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ZMH > SEC Filings for ZMH > Form 10-Q on 8-May-2013All Recent SEC Filings

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Form 10-Q for ZIMMER HOLDINGS INC


8-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and corresponding notes included elsewhere in this Form 10-Q. Certain percentages presented in this discussion and analysis are calculated from the underlying whole-dollar amounts and therefore may not recalculate from the rounded numbers used for disclosure purposes. In addition, certain amounts in the 2012 condensed consolidated financial statements have been reclassified to conform to the 2013 presentation.

Executive Level Overview

First Quarter 2013 Results

Our results for the first quarter of 2013 were in line with our expectations. Sales growth was essentially flat compared to the same prior year period, as expected, due to modest growth from increased volume and changes in the mix of product sales, offset by continued pricing pressure and unfavorable foreign currency exchange rates. We believe the global market for our musculoskeletal products was stable, considering there were two fewer billing days in most of our key markets in the first quarter of 2013 compared to the same prior year period.

We were able to achieve leveraged earnings and diluted earnings per share growth through lower operating expenses, a favorable effective tax rate (ETR), and repurchases of our common stock. Operating expenses were lower as certain significant research and development (R&D) projects, such as our PersonaTM, The Personalized Knee System, were completed in 2012. Additionally, we experienced lower legal expenses and savings from our operational excellence initiatives. Our ETR benefited from U.S. tax law changes that were implemented in January 2013, but will be effective for our 2012 tax returns. Under GAAP, the 2012 tax benefits were recognized in the first quarter of 2013.

2013 Outlook

We estimate our net sales will grow between 1 and 3 percent in 2013. This assumes the market for knee and hip procedures will remain stable and grow in low single digits. We expect pricing to have a negative effect on sales growth of approximately 2 percent, and foreign currency exchange rates to have a negative effect on sales growth of approximately 1.5 percent based upon March 31, 2013 rates.

Assuming currency rates remain at March 31, 2013 levels, we expect our gross margin to be between 74.8 and 75.3 percent of sales in 2013, which includes inventory step-up and other inventory charges related to acquisitions and operational excellence initiatives. This range assumes that foreign currency hedge losses will be lower in 2013 than in 2012. The range also takes into consideration the impact of the new 2.3 percent medical device excise tax on a majority of our U.S. sales. While we started paying the excise tax in January 2013, it will not significantly increase our cost of products sold expense in our consolidated statement of earnings until later in the year. Once our cost of products sold starts reflecting this excise tax, we estimate the cost to be $10 million to $15 million on a quarterly basis.

We do not expect to be able to offset the full impact of the U.S. medical device excise tax on net earnings through higher pricing on our products or through higher sales volumes resulting from the expansion of health insurance coverage. However, we do expect to offset the tax with cost savings from our operational excellence initiatives.

We expect to continue making investments in R&D of approximately 5 percent of sales in 2013. Selling, general and administrative (SG&A) expenses as a percent of sales is expected to be between 39.5 and 40.0 percent in 2013 as we realize efficiencies from our operational excellence initiatives and further leverage revenue growth.

We expect to incur $120 million to $130 million of expenses in 2013 related to our operational excellence initiatives. These programs are targeted at streamlining the organization and business processes. They are expected to be mostly completed in 2013. We also expect to incur $5 million to $15 million for certain acquisition and integration costs connected with recent acquisitions. We expect to recognize the majority of these


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expenses in "Special items" on our statement of earnings, but some will be related to inventory and be reflected in costs of products sold.

Assuming variable interest rates remain at March 31, 2013 levels, we expect interest income and expense, net, to be approximately $60 million in 2013, which is similar to 2012.

Net Sales by Operating Segment

The following table presents net sales by operating segment and the components
of the percentage changes (dollars in millions):



                               Three Months Ended
                                    March 31,                                     Volume/                          Foreign
                              2013            2012           % Inc (Dec)            Mix            Price           Exchange
Americas                    $   634.7       $   634.4                   - %              2 %           (2 )%               - %
Europe                          307.5           300.8                   2                3             (1 )                -
Asia Pacific                    196.7           205.5                  (4 )              6             (3 )               (7 )

Total                       $ 1,138.9       $ 1,140.7                   -                3             (2 )               (1 )

"Foreign Exchange", as used in the tables in this report, represents the effect of changes in foreign currency exchange rates on sales.

