating margin | 22.7% | 19.7% | 23.4% | 21.3% |
Reported gross margin was approximately 73.0% in the quarter and 72.8% for the nine-month period, compared with approximately 69.4% and 72.1%, respectively, in the prior-year periods. Net earnings increased 7% in both periods. The effective tax rate was 27.3% for the quarter and 25.0% for the nine months, versus 22.3% and 22.8% in the prior-year periods.
Net cash provided by operating activities was $698.6 million for the nine months, compared with $662.9 million in 2013. Investing activities used $498.1 million, including $95.7 million for property, plant and equipment and $162.9 million for instruments. Financing activities used $307.0 million, including $108.0 million of dividends, $400.5 million of share repurchases and $64.1 million of debt issuance costs.
At September 30, 2014, cash and cash equivalents were $967.3 million and short- and long-term investments totaled $1,033.5 million. Total debt was approximately $1,676.4 million, consisting of $250.0 million of short-term debt and $1,426.4 million of long-term debt. The company had $1.35 billion of unused multicurrency revolving capacity; the proposed merger financing also included a $3.0 billion term loan commitment and a $7.66 billion bridge facility, neither conditioned for ordinary operating borrowings at that date. The company was in compliance with applicable debt covenants.
Inventory was $1,177.5 million, or 356 days on hand, at the high end of the company’s recent range. Trade receivable days were 71. The quarterly dividend was $0.22 per share, and 2014 declared dividends represented a 10% increase in the annualized dividend rate versus 2013.
Material changes versus the prior comparable period
- Sales increased 3% in the quarter and 2% year to date, driven primarily by volume and product mix; pricing reduced growth by approximately 2 percentage points in the quarter.
- Knee sales increased 6% in the quarter and 4% year to date, supported by the Persona Personalized Knee System. Reconstructive sales increased 4% in the quarter and 3% year to date.
- Europe and Asia Pacific produced stronger sales and segment operating profit. Americas sales increased 1% in the quarter but declined 1% year to date.
- Cost of products sold declined as a percentage of sales, primarily because the prior-year period included significant excess and obsolete inventory charges and because of higher foreign-currency hedge gains.
- Special items increased to $66.9 million in the quarter and $177.5 million year to date, compared with $46.4 million and $155.5 million, respectively. The increase was principally related to Biomet merger costs and quality and operational-excellence initiatives.
- R&D declined to 4.2% of sales in the quarter and 4.1% year to date, while SG&A declined to 40.1% and 39.5% of sales, respectively.
- Other expense of $10.5 million in the quarter and $20.5 million year to date represented amortization of debt issuance costs for merger-related financing.
- Comprehensive income attributable to Zimmer declined to $77.8 million in the quarter and $464.8 million year to date, primarily because of unfavorable foreign-currency translation adjustments.
Guidance, outlook, risks and unusual items
Management estimated approximately 1.5% sales growth for 2014, with pricing expected to reduce growth by 2% to 3% and foreign exchange by 0% to 1%. Reported gross margin was expected to be 72.5% to 73.5%; R&D was expected at 4% to 4.5% of sales; SG&A was expected at 38.5% to 39.0% of sales; and reported net earnings and diluted EPS were expected to increase approximately 7% to 9% versus 2013. Management expected approximately $250 million of quality, operational-excellence and recent-acquisition integration costs and approximately $70 million of Biomet merger expenses in 2014.
The proposed Biomet transaction was valued at approximately $13.35 billion, consisting of $10.35 billion in cash, subject to adjustments, and 32.7 million Zimmer shares. Completion depended on customary closing conditions and regulatory approvals. Risks included financing execution, potential credit-rating downgrades, integration and synergy realization, regulatory and antitrust approvals, and increased leverage.
Durom Cup product-liability claims had generated $472.0 million of cumulative expense. The remaining estimated liability was $352.5 million, including $50.0 million short term and $302.5 million long term, partially offset by a $168.0 million receivable for expected insurance recoveries. Insurance coverage remained subject to insurer reservations, a 20% co-payment and a cap.
Other material contingencies included an appealed Stryker patent judgment that could require payment of up to $210.0 million plus interest and attorneys’ fees, unresolved IRS tax matters that could materially affect future cash flows and tax expense, and pending NexGen product-liability litigation for which no loss was accrued. An FDA warning letter concerning the Ponce, Puerto Rico facility remained pending and could lead to additional regulatory action.
Important facts for investors to verify
- Whether the Biomet merger closed on the expected timetable, the final purchase price and the amount and terms of debt issued or drawn.
- Post-merger leverage, credit ratings, covenant headroom and the company’s ability to reduce debt while maintaining dividends.
- Actual resolution and cash cost of Durom Cup claims, insurance recoveries and any changes to the $352.5 million accrued liability.
- Outcomes of the Stryker appeal, NexGen and other product-liability matters, and the potential effect of unaccrued losses.
- Resolution of IRS examinations and disputed tax positions, including possible future payments and effective tax-rate effects.
- Progress in addressing the FDA warning letter and other quality-system observations.
- Inventory levels, excess and obsolete inventory exposure, pricing pressure, currency effects and sustainability of reported margin improvements.
- The filing text does not provide a clear value for any completed Biomet financing or merger closing, because those events had not occurred as of September 30, 2014.