Zimmer Biomet Holdings, Inc. Q2 FY2023 Earnings Call

Good morning, everyone, and welcome to the Zimmer Biomet Second Quarter 2023 Earnings Conference Call. I will now hand the conference over to Keri Mattox, Chief Communications and Administration Officer. Please proceed.

Thank you, operator, and good morning, everyone. Welcome to Zimmer Biomet's Second Quarter 2023 Earnings Conference Call. Joining me today are Bryan Hanson, our Chairman, President and CEO; EVP and CFO, Suky Upadhyay; and COO, Ivan Tornos. 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 and 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 Q2 earnings release, which can be found on our website, zimmerbiomet.com. With that, I'll turn the call over to Bryan. Bryan?

All right. Thanks, Keri, and thanks to everyone for joining us on the call this morning. It's always good to be with you. But I would say it's even a little better and certainly more fun when we have great performance in the quarter. So we're pretty happy about the results that we get to discuss today, and I can tell you we're looking forward to the dialogue. And I'll start things up, as we normally do, I'll talk about our Q2 performance and the key drivers inside of the quarter. But I think also really important is to talk about the key drivers that we see continuing to move this business forward. And then Suky will walk us through the financial details of the quarter and importantly, discuss how we are again raising our full year financial guidance. And then, of course, we'll close things out with a Q&A session, and we look forward to answering your questions and having a dialogue in that session. Okay. To kick things off, I'm just going to take a step back, which I've been doing now for the last handful of quarters and I think deservedly so, because I want to say thank you. I want to say thank you to each and every one of our team members around the world because it's your hard work, it's your dedication to getting the job done that is moving this business forward. And I will tell you that I'm proud to say that you have delivered another very strong quarter, while once again making ZB a certified Great Place to Work. And you've done all of this while improving our scores and as a result of that, our rankings on the environmental, social and governance front. So I think simply stated, we are doing well while also doing good. And that means for our team members, our patients, our customers, and our communities and even our planet. So once again, I want to say thank you to our team for all that you do for ZB and to move our mission forward. And most importantly, for doing it together as one team, one ZB team. Now let's talk about the second quarter. And I'm just going to say simply, we delivered another strong quarter, again beating our own expectations. And that performance positions us to again raise our financial guidance on both the top and bottom line. And this is in the face of some pretty significant macro factors that are impacting us in the entire market. Ongoing supply challenges are very real, and I'll talk about those in a minute, but also inflationary pressure, a tough labor market, and the geopolitical landscape that is putting pressure on everybody. But against that, I feel very confident about our pipeline, our execution and the team's demonstrated ability to navigate these headwinds, which gives us confidence to increase our financial outlook. Okay. With that said, let's talk about the key drivers inside of Q2, and there were some positives and there were some negatives. I'll start with the positives, and the most important one, in my view, is that our team's execution remains flawless. We're seeing significant traction, probably the best we've ever seen with our new product innovation. And that paid dividends in the quarter for sure, but most importantly, is it pays dividends as we move this business forward. And I would say that procedure recovery continued in the quarter, again showing no meaningful impact from COVID or staffing challenges, and that allowed for a tailwind from increased provider capacity, and that resulted in backlog pull-through in the quarter. In terms of headwinds, I would say that the team is doing a great job of managing the supply-constrained environment. But I would say that it is still very clearly a governor to our overall growth in the quarter, and it continues to be a distraction for the organization. See if I combine these things, though, all in all, our momentum continues, and it continues to grow. And I've said before, my confidence in this business, our confidence in this business is as high as it's ever been. And it's high for a good reason. If you just look at the knee franchise alone, our innovation strategy is working. We now have four meaningful pillars inside of this business, all of which can drive pricing stability, mix benefit and competitive conversions. First, let's look at the ROSA Robotic Platform combined with our Persona cementless Knee. Now this is a powerhouse combination that is and will continue to accelerate growth. And based on the traction we're seeing so far, we continue to believe that ROSA and Persona cementless together will enhance our robotics and cementless penetration from the current mid-teen level to 50% or better. The second pillar that we're focused on is Persona revision. This provides a meaningful conversion and mix opportunities inside the revision category. But importantly, it also acts as a powerful tip-of-the-spear product for conversions and primary needs. And then third, it's just the overall shift of the ZB legacy knee systems to our now fully rounded out Persona portfolio. And this is a meaningful mix benefit that we can take advantage of that, I would say, is somewhat unique to our business. And then fourth, on top of all this, we have the world's first and only Smart Knee which is Persona iQ. And I know this is still in limited launch, but already, it offers surgeons unparalleled data access and is attractive to patients, those patients who want more direct engagement with their care recovery. And we're taking on a similar approach to our hip portfolio where we continue to launch meaningful innovation, again, giving us the opportunity for price stability, mix benefit and competitive conversions. And we have four pillars of focus here as well. First, it's ROSA and Hip Insight. These are technology shifts in robotics and mixed reality that are setting up the ZB Hip portfolio for greater adoption and growth. Second is the Avenir Complete. This is our current flagship product combined with G7, which gives us a very strong position in both the attractive direct anterior and revision submarkets of hip. And then third, this position will be enhanced with work being done on a triple taper stem which will fully round out our direct anterior approach portfolio. We believe this new portfolio, combined with the G7, which is the most versatile acetabular component available will be unmatched in the industry. And then fourth, HAMR. This is our upcoming full launch of an automated impaction system that builds on a proven need in the market, and we fully expect that this launch will create surgical efficiencies while bringing personalized precision to each and every patient. And then finally, in S.E.T., we are being disciplined and targeting investment in our growth driver categories, Upper extremities, Sports and CMFT, and each of these categories continue to perform. And given our momentum in these businesses and continued investment in innovation and dedicated infrastructure, we fully expect the S.E.T. set business to be a mid-single-digit grower in a normalized market environment. So overall, we're very excited about our innovation momentum. It's very real. Remember, we've called out that we have 40 planned product launches between this year and the end of 2025. With the majority in 4%-plus growth markets. And that's important because these innovations will certainly drive near-term growth. There's no question about that, but also create better sustainability of that growth because of the markets they're in. This portfolio shift that we're seeing and the team's execution capabilities are clear signs that our ZB transformation has taken hold. But I can tell you right now that we're not going to stop there. The goal is to continue to enhance our growth profile through our ongoing focus on active portfolio management, and that is supported by our already strong and strengthening balance sheet. And with that, I'll turn the call over to Suky for a closer look at Q2 and our latest expectations for the remainder of 2023. Okay, Suky?

