Zimmer Biomet Holdings, Inc. Q3 FY2021 Earnings Call

Good morning, ladies and gentlemen and welcome to the Zimmer Biomet Third Quarter 2021 earnings conference call. If anyone needs assistance at any time during the conference, please press the operator for assistance. As a reminder this conference is being recorded today, November 4th, 2021. Following today's presentation, there will be a question-and-answer session. At this time, all participants are in a listen-only mode. If you have a question, please press the operator for assistance. I would now like to turn the conference over to Keri Mattox, Senior Vice President, Investor Relations and Chief Operating 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 2021 Earnings Conference Call. Joining me today are Bryan Hanson, our Chairman, President, and CEO, and Suky Upadhyay, our EVP and CFO. Before we get started, I would 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 our Q3 earnings release, which can be found on our website, zimmerbiomet.com. With that, I will now turn the call over to Bryan.

All right. Great. Thanks, Keri, and thanks everyone for joining us this morning. Let me just start with the things that I'm happy about when it comes to Q3. First of all, I'm happy on our progress with our new product introductions, they're going quite well. Our execution on recent M&A is going as planned, if not better. Our commercial focus and discipline is as good as I've seen it and I'm very happy with our growth versus our key competitors in both large joints and S.E.T., particularly when it comes to the U.S. The team, in my view, continues to drive results in the areas under our control. And as a result, I continue to be proud of them for doing so. Alternatively, Q3 was also a quarter with unexpected negative environmental impacts, that are for the most part, out of our control. Q3 brought greater COVID pressure than I think anybody expected: more customer staffing shortages than we expected; and an earlier China VBP impact than we anticipated. And this resulted in Q3 revenues that were lower than we had projected. And unfortunately, we expect these pressure points to continue into Q4. And as a result, we need to update our 2021 financial guidance, and really, the view we have with the fourth quarter. As we look forward, until we see a fundamental shift in these trends, we're just going to assume that these pressure points aren't going away; but will be with us into Q4 and possibly into early 2022. Let's just start by taking a look at COVID and staffing concerns together because I believe they're somewhat related. As I think most of us know by now, there was a significant Delta variant surge in Q3 that drove more COVID pressure than, again, I think anybody expected. We previously thought COVID pressure would lessen through the back half of the year; but instead, while procedures did seasonally step up in September, it wasn't by as much as we expected, again due to the enhanced COVID and staffing pressures. And as a result, September was our least attractive month relative to growth and until we see a real shift in COVID and staffing related recovery, we're projecting that the pressure we saw in September will continue through the end of the year. That's a view of COVID. We think about China VBP, the process in China is moving forward. And although it's still fluid, we are getting more clarity on what it will mean this year and in 2022. Our assumption going into the process was that VBP would pose no more than a 1% risk in terms of impact to Zimmer Biomet's overall revenue. And although for a number of reasons, the overall impact will likely be greater than what we originally anticipated, we do believe that sizing this at around 1% of revenue impact is still accurate. That is the right way to size it. That said, the timing of the revenue impact has definitely shifted forward. And we now expect that much of this impact will be felt in 2021. There are a few factors driving the shift into 2021: around current year inventory reductions by distributors; ongoing negotiations we have with our distributor partners that are beginning to include price concessions on existing inventory; and unfortunately, what we're now seeing is patients deferring their surgeries until after the lower VBP pricing is in effect. Apparently, even though China achieves near universal public medical coverage, there are out-of-pocket expenses that increase or decrease based on implant pricing. And this is substantial enough for patients to defer their procedures. Clearly in summary, although we feel very good about our execution in the areas we can control, these macro environmental issues continue to mute our overall performance. These issues are fluid, but we've done our best to incorporate our current view of their impact in our revised guidance. And I think that's a pretty good segue to move to Suky's section where he is going to focus on Q3 financial performance, and very importantly, our forward-looking guidance. Okay, Suky.

