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ZMH > SEC Filings for ZMH > Form 10-Q on 7-Aug-2014All Recent SEC Filings

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Form 10-Q for ZIMMER HOLDINGS INC


7-Aug-2014

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 2013 condensed consolidated financial statements have been reclassified to conform to the 2014 presentation.

On April 24, 2014, we entered into a definitive agreement to merge with LVB, the parent company of Biomet, in a cash and stock transaction valued at approximately $13.35 billion. We will pay $10.35 billion in cash, subject to certain adjustments, and issue 32.7 million shares of our common stock. In connection with the merger, we will pay off all of LVB's outstanding funded debt, and the aggregate cash merger consideration will be reduced by such amount. This management's discussion and analysis describes the financial arrangements that we may utilize to fund the payment of LVB's outstanding debt and to pay the cash merger consideration. The merger, which is subject to customary closing conditions and regulatory approvals, is expected to close in the first quarter of 2015. We are currently incurring costs and recognizing expenses related to the Biomet merger, as further described in this management's discussion and analysis below.

Executive Level Overview

Results for the Three and Six Month Periods ended June 30, 2014 (2014 periods)

Our sales results for the 2014 periods increased due to increased volume in the joint replacement market and product mix growth from premium priced new products, such as Persona® The Personalized Knee System. This was partially offset by continued pricing pressure.

The increase in sales resulted in increased gross profit. Meanwhile, operating expenses decreased, primarily from lower "Certain claims" expense and lower legal settlement expenses, since in the prior year periods a significant legal settlement was recognized. In the 2014 periods, we recognized "Other expense" related to debt issuance costs incurred for our pending Biomet merger. Interest expense, net, decreased due to fixed-to-variable interest rate swaps we entered into in the second half of 2013. Additionally, our effective tax rate (ETR) was higher in the 2014 periods primarily from non-deductible expenses associated with the pending Biomet merger. As a result of the combination of these factors, net earnings in the 2014 periods increased from the same prior year periods.

2014 Outlook

We estimate our net sales will grow between 1.5 and 2.5 percent in 2014. This assumes the market for knee and hip procedures will remain stable and grow in the low to mid-single digits. We expect pricing to have a negative effect on sales growth of between 2 and 3 percent, and foreign currency exchange rates to have a negative effect on sales growth of between 0 and 1 percent based upon June 30, 2014 rates.

Assuming currency rates remain at June 30, 2014 levels, we expect our gross margin to be between 72.5 and 73.5 percent of sales in 2014, compared to 72.2 percent for the full year in 2013. In the 2013 period, we recognized significant excess and obsolescence charges related to products we intend to discontinue and similar significant charges are not expected in 2014. The 2014 range assumes that foreign currency hedge gains will be higher than in 2013. The range also takes into consideration the full year impact of the 2.3 percent medical device excise tax on a majority of our U.S. sales. Based upon the levels of inventory we were carrying before the medical device excise tax was effective on January 1, 2013, we did not recognize any significant expenses from the excise tax until the fourth quarter of 2013. We estimate the cost in 2014 will be approximately $10 million per quarter. Since we recognize the medical device excise tax as a part of the cost of inventory, the amount expensed in any particular quarter will vary according to U.S. sales levels in that quarter.


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We expect to continue making investments in research and development (R&D) of between 4 and 4.5 percent of sales in 2014. Selling, general and administrative expenses (SG&A) as a percentage of sales is expected to be between 38.5 and 39 percent in 2014 as we realize efficiencies from our quality and operational excellence initiatives and further leverage revenue growth.

We expect to incur approximately $250 million of expenses in 2014 related to our quality and operational excellence initiatives and integration costs from recent acquisitions. The quality and operational excellence programs are intended to improve our future operating results and include centralizing or outsourcing certain functions and improving quality, distribution, sourcing, manufacturing and information technology systems. We also expect to incur approximately $70 million of expenses in 2014 related to our pending merger with Biomet. We expect to recognize the majority of the $320 million of expenses in "Special items" on our statement of earnings, but some will be related to inventory and will be reflected in costs of products sold and some will be related to the financing we secured for the Biomet merger and will be a non-operating expense.

Assuming variable interest rates remain at June 30, 2014 levels, we expect interest income and expense, net, to be similar to 2013, absent additional interest expense related to the pending merger with Biomet.

We expect our ETR to increase in 2014 relative to 2013, as we do not anticipate certain significant costs, such as excess and obsolete inventory charges that were incurred in jurisdictions with higher tax rates in 2013, to recur, thus increasing the profit in those higher tax jurisdictions. Additionally, we expect to incur non-deductible costs related to our pending merger with Biomet which will also increase our ETR.