Thanks, and good morning, everyone. As Bryan noted, we had another excellent quarter. Our results were driven by strong end markets as well as strong execution across the entire organization. As a result, we are again increasing our full year financial outlook. With that, let's turn to our results and updated full year guidance. Unless otherwise noted, my statements will be about the second quarter and how it compares to the same period in 2022. And my commentary will be on a constant currency and adjusted operating basis. Net sales were $1.870 billion, an increase of 4.9% on a reported basis and an increase of 6%, excluding the impact of foreign currency. Additionally, we had a selling day headwind of less than 50 basis points in the quarter. Overall, the business continues to benefit from a recovery of elective procedures driven by continued market normalization, including hospital staffing and procedure cancellations returning to pre-COVID levels. We also benefited from some backlog recapture. While market momentum is strong, we continue to face certain macro challenges, including global supply chain pressures that muted performance across the business. U.S. growth of 5% continued to outpace our expectations and international growth of 7.2% was driven by strong performance in both EMEA as well as Asia Pacific. All regions benefited from continued recovery of elective procedures, backlog recapture as well as strong commercial execution and new product uptake. Turning to our business category performance. Global Knees grew 10.5% with U.S. growing 9.8% and international growing 11.4%. The strong performance in Knees was driven by the four pillars that Bryan mentioned earlier, centering on a very attractive Persona portfolio, combined with the benefits of our ROSA robotics platform. Global Hips grew 4.9% with U.S. Hips up 2.7% and international up 7.1%. Both regions posted good growth on the back of new product flow, execution, and market recovery. Next, the S.E.T. category was down 30 basis points year-over-year. Inside of that, we saw continued strong performance from our three focus areas within the business segment. As expected, we saw pressure from reimbursement headwinds within the Restorative Therapies business. In addition, we experienced more acute supply challenges within Sports and Trauma. In the backdrop of this, we believe we will move beyond these headwinds, and this segment will rebound in the second half of the year. Finally, our Other category grew 6.5%. Now moving on to the P&L. In Q2, we reported GAAP diluted earnings per share of $1 compared to GAAP diluted earnings per share from continuing operations of $0.73 in the prior year. The increase was driven by higher revenues combined with lower non-operating expenses due to ZimVie investment losses from the prior year that did not repeat as well as lower spend related to restructuring costs. These benefits were partially offset by increased investment in R&D and commercial initiatives to drive future growth. On an adjusted basis, we reported diluted earnings per share of $1.82 were flat to the prior year. Higher year-over-year revenues and better gross margins were offset by higher R&D expenses, increased investments into commercial infrastructure for new product launches, and higher interest expense. Our adjusted gross margin was 72%, up 40 basis points from the prior year despite absorbing current year inflationary pressures as well as pressure from prior year that was capitalized and flowing into this year's P&L. Favorable mix and FX hedge gains also helped support the increase in gross margin. Adjusted operating margin for the second quarter was 27.5%, down 50 basis points from the prior year. While gross margin was up, this was offset by higher operating expenses due to increased investments in R&D, aligned to our plan to improve our vitality index through new product innovation as well as higher commercial infrastructure costs to support new product uptake. Net interest and other non-operating expenses of $57 million was higher than our expectations and significantly higher than the prior year due to certain foreign currency losses in the quarter as well as higher interest rates. Our adjusted tax rate of 16.3% was in line with expectations. Turning to cash and liquidity. Operating cash flows were $348 million and free cash flow totaled $165 million. We ended the quarter with cash and cash equivalents of $320 million. Our balance sheet remains strong, providing strategic and financial flexibility for future growth. Moving to our updated financial outlook for 2023. Based on another strong quarter of results, we are again raising our full year 2023 outlook. We are confident that we will continue to grow our top line above market rates and expand operating margin while continuing to reinvest in our business for future growth. We are increasing and narrowing our constant currency revenue growth range to 7% to 7.5% with an expected foreign currency exchange headwind of 50 basis points. We are also increasing our adjusted EPS guidance range to $7.47 to $7.57. Additionally, due to certain FX-related pressures and higher interest rates, we now expect net interest and other non-operating expenses to be around $200 million for the year. Our expectation around tax rate and total shares outstanding remain unchanged. And we continue to expect free cash flow to be in the range of $1 billion to $1.1 billion. Our Q3 and Q4 revenue cadence expectations are unchanged. Q3 revenue dollars are expected to be sequentially down versus Q2 and in line with normal seasonality, and Q4 will be our strongest quarter on a dollar basis. While we expect momentum gained from the first half to flow into the second half of the year, recent and new sanctions on Russia may mute growth. And regarding selling day impact, we continue to expect Q3 to have a selling day headwind of about 150 basis points, while Q4 will have about 100 basis point tailwind. Overall, the net day rate impact for the full year is not meaningful. From a margin perspective, we expect Q3 to be our low watermark for the year from both a gross margin and operating margin standpoint. While gross margin will have less variability from quarter-to-quarter, we expect Q3 operating margin to step down sequentially between 150 and 200 basis points due to the normal seasonality of our business. We expect Q4 to step up significantly on a sequential basis, delivering our highest operating margin for the year. Importantly, we remain committed to investing for future growth while delivering meaningful full year margin expansion in 2023. We're really pleased with how our team is navigating a challenging environment. In summary, we delivered another quarter of excellent top line results, beating our expectations while managing very real supply chain challenges. We are building on our early momentum through continued execution and are again able to increase our full year guidance. We are also reiterating our confidence and expectation to be a 4%-plus or even mid-single-digit top line grower in a normalized market while delivering strong earnings. In short, our business has never been stronger. With that, I'll turn the call back over to Keri.