Thanks, Bryan. And good morning, everyone. I'm going to briefly discuss our Q3 results and the updates that we've made to our full-year 2021 financial guidance. Moving forward, unless otherwise noted, my statements will be about Q3 '21 and how it compares to the same period in 2020. My revenue and P&L commentary will be on a constant currency or adjusted basis. We've also provided comparisons to the third quarter of 2019, as we feel that performance relative to pre-pandemic results is an important comparator. Net sales in the third quarter were $1.924 billion, a reported decrease of 0.3% and a decrease of 0.8% on a constant currency basis. When compared to 2019, net sales increased 0.4%. On a consolidated basis, as Bryan mentioned, we were growing through August, but then declined in September, as we saw Delta variant cases and staffing shortage increases. In short, there was a seasonal step-up in procedural volumes for the quarter, but the recovery has not taken hold as fast as we thought it would, especially in our hip and knee businesses. The Americas declined 3.2% or were flat versus 2019. The U.S. declined 4.4% or was up 0.1% versus 2019. Lower U.S. performance in September was the key driver to lower consolidated results. EMEA grew 5.9% or was up 0.3% versus 2019. This is the first time the region posted positive growth since the start of the pandemic. In the quarter, we saw an improving trend across a number of markets; however, the UK, France, Spain, and most emerging markets continue to be challenged, despite higher vaccination rates. Lastly, Asia-Pacific grew 0.5% or was up 1.5% versus 2019. While we did see growth versus 2019, it decelerated compared to what we observed in the first half of the year. This was driven in part by pricing adjustments and channel inventory reductions as we continue to negotiate with our distributor partners ahead of VBP implementation in tandem with continuing COVID pressure throughout the region, especially in Japan, Australia, and New Zealand. Turning to business performance in the third quarter, the Global Knee business declined 0.7% or was down 1% versus 2019. In the U.S., Knee declined 5.3% or was down 0.7% versus 2019. Our global Hip business declined 6.6% or was down 2.4% versus 2019. And U.S. Hips declined 11.3% or were down 2.4% versus 2019. The sports, extremity, and trauma category increased 4.2% or 7.7% versus 2019 driven by continuing commercial specialization, new product introductions, and the contribution from strategic acquisitions we added to this portfolio in 2020. Our dental and spine category declined 6.1% or were down 2% versus 2019. The dental business posted good growth in the quarter and continued to benefit from strong execution and market recovery, while the spine business declined compared to 2020 and 2019 due to increased COVID pressure throughout the quarter. Finally, our Other category grew 15.4% or was down 1.1% versus 2019. Inside this category, we saw ongoing demand for ROSA Knee, as well as increased revenues from the launch of our ROSA Partial Knee and Hip applications. Moving to the P&L. For the quarter, we reported GAAP diluted earnings per share of $0.69, lower than our GAAP diluted earnings per share of $1.16 in the third quarter of 2020. This decrease was driven primarily by cost of goods and higher spending related to litigation, our spin-off, and R&D. In addition, our share count was up versus the prior year. On an adjusted basis, diluted earnings per share of $1.81 was flat compared to the prior year, even though sales were down. We implemented targeted reductions in SG&A, which in tandem with a slightly lower tax rate helped offset higher investments in R&D and a higher share count. Adjusted gross margin of 70.3% was just below the prior year and the results were slightly below our expectations due to lower volumes in tandem with less favorable product and geographic mix. Our adjusted operating expenses of $852 million were in line with the prior year and stepped down sequentially versus the second quarter. In spite of that, we continue to ramp up investment in R&D and commercial infrastructure across priority growth areas like robotics, and data and informatics. And we are offsetting those increases with improvements in efficiency across other areas of SG&A. Our adjusted operating margin for the quarter was 26.1%, largely in line with the prior year and prior quarter. The adjusted tax rate of 15.8% in the quarter was in line with our expectations. Turning to cash and liquidity, we had operating cash flows of $433 million, and free cash flow totaled $307 million with an ending cash and cash equivalents balance of just over $900 million. We continue to make good progress on deleveraging the balance sheet and paid down another $300 million of debt totaling $500 million of debt paydown for 2021 to date. Moving to our financial guidance. We've updated our full-year 2021 outlook based on two factors: COVID and customer staffing pressure is continuing at levels higher than previously expected. While we expect procedure volumes to seasonally improve into the fourth quarter, we are taking a cautious approach and currently assuming that the more acute pressure we saw in September will continue through the fourth quarter; and as Bryan mentioned, we now know more about the dynamics leading up to the implementation of the China VBP and project that it will have a bigger impact on the fourth quarter than originally assumed. The impact across inventory reductions, price write-downs on existing inventory, and a new factor which is patients deferring their procedures have increased the impact of VBP and the timing of that impact. As a result, our current projections for Q4 VBP impact is about 300 basis points of headwind to our consolidated results. But the situation remains fluid and we will continue to update you as the implementation of VBP unfolds. For the full year, we now expect reported revenue growth to be 11.3% to 12.5% versus 2020 with an FX impact of about a 140 basis points tailwind for the year. While we are taking steps to further reduce spending in the fourth quarter as a response to our lower revenue outlook, we're reducing our adjusted operating margin projections to be 26% to 26.5% for the full year. Our updated full-year adjusted diluted earnings per share guidance is now in the range of $7.32 to $7.47. Our adjusted tax rate projection is unchanged at 16% to 16.5%. And finally, our free cash flow estimates remain in the range of $900 million to $1.1 billion. This updated full-year 2021 guidance range implies that Q4 constant currency revenue growth will be between -2.3% and +1.8% versus Q4 2020. And we project Q4 adjusted earnings per share to be between $1.90 to $2.05. We kept a wider range of potential Q4 outcomes in our guidance to account for the uncertainty around COVID surges, customer staffing pressure, and VBP implementation. As a note, we do believe that COVID pressure, including the related staffing shortages will continue to mute pandemic recovery as we move into 2022. Additionally, as we mentioned earlier, VBP is expected to reduce 2022 consolidated revenues by about 100 basis points. That impact will be felt in our large joint segments and will negatively impact gross margins as we move forward. To respond to this, we are accelerating transformation and efficiency efforts to help offset these headwinds. In summary, the macro environment presents challenges, but our underlying business fundamentals remain strong as we continue to execute successfully against what we can control. With that, I will turn the call back over to Bryan.

