Zimmer Biomet Holdings, Inc. (ZBH) Earnings Call Transcript & Summary

Good morning again, Rick Wise here once more. I'm thrilled to welcome the management of Zimmer Biomet. Joining us today are Bryan Hanson, Chairman, President, Chief Executive Officer; Suky Upadhyay, Chief Financial Officer and EVP; the always wonderful, Keri Mattox, as well. Unfortunately, we had a little technical glitch, so we're not going to see Bryan's full beauty visual aid. But even -- Bryan, we're going to push it even harder for even better answers than -- better than the magnificent answers you've always given actually. So thank you all for being here. Really appreciate it.

Bryan, let me just kick it off real quick with one topic I've been spending a lot of time trying to explain. I'd rather hear you explain it and talk us through it again. Just my recent investor conversations, there's been a lot of confusion about China volume-based procurement, the VBP program and implementation, what it means for Zimmer's fourth quarter and 2022. If I'm understanding it correctly, '21, the impact sounds like it's more onetime in nature related to inventory write-offs, et cetera, '22 more recurring. Am I thinking about it correctly? What are the headwinds? And how do you want us to think about this?

Okay. Great being here, Rick. Sorry about the technical difficulties. I would like to be able to see you as well. So what I would tell you is that it's a bummer because we try to be very clear in this area, but it's clear that people are still challenged to understand what it is we're saying. So maybe I'll start with this and try to simplify the message as much as I can. And then Rick, if you're not getting what you're looking for, just keep asking until we get there. What I would tell you is that from the very beginning, we said this could be about a 1% impact, the VBP process in recon could be about a 1% impact to our consolidated revenue results, so our full revenue results. That has not changed. It's that 1%, even though it's a little worse than we thought, I thought we had more cushion than maybe we did, that 1% still holds. The thing this changes at the time when the impact is actually occurring, and that's moving into 2021. And so with that said, we're now going to capture a lot of the negative impact of VBP albeit with elements beyond just price in 2021 but that also means, as a result of that, that it's a less challenging comp for 2022, if I think about the growth in '22 versus '21. So maybe said in another way, we still see about a 1% coming off of our pre-VBP consolidated revenue base in '22, but that 1% is not incremental to the 2021 revenues that we're talking about, the impact that we have in 2021. So if you compare 2022 versus 2019, there's 1%. If you compare it to 2020, it should be about a push, about equal from a revenue standpoint.

All right. No, I think that's very clear and appreciate that incremental color. Bryan, it's been very difficult not to start off early in these conversations asking about recent trends. And I feel like as I reflect on the third quarter, there seem to be sort of 2 groups of companies, those that saw August and September as the worst months and then stabilization but a continuation of sort of stable as opposed to a sharp rebound. And others are talking about more dramatic improvement as we went into October, November. Can you help us think through where are you now as we're halfway through the quarter? Which camp do you fall in? And how are you thinking about the setup now for the rest of the year?

Yes. So maybe I'll start with this, and then Suky, if you want to provide additional color. But what we're trying to do -- be in that -- a good 80% or so of our revenue is contingent upon elective procedures, in other words, those procedures that have been defined during this pandemic as things that can be deferred. We really want to make sure that we're taking an appropriate view given the history so far now what COVID is going to do because it has a significant impact on our business. And so what we're trying to do is to look at the rest of the year and from here on look at COVID as whatever is happening in the moment, we're just going to assume that's going to continue until we actually see something change in the marketplace that tells it just not. And what we've done in the past is probably -- depend more on what others are saying about the market just in terms of the people that are supposed to know, saying that there's going to be a recovery. We've just stopped paying attention to that. And we're just focused on what we're actually experiencing. And so as a result of that, we said as we look going forward that we would expect Q4 to be impacted by COVID at about the same rate as it was in September, which would make Q4 a more challenging COVID quarter than Q3. And whether that's more conservative or more aggressive than what others are doing, I don't know, I'm trying to pay more attention to what we're focused on. But that's the way we looked at it is we truly believe until we see something fundamentally shift, we're just going to assume it's going to continue. You might say that that's aggressive because that means COVID's not going to get worse with that assumption. And as we've seen in the past, sometimes it does when we least expect it to. I would tell you inside -- go ahead.