Thanks, Suky. Before we start the Q&A session, just a quick 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?

We'll go first to Travis Steed with Bank of America.

Good Morning Bryan and Suky. Nice quarter. I guess I'd start out with looking at the Hips and Knees in the quarter. I would think that knees 2x the growth rate of hip this quarter, backlog will be similar there. Is the elevated knee growth mostly the mix shift from cementless and ROSA coming through? I'm curious how much supply is limiting growth in Hips and Knees here and what you're assuming about that improving in the back half?

Thanks, Travis. Well I think maybe I'll do because obviously, Ivan is here with us and as close to the action as any of us. So maybe I'll pass it on him to answer the question. Ivan?

The growth in knees is primarily driven by innovation. We are experiencing strong momentum with ROSA penetration, showing a considerable increase in the U.S. and key international markets. The launch of Persona OsseoTi, the cementless option, is also gaining significant traction in the U.S. Bryan mentioned our plans to increase our market share from 15% to 50%. While I can't share our exact position for Q2, we saw a notable increase in that area as well. Additionally, we are seeing strong growth in ambulatory surgical centers in the U.S., with double-digit growth. There has been some backlog in major markets globally, with better backlog consumption in EMEA compared to the U.S., but backlog played a role in our performance. Regarding your latter question, supply has certainly been a constraint. However, we believe that in a more favorable environment with improved supply, our already strong growth rate could have been even higher. In summary, backlog, innovation, and effective commercial execution were the main factors driving knee performance.

Great. And I guess looking forward, that the sustainability of this kind of the plus and the 4 plus, and I think I heard the comment even mid-single-digit growth. It sounds like even with some tougher comps, you're still confident in that seeing the plus in the 4 plus? And I assume that price is better. You got the mix of backlog is probably still lasting through 2024. I just kind of love to hear your confidence in kind of seeing the upside to that 4-plus?

Yes, Travis, this is Suky. You're very perceptive about our comments. We are confident that in a normalized environment, we will achieve growth of four percent or more, or as I mentioned, a mid-single-digit growth rate. There are several factors contributing to this. First, our execution is incredibly strong. Our weighted average market growth continues to improve, largely due to our investments in research and development in higher-growth submarkets, including recon, sports, extremity, and trauma. Moreover, our mergers and acquisitions have targeted higher-growth areas in sports and upper extremities. This has led to an overall improvement in our weighted average market growth. Next, our innovation enhances our competitive edge in the market, positively influencing our share of wallet and product mix. Additionally, we've consistently demonstrated that we can perform at or above market levels for several quarters, which underscores our strong execution. We are also seeing some favorable changes in market dynamics. The average age of our patients is decreasing, which is broadening our overall market. Patients are becoming more confident in the outcomes of recon and sports procedures due to advancements in technology and innovation, which provide real value. Finally, the increasing convenience and acceptance of the ASC setting are further propelling market growth. Although the market dynamics are still in the early stages, our execution remains strong and credible. Overall, we maintain a high level of qualitative confidence. If you examine our guidance for the latter half of the year, the implied growth rate of approximately five percent serves as a quantitative proof point that reinforces our confidence. Thank you for bringing this up, and these elements contribute to our assurance.

We'll go next to Richard Newitter with Truist Securities.