All right. Great. Thanks Suky. And to close out our prepared remarks, I'm going to talk about what Zimmer Biomet can control, our strategy and our execution, and that's why I have such confidence in our long-term growth projections. The Zimmer Biomet team remains intensely focused on creating value and, most importantly, delivering on our mission. Our underlying business is strong and overall, we're pleased with our performance in Large Joints and S.E.T. versus market. This is a significant shift for Zimmer Biomet versus where we were just a few years ago and an important driver of our ongoing growth. Our innovation is in full stride, and that's a big part of this. We're going to enter 2022 with a new product pipeline of more than 20 anticipated product launches across the next two years. And of course, this is incremental to a number of new products we recently launched, including, but certainly not limited to ROSA Partial Knee, ROSA Hip, and Persona IQ, which is the first smart knee implant in the world. We're very excited about this launch. We continue to see strong ROSA placements, increased robotic penetration into our accounts, and most importantly, more robotic procedures as a percentage of our overall procedure base. ROSA is even more attractive because it's a key component of our ZBEdge suite of truly integrated solutions. It really helps to tie pre-, intra-, and post-op data together with the goal of changing patient care. Finally, we are accelerating our corporate transformation. We're making great progress on the planned spin-off of our spine and dental business. We just recently appointed a new CFO and other key leadership team members for the spin-off. And we continue to be strategic and selective in our active portfolio management process, and have acquired key assets over the past year that have helped us to better compete, and more importantly to win across robotics and data, dental, S.E.T., and the broader ASC market. We're reinvesting in our business for sure, but we're also advancing efficiency programs designed to streamline and improve how we operate, and very importantly, drive savings. All of this forward momentum plus Zimmer Biomet's differentiated portfolio, the expected value creation of our plans for the spin-off transaction, and our ability to execute really does give us continued confidence in our path to grow revenue in the mid-single digits and to deliver a 30% operating margin by the end of 2023. I can tell you, this is clearly a time of significant challenge in market pressures, particularly given the fact that we have such a dependence on elective procedures; there's no doubt about that, but this is also a time of significant opportunity for Zimmer Biomet. We look forward to delivering for our team members, delivering for our shareholders and most importantly, the customers and patients that we serve. And with that I'm going to turn it back over to Keri to begin the Q&A session.

Thanks, Bryan. Before we start the Q&A session, just 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. Ladies and gentlemen, at this time, we will now begin the question and answer session. One moment please for the first question. Our first question comes from Ryan Zimmerman with BTIG.

