Zimmer Biomet Holdings, Inc. Q3 FY2020 Earnings Call

Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet Third Quarter 2020 Earnings Conference Call. As a reminder, this conference is being recorded today, November 6, 2020. Following today's presentation, there will be a question-and-answer session. At this time, all participants are in a listen-only mode. I would now like to turn the conference over to Keri Mattox, Senior Vice President, Investor Relations, Chief Communications Officer. Please go ahead.

Thank you, operator, and good morning everyone. I hope you are all well and safe. Welcome to Zimmer Biomet's third quarter 2020 earnings conference call. Joining me virtually today are Bryan Hanson, our President and CEO; and CFO, Suky Upadhyay. Before we get started, I'd like to remind you that our comments during this call will include forward-looking statements. Actual results may differ materially from those indicated by the forward-looking statements due to a variety of risks and uncertainties. Please note, we assume no obligation to update these forward-looking statements even if actual results or future expectations change materially. Please refer to our SEC filings for a detailed discussion of these risks and uncertainties in addition to the inherent limitations of such forward-looking statements. Additionally, the discussions on this call will include certain non-GAAP financial measures. Reconciliation of these measures to the most directly comparable GAAP financial measures is included within the earnings release found on our website at zimmerbiomet.com. With that, I'll now turn the call over to Bryan. Bryan?

