Zimmer Biomet Holdings Inc

NYSE:ZBH

Earnings Call Transcