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

All right. Thank you, everyone, in the audience for joining. I'm Jamie Perse, the healthcare provider analyst here at Goldman Sachs, and I've covered Zimmer for many years. Thank you for both of you for joining. We have Bryan Hanson, the CEO; and Suky Upadhyay, the CFO from Zimmer Biomet. Thank you.

Sure. Absolutely. Happy to [indiscernible] for you.

Well, with this conference, we try to start a little bit high level and we'll certainly get to some Zimmer-specific questions. But big picture, what do you think about for the next 5 years in terms of trends that you need to capitalize on as a company that also might shape medtech over the next 5 years?

It is more high level, isn't it, that question? So I would say that...

We'll give more detail.

Yes. Okay. So I'm going to be a little biased to where we play as a company because there's a lot happening in medtech across the board. But I would say probably 2 things stand out for me that we're seeing happen. Number one, we're seeing technology adoption at probably a faster rate than what I would have expected in orthopedics, and I think broadly in medtech. And to me, that's really important because as robotics comes in, data and informatics comes in, use of artificial intelligence, even augmented reality, which is new, but entering the space. It really changes the way that we care for patients. And I think we'll change the face of medtech over time. It is already. So that's one. That's a pretty big one, I think. And then the second, I would say, is just a change in setting, at least in orthopedics to migrate towards the ASC, which is a more dedicated space to the procedure that you need to have. And I think a lot of patients feel like it's more efficient and probably a little safer, perceived or real because you don't have sick people there, you have people going in to get the procedure they need, you don't have COVID patients or others. So those are 2 pretty big changes. And maybe what's underappreciated about those things are that they both can impact the growth rate of the market. So first of all, if you look at technology, it could be 2 ways. The first one is that you've got now the same procedures bringing in technology that actually matters that can actually increase the amount of revenue you get per procedure. So if you get no more volume in procedures, but you get more revenue per procedure, you can actually have the dollar market grow faster. And I think as we continue to see adoption of technology, you're going to see that happen. The other thing that can do there is you've got a lot of patients still that are not coming into the funnel because they're concerned about the procedure. They don't think they're going to get the outcome that they want. And as technology gets better, as we bring more technology in that people can see and feel, I think you'll have more people feel comfortable with the procedure, come in and enter the funnel, and you'll see an expansion procedurally as well. And I think the ASC could do the same thing. I think people feel more comfortable not going to the hospital and going to the ASC. So you could actually expand the market just because you've got a setting that is more comfortable for the patient.

Well, technology and data analytics, robotics and setting of [indiscernible] surprising answers. We'll touch on all of those today. Second big picture question, and then we'll get to some more detail. We're moving to the endemic phase, hopefully, of COVID. What are some of the lasting changes you think will impact health care -- the health care system over the next few years?

I'd say the ASC setting is -- will cross over there, too. I think that it was happening anyway, but COVID definitely created a catalyst to move it further because, again, people were concerned about going into a hospital setting where people are sick. Because you're getting a knee procedure, you're going to actually sick, you have arthritis and you just got to get a procedure done. And so I think that, that setting will continue. It's more efficient, it's lower cost overall, and I do believe people would rather go to an ASC than a hospital. The other one I think would just be comfort with telemedicine and care that's remote. That's a pretty big shift that I think was occurring anyway. But man, the catalyst associated with how people are digesting that now because of COVID is pretty significant. And it really helped us because we are already spending money in things like mymobility, smart implants, robotics and OrthoIntel to be able to make sense out of that and be able to have surgeons and care teams to be able to manage their patients remotely. And we believe that we're going to benefit from the fact that people feel more comfortable with that now.

Hoping to move to a procedure recovery update. You guys made some comments during the quarter that you were on track with how you had talked about trends in the third quarter. What are you see now just in terms of procedure trends? We've obviously got COVID and flu as factors here late in December. Are those impacting cancellation rates and things like that? Just any comments you can make on the procedure environment and maybe we'll start with the U.S.