All right. Great, Keri, thank you. And here now with our third virtual earnings call, it was hard to believe that so much time has already passed as we live inside the pandemic environment. But either way we're here, and I certainly hope that you're listening somewhere safe and socially distanced. We're clearly taking precautions here and we continue to follow our safety protocols and that's the reason why Keri, Suky and I are in different locations again for this call. As we've seen in the past hopefully we again do not have any jet mishaps, but just know if we do for whatever reason we will push fast and make sure that we move forward. So, 2020 has clearly been unlike any other year in ZB's nearly 100-year history, as I'm sure it is for every company that's out there right now. And as you know, I think we're all probably too aware, it's not over yet, it's definitely not over yet. And that said, I have to say that looking at how we have managed and navigated COVID-19 this year and specifically in the third quarter, I’d say that I'm proud of the team, I am confident about ZB's future, I'm more confident now than I have ever been about ZB's future. I truly believe we are well positioned for success and our strategy is absolutely working. As you all know, we have been acutely focused on transforming ZB since I joined the company almost three years ago now. We faced challenges before and while nothing could have ever prepared us fully for COVID-19, I do believe our ability to rise to those earlier challenges has truly put us in a stronger position to effectively manage the pandemic situation, the environment that we're in right now. I actually think it's been a catalyst for ZB. The team is focused on our mission, our strategy, and how we show up and execute every day is the strongest it's been since I joined the company. The way I look at it is that the things we can control, we are absolutely galvanized around and executing flawlessly against. So, it feels good right now as much as it's noisy around with COVID. The execution inside the organization is as strong as I've seen. And that said, the unpredictability of COVID means there are several variables and unfortunately they are pretty big variables that are outside of our control. And as a result, the pandemic continues to be challenging. It continues to be fluid. This requires us to quickly adjust to change given the changing environment. Ultimately, we can effectively meet the needs of our customers, and very importantly our patients at all times and that's exactly what we've been focused on. Along those lines, there are really three key areas that I'm going to talk about today that I think are important for you to take away and be aware of and also see the progress that we're making inside of each. The first one, you should find to be pretty obvious, it's our view of the COVID-19 recovery path from here, where we see it going. And I think importantly inside of that the areas of concentration or execution that we're going to have inside of the COVID recovery path. The second is an update on our strategy to drive long-term growth and through that value for ZB and for you. And the third is an update on the ongoing transformation of our business, which I believe we're making great progress on. Again, I'll spend time on each of these and then I'll pass it to Suky, who will give you more detail and color about Q3 on the financials and then how we're thinking about and framing Q4 in our minds. So, first, let's talk about the recovery and execution we saw in the third quarter. Ultimately, the recovery of the elective procedures going from Q2 to Q3 is encouraging. I would imagine it's encouraging for everybody at this point looking at Q2 to Q3. But it's still difficult to predict from here what's going to happen. The fact is, we've talked about how the key variables impacting procedure volumes needed to remain constant, obviously, they can improve, but they needed to at least stay where they were for the recovery to continue and to see sequential improvement from Q2 to Q3. As you remember, these variables included both positive and negative influences on procedure volume. On the positive side, we have the new patient volume and the backlog of patients that had deferred treatment during the pandemic for various reasons. On the negative side, we have the effects of the economic downturn, but most importantly surges in the virus that can drive negative policy decisions and/or increased patient fear. Those would be the negative influencers, obviously, if I look at the combination of those in terms of recovery in Q3, the variables played out in a way that allowed continued improvement over Q2. Overall, for the full quarter, we were stronger than expected and we actually returned to growth over 2019 faster than we thought we would. This was driven again by these COVID recovery dynamics, but importantly, our team's strong focus on and probably even more importantly execution against our strategy. We've been very focused on moving the strategy forward regardless of the noise around us. We saw a steeper rate of recovery in July, followed by a more modest recovery or even a flattening of the curve toward the end of the quarter. This was driven by the shift in the recovery variables that I just outlined a minute ago. We've seen continued increasing surges of the virus, especially in Europe, the Middle East, and Africa and in the US, and this is negatively impacting patient fear and in certain areas policy decisions. As a result, we exited the quarter with September growth flat versus 2019. There is not much we can do to end the virus surges, but we have launched a unique and large-scale direct-to-patient campaign focused on patient fear. So, we can't influence the virus, but we can try to influence patient fear focused on educating and supporting patients about their options to get procedures during COVID and even beyond, focusing on the fear the patients typically have to come and get a procedure. What we're finding early on in this campaign is that the feedback has been very positive, particularly associated with the concept of mymobility and its ability to allow for virtual care capabilities during this challenging time. So, those are obviously some of the factors surrounding COVID and its recovery dynamics. But I also want to ensure that we spend time talking about the things that we have more control over, the execution of our strategy and the performance of our business inside the impact of the pandemic. Even in the midst of this turbulence, we continue to deliver against our goals. This focus and execution against our strategy is the reason we have performed well over the last two quarters versus the overall market. Specifically, if you look at Q3, our performance in US knees and hips is a great example of this underlying momentum. We grew 3% in the quarter in US knees. We also saw 10% growth in US hips. These numbers are strong even without the backdrop of COVID. So, the question is going to be, what’s driving the performance? I'm sure I'm going to get that right away, so I'm just going to answer it now. Our core business is strong really for four major reasons in the way that we view it. The first is pretty obvious, we have truly shifted from this triaging of execution challenges to launching meaningful innovation. Now, I'm going to spend a little bit more time on this one in particular, but that's a big one. Second, our operating mechanisms and really the resulting operational discipline have never been stronger and I would argue probably as good as I've ever seen it anywhere. Third, our compensation programs have shifted towards disproportionately rewarding growth not just paying you for keeping the business you have but truly disproportionately paying and rewarding for growth. Finally, and I'm not sure if this is causing it or because of it, but our commercial confidence is higher than I've ever seen during my tenure here at ZB. The commercial confidence, the swag, or whatever you want to call it, is higher than I've ever seen. Again, those are really the combination of things that is helping create the momentum inside the pandemic. Let's specifically talk about innovation as a component of this equation. Broadly speaking, over the last year, we've taken a very low single-digit vitality index to a low double-digit number, and that's still not as good as we'd like it to be, but that's a pretty big jump. With our current product pipeline, I can promise you that's only going to continue to move in the right direction. As you know, the vitality index speaks to the percent of sales driven by new product launches. So, in other words, those products that have been launched within the last three years. The revenue associated with them versus your overall revenue shows a real nice jump in the right direction in the vitality index and more coming. To get a little more specific, I think let's talk about some of the key launches that you're interested in and I'll start with our knee franchise. Our ROSA execution continues and I'm very proud to report that we have already passed the 200 ROSA Knee placement mark in the worldwide placement strategy that we have. Importantly, our utilization continues to increase and the placement pipeline remains very strong. Remember we're way under-penetrated in robotics for our business across all orthopedics. The tailwind associated with ROSA in our opinion is going to be around for a while and it feels very good right now. On the Persona Revision side of things, we keep gaining traction in the marketplace with this product launch, and Q3 results were even stronger than the last quarter, which had been our best quarter to date post the launch. Revision remains on track as I said before to hit $100 million of gross revenue this year, and 40% of that will be new growth. In other words, $40 million of net of cannibalization revenue this year from Persona Revision by itself. This is really exciting, not only because it shows strong momentum for Persona Revision, but it also opens the door to more growth. The Revision System is truly a tip of the spear product. When we convert competitive surgeons to our Revision System, we absolutely have the right to hunt for their primary knee business and that's exactly what we're going to do. If you know about this marketplace, you would also know that the primary business is usually much larger than the Revision business. So, you can understand the order of magnitude of opportunity we have to go after now, so exciting stuff there on the knee side. Shifting to hips, Avenir Complete is really still outperforming our expectations for 2020, even with the pandemic impact. These are the expectations that we had for 