I'm trying to understand if we're returning to sustainable normalized margins. What do you see as your normalized margin and prospects for margin improvement? In the first quarter, you achieved about 200 basis points of year-over-year operating leverage while growing double digits on the top line. Now, in the second half, you're at roughly 100 basis points, which suggests a mid-single-digit implied growth rate on the top line. Can we assume that these levels of operating leverage are appropriate to align with upper mid-single-digit growth? If you're achieving over 100 basis points, are we looking at something more like lower mid-single digits or upper low single digits, with 50 basis points plus operating leverage?

Yes. So first of all, thanks for the question, Rich. I'll just step back a little bit and just say, if you go back to 2022 even in a very challenging market with a lot of inflationary pressure, supply chain disruption, et cetera, we were able to grow our operating margins. As you look at 2023, you take our implied guidance, it would suggest we're going to grow operating margins by almost another 100 basis points at the midpoint. So we feel really good about what the company has been doing. And inside of that, we've been doing that with very strong, as you've seen, mid-single-digit growth, very good gross margin performance. I'll break that down in just a moment. Offsetting continued challenges with inflationary pressures, but also inflation from '22 that capitalized into this year, which we've talked a lot about, while still investing against the business for future growth, right? So a very strong profile, good top line growth, good gross margin, offsetting the challenges and continuing to invest against the business. So I do think our ability to sustain these very high, very attractive margins this year into the future is absolutely table stakes, but I also think that we're going to be in a position going forward in a normalized market, where we're going to be able to expand margins from here. So that's how we think about things. I won't try and break down between what level of revenue growth, how much margin expansion. There are a lot of factors that play into that. The big picture takeaway is we're at a really good level now, we're going to sustain that, if not grow that into '24 and beyond.

Okay. And just maybe feeding that into M&A. As we think about your M&A and tuck-in strategy, how should we think of the prioritization of top line from tuck-in M&A versus margin and earnings dilution trade-off?

Yes. So we know how to work around this as a leadership team. And clearly, what you see by looking at other companies in our sector is that valuations are correlated at a very high level to revenue growth. So understanding the ability to get our revenue growth at a higher rate. The mid-single digit is a great accomplishment given where the company was just three to five short years ago, and we're happy about the progress we've made, but we're not satisfied, right? And we believe that M&A, investing into faster-growth markets absolutely is the right thing to do and ultimately, we'll improve our overall weighted average market growth and the overall growth rate for the company. And then once you get there, you get natural leverage, the P&L starts to flow through and over time, you start to get to a profile where you get very strong earnings growth well ahead of revenue growth. And so that's the profile that we're going for long-term. From an M&A standpoint, our first priority is that revenue growth and that diversification of the company into faster-growth markets. That may come with some near-term dilution, but we're also going to be very conscious about driving P&L discipline and looking for accretion in a reasonable amount of time, let's say, within the first two years. So that's how we think about M&A. The priority is going to be about accelerating the overall company's growth.

We'll go next to Pito Chickering with Deutsche Bank.

Can we touch more into S.E.T.? You talked about strength in 3 focus areas, as process of supply challenges. What were those issues? Are they fixed at this point? And how should we be modeling S.E.T. in the back half of the year? And if the supply tunnels are fixed, should we think about bolus in the third quarter?

In the second quarter, we continued to address some reimbursement changes in our Restorative Therapies business that we discussed last year. We believe those issues have now been resolved, so they should not pose a challenge as we move into the third and fourth quarters. However, we did encounter significant supply issues, particularly in our Sports division and to a lesser extent, Trauma, which impacted growth. Despite this, our focused areas of Sports, Upper Extremities, and CMFT performed exceptionally well, and we are pleased with the ongoing progress and momentum in those segments. We anticipate a turnaround in the S.E.T. category in the latter half of the year, with stronger performance expected in the fourth quarter as we navigate the ongoing supply challenges in the third quarter.

Okay. Great. And then in the script, you talked about Russia getting growth. Can you walk us through how Russia could impact growth at this point and quantify the revenues and raw materials exposed to Russia?

Overall, Russia accounts for less than 1% of our total sales on an annual basis. We became aware towards the end of the second quarter that new and unexpected sanctions were imposed on certain medical device products, which include our offerings. This requires us to reapply for licensing for all our products. While we don't believe this will be a long-term issue, it will create some challenges for the third quarter and possibly into the fourth quarter. We estimate that this headwind will be around 50 basis points in the latter half of the year, with the most significant impact felt in the third quarter. Regarding raw materials, our titanium supplies from Russia have remained relatively stable, which is promising. Additionally, we implemented measures at the end of 2022 to establish redundancy and sourcing from multiple alternative suppliers outside of Russia, making us feel confident about our titanium supplies.

We'll go next to Jeff Johnson with Baird.

Kind of, I guess, we're ticking through all the segments here. So maybe if we just look at the Other segment, the 6% growth that was at least a nice step-up from what we've seen on a trailing 12-month basis. Maybe any insights there what drove that and just kind of how we're seeing mix between leasing contracts and/or outright purchases on ROSA?

Yes, sure. Jeff, I'll take that, Suky again. I think the biggest driver was bone cement, not surprising when you see the recon growth numbers in the second quarter to see a very good other performance, especially for bone cement. We also saw some good performance outside in surgical as well, which also creeped up. Your last question inside of that was around ROSA placements versus outright sales. And consistent with prior commentary, we're seeing the majority of our ROSA placements or installments, I should say, being done through the placement strategy versus sales. So that trend continues.

