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

All right. Thanks, everyone, for joining us today for another session. So I'm Drew Ranieri, one of the medical device analysts here. And it's my pleasure to have Suky Upadhyay and Ivan Tornos with us here, CFO and CEO of Zimmer Biomet, and Keri somewhere in the crowd here. But before we jump in, the important disclosure. So Morgan Stanley research disclosure website for any important disclosures and if you need to reach out to a salesperson. So Suky and -- thanks for being here today.

And maybe just to start, I don't think it's going to be a surprise that we'll hit on kind of the macro. And you've heard commentary out of the past week, 1.5 weeks across med tech that things are stable, if not improving. But maybe let's hear kind of Zimmer Biomet's view on inflation, on the macro, on supply chain.

Yes. Sure. So first of all, thanks, Drew. It's great to be here. I think this is our first conference since the early part of 2020, so it's good to be live again with people. So the first thing I'd start with is, we've had a really good first half of the year. And I would say, a very promising first half of the year, underpinned by faster-than-expected recovery, advancing pipeline, great product launches and really strong execution across the board. And that's given us the confidence to raise our outlook now, the second time on the second quarter, despite a lot of macro headwinds that I know many of you are already in tune with. So we're cautiously optimistic about where things are headed. There are, of course, things that we got to continue to watch relative to procedure volumes, cancellation, inflationary pressures, et cetera. You know the drill. But by and large, we're cautiously optimistic about where things are headed. And the great thing is now that we're seeing the COVID cloud start to separate, you're beginning to see the underlying execution of the business start to come through. And I would say, that execution has always been there for the last 2 years, it's just been masked. And so we're excited, if nothing else, most about that -- about seeing that execution actually play through.

Got it. And maybe just on the procedure volume side, I mean, there's been kind of commentary that you saw -- some companies have seen a step down in July and August. But to the extent that you can provide, like how are you kind of seeing that flow? And maybe remind us kind of what the expectations are for the back half of the year.

Yes. So when we updated our guidance and lifted our guidance on the second quarter call, we noted that while we were seeing stronger-than-expected recovery, that led to the very strong second quarter beat. And we were seeing some moderation in elective procedures, primarily driven by cancellation in June and then into July, the beginning of the third quarter. The good thing underlying that is we're actually seeing procedures get scheduled. Procedures are coming back, which also suggests that maybe we're starting to see some moderation and stabilization in staffing levels and staffing challenges. What we're seeing, however, through June and July was that, basically, episodic cancellations. So either the staff was getting tested positive for COVID or the patient tested positive for COVID. And therefore, you'd see these episodic cancellations. The good thing, though, coming out of that is you'd see those procedures getting rescheduled very quickly, right? So it wasn't about hospital capacity or beds, it wasn't necessarily as much or a growing concern around staffing challenges, it was really about that testing and some cancel -- near-term episodic cancellations around that. And so what we've seen in August, so far, is actually things have improved since June and July. So that's a really encouraging sign of where we're headed. And again, so those cancellations are starting to moderate back down, which is a great sign. But we also want to be cautiously optimistic. Look, we're going to continue to remain humble in the backdrop of a lot of dynamics and challenges out there. And September is our biggest month in the quarter. We've got a lot of people returning back to office, back-to-school, et cetera. So we just want to see how things unfold in September, but we're encouraged with what we've seen so far in August.

Got it. And just with August, I mean, is this large joint, is this that? I mean, is this kind of a broad-based improvement? Or is there kind of one geography, one product line that might be more of a beneficiary than other?

It's a great question. I'd say it's broad-based. We're seeing it disproportionately in our recon business, so knee and hip. And in the areas where we're really focused in SET, we're also seeing some optimism there. And then regionally, in Europe, for sure; in EMEA, for sure; China is still a little tentative with some lockdowns; but broadly based in Asia Pacific beyond China, where we're also seeing some pretty good momentum.

Got it. So improvement in procedures. So let's maybe take a look at capital for a second. And I know you don't have like a lot of capital exposure, but kind of our channel checks with hospital executives say that they're still spending. There's maybe an elongated cycle. But how are you kind of seeing that play out into the back half of the year? And there was kind of this dynamic on the second quarter call, where you're seeing more of a shift from capital into leases, into placements for ROSA. Just talk about that and maybe just the overall capital environment that you're seeing.

Sure. The primary driver for us on capital is going to be ROSA. So maybe I'll turn it over to Ivan to [ talk about capital ].