2020 before we knew about the pandemic, just to give you some perspective on how well it's doing. This launch has really helped provide a great implant to leverage the high-growth direct anterior approach submarket in hips, one of the most attractive sub-markets in hips in the US implant space, the perfect opportunity for us to take advantage of this attractive market. One more product I'll highlight in the quarter is from our upper extremities business, our Signature ONE Planner, I talked about this last quarter as well. We had another 50-plus percent increase in surgeon registrations in Q3 and we already have one in four cases using pre-surgical planning for shoulder replacement. This increased penetration of the system is important in my mind in two very important ways. First of all, there is a real potential for mix benefit where maybe said another way, share of wallet gain in each procedure that you use pre-surgical planning in and it also provides more stickiness with the surgeon. On the share of wallet benefit, this may not be as obvious, but it's a pretty significant opportunity. It comes because you get a higher utilization in augments and guides when you do a pre-planned procedure versus those without pre-surgical planning because you know the anatomy before you get in. If you find out you have an anatomy issue, you've already got your augments ready to go and guides ready to go. That's great for the patient because they are going to get a better outcome, it's great for the surgeon because they have what they need to do the procedure, and it's great for us because we get more revenue for that surgical procedure. So, very exciting stuff. In short, I would just say that even with the challenges of COVID, we're driving our business forward, meeting our customer needs, and improving patient lives as we go. That's the whole mission of this organization, right? It truly is what we do and wake up for every day, alleviating the pain of patients around the world and improving the quality of their life, and we are doing that during COVID. As a team, we've dealt with many challenges over the past three years. We've prepared us for this moment. I've said it before, this fits on when companies and teams can slow down, hesitate, and take their foot off the pedal. Hey, we're being smart and safe, but we are not letting up and it shows in ZB's performance and the energy of this team right now. I'm going to move on to cover our strategy to deliver long-term organic growth and ultimately drive more value for ZB and very importantly for you as well. As we've outlined, to drive our strategic pillar of top quartile performance in total shareholder return and truly bring value to you. To achieve mid-single-digit growth organically, we have got to focus most intensely on driving long-term growth in our key focus areas. First, as we've said in the past, the foremost area of concentration is above-market performance in knees. Just given the size and the scale of this business, we need to be ahead of market here and we're going to do that by focusing aggressively on the fastest growth sub-markets of knee, robotics, data and informatics, cementless, and for us, revision. These are the areas of concentration and investment that are going to allow us to sustainably perform above market in knees. Next, we've got to drive consistent at-market growth, and if not, the higher end of market for our performance in S.E.T. For us, that's going to be sports and it's going to be extremities. We also need to ensure that we have consistent at-market performance in hips in the short term. In the longer term, when we launch into robotics, we absolutely expect above-market growth in hips as well. Finally, while our other businesses, at least at this point, will not receive the same level of investment and will be managed differently, we still expect these businesses to drive in line to the lower end of their market growth. That's our pathway for long-term durable 4% to 5% organic growth rates in this business. Next, I want to talk about ZB's transformation. You've probably heard me outline the three phases of our ZB transformation. Now I'm just going to quickly go over them again. Phase 1 is capturing the hearts and minds of the team, truly addressing our execution challenges. Phase 2 is around shifting to a disciplined strategic clarity for the organization, more focused on long-term success, not solving problems but truly pursuing long-term success. This is where ZB shifts to innovation that drives our strategic plan, has our pillar priorities that are very clear to the organization, locks in our operating mechanisms and involves organizational structure to ensure that we can drive a focused approach to the execution of this strategy. Phase 3 is where we transform for the future. Through active portfolio management, we look to change the portfolio composition to accelerate growth. We have made pretty significant and durable progress in Phase 1. We've laid the foundation for and are absolutely executing against Phase 2, and now we're moving squarely into Phase 3 of the ZB turnaround. I think about Phase 3, I think about that active portfolio management including three main components which should include the same three for anyone looking at active portfolio management. The first one is disproportionately investing in our priority businesses, in our priority markets across research and development and commercial infrastructure, just mind share being disproportionately invested in those areas. For number two, selective in M&A, prioritizing opportunities that are accretive to our weighted average market growth and aligned to our strategy. The final one, when appropriate and in line with our overall strategy, is divesting non-core assets that are financially less attractive in our core businesses. Those are the three components of active portfolio management in a way that we see them. As we manage the ZB portfolio, we're going to continue to focus on high-growth areas and areas where we truly believe we have a right to win. No size is going to be a factor here, particularly in the short term. Out of the gate, here we have a preference toward smaller tuck-in deals that can be easily integrated and operationalized while also maintaining our investment grade rating. I believe this philosophy is apparent when looking at the recent transactions we just highlighted in our earnings press release. While these deals are not material in terms of acquired revenue, they are absolutely instrumental in filling some of the product gaps we have at ZB in our ASC, sports portfolios, and they add to our pipeline of new technologies and product launches in markets that are accretive to our growth rates. These are small deals so they are going to be easily integrated; we will be able to validate our new deal processes, and our new team, the integration playbook that we now have in place. A great first step in the M&A side of things would come from the acquisition of Incisive. This is an OR solutions company in the $1.2 billion integrated OR market. This is going to provide ZB with a soon-to-be-launched surgical booms and lights portfolio that will help us push more aggressively into the attractive ASC market, an area we want to go. We also see some real differentiation; it’s not just filling the gap in the portfolio, it’s about differentiation for two reasons. First, we have a smaller footprint and this focuses on reducing the acquisition cost but also the construction cost, which we know is critical in the ASC market, looking at controlling these costs. The second reason why we think it's differentiated is that we've incorporated an innovative and automated way to capture data in the operating room that leverages artificial intelligence, and that helps us in the operating room drive efficiency and productivity and potentially even better outcomes. This is really lending itself to the needs of the ASC setting. Another key focus is our exclusive relationship with a partner, which we see the opportunity to further differentiate our knee ecosystem. Our goal is to launch an intelligent Persona total knee implant that incorporates smart sensor technology. We feel the combination of active data capture from this smart implant and from mymobility as well as from ROSA is going to provide an unmatched dataset that ultimately could be leveraged through AI for a decision support related to how best to treat and care for the patient. This will give us a unique opportunity to create an intersection between the $4 billion total knee market and the telehealth solution space, which is growing somewhere north of 15%, so a very attractive area for us to differentiate the ecosystem and kind of enter into an adjacent space in telehealth. The last deal I want to talk about is our acquisition of Reline, which is focused on the sports medicine market, a $5 billion market growing 5% to 7%. This deal clearly helps fill our gaps in arthroscopy capital. The capital makes up about 30% of the sports market, and until now we had no offering in this space. With this acquisition, we have not only filled the gap, we also see some real differentiation in the portfolio. They have done a nice job of innovatively consolidating three tower components into a single comprehensive system, both at the equipment and on the end product side. This is the first in the industry. This system is very early in the commercialization stage, but it’s getting very positive feedback early on, and we consider this another great opportunity to drive a successful product launch, leveraging our ZB commercial infrastructure, which we know we can do. We have other portfolio management opportunities in the near-term funnel and we're not ready to talk about those yet, but we have a pipeline and we will continue to keep you updated as we make progress here. Finally, we are fully committed to our margin expansion goal of at least 30% operating margin by the end of 2023. Suky is going to talk more about this, but our restructuring plan is on track and the cost savings we're delivering will help drive margin expansion while also supporting reinvestment in the business for growth. Overall, we are clearly watching the COVID recovery trends closely and completely realize, like everyone does, that market performance is out of our direct control due to the COVID recovery trends. That said, I hope it's very clear that we feel confident in ZB, we feel confident in our business strength, our execution, and the long-term growth prospects we have as a business. As a result of that, the value creation opportunity we have as a company. With that, I'm going to turn the call over to Suky for more financial details for the quarter and looking forward.