See when you asked a tougher question, he looked at you. I'll rewind a little bit and go back to 2022, we came out of the third quarter. It was choppy, but we started to begin to see some recovery towards the back end of the third quarter. We said that, that would -- we expected that to be somewhat stable into the fourth quarter. And that's what we saw, fortunately. As we move into 2023, it's still very early days, but we've always characterized when we talked about all the color we provided for 2023 that we did not expect it to be a normal environment, especially in the early days. I think we're still dealing with staffing issues, which are in some areas, a modest headwind on procedure volume uptake. We're still dealing with some supply chain challenges, foreign currency, while you're seeing some moderation of the dollar, it's still a year-over-year headwind for the company and then inflation, right? So those variables are still very much in place in 2023, maybe not at the same level that we saw in '22 but still definitely there. And so we've always said that we would expect from a procedural volume standpoint to translate into, let's call it, we'd be disappointed if we didn't see a 4% type of ex-FX organic growth rate for the company in a normalized market. Now as I just described, 2023 will not be normal for all the reasons I just mentioned, and that shouldn't come as a surprise to anyone. However, given the optimism we have around the portfolio and the pipeline, our execution, the potential for some backlog relief over time, we do think that we can maintain a 4 handle within our guidance range for 2023. Again, organic ex-FX. So we still feel very confident about that. So overall, things are sort of playing out with how we talked about the end of 2022 and the color that we provided for '23 so far.

Okay. I'll come back to some of the financial questions, let's stick with patient volumes for a moment. You mentioned some of the factors, hospital capacity, maybe some manufacturing in pockets and being able to supply at patient behavior, maybe excess mortality. Some of these factors that have inhibited this recapture backlog or even getting back to normal in some categories. Which of those factors do you think is most important in improving in '23 where you have high probability that we'll see some improvement and start to get back towards normal?

I'll give my view. So in my view, I would love to see supply constraints get out of the way because they put a drag on the organization in a couple of different ways. Number one, you've got sales reps that are supposed to be selling. That's what they're supposed to be spending their time doing are actually playing logistics partners now trying to make sure that they get what they need for the procedure that the doctor is going to be taken care of, that the hospitals got what they need and that's absorbing time that could be used to go convert another account. So that's one challenge that I really like to get out of the way. The other part of that equation is they're also in a position now because of the technology we have, probably ready to convert surgeons they've been working on for a year plus and they're tentative to do it. They're not saying it, but I know they are because I've been in their shoes. So if you've been working for a year to get somebody to convert, they're finding really to do it, and you think you've got a risk in not being able to supply, you're probably not going to convert them in that moment. So I'm guessing we're missing conversions that could happen because of supply constraints. And so it's putting pressure on our revenue growth. So for me, I would like that one to subside more quickly. To me, it's the most important variable as we go into 2023. And that's only because COVID seems to be abating. If it was -- COVID was still in the same place, it was eating up ICU beds, that would be my #1, my #1 right now is probably more from a revenue growth standpoint is probably more around supply.

Okay. And I think the quick second to that would be some staffing storages, which are still impacting pockets of our markets and our accounts and why that becomes important not only to get to normalization of market growth. But then when you can finally start to get some stability in staffing, you then now have an opportunity to get after that backlog in a more meaningful way. So I think that takes a very quick second to supply chain.

Yes, that totally makes sense conceptually. Are you seeing it in real time? The hospital staffing situation getting better? What are your hospital customers telling you about their ability to do procedures because of that bottleneck?

I'd probably say it's more stabilization. I don't know if it's getting any better. I mean maybe the reasons why staffing might be shifting a bit, again, before it was eating up capacity of staffing because ICU beds were filling up with COVID patients. And then it's become more just a natural capacity -- lack of capacity and staffing that is still there. And now it's staff members getting sick, either the flu or COVID and not being able to come in to do procedures. The benefit that we have right now, though, because you're not filling up those ICU beds and there is a runway. If a procedure gets canceled because the patient or the staff member has COVID or the flu, it almost immediately gets rescheduled. So that wasn't happening before. So as much as it's a headwind for us now, the dynamics of that headwind are different than they used to be during COVID. The True COVID.