Based upon the above, we expect reported net earnings and diluted earnings per share to increase in a range of approximately 5 to 7 percent in 2014 as compared to 2013, stemming from anticipated higher sales, an improved gross margin and lower SG&A expenses as a percentage of sales.

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
                                        June 30,                                    Volume/                        Foreign
                                  2014           2013          % Inc (Dec)            Mix           Price          Exchange
Americas                        $   639.7      $   660.1                 (3 )%            -  %          (3 )%             -  %
Europe                              334.7          307.5                  9                7            (2 )               4
Asia Pacific                        208.5          201.9                  3                9            (2 )              (4 )

Total                           $ 1,182.9      $ 1,169.5                  1                4            (3 )              -

                                    Six Months Ended
                                        June 30,                                    Volume/                        Foreign
                                  2014           2013          % Inc (Dec)            Mix           Price          Exchange
Americas                        $ 1,278.4      $ 1,294.8                 (1 )%             2 %          (3 )%             -  %
Europe                              661.6          615.0                  8                7            (2 )               3
Asia Pacific                        404.4          398.6                  2                9            (1 )              (6 )

Total                           $ 2,344.4      $ 2,308.4                  2                5            (3 )              -

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


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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
                                         June 30,                                   Volume/                        Foreign
                                   2014           2013          % Inc (Dec)           Mix           Price          Exchange
Reconstructive
Knees                            $   497.9      $   481.0                  4 %             7 %          (4 )%              1 %
Hips                                 341.0          338.4                  1               3            (3 )               1
Extremities                           51.5           48.6                  6               9            (4 )               1

                                     890.4          868.0                  3               6            (4 )               1

Dental                                61.1           61.4                 (1 )            (1 )          -                 -
Trauma                                78.8           74.1                  7               8            (2 )               1
Spine                                 52.2           54.2                 (4 )            (3 )          (1 )              -
Surgical and other                   100.4          111.8                (10 )           (10 )          -                 -

Total                            $ 1,182.9      $ 1,169.5                  1               4            (3 )              -

                                     Six Months Ended
                                         June 30,                                   Volume/                        Foreign
                                   2014           2013          % Inc (Dec)           Mix           Price          Exchange
Reconstructive
Knees                            $   985.8      $   952.0                  4 %             7 %          (3 )%             -  %
Hips                                 672.7          669.2                  1               4            (3 )              -
Extremities                          103.6           96.4                  7              10            (3 )              -

                                   1,762.1        1,717.6                  3               6            (3 )              -

Dental                               122.1          121.1                  1               1            (1 )               1
Trauma                               158.5          156.1                  2               3            (1 )              -
Spine                                100.5          101.9                 (1 )            -             (2 )               1
Surgical and other                   201.2          211.7                 (5 )            (3 )          (1 )              (1 )

Total                            $ 2,344.4      $ 2,308.4                  2               5            (3 )              -


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The following table presents net sales by product category by region (dollars in millions):

                                       Three Months Ended June 30,                          Six Months Ended June 30,
                                 2014             2013          % Inc (Dec)           2014           2013          % Inc (Dec)
Reconstructive
Knees
Americas                      $     282.0       $   281.8                 -  %     $    565.5      $   557.3                  1 %
Europe                              133.0           117.6                 13            264.1          240.1                 10
Asia Pacific                         82.9            81.6                  1            156.2          154.6                  1
Hips
Americas                            153.0           156.7                 (2 )          303.4          308.6                 (2 )
Europe                              117.2           113.7                  3            232.7          225.5                  3
Asia Pacific                         70.8            68.0                  4            136.6          135.1                  1
Extremities
Americas                             37.8            37.4                  1             76.7           74.7                  3
Europe                               10.5             8.4                 24             20.4           16.2                 26
Asia Pacific                          3.2             2.8                 15              6.5            5.5                 19

                                    890.4           868.0                  3          1,762.1        1,717.6                  3

Dental
Americas                             36.4            35.3                  3             71.4           70.8                  1
Europe                               21.0            21.4                 (2 )           41.2           41.0                 -
Asia Pacific                          3.7             4.7                (19 )            9.5            9.3                  3

Trauma
Americas                             35.5            37.0                 (4 )           73.1           78.2                 (7 )
Europe                               21.6            18.2                 19             42.2           37.0                 14
Asia Pacific                         21.7            18.9                 15             43.2           40.9                  6

Spine
Americas                             31.9            35.0                 (9 )           62.0           65.7                 (6 )
Europe                               14.4            13.7                  5             26.9           25.9                  3
Asia Pacific                          5.9             5.5                  8             11.6           10.3                 13

