ZIMMER BIOMET HOLDINGS, INC. - Quarter Report: 2018 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, 2018

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 every Interactive Data File required to be submitted 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 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 25, 2018, 203,976,311 shares of the registrant’s $.01 par value common stock were outstanding.

ZIMMER BIOMET HOLDINGS, INC.

INDEX TO FORM 10-Q

September 30, 2018

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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 our Annual Report on Form 10-K for the year ended December 31, 2017.

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, 2017 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.

We have reclassified expenses that were previously recognized in a financial statement line item labeled “Acquisition, quality remediation and other” (and prior to that, labeled “Special items”) to the financial statement line items of “Research and development,” “Selling, general and administrative,” “Goodwill and intangible asset impairment,” “Acquisition, integration and related,” and “Quality remediation”.  Prior periods have been reclassified to conform to the current year presentation.  Please refer to Note 2 for additional details on the reclassified items.  We made this change to provide additional transparency and better reflect the nature of these expenses.

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  

We use the financial statement line item “Acquisition, integration and related” to recognize expenses resulting from the consummation of business mergers and acquisitions and the related integration of those businesses.  In 2015, we completed our merger with LVB Acquisition, Inc. (“LVB”), the parent company of Biomet, Inc. (“Biomet”) (which merger is sometimes referred to herein as the “Biomet merger”).  In 2016, we acquired LDR Holding Corporation and other individually immaterial companies.  Acquisition, integration and related expenses are primarily composed of:

We use the financial statement line item “Quality remediation” to recognize expenses related to addressing inspectional observations on Form 483 and a warning letter issued by the U.S. Food and Drug Administration (“FDA”) following its inspections of our Warsaw North Campus facility, among other matters.  See Note 15 for additional information about the Form 483 and warning letter.  The majority of these expenses are related to consultants who are helping us to update previous documents and redesign certain processes.

Accounting Pronouncements Recently Adopted

In August 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“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 early adopted this ASU in the first quarter of 2018.  Based upon our hedging portfolio that existed prior to adoption, the adoption of this ASU did not have any impact on our financial position, results of operations or cash flows.  However, after adoption we entered into cross-currency interest rate swaps that we designated as net investment hedges.  Under this ASU, we have made a policy election for changes in the fair value of the cross-currency component of the cross-currency interest rate swaps to be recorded in accumulated other comprehensive income.  Therefore, all changes in the fair value of the cross-currency interest rate swaps are recorded as a component of accumulated other

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comprehensive loss in the condensed consolidated balance sheet.  The portion of this change related to the excluded component will be amortized into earnings over the life of the derivative while the remainder will be recorded in accumulated other comprehensive loss until the hedged net investment is sold or substantially liquidated.  Under previous guidance, the fair value change related to the cross-currency component was recognized in earnings.  See Note 10 for additional information.    

In February 2018, the FASB issued ASU 2018-02 – Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income.  Under GAAP, when there is a change in tax rates, it requires remeasurement of deferred tax assets and liabilities to be recognized as part of income, even if the deferred tax asset or liability had been recorded and recognized in Accumulated Other Comprehensive Income (Loss) (“AOCI”).  As a result, a portion of the amount recognized in AOCI at the previous tax rate would remain stranded in AOCI permanently.  ASU 2018-02 allows the stranded tax effects in AOCI related only to the Tax Cuts and Jobs Act of 2017 (“2017 Tax Act”) to be reclassified from AOCI to retained earnings.  The only stranded tax effects in AOCI we had related to the 2017 Tax Act were due to changes in the U.S. federal corporate income tax rate.  We early adopted this ASU in the first quarter of 2018 and elected to use the beginning of period transition method, which means we recognized the reclassification as of January 1, 2018.  As a result, we reclassified $42.9 million from AOCI to retained earnings.  

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 are required to report the other components of net benefit costs in other income (expense) in the statements of earnings.  This ASU was effective for us as of January 1, 2018.  This ASU must be applied retrospectively for the presentation of the service cost component and the other components of net periodic pension cost in the statements 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.  This ASU provides a practical expedient that allows companies to use the amounts disclosed in prior financial statements as the basis for the retrospective application.  We elected to use this practical expedient.  The impacts of this ASU on our condensed consolidated financial statements for the three and nine month periods ended September 30, 2017 are included in the tables below.  See Note 12 for further information on the components of our net benefit cost.