Great. Thank you for taking the questions. Suky, I really appreciate the guidance for the fourth quarter. It looks like you're maybe about $200 million or so below where the street was landing for the fourth quarter and the top-line is about $0.40 or so below consensus in terms of EPS. I'd love to understand specifically where you see the greatest delta between your previous expectations from a product segment and recovery standpoint. It sounds like VBP is maybe three quarters of that $200 million. But outside of that, where do you see an impact that we should be thinking about from a guidance perspective?

Yeah, thanks for the question, Ryan. Absolutely, our Q4 implied is lower than where we were when we last provided guidance in August and updated in September. That guidance was predicated on COVID not worsening and actually starting to see things recover and improve. As we came into the third quarter, the early part of the third quarter, we actually saw some positive momentum with some modest growth in the first two months. But then as we came into September, while we saw elective procedures increase in September as they generally do seasonally, the pressure from COVID and from staffing shortages was greater than expected, such that the growth wasn't there; and we just didn't get to 2019 levels. So you really have to think about recalibrating the third quarter as you move into the rest of the year because those levels were much lower than we thought. Our original guidance suggested that Q4 would be at about market growth or slightly better. That clearly is not what we saw in September and so what we're doing is we're taking that September trend, which was down, and we're carrying that forward into the fourth quarter. So that, I would say, is the largest component of our takedown for our rest of year guidance and for Q4 specifically. In addition to that, there's been some incremental additional pressure due to VBP. We had always assumed that there would be some inventory dynamics that we accounted for within our forward-looking guidance range. But what we're seeing now is a slightly bigger impact primarily driven by this notion that in-market and from our local teams, patients are beginning to defer their procedures until the implementation so they can secure a lower out-of-pocket. So I would pull back and say that the biggest component is the headwind due to COVID. And instead of the fourth quarter growing, as we originally thought, the pressure that we're seeing in September we're assuming continues for the rest of the year and that really is your biggest deviation.

Okay, I appreciate that color. From a margin perspective, Suky, on longer-term margins you talked about 30% adjusted operating margins. The Street is assuming about 26.7% in 2022 given today's dynamics and expectations; how does that sit with you relative to where consensus is right now? What is your view of a normalized, steady-state operating margin, since you do have operating expenses and fluctuations as a result of these dynamics?

Great, great question. I'll try and unpack that. First of all, we see next year as a bridge year to that 30% operating margin. There are a lot of moving parts into 2022. First off, you have to recalibrate the starting point given the fourth quarter pressure; we're going to be on a lower revenue base because of the pressure we are projecting to see in the fourth quarter. We would expect COVID pressure to continue at least into the early part of '22, so revenue will be pressured. Margin largely follows revenue from a leverage standpoint and the ability to get profit off of our fixed cost base. Inside operating margin, there are a number of components. On gross margin, I think about gross margin being stable to the back half of 2020 as a starting point. We still think that's the right starting point, but we have to watch out for the impact of VBP and what that does as a headwind, and we're also seeing some inflationary pressure on cost of goods and input costs and labor costs. We're working to offset those, but it's a moving target. The second key component is SG&A. I'm really proud of what the team has done already this year to respond to lower revenues and lower margins. We're accelerating our transformation journey in a number of ways. We're looking at regional profitability and restructuring a number of markets that are below expectations. We're looking at other areas of our cost base and accelerating our Global Business Services strategy, and other structural initiatives inside SG&A to help offset those revenue and gross margin headwinds. I'm not going to get into exactly what '22 looks like yet. I think we have to let a lot more play out in the rest of this year, especially around COVID before we can give a more detailed view of '22. But hopefully you've gotten some good color there to help you start on '22.

Thanks, Ryan. Our next question comes from Drew Ranieri with Morgan Stanley.

Hi, Bryan and Suky. Thanks for taking the question. I guess just to go off of the previous question, but more on your long-range plan. Suky, you're mentioning that you're pulling forward some initiatives, but just how are you thinking about your long-range growth right now at margin targets? Maybe help us better understand if any of the composition has really changed in reaching that 30% operating margin. It's about a 400 basis points of expansion; any more you can provide there?

Maybe what I'll do is start with the components that we've defined as what we need to see for growth rates, then you can take it from there on the operating margin piece. First of all, when we think about the 4% to 5% growth that we're trying to accomplish, we've been pretty clear on what we need to see to make that happen. First and foremost, we need to see above-market growth in our biggest franchise, which is Knee. We've been able to prove that over the past six quarters that we were able to get a trend in that direction.

