Stryker Corp Q3 FY2020 Earnings Call

Welcome to the Third Quarter 2020 Stryker Earnings Call. My name is Karen, and I'll be your Operator for today's call. At this time, all participants are in a listen-only mode. Following the conference, we will conduct a question-and-answer session. This conference call is being recorded for replay purposes. Before we begin, I would like to remind you that the discussions during this conference call will include forward-looking statements. Factors that could cause actual results to differ materially are discussed in the company's most recent filings with the SEC. Also, the discussions will include certain non-GAAP financial measures. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release that is an exhibit to Stryker's current report on Form 8-K filed today with the SEC. I will now turn the call over to Mr. Kevin Lobo, Chairman and Chief Executive Officer. You may proceed, sir.

Welcome to Stryker's third quarter earnings call. Joining me today are Glenn Boehnlein, Stryker's CFO, and Preston Wells, Vice President of Investor Relations. For today's call, I will provide opening comments, followed by Preston with insights on the recovery trends across our diverse businesses. Glenn will then share additional details regarding our quarterly results before we open the call to Q&A. I'm pleased to report that we returned to growth in Q3, with organic sales growth of 3%. This marks a rapid improvement in our business, driven by a gradual recovery of elective procedures, ongoing demand for our medical capital products, and continued strong performance from Mako. In the quarter, we observed uneven growth globally that correlates with the state of the pandemic, which Preston will address shortly. While we are encouraged by our business's recovery, the environment remains uncertain due to ongoing flare-ups of COVID cases. We achieved significant milestones this quarter, highlighting our commitment to innovation and providing our customers with the necessary technologies to serve their patients. Notably, we celebrated the installation of our 1,000th robotic system for Mako in this quarter. We have seen remarkable success with Mako since launching the total knee application in 2016, and this quarter was consistent with that trend. We continue to be confident in our potential for sustained future success with Mako. Our spine, trauma, and extremities segments have benefitted from several recent product launches, and Wright Medical introduced an exciting new acute care bed. Our neurovascular division also secured new product approvals in key markets, contributing to their double-digit global growth this quarter. We have maintained many policies established at the start of the pandemic, emphasizing the safety of our employees and customers while managing expenditures carefully. Although sales and manufacturing have approached normal levels, our spending remained unusually low due to uncertainty about the pace of recovery. Our adjusted R&D spending was 6.1% of sales, slightly below expectations due to challenges related to COVID and some timing issues, but we do not anticipate any significant delays to new product timelines. The combination of sales growth and reduced spending resulted in adjusted earnings per share of $2.14, reflecting a 12% increase compared to last year. Although some of our spending measures will stay in place, we anticipate some return to hiring and investments to support future growth in Q4. Given the ongoing uncertainty and instability in various markets, we are not providing guidance for Q4 at this time. We experienced positive momentum across numerous businesses in Q3, with a meaningful acceleration in recovery observed in August and September, a trend that has continued into October. We are moving forward with integration efforts related to the Wright Medical transaction and are cooperating with regulators to secure the necessary approvals for this deal, including the previously announced proposed divestiture of our STAR, Total Ankle Replacement product. We expect to finalize the transaction in November. Please note that we will not be taking questions regarding Wright Medical on today's call. Finally, I would like to express my gratitude to our employees for their dedication in serving our customers and finding success during these challenging times. From our sales and service teams on the ground with our customers to our marketing and R&D teams developing innovative solutions, and to our manufacturing teams and office staff ensuring business continuity, we are living our mission statement: together with our customers, we are driven to make healthcare better. Now, I will turn it over to Preston.

Thanks, Kevin. Today, my comments will focus on providing additional thoughts on the current environment and the recovery of select devices and geographies during the third quarter. We've generally seen a V-shaped recovery through the second quarter with the continued momentum and growth in the third quarter, although at a more moderated level of month-over-month improvement. The sales growth and improved performance in the third quarter was driven by three main factors: the continued acceleration of elective procedures, strong demand for many of our large capital products, and the return of our more event-driven businesses like trauma and stroke. Small capital products, including our video cameras and power tools, showed nice improvement for the lack of other products in their recovery. These products generally trail elective procedure volumes by a few months. Despite a resurgence in infection rates globally, we saw sales growth in most developed markets led by strong recovery in the United States, Australia, Germany, and Canada. These markets were operating around pre-COVID levels throughout the quarter. Our China business returned to double-digit growth in the quarter, with procedures returning to more normal levels despite the government taking a more aggressive approach to lockdowns around COVID infection. The UK, India, and parts of our Latin American businesses continue to lag as they work through heightened impacts of the pandemic. Procedural areas that were deferred or soft during the second quarter showed significant improvements in the quarter; our knee, spine, trauma, extremities, and sports medicine businesses all achieved year-over-year growth. This also showed significant improvement in the quarter, reaching prior year levels. Each of these businesses benefited from the acceleration of elective procedures during the quarter that was fueled by the addition of new patients and the recovery of the previously deferred backlog. Surgeons and healthcare providers continue to work through the new and existing backlog by adding incremental procedures to their normal schedules. With the continued variability of the infection rate, we believe that hospitals are better prepared to ensure that these types of elective procedures can still be performed at some level, unlike the dramatic drop that we saw in April. However, the efficiency ratio remains fluid, and procedural impact and recovery will continue to vary across geography. Demand for our large capital products drove strong growth in the quarter, including ongoing high demand for our Mako robotic technology. In the third quarter, we were very pleased with the acceleration of Mako installations both within the U.S. and markets outside the U.S., so we continue to expand our Mako presence. Recently, Brazil approved full use of our Mako robotic technology for both hip and knee procedures. We are also experiencing increased utilization with a growing percentage of hip and knee surgeries being performed with a Mako robot. Within our medical division, we saw strengthen our emergency care business along with continued high demand for our beds and stretchers, demonstrating improved financial stability of our customers aided by government subsidies like the CARES Act, and the resurgence of the positive cash flow driven by the continuation of elective procedures. As a result, our order book remains robust for both Mako and many of our medical practices. The launch of the new acute care bed security is a contributor to that order book and a demonstration of our ongoing commitment to innovation during the pandemic. With our specialized unit, category-leading product portfolio, and innovative technologies, we are well-positioned to continue our above-market Medtech growth. With that, I will now turn the call over to Glenn.