Okay. I want to touch on patient behavior a little bit too. We get asked all the time, why are things not back to normal or the backlog recapture opportunity not coming through. And I always -- that's one of the factors -- I'm curious how you think about that. If something has changed there, patients really just not coming in the funnel in the same way they did pre-COVID. Do you have any thoughts on patient behavior as a factor?

I don't think so, so much now. I mean I'm going to take kind of maybe China out of the equation right now because there's a lot of stuff going on there. But if you just take that out and look at the rest of the world, I think there was a period of time where people were afraid to come in because of COVID. And so even if the hospital or the provider was saying, "Hey, you can come and get your procedure," I think people did not want to go in. They didn't want to risk getting sick. And so I think that was definitely impacting people's decision on whether they got a procedure or waited or they went to an ASC versus a hospital. I don't think that's the case now, though. I really don't believe that there's been any fundamental shift in whether a patient would or would not come in to get a procedure. I think some of the same barriers exist today that they did before. I don't think that we've added any new, particularly now that COVID getting behind us.

Okay. Okay. Perfect. Let's move internationally, you mentioned China, we're seeing the significant infection wave happening there and in the context of their reopening. What are you seeing in China in terms of the procedure environment and -- and how quickly are you thinking about that getting back to something more stable?

It's interesting because we spent a lot of time in China over the years and I haven't been in China in 3 years. It's hard to believe it's by longest in decades. And it's -- so we're getting at arm's length as we get the information. But it's -- as one would expect, it's disruptive. It started off with the [ draconian ] policies of Zero COVID and just not people not being able to leave their houses, and that was impacting procedures for sure. And then when they opened everything up so dramatically, then everybody started getting sick, and you did see a run in ICU beds. And as a result of that, you saw some pressure on procedures. So when I think about commercially in China, the fourth quarter has been a challenge for us. The good news, bad news, however you want to look at it. It's a much smaller business for us now than it was before. And that was kind of built into not that specific thing, but we had enough play in our expectations for Q4 and our guidance for Q4 that we were able to digest it. But it's a challenging market. On the other side of the equation, we manufacture in China for the globe. It's a relatively small footprint, but it still supports the globe. And we have to bring products in to be able to support the local market. We've been able to keep those factories running. So we're definitely seeing people that work in the factories getting sick and having to not come into the office, come into work. But we've been able to continue to run the factories. We haven't had any supply challenges and we've been able to get stuff in and out of the country. So commercially speaking, it's been disruptive, but from a manufacturing standpoint, it's been pretty smooth.

From a procedure volume standpoint, where do you think you guys are at in terms of percent of normal for China? Any similar kind of way to describe where we're at today?

I don't have -- I don't know I would give you a percent, if I haven't, but I don't have a percentage. I just know that we're off right now. For China pretty materially, but for the company, it's not overly material. But China is off for sure. And it's been more in the last 6 weeks or so.

Okay. And EMEA, just any comments on procedure environment in Europe and other key markets for you.

Kind of what Suky was saying is it's steady as she goes right now. I mean we're definitely seeing more flare-ups of either flu or COVID, but we're not seeing a run on the ICUs. You're seeing cancellations maybe going up slightly because of those people actually have the flu or COVID. But so far, so good. The recovery continues to stay on track.

Okay. Sounds like good news on several fronts and wait to see on China. Let's move to some of the macro pressures mentioned a few of them, but I want to go a little deeper. First, inflation, maybe just as context, you Suky, how much incremental cost is in the P&L over the last 2 years or so from these inflationary pressures that you guys have absorbed?

