James Crines – Chief Financial Officer, Executive Vice President – Finance
David Lewis - Morgan Stanley
Zimmer Holdings Inc. (ZMH) Morgan Stanley Global Healthcare Conference September 9, 2013 9:25 AM ET
All right, well let’s go ahead and get started. My name is David Lewis. I direct the medical device franchise here for Morgan Stanley. Throughout the day, you’ll have me talk about my research disclosures. You can go to the fancy Morgan Stanley website and get my research disclosures and see all the things that I own and don’t own. I’m not a very good stock picker – sorry.
But anyway, thanks for joining us here. As I said in our 8:45 presentation, attendance is up. We think we’ll have well over 2,000 attendees this year at the healthcare conference, up at least 15 to 20% by last count, so thank you so much for your attendance and support.
Starting off our inaugural first med tech presentation here at the conference is going to be Zimmer. Those who do not know Zimmer, they are a leading provider of orthopedic and specifically reconstruction - dominant player in hips and knees, as well as other players within the musculoskeletal franchise, including spine, extremities and trauma, things of that nature. It’s my pleasure to have with us here today the Executive Vice President and CFO, Jim Crines; and Jim is not going to make any initial statements – we’re going to go directly into Q&A.
Question and Answer Session
I’d like to make this as interactive as possible. We have a pretty good room here, so please raise them high and I’m happy to call on you. But Jim, I was going to—no softballs here. This is old hat for you, so we’re going to go right into what I think is most important here as you wrap up the year, which is frankly guidance and the numbers.
If we think about what’s happening in the second half of the year – first half of the year, growth rates were slightly below 4%. You’re sort of guiding that they could be maybe higher than 5% exiting the year, so the question is what happened in the first half and what really can accelerate in the second half here. Is it simply comps, extra selling days, or organically what has to happen to get you where you need to be here in the back half of the year.
Well, I would say what’s true about the back half of the year is going to be true for the next several years, and that is we’re going to leverage what is the most robust pipeline f new products that the Company has had at least since I’ve been with the Company, for the last 15 years, and that includes most importantly the launch of an entirely new knee platform – that’s our Persona knee. But on top of that, we also are launching a number of new products across all of our other six product franchises, so we’ve got the Vitamin E polyethylene in hips. We’re launching an Avenir stem, a stem that’s been very popular in Europe and is used with the anterior supine approach, which has gotten to be more and more popular, so it’s kind of a less invasive technique on the hip side. That’s getting launched into the U.S.
In extremities, we have an awful lot going on. That’s one of the fastest-growing sub-segments within orthopedics, as many people know. We just recently closed an acquisition to get access to a line of plates and screws for foot, ankle, hand, wrist, and are going to be able to combine the foot and ankle plates with the total ankle system that incorporates our proven Trabecular metal technology. That was a product that we had cleared at the end of last year and in the process of launching this year.
We’ve got in our surgical products business, the power tools. This is acquisition we did a couple of years ago, a European company, and the launch of that—the power tools outside the U.S. is going extremely well. In the U.S., we’ve had some challenges and while it may take us just a little bit more time to get the product line where it needs to be to go into a full U.S. launch and really take full advantage of that opportunity, we have other recently acquired products within that surgical products business that are driving significant growth. We saw 45% growth in what is a pretty significant franchise for us in the second quarter, and that was all driven from the acquisition of the fluid waste management product. This is a business that we had acquired about a year that was doing somewhere in the order of $8 million to $10 million a year of revenue, and we did more than two times that in the second quarter, so that just demonstrates the kind of opportunity we have to acquire products in categories that fit with our core reconstructive franchise, bring those products—launch those products through our global sales channel, and leverage the existing relationships that we have through that channel.
So how do we avoid—it sounds like it’s more pipeline than it is market. You’re betting on Zimmer, you’re not betting on the market. That’s a fair estimation listening to your comments?
I think that’s fair. I will tell you that as far as the core reconstructive markets go, I think that we see a reasonably healthy market here in the U.S., a somewhat weaker market in Europe but offset when we go outside the U.S. Again, a somewhat weaker market in Europe, but that’s offset by what we see as pretty strong markets in Asia Pacific. So Japan, Australia –the two major markets for us – and our Asia Pacific operating segment, and as well the emerging markets that make up that Asia Pacific operating segment are also pretty healthy.
So how do you avoid—when I hear you talk about the pipeline, there’s a lot going on. How do you avoid the tyranny of success – there is so much going on, certain things do better than others, and when you set your expectations in the back half of the year for the acceleration, do you think that you were appropriately conservative or realistic as you thought about these multiple opportunities? There’s a lot of execution risk across multiple platforms that we haven’t seen, really, in prior years.