No, you go ahead.

Yes, I was going to say, inside of that, there's slight puts and takes. Our overall view of that is the same. But you've seen a little bit of a pickup in the U.S. not nearly where we'd like it to be, but you see more pressure with some of the COVID surges in Europe, and those have offset each other. So even though there's been slight mix shifts inside of that broader assumption, the broader assumption still holds.

Got you. Suky, did you want to add to that? Any more color you can provide as you headed into November and looking at December?

Yes. I think, first of all, Bryan summed it up really well. Trying to predict the recovery has been elusive for us. I believe it's been elusive for everyone. But specifically for us, it's been elusive. And so as Bryan said, we're taking the position that where we see most recent trends is how we're going to predict at least the near term, at least the near quarter because that's the best data we have. As Bryan said, we expect procedural volumes to sequentially improve in the fourth quarter. That's generally due to seasonality, but it's not going to happen as fast a rate as we originally thought, and that's why we took that fourth quarter by fourth quarter guide down. Largely, things are in line with our original expectations. As always, in a company of our size and complexity, there's puts and takes. As Bryan said, we're seeing marginally more pressure in parts of Europe with additional surges which is, again, another proof point and validation of why this is so elusive to try and predict. I would not have said that 3, 4 weeks ago, right? So this is relatively new. On the flip side, we are seeing some modest improvement in the U.S., nowhere near where we'd like it to be but slightly better than where we originally thought it would be at this point in the quarter. But broadly speaking, those 2 sort of net out and we're right back where we originally thought we would be, so broadly in line with how we originally thought about the fourth quarter.

That's very helpful. Bryan, just an unusual question maybe to ask, but knowing you as I do, I know that you're not just sitting around chilling at the pool waiting for COVID to go away and that you're getting ready for the future always. What are your priorities in this time so that you're maybe focused on ensuring that Zimmer Biomet emerges from all this even stronger, even further along in ways that maybe aren't so visible to us?

Yes. It's -- and hopefully, a lot of things are visible. And I'll tell you the biggest thing that we're focused on is not deviating from the strategy that we have in place and not pulling back on the investment where we know it can drive future revenue growth. We've been pretty disciplined throughout this to reduce spend where we can. We've been extremely disciplined in making sure that we continue to spend in the areas that will allow us to drive revenue growth in the areas that we consider growth drivers. And so that strategy commitment is really what we're focused on right now, and it's working. I just point to some proof points. You look at our biggest franchise, which is our knee franchise, and you look at our growth rates versus our competitors over the last 6 quarters, and it's clear that we've -- there's been a paradigm shift for this organization. We had 20-plus quarters before those, 6 quarters where we never had a quarter above-market growth. And now we've had 5 out of the last 6 above market. And I would say really importantly, at the very beginning phases of our innovation pipeline, we're still in the single-digit vitality index. But the pipeline that we have and it's just starting, we actually predict that to move significantly higher over the next 5 years, 2 to 3x higher than what we have today. So I think that's the key thing is we have stuck to the strategy because we know it's going to work. And where we can control things, we're delivering on those expectations. The second part of that is what we've been doing as well is to then look at active portfolio management, how do we continue to add assets to our portfolio that fill gaps in important fast-growth areas and give us the opportunity to then take share. And that's exactly what we're doing in sports. That's exactly what we're doing in the ASC market, which is very attractive to us and also in our thoracic market that a lot of people didn't even know we're in. So those are the things that we're doing. We're just sticking to the game plan and executing on the things we can control and keeping the faith. And when going gets behind us, that the real performance of the business is going to shine through and the financials will represent that.

Yes. I'm not surprised that you're focused in that way. It's hard to resist asking about procedural backlogs at a time when it seems like -- feels like procedures are being delayed or postponed or not initiated. And I know that the future won't be exactly like it was in the summer and fall of 2020 maybe. But surely, there is a backlog, and that has the potential to be a very serious positive for you as we look ahead into maybe the second half of next year into '23. Is that the right way to think about it?