Net Sales by Product Category

The following table presents net sales by product category and the components of
the percentage changes (dollars in millions):



                                Three Months Ended
                                     March 31,                                      Volume/                          Foreign
                               2013            2012           % Inc (Dec)             Mix            Price           Exchange
Reconstructive
Knees                        $   471.0       $   474.6                  (1 )%              2 %           (2 )%              (1 )%
Hips                             330.8           344.5                  (4 )               1             (3 )               (2 )
Extremities                       47.8            44.8                   7                 9             (2 )                -

                                 849.6           863.9                  (2 )               2             (3 )               (1 )
Dental                            59.7            60.2                  (1 )              (2 )            1                  -
Trauma                            82.0            75.5                   9                12             (1 )               (2 )
Spine                             47.7            53.2                 (10 )              (7 )           (3 )                -
Surgical and other                99.9            87.9                  14                16              1                 (3 )

Total                        $ 1,138.9       $ 1,140.7                   -                 3             (2 )               (1 )

Beginning in 2013, our Knees product category net sales include certain early intervention products that are primarily used in knee procedures. In 2012, these products were included in the Surgical and other product category. Net sales in the three month period ended March 31, 2012 related to these products have been


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reclassified to conform to the 2013 presentation. The following table presents net sales by product category by region (dollars in millions):

                                        Three Months Ended March 31,
                                    2013            2012         % Inc (Dec)
           Reconstructive
           Knees
           Americas             $      275.5      $   282.5                (2 )%
           Europe                      122.5          118.1                 4
           Asia Pacific                 73.0           74.0                (1 )
           Hips
           Americas                    151.9          153.9                (1 )
           Europe                      111.8          114.0                (2 )
           Asia Pacific                 67.1           76.6               (12 )
           Extremities
           Americas                     37.3           35.2                 6
           Europe                        7.8            7.0                11
           Asia Pacific                  2.7            2.6                 1

                                       849.6          863.9                (2 )
           Dental
           Americas                     35.5           35.3                 -
           Europe                       19.6           20.1                (3 )
           Asia Pacific                  4.6            4.8                (1 )
           Trauma
           Americas                     41.2           37.2                11
           Europe                       18.8           16.0                18
           Asia Pacific                 22.0           22.3                (2 )
           Spine
           Americas                     30.7           36.6               (16 )
           Europe                       12.2           12.4                (1 )
           Asia Pacific                  4.8            4.2                15
           Surgical and other
           Americas                     62.6           53.7                17
           Europe                       14.8           13.2                12
           Asia Pacific                 22.5           21.0                 7

           Total                $    1,138.9      $ 1,140.7                 -

Demand (Volume and Mix) Trends

Increased volume and changes in the mix of product sales contributed 3 percentage points of year-over-year sales growth during the three month period ended March 31, 2013, which is 2 percentage points worse than the three month period ended March 31, 2012, and 1 percentage point worse than the three month period ended December 31, 2012. Sales in the first quarter of 2013 were negatively impacted by two fewer billings days, which we define as non-holiday weekdays.

Absent the effect of billing days, procedure volumes in the broader musculoskeletal market remained stable in the first quarter of 2013 relative to the fourth quarter of 2012, consistent with our expectations. We believe long-term indicators point toward sustained growth driven by an aging global population, growth in emerging markets, obesity, proven clinical benefits, new material technologies, advances in surgical techniques and more active lifestyles, among other factors. In addition, the ongoing shift in demand to premium products and the introduction of patient specific devices is expected to continue to positively affect sales growth.