Thank you, and good morning, everyone. To echo Bryan’s comments, ZB's underlying fundamentals remain strong. Overall, our Q3 performance was better than expected. Revenue was ahead of expectations as we posted operational growth due to faster market recovery across most developed markets in tandem with strong commercial execution. Improved revenue performance drove better margins and a solid quarter of free cash flow. I feel a genuine sense of pride in how our 20,000 plus team members have responded to a very challenging environment. Net sales in the third quarter were $1.9 billion, a reported increase of 2% and constant currency increase of 1.1% versus the same period in 2019. Sequentially Q3 improved over Q2 as expected. Inside of that, we continue to see variability and recovery by market and region as we progress throughout the quarter and we did see a flattening of the recovery curve with September effectively flat versus the prior year. I'll talk about performance across our regions and then move to our business segments. Moving forward, unless I note otherwise, my comments will be on a constant currency basis. Beginning with Asia Pacific, the region returned to growth, increasing 0.7% versus Q3 2019. We saw strong performance in China with results well ahead of normal levels. While Japan has not yet returned to prior year volume, the market continues to show stability. Australia and New Zealand made steady progress in Q3, but were negatively impacted by surges of the virus late in the quarter. Lastly, India and other small Southeast Asian countries continue to underperform the broader region. EMEA decreased 5.7% while we saw recovery from Q2, the region did not return to growth in any part of the quarter, and we observed a slowing in September due to recent COVID-19 surges and corresponding policy actions. Developed countries excluding the UK showed the strongest signs of recovery but decelerated in the latter part of the quarter. The UK and emerging markets continue to be a significant drag on overall regional growth and are lagging developed markets recovery. Lastly, the Americas region continued to grow, increasing 3.3%, with strong growth of 5% in the US. While the recovery was robust in the US, we observed the same flattening in the recovery curve due to increases in virus surges in September. Similar to Q2, caseloads in elective procedures in hard-hit regions are continuing at about 70% to 90% when compared to 2019 volumes. Outside of the US, the rest of the Americas continues to lag with numbers well below normal levels. Turning to our business performance for Q3, the global knee business declined 1.4% versus Q3 2019, a marked sequential improvement from the 47% decline we saw in Q2. The US knee business returned to growth, increasing 3% in the quarter. Overall execution was strong with continued momentum for ROSA. Additionally, our Persona family of primary, revision, and partial knee continues to gain traction with existing and new customers. Our global hip business increased 4.4%, another significant sequential improvement from the 31% decline we saw in Q2. I want to highlight that US hips increased about 10% in the quarter, strong market recovery but also a testament to our commercial team's execution against new product introductions. Sports, extremities, and trauma sales grew 2.5% over Q3 2019. Notably, the Americas grew about 6%, but that growth was offset by softness in EMEA and Asia Pacific. Also, strength in upper extremities was partially offset by slower growth in sports and trauma due to lower social activities as a result of COVID. Dental, spine, and CMFT increased 6.5% due to strong execution of new products including robotics and market recovery. Lastly, our other category was down 11.1%. I'll now walk through our third quarter P&L and liquidity and then share more color and insights that may shape our expectations for the remainder of the year. Moving on to the P&L, as we have previously discussed, we moved quickly and have taken a disciplined, proactive approach to mitigate the earnings impact of the pandemic while also enhancing ZB's liquidity profile. Results in the third quarter were better than we expected at the time of our second quarter call, as we saw margins, earnings, and cash flow sequentially improve versus the second quarter, consistent with our revenue improvement. In the third quarter, we reported GAAP diluted earnings per share of $1.16, and adjusted diluted earnings per share of $1.81. GAAP earnings per share versus the prior year were lower, primarily due to a sizable one-time Swiss tax credit that the company realized in 2019. For additional details on GAAP results, please refer to today's press release and our 10-Q, which will be filed later today. On an adjusted basis versus 2019, earnings grew in line with revenue growth, as lower SG&A spending offset lower gross margins and a higher share count. Adjusted gross margin was 70.6% for the third quarter and as expected, results were sequentially better than Q2, but lower than 2019. Versus the prior year, pressure from prior-period deferred costs and lower volumes due to COVID were partially offset by a favorable regional mix tailwind as we saw stronger recovery in the US and developed markets in the quarter. Adjusted operating expenses increased sequentially over Q2, driven by commissions related to higher revenues and increased commercial investments. Expenses were lower than prior year due to the early impact of our restructuring programs and moderated investment levels as we continue to navigate pandemic uncertainty. Overall, the adjusted operating margins for the quarter were 26.3%, better than expected and driven by the favorable geographic mix in gross margin and a slower ramp on spending. Moving beyond operating margin, net interest expense and adjusted other income totaled $52 million, and the adjusted tax rate of 16.6% was slightly better than expected due to some modest discrete benefits in the quarter. Turning to cash and liquidity, we'll return to positive free cash flow earlier than expected, totaling $287 million. This is lower than the prior year as we used a portion of our better-than-expected operating cash performance to reduce our accounts receivable securitization program. We ended Q3 with cash and cash equivalents of just under $1 billion and our $2.5 billion of credit facilities remain untapped. Relative to the deals that Bryan referenced earlier, we expect the cash call to be approximately $80 million in the second half of this year, and that will be funded through existing cash balances. Turning to Q4, our consolidated revenue outlook for the remainder of the year has a heightened level of uncertainty given recent COVID surges that we have seen in a number of markets, and due to that backdrop, we will not be providing financial guidance for the fourth quarter. So far, through October regional trends have been similar to what we saw for the full third quarter except for EMEA. That is, Asia Pacific and the Americas continue to grow in line with full Q3 growth rates, albeit with more pressure or risk in the US due to increased virus surges. On the other hand, EMEA has worsened due to surges in the virus, as declines have accelerated in October with some governments in the region taking new policy actions to limit elective procedure. We expect consolidated Q4 revenue performance to continue to be fluid based on the major variables impacting the recovery, which include the rate of pull-through on the backlog, patient anxiety, and elective procedure capacity constraints due to COVID surgeons and/or resulting policy actions. While market dynamics remain uncertain, what I do know is that our commercial and supply execution, combined with our innovative new product introductions, will continue to drive strong performance relative to the market. Looking ahead on gross margin, we expect sequential improvement, but continued year-over-year pressure due to the same drivers we saw in Q3. Adjusted operating expenses are expected to be sequentially higher in Q4 but down versus prior year as we also saw in Q3. Interest expense will be stable to Q3, and we expect that our tax rate will be slightly higher than Q3 2020. Lastly, fully diluted shares outstanding are expected to step up in Q4 due to the exercise of options as a result of the acceleration of stock price we saw in the third quarter. Longer term, we remain committed to our target of at least 30% adjusted operating margins by the end of 2023. Our near-term initiatives relative to reorganization, consolidation, and zero-based budgeting, as examples, are complete or near completion. We are steadily advancing our longer-term structural initiatives around supply and G&A efficiency. To summarize, our underlying business performance is strong. Our execution is on point and ZB's transformation is delivering positive proof points even in the midst of the challenging pandemic. We continue to believe that ZB is well positioned to address near-term challenges and to accelerate growth over the long term. With that, I'll turn the call over to Keri.