Sure. Absolutely. Drew, so first of all, we're not seeing a massive slowdown when it comes to capital. We saw that Q2 was better than Q1 from a sequential standpoint, worse than last year, and the negative percentage in the Other category, but we're not seeing a massive slowdown. We actually prefer to place capital, to place on ROSA for the strategic and financial reasons. Why did we sell so much capital last year? We had, let's say, a need to get some capital there. There was a willingness to buy, and we took advantage of that. But in a regular quarter, we actually do prefer to place. We offered every option, and we're not seeing a slowdown.

Yes. I'd say the momentum for robotics continues to be very strong. And the beauty of our launch from the beginning has been optionality for the customers between a straight-out buy or some type of lease. So I think that flexibility will continue to help provide strong fulfillment of demand for ROSA.

Right. And with the demand you're seeing in ROSA, is this really kind of across the board at institutions, at ASCs, existing customers? Or are you really seeing kind of competitive conversions and maybe it might be a good time to kind of talk about kind of the digital ecosystem that you're continuing to kind of roll out?

I can tell you -- I can talk about that. I'll give you a couple of stats that I think we have discussed openly. So first things first. About 30% to 40% of replacements or sales are going to an ASC environment. And I think that makes sense. We do have a time-neutral robot. We have a system that is actually fully integrated with the surgical workflow. We don't require a CT scan, and those are things that are highly attractive when you run an ASC. So 30% to 40% in an ASC environment. I would say between 40% to 50% of our installations, whether it's a sale or replacement, are with what, what we call, gold customers. Those are competitive accounts, and we're gaining some momentum there. Our penetration rates continue to increase. So the last time we reported the penetration rate was in January of '22, and that was around 10%. I won't disclose the number openly here. I don't know who's in the audience, but I'll tell you it's a much higher number than what we disclosed back in January. And as we continue to launch new ROSA indications, you can expect the number is going to continue to go higher and higher. The number of ROSA cases, actually, in Q2, towards the end, was one of the highest we have had, if not the highest, as we launched in March 2019. So very pleased with the development. On your second question on the digital piece, we continue to bring peripheral ancillary products to ROSA, which is one of the key things I want to highlight. We're not a robotic company. We're a data, technology and solutions company. ROSA is one element of CVH. Where we do place a ROSA? We do try to bring the data software around ROSA, called that mymobility, called that the launch of predictive analytics, called that smart implants. So there's many other elements that are part of the ecosystem. So it's not just a robotic placement that we're putting in place.

And I think that's an important differentiation because there are a number of companies already that have robotic applications and probably more to come out. But what differentiates ROSA and what differentiates Zimmer Biomet, we believe, is that, that ecosystem of the ability to collect data pre, intra and postoperatively to help improve predictability of outcomes as well as make the health care environment more efficient. So it's not just a robot, it's -- as Ivan said. We think it's the surround system, surround sound that really sets us apart.

Got it. So maybe a question, actually, for both of you. But as you're kind of thinking about the digital ecosystem and really innovation cycle within orthopedics and within Zimmer Biomet, I mean, what does this actually do for the growth rate of orthopedics as you're moving into digital connected assets, robotics, smart implants? How should we kind of think about that over the next couple of years? And sorry, one other thing. And like what would that potentially do maybe for the pricing discussion? Is there a potential that you actually get to neutral pricing at some stage in ortho or so?

Yes. So the short answer to number 1 is that it's going to be an all-boats-rise type of situation. We're going to increase the market growth rates. So as you increase the revenue per procedure, if you increase what we call the share of wallet, and you upgrade a case where you're including robotics and you carry a higher disposable revenue, or you bring your cementless platform or you bring this data and technology we're talking about, that's going to elevate the revenue per procedure. Competitors are doing similar things. That increases the weighted average market growth rate. And then we see in the different categories, there are spaces that are growing faster. So I think the short answer to your first question is, I do think that the historical growth rate of 2% to 3% is going to get higher. And then some subcomponents of the market are going to get even into the upper single digits. So it's a good situation. In terms of your second question, we're not going to stop innovating in the metal and plastic, let's call it, implant side of things. We are the largest recon company globally. We do a lot of knees and hips every single week. We're going to continue to bring awesome offerings in that space. But I think the fact that -- as Suky mentioned, the fact that we had the integration of the intra with the rest of the ecosystem is a competitive advantage.

Got it. And maybe just on ROSA, you talked about indication expansion or new technology coming. It's like kind of what does that road map look like over the next 6, 12 months? And how are you thinking about that?