Surgical and other
Americas                             63.1            76.9                (18 )          126.3          139.5                (10 )
Europe                               17.0            14.5                 18             34.1           29.3                 17
Asia Pacific                         20.3            20.4                 -              40.8           42.9                 (5 )

Total                         $   1,182.9       $ 1,169.5                  1       $  2,344.4      $ 2,308.4                  2

Demand (Volume and Mix) Trends

Increased volume and changes in the mix of product sales contributed 4 percentage points of year-over-year sales growth during the three month period ended June 30, 2014. The 4 percentage points of growth was 1 percentage point less than the year-over-year sales growth from volume/mix in the three month period ended March 31, 2014. The three month period ended June 30, 2014 had one less billing day compared to the same prior year period in many of our markets, which contributed to the decrease in volume and mix. The Europe and Asia Pacific growth was driven by key emerging markets.

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, demand for clinically proven premium products and patient specific devices are expected to continue to positively affect sales growth in markets that recognize the value of these advanced technologies.

Pricing Trends

Global selling prices had a negative effect of 3 percentage points on year-over-year sales during the three month period ended June 30, 2014. Our Americas and Europe reporting segments and certain countries in our


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Asia Pacific reporting segment continued to experience pricing pressure from governmental healthcare cost containment efforts and from local hospitals and health systems. For the entire year, we expect lower prices will have a negative effect on sales growth of between 2 and 3 percent.

Foreign Currency Exchange Rates

For the three month period ended June 30, 2014, foreign currency exchange rates had a minimal impact on sales, as the weakening U.S. Dollar versus the Euro was offset by the strengthening of the U.S. Dollar versus the Japanese Yen and Australian Dollar in the period. If foreign currency exchange rates remain consistent with June 30, 2014 rates, we estimate that a stronger dollar versus foreign currency exchange rates will have a negative effect on sales growth in 2014 of between 0 and 1 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 increased 4 percent in each of the 2014 periods when compared to the same prior year period. Our Knee product category has benefited from new product introductions, such as Persona The Personalized Knee System and early intervention products. However, the volume/mix growth from new product introductions has been tempered by pricing pressure in all our reporting segments.

In 2014, we have 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 during the remainder of 2014 and beyond. In the meantime, our NexGen® Complete Knee Solution product line is still our leading knee system in terms of sales. Products driving growth in this category in addition to Persona The Personalized Knee System included the Zimmer® Unicompartmental High Flex Knee and our early intervention products.

In Europe, changes in foreign currency exchange rates positively affected knee sales in the three and six month periods ended June 30, 2014 by 4 percent and 3 percent, respectively. In Asia Pacific, changes in foreign currency exchange rates negatively affected knee sales in the three and six month periods ended June 30, 2014 by 4 percent and 7 percent, respectively.

Hips

Hip sales increased 1 percent in each of the 2014 periods when compared to the same prior year period. Positive volume and mix trends continued to be offset by pricing pressure.

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, the Alloclassic® Zweymüller® Hip Stem and the Fitmore®Hip Stem. Products experiencing growth in this category included the Avenir® Müller Stem, the Wagner SL Revision®Hip Stem, the Continuum® Acetabular System, the Trilogy® IT Acetabular System, the Allofit® IT Alloclassic® Acetabular System, Vivacit-E® Highly Crosslinked Polyethylene Liners and BIOLOX®1 delta Heads.

In Europe, changes in foreign currency exchange rates positively affected hip sales in the three and six month periods ended June 30, 2014 by 4 percent and 3 percent, respectively. In Asia Pacific, changes in foreign currency exchange rates negatively affected hip sales in the three and six month periods ended June 30, 2014 by 4 percent and 6 percent, respectively.

1 Registered trademark of CeramTec GmbH


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Extremities

Extremities sales increased by 6 percent and 7 percent in the three and six month periods ended June 30, 2014, respectively, when compared to the same prior year periods. The sales increase reflects growth from our shoulder systems, such as the Zimmer® Trabecular MetalTM Reverse Shoulder System and the Sidus® Stem-Free Shoulder, and a broader product portfolio to compete in the foot and ankle and hand and wrist areas of the Extremities category. The broader portfolio includes the Zimmer Trabecular Metal Total Ankle and products from the acquisition of NORMED Medizin-Technik GmbH in June 2013.

Dental

Dental sales decreased by 1 percent in the three month period ended June 30, 2014 when compared to the same prior year period and increased by 1 percent in the six month period ended June 30, 2014 when compared to the same prior year period. The increase in the six month period was the result of improved sales of dental reconstructive implants partially offset by decreases in digital solutions and restorative products. Sales were led by the Tapered Screw-Vent® Implant System. In our Dental product category, in certain markets, especially in our Asia Pacific region, our customers are distributors. The timing of distributor purchases can have a significant influence on sales in those markets in any particular quarter.