Second, is we need to be at market growth in Hip, trending to above-market growth as we get ROSA traction, which is now in the market. New to the market, but now in the market. And then we need to be in that mid-single digit growth rate for other priorities, if not to the upper end of that. Those are the areas that we're focusing on. We believe they are the building blocks as we get into 2023 to get that 4% to 5% revenue growth. We still believe that is absolutely possible for this organization since that's the topline view, which should be a big component of driving that operating margin projected in 2023 as well.

That's one of the key components, and we're consistent on how we think about that operating margin expansion. It's largely leverage-driven. Gross margins being stable and SG&A becoming a lot more efficient with the ability to reinvest that back against higher growth gives us that leverage to 30% operating margin. In addition, through active portfolio management, we now also have the spin-off, which is going to create a tailwind for us from an operating margin standpoint as well, so we feel good about that. We still think we have all the right building blocks in place to get to that 30% operating margin run rate as we exit 2023.

All of this obviously assumes that when we're in 2023, COVID is in the rearview mirror and no longer a headwind.

Great. Thank you. And just a follow-up on Persona IQ. Bryan, you just launched the product, but would love to get your initial feedback on what you're hearing in the field and maybe if you could set expectations of how a launch should progress over the next 12 months. Would you be disappointed if it wasn't 5% of your total Knee implants, just any flavor would be helpful?

I'm looking at my COO across the table and I just gave him a new target of 5% for IQ and related implants; he's a little worried about that. All tongue in cheek aside, we're very excited about IQ; this is the first of its kind. It's good to bring technology to the market that is new to market. Although we're excited about IQ by itself, it's a really important variable in a much broader equation which we call ZBEdge. ZBEdge is focused on collecting data before, during, and after the procedure. As that data lake increases, we'll be better able to predict what kind of care we should provide for the patient. Every surgeon will tell you there are patients who look perfect procedurally but are not happy. As we collect data and the dataset grows, we'll be able to predict why and be able to change that outcome. When we can do that, we can get more patients into the funnel who are currently sitting on the sidelines because they fear they won't achieve satisfaction. IQ is attractive to us, but it's part of a bigger equation. We're in a very limited launch — we want to learn as much as we can as fast as we can. We do have some supply constraints; microchips are tough to come by. It's not impacting ROSA because you're talking hundreds; with IQ you're talking thousands. It is going to put a damper on how we roll this out in the short term as we work through it, but demand is great and people are very interested, so that's a good sign. We've got to work through the supply constraints and move this forward, but overall, we're very happy.

Thanks for taking the questions.

Thanks and Loren, can we move to the next question in queue, please?

Our next question comes from Amit Hazan with Goldman Sachs.

Thanks and good morning. I want a clarification on the China situation. I'd love a little bit more color on what you're thinking now in terms of your share within the China market going forward, but also whether you're contemplating spine and trauma in the VBP impact. And perhaps most importantly, why would next year be a 100-basis-point impact given that you're already seeing a pretty significant impact this year?

I'll start with the impact. No matter what happens in this base year, we're still predicting a 1% shift to whatever revenue assumptions you've had in 2022. So if you look at growth rate from '21 to '22, that's going to change because you can have more in your base. But the actual impact to consolidated revenues is still 1% in '22. That said, there's still variability; it could be a bit more or less, but model it as 1%. Remember that even though it's 1% of consolidated revenue, it's all in large joints. If I think about our share position in China, we look strong. As a factoid, if you look at our Asia-Pacific Knee business revenue on an annual basis, it's bigger than all three of our major competitors' outside-the-U.S. Knee businesses. That gives you a sense for our market share inside Asia-Pacific and China. This is an important market for us. Even though margin dynamics may be less attractive now, we won every one of the categories in China across eight categories. We are the only multinational company to do that. Now it's going to be about negotiating with distributors to get the best distribution partners to capture share at the best margin. On trauma and spine, it's too early to quantify. There was a provincial tender for 12 provinces that might transition to a national tender, but we don't have a sense for timing. That's our sense for China, our share position, and the dynamics.

And then on share in the U.S., specifically, there's been quarter-to-quarter fluctuations that make it hard to assess whether you're consistently gaining share. Is anything changing in the way you sell product? Is there more end-of-quarter selling? What is making it more difficult in this COVID era to assess consistency?