Well, we’re learning as we go deeper into these launches – you know, where we’re going to have success, where we have some more work to do. I mentioned for example with the power tool launch in the U.S., not see the kind of success we had anticipated seeing early on, and as a consequence have decided we’re going to make some adjustments to that product line and are going to need to make those adjustments before we can really fully leverage that opportunity in the U.S.
The real key for us is the Persona launch, so that’s an enormous undertaking for us. It’s the largest product development undertaking for the Company in the last 15 years. It’s the first launch of a whole new knee platform for the Company in over 20 years, and we have good visibility at this stage of the year, two quarters into the full launch of the product, of just how things are going with the launch of the new platform. We’re extremely pleased with the feedback we’re getting from surgeons, on the clinical results we’re getting, the early clinical results they’re getting. We’re talking about now thousands of procedures that are being done on a monthly basis. We’ve got over 1,000 sets of instruments that are fully launched now into the U.S. We’ve got a real focus, talked about this, on competitive surgeons and are excited about the opportunity that we’re going to have over the next few years to convert competitive business with that platform.
One of the things that may be not fully appreciated with that platform is we talk about this being the highest fidelity knee system available in the marketplace today, and what we mean by that is if you go back to the NexGen system, which is this is—NexGen is the leading selling knee system, and this is what put Zimmer in the number one share position in knees globally. When that was first launched, if you look at the various components – you know, the knee replacement, the tibia, the articular surface and the femoral component – there were maybe about 100 options available to a surgeon with that system. When we added Gender to NexGen, that probably doubled with the more narrow femurs and articular surfaces and tibia trays – you know, that made it up with those more narrow femurs. That probably doubled the number of options that a surgeon would have available to treat an individual patient.
With Persona, we have over 600 options that are available to the surgeons for them to achieve fit and function. With the articular surfaces alone, you have three different levels of constraint. Our Ultracongruent articular surfaces are crucial at retaining posterior stabilize. You’ve got now the Vitamin E with some really proven new technology. The Vitamin E technology that offers low wear resistance and higher fatigue strength, something you didn’t really get with the highly crosslinked polyethylene to the knee construct. We’ve got Trabecular metal now on all components, another proven technology, proprietary technology to Zimmer, not just on the tibia tray but on the patella and also now on the femur for the first time. That’s a really exciting opportunity for us.
So with 600 options available intra-operatively, obviously, the more significant challenge for us is to drive the kind of penetration we’re going to want to see with PSI, intelligent instruments, digital templating, so we can get the surgeons and the hospitals planning these cases in advance, and that’s what enables us to fully leverage what we refer to as your intelligent kitting. That’s how we can manage the inventory and the instruments investments with that many options available.
Jim, there’s 600 options, a lot of fancy words you just used there; and because of that, people like me got very excited about Persona heading into this year. We got excited about Gel-One, and then we had sort of this—we got very excited at AOS and then at AOS, people went, oh God, it’s not going to be as interesting as we thought. When we think about Persona and Gel-One right now, would you say they are executing in line with where you thought they’d be January 1, ahead, or slightly behind?
I’d say right in line with where we expected to be at this point in time in the year. The only little bit of a surprise at this point for us in terms of where we are relative to our internal plans is that we are getting to spend—we are going to have to spend a little bit more money on instruments than we had planned on coming into the year. That in part has to do with the fact that we’re going to remain very focused on putting sets in hands of competitive surgeons and giving them the opportunity to trial with Persona. What we’re finding is we go after competitive business—it’s a process. You don’t get a competitive surgeon to convert all of their business over to a new platform in a day. It takes months, and with the set of instruments that we’ll park with the competitive surgeon, they may trial it on a few patients. They want follow-up visits, want to go through their follow-up visits, one month, two-month follow-up visits with those patients to see how they are doing before they will begin to schedule more cases. So we end up having somewhat unproductive sets of instruments that are parked with competitive surgeons, and to the extent we want to continue to drive that opportunity hard, we’re having to—as I said, we’re having to spend a bit more money on instruments than we had planned on.
But otherwise in terms of the number of sets, they’ve been able to launch out into the field, and getting those sets into the hands of not just competitive but also high volume Zimmer surgeons that are anxious to get their hands on the new platform, we’re right where we expected to be.
Do you think you’re seeing—if you had to force rank it, is it mix improvements, getting better price mix from existing Zimmer surgeons, or is it really more the competitive surgeons that are driving the growth? Where are you being more successful?