All right. Great. And then maybe just a follow-up, just on backlog. I know you don't guide on backlog and any high-level comments though on how you're thinking about that backlog clearing in EMEA and what you saw in the U.S.? And just kind of comfort with that backlog still continuing to provide some tailwinds maybe over the coming year or two? Thanks.

Yes, we certainly experienced that in the second quarter, which helped to mitigate some of the supply challenges we faced. We anticipate that backlog will keep contributing for the remainder of this year. It’s always challenging to specify exactly how much was attributed to any particular quarter and to forecast how much will be realized. While it’s somewhat unclear, we are confident that it will continue to be significant as we move through the end of this year and likely into 2024.

We'll go next to Larry Biegelsen with Wells Fargo.

Congratulations on a strong quarter. I have a couple of questions regarding the pipeline. For Persona iQ, do you have everything you need for a full launch in terms of clinical data? If so, what data will you promote and file for the label? I also have one follow-up question.

Absolutely, Larry. I'll take that one. First and foremost, we remain on track with our limited market release. We've been saying all along that by January Q1 of 2024, we'll be ready for a full launch. And I will say that we're almost there in gain on the data. We're approaching 1 billion data points from multiple patients thousands of implants by now. And really we're answering three questions. Number one is, to your point, what is the value proposition? Can we demonstrate a reduction in the length of the episode of care? Can we bring objectivity to a range of motion metrics? Can we demonstrate better gate performance given better technique, better surgery? Can we compare recovery curves? Who does better post implantation? There's a lot of data we get in that regard, and we'll be filing some claims once we digest the multiple data points that we're getting. So that's question number one. Question number two in the limited market release is how do we make the whole thing seamless? This is new to the word technology. It's got a home base station, as you know. It involves the patient, involves the surgeon, the caregiver. So we want to make sure that is a best-in-class experience, and there are some things that we're working around. And then the third question, and I know this is near and dear to you, is who's going to pay for the technology? To that end, we got the NTAP kicking in at the beginning of October. You'll be pleased to know that we follow up with your question around TPD, transitional pass-through. We had a deadline of August 23 to submit. We're in the final stages of evaluating what the submission could look like. We're evaluating commercial payer strategy as part of this limited market release. So we continue to think about the payer as well. So with all of that said, the what, the how and the who will pay, I think going to be in a good position to start to see a full market release by January, if not late Q1 2024.

Ivan, thank you for that detailed answer. I have another question for you regarding the Robot, specifically for the shoulder application. Could you confirm that you still anticipate being the first to market and elaborate on what needs to be done? Additionally, any more information on the timeline would be appreciated.

I'd love to give you more color, but Bryan and Keri will shoot me. I will tell you that we remain convinced capital letters that would be first to market in Shoulder Robotics, and beyond the speed to market, what I like is what the actual platform offers. Faster surgeries, more accurate outcomes, shorter recovery. So a lot of what we've seen, we've done our final validation labs with customers, both friends and family customer surgeons and also competitive surgeons and the feedback has been outstanding. Beyond the platform dynamics that I mentioned around shorter recovery, faster surgery, I just love the integration that ROSA shoulder will have with the rest of the CDH ecosystem. So more than that soon.

We'll go next to Ryan Zimmerman with BTIG.

We all heard United Healthcare's comments this quarter. It was evident in results, but it was specific to recon on Medicare. I'm just wondering if you can kind of parse out the procedure environment within S.E.T.? It's hard to see given some of the supply chain dynamics. I'm just wondering if you can kind of speak to that environment relative to recon in your expectations for durability of its robustness, if you will? Through the remainder of this year, similar to the recon environment.

Ryan. I'll take that one as well. So obviously, it varies from region to region. What I will tell you here in the U.S., we saw greater backlog consumption coming from Knees and Hips. It was actually quite the opposite in EMEA. When it comes to S.E.T., a lot of those cases here in the U.S. are done in an ASC environment. And other cases, are commercial payers, and it's been pretty consistent. But again, it varies quarter-to-quarter, geography to geography. We do believe that the backlog is going to be here for a while, and we'll see fluctuation given ASC non-ASC in the U.S. And then again, different variables outside of the U.S.

I think the key takeaway is you just don't see as much impact on the S.E.T. business as you do the Recon business when you think about backlog.

That's helpful, Bryan. We previously discussed Russia, and last year we focused on China and the effects of BBP. Can you provide an update on the situation in China? We've heard from several of your competitors that China is improving. What are your growth expectations for China as we move past the BBP impacts?

Yes. So first of all, BBP is not a material driver for us at all in 2023. We sort of turned the corner on that between the end of '21 and 2022. So we actually see China as a growth driver for us, albeit at a lower level, but we do believe that, that market has some very strong growth for us. I'd say pre-BBP, that market was growing in the low double-digit range. And we'd be surprised if we didn't return to that level, if not better.

We'll go next to Mike Matson with Needham & Company.