There's nothing that I'd point to for us that's changed structurally. We're conducting business the way we always have. My sense is others are too. What's happening is a lot of variability because of COVID. COVID is surging at different times in different states and cities in the U.S., and it all depends on your mix in those states. Outside the U.S. it's even broader and more volatile. The challenge in seeing odd deltas between competitors is not necessarily because competitors are doing anything different. It's because the market dynamics are very different. That's why I continuously look at trends; trends typically tell us a story because they neutralize some of that variation. But I don't think anyone's doing anything dramatically different; the market is creating a more challenging environment to look at consistency from company to company.

Thanks, Amit. Lauren, can we go to the next question in queue?

Our next question comes from Joanne Wuensch with Citi.

Good morning and thank you for taking the questions. Two in particular. First, about the month of October — it sounds like you're taking September and applying that, but we've had a whole other month of data in between. Is there anything you can share with us on how October looked?

Without giving specifics, we haven't seen anything in October that would indicate the logic we're using is incorrect.

Okay. And then the ROSA category — could you share a little color on how that launch is going in terms of utilization, halo effect to other products, competitive accounts, anything that flushes that out a bit would be appreciated. Thank you.

In these turbulent times, you always look for things to be excited about, and our innovation pipeline is one of those, with ROSA at the center. We continue to deliver on expectations there, if not above. We designed a robotic system that surgeons really want; we've learned from who went first and created a system that keeps the surgical flow as close as possible to non-robotic procedures. Surgeons don't want to change the flow of their procedure. We made ROSA time-neutral — to be able to use robotics in roughly the same amount of time as a non-robotic procedure — and we didn't change the standard imaging requirement; we don't require CT scans. Those design choices plus the strength of our Persona implant are driving traction. We're seeing strong demand and deeper penetration into our accounts, including competitive accounts. The pull-through benefit from the placements will be muted by COVID in the short term, but those units in place will increase their overall throughput once pressures ease, and that will help beyond the disposable price point associated with robotics. So we're very excited about ROSA; we believe we have the right design in place and we're seeing strong traction.

Thank you.

Thanks, Joanne.

Our next question comes from Kyle Rose with Canaccord.

Great. Thank you for taking the questions. First on accelerating transformation programs — can you break that down more granularly? What specifically have you accelerated, and what costs do you expect to unlock over the next 12 to 15 months?

Thanks for the question. We're still in the planning phase and we'll have more detail on our fourth quarter call as we come into 2022. The key areas are: accelerating our view of market and regional profitability and how we go to market, making sure infrastructure in smaller markets is aligned to growth and opportunity. Second, we're reviewing organizational structure relative to benchmarks to identify outliers where costs are higher and we can be more efficient, including restructuring, de-layering, and accelerating movement to our Global Business Services in lower-cost geographies. Third, continued consolidation of ERP systems to give us better global process orientation, which can yield savings over time. And of course, we're actively looking at site rationalization to help gross margin and are focused on pricing improvements. We'll provide more detail as those plans become refined and quantified on the fourth quarter earnings.

Great. And maybe Bryan on some of the bigger picture longer-term initiatives you talked about, like ZBEdge and Persona IQ. Where are you as far as commercialization and when should investors expect these to materially impact the business and be a competitive differentiator?

You're already seeing some of this. One of the most important things is the trend break we've had in Knee — five quarters out of the last six above market — and that's a reflection of the transformation taking hold. Historically, Zimmer Biomet did not have a quarter above market in Knees; we've had a trend break. Our vitality index for innovations is mid-single-digit now and our strap plan indicates that will triple over the plan period — that's a dramatic tailwind. Execution in Knees is much better, compensation is focused on growth, operating mechanisms are strong, and supply issues are resolved. Innovation now drives performance: Persona Revision conversions are occurring, ROSA Knee has headroom and continues to pace well, ROSA Partial just launched where we already have a large share position, Persona IQ is starting, and in 2022 we have a new form factor for Persona Cementless that removes barriers to pursuing a conversion to Cementless Knee. All of those give many shots on goal to drive strong Knee performance.

Great. Thank you.

Thanks Kyle. Loren, can we go to the next question in queue, please?

Our next question comes from Sam Broido Kodatsky with Truist.