Thanks, Preston. Today, I will focus on our third quarter financial results and the factors that influenced them. We have shared detailed financial results in today’s press release. Our organic sales growth for the quarter was 3.3%, with U.S. growth at 3.5% and international growth at 2.8%. It’s worth noting that this quarter had the same number of selling days as Q3 2019. Pricing for the quarter was down 1.4% compared to the same period last year, while foreign currency had a positive impact of 0.4% on sales. The quarter saw a return to growth as demand for our procedural base products rebounded strongly across most key regions, and demand for large capital equipment, especially Mako and medical beds, remained robust. Our adjusted quarterly EPS was $2.14, reflecting a 12% increase from the previous year. The foreign currency impact on the third quarter EPS added $0.01. The strong EPS growth was primarily due to sales drop-through, a favorable sales mix, disciplined cost management, and better-than-expected gross margin leverage as our manufacturing output returned to more normalized levels. Now, I will provide a brief overview of our segment sales. Orthopedics experienced constant currency and organic growth of 3.8%, including U.S. growth of 7.5%. We observed growth across knees, hips, trauma, extremities, and Mako, which saw a significant 30.2% increase in the quarter. All these products are growing off strong U.S. comparables from Q3 2019. Internationally, orthopedics had an organic decline of 4.7%, reflecting the slower recovery of elective procedures in Europe due to COVID restrictions, slightly offset by positive performance from Mako. Medsurg reported constant currency growth of 2.9% and organic growth of 2.5%, which included 1.4% organic growth in the U.S. Instruments had U.S. organic sales growth of 1.9%, driven by increased demand for our safety-related products, including waste management and smoke evacuation products, with the latter growing at double digits. Endoscopy reported U.S. organic sales growth of 1%, primarily driven by our sports medicine business, which also had double-digit growth, offset by modest declines in our core endoscopy and communications segments. The medical division had U.S. organic growth of 3%, fueled by strong demand in the bed business, which grew in double digits, and our emergency care business, which increased in high single digits, although this was somewhat offset by a decline in our other business. Internationally, Medsurg saw organic sales of 6.7%, reflecting robust demand for medical products and strong performances across nearly all product categories in major regions. Neurotechnology and spine had constant currency growth of 5.5% and organic growth of 4.3%. Our U.S. neurotech business achieved constant currency growth of 3.1%, with organic growth of 1.7% for the quarter, reflecting positive performance in our spine, CMF, and neurovascular divisions, including double-digit growth in ischemic products. Internationally, neurotechnology and spine had organic growth of 9.8%, featuring double-digit growth in hemorrhagic and ischemic products as well as a strong performance in our spine business. Next, I will review our operating metrics for the quarter. Our adjusted gross margin of 65.9% improved by 20 basis points compared to the prior year. Gross margin benefited from higher volume and a favorable business mix, though this was partially offset by pricing pressures and unabsorbed fixed costs. Despite our manufacturing output returning to more normalized levels during the quarter, there were some negative effects associated with idle manufacturing lines at the beginning of the quarter. Adjusted R&D spending was 6.1% of sales. Our adjusted SG&A as a percentage of sales was 31.7%, which represented a 210 basis point improvement over the previous year. This SG&A decrease was positively impacted by cost-saving measures implemented in March, which continued through the third quarter. In summary, our adjusted operating margin was 28% of sales for the quarter. The cost control measures initiated in March were maintained throughout Q3, addressing discretionary spending in areas like hiring, travel, meetings, and outside consulting. As our businesses continue to recover to more normal levels, we expect to see increases in hiring, discretionary spending, and other costs that will facilitate future growth and expansion. Regarding other income and expenses compared to the previous year, we experienced a decline in investment income from deposits and an uptick in interest expenses due to additional outstanding debt. Our third quarter effective tax rate was 16.1%. In terms of cash flow and liquidity, we concluded the third quarter with cash and marketable securities totaling $7.2 billion, which includes $5 billion related to the Wright Medical acquisition. We also produced around $830 million in cash from operations during the quarter, exceeding our internal benchmarks. This solid operating cash flow reflects strong net earnings and a reduction in working capital needs compared to the previous year. The cash conservation measures taken earlier in the year continued through Q3, which involved controlling discretionary spending, cutting planned capital expenditures and project expenditure, focusing on accounts payable opportunities, and slowing M&A activities. As for our guidance for Q4 and the full year, we reaffirmed our earlier decision to withdraw guidance due to ongoing uncertainties. I will now open the call for questions.