I mean I do think so. I just -- again, anybody's guess is as good as anybody else's. I think we do a lot of homework on this. But I just never would have thought that we would be almost 2 years into this and this continuing to be a pressure point. And so when I originally thought about this whole backlog and what should likely occur, I kind of expected COVID to be a speed bump. And given that speed bump that we would find that you'd have a backlog of patients that were deferred, those patients would be very likely to come kind of right back into the system from a large majority standpoint, and we would benefit from those as we typically would in the past. But after 2 years, I just -- I'm having a hard time knowing when they're going to come back. I still fundamentally believe there's got to be a growing backlog because, again, I don't think there's been any structural change in the disease state. But I just can't -- I can't predict anymore when they're going to come back into the system and at what pace. My current thinking is, clearly, you're not going to see any kind of a benefit -- net benefit until COVID is truly in the rearview mirror, so that's step one. And then step two is right now, I think it's going to be a slow burn. I think you're going to work through that backlog on a relatively slow volume over a longer period of time. I don't currently expect, just given some of the things we've experienced, capacity has dramatically jumped and be able to absorb that quickly. So I would think about a backlog likely there, probably very sizable. COVID's got to be in the rearview mirror before we start to see a net benefit from it. And I would think it'd be a slower benefit, not a more material benefit. It would take a longer time to work through.

Got you. Maybe this is for you, Suky, just thinking about inflation. I think this came after you reported the news that we're at record -- recent high U.S. inflation levels. How is that changing the way you're thinking about planning for the year ahead? And anything to do with your cash generation or balance sheet? Or just any updated thoughts there?

Yes. So first of all, I don't think it changes some of the strategic levers that Bryan talked about relative to being efficient. If anything, it accelerated them but it didn't change them. And so we are seeing headwinds because of higher inflationary pressures on input costs, whether it's raw materials, labor, freight, et cetera. So our procurement group, our -- the rest of our organization is working really hard to try and offset those. We're also accelerating a number of efficiency initiatives across the company, especially in SGA. One of the things we found, Rick, over the last -- the first part of this year is we've done a pretty deep dive on many of our functional groups, functions, meaning HR, IT, finance, things like that. And what we realized is while we've been making improvements over the last couple of years in all of those areas, we're still operating at above benchmark relative to percent in that. And so we're taking a much more -- a circumstance on getting those areas more efficient. And we're going to be able to do that through some of the heavy lifting we did back in '19 and '20, creating global shared services centers in lower-cost countries. So we feel really good about that as being potential mitigative to some of these headwinds we're talking about. So that's one area that we're, again, not changing our approach but rather changing the pace of and accelerating it to help offset. Relative to balance sheet and cash flow generation. Look, we still continue to make a very -- generate a very robust level of our cash flow. Our guidance hasn't changed this year on cash flow, even though our revenue expectations have. We're still in that $900 million to $1.1 billion. And that's even in the backdrop of a COVID-pressured environment. So still a very robust level of cash flow. Things that we are doing differently around capital structures that help offset those headwinds, we recently just went out and we did a refinancing because we saw a very attractive market with low rates in a rising interest rate environment to take out some higher coupon bonds. That's going to help us from an interest expense standpoint moving forward. So we're always looking at opportunities there to not only help improve our area in a status quo environment but especially in one where we're pressured like we are with COVID and some of these inflationary costs. So trust us when we're saying we don't leave any stone unturned in one finding efficiencies and especially in this environment where we're more pressured than we thought we've been.

I believe you on that, Suky. Bryan, if I could come back to pipeline, you highlighted the innovation pipeline is going to be significantly higher over the next 5 years. And I wanted to get a little more clarity. I was hoping to get a little more clarity on some of the products that -- or the pipeline initiatives you're most excited about. Obviously, you've recently launched ROSA Partial Knee, ROSA Hip, Persona IQ. Is there one or is the collective -- the mass of them and the ability to impact the market that you're most excited about? And as we think about the pipeline and this potential impact, are you investing more heavily behind some of the areas, like you mentioned, sports, ASC, thoracic, that maybe are a little below the radar screen for most people? Just help us -- again, what are you most excited about? And just where is the bulk of your investing going?