Hi, thanks for taking the questions. When we think about that September pressure continuing into the fourth quarter with the two components being COVID and staff shortages, the general thinking is that COVID is getting a bit better here. Should we take that to mean staff shortages are becoming a bigger portion of the problem into the fourth quarter? And how long do you think these staff pressures could impact volumes and what are you looking for to indicate that staffing pressure is easing?

Either one of us can answer this. It's probably conservative to take September and assume it continues. A lot of indicators would say it's going to get better; however, every time I try to use an external view of when COVID will get better, we seem to be wrong. I'm going with what we're actually seeing in the marketplace, and what we see is consistency — not always the same mix of pressures between COVID and staffing, but consistency in the overall pressure in October that we saw in September. I've learned my lesson; I'm not going to try to predict this anymore until I see proof in the marketplace that the curve is bending. We would expect some of this pressure to continue into 2022. Others have tried to predict when this will stop; your guess is as good as ours.

Sam, the labor shortage is the toughest component to read because it's unprecedented and not just at the nurse level — it's throughout the hospital setting. Through survey data, over half of the physicians reported in the third quarter that they've suffered from staff shortages, and when those physicians have that challenge, they're doing about 10% fewer procedures than they normally would. That's real. We're also seeing the impact is greater in hospital settings than in ASCs, and because we have a more prominent share in hospitals, it more disproportionately impacts us. Because of those factors, until we see substantial, durable improvement, we're taking the view this will linger with us. But hopefully it's conservative and it'll lift sooner than expected.

And Sam, did you have another follow-up? I think that was two questions in one, but anything to close out there?

No, that's it — thank you.

Great. Lauren, can we have the next question in queue then?

Our next question comes from Mike Matson with Needham & Company.

Yes, thanks for taking my question. I guess I wanted to start with M&A. I thought you would have done more by now. Are multiples too high, are you waiting to get through COVID uncertainty? Do you need to de-lever the balance sheet more? Or is there some other reason you haven't been more active?

We would like to do more too, but if you think about COVID pressure from an EBITDA standpoint and look at our leverage ratio, the fact that we've done as much as we have with limited firepower is impressive. I compliment the team for selecting targets and getting creative in how we pay for targets even in an environment with high multiples, bringing technologies fundamental to success in S.E.T. Our A&E acquisition helps in thoracic space; the technology we brought filled gaps in sports and helps us leverage the portfolio. Omni Suite gives us presence in ASCs. All those things happened while we had limited firepower. We expect over the next five years to increase firepower, particularly as COVID gets behind us, and we will flex more muscle in this area. But we've done more than might have been expected given our firepower.

Okay, that's helpful. Then in recon, Hips were down more than Knees in the quarter. I thought Hips were somewhat less elective and might have been less affected by the COVID wave than Knees. Is that just a reflection of new product and ROSA Knee momentum or is something else going on?

That is a switch from typical patterns. Historically, Knee procedures lag Hip because hip patients often present with more urgent pain or trauma. What we're seeing now is that hip backlog was consumed earlier and now knee patients — who have been waiting a long time — are moving into the funnel. Many knee patients have been waiting as long as they could due to pain tolerance and are now entering the market. That likely explains why knees have stronger relative performance recently compared to hips, but we'll see how this develops next quarter.

Okay. Got it. Thank you.

Thanks, Mike. Lauren can we go to the next question in queue, please.

Our next question comes from Robbie Marcus with JPMorgan.

Great. Thanks for taking the question. Suky, on the 100 basis points impact from China next year, is it fair to assume that since it's price-based it will drop through the bottom line as well?

Yes, that's the right way to think about it, Robbie.

Got it. Second, does that hinder your ability to get to your operating margin target in 2023? And then just two quick clarifications: what was the day-rate benefit in the quarter, and what was the M&A contribution?

It certainly adds a headwind to get to 30%. But when we put the 30% aspiration out, there were two big components we had not fully contemplated — VBP as you mentioned, and active portfolio management including the spin of the spine and dental business, which will be margin accretive. We think those two largely offset one another. That's another reason why, even with this headwind, we're confident in delivering that exit run rate by the end of 2023. Relative to day-rate, there's no meaningful headwind or tailwind; that was true for the quarter and for the full year. On M&A contribution, I'd put it in the low single-digits. If you look at S.E.T., which is about 20% of our overall revenue, acquisitions helped by roughly 300 basis points in that portfolio. So, it's less than a percent for consolidated results, but meaningful within S.E.T.

