ZIMMER BIOMET HOLDINGS, INC. - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017

Commission File Number 001-16407

ZIMMER BIOMET HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

345 East Main Street, Warsaw, IN  46580

(Address of principal executive offices)

Telephone:  (574) 267-6131

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes  ☐    No  ☒

As of October 27, 2017, 202,473,076 shares of the registrant’s $.01 par value common stock were outstanding.

ZIMMER BIOMET HOLDINGS, INC.

INDEX TO FORM 10-Q

September 30, 2017

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Part I – Financial Information

Item 1.  Financial  Statements

ZIMMER BIOMET HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(in millions, except per share amounts, unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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ZIMMER BIOMET HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in millions, unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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ZIMMER BIOMET HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in millions, unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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ZIMMER BIOMET HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions, unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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ZIMMER BIOMET HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.  Basis of Presentation

The financial data presented herein is unaudited and should be read in conjunction with the consolidated financial statements and accompanying notes included in the 2016 Annual Report on Form 10-K filed by Zimmer Biomet Holdings, Inc.

In our opinion, the accompanying unaudited condensed consolidated financial statements include all adjustments necessary for a fair statement of the financial position, results of operations and cash flows for the interim periods presented.  The December 31, 2016 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America (“GAAP”).  Results for interim periods should not be considered indicative of results for the full year.

The words “we,” “us,” “our” and similar words and “Zimmer Biomet” refer to Zimmer Biomet Holdings, Inc. and its subsidiaries.  “Zimmer Biomet Holdings” refers to the parent company only.

2.  Significant Accounting Policies  

Special Items - We recognize expenses resulting directly from our business combinations, employee termination benefits, certain research and development (“R&D”) agreements, certain contract terminations, goodwill and intangible asset impairment, consulting and professional fees and asset impairment or loss on disposal charges connected with global restructuring, quality enhancement and remediation efforts, operational excellence initiatives, and other items as “Special items” in our condensed consolidated statement of earnings. “Special items” included (in millions):

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Consulting and professional fees include expenditures related to third-party integration consulting performed in a variety of areas such as tax, compliance, logistics and human resources for our business combinations including our merger with Biomet, Inc. (“Biomet”); legal fees related to the consummation of mergers and acquisitions and certain litigation and compliance matters; other consulting and professional fees and contract labor related to our quality enhancement and remediation efforts and operational excellence initiatives; third-party fees related to severance and termination benefits matters; costs of complying with our deferred prosecution agreement; and consulting fees related to certain information system integrations.  

Dedicated project personnel expenses include the salary, benefits, travel expenses and other costs directly associated with employees who are 100 percent dedicated to our integration of acquired businesses, employees who have been notified of termination, but are continuing to work on transferring their responsibilities and employees working on our quality enhancement and remediation efforts and operational excellence initiatives.  

As part of the Biomet merger (defined below), we recognized $209.0 million of intangible assets for in-process research and development (“IPR&D”) projects.  We recorded impairment losses related to IPR&D intangible assets of $18.8 million and $28.0 million during the nine month periods ended September 30, 2017 and 2016, respectively.  The impairments were primarily due to the termination of certain IPR&D projects.  We also recognized $479.0 million of intangible assets for trademarks that we designated as having an indefinite life.  In the nine month period ended September 30, 2017, we reclassified one of these trademarks to a finite life asset which resulted in an impairment of $8.0 million.

During the three and nine month periods ended September 30, 2017, we recognized a $32.7 million goodwill impairment charge on our Office Based Technologies reporting unit.  See Note 9 for additional details.

A further detailed description of expenses included in “Special items” can be found in Note 2 to our Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2016.