At this stage, it’s more the competitive surgeons, and obviously that’s the bigger opportunity, is between the two. The mix opportunity is there. We launch the system at a price premium that’s somewhere in the order of 5% to 10% above NexGen, if you will, and that opportunity is still there in front of us. We’re getting a little bit of contribution where we are launching sets out into some of the higher volume NexGen users that are converting over to the next platform, but the bigger opportunity clearly is and will continue to be, obviously, getting competitive business.
Is there any question in your mind, looking out a year from now, based on what you’re saying to us and what you’re seeing in ’13 competitive sets, that you are a U.S. niche share gainer as we look into ’14?
Not in my mind; and understand, it’s not only Persona. You’ve seen us more recently announce transactions and also talk on our conference calls about what is a growing platform of products that we refer to as early intervention joint preservation products. That, to us, is a very exciting area, really exciting. Again, if you look at the number of meniscectomies that are done on an annual basis and scope procedures where surgeons are sort of searching for a solution for a younger patient who is maybe not yet a candidate for a total hip or knee replacement, or even a partial knee replacement in particular. So we now have five really platforms for surgeons, to put in surgeons hands for them to deal with their younger patients, and that includes Gel-One – a big market and really nice opportunity for us – but it also includes our DeNovo Natural Tissue, our biologic product that is used to treat cartilage defects We’ve got some work to do to develop the clinical data that’s going to be required to bust through some of the reimbursement challenges we’ve run into with the private payors with the DeNovo NT, but it’s a technology that works, and works extremely well. I’ve talked with the surgeons who have been able to get access to it and use it in their institutions – it’s a great, great technology.
Chondrofix, where you have defects that have a little deeper actually in the bone, so a bone plug, and then you start to work your way into the partial Uni Knee replacements now with the PSI technology. That’s a tremendous sort of platform for us to go to these surgeons that are dealing with these younger patients – as I said, patients that maybe have early stage osteoarthritis and are not yet candidates for total hip or knee replacements.
Questions for Jim?
So previously you’ve obviously had very good pricing over a long period of time, and then recently it stepped down to minus-1, minus-1.5. Is that the equilibrium over the long term, or is this just kind an intermediary stage before a change?
If I can add to that, your pricing in this last quarter was significantly better, I would say, than one of your peers; and the question is maybe shed some light on that. Why would your pricing be better than one of your peers’ pricing in the second quarter?
A couple of things on pricing, and to answer that question I’ll focus first on the U.S. and then come back to this more, what’s the global sort of outlook.
So we’ve been talking over the past couple of years about the effect that hospital consolidation, surgeon employment is having on our individual pricing arrangements that we have across our thousands of hospital accounts. So not surprisingly, as hospitals consolidate and they see that nodes within these large integrated networks are paying different prices for our products, they come to us and tell us, we’ve got to get to a single price point, and it’s unfortunately not the highest price point, the one that’s paying the highest price.
So we’ve been working through what we refer to as price compression with U.S. hospitals and the large integrated networks over the past few years. People have asked me and said, at some point you ought to be able to get through that price, kind of revert to a mean selling price, and that’s a fair point. I would tell you that for the first time, if you look back to last quarter, you did see finally some moderation in that pressure. If you look at U.S. hip and knee pricing, we provide a lot of detail on what’s going on with average selling prices across our product franchises by geography, you would have seen that. So it’s just getting through those negotiations with the large integrated networks, getting to whatever the negotiated capitated price is going to be for those products, and then getting that price locked in, which is what we attempt to do in all those negotiations is get it locked in for an extended period of time. It can be anywhere from one, three, to five years. So that’s a good sign and hopefully we’ll see that continue in the U.S.
With respect to what’s happening with pricing globally, what we would anticipate as we develop our strategic plans and are thinking about the next several years, I think we have to assume that there’s going to continue to be some pressure if you look at the austerity measures that are underway in Europe and the way that’s really pressured those markets, particularly this year. We’re seeing some price erosion in some of the developed markets in Europe. We tend to see, we know, in a big market for us in Asia Pacific and Japan, every two years an adjustment in reimbursement prices. So we would anticipate somewhere in the order of what we saw in the second quarter, maybe somewhere in the order of minus-1 to minus-2% price erosion. I think we have to plan for that. We have to think about how we’re going to offset that. That’s the way we develop our strategic plans. That’s what leads us to develop what we refer to as our innovate and improve, these big restructuring and transformation initiatives that will help us offset the effect of that price erosion on our gross margins and EBIT margins.