Great, thanks a lot.

Thanks, Robbie. Lauren, we have time for a few more questions. Can we go to the next one in the queue?

Our next question comes from Matt Taylor with UBS.

Thanks for taking my question, guys. Bryan, I wanted to ask about what you're seeing in the marketplace and about predicting COVID. What about the last year would inform you on what we could see for 2022 in terms of recovery? We saw a strong rebound after the earlier shutdowns; this delta wave seems more muted in terms of comeback. Is the Delta variant acting differently or is something else going on?

It's hard to predict. The Delta surges are real and they impact capacity, particularly in hospitals. Staffing shortages are also real and more acute in hospitals than ASCs. We typically look at when patients enter the funnel; normally it takes four to five weeks from entry to procedure, but that can be extended now because of capacity constraints. Procedures are increasing seasonally — August to September was better — and we expect Q4 to be better than Q3, but those gains are muted by COVID and staffing pressures. That's the reason for our guidance change; procedures are increasing but not at the clip we'd expect because of these pressures. I don't have a better predictive answer.

Sure. I wanted your view on how much of the staffing shortage is tied to COVID itself. If COVID wanes in 2022, do you think staffing issues will ease as well, or could they linger into the second half of next year?

It's challenging. There are multiple components. Some is due to vaccination requirements and mandates for employment, which may be discrete, but there are also structural labor market changes — such as people choosing to leave roles or prefer traveling nurse positions that pay more. Those dynamics could linger beyond the period where COVID is the primary driver. My sense is they may be somewhat disconnected and staffing could persist beyond COVID, but I can't say with precision.

Thanks Matt.

Our next question comes from Imron Zafar with Deutsche Bank.

Hi, good morning. Thanks for taking my question. How are you thinking about blended implant ASPs in the U.S. over the next couple of years in large joints? There are many moving parts — new products, higher robotics mix, case setting shift to ASCs — so how are you thinking about implant ASPs over the next couple of years?

Two ways to answer. First, pricing discipline is a major focus for the organization, and improving pricing capture could mute some of the long-standing pricing pressure. Second, mix is a key benefit: technologies we launch often increase the dollar captured per procedure. Robotics carries a premium, Cementless has a premium, Mymobility has a premium, Persona IQ will have a premium. As we get deeper penetration in these technologies, we expect the ASP per procedure to increase and be a tailwind for growth.

Great, thanks. And secondly, can you comment on the international opportunity for ROSA and the timing in key markets?

We've been very happy with traction outside the U.S. In certain markets, specifically Asia-Pacific, we have the opportunity to surpass others in robotics if current trends continue; we could be the number one share player in robotics in Asia-Pacific relatively quickly, and not too far behind in EMEA. The U.S. could take a bit longer, but we're seeing strong international traction.

Thank you very much.

Thanks Imron. I think we have time for maybe one last question.

Our final question comes from Anthony Petrone with Jefferies.

Great. Thanks for taking my question. Maybe to double back on staffing — there are a number of headwinds: burnout, turnover, personnel leaving healthcare services, early retirements. How deep into 2022 do you think these trends could last and what could they mean for throughput in ortho recon? Quick follow-up on pricing for hips and knees as we navigate the next few quarters would be helpful.

It's challenging to predict when staffing concerns will end. The rise of traveling nurses and other market shifts is creating a sub-market that exacerbates shortages. I can't accurately predict timing; I assume some continuation into 2022. Regarding pricing, hospitals under pressure may push on suppliers for better pricing but that's nothing new. I don't anticipate a structural change in pricing dynamics from these staffing pressures. Over the five-year strap plan, we expect to reduce the pricing impact via better pricing discipline and improved contracting, especially with ROSA and multi-category contracting to stabilize pricing. There will always be push for better pricing, but this variable alone should not materially change our pricing strategy.

That does conclude today's question-and-answer session. I would like to turn the conference back to Keri Mattox for any additional or closing remarks.

Thanks, Lauren, and thanks everyone for your questions today. Of course, we'll be speaking to many of you today, tomorrow and throughout the next couple of weeks. If you have questions and need more information, please don't hesitate to reach out to the IR team anytime. Thanks so much for joining.

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