Sure. I think Keri will shoot me if I give specifics, although I'm tempted to give a lot of specifics here. But I would say, we have probably the broadest set of indications coming to market. We already have a ROSA Hip market. We got ROSA Knee. We got ONE Brain offering. We recently got 510(k) FDA approval for the first-ever Mixed Reality platform that incorporates the Microsoft exclusive technology with ROSA to speed up cases. So that's already public. We got 4 to 5 indications coming period here over the life of the strat plan. So what we believe is a great advantage of ROSA is that the same platform that is CT scanless is highly scalable. You can do things like revision cases. You can get into all kinds of areas. And the feedback has been very positive in terms of the opportunity there.

Got it. And kind of those, we're talking to orthopedic surgeons, one thing that has kind of come up is kind of just vendor consolidation as a potential offset for some of the inflationary pricing. So I mean, are you seeing stepped-up vendor consolidation? And maybe it's not against some of your larger competitors, but are you able to kind of take out some of the small, like, 1%, 2% market share players in the hospital?

Yes. Well, maybe I can touch on that briefly. And Suky, if you have any other comments on pricing, go for it. But I've not seen vendor consolidation. So for years, I've been doing medtech around the world for 20 years, that's been the topic. That where you have 5, 6 companies, there'll be 1 or 2. It wouldn't be a bad situation for us. We have the #1 market share in hips and knees globally. Here in the U.S., we are probably in the top contracts in all key institutions around the U.S. So if tomorrow, this becomes an environment of 2 players, it's highly unlikely that Zimmer Biomet is going to get kicked out of an account, given the portfolio and given the surgeon role in making decisions. So I don't see that happening. If it were to happen, frankly, it will be a good situation for us. And then on pricing, do you want to talk about that?

Yes. So just building on what Ivan said, I think there is a barrier to entry for many of these smaller companies when you think about the data and technology revolution that's happening in orthopedics, whether it's robotics or AI, et cetera. It takes size and scale to be able to invest against that and effectively create new markets and to create new products there. And that -- I think that also brings an opportunity for an improved pricing environment, where, at least, a mix shift to better price, better margin products as we move forward. So yes, on that side, we think that the overall ability to bring value to the marketplace is going to, one, drive improved share, but also potentially better pricing environment.

And maybe I didn't answer earlier your second question, you mentioned pricing. Our pricing dynamics today, after launching data and technology solutions, are better than 2, 3 years ago. So definitely, we've seen a correlation between innovation, increasing our vitality index, percentage of sales coming from new products and pricing dynamics. So you will think that will be maybe different, but that's not what we're seeing. We've seen much better pricing dynamics here today.

Got it. And maybe just on some of that innovation in orthopedics with like Persona IQ, I mean, it's very early days. You're still in kind of a limited launch mode. I mean, do you have any visibility that you can share on how utilization, how adoption is going now? And maybe kind of what do you need to see to get that green light to go into a full commercial launch?

Sure. I think the headline is that Persona IQ, the first smart implant to be launched in orthopedics is in line with expectations. This is a complex device. It's the first time that a company is introducing a sensor that is part of the tibia component of the implant that stays with the patient for life. So out of respect to that, we're taking our time in making sure that we understand the clinical value proposition, gathering as much data as we need to, to make sure that we understand what is truly the value proposition of the device. And we are in the early, I would call it, limited market release of the platform. Again, in line with expectations, we're collecting millions of data points. We believe there are multiple opportunities for us to use the device to track things such as infection, such as loosening, needless to say, basic things around range of motion and whatnot. I would expect that we'll get into a full launch mode at some point in 2023, but that we're taking it one quarter at a time.

Got it. And maybe talk about how the technology can evolve over time, and it's an extension right now. When can we see a smaller profile so you can get a larger portion of the market? And maybe what are some other indications that are potentially down the road, whether it's hip, although you don't have such a high revision rate, what, shoulders, anything else that we should be thinking about?

Sure. Again I won't get into the specifics of the actual launches, but we have a vision of having a smart technology in all of our offerings. So you should expect that Canary Medical, the company we work with, and Zimmer Biomet are going to have not only primary need that is smart with a sensor, we're going to get that cementless knee that has a sensor. We should expect to have a hip that has a sensor getting to sold in other areas. But again, we've taken one step at a time. Let's first prove the value proposition in primary knees and scale up from there. But it is our vision to truly have a smart ecosystem and smart implants across all of our offerings.

Got it. And as you're kind of thinking about digital for a moment, I mean, are you putting more resources behind Persona IQ versus some of the other initiatives? I just -- is Persona IQ really kind of the favorite child to lead the digital ecosystem beyond ROSA?