So you see to feel good about the revenue and the pipeline and how it’s progressing here in 2013 and into ’14. The other big debate on Zimmer, we feel like we have this conversation every year, is leverage So organic growth went up in the second quarter, gross margin guidance came down, so I think a lot of investors are a little frustrated about where is the leverage. Zimmer is trading at a discount to its peers. If there really was leverage on this 4% or 5% top line, the stock actually would really move; so the question is you’re seeing gross margins tick down, you’ve talked about that in terms of inventories and instruments sets in the marketplace, but you’re also midway through your significant $400 million cost restructuring initiative, so exing out this inventory dynamic, it seems like you are on the precipice of leverage improving. You should be getting to the back half of the restructuring plan. It seems like earnings should accelerate in ’14 and ’15, yet we come into the second quarter and gross margins go the wrong way.
So what happened second quarter, and how do you get earnings acceleration at Zimmer?
Well, I would tell you I get a little frustrated too because we’re working awfully hard to drive—these are not easy, these big programs, these big innovate and improve initiatives, and we still have a lot of work to do, I will admit. The harder work, frankly, is in front of us, especially with respect to manufacturing because of the implications on regulatory and quality systems – you’ve got to approach that very thoughtfully – and because of the fact that you also have to put inventory to the shelf every day. You just don’t go in and kind of reengineer all your manufacturing processes in a single quarter or even a single operating period. It’s going to take some time.
Our go-to-market initiatives where we would look to put some different incentives in place with respect to the sales channels and begin to build out some more specialized sales support for this growing portfolio of products is something as well that has to be done very thoughtfully and somewhat carefully so we don’t create or cause any unwanted turnover in the sales organization. But we’re working very hard to get those changes in place.
We’ve also as part of that—well, along with that go-to-market initiatives, there is a forward logistics initiative that’s not simple, everyday. We have people in over 100 warehouses in the U.S. that are preparing kits for surgeries, and that’s not done in the most efficient way. It’s not something that frankly we ever paid a lot of attention to in terms of how it’s being done. We always paid a lot of attention to the level of service that they were achieving, knowing that you could never afford to miss a surgery, so there’s a lot of inventory—so the way we addressed that was push a lot of inventory out into the field, a lot of instruments, and there are a lot of people. I think there is a more efficient way to do that, and over time we’re going to work with our independent agents to design just a more efficient forward logistics.
But again, I get frustrated because we have made a lot of progress. There are a number of initiatives that we have completed that have delivered on the savings that we committed to, and we saw the leverage last year. We saw significant leverage in the P&L on a top line that I understand--maybe that’s what was frustrating investors last year, on a top line that was flat, we had 100 basis points of operating leverage delivered in the P&L largely through these programs.
I’m not in the least bothered by us, you know, the gross margin ratio stepping down if what’s causing that is the fact that we bought a business last year that was doing $8 million to $10 million a year in revenue, and we did two times that in a single quarter. And it is the case that we’re talking about a product line at this stage where we’re installing the capital piece of that – this is the fluid waste management product, and the capital unfortunately is sold at a gross margin that is less than half our enterprise margin. We need to get to the point where we’re selling the single-use disposables that are used with the capital and the margin on the disposables is above our enterprise margin, so that is going to balance out over time and we’ll get some significant leverage out of that business.
So we’re going to continue to work those initiatives, work them very hard. We’re going to continue making progress on the launch of what is, as I said, an extremely robust pipeline of new products. The pipeline is finally stepping up to where we would hope to be able to sustain it over the long term, and we look forward to delivering on the promise, on producing the kind of results that, as you said, investors would hope to see.
The investments you’re having to make in the new products and the inventories, is that changing your view about when you can get to those targets you laid out for when you can see that leverage three and four and five years out? Is it maybe shifting out more, or do you still believe that ’14 and ’15 should be better leverage years for Zimmer?
Well, I would tell you that if we get a sustained—get to the point where we see sort of sustained 4 to 5 or even better percent top line growth and are driving anywhere from 50 to 100 basis points of leverage in the P&L, we’re going to get to what we’ve kind of aspired to get to in terms of bottom line performance. We continue with our capital allocation program as we’ve currently outlined it, which has us buying—or spending, rather, $500 million a year on stock repurchases, and we’ll get to that 8% to 12% bottom line growth that we’ve talked about as being an aspirational goal for the Company long term.
I think there’s a question in the back.