In May 2014, the FASB issued ASU 2014-09 – Revenue from Contracts with Customers (Topic 606).  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 was effective for us as of January 1, 2018.  Entities were 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.  We adopted this new standard using the retrospective method, which resulted in us restating prior reporting periods presented.  This ASU did not result in a change to the timing of our revenue recognition.  However, we were required to reclassify certain immaterial costs from selling, general and administrative (“SG&A”) expense to net sales, which resulted in a reduction of net sales, but had no impact on operating profit or retained earnings.  This ASU also required us to reclassify our estimated refund liability for products expected to be returned from a reduction of accounts receivable to other current liabilities and the related right to receive products from the return from inventories to prepaid expenses and other current assets.  The impacts of this ASU on our condensed consolidated financial statements for the three and nine month periods ended September 30, 2017 and as of December 31, 2017 are included in the tables below.

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Accounting Pronouncements Not Yet Adopted

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.  We own most of our manufacturing facilities, but lease various office space, vehicles and other less significant assets throughout the world.  We have collected all of our lease agreements from across the organization that were entered into prior to 2018.  We substantially completed our analysis of the key terms of these lease agreements to determine the appropriate accounting treatment.  We are also nearing completion of our methodology to determine discount rates as well as our implementation of software that will be utilized to account for this ASU.  We will continue evaluating our leases, including the collection and analysis of leases entered into during 2018, and the related impact this ASU will have on our consolidated financial statements through the remainder of 2018.

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.

3.  Revenue Recognition

We recognize revenue when our performance obligations under the terms of a contract with our customer are satisfied.  This happens when we transfer control of our products to the customer, which generally occurs upon implantation or when title passes upon shipment.  Revenue is measured as the amount of consideration we expect to receive in exchange for transferring our product.  Taxes collected from customers and remitted to governmental authorities are excluded from revenues.

We sell product through three principal channels: 1) direct to healthcare institutions, referred to as direct channel accounts; 2) through stocking distributors and healthcare dealers; and 3) directly to dental practices and dental laboratories.  The direct channel

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accounts represented approximately 80 percent of our net sales in 2017.  Through this channel, inventory is generally consigned to sales agents or customers so that products are available when needed for surgical procedures.  No revenue is recognized upon the placement of inventory into consignment, as we retain the ability to control the inventory.  Upon implantation, we issue an invoice and revenue is recognized.  Pricing for products is generally predetermined by contracts with customers, agents acting on behalf of customer groups or by government regulatory bodies, depending on the market.  Price discounts under group purchasing contracts are generally linked to volume of implant purchases by customer healthcare institutions within a specified group.  At negotiated thresholds within a contract buying period, price discounts may increase.  Payment terms vary by customer, but are typically less than 90 days.  

Sales to stocking distributors, healthcare dealers, dental practices and dental laboratories accounted for approximately 20 percent of our net sales in 2017.  With these types of sales, revenue is recognized when control of our product passes to the customer, either upon shipment of the product or in some cases upon implantation of the product.  It is our accounting policy to account for shipping and handling activities as a fulfillment cost rather than as an additional promised service.  We have contracts with these customers or orders may be placed from available price lists.  Payment terms vary by customer, but are typically less than 90 days.  

We offer standard warranties to our customers that our products are not defective.  These standard warranties are not considered separate performance obligations.  In limited circumstances, we offer extended warranties that are separate performance obligations.  We have very few contracts that have multiple performance obligations.  Since we do not have significant multiple element arrangements and essentially all of our sales are recognized upon implantation of a product or when title passes, very little judgment is required to allocate the transaction price of a contract or determine when control has passed to a customer.  Our costs to obtain contracts consist primarily of sales commissions to employees or third party agents that are earned when control of our product passes to the customer.  Therefore, sales commissions are expensed as part of selling, general and administrative expenses at the same time revenue is recognized.  Accordingly, we do not have significant contract assets, liabilities or future performance obligations.  

We offer variable consideration through volume-based discounts, rebates, prompt pay discounts, right of return and other various incentives.  If sales incentives may be earned by a customer for purchasing a specified amount of our product, we estimate whether such incentives will be achieved and recognize these incentives as a reduction in revenue in the same period the underlying revenue transaction is recognized.  We primarily use the expected value method to estimate incentives.  Under the expected value method, we consider the historical experience of similar programs as well as review sales trends on a customer-by-customer basis to estimate what levels of incentives will be earned.  Occasionally, products are returned and, accordingly, we maintain an estimated refund liability based upon the expected value method that is recorded as a reduction in revenue.  

We analyze sales by three geographies, the Americas, Europe, Middle East and Africa (“EMEA”) and Asia Pacific, and by the following product categories: Knees; Hips; Surgical, Sports Medicine, Foot and Ankle, Extremities and Trauma (“S.E.T.”); Dental; Spine & Craniomaxillofacial and Thoracic products (“CMF”) and Other.  As discussed in Note 14, we have seven operating segments that are based upon geography and product categories.  The geographic segments include sales of all product categories exclusive of the specific product category operating segments.  The geographic operating segments are the Americas, EMEA and Asia Pacific.  These three operating segments are our reporting segments.  The product category operating segments are Spine, less Asia Pacific; Office Based Technologies; CMF and Dental.  The product operating segments do not constitute a reporting segment because they are, individually and on a combined basis, insignificant to our consolidated results.  