Back to the S.E.T. business. So Bryan called out kind of the subcategories there that seem to be the area of focus. But the things I didn't hear a mention were lower extremities, i.e., foot and ankle or trauma? So can you maybe just comment on why those were kind of left out of the comments?

Yes, sure. I can do that as well. So I think Suky alluded to the trauma headwinds that we had in the quarter. We had some supply challenges. And obviously, you got the comp in China versus a year ago. Here in the U.S., there were some contracts that we lost about a year ago. We're anniversarying out of those. There were some product launches that were delayed, '22 and '23 that are coming out now. So I will say that moving forward, given the better comps or U.S. and the contract capabilities now in the U.S. along with innovation, the trauma business is going to be in a better position. Foot and ankle has been one of the businesses, frankly, within S.E.T. that we didn't prioritize. We wanted to prioritize upper extremities, SportsMed and CMFT. That being said, I do think there are a couple of product launches that are going to make a difference in the space. So all in all, I do think you'll see better performance. But trauma, foot and ankle are not the key priorities within S.E.T.

Yes. To clarify, we do recognize that foot and ankle, trauma, and restorative therapies are potentially promising markets. However, we aim to be thoughtful about our investments. Our strategic plans for upper extremity, CMFT, and Sports are particularly appealing, and we intend to concentrate our resources there. If the teams responsible for foot and ankle, trauma, or restorative therapies present a compelling plan, they could become sources of growth. For now, we want to clearly distinguish between growth and non-growth initiatives; this isn't a reflection of the value of other categories, but rather an indication that our current focus is on those three areas.

And just on restorative therapy, that was restorative therapies was part of your question, but we anniversary out of the reimbursement change, July of 2023. So you should expect that business to do dramatically better now.

All right. Got it. And then just in terms of the supply chain issues, I don't know if it's possible, but is there any way you could quantify the impact either to your revenue growth and/or your margins in the quarter?

I think we'll try to stay away from quantifying, it's pretty challenging, actually, because when you talk about supply issues, you always get feedback from the field on what could have happened if you had more supply and you've got to make sure that you're kind of sifting through what's real, what's not. But the fact is it is a governor for us right now, and that's why we continue to say it. What's important, though, is it's a macro-challenge. There's not a company in orthopedics right now that is not being impacted by supply challenges. So it's impacting everyone. AAOS just did a survey actually with surgeons asking this question and across the board regardless of who they were using, they were experiencing supply challenges. Really important thing for us that's built into the guidance that Suky just provided. So that's key. But when I think about that growth driver, the impact it's having on our ability to grow. I think it's important to look at that. That means is getting in the way of our team using new innovation to drive mix benefit and competitive conversions. We truly do believe that it was not a factor. We'd be getting more mix benefit, we'll be getting more competitive conversions because the demand is there. So it's frustrating. We have great momentum in the business, great innovation, and supply is in the way of driving that growth. And we believe it's going to continue to be there for a period of time.

We'll go next to Robbie Marcus with JPMorgan.

Congrats on a good quarter. Maybe I could start on margins. If I take the third quarter and fourth quarter commentary that you provided, I have a little trouble getting to the high end of the range. So maybe just speak to some of the pluses and minuses there and what you need to get to the top of the range? And then second question, I'll just throw in as well. You have a big gross margin benefit from currency in '23. There's a pretty wide range of operating margin expansion next year or contraction on The Street. Any early thoughts into how we should be thinking about your ability to grow operating margins next year?

Sure, Robbie. Great to talk to you. So one of the biggest drivers in the overall profile in the back half of the year, by the way, we do believe operating margin in the back half will be modestly better than what you saw in the first half. That's largely going to be driven by better revenue, mostly coming from the fourth quarter. The second thing is you're likely going to see a step down in overall operating expenses from the second quarter. That was sort of our high watermark as we were dealing with a number of inflationary pressures. But quite frankly, also investing pretty handsomely against things like R&D, which was up like 19% in the quarter, investing against commercial infrastructure in places like sports and upper extremities to continue to specialize that sales force as well as ASCs. So the two common combined things of higher revenue, lower OpEx as we move into the back end of the year is what's going to drive that margin expansion improvement versus the first half. As we look into 2024, you're right, we did talk about some FX hedge gains this year, which we sized at about 50 basis points on the full year that won't repeat into next year. That will be a headwind, but we're still confident that we can grow operating margins into 2024. It may not be at the same level of 100 basis points that you're seeing this year. But we do believe, as I said earlier, that we can take this sort of high watermark that we are in operating margins and continue to enhance that as we move into 2024. What are some of the building blocks? One, pricing is still a headwind, but we're seeing really great performance. It's not the headwind that it used to be for the company. And what's even more exciting about that is we're truly seeing very strong mix benefit inside the company, and that's coming from our new products and the innovation into the marketplace, which is helping to offset that price erosion. So we think that that can be a tailwind for us. Secondly, we continue to work aggressively on our site optimization in manufacturing and supply chain, which we think can generate some tailwind in cost of goods as we move forward. And then as you move through the rest of the P&L into SG&A, there's still ample opportunity with our Global Business Services agenda that we just started a few short years ago. We've got a completely different culture and mentality when we think about go-to-market and market profitability. Where at one time, it was revenue growth at all costs. And now it's all about revenue growth at the right profitability level and with earnings growing faster. And so there's just those cultural shifts and that discipline is also driving some really nice margin expansion both in the U.S. as well as outside. So these are just a few levers that quite frankly, we've been pulling on already. There's still room to go and why we feel confident that we can take this high watermark for 2023 and grow it into 2024.