On June 24, 2015, pursuant to an agreement and plan of merger dated April 24, 2014, we acquired LVB Acquisition, Inc. (“LVB”), the parent company of Biomet, and LVB and Biomet became our wholly-owned subsidiaries (sometimes hereinafter referred to as the “Biomet merger” or the “merger”).  After the closing date of the Biomet merger, we started to implement our integration plans to drive operational synergies.  Part of these integration plans included termination of employees and certain contracts with independent agents, distributors, suppliers and lessors.  Our integration plans are expected to last through mid-2018 and we expect to incur a total of $170 million for employee termination benefits and $140 million for contract termination expense in that time period.  As of September 30, 2017, we have incurred a cumulative total of $163.8 million for employee termination benefits and $134.9 million for contract termination expense.  The following table summarizes the liabilities related to these integration plans (in millions):

Recent Accounting Pronouncements – In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-04 – Simplifying the Test for Goodwill Impairment.  This ASU requires goodwill impairment to be measured as the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill.  Under previous guidance, if the carrying amount of a reporting unit’s net assets were greater than its fair value, impairment was measured as the excess of the carrying amount of the reporting unit’s goodwill over its implied fair value.  The determination of a reporting unit’s implied goodwill generally required significant estimates to fair value its net assets.  Therefore, this ASU simplifies goodwill impairment testing by eliminating the need to estimate the fair value of a reporting unit’s net assets.  The impact of this ASU is dependent on the specific facts and circumstances of future impairments and is applied prospectively on testing that occurs subsequent to adoption.  We elected to early adopt this ASU in the third quarter of 2017.  As a result, the new ASU was used to determine the goodwill impairment charge on our Office Based Technologies reporting unit that was recognized in the third quarter of 2017.  See Note 9 for additional details regarding this goodwill impairment charge.

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In October 2016, the FASB issued ASU 2016-16 – Intra-Entity Asset Transfers of Assets Other than Inventory.  This ASU changes the accounting for the tax effects of intra-entity asset transfers/sales. Under current GAAP, the tax effects of intra-entity asset transfers/sales are deferred until the transferred asset is sold to a third party or otherwise recovered through use.  Under the new guidance, the tax expense from the sale of the asset in the seller’s tax jurisdiction is recognized when the transfer occurs, even though the pre-tax effects of that transaction are eliminated in consolidation.  Any deferred tax asset that arises in the buyer’s jurisdiction would also be recognized at the time of the transfer.  The new guidance does not apply to intra-entity transfers/sales of inventory.  We early adopted this standard effective January 1, 2017.  The modified retrospective approach is required for transition, which resulted in us recognizing a cumulative-effect adjustment in Retained earnings as of January 1, 2017 for intra-entity transfers/sales we had executed prior to that date.  The January 1, 2017 cumulative effect adjustment resulted in a $72.7 million decrease to Retained earnings, a $3.9 million decrease to Other prepaid expenses and current assets, a $22.4 million decrease in Other assets, a $2.0 million decrease to Income taxes payable, and a $48.4 million increase to Deferred income taxes.  The adoption of this ASU resulted in additional tax expense of $1.5 million and a tax benefit of $2.2 million to our provision for income taxes in the three and nine month periods ended September 30, 2017, respectively, compared to what it would have been under the previous accounting rules.

In May 2014, the FASB issued ASU 2014-09 – Revenue from Contracts with Customers.  This ASU provides a five-step model for revenue recognition that all industries will apply to recognize revenue when a customer obtains control of a good or service.  This ASU will be effective for us beginning January 1, 2018.  Entities are permitted to apply the standard and related amendments either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the ASU recognized at the date of initial application.

During the fourth quarter of 2016, we commenced an initial evaluation of the new standard and a related assessment and review of a representative sample of existing revenue contracts with our customers on some of our most significant revenue streams.  In 2017, we have expanded our scope to perform an analysis at locations with less significant revenue streams and have provided training on the new standard to finance personnel across all of our locations.  Our assessment of our revenue streams is substantially complete.  Based upon our assessment, we do not believe there will be a material change to the timing of our revenue recognition.  However, we will be required to reclassify certain immaterial costs from selling, general and administrative (“SG&A”) expense to net sales, which will result in a reduction of net sales, but have no impact on operating profit.  In the fourth quarter of 2017, we will focus on additional disclosures we may need to make and the effect of this ASU on our internal control over financial reporting or other changes in business practices and processes.  We plan to adopt this new standard using the retrospective method, which will result in us restating prior reporting periods presented.  As noted previously, we expect this will result in us reclassifying certain immaterial costs from SG&A expense to net sales in each of those prior reporting periods.  Our evaluation of ASU 2014-09 is ongoing and not complete.