Our sales analysis differs from our reporting operating segments because the underlying market trends in any particular geography tend to be similar across product categories, we primarily sell the same products in all geographies and the product category operating segments are not individually significant to our consolidated results.

Net sales by geography are as follows (in millions):

Net sales by product category are as follows (in millions):

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4.  Inventories

5.  Property, Plant and Equipment

6.  Transfers of Financial Assets

In the fourth quarter of 2016, we executed receivables purchase arrangements with unrelated third parties to liquidate portions of our trade accounts receivable balance.  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, 2018 of $400 million combined.  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.  As a result, our risk of loss is 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 $31.0 million and $22.9 million as of September 30, 2018 and December 31, 2017, respectively.

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

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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 periods ended September 30, 2018 and 2017, we sold receivables having an aggregate face value of $1,942.8 million and $1,050.5 million to third parties in exchange for cash proceeds of $1,942.1 million and $1,049.8 million, respectively.  Expenses recognized on these sales during the nine month periods ended September 30, 2018 and 2017 were not significant.  In the nine month periods ended September 30, 2018 and 2017, under the U.S. and Japan programs, we collected $1,613.1 million and $682.2 million, respectively, from our customers and remitted that amount to the third party, and we effectively repurchased $166.7 million and $58.9 million, respectively, of previously sold accounts receivable from the third party, due to the programs’ revolving nature.  As of September 30, 2018 and December 31, 2017, we had collected $48.9 million and $103.5 million, respectively, of funds that were unremitted to the third party, which are reflected in our condensed consolidated balance sheets under other current liabilities.  The initial collection of cash from customers and its remittance to the third party is reflected in net cash provided by/(used in) financing activities in our condensed consolidated statements of cash flows.  We estimate the incremental operating cash inflows related to all of our receivables purchase programs were approximately $25 million in the nine month period ended September 30, 2018.

At September 30, 2018 and December 31, 2017, the outstanding principal amount of receivables that has been derecognized under the U.S. and Japan revolving arrangements amounted to $341.8 million and $261.2 million, respectively.

7.  Debt

Our debt consisted of the following (in millions):

At September 30, 2018, our total debt balance consisted of $7.9 billion aggregate principal amount of our senior notes, which included $1.2 billion of Euro-denominated senior notes (“Euro Notes”), $410.0 million outstanding under a U.S. term loan (“U.S. Term Loan A”) that will mature on June 24, 2020, $600.0 million outstanding under a U.S. term loan (“U.S. Term Loan B”) that will

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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 will each mature on September 27, 2022, and fair value adjustments totaling $16.7 million, partially offset by debt discount and issuance costs of $49.4 million.

On March 19, 2018, we completed the offering of $450.0 million aggregate principal amount of our floating rate senior notes due March 19, 2021 and $300.0 million aggregate principal amount of our 3.700% senior notes due March 19, 2023.  Interest on the floating rate senior notes is equal to three-month LIBOR plus 0.750% and is payable quarterly, commencing on June 19, 2018, until maturity.  Interest is payable on the 3.700% senior notes semi-annually, commencing on September 19, 2018, until maturity.  We received net proceeds of $749.5 million from this offering.  On April 2, 2018, these proceeds, together with borrowings under the Multicurrency Revolving Facility (as defined below) and cash on hand, were used to repay the 2.000% Senior Notes due 2018.

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 under the 2014 and 2016 Credit Agreements as of September 30, 2018. As of September 30, 2018, we had no borrowings outstanding under the Multicurrency Revolving Facility.   

Under the terms of U.S. Term Loan A, we have the ability to prepay principal without penalty. We have paid $2.59 billion in principal under U.S. Term Loan A, resulting in $410.0 million in outstanding borrowings as of September 30, 2018.  The outstanding balance is due June 24, 2020.

Under the terms of U.S. Term Loan B, the remaining balance of $600.0 million is due on the maturity date of September 30, 2019.      

The estimated fair value of our senior notes as of September 30, 2018, based on quoted prices for the specific securities from transactions in over-the-counter markets (Level 2), was $7,850.1 million.  The estimated fair value of Japan Term Loan A and Japan Term Loan B, in the aggregate, as of September 30, 2018, based upon publicly available market yield curves and the terms of the debt (Level 2), was $290.9 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

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 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.  Amounts related to defined benefit plans that are in AOCI are reclassified over the service periods of employees in the plan.      

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

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):