Thank you. We will now begin the question-and-answer session. First question comes from Vijay Kumar with Evercore ISI.

Okay, guys. Can you hear me?

Perfect.

We can now.

Congratulations on an impressive report, Kevin. Looking at these numbers, while some peers are experiencing low single-digit declines, your company is seeing a positive trend. Can you explain what factors in the market are contributing to this growth versus Stryker gaining market share? What is driving this trend? Also, are there any new trends worth mentioning? I noticed there was no guidance for Q4, but based on the trends in Q4, do you expect them to be different from what we observed in Q3?

So thanks, Vijay. We're pretty excited about the performance in our business. It's not a one-quarter thing. I think you've seen our joint replacement division, which includes hips, knees and Mako, have been performing well for some time. And that momentum is continuing. I mentioned in my opening remarks that we're pleased with October; it's going well so far in the month. But I really don't want to speculate on November or December, just given all the products that are occurring. Assuming that the market stays fairly stable, we're going to have a good fourth quarter. But that's a big assumption given this is, obviously, a once-in-a-lifetime-type of pandemic, so I don't want to get ahead of myself, but we were feeling good about the business through the month of October.

Got you. Regarding the capital side, you mentioned a strong order book for Mako and significant capital. I know you just launched a new bed, so could you discuss the visibility you have on the capital side of the business? Can you confidently extend this outlook into next year, or will it primarily be limited to Q4? Let's see how the market develops for next year.

Hey, Vijay, it’s Preston. Just to expand on that a little bit, I mean, we do continue to have confidence in our capital business. I think, as I mentioned in my prepared remarks, if you look at our large capital business and demand that we saw on Mako, and then on the medical business in particular, we feel really, really good about that. Small capital, as we talked about in the remarks as well, we expect that to continue to come along in the recovery curve as well. Although it has shown that improvement, it lags a little bit some of the other products in terms of that recovery. And I think overall we feel good about it; we feel good about where orders have come in and feel good about where our customers are in terms of their financial stability at this point in time, certainly compared to where it was a quarter ago, and because of those items, we feel confident in where our capital business is headed. I think all of that is underscored, as Kevin said, by the uncertainty that still remains with regards to debt flare-ups and how the virus continues to kind of move through different regions.

Next question comes from Robbie Marcus with JPMorgan.

Great. Thanks for taking the question. And again, congrats on a much better than expected quarter. Kevin, how should we think about interpreting the comments on a go forward basis in respect to how much of a backlog is worked through? Are there still patients to deferred procedures that still need to get into the queue here? And because it sounds like July was probably the best quarter, in the third quarter, will fourth quarter current trends hold be similar, better, or worse than third quarter here?

Hey, Robbie, it’s Preston. So, I’d say, in general, it's hard to predict exact percentages with regards to how much of a backlog has been worked through versus what are new patients that are coming into that funnel. Based on the feedback that we've got, we know that surgeons are continuing to work through that backlog, and that they're also adding new patients. So, it's definitely a mix of the two. We also know that there are some patients that are still waiting with anxiety to get their procedures done. But all-in-all, clinics and surgeons remain busy, and they're continuing to look to add additional shifts or additional opportunities to add surgery or even a shift to the outpatient setting. Our expectation is that that trend will continue, again, barring any major disruptions from a COVID perspective.

Got it. And maybe just a quick follow-up. Once again, you had another great Mako quarter here even in the tough times of COVID. And I was wondering if you could speak to how willing your hospital systems are to go out still and buy the large capital, considering it seems like your main competitor in robotics has shifted strategy to place a lot more units rather than recognize revenue up front. It appears you're still able to recognize a healthy amount. So just wondering what the environment is like, and if you're seeing them on the competitive side? Thanks.

Yes, look, we continue to feel very bullish about Mako. I think in Q4, unless something bizarre happens in the marketplace, it'll be a record quarter in Q4 because the order book is still very strong, with over 1,000. And we've kind of hit an inflection point. And in robotics, the interest in robotics is increasing every day; teaching hospitals are adopting robotics. And they're feeling the pressure to have robotics as part of their programs. In some cases, they've been holding off a little bit. So for us, the momentum is palpable, it's continuing, it's strong, and it's even starting to pick up in other markets such as Japan and countries in Europe; they did a little bit of a pause in that second quarter. We saw them coming back, frankly, in the third quarter. So, the outlook for Mako continues to be very bullish, and it's really irrespective of competition. This is sort of a market trend that's changing the market shifting. And we really love the offering that we have in this category.