In February 2016, the FASB issued ASU 2016-02 – Leases. This ASU requires lessees to recognize right-of-use assets and lease liabilities on the balance sheet. This ASU will be effective for us beginning January 1, 2019. Early adoption is permitted. The ASU must be adopted using a modified retrospective transition approach at the beginning of the earliest comparative period in the consolidated financial statements. We own most of our manufacturing facilities, but lease various office space throughout the world. We are formalizing our project team and in the fourth quarter of 2017 will begin evaluating our leases and the related impact this ASU will have on our consolidated financial statements.

In March 2017, the FASB issued ASU 2017-07 – Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.  This ASU requires us to report the service cost component of pensions in the same location as other compensation costs arising from services rendered by the pertinent employees during the period. We will be required to report the other components of net benefit costs in Other Income (Expense) in the statement of earnings.  This ASU will be effective for us beginning January 1, 2018.  The ASU must be applied retrospectively for the presentation of the service cost component and the other components of net periodic pension cost in the statement of earnings and prospectively, on and after the effective date, for the capitalization of the service cost component of net periodic pension cost in assets.  See Note 12 for further information on the components of our net benefit cost.

In August 2017, the FASB issued ASU 2017-12 – Targeted Improvements to Accounting for Hedging Activities.  This ASU amends the hedge accounting guidance to simplify the application of hedge accounting, makes more financial and nonfinancial hedging strategies eligible for hedge accounting treatment, changes how companies assess effectiveness and updates presentation and disclosure requirements.  We are currently evaluating the impact this ASU will have on our consolidated financial statements; however, based on our current hedging portfolio, we do not anticipate that this ASU will have a significant impact on our financial position, results of operations or cash flows.  This ASU will be effective for us January 1, 2019, with early adoption permitted.  After adoption, we may explore new hedging opportunities that are eligible for hedge accounting treatment under the new standard.  

There are no other recently issued accounting pronouncements that we have not yet adopted that are expected to have a material effect on our financial position, results of operations or cash flows.

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3.  Business Combinations

LDR Acquisition

On July 13, 2016, we completed our acquisition of LDR Holding Corporation (“LDR”).  We paid cash of $1,138.0 million.  The total amount of merger consideration utilized for the acquisition method of accounting, as reduced by the merger consideration paid to holders of unvested LDR stock options and LDR stock-based awards of $24.1 million, was $1,113.9 million.  The addition of LDR provided us with an immediate position in the growing cervical disc replacement (“CDR”) market.  The combination positioned us to accelerate the growth of our Spine business through the incremental revenues associated with entry into the CDR market and cross-portfolio selling opportunities to both Zimmer Biomet and LDR customer bases.  The goodwill was generated from the operational synergies and cross-selling opportunities we expected to achieve from our combined operations.  None of the goodwill is deductible for tax purposes.

The following table summarizes the final estimated fair value of the assets acquired and liabilities assumed in the LDR acquisition (in millions):

We have not included pro forma information and certain other information under GAAP for the LDR acquisition because it did not have a material impact on our financial position or results of operations.

Other acquisitions

During the year ended December 31, 2016, we completed individually immaterial acquisitions of companies including Cayenne Medical, Inc. (“Cayenne Medical”), a sports medicine company, Compression Therapy Concepts, Inc. (“CTC”), a provider of non-invasive products for the prevention of deep vein thrombosis, CD Diagnostics, Inc. (“CD Diagnostics”), a medical diagnostic testing company, and MedTech SA (“MedTech”), a designer and manufacturer of robotic equipment for brain and spine surgeries.  The total aggregate cash consideration was $441.7 million.  These acquisitions were completed primarily to expand our product offerings.  We have assigned a fair value of $58.0 million for settlement of preexisting relationships and additional payments related to these acquisitions that are contingent on the respective acquired companies’ product sales, commercial milestones and certain cost savings.  The fair value of the aggregate contingent payment liabilities was calculated based on the probability of achieving the specified sales growth, cost savings and commercial milestones and discounting to present value the payments.  The goodwill was generated from the operational synergies and cross-selling opportunities we expected to achieve from the technologies acquired.  None of the goodwill related to these acquisitions is deductible for tax purposes.