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Pricing Trends

Global selling prices had a negative effect of 2 percent on year-over-year sales during the three month period ended March 31, 2013, which is consistent with the three month period ended March 31, 2012, and the three month period ended December 31, 2012. In all reporting segments, we continued to experience pricing pressure from governmental healthcare cost containment efforts and from local hospitals and health systems. For the remainder of the year, we expect this pressure will alleviate slightly as we anniversary out of a biennial negative price adjustment in Japan that went into effect in April 2012. However, for the year, we expect lower prices will continue to have a negative effect on sales of approximately 2 percent.

Foreign Currency Exchange Rates

For the three month period ended March 31, 2013, foreign currency exchange rates resulted in a 1 percent decrease in sales. If foreign currency exchange rates remain consistent with March 31, 2013 rates, we estimate that a stronger dollar versus foreign currency exchange rates will have a negative effect on sales in 2013 of approximately 1.5 percent. We address currency risk through regular operating and financing activities and through the use of forward contracts and foreign currency options solely to manage foreign currency volatility and risk. Changes to foreign currency exchange rates affect sales growth, but due to offsetting gains/losses on hedge contracts and options, which are recorded in cost of products sold, the effect on net earnings in the near term is expected to be minimal.

Sales by Product Category

Knees

Knee sales decreased 1 percent in the three month period ended March 31, 2013 when compared to the same prior year period, which is 1 percentage point worse than the three month period ended December 31, 2012. Positive procedure volume/mix in the three month period ended March 31, 2013 was offset by negative price and foreign currency exchange rate effects in the period.

In the first quarter of 2013, we continued a broader launch of our new knee system, Persona, The Personalized Knee System. We intend to continue to deploy implant and instrument sets to all geographic regions in 2013 and beyond. In the meantime, our NexGen® Complete Knee Solution product line is still our leading knee system. Products experiencing growth in this category included Zimmer ® Patient Specific Instruments, the Zimmer® Unicompartmental High Flex Knee and our early intervention products.

The 1 percent decline from changes in foreign currency exchange rates in this product category was primarily attributable to our Asia Pacific reporting segment, which experienced a 5 percent decline.

Hips

Hip sales decreased 4 percent in the three month period ended March 31, 2013 when compared to the same prior year period. The decrease was primarily from lower sales of our primary stems, but was partially offset by growth in revision stems.

Leading hip stem sales were the Zimmer ® M/L Taper Hip Prosthesis, the Zimmer® M/L Taper Hip Prosthesis with Kinectiv® Technology, the CLS® Spotorno® Stem from the CLS Hip System and the Alloclassic® Zweymüller® Hip Stem. Products experiencing growth in this category included the Wagner SL Revision® Hip Stem, the Continuum® Acetabular System, the Trilogy® IT Acetabular System, the Allofit® IT Alloclassic® Acetabular System and Vivacit-E® Highly Crosslinked Polyethylene Liners.

The 2 percent decline from changes in foreign currency exchange rates in this product category was primarily attributable to our Asia Pacific reporting segment, which experienced a 7 percent decline.


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Extremities

Extremities sales increased by 7 percent in the three month period ended March 31, 2013 when compared to the same prior year period. The Zimmer Trabecular Metal™ Reverse Shoulder System and the Sidus® Stem-Free Shoulder drove sales growth. Reverse shoulder procedures continue to gain popularity as a solution for patients with rotator cuff damage.

Dental

Dental sales declined by 1 percent in the three month period ended March 31, 2013 when compared to the same prior year period. The decrease was driven by lower sales of dental reconstructive implants, restorative products and regenerative products, partially offset by sales growth in digital solutions. We believe this market continues to be weak both in the U.S. and internationally. Sales were led by the Tapered Screw-Vent® Implant System.

Trauma

Trauma sales increased 9 percent in the three month period ended March 31, 2013 when compared to the same prior year period. The Zimmer Natural Nail® System continued to increase sales significantly. In addition to the Zimmer Natural Nail System, the Zimmer® Periarticular Locking Plates System led Trauma sales. Sales in this product category benefited from certain competitive product issues, especially in the U.S.