Next question we have is David Lewis with Morgan Stanley.

Questions. Kevin, I wonder if we could just talk maybe 2021, if we can't get the specific numbers, either relative to 2019 baseline or maybe just some top-line qualitative commentary about how you're sort of seeing the top and bottom line for 2021, or specific product launches and innovation pipeline we should be thinking about for 2021. And then I have a quick follow-up.

Yes, David, we're not going to really get into guidance for 2021. We do that in every January and right now, we're planning to provide that in January. I think we've gotten good momentum across a lot of our businesses; you saw the trauma number, we posted a really strong number, they've launched a number of new products and feeling very good about that. And that's frankly before Wright Medical kicks in. So we're really excited about the momentum we're going to see across trauma and extremities next year. Neurovascular would be one point that I'm really excited about. We have the Surpass Evolved next-gen flow-diverting stents approved in the United States, and that had very good growth even though we're still having to go through the pains of posturing, but in the midst of a pandemic, so liberally from a small base, but that's going to pick up steam next year as well; our aspiration offerings with the neurovascular. So, neurovascular are very good as I look through into next year. And of course, Mako will continue its positive trajectory that affects not just the Mako business, but of course, hips and knees. And so those are all going well; instruments continues to be a really strong business for us and smoke evacuation you see is now becoming a standard in many areas called safety push, I think will continue beyond frankly the pandemic. And we've really established a really great stable of products related to safety. So, a lot of tailwinds. I think that will continue on an underlying basis. The big unknown is sort of how this pandemic evolved. It's still going to be with us obviously through the first half of next year in some way, shape, or form. And so that's the big unknown, but a lot of the businesses that we have, we’re feeling good about the momentum and the product cadence in your product, which I've already touched on some of them, we think will position as well for 2021.

Okay. Very, very helpful. And the one business I wanted to highlight was just spine; obviously, that's been the sore point is last several quarters in years, some of your performance frankly was better than some of the emerging mid-cap spine players. Just what you're seeing in spine, have you finally turned the corner from an integration perspective; do you see more traction on sort of rep hiring, but it was a surprisingly strong quarter for you in spine just curious the underlying drivers. Thank you.

We are very pleased with the spine performance. Although integrating K2M was challenging, we believe that most of those difficulties are behind us. We found some relief in the second quarter, allowing us to stabilize our inventory and position. Internationally, the business has been strong from the outset, and we feel that our U.S. operations are also on a better path. The launch of new products, including Niagara, a lateral access product and a Corpectomy Cage, has us focused on product launches again, which is essential for K2M. We are excited that we can now concentrate on launching new products rather than just addressing integration challenges related to our salesforce. The situation has been stable, and we are seeing interest from sales reps wanting to join Stryker in the spine division. We genuinely believe we are witnessing a shift in the spine market, and this quarter has been quite positive for us.

Next question comes from Bob Hopkins with Bank of America.

Hey, thanks, and good afternoon. Just first question I want to ask Kevin about your hip growth in the quarter and then just hit generally, your hip growth in the quarter was India's major below peers. So just wanted to talk about or ask you about dynamics there. But probably more importantly, also want to get your view on your pipeline in hips. And when you've got new launches coming because I think in previous conversations, you’ve talked about some exciting launches potentially in that area?

Yes, Thanks, Bob. We're actually very pleased with our hip performance. We had good growth in hips, and we had a very tough comp from the prior year quarter where we outperformed the market in hip. So, overall, yes, competitors did well in hips; we also did well in hips. As you know, hips are a little less deferrable than knees, which really speaks to the strength we added in knees. But as it relates, the hips were very excited about two aspects of the pipeline. The first is the on Mako; we have a new software upgrade for hips that we launched in the second quarter. Because of the pandemic, we haven't really been able to roll that out fully. It will get fully rolled out probably by the end of Q4. So it's a progressive rollout, but really will have more of an impact next year. And in the second part of the pipeline is a new standard that we have planned sometime in the middle of next year; we'll get more specific around timing maybe in the January call. But that's going to be an exciting span, which has some features that surgeons like in a little bit of a gap in our portfolio. But overall, still pretty good quarter.

Yes, yes. Okay, thank you. And then I also want to ask you a little bit about the potential for durability of growth in the medical division. And I'm not asking about fourth quarter; I'm thinking a little bit more longer-term because there are a lot of moving pieces in that division. Right now, it sounds like Sage might be struggling a little bit, but then OUS strength has been enormous. You're launching a new bed, and then there's the corner underlying bed market; maybe just talk about your thoughts on the durability of the growth outlook for that business in light of all the moving pieces?