I don't think we have a favorite child. We love all of our children equally. But what we have disclosed externally is that 70% of our new product development budget is going into data technology and solutions. And again, is not one product. So you have Persona IQ, you have WalkAI, which is the first predictive analytics platform. We got multiple robotic indications, as I alluded. We're doing a lot of good stuff with Microsoft in Mixed Reality. We got an exclusive partnership with Apple in informatics and how we bring data to the entire episode of care. So a lengthy way to answer your question, Drew. Now I want to say that Persona IQ has a disproportionate amount of the budget, but we're making sure that we're funding the right offerings within our smart implants.

And I would say that's being complemented with some very robust and exciting investments into product, such as cementless, new shoulder applications. We've got some very exciting things coming on the horizon in hip in 2023. So it's both a mix of data and technology as well as product enhancement.

That's an important -- thanks for reminding me, that is an important factor. We're not abandoning implants. We obviously make up a lot of revenue, and we help a lot of patients through implants. And the fact that we're launching cementless knees, shoulders and whatnot is an example of that.

Got it. And maybe just on the Persona cementless you're launching or have launched a new form factor, I guess, can you remind us kind of where you are today in cementless mix? And kind of how you're thinking about that evolving over the next 12, 24 months with some of the other initiatives on technology side that will be coming?

Yes, sure. Well, first of all, just small correction. We haven't launched the Persona [ Link ], which is the new device, a new form factor, which is going to be complementary to the one already in place, which is sort of TM, trabecular metal, I can't believe I know how to pronounce that, offering that is in market already. Or penetration we have in the past, giving you guys a number that is in the 12% to 13% range and begin traction. We believe that as we launch Persona Link at some point this year, it's a new anatomic [indiscernible] platform, a different design on the tibia component. I believe -- we believe that, that's going to increase dramatically our penetration rate because it's a totally different type of customers with different techniques than what we are solving today.

And relative to cementless, the bad news is we have low penetration because of our current form factor. The good news is, if you look at some of our competitors, a very high level of penetration of cementless. So that gives us a very long runway that we should be able to capitalize on as the market leader, and that presents a mix shift opportunity for us from a pricing and margin perspective.

Yes.

So it's an exciting product launch for us in the near term.

Yes. And how key of a driver could that be for next year?

Yes. Nothing is going to be substantial. I want to be careful, in case my boss is listening, what comments I may make here, but I think it's going to be substantial. Again, going back to Suky's point, penetration of cementless in the teams, we got nowhere to go but up. As we launch new robotic indications at some point, we get into painless and whatnot, this is only going to drive additional cementless penetration. So we're very excited about where we are and where we're going with cementless.

And Suky, I know you're going to be anxious to answer this question. But just in terms of thinking about 2023, and I know it's still early days and you're putting together a framework, but just maybe help start us kind of on that discussion. What are kind of the big moving pieces that we should be kind of considering next year on both the top line side as well as just the macro environment? And maybe if some of these things are improving, how quickly could they reverse and actually help the P&L next year?

Yes, sure. I think we've actually put a fair bit of color out there already on 2023. If you go back to our second quarter call, one of the things we've talked about was, in a normalized market, top line growth organically of at least 4%, right? And so the key question there is, when do we get to normalized markets relative to COVID? I think the rest of this year is going to show us a lot. And then the second variable we got to watch is supply chain, which continues to be challenging. But as that continues to moderate, if we're able to get into a normalized market in 2023, we've put a kind of a marker out there, which, I think, is a positive proof point. Some of the levers behind that will clearly be the new products that Ivan talked about. Link is going to be a very nice addition for us. Persona IQ, we're looking forward to validating that value proposition and launching that product. We have a host of products within our SET business, especially the 3 areas that we focus, which are CMFT, upper extremities and then sports med. So we're pretty excited about where the top line could go into 2023. Now again, that's in a normalized market. So we -- again, we're going to remain humble through the back end of this year, look at what happens relative to procedural rates with COVID, cancellation rates, supply chain. But barring those things, we think we've got a pretty nice runway for top line growth. And then on the P&L side, we've already talked about despite some gross margin headwinds into next year relative to inflationary pressures this year that capitalize into 2023, we feel we're committed and confident that we can grow operating margins into 2023, albeit at a more modest pace because of those headwinds. But we still feel confident that we grow operating margins, primarily through SG&A efficiency. In some of those areas, we're going to continue to leverage our shared service footprint, which we established over the last 2 years. I would consider those world-class. We are working more aggressively, more assertively on footprint optimization within supply chain. And then I think the third area is we're taking a much more granular look at country profitability and go-to-market model, and I think doing some leading things in orthopedics to drive better efficiency and profitability in many of our markets and product areas. So we feel confident that we can, again, grow margins modestly and have a profile where EPS is growing in leverage relative to the top line.