Thanks, Suky. Before we start the Q&A session, a reminder to please limit yourself to a single question and one follow-up, so that we can get through as many questions as possible during the call. With that operator, may we have the first question please.

Thank you. Our first question comes from Ryan Zimmerman with BTIG.

All right. Thank you. Good morning, everyone. So, Bryan, I want to start on the backlog and the commentary about the September exit rate. I have one on ROSA. If you recall back, the last quarter you talked about a $700 million backlog for ZB. I'm just wondering if you could comment a little bit around that backlog in terms of what do you feel like you achieved against that in the third quarter, and how we should think about that maybe refilling back up in light of some of the dynamics of COVID in the fourth quarter that you're talking about?

Yes. So, I appreciate the question. What I would tell you is that what we saw in Q3 is that we actually saw positive growth relatively in line if not a little above, say, for instance, in hips in a typical market growth. That would indicate that we did not build further backlog or deferred patients in a way that did not calculate in Q3. That said, we still have hundreds of millions of dollars of deferred patients that will eventually come back in the funnel. So, I still feel very bullish that we have these deferred patients. There are patients, as we know for most of our business that have a disease that progresses. It does not get better by itself. As a result, those patients typically come back in the fall. So, I wouldn’t say that we built more backlog in Q3, but we certainly still have quite a backlog to go through. That's my view of where we are from a backlog standpoint. I think that eventually when we get to the point where we have a vaccine that people have confidence in or treatment that people have confidence in, we're going to have that backlog of patients begin to come through in concert with new patients, and that should be a really nice headwind for our business moving forward.

Understood. Now regarding the second question about ROSA, it's great to see the placements exceeding 200. Could you provide some insight into the order book and your expectations for 2021? Is it feasible to think you might accelerate past the anticipated 200 to 300 placement rate this year? Thank you for addressing my questions.