We'll go next to Rick Wise with Stifel.

To start, can you provide an update on the key new product launches you mentioned? Bryan, you referenced the four pillars of Knee growth, with the ROSA+ cementless Knee launch as your primary focus, aiming to increase the cementless market share from the mid-teens to 50% over time. Where do we currently stand in the rollout? Are we at full launch, or is there more needed? How do we anticipate the acceleration of this launch in the next year or two?

Thanks, Rick. What I'd say first is just to make sure that I clarify. I'm saying that both ROSA and cementless will move from the mid-teens to 50% plus. So not just cementless. And they kind of do play off of each other. They benefit each other as they're trying to get adoption in the marketplace. But speaking specifically to cementless, maybe I can pass that to you.

Yes, I would say, Rick, that it's early innings, frankly, both for ROSA as well as cementless. We are in what I think is not still a full launch for cementless, given some of the supply constraints. I think as we exit 2023 and early 2024, we'll have as much supply as we need to meaningfully drive the penetration of cementless with a goal of going from 15% to 50%. I won't say when 50% is going to happen, but that's definitely the North Star. ROSA is the same situation. We launched two platforms in Knee. We are about to launch ROSA Partial this summer, a new and improved version of that. We're working actively on next-generation total knee, which will be a meaningful launch going into '24. We got all kind of ZBEdge add-ons data technology solutions that are going to augment the penetration there. But I would say net-net, both for ROSA, cementless and some of the peripheral launches around those two components, we are in the early innings.

Great. Bryan, for my second question, I'd like to hear about your personal priorities. Execution seems to be going well, with Ivan and the team effectively managing the pipeline and moving the business forward. Suky is positively steering the financial organization. As you look to the next year or two, what are your current priorities? Are you concentrating on efficiency or your portfolio? What are your thoughts that we should discuss today?

Thanks, Rick. I mean I'll kind of tongue-in-cheek say we're thinking about everything. But obviously, that doesn't get you anywhere you focus. And we've been very clear from the very beginning that we had three phases of the transformation of this company. Phase one is always going to be alive, but we're in great shape Phase two is kind of what you just said. We have a great innovation pipeline. We're executing from an organic standpoint. We feel very confident in that phase. And now we're squarely in Phase three, as we've been saying, and the big focus for us is that portfolio transformation that will leverage our balance sheet. And the balance sheet is strong and strengthening us in the prepared remarks, and that is the area of focus for us. How do we continue to move our weighted average market growth forward? I can tell you we've already made great progress in the focus area here. We've already moved it North. With the balance sheet strength, we expect it to continue to move in the right direction. So that's an area of focus, not just for me but for this entire team.

We'll go next to Josh Jennings with TD Cowen.

Hi good morning...

Do we still have you?

I think he got cut off...

No, Josh, we hope you are okay. Katie maybe we can go to the next one in the queue, and then hold Josh back if he dials back.

We'll go next to Jayson Bedford with Raymond James.

I apologize if I missed this, but what was the impact of price in the second quarter and have your expectations around price changed at all?

There was about 1% decline year-over-year in the second quarter. In the first quarter, the average is estimated to be similar for the first half of the year. We anticipate that in the second half, the decline will be between 100 to 150 basis points. We are seeing strong progress for several reasons that I have discussed in detail before. However, what is particularly exciting is that we are beginning to see the benefit of our product mix from new introductions, which is helping to mitigate even an improved price decline profile.

Okay. Great. And then just secondly, on the supply challenges, are these new issues or the kind of legacy carryover issues? And then Bryan, I think you mentioned that you expect this dynamic to continue for some time. Does the impact lessen with each quarter going forward? And any visibility as to kind of when these issues will abate?

I'll start by stating that we have not encountered anything new. Throughout this period, we have identified three main categories that summarize the issue: materials, labor, and sterilization. We have set aside the demand plan because the demand we anticipated has consistently improved. Sequentially, we have observed enhancements and greater accuracy in our demand forecasts. In terms of labor, at the Tier 1 level, our labor capabilities are now significantly stronger than before, as we are actively hiring at our sites. Regarding sterilization, our strategies are effective; while materials remain a challenge, the situation has indeed improved. Overall, I would say there is noticeable progress compared to the past. We continue to see improvements sequentially across both supply and demand.

I mean the challenge, it's a fixed equation, right? I mean as you start to improve as we would expect in materials, labor, and sterilization because we've put great planning around that, as demand continues to be strong, it's going to delay supply recovery. And so that's what we're seeing, is we're seeing a great dynamic strength in the marketplace, better traction in our new innovation than we even expected, but that puts pressure on that equation, and it pushes the supply challenges out.

We'll go next to Kyle Rose with Canaccord.