Yes. We've characterized '22 probably -- if you think about extraordinary inflationary pressure, right. Every year, you've got merit increase. You've got some CPI increases in some of your contracts from suppliers, et cetera. But if you kind of put that off to the side, extraordinary increase in 2022 was somewhere between 100 to 200 basis points, either in COGS or in SG&A. And what we said is, as part of COGS, we also saw pressure that would get capitalized into inventory and not actually see itself into the P&L until '23. We originally sized that at about 50 to 100 basis points back in the middle of 2022. As we went through the third quarter and the fourth quarter, we actually revised that up to the upper end of that, so we think that there's about 100 basis points of pressure in gross margin year-over-year '22 versus '23. The good thing is that it remains stable. It's not gotten worse, but we've not seen any meaningful improvement in that. The one bright spot is I'm very excited about and impressed with what our supply chain and commercial teams are doing to help offset some of that. But there's definitely a -- that 100 basis point headwind that we talked about last year is flowing into this year.

The last point is where I wanted to go next. I mean every year medtech companies, yourself included, tried to take out costs from manufacturing or run the business more efficiently in the context of a market that tends to lose a little bit of price every year. So you kind of have to fight that battle over a year. How do you do that in an inflationary environment? And you've started going in that direction. I'd love to hear more on that.

Yes. We really look up and ultimately where you're getting at is how do you maintain earnings power, right, better than growth of earnings faster than revenue is how we think about it. And we really think about all the levers throughout the P&L. And first and foremost is a strong top line really does solve a lot of issues. And so we want to make sure we're continuing to invest against our top priorities from a growth perspective. And so that is a sacred cow. We make sure that we continue to invest against our growth drivers. Beyond that, pricing has -- is going to be -- there's going to be erosion year-over-year, but we're trying to minimize that. And we've done a really nice job in '22 in getting to a lower pricing erosion than what we've historically seen. And we'd expect to see in 2023 being towards the lower end of that historic pricing erosion. So we've made some structural changes around pricing that I think is going to stick and be durable and help with margin. And then beyond that, within cost of goods, you've got a number of levers, things like site optimization, making sure we're downsizing inefficient plants that are in high-cost country, moving those lines to more efficient plants with a lower cost base. We're looking at things like just general Six Sigma and Lean out costing from a manufacturing standpoint. We're looking at product rationalization to simplify the portfolio which ultimately then reduce costs over time. And then further into SG&A, there are a number of opportunities and levers, things like our Global Business Services, which we established during the pandemic. We can do a lot more to leverage those, which are putting back office-type activities and transactions into lower-cost countries. So there's a number of levers that we look at. Generally, when you see inflationary pressure, the first protocol is sourcing, right? You try to get procurement savings either through -- going through different suppliers or renegotiating contracts. That's probably less of an opportunity right now. And so we're really focused on those other levers I talked about.

Given all the challenges of manufacturing in the last year or so, how do you think you as a company will evolve your manufacturing footprint longer term? Or even medtech, if you have thoughts, do you see more regionalization or domestication of manufacturing? Just curious longer term, how you're thinking about that? And does that impact cost structures at all?

I'll maybe just [indiscernible]. We always look at -- every year, we do a new [ strapline ]. We look at the footprint strategy that we have, manufacturing strategy that we have. And just kind of stress test, do we have the right footprint in the right places and we look at things like continuity of the supply chain, is there a risk or benefit and any change we might make, the cost of manufacturing, whether it goes up or down depending on those decisions, geopolitical risk and any other risk you might have. And right now, when you look at all those variables and the decisions that we would typically make, the geopolitical risk factor is probably one we're paying more attention to than we have in the past for very good reasons. And we're spending time now with an external party to look at those geopolitical risks, get a better sense for those and see if that augments our plan. The fact is if we make a change in our strategy, which we typically do at least some every year, it would take time to do. I mean it will be a thoughtful process. We'll make the decision, we'll put a 5- to 10-year plan in place and begin to move in that direction. But there's no question that I think anybody right now, medtech or otherwise, has to be looking at the geopolitical risk and maybe augmenting the way they manufacture as a result of it. No major changes from us have been made at this point. But certainly, it's a variable that's -- that we're paying more attention to.