For just clarification, just to make sure that 200 to 300 is what we've done from an operational standpoint since launch. There wasn't 200 to 300 that we would expect just in 2020, but it would be since launch, which is just a little over a year and a half now since the full launch of the ROSA System. What I’ll tell you is that, I’m pretty enthusiastic as is the team around the ROSA placements that we saw in Q3, it was the best quarter that we’ve had relative to the number of installations we did in a single quarter and I can tell you that that momentum is continuing into Q4. Even though I think it will be slightly better, if it is still slightly better than what we did in Q3, that's what our expectation will be in Q4. The pipeline of future customers is robust as it's ever been with our product, and as I mentioned before in the prepared remarks, I genuinely believe the under-penetration of robotics is at such a point that this is a tailwind for the organization for a long time to come. It’s a very exciting tailwind. No question about it. Because not only is it before us, it represents the patients. It really is providing a level of accuracy in the operating room that you can see when you're in the operating room with the surgeon. Forget studies; we've got those coming, but when the surgeon uses the robotic system in the operating room, you can see the lights go off. I mean, go on. They clearly understand that they have an opportunity to get better cuts, more accurate cuts, but also and very importantly feedback right away in the operating room around tissue balancing. You need to see actually to have the opportunity to see that kind of light bulb go off in the surgeon's mind when they're using it is pretty amazing. Relative to 2021, I don't want to give specifics there. What I would tell you is that I would be disappointed if the level of placements that we saw in Q3 and Q4, which were better than the first half of 2020, didn’t continue into 2021. That will indicate that indeed that happens that 2021 should see more placements overall than 2020 did. Again, I think there is real positive momentum, great feedback from our customers, and a robust pipeline of future customers that are out there.

Thanks, Bryan.

Our next question comes from Bob Hopkins with Bank of America.

Hey, good morning. Thanks. Can you hear me okay?

Yes.

Yes. Maybe great.

Good morning. Thanks. So, first quick question, I appreciate, Bryan, your comments on deals and divestitures and the two deals you announced. So, a quick question there, are those deals that could start to have an impact from a revenue perspective more in 2022? How should we think about those launches? On the divestiture side, how would you characterize how likely divestitures might be in 2021? Thank you.

Okay. So, what I would tell you is that the deals that we just talked about, obviously, are not super accretive relative to acquired revenue growth, just not much there. Think about most product launches that we have facilitating product launches in these very attractive spaces, ASC; it would also be in sports, which is kind of a combination of ASC impact, and then also in the data informatics portion of things. I would absolutely expect revenue growth to be driven in 2021; I wouldn't say 2022. I definitely believe that the portfolio being provided by these acquisitions will immediately give us traction to be able to go out and hunt in the ASC marketplace, in the sports marketplace, and continue in 2021 to provide more unique offerings inside of our knee category and we talked about that knee ecosystem. All three of the things that we just talked about in prepared remarks will provide revenue growth, just not acquired revenue growth in 2021 and well beyond, by the way. As far as divestitures go, clearly, I wouldn't talk about the time frame, I don't want to give anybody any expectations here. But the fact is when we think about active portfolio management, that is one of the vectors. One of the obvious ones is M&A. With M&A, we're going to focus on building scale and innovating with products that matter in markets that are accretive to our ZB weighted average market growth. Very importantly, we’ll see that we have a right to win, and there is a clear path to leadership in those categories that would be potentially on the docket for divestiture. It would be in those areas that are not as financially attractive to the business, are not as core to our strategy, and where we don’t really see a clear pathway to leadership. Those would be the things that we would look to in thinking about sharing the business; I just don't want to give you a specific time frame because I don't want to set that expectation. Just know that that's part of the equation as we think about active portfolio management with the intent over time to move more of our revenue to higher growth markets. If we're going to be a top quartile performer in total shareholder return, we have to have more of our revenue in higher growth markets.

Thanks so much, Bob. Bryan, can we go to the next question in the queue, please.

Our next question comes from Josh Jennings with Cowen.

Hi. Good morning. Thanks for taking the questions. One on ROSA and then just one on your average Chinese business. Just on ROSA, I was just wondering, can you parse out just the implant performance in knees in the quarter? Was there a headwind from third quarter 2019 ROSA upfront purchase revenues versus the placement dynamics happening over the course of the pandemic? Also, can you help us as we think about modeling these ROSA placements out in 2021, and just all robotic solutions out there in the orthopedic marketplace? Do you think that the percentage of systems that are placed that will drive an upfront capital purchase and that upfront revenue is at a 50% bar or at 25%? Anything you can help us with just in terms of modeling out that system revenue as we think about 2021 and beyond would be helpful.

We are definitely noticing a shift back to customers wanting to either lease or purchase robotic systems. While it seems to be starting to happen, it isn’t at the speed we saw last year. As we approach 2021, we might see a more pronounced shift in that direction, but I can't predict exactly where it will end up. Currently, a significant portion of our installations are through placement programs, which we prefer because it establishes a long-term contract with our customers, requiring them to make certain volume commitments to us, thus building a more stable relationship. However, as our customers gain confidence in the market, they may want to return to their previous purchasing behavior, although I cannot specify what percentage that might be. It is gradually moving back in that direction. In Q3, despite some sales of ROSA, it actually presented a challenge for us. Specifically, I noted a 3% growth in US knees, but if we remove ROSA from that analysis and focus on core and base knees, we actually grew closer to 4%, possibly even slightly more than that in base knees in the US. So, ROSA was a headwind of over 100 basis points in that quarter. Hopefully, that clarifies things.

That's very helpful. Thanks for those details. I heard Suky call out strength in upper extremities in the quarter; are you seeing any disruption from the Stryker-Wright combination? It may be hard to parse out in the middle of the pandemic, but I just wanted to get your thoughts on the opportunity with the integration next year from your second biggest competitor and what that opportunity represents in your mind for the upper extremities business? Thanks for taking the questions.