Yes. It's a great question. So you know from my past that I'm a very focused individual on what we decide our growth initiatives because everything can't be -- everything cannot be invested in the same level. And so we were very intentional in selecting the areas that would be growth drivers for the organization and as a result of being a growth driver would then warrant additional just mind share resources. And the areas that we're concentrating on -- so I'll start there and then get into some of the products I'm most excited about, is knees, for sure, just given the overall scale of that business. And then again, inside of S.E.T., we're looking at sports, upper extremities and really our thoracic business, our CMFT and then, from a market standpoint, ASC. And so those are the areas of real concentration and investment to the organization. So if I start with just knees, I'll start with kind of the traditional implants. Revision is still very exciting. I know it came out of the gates rocketing in 2020, did $100 million in the middle of the pandemic from beginning of the year to the end of the year, which is absolutely phenomenal, one of the best product launches we've had in a long time, and it's going to do quite a bit again this year. But what's interesting about it is it's not just the conversions we're getting in Revision because when people use it, they love it and they're committed to it. But it's also then the periphery business around those Revisions because a lot of those surgeons are still using competitive primary knees. And I'm talking hundreds of millions of dollars of primary knees being used inside those accounts because always the primary volume is bigger than the Revision volumes. So that gives us a right to hunt now because we have a relationship with those surgeons, and we're certainly working on getting the primary need converted as well. So it's not just Revision. It's the periphery, the potential it has as well that I'm very excited about. Moving away from kind of the traditional thing. It's really around ZBEdge and it's all around ROSA, which continues to get traction in all the applications that we're launching there as well. It's mymobility, which continues to give us the ability to collect data in a way that others can't before surgery, during surgery and after. And then it's Persona IQ. That's a brand-new launch for us, but I can tell you the excitement that we saw around this is real. It's very tangible. And so it's not really one of those individual components, but it's the combination of those integrated capabilities that provide us a data collection capability that's beyond anybody else. And we truly do believe that, that data collection and the insights we're going to gain from that will change the way we care for patients and will absolutely differentiate us. So it's -- that's what I'm most excited about right now is that traditional -- on the traditional side of Revision, on the nontraditional side of ZBEdge, in a bunch of other things that I like in S.E.T., but if I really just picked the 2 big ones, those are that.

All right. And just to sort of take that to the next logical step, I feel like turnarounds always have multiple phases. I think -- I hope I'm not misquoting you. You've described this as the transformational phase. I want to believe that maybe even if you haven't said it -- of the story. And it seems to me with the balance sheet, Bryan, now back under 3x, I think it's 2.7x, Suky, if I'm remembering correctly, that you really do have a lot more flexibility than you've had since you've gotten there to be more aggressive on the M&A front. Just if I could just push, I mean is your activity increasing? Is the pipeline of potential tuck-in technologies more available? How are you thinking about it now? And can we hope for something that changes the nature of this aspect of the conversation in the near term -- near to medium term?

Yes. So first of all, a great question again. So there are 3 phases of the transformation in the way that we said. The first one was around kind of hearts and minds in just fixing all the challenges that we had, these execution challenges. That was a good 1.5 years, as you remember. That took us to the second phase, which is more around a true longer-term strategic plan and really double down on innovation. And the third phase is really this idea of transformation, and that could be our business model transformation to look for additional efficiencies. It could be the portfolio transformation as we've been talking about. And it could be a brand transformation that we're looking at to say that when people think about Zimmer Biomet, they think more of a high-tech company versus just med tech company. So all those are captured in that Phase 3. And I would tell you that we've not stopped in that active portfolio measure. Even though we haven't had the fire power we would like, we've been doing deals all along, tuck-in deals, in those areas that are faster-market growth categories for us, where we have good profitability and we have a right to win. And so we've seen that even during a challenged time of COVID, where we just haven't had the same capital firepower as one would have liked. That said, it's not going to stop the portfolio management strategy. We will continue to acquire companies, and they will get larger in scale as that firepower increases. So I just -- I don't want people to think we've been pausing that part of the transfer. We've been doing it, although a bit curtailed because of the firepower was lower than we wanted. You look at our 5-year strat plan, we absolutely believe we're going to have firepower here to make real change in our portfolio.

And it would seem that -- so the answer -- I'm putting words in your mouth, it's like you're as active as ever, and this is going to continue to be part of the story going forward.

Yes.

