Zimmer Posts Q2 Earnings Beat, Revenues Miss; Guides Low

Zimmer Holdings ZMH reported second-quarter 2014 adjusted earnings per share of $1.49, up 4.2% year over year and a penny ahead of the Zacks Consensus Estimate. After including certain one-time items, the company reported earnings of $1.03 a share, an increase of 15.7% year over year.

Revenue Details

In the second quarter, revenues stood at $1.18 billion, up 1.2% (up 0.9% at constant exchange rate or CER) year over year. However, the top line missed the Zacks Consensus Estimate of $1.20 billion.

Revenues generated in the Americas were $640 million (down 3% year over year at CER). The same in Europe grossed $335 million (up 5% at CER) while in Asia-Pacific the figure was $208 million (up 7%).

Segments

Zimmer's biggest segment – Reconstructive Implant recorded revenues of $890 million, up 2% year over year at CER. This was due to a 7% increase in Asia Pacific and 5% sales growth in Europe. Revenues in Americas remain at $473 million, unchanged year over year.

Revenues derived from Knees (within Reconstructive) were up 3% year over year at CER to $498 million, while Hips recorded flat sales of $341 million compared with the prior-year quarter. Revenues from Extremities increased 5% year over year to $51 million.

Among the other segments at Zimmer, spine recorded a decline of 4% at CER to $52 million whereas trauma increased 6% to $79 million in the reported quarter. Dental and Surgical and other group, both disappointed with decline of 1% and 10% to $61 million and $101 million respectively.

Margins

Zimmer's gross margin contracted 50 basis points (bps) to 71.8% in the second quarter. Selling, general and administrative expenses edged down 0.4% to $455.8 million while research and development expenses were down 12.4% to $48.1 million. As a result, adjusted operating margin expanded 76 bps to 29.2%.

Cash Position

Zimmer exited the quarter with cash and cash equivalents and short-term investments of $1,698.0 million compared with $1,807.6 million as of 2013. Long-term debt increased marginally to $1.69 billion compared with $1.67 billion at the end of 2013.

Year-to-date operating cash flow was $442.9 million compared to $370.2 million in the year-ago period. The company also paid $36.9 million dividend and declared dividends of $22.0 per share during the quarter, an increase of 10% year over year.

2014 Outlook Lowered

Zimmer lowered its full-year 2014 revenue guidance to the range of 2.0% and 3.0% at CER from earlier range of 3.0% to 5.0%.The currency movement is expected to lower revenues by 0.5%, which in turn would lead to 1.5% to 2.5% revenue growth on a reported basis (2.5% to 4.5% expected earlier).The current Zacks Consensus Estimate for revenues remains at $4.77 billion.

The company also lowered the upper end of its 2014 adjusted earnings guidance to the range of $6.00 to $6.10 from earlier range of $6.00 to $6.20. This updated guidance takes into consideration expected charges for inventory and manufacturing related expenses, quality and operational excellence initiatives, certain claims, special items and additional expenses related to the impending acquisition of Biomet. The current Zacks Consensus Estimate of $6.12 remains within the guided range.

Biomet Acquisition Update

During the first quarter earnings call, this leading player in musculoskeletal space also disclosed that it has entered into a definitive agreement to acquire Biomet, Inc. – provider of surgical and non-surgical products used primarily by orthopedic surgeons and other musculoskeletal medical specialists, for a transaction value of $13.35 billion.

According to Zimmer, the successful completion of this acquisition, which is expected in the first quarter of 2015, will be beneficial for healthcare investors as the merged entity will successfully advance innovation and help create a more diversified and predictable revenue mix consistent with the comprehensive portfolio.

The company believes this impending acquisition will be perfectly in line with its strategic framework that focuses on growth, operational excellence and prudent capital allocation.

Moreover, Zimmer expects enormous financial benefits from this takeover. According to the company, upon completion, the transaction is expected to be accretive to Zimmer's adjusted earnings per share in double digits in the first year. Moreover, by the third year, the net annual synergies should reach approximately $270 million with roughly $135 million anticipated in the first year itself.

The combined entity will also likely generate operating cash flow of more than 1.5 times Zimmer's stand-alone estimates. Accordingly, with strong cash flow, Zimmer is expected to maintain a stable dividend of 15% to 20% of net income following the closure of the transaction.

Our Take

Zimmer reported a mixed second quarter with a bottom-line beat and a top-line miss. Barring Americas, we are encouraged by the overall sales growth in the other geographies which acted as a major upside for the company.

We believe, with the grand $13.35 billion acquisition of Biomet, Zimmer will be able to create a market leader in the $45 billion musculoskeletal industry thereby improving the merged entity's position in the competitive niche. We are impressed with the company's strong strategic and financial goals which the combined entity expects to reach after closing of the deal.

However, the intense competition in the orthopedic market and pricing pressure remain areas of concern. Besides, macroeconomic uncertainties, pricing pressure and unfavorable currency adversely impacted sales during the reported quarter.

Currently, Zimmer carries a Zacks Rank #3 (Hold). Some of the better-placed medical products stocks are Alere Inc. ALR, CareFusion Corporation CFN and Mead Johnson Nutrition Company MJN, all carrying a Zacks Rank #2 (Buy).