Absolutely. When we look at the performance in Wright, they had a pretty good quarter, so clearly, at least based on that performance, one would indicate that it's not disruptive yet. While I'm always hoping for things to happen, I would be very happy if there was disruption when you try to bring those two organizations together finally. The fact is, most of the time in our industry when they're bringing two organizations together, there is dis-synergy risk, there just is. I like some of the small deals that we just did, because it really eliminates that dis-synergy risk because there are really more product launches versus bringing two sales organizations together. I expect at some point just given the historical views of acquisitions in our space that you are going to see some level of dis-synergy. I’m hoping that we have an opportunity to take advantage of that. That said, I hope is our strategy; we have a very clear strategy in our extremities business, and we're executing against that. I feel very confident in the commercial infrastructure we're putting together, the product pipeline that we have and the traction that we’re getting in the marketplace right now with or without disruption from our competitors.

Thanks, Bryan.

Our next question comes from Vijay Kumar with Evercore ISI.

Thank you for taking my question and congratulations on a solid presence here. Bryan, I have a broader question. When examining 2021, the analysts' forecasts indicate earnings will surpass those of 2019. I'm curious, as some of your competitors have mentioned variances in gross margin and manufacturing. Is there anything we should consider regarding margins? Are you comfortable with the analysts' earnings per share projections?

Maybe I'll pass it over to Suky to provide a little more color there. I know you had some of that in your prepared remarks, Suky, but maybe you can comment on that.

Sure. We aren't providing guidance for 2021 or commenting on Street forecasts. However, next year's performance will be largely influenced by revenue, which is closely tied to developments regarding COVID-19. If we see a reduction in recent case surges and conditions stabilize, there’s a chance that 2021 revenues could align with those of 2019. If stabilization occurs alongside a vaccine or viable treatment, we might even see revenue surpassing 2019 levels. This is how we view it in broad terms, but there's still much to navigate regarding COVID-19's trajectory. On margins, they will align with overall revenue and volume. As expected, if revenue and volume improve, margins should also improve. When we consider margins for next year, we are aware of several factors that could impact them, using the second half of this year as a baseline. In terms of gross margins, we had a solid performance in the third quarter and anticipate improvement in gross margins in the fourth quarter due to volume increases and typical seasonal trends. However, as we move into next year and the regional mix stabilizes with a reduction in COVID cases, the favorable mix we’re experiencing may lessen, presenting a small challenge moving forward. We've faced cost pressures this year from lower volumes and deferred costs from previous years, and these factors will carry into next year. Thus, we are monitoring a few headwinds for gross margins. That said, we are actively pursuing cost reduction opportunities in our goods, which could provide a positive impact next year. Our ongoing restructuring efforts aim for a 30% operating margin, with expectations for stabilization from 2020 toward 2023 regarding gross margins. Regarding operating margins, we will continue increasing our investments. The strong market performance in the last two quarters is partly due to our strategic investments, and our commercial teams are effectively optimizing these investments for rapid returns. We plan to maintain this increased investment strategy as we transition into 2021, benefiting from our excellent products and execution in thriving markets. With that context, we are aligned with our previous stance; if revenues reach 2019 levels, it would be disappointing if operating margins in 2021 did not also reach comparable levels, even if not for the entire year. We are optimistic about attaining those margin targets within 2021. I hope this provides some insight into our perspective for 2021, noting that much still depends on COVID-19's development.

That’s extremely helpful. And Bryan, one for you on that. Thanks for all the color on the Persona Revision. I guess when you look at next year, as you gain traction on the Revision side, should those gains accelerate as you gain a beachhead into the primary side of knee as well?

I'm sorry, could you repeat that? I missed part of the first part of your question; you went out a little bit for me. Could you repeat that?

On the Persona Revision knee side, I think the comment you made was that should allow you guys to go after the primary implant side as well. So, when you think...

Yes, I would say that the most exciting aspect for me regarding Persona Revision is its potential. Initially, it might have seemed excessive to focus on impurities, as I believed there was a strong correlation between Revision sets and primary sales. What we're discovering is that a significant portion of the $40 million or so in competitive conversions is within our existing primary business, although we lacked the Revision System. Many cases are reversed; we didn't have either the primary or the Revision. However, when we acquire that Revision business, it definitely provides us with the opportunity to pursue the primary business, which is substantially larger than the Revision business. When considering the market differentiation, let's estimate the Revision market share to be around 10% to 15% of the overall knee market. The balance consists mainly of primary units available. Once we secure the Revision business, we can then target the primary business. While it doesn't guarantee success, it gives us the opportunity to pursue it and foster trust with the surgeons. I fully anticipate that in 2021, competitive conversions will persist for both primary and Revision, along with the potential to attract primary business. This will clearly serve as a key driver in our strategy to achieve above-market growth in knee products, as we have been stating. It will undeniably assist us in this direction in 2021.

Understood. Thanks, guys.

Our next question comes from Raj Denhoy with Jefferies.

Hi, good morning. A couple of questions if I could, I'm just trying to put a finer point on your comments around the fourth quarter. It sounds like you're suggesting that Asia Pacific and the Americas perhaps in line with the third quarter, but given that EMEA is worsening, I guess we should assume that the growth rate in the fourth quarter will be below what you posted during the third quarter, is that a fair way to think about that?