Hi. Can you talk about the disparity in gross margins between U.S. and non-U.S.? I recall reading an article – I don’t know if it was in the New York Times, journal – it was an expose about a gentleman who went overseas to get a hip or a knee replacement, and he was making the claim it was 50% or 30% or 40% of the cost of doing it in the U.S. The implication was that the products were being sold less expensively in other markets than in the U.S., so I don’t know if you could elaborate in terms of your lowest gross margin market non-U.S., and your U.S. market – how wide is that? Is that 2%? Is that 10%? Is that 15%? Can you quantify the disparities in gross margins in disparate markets around the world?
I would tell you that—well first of all, I would tell you that I think the sell-side analyst community is probably a better resource for information on margins within the med tech community, as opposed to the source that you mentioned. But it is the case that the margins are lower, and they have been—they always have been, frankly. You go back all the way to 2003 when Zimmer acquired CenterPulse, a largely European supplier of hip and knee products with a very significant share position in Europe, and that’s what really transformed the Zimmer enterprise into a global leader. But we knew even back then when we acquired CenterPulse that the gross margins in their international businesses were going to be somewhere between 5 and 10 points below what we see in our highest margin markets, and our highest margin markets being the U.S., Japan, Australia, just to name the three big ones at least.
So that is still the case today. As a consequence, our go-to-market structures are different in those markets outside the U.S., and in many case our EBIT margins are as high or could even be higher. If you get to a market like Germany, as an example, where the healthcare system is just operating in a much more efficient way, unfortunately not something you can easily do here in the U.S. but they force their citizens to travel to these centers of excellence, and you have to go to one of these centers to get a total hip or knee replacement. We don’t have reps in the operating room. We consign the inventory into the hospital and we fill replenishment orders, and it’s highly efficient. We get a high return—you know, the instrument sets that we put into those institutions are highly productive. We see those instrument sets turning at rates that are at least double the kind of turns that we see in the U.S., because in the U.S. we’re carrying instruments in, they’ve got to pick them back up when the surgery is done, and then maybe bring them the next day to a different hospital across town. That’s just not the case in some of these more efficient markets outside the U.S.
I think we have time for a couple more questions. Let them bring the mic over, and let me just get one more out of you, Jim. Cap deployment – you’ve bought back a tremendous amount of stock over the years to support the earnings base. Now the top line is moving, leverage you think is going to start coming back in this year, more ’14, ’15 potentially. Dividend, though – you’re still kind of below your peers on dividend. We talk about this every year, but when is the right appropriate time for you to start to grow your dividend faster than the rate of earnings?
Well, at the earliest it would have to be 2015, because the current share repurchase program we have in place expires at the end of 2014. So at this point, I would tell you that we would expect to again in 2014 be spending about $500 million on share repurchases, but as we start approaching 2015 we’re obviously going to need to have conversations with our board as to what management’s recommendation might be and what their preference might be with respect to how we would potentially look to sort of change the mix in the way that we’re returning some of the free cash flow, or two-thirds of the free cash flow to the shareholders, change in the mix as between the dividend, which is now targeted at about a 15% payout ratio, and the share repurchase program.
Michael, you have a quick one?
Yeah, I have a quick question on 3D printing. In the European context, for instance, we’ve got a company called Arcam in Sweden which makes claims that you can produce hip or knee implants 35% cheaper using 3D printing than the conventional way. Do you believe in that? Have you looked at that? And also when it comes to capital efficiency, do you feel that 3D printing could have a meaningful impact on inventory, especially for just-in-time manufacturing? Thank you.
We do believe there are technologies that could lead to a much more efficient deployment of inventory and instruments, not necessarily 3D printing. We think the PSI technology, the digital templating to the extent that we can drive usage of that technology by surgeons and hospital institutions, we could eventually—the industry could potentially at some point get to a made-to-order model, and that would be transformational. But it is a real challenge in some cases to get the hospitals and the surgeons to embrace that technology, in part because there is some additional cost associated with that technology and in some cases it’s just the time and effort that it takes to use that technology.
We do have some capability internally to use the 3D printing technology, and we’re looking to leverage that mostly around the instruments; and specifically where we would look for ways to kind of simplify the instruments to the point where we could produce a set of instruments at a fraction of the cost of an instrument set today, and frankly we’re going to need to do that as we continue to see the kind of growth we’re seeing in emerging markets. We’re getting business in emerging markets at a lower price point. Those markets pretty consistently grow. Today, they represent less than 10% of our total revenue, but they’re growing pretty consistently in mid-teens in the aggregate. So a lot more—in terms of procedures, because we’re talking about, again, business at a lower price point. It’s a lot of procedures, and it’s procedures that we need to be able to service more efficiently than we can with what is a very expensive set of instruments that are typically used in our developed markets.
Unfortunately with that, we’re out of time. Jim, thanks so much for being here with us this morning.
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