Hey, Bob, it’s Preston. I think as I mentioned specifically on the capital side, we feel very confident where we're heading in terms of durability on that business, particularly as we think about things like beds and stretchers, with the launch of the new bed adding to that portfolio, very, very excited about what that's going to bring and do for us. Sage had a smaller quarter in terms of hip growth, obviously, an improvement from the second quarter, but still a little bit of a decline versus prior year. Given that business in terms of stocking and the purchase cycle, we really do expect that business can turn the corner as well as we go into the next quarter and into 2021. So I think we'll see some positive dynamics from that business. And then overall, obviously, we've seen some impact on the pandemic. And we would expect that we'll continue to see momentum on our businesses as we go forward. Specifically, as it relates to the OUS business, as you noted, we had a very strong Q3 performance really across both emergency care and our acute care business. I think it's important to note that we were really having big performances in the OUS space even before really the impact of the pandemic. And our expectation would be that even though while we're seeing some benefits, certainly from the pandemic, that we will continue to build on the momentum that started giving before that as we go forward. So I think all-in-all, feeling very good about the future from a medical standpoint.

Next question comes from indiscernible.

I would like to add one comment. The other part of the physio business is called public access. So that's outside of the emergency in the hospitals. And that business really got very, very quiet in the second quarter; it came to a halt almost. And so that'll come back; that'll probably be a little slower, maybe more in the first quarter, second quarter of next year. So, Sage will come back a little bit sooner, maybe towards the end of the year, and then public access will come back maybe in the first or second quarter of next year. So there are parts of the business that are drags right now that will turn positive. And now, of course, some pops that took off in the pandemic that will start to moderate. But we love our medical business. We love the leadership we have in that business, and it will continue to be a really good performer for us.

Next question comes from Matt Miksic with Credit Suisse.

Thanks so much for taking the question. Kevin, I just had a follow-up on this, ASC strategy have been pursuing and talking about a little bit. And I didn't want to tip your hands too much as to exactly how that all is going to work. But we'd love to get anything you are willing to share, progress so far, how it complements another efforts to grow and maybe how it complements your relationships with some of the larger networks, which have an outpatient channel often? And I have one follow-up.

Yes, look, I'm not going to get into too many of the details about how we're doing it. But we are very pleased with our performance in ASCs; Mako number in the third quarter in ASCs was the highest number we've had so far in ASC, so Mako is part of the solution. We had double-digit growth in our sports medicine business. And of course, that plays in the ASC primarily. And so those are the proxies that you could use to figure out sort of how we're doing in the ASCs as we look at our sports med business. Look at the growth that we're having with Mako; there's a lot of other products that we have played very well in the surgery center market. And we just basically created align offerings that align our divisions. As you know, in the hospital, we tend to operate very separately, and we go in by product category; we're not doing that in the ASC, and this aligned offering is really working very well. And I want to give credit to Eddie Pearson and the entire team that sort of established this office. It's working ahead of what I was expecting, and I feel very bullish about it going forward.

That’s terrific. And then just a follow-up, you mentioned strengthen growth in China, despite some of the pandemic controls you are putting back into effect there. And you've mentioned last call on the call before just about the move into China was Mako going forward and understanding that I'm guessing that a lot of that early activity is in the sort of premium self-pay market. And maybe any update or progress as to how that's going and any early results that you've seen in terms of feedback or uptake?

Sure, thanks, Matt. So let me start with Mako. So we only have the hip approved right now in China; we don't yet have a total knee. We hope to get that in the first or second quarter of next year. It's taking longer than we had expected, but we're on track so we won't get it eventually approved. But we are getting sales with Mako for hip. But of course, once you get the knee on the robot, and of course the sales will start to really accelerate. There's just been a general pickup in general. So the pandemic, they've done a good job controlling the pandemic in the country. We've seen a pickup both in our Carson business, which is our lower priced products, as well as in the premium segment. So it's kind of I would say an across the board pickup that's occurring and really related to the Coronavirus. I think we had a great year last year in China, our best year on record in a good year, the year before we have strong management teams both on the trusting side and in the premium segment. As you know, that's been a more recent thing for Stryker. So I would expect that we'll continue to see that kind of performance since the market conditions improved markedly.

Your next question comes from the line of Larry Biegelsen with Wells Fargo. You may proceed.

Good afternoon. Thanks for taking the question. To Kevin on the operating margin. In Q3, it obviously stood out the 260 basis points or so improvement year-over-year. And I heard the comments that some of it was spending that you deferred because of the pandemic. But my question is, how much of this may be durable because of things you've learned to do more efficiently during the pandemic, and how does it make you feel about the 30 to 50 basis points of operating margin improvement that you've targeted?

Yes. Hi, Larry, this is Glenn. You're right. During the second and third quarters, we continued many of the cost containment measures we implemented in March. These included looking closely at expenses related to travel, meetings, training, consulting, and all sorts of discretionary spending. We also slowed down our hiring and reduced spending on non-research and development projects. I agree that we've discovered new ways to work; this call is happening virtually, and it's functioning well. We've also introduced virtual training for both customers and internally, which has been quite effective. Some of these practices will certainly continue as we move forward, reflecting how we have adapted post-pandemic and what our operating structure will look like. However, as we transition back to more normal operations and a growth trajectory, we will see an increase in those expenses, with some returning to pre-COVID levels to support our anticipated growth. Key projects will resume, and hiring will increase. All of this will expand as we progress. Regarding the 30 to 50 basis points, I believe a more normalized benchmark would be based on 2019 margins for assessing relative growth. Nonetheless, we remain committed to our financial targets; we expect to grow at the high end of the Medtech sector and continue to increase our operating margin by 30 to 50 basis points.