Spine

Spine sales decreased 10 percent in the three month period ended March 31, 2013 when compared to the same prior year period. This product category continues to face challenges related to pricing pressure and payor approvals. Additionally, we faced some disruption in the period stemming from our fourth quarter 2012 actions related to the Inserter instrument for our PEEK Ardis® Interbody Spacer. Solid sales of the PathFinder NXT® Minimally Invasive Pedicle Screw System and Trabecular Metal Technology products partly offset a decline in sales of the Dynesys® Dynamic Stabilization System, PEEK Ardis Interbody Spacer and other products.

Surgical and other

Surgical and other sales increased 14 percent in the three month period ended March 31, 2013 when compared to the same prior year period. The primary driver of sales growth in this product category was fluid waste management systems, which we acquired in October 2012 through our Dornoch Medical Systems, Inc. acquisition. Surgical and other sales were led by PALACOS®1 Bone Cement and tourniquet and wound debridement products.

Expenses as a Percent of Net Sales



                                             Three Months Ended
                                                  March 31,
                                             2013            2012        Inc (Dec)
     Cost of products sold                      25.7 %        25.3 %            0.4
     Research and development                    4.7           5.2             (0.5 )
     Selling, general and administrative        40.5          40.6             (0.1 )
     Special items                               2.9           2.9              0.0
     Operating profit                           26.2          25.9              0.3

Cost of Products Sold

The increase in cost of products sold as a percentage of net sales for the three month period ended March 31, 2013 compared to the same prior year period was primarily due to lower average selling prices. Additionally,

1 Registered trademark of Heraeus Kulzer GmbH


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excess and obsolete inventory charges and foreign currency hedge losses were unfavorable in 2013 when compared to 2012. These unfavorable items were slightly offset by lower unit costs, lower royalties and certain other favorable items.

Operating Expenses

R&D expenses and R&D as a percent of sales decreased when compared to the same prior year period. Lower spending reflected the effects of our operational excellence initiatives, as well as a natural decline from certain large projects that achieved full commercialization, including Persona, The Personalized Knee System. We expect R&D spending in 2013 to be approximately 5 percent of sales for the full year.

SG&A expenses and SG&A as a percent of sales decreased slightly when compared to the same prior year period. The dollar decrease was primarily due to lower legal and bad debt expenses. Legal expenses were lower due to the conclusion of certain matters in 2012 for which we are no longer incurring outside counsel fees, as well as normal variations in the phases of litigation, including product liability litigation. These favorable items were partially offset by higher marketing costs in the U.S., primarily for Persona, The Personalized Knee System.

"Special items" for the three month period ended March 31, 2013 were the same as the prior year period. We continue to implement our operational excellence initiatives, which are intended to improve our future operating results by centralizing or outsourcing certain functions and improving quality, distribution, sourcing, manufacturing and our information technology systems. "Special items" expenses include consulting and professional fees and dedicated personnel costs for those programs, as well as other costs. In addition to expenses for our operational excellence programs and integration of business acquisitions, we recognize certain amounts related to litigation in "Special items". In the first quarter of 2013, we settled certain matters and recognized income, whereas in the same prior year period we recognized expense related to settlements of other matters. See Note 2 to the condensed consolidated financial statements for more information regarding "Special items" charges.

Interest Income, Interest Expense, Income Taxes and Net Earnings

Interest income and expense, net, was the same in the three month period ended March 31, 2013 when compared to the same prior year period.

The ETR on earnings before income taxes for the three month period ended March 31, 2013 decreased to 23.1 percent, from 25.7 percent in the same prior year period. The decrease was primarily due to the retroactive extension of the R&D tax credit and other tax benefits resulting from implementation of legislation in the U.S. in January 2013. Due to the timing of the laws' enactment, the 2012 tax year benefits were recognized in the first quarter of 2013 for financial reporting purposes. We anticipate the outcome of various federal, state and foreign audits as well as expiration of certain statutes of limitations could potentially impact our 2013 effective tax rate in future quarters. Currently, we cannot reasonably estimate the impact of these items on our financial results.