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The following table summarizes the aggregate final estimated fair value of the assets acquired and liabilities assumed related to the Cayenne Medical, CTC, CD Diagnostics, MedTech, and other immaterial acquisitions that occurred during the year ended December 31, 2016 (in millions):

We have not included pro forma information and certain other information under GAAP for the Cayenne Medical, CTC, CD Diagnostics, or MedTech acquisitions because, individually and in aggregate, they did not have a material impact on our financial position or results of operations.

Goodwill

The following table summarizes the changes in the carrying amount of our goodwill (in millions):

During the three and nine month periods ended September 30, 2017, we recognized a $32.7 million goodwill impairment charge on our Office Based Technologies reporting unit.  See Note 9 for additional details.

4.  Inventories

Finished goods inventory as of September 30, 2017 and December 31, 2016 included $0.7 million and $35.3 million, respectively, to step-up acquired inventory to fair value.

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5.  Property, Plant and Equipment

6.  Transfers of Financial Assets

In the fourth quarter of 2016, we executed receivables purchase arrangements to liquidate portions of our trade accounts receivable balance with unrelated third parties.  The receivables relate to products sold to customers and are short-term in nature.  The factorings were treated as sales of our accounts receivable.  Proceeds from the transfers reflect either the face value of the accounts receivable or the face value less factoring fees.  

In the U.S. and Japan, our programs are executed on a revolving basis with a maximum funding limit as of September 30, 2017 of $315 million.  We act as the collection agent on behalf of the third party, but have no significant retained interests or servicing liabilities related to the accounts receivable sold.  In order to mitigate credit risk, we purchased credit insurance for the factored accounts receivable.  The result is our risk of loss being limited to the factored accounts receivable not covered by the insurance.  Additionally, we have provided guarantees for the factored accounts receivable.  The maximum exposures to loss associated with these arrangements were $24.4 million and $5.2 million as of September 30, 2017 and December 31, 2016, respectively.

In Europe, we sell to a third party and have no continuing involvement or significant risk with the factored accounts receivable.

Funds received from the transfers are recorded as an increase to cash and a reduction to accounts receivable outstanding in the condensed consolidated balance sheets.  We report the cash flows attributable to the sale of receivables to third parties in cash flows from operating activities in our condensed consolidated statements of cash flows.  Net expenses resulting from the sales of receivables are recognized in selling, general and administrative expense.  Net expenses include any resulting gains or losses from the sales of receivables, credit insurance and factoring fees.

In the nine month period ended September 30, 2017, we sold receivables having an aggregate face value of $1,050.5 million to third parties in exchange for cash proceeds of $1,049.8 million.  Expenses recognized on these sales during the three and nine month periods ended September 30, 2017, were not significant.  In the nine month period ended September 30, 2017, under the U.S. and Japan programs, we collected $682.2 million from our customers and remitted that amount to the third party, and we effectively repurchased $58.9 million of previously sold accounts receivable from the third party due to the programs’ revolving nature. We estimate the incremental operating cash inflows related to all of our programs were approximately $273 million in the nine month period ended September 30, 2017.

At September 30, 2017, the outstanding principal amount of receivables that has been derecognized under the U.S. and Japan revolving arrangements amounted to $210.6 million and $65.5 million, respectively.

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7.  Debt

Our debt consisted of the following (in millions):

At September 30, 2017, our total debt balance consisted of $8.3 billion aggregate principal amount of our senior notes, which included $1.2 billion of Euro-denominated senior notes (“Euro Notes”), $1.14 billion outstanding under a U.S. term loan (“U.S. Term Loan A”) that will mature on June 24, 2020, $675.0 million outstanding under a U.S. term loan (“U.S. Term Loan B”) that will mature on September 30, 2019, an 11.7 billion Japanese Yen term loan agreement (“Japan Term Loan A”) and a 21.3 billion Japanese Yen term loan agreement (“Japan Term Loan B”) that each will mature on September 27, 2022, and other debt and fair value adjustments totaling $29.2 million, partially offset by debt discount and issuance costs of $56.3 million.