That's super helpful, Glenn. And one follow-up question, just I think for Kevin, on M&A, with the exception of the Wright deal, you've been relatively quiet on the M&A front. Any thoughts? And is it due to valuations? Just any thoughts on kind of your appetite and pipeline for M&A? Thank you.

Yes, thanks. We intentionally slowed down M&A in the second quarter, just because we were not sure what was going to happen with the pandemic. We asked the teams to sort of put their pencils down, stay active in discussions. But we really wanted to be sure that we didn't know that recovery would happen quite this quickly. So we're pleased with that. We do have our M&A teams back up and running. Because of Wright Medical and the debt that we're taking on because of that, we don't expect to be doing very large deals in the next year or so. But we look for more tuck-in deals. And we do want to stay busy with M&A. And we've said that to the rating agencies. Our teams are actively looking at targets, but they sort of never really stopped. It did just slow down a little bit while we saw a pace of recovery. But you should expect us to get back to our normal kind of tuck-in offense, which will complement the Wright Medical acquisition.

Next question comes from Matthew O'Brien with Piper Sandler. You may proceed.

Good afternoon. This is Patrick on for Matt. Thank you so much for taking the questions. I want to start with Mako. You've done a really nice job with placing Mako, and the underlying demand is really strong. But I'm curious if you could give us more color on the sales cycle. Specifically, I'm wondering if there's a chance that the sales cycle kind of over the longer term remains elongated as some of these hospitals work through financial pressures. So any color you have there would be really helpful? And then I have a quick follow-up.

Just to answer that; no, we don't expect that the sales cycles elongate. Matter of fact, it's one of the things that we've seen over the last couple of quarters is we've actually been able to get out and drive Mako even faster. And so there's still quite a bit of runway as you think about opportunities for Mako. So don't expect that that cycle to elongate.

Great. That's really helpful color. And briefly, I know this might be kind of a longer level, higher-level. But I'm just curious if there's any changes to the way you guys are thinking about the robotic offering in spine, either through a Mako platform or the Mobius asset. I'm just kind of curious about how you're thinking about that pipeline as the spine business really picks up momentum and starts heading in the right direction? Thanks for taking the questions.

Yes, thanks. We're really not ready yet to publicly talk about what the robotic offering is. It will be important for our sponsors. It's no question. Mobius did come with a robotic pipeline product. Once we're ready, we'll share. We're actively working on an offering; we're just not quite ready to share what that will be and what the timeline is. But stay tuned.

Next question comes from Ryan Zimmerman with BTIG. You may proceed.

Thank you. Appreciate taking the questions. Congrats in the quarter. Kevin, you called about Sage performance being maybe a little weaker than expected, was that a reflection of procedural volume? Or is there anything from a protocol perspective in terms of preoperative sterilization that may have changed for some customers given the pandemic?

We weren't surprised by the STAR; it wasn't weaker than expected, although it did show negative sales growth. In fact, everything we had was slightly better than anticipated regarding the pace of recovery. The sales cycle for Sage relies heavily on hospital activity, specifically the number of procedures and the usage of products, as they are consumed by patients in the ICU receiving procedures. The hospital census was lower in the second quarter and even lower in the third quarter. These products are typically bought in bulk and stored, since they are used daily. Therefore, the sales cycle requires inventory depletion before reorder occurs. This explains why the negative sales were a drag on our medical business in the U.S. Sage does not have a significant presence outside the U.S.; it's mainly a domestic issue. However, we are excited about our products, including a newly launched self-oral care product that has received excellent customer feedback during the pandemic, although it will take time for orders to come in. Once ordering and usage pick up and inventory levels decrease, we expect a surge in reordering. This may not happen fully in the fourth quarter but should start towards the end of that quarter and into the first quarter. We anticipate Sage will return to its usual strong growth.

Okay. And then just as a follow-up, one on Mako, not so much on the unit volumes, although it's certainly encouraging. But I think there was a software upgrade cycle earlier in the year; I could be wrong on that. I certainly call that the hip software upgrades. But how should we think about the upgrade cycle for software of Mako in the install base, and what that can do for growth, maybe over the next 12 to 24 months within the existing customer base?

Software upgrades are essential as they enhance usability and billing efficiency for surgeons. We implemented a software upgrade for hips in the second quarter and are also developing one for knees. The hip upgrade included features that address common frustrations, such as registration, and provides surgeons with valuable information on pelvic tilt, which has proven to be beneficial. I anticipate that this will not only boost the usage of Mako for hips but also likely accelerate this trend into the next year. The ongoing deployment of this software upgrade in the field will be complemented by updates on the new one when it becomes available. We consistently strive to improve usability and overall experience for our surgeons across all our products. However, I wouldn’t categorize this as an inflection point; it is simply a continuation of our commitment to delivering a positive customer experience. The significant growth stems from the increasing adoption of Mako, the success surgeons are experiencing, multiple purchases of Mako systems by hospitals, and expansion in teaching hospitals and surgery centers. This trend reflects the inflection point we are observing, which I believe will sustain in the coming quarters.