Net earnings of Zimmer Holdings, Inc. of $218.6 million for the three month period ended March 31, 2013 increased 4 percent over the same prior year period as a result of the changes in revenues and expenses discussed above. The 2013 period basic and diluted earnings per share increased 10 and 9 percent, respectively, over the same prior year period. The disproportional change in earnings per share as compared with net earnings is attributed to the effect of share repurchases.

Non-GAAP operating performance measures

We use non-GAAP financial measures to evaluate our operating performance that differ from financial measures determined in accordance with GAAP. Our non-GAAP financial measures exclude the impact of inventory step-up and other certain inventory charges, "Special items," and the taxes on those items. We use this information internally and believe it is helpful to investors because it allows more meaningful period-to-period comparisons of our ongoing operating results, it helps to perform trend analysis and to better identify operating trends that may otherwise be masked or distorted by these types of items, and it provides a higher degree of


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transparency of certain items. Certain of these non-GAAP financial measures are used as metrics for our incentive compensation programs.

Our non-GAAP adjusted net earnings used for internal management purposes for the three month periods ended March 31, 2013 and 2012 were $240.8 million and $231.3 million, respectively, and our non-GAAP adjusted diluted earnings per share for those periods were $1.41 and $1.30, respectively.

The following are reconciliations from our GAAP net earnings and diluted earnings per share to our non-GAAP adjusted net earnings and non-GAAP adjusted diluted earnings per share used for internal management purposes.

                                                         Three Months Ended
                                                              March 31,
       (In millions)                                     2013           2012
       Net Earnings of Zimmer Holdings, Inc.           $   218.6       $ 209.6
       Inventory step-up and other inventory charges         2.2           1.0
       Special items                                        33.5          33.5
       Taxes on above items*                               (13.5 )       (12.8 )

       Adjusted Net Earnings                           $   240.8       $ 231.3

* The tax effect is calculated based upon the statutory rates for the jurisdictions where the items were incurred.

                                                         Three Months Ended
                                                              March 31,
                                                         2013           2012
       Diluted EPS                                     $    1.28       $  1.17
       Inventory step-up and other inventory charges        0.01          0.01
       Special items                                        0.20          0.19
       Taxes on above items*                               (0.08 )       (0.07 )

       Adjusted Diluted EPS                            $    1.41       $  1.30

* The tax effect is calculated based upon the statutory rates for the jurisdictions where the items were incurred.

Liquidity and Capital Resources

Cash flows provided by operating activities were $180.5 million for the three month period ended March 31, 2013, compared to $207.4 million in the same prior year period. The principal source of cash from operating activities was net earnings. Non-cash items included in net earnings accounted for another $99.9 million of operating cash. All other items of operating cash flows reflect a use of $137.4 million of cash, compared to a use of $112.1 million in the same 2012 period. The lower cash flows provided by operating activities in the 2013 period were primarily due to increases in inventory value for our U.S. inventory caused by the medical device excise tax and inventory to support new product launches.

At March 31, 2013, we had 70 days of sales outstanding in trade accounts receivable, which represents an increase of 6 days compared to December 31, 2012 and is the same as March 31, 2012. The increase from December 31, 2012 reflects some seasonality in our business. At March 31, 2013, we had 319 days of inventory on hand. This is an increase of 18 days compared to December 31, 2012 and an increase of 26 days from March 31, 2012. This increase reflects a higher 2013 inventory balance due to the U.S. medical device excise tax (increased days on hand by 8 days) and new product launches.

Cash flows provided by investing activities were $53.0 million for the three month period ended March 31, 2013, compared to cash flows used in investing activities of $164.2 million in the same prior year period. Additions to instruments increased in the 2013 period compared to the 2012 period due to purchases related to some significant product launches, such as Persona, The Personalized Knee System. Spending on other property, plant and equipment was relatively consistent between the 2013 period and the 2012 period, reflecting cash outlays necessary to complete new product-related investments and replace older machinery and equipment. We


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invest some of our cash and cash equivalents in highly-rated debt securities. The purchases and any sales or maturities of these investments are reflected as cash flows from investing activities. The timing of these investments can vary from quarter to quarter depending on the maturity of the debt securities and . . .

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