Yes. So, maybe, Suky, I'll start, if you want to provide any more color, feel free to do so. I would say, generally, what you're saying is accurate. I would say that Asia Pacific, which is clearly being less impacted by surges of the virus, seems to be relatively consistent. Again, it's early in the quarter based on what we've seen so far, pretty much in line with the growth rates that we saw in Q3 overall. The Americas, even though it's a positive growth, has slightly decelerated versus Q3. But the good news is even with the surges that we're seeing in the US, we're still seeing positive growth. It's close relative to what we saw in Q3 again, it's early. The risk feels a little more tenuous right now because the surges are so much more prominent than they were in Q3. The fact is that the US is hanging in there and still has positive growth, but in EMEA, to your point, we are seeing more pressure. The policy decisions and the reaction to the virus surges are more acute in Europe, the Middle East, and Africa. No question about it. I would expect Q4 to be slower growth and it was already negative in Q3 than Q3 was. So we're really watching this everywhere, obviously, but right now Europe, the Middle East, and Africa is a key area of focus for us to understand what's happening in that region. Then, importantly, inside of that storm, if you will, what are we going to do to make sure that we stay ahead of the competition while it's occurring.

Okay. But maybe just...

No, I think you summarized it really well Bryan.

And really my second question is, I guess, somewhat related. Frankly, Suky made a comment that demand in some areas is still at 70% to 90% of normal. I guess I'm curious how to think about that as a broad statement. Are you still more than 10% below what you would consider normal demand? Is it going to take something like a vaccine or better treatment ultimately to get to 100% and beyond?

Let me clarify what you're saying there is, what you're saying is that, so take the US, for instance, if you look at a specific state or a county inside the US that is being very hard hit by surges, what he was referencing is that even in those very hard-hit areas, the county or the state, you're still seeing 70% to 90% of procedure volumes that you would typically see, say, versus 2019. That doesn’t necessarily mean that broadly we're seeing 70%, 90% of demand; it’s just let's say that in that hard-hit area, you're still seeing 70% to 90% of typical procedure volume, so that is what he was referencing.

Yes, the extrapolation from there is that even in the very acute second surges, we're not seeing anything that resembles what we saw in April and May, right? Clearly, the end markets, the hospital systems with precision and more deference being provided to them, they are better prepared to deal with COVID. They have better protocols and triage for patients; they’ve got incentives to get the elective procedures through. That’s the key point of that statement of 70% to 90%.

Very clear. Thanks for the clarification.

Thanks. And Bryan, It looks like we have time for at least one, maybe two more questions.

We’ll take our next question from Matt Miksic with Credit Suisse.

Hi, good morning. Thanks for taking the questions. I have one on S.E.T. and one just to follow up on Raj's question on trend. So, on sports medicine, extremities, trauma, you provide a global reporting line here, it's a 20% or so of your business. I was wondering if you could maybe expand a little bit on how the major moving parts of that business are performing and maybe proportions or geographic color would be helpful. Then, I actually have one quick follow-up.

We don't really provide a breakdown beyond the S.E.T. Overall category but what I would tell you is that the US and I think that Suky referenced this in your prepared remarks, the US was definitely the strongest performer in the world. I think we have somewhere in the neighborhood of 6% in US S.E.T. performance from a growth standpoint, so that would indicate we clearly had lower growth in other parts of the world which isn't surprising when you think about our S.E.T. category; say for instance in Asia Pacific, a bigger part of that category would be trauma in that region. Even though we’re seeing less surges of the virus in that part of the world, we still see less activity, which typically will drive lower volumes in either revenue growth in sports or trauma. When people aren't moving as much and they're not doing as much, we typically see those two businesses within S.E.T. get hurt. As I mentioned, we’ve had a pretty significant focus in extremities obviously; upper extremities is one of the key areas of focus for us. I would just say our growth rate there is promising, and that's probably all the detail I'd provide below S.E.T. But overall, if I look at the category, the US region or the Americas was definitely the strongest growth region.

Thank you for that. Suky, could you elaborate on the trends and considerations regarding a tightening environment? There was a notably tight period this summer in Arizona and Texas, where we faced some specific constraints by county. Could you share your observations on that situation, how quickly things recovered, and what insights we might gain from it for the next few months in other regions?

Yes, we discussed this during our second quarter call. The counties most affected in the states mentioned were operating in the 80% to 90% range. We've noticed a consistent trend over the past few months, showing increased activity. This is a positive development; we don’t expect to revert to the conditions of April and May, even with recent spikes, at least based on current observations. The duration of recovery varies significantly depending on the specific market and sub-market in question, as well as the frequency of surges and how quickly those rates decline. While it's challenging to predict, in some of the areas severely impacted, recovery has been seen within a few months, sometimes returning to normal or slightly exceeding normal levels. However, these conditions are quite variable from one market to another.

Thanks.

And that concludes today's question-and-answer session. I'd like to turn back to Keri Mattox for additional or closing remarks.

Thanks so much, and thanks everyone for joining us. I know we'll be in touch today, and if you have questions, please don't hesitate to reach out to the IR Team. We look forward to continuing the conversation.

All right, great. Thanks, everyone.

Thank you again for participating in today's conference call. You may now disconnect.