Next question comes from Joanne Wuensch with Citibank.

Good evening, and very nice quarter. Two questions. The first one is Mako related. There's a lot on this call. So I'll turn line in. Can you give us an idea of what percentage of hospitals currently have a robot? And where do you think it ultimately goes to? And instead of a cheaper question, because when we do our survey work, I talked to hospital administrators and physicians that have one, two, three, they seem to not be able to get enough robots or enough types of robots. I'd love your sort of view on the landscape. And then really, the second question has to do with seasonality. Is there anything happening in the big broad world outside of the pandemic that you think will impact the fourth quarter? Thanks.

Thank you, Joanne. The first question is about predicting the adoption of new markets, which can be challenging. If robotics becomes standard practice, like we’ve seen in other areas, there’s potential for expansion. If it becomes a common standard, there’s a significant number of hospitals and surgery centers that could adopt robotic procedures, indicating many robots are yet to be sold. The key question remains whether robotics will become the standard across all procedures, which we are actively working towards. The industry is trending in this direction, but the speed of adoption is hard to forecast. We prefer having champions for each robot we sell; we don’t engage in mass or C-suite sales without such advocates. When a robot is sold, it is quickly implemented and used in surgeries, leading the surgeon to share their positive experiences with peers. This generates interest among other orthopedic surgeons, resulting in requests for more robots. This pattern has consistently emerged. Currently, there are many hospitals performing these procedures, indicating we have a long way to go in terms of robotic adoption for orthopedics. I apologize for losing my thought. Can you please repeat the second question, Joanne?

Of course, second question that is in on seasonality, I can't we have a pandemic.

Yes. Regarding seasonality, the fourth quarter is typically our strongest season. November and December are difficult to predict this year; it's uncertain if we will experience the usual seasonal effects. Surgeons express a desire to remain busy, and hospitals understand the significance of elective procedures for their profitability. Will we see the usual uptick? I can't say for sure; the surgeons we've spoken to believe they will stay active. However, it's a question without a clear answer, as we haven't experienced this during a pandemic before. Currently, there are no indications of change. The situation appears to be normal outside of a pandemic context. As long as surgeons are able to operate, they will do so, and they've become quite innovative in maintaining their cleaning protocols. Many hospitals are extending their hours or even operating on Fridays and weekends to keep up with demand. We'll need to monitor this closely, but I don't have any new insights to share; I don't anticipate significant deviations from past trends.

Next question comes from Josh Jennings with Cowen. You may proceed.

Thanks for taking the questions. Congratulations on the strong recovery. Wanted to ask future medical indication question; you're not giving timelines. But just thinking about the development of the shoulder indication should be thinking about the development, they’re being exclusive for the right medical extremity portfolio? And those just the push out of that acquisition do anything to the timeline of make shoulder indication?

We're not going to discuss the timeline. We believe that the robotic shoulder will be very compelling. The shoulder procedure is quite challenging, more similar to a partial knee than to total knee or total hip procedures. We're excited about the progress our team has made on the application, and we won't be discussing yet which implants will be integrated with the robot. However, we will share that information at a later date.

Next question comes from Kaila Krum with Truist. You may proceed.

Hi, this is Sam asking for Kaila. Thank you for answering my question. First, I wanted to ask about the Arrow System, Mobius. I'm curious about how you described it a year ago and how it is performing now. Additionally, how is the capital market for imaging doing compared to the strength in robotics? Are you seeing any effects on other businesses from that system?

We are very pleased with the Mobius acquisition as it brought us excellent technology. Our main challenge has been scaling up manufacturing due to the high demand for Mobius. It was a small company based in Shirley, Massachusetts, and we are facing similar challenges as we did with TSO3, the sterilizing company we acquired. Typically, when we acquire smaller companies, the demand can sometimes surpass our capacity. We need to revisit design robustness and scale manufacturing as well as establish new production lines. This issue is a positive one, and we are very satisfied with the Aero product, which is performing exceptionally well and has seen increased demand, particularly for COVID imaging. We have been struggling to keep up with this demand, but as I mentioned, it's a positive challenge. We are also excited about the other strong products they have in development. Overall, this acquisition will greatly benefit us in the long term, but we are still in the process of scaling up.

Great. Thanks. And then just with resuming more spend on rep hiring into the fourth quarter, if you've maybe tease that out a little bit, we actually think about that in terms of more returned to normal rep hiring? Or are you thinking about maybe pressing your strength a little bit and getting a little more aggressive while some competitors may be struggling? Thank you.

Yes. It's a good question, Sam. You know, I think it's the divisions look out towards 2021. And they're planning sort of their budgets and where they can get to; it always will include new rep hiring. And so an absolutely our regular cycle is that we would get started on that in Q4. So I think that most divisions are planning to expand their rep sales forces towards the end of Q4 and certainly on into January of next year. And that would be just part of the sort of the general territory management that we go to every single year.

Next question comes from Matt Taylor with UBS. Please go ahead.