Trauma

Trauma sales increased 7 percent and 2 percent in the three and six month periods ended June 30, 2014, respectively, when compared to the same prior year periods. New product launches, especially in our Europe and Asia Pacific reporting segments, have positively affected sales. In the Americas, in the prior year periods we benefited from a certain competitor having a commercial disruption in this category. Without that disruption in the 2014 periods, it has negatively affected our Americas trauma sales compared to the same prior year periods. The Zimmer® Natural Nail® System and Zimmer® Periarticular Locking Plates System led Trauma sales.

Spine

Spine sales decreased by 4 percent and 1 percent in the three and six month periods ended June 30, 2014 when compared to the same prior year periods. We continue to focus on and have had some success in our core fusion portfolio and market adjacencies, including minimally invasive surgeries. 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 and other spine products.

Surgical and other

Surgical and other sales decreased 10 percent and 5 percent in the three and six month periods ended June 30, 2014, respectively, when compared to the same prior year periods. The primary cause of the sales decrease in this product category was the Transposal® Fluid Waste Management System. With this system we sell capital equipment that is used with a one-time disposable manifold. In the prior year, our system benefitted from a competitive product with a commercial disruption. This especially helped our sales of the capital equipment component. With that competitive product back and since many customers bought our capital equipment component in the prior year, sales of our capital equipment component decreased significantly from the prior year. However, this decrease was partially offset by an increase in disposable manifold sales to be used with our capital equipment. Other products leading sales in this category were PALACOS®2 Bone Cement, tourniquets and wound debridement devices.

2 Registered trademark of Heraeus Medical GmbH


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Expenses as a Percentage of Net Sales



                                           Three Months Ended                                   Six Months Ended
                                                June 30,                                            June 30,
                                         2014              2013           Inc (Dec)          2014              2013           Inc (Dec)
Cost of products sold                       28.2 %            27.7 %             0.5            27.2 %            26.7 %             0.5
Research and development                     4.1               4.7              (0.6 )           4.1               4.7              (0.6 )
Selling, general and administrative         38.5              39.2              (0.7 )          39.2              39.8              (0.6 )
Certain claims                               1.8               4.0              (2.2 )           1.0               2.0              (1.0 )
Special items                                5.5               6.5              (1.0 )           4.7               4.7               0.0
Operating profit                            21.9              18.0               3.9            23.8              22.0               1.8

Cost of Products Sold

The increase in cost of products sold as a percentage of net sales for the 2014 periods compared to the same prior year periods was primarily due to the medical device excise tax and lower average selling prices. These negative effects were partially offset by increased hedge gains recorded in the 2014 periods from our foreign currency hedging program compared to the same prior year periods, and lower excess and obsolete inventory charges in the 2014 periods compared to the same prior year periods. The hedge gains were primarily the result of the U.S. Dollar strengthening against the Japanese Yen. Under the hedging program, for derivatives which qualify as hedges of future cash flows, the effective portion of changes in fair value is temporarily recorded in other comprehensive income and then recognized in cost of products sold when the hedged items affect earnings.

Operating Expenses

R&D expenses and R&D as a percentage of sales declined in each of the 2014 periods when compared to the same prior year period. The lower expense reflects a dedication of resources to our quality and operational excellence initiatives. We expect R&D spending in 2014 to be between 4 and 4.5 percent of sales for the full year.

SG&A expenses were about the same in the 2014 periods compared to the same prior year periods, but SG&A as a percentage of sales decreased in the 2014 periods relative to the same prior year periods. SG&A reflects the effects of our operational excellence initiatives. Although variable expenses increase with higher sales, our SG&A expenses have remained relatively consistent. Accordingly, this has reduced SG&A as a percentage of sales as our operational excellence initiatives produced lower variable and fixed costs in SG&A as net sales increased. Additionally, selling and distribution expenses are lower in our Europe and Asia Pacific reporting segments compared to our Americas reporting segment. The mix of sales with increases in Europe and Asia Pacific and a sales decrease in the Americas has helped to lower SG&A as a percentage of sales in the 2014 periods.

"Certain claims" expense is for estimated liabilities to Durom Cup patients undergoing revision surgeries. We recorded expense of $21.8 million in the 2014 periods compared to $47.0 million in the same prior year periods. The additional expense recorded in 2014 was the result of new developments related to international claims activity. For more information regarding these claims, see Note 14 to the interim condensed consolidated financial statements included in . . .

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