Suky, maybe just to turn to margins. I mean I think you indicated on the third quarter that in the near to medium term, gross margins are going to be stable relative to the second half of 2020 levels. That's 71%, if I'm remembering correctly. But as we look ahead to '22, how do we think about gross margin trends? Obviously, volume is key. I get that. But maybe help us understand how mix and cost and maybe other factors are going to affect that line as we contemplate the year ahead.

Yes. It's a great question. And like you said, right, there are a number of variables inside of gross margin. So I try not to overfocus on any one because there's generally others that offset that and any given variable that you might have. So you're right, our starting point was sort of stable to 2020 back half. And inside of that, I think it's important to understand, we -- I believe it had finally gotten to a point where our supply chain has initiated their structural and tactical changes to drive efficiency in tandem with the commercial organization doing a better job with managing price such that we're now able to largely offset that price erosion, which the company was not able to do for the, I guess, last half decade since the merger, right? So we're starting to enter that point in stabilization. That's a good first step to ultimately get to improvement, but an important first step. That's the starting point we would see for 2022. Now inside of that, then, there are some headwinds and tailwinds, as you pointed out. One, I think we and many others in our industry, outside of our industry are seeing headwinds relative to input costs, labor, freight, et cetera. I think we've talked a little bit about that. Two, we've got the VBP. That will be a headwind as we move into next year. But as we think about those 2 headwinds, we do have what I believe will be some tailwinds, right? One is around our supply chains and commercial organizations aren't just resting back on price improvement or efficiency. So there will be an element of that as we move into 2022. And we're going to try and accelerate those. Next, from a tailwind perspective, mix could be a tailwind. If we begin to see the U.S. come back in a bigger way, we begin to see recon come back in a bigger way, that's going to have a positive mix shift from a gross margin perspective. So that could potentially be a tailwind. Some of the new products we're launching in recon and the throughput that hopefully we begin to see rampup relative to ROSA if we get to normalized volumes could be an uptick to gross margin. But at the same side, we're going to have to watch while we're growing our S.E.T. business at a much faster rate, that comes at a lower margin. So you can start to get the picture that there are a lot of headwinds and tailwinds, but the ones that we're most focused on right now as a starting point is, again, that stabilization for the back half of [ '20 ] and we really got to look at what are the opportunities to offset those input cost headwinds and the VBP headwinds that we're currently seeing here now.

Got you. Bryan, we're almost out of time, and I saved one left field question for the end. Just remembering, as you said, that first phase of your journey at Zimmer Biomet was the hearts and mind phase. And I remember compelling anecdotes about you visiting sales teams and customers. I just -- I'm always curious as things change and evolve and you have your team in place, where are you spending your time these days? Is it -- are you -- is it the bulk of your time on strategy and what's next? Or is it still with customers? Or I'd just be curious to see how that's changing and your priorities for yourself right now.

Yes. Another good question. Interestingly enough, I'm actually -- I just got back from a conference. Obviously, that's a great place to get a lot of customers at the same time and see how they respond to our technologies. And I'm leaving right after this conference to go visit customers out West. So it's -- I'm still obviously out and about. We're working with customers. But I've got a great team around. [ Bob ] coming in. He's done a fantastic job in putting good talent in around him. I've got the level of talent that I really want now in the organization. So part of that responsibility of being out in front of customers has been shifted for sure. Although the travel is still there for me, and that touch point is really important to me, the intensity of it is different. I still spend a lot of time on just talent generally in the organization, a lot of time on culture, as you can imagine. I think it's 2 of the most important things you're going to focus on beyond mission. And then a lot of it is portfolio management. I mean that is really strategy. Portfolio management is where we're spending the bulk of our time right now. So again, to look at what we should look like as an organization over the next 5 years relative to mix in that portfolio, how much of our business is in faster growth markets versus what we have today and how we would get there. But that focus on customer talent, culture, that will always be there but a lot of it has now shifted more to strategy and active portfolio management.

Excellent. Thank you. Appreciate the color. Bryan Suky, Keri, thank you so very much for being here with us today. We really appreciate it. and look forward to seeing you soon.

Thank you, Rick.

Thanks so much, Rick. Bye-bye now.

Bye.