Hi, thank you for taking the question. The first one I had, I want to follow-up on your comments on your bed launch and the bed market. And it had kind of a two-part question. Really trying to understand if you're seeing a trend towards bed market expanding and that could create more opportunity for you? And then was just hoping that you could comment on how this new rollout to go you expect it to go into your own dates and do mostly conversion of your older beds? Or do you think there's a share game opportunity?

Yes. So in terms of the bed market itself, I think there's probably a bit of both right. So there’s, there’s obviously going to be the replacing cycle of beds, it's going to continue to happen. But I think the pandemic has also created some opportunity for expansion in the market as well. So I think there's going to be a mix of both of those items as we go forward. With regards to productivity, and what that's going to do for us, again, we feel really strongly about that bed and the opportunity. And there will be some opportunity, like I said, both in terms of replacing a cycle that'll fit into and then expanding into competitive opportunities as well.

And can I just ask the follow-up those really interested in your comments about standard of care robotics of Mako, and I think we've seen the knee value proposition is very strong. And I was wondering if you also think that you can convert that to be the standard of care for hips over time and other areas that your vision that will be standard in many areas or more siloed?

Yes. No, the vision is for it to be standard care everywhere where we have an application now. I think it will take longer; you've seen the adoption of hips has trailed the knees; the adoption in partial knee, which very, very strong. I think the adoption a shoulder will be very, very strong. Knees will continue. And I think it's eventually just it's just going to take a little longer because frankly, the satisfaction level of patients with hips has been quite good relative to knee, so relative to shoulder. And I think over time, total ankles; there's many other areas that robotics will play in. And that's our expectation is that it will become standard of care. Just a question of how long will that take, and what iterations are required for us to get there.

Next question comes from Richard Newitter with SVB. Please proceed.

Hi. This is Jamie on for Rich. Thanks for taking my questions. I guess the first one I wanted to ask you guys been pulled out some strength and smoke evacuation product line? I wanted to make sure I heard you correctly. Did you say that that grew double digits in the quarter? And then just kind of digging into that a little bit what's really driving the strength in that product category? Is it something that you're really starting to see pickup now kind of just in the wake of COVID?

Sure. On the smoke evacuation, yes, I did reference that we had double-digit growth in that product line. And honestly, even before COVID, most hospitals and caregivers have been very focused on safety, and smoke evacuation lines up extremely well with that safety focus. I think with COVID, it's a sort of even more emphasized in terms of what that product does to the environment that they operate in and how it contributes to the overall safety sort of platform and focus that we're seeing across all hospitals.

Okay. And then just as my follow-up. Talking about double-digit growth in the neurovascular business, just curious and to get your thoughts on how sustainable you think that is with some of the new product launches you have had into 2021? Thanks.

Yes. We are used to seeing our neurovascular business achieve double-digit growth. This trend has been consistent since we acquired the business, especially after the launch of our target products and the growth of the phoenix segments. With our proposed voting stance in the U.S. market and strong growth in China, we anticipate this double-digit growth to continue for a while, supported by the momentum in the phoenix segment. Our management team has been exceptional for a long time, and we expect this business to keep performing very well.

And we have a question from Steve Beuchaw with Wolfe Research. You may proceed.

Hi. Thanks. I wonder if you could spend a bit more time on the ASC and outpatient environment. I think once upon a time, there were questions around the category that were probably rooted in some concern about pricing. But in this environment, it's clearly a tailwind. I know there was a question already about market share. But can you speak a little bit about the procedure growth trends and ASC and outpatients relative to hospitals? How much you think that's a sustainable trend beyond COVID? And how do you think about that commercially in as much as it could be a structural advantage of a multi-line player versus a more concentrated line-specific player? And then I do have a follow-up?

Yes, look, first, let's start by keeping in mind that a small number of our procedures, let's call it around 10% of our large joint spine procedures are being done in the ASC. So it's not a big part of our business yet. But the trend is no doubt headed for more of these procedures being done in the ASC, part of that changing Medicare around needs. And we expect that to happen in hips. And so it's a trend that was already happening pre-pandemic; it's a trend that will accelerate going forward. There's all kinds of prognostications about how much it'll be; could it be 50% of our procedures? It's hard to predict how fast it'll move. But we believe we're really, really well positioned for this trend. And we do intend to be a multi-line player; that's what the ASC actually wants. It's unlike how the hospital but they have a different buying pattern in the surgery center. And the breadth of our portfolio is a huge advantage. And we plan to really leverage that strength wherever we can. So we're feeling very good about it. It's a trend that in terms of pricing, we're not seeing really any change so far in the pricing dynamics; there is a constraint around capital; ASCs are much more capital-sensitive. So we do tend to have more financing involved in surgery centers, but the overall equipped to do that without Flex Financial, we've been doing financing for a long, long time. So we're feeling very good about our position to be able to win in the ASC. And we do think it's going to be more important, and the trend will accelerate. Okay. Great. Thank you.

And at this time, I'll turn the call over to Mr. Kevin Lobo.

Thank you all for joining our call. We look forward to sharing our Q4 results with you in January. And that concludes the call.

Thank you, ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.