Suky, I want to revisit the topic of gross margins, which have been robust in 2023. You've discussed some advantages already. Can you help us understand the extent of inflation and supply chain impacts on the underlying gross margins? I recognize the positive factors you've mentioned, but how much are they truly offsetting the challenges? Additionally, when discussing supply chain issues, increased unit costs, and wages, is there a possibility of facing further setbacks? I'm trying to grasp how inventory turnover will reflect in the financials over time. Lastly, regarding a return to a normalized operating environment, we all acknowledge the past few years have been quite tumultuous. When do you think we can realistically expect to transition to a more normalized operational state, considering the industry's supply and staffing challenges? How should we approach the idea of reaching mid-single digit growth again?

Yes, thank you for the question, Kyle. Regarding gross margin, keep in mind that we have about 100 basis points from 2022 being capitalized and affecting our P&L this year, and we are observing that impact. Additionally, we are experiencing some new inflationary pressures in 2023, mainly due to ongoing spot purchasing of certain raw materials like packaging and some metals we use, as well as increased costs related to logistics and product movement compared to a stable supply environment. This is one area where we are seeing higher costs. Furthermore, we decided to provide additional incentives to our sales team as we recognize the difficulties they are facing in the marketplace due to supply challenges, and we have been very impressed with their performance. These factors are contributing to our P&L. However, we are managing these costs while also investing in the business and improving our operating margin for this year. The company and our team are maintaining discipline amid better revenue and significant operating margin expansion. As we approach next year, some of the inflationary pressure we’re seeing this year could carry into 2024, but it will be much more modest compared to what occurred from 2022 to 2023. We have various strategies to help mitigate that as we move into 2024. However, I’m not providing guidance on 2024 regarding specific gross or operating margins. There are several factors at play, which may present another slight challenge. That said, we have multiple strengths that can help as we transition back to a normalized market. While revenue growth may seem normal, the fundamental dynamics are not yet stable. From our current perspective at the beginning of 2024, we don't anticipate being in a normalized state just yet. It's a long way off, and we'll see how things develop in 2024. Once we reach a more normalized growth phase, we believe we can sustainably achieve a growth rate of 4% or mid-single digits, as I mentioned earlier.

All right. Katie, I think we might have time for one last question in the queue.

We'll go next to Matt Miksic with Barclays.

I have a couple of follow-up questions. First, regarding margins, I know there has been considerable discussion about the commitments to leverage this year. Could we take a step back and consider where margins were before the pandemic, in the low 30s range? Can you remind us if that is a target we aim to return to and what the timeline for achieving that might be? Additionally, I have a brief follow-up about the Persona iQ, if I may.

The margins are in the low 30% range. I'm not certain about your reference, Matt, but it might relate to the merger of Zimmer and Biomet. Since that time, those margins were clearly affected by insufficient investment in supply chain and commercial infrastructure, among other factors. I don't believe that's the ideal reference point. What I can share is that from pre-pandemic to now, we are expanding our operating margins as we work to drive revenue growth and invest in the company. I'm optimistic about our current position and future trajectory. What was your second question?

Sure. I just wanted to follow up on Persona iQ. I believe the number mentioned earlier was around 1,000 implants. That's quite a small percentage of your total implants for the year, maybe about 1% or even less. I would like to understand at what point do you begin to see data results? Is it around a couple of thousand implants, or does it start showing at 300 to 500 implants? When do you anticipate seeing some of the outcomes you discussed earlier in the call?

Yes. Thank you, Matt. First and foremost, we don't disclose the number of patients, but I'll tell you, it's far greater than 1,000 patients. When are we done with the limited market release? I think we're about to complete that? The size matters more for certain claims than others, but I will tell you, we've got enough of a sample size to be able to engage in a full market release by 2024. What's the expectation going forward, this is going to be a flagship product for Zimmer Biomet. We plan to see meaningful penetration of this technology. First in Knees, then in Hips and then at some point in Shoulders as well. What's the right penetration? Again, we won't disclose that. But given the unique technology, we will leverage this to the fullest.

Thanks, Ivan, and Matt thanks for your question. I think we're almost at the bottom of the hour. I'll actually turn it over to Bryan just for some closing remarks.

Just a quick summary regarding what we discussed about the market normalization. We believe 2024 will not be a normalized year for two main reasons. Firstly, there will still be backlog that we need to monitor, which we view as potentially neutral to negative depending on its stability or decline. We do not expect it to increase. Secondly, the supply aspect will lean towards neutral to positive as the benefits of supply continue, creating a favorable condition for next year. These two factors indicate that while 2024 may not be a typical year, they balance each other out. Therefore, we believe that despite not being normal, 2024 could still resemble a normal year in terms of growth. It's important to highlight that we are not only optimistic about our current position, but also about the future of the company. Our disciplined portfolio decisions have already enhanced the average market growth of our business, boosting our confidence in future growth. Our strong balance sheet positions us well to solidify our presence in rapidly growing markets, which will be a key focus as we progress through Phase 3 of our transformation. The strength of our innovation pipeline offers us opportunities for improved product mix, pricing stability, and competitive advantages. As supply issues get resolved, these improvements should accelerate. I have enough experience to recognize when our team is motivated and equipped to drive sustainable performance, and we are in that position now. Thank you for joining us today.

Thanks, everyone. We'll talk to you soon. And obviously, if you have any further questions, please don't hesitate to reach out to the IR team.

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