On September 22, 2017, we entered into a term loan agreement for the Japan Term Loan B, and an amended and restated term loan agreement, which amended and restated the Japan Term Loan A loan agreement dated as of May 24, 2012, as amended as of October 31, 2014. As described above, the term loans under both of these agreements will mature on September 27, 2022. Each of these term loans bears interest at a fixed rate of 0.635% per annum.

We have a revolving credit and term loan agreement (the “2016 Credit Agreement”) and a first amendment to our credit agreement executed in 2014 (the “2014 Credit Agreement”).  The 2016 Credit Agreement contains the U.S. Term Loan B and a five-year unsecured multicurrency revolving facility of $1.5 billion (the “Multicurrency Revolving Facility”).  The Multicurrency Revolving Facility replaced the previous multicurrency revolving facility under the 2014 Credit Agreement and will mature on September 30, 2021, with two available one-year extensions at our discretion.  The 2014 Credit Agreement also provided for the U.S. Term Loan A, which remains in effect.

Borrowings under the 2014 and 2016 Credit Agreements generally bear interest at floating rates. We pay a facility fee on the aggregate amount of the Multicurrency Revolving Facility. If our credit rating falls below investment grade, additional restrictions would result, including restrictions on investments and payment of dividends.  We were in compliance with all financial covenants

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under the 2014 and 2016 Credit Agreements as of September 30, 2017. As of September 30, 2017, there were no borrowings outstanding under the Multicurrency Revolving Facility.   

Under the terms of U.S. Term Loan A, starting September 30, 2015, principal payments are due as follows: $75.0 million on a quarterly basis during the first three years, $112.5 million on a quarterly basis during the fourth year, and $412.5 million on a quarterly basis during the fifth year.  We have paid $1.86 billion in principal under U.S. Term Loan A, resulting in $1.14 billion in outstanding borrowings as of September 30, 2017.    

Under the terms of U.S. Term Loan B, future principal payments are due as follows:  $75.0 million on September 30, 2018, with the remaining balance due on the maturity date of September 30, 2019.  We have paid $75.0 million in principal under U.S. Term Loan B, resulting in $675.0 million outstanding on the U.S. Term Loan B as of September 30, 2017.    

The estimated fair value of our senior notes as of September 30, 2017, based on quoted prices for the specific securities from transactions in over-the-counter markets (Level 2), was $8,520.9 million.  The estimated fair value of Japan Term Loan A and Japan Term Loan B, in the aggregate, as of September 30, 2017, based upon publicly available market yield curves and the terms of the debt (Level 2), was $291.8 million.  The carrying values of U.S. Term Loan A and U.S. Term Loan B approximate their fair values as they bear interest at short-term variable market rates.

8.  Accumulated Other Comprehensive Income

Accumulated other comprehensive income (“AOCI”) refers to certain gains and losses that under GAAP are included in comprehensive income but are excluded from net earnings as these amounts are initially recorded as an adjustment to stockholders’ equity.  Amounts in AOCI may be reclassified to net earnings upon the occurrence of certain events.  

Our AOCI is comprised of foreign currency translation adjustments, unrealized gains and losses on cash flow hedges, unrealized gains and losses on available-for-sale securities, and amortization of prior service costs and unrecognized gains and losses in actuarial assumptions on our defined benefit plans.  Foreign currency translation adjustments are reclassified to net earnings upon sale or upon a complete or substantially complete liquidation of an investment in a foreign entity.  Unrealized gains and losses on cash flow hedges are reclassified to net earnings when the hedged item affects net earnings.  Unrealized gains and losses on available-for-sale securities are reclassified to net earnings if we sell the security before maturity or if the unrealized loss is considered to be other-than-temporary.  Amounts related to defined benefit plans that are in AOCI are reclassified over the service periods of employees in the plan.  The reclassification amounts are allocated to all employees in the plans and, therefore, the reclassified amounts may become part of inventory to the extent they are considered direct labor costs.  See Note 12 for more information on our defined benefit plans.    

The following table shows the changes in the components of AOCI, net of tax (in millions):

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The following table shows the reclassification adjustments from AOCI (in millions):

The following table shows the tax effects on each component of AOCI recognized in our condensed consolidated statements of comprehensive income (in millions):