Can you go into a little bit more detail on like the international profitability side? I feel like that's maybe something newer that you've been kind of discussing.

Yes. I mean we've already had great success with our EMEA, Europe, Middle East and Africa team. They've taken on a number of initiatives on go-to-market, whether it's lower profitability, lower-growth type markets, where we've said, hey, we just -- we can't afford to go to market with the existing infrastructure. And so we've looked at either going to a distributor or taking from a distributor and going direct, looking at pricing differently in those markets, looking at that segmentation of customers in those markets much differently, leveraging across or pan-country. So instead of creating specific infrastructure for each market, rather looking at how do we support maybe 3 or 4 countries through 1 management team. So we think we're still in early innings, and there's upside left to drive more profitability there.

Got it. And then just thinking longer term, I mean, you pulled some of the longer-term guidance earlier this year. We're kind of getting into an endemic phase, procedures are sending positive. The macro is still a little iffy, but stable and improving. I mean, are you getting to a point where you would be more comfortable revisiting those targets and communicating them to kind of what next-gen Zimmer Biomet kind of looks like?

Yes. We're not going to put a target out there. We're committed to growing earnings faster than revenue. The pace of margin expansion inside of that, I think, will depend on what we continue to see relative to inflation, but also, quite frankly, how the portfolio progresses. Because the one thing we don't want to do is under invest against that portfolio and either maturing that or launching those products commercially at the sake of potentially putting a barrier or hurdle against revenue. So I think those are the 2 variables that we're going to watch very closely. But even inside of that, we see a pretty clear path to being able to grow earnings faster than revenue over the near and midterm.

Got it. And on M&A and capital allocation, I think you're around 2.5x levered right now. You have high 30s share in global hip and knee market, but you talked about kind of individual segments might have better growth opportunities. Just how are you kind of thinking about M&A looking ahead? You've been kind of fairly quiet over the past couple of years with the reason there's been some stuff going on in the environment. But just tuck-ins, transformation, portfolio gaps, just help us kind of think through.

Yes. So first off, you're right, we've made significant progress even in the backdrop of the pandemic and strengthened the balance sheet. On a covenant calculation basis, our net debt leverage ratio is somewhere in the mid-2s. When you look at the rating agency calculation, it's somewhere in the low 3s. So we've significantly strengthened the balance sheet, which has created a lot more strategic optionality for us relative to M&A. Now even inside of that, we've done some small tuck-in acquisitions along the way in faster-growth submarkets within ASCs, within sports med, within CMFT. We feel pretty good about what we've already started, but we're really in a position now. As our financial performance is improving, we've paid down a lot of debt to really start to accelerate that Phase III or Chapter 3, as Bryan talks about, which is active portfolio management. The types of things we would look for or filtering criteria, one, is it mission-centric? Number two, does it provide us or offer us an opportunity to be a leader in that particular subsegment? Three, does it increase our WAMGR, right? Is it in a faster growth submarket, which gives us faster revenue growth? And the last one, does it give us an opportunity to accelerate growth on the bottom line? So those are the filtering criteria that we look at for any deal. And I would say that, inside of that, where would we look to go? It's likely would be an adjacency to somewhere where we already have channel or already have scale in infrastructure as opposed to a completely new white space. And likely, from a sizing standpoint, we prefer, at this time, to stay more in that tuck-in type environment. However, having said that, given the optionality we've created with strengthening our balance sheet, we could look at larger-sized deals more opportunistically, but always with an eye towards maintaining investment grade. But one thing you should take away is that, clearly, we're in a different spot than we were over the last 2 years, and our ability to execute M&A to accelerate top and bottom line growth.

Maybe not a fair question, but would you consider moving beyond orthopedics and to MedSurg, just kind of thinking about some of that strategic filters that you're talking about?

Absolutely. If it fits those defining criteria that I had, MedSurg could be an area. There are several other very attractive spaces and opportunities we're looking at as well.

Okay. Unfortunately, I'm going to have to cut it right there.

All right, Drew. Thank you very much.

Appreciate the time.

Thank you, Drew.

Thank you for joining us.

Thanks, everybody.