Okay. More short term on the manufacturing piece. Are you seeing more consistency in your ability to get products where they need to go, when they need to be there, just your supply chain generally? Is that continuing to get to a place that's easier to manage for you?

It's pretty tough right now, still. I would say, again, that's my primary thing that I like to see recovery. I think we're doing a good job given the circumstances. We have a team that unfortunately or fortunately, has been battle-tested back in the days when we couldn't get supply out the door, and we've managed through that across the board, not just in manufacturing and logistics, but also in the field sales organization and how we manage a situation like this. So we have that muscle memory that we're leveraging. But it's tough right now and the supply challenges are tough, they're real and they're not getting worse, but they're not getting better.

So I guess, what needs to change there? Is it all external? And what are you waiting for from an external perspective and not waiting for it, but what needs to happen for that to improve? What can you do internally to cope with this type of environment?

Probably one of the big variables is just hiring people. It's been a real challenge to hire people in our manufacturing facilities. We kind of hit -- this is a perfect storm. We had come off of COVID for so many years, not seeing that full recovery, and then it just almost feel like it may not happen for a while. And so you weren't really prepared for the quick turnaround in COVID recovery. So right at the time that all the volumes started coming back in, which is bigger than our expectation, we also had all the supply challenges from a raw material standpoint. And in concert with that, you couldn't hire anybody because there was almost no unemployment. That's still a problem. It's getting better but it is still hard to hire the labor force. And we've been doing some pretty creative things to be able to try to move past that, but it's still a challenge to hire at the rate that we want to. And the other part is just getting the raw materials. I mean you still have trouble getting tieback for just basic packaging and this is a thing that pretty much everybody in health care uses because of ETO sterilization. ETO sterilization has met capacity because, again, the rebound has been significant. It's a fixed amount of capacity and everybody is rushing in to try to get their items sterilized and it's just taking more time than usual. So there's a lot of external factors that have to get in line, not just internal factors.

Okay. A couple more macro variables I just want to touch on. Currency, seems to have gotten a little bit better since the 3Q update. Resin and oil seem to have gotten a little bit better. Freight costs seem to continue to come down. It seems like a lot of these things are moving in the right direction. How would you frame the magnitude of the improvement maybe relative to the comments you generally gave about 2023?

Yes. I think things haven't gotten worse, which is great. On the FX side, we did see some moderation of the dollar towards the back end of the fourth quarter. It's not going to have a meaningful impact in 4Q, but it should provide some modest tailwind into 2023. However, there's still going to be significant pressure or erosion from FX year-over-year. On the supply chain side, so I think you mentioned freight. There was one other one, sorry.

Resin, oil.

Correct. Yes. So resin oil currency, we could potentially -- hopefully, we do see a moderation in supply chain costs or input costs. The thing you have to remember is we got into contracts back in 2022 when there was a lot of uncertainty around the supply chain, especially with the Russia-Ukraine war, COVID continuing to persist. And so we locked in a lot of our supply contracts at that time to make sure that we could meet demand. That was our primary objective. And so with that, you're signing multiyear contracts 2, 3 years, let's say, on some of the supply materials. So as those prices come down, we may not see a direct dollar-for-dollar reduction in our input costs because of those contracts being signed. You should see some, but it won't be dollar-for-dollar. So hopefully, if those prices continue to come down, you could potentially see some tailwind against supply costs in 2023. But again, as you see those, just like it happened in '22, that relief may not manifest itself into the P&L to 2024 because of that capitalization cycle, okay? And then on the freight side, we are seeing some moderation to reduction in the per unit cost of freight but still, our freight volume is much higher than it normally would be because of all of the supply chain disruptions. It just requires you to move a lot more product from location to location just to make sure that you can meet demand. So overall, I would say things are stable. Hopefully, these are all pointing into favorable type tailwinds into 2023. We'll provide a lot more color on that when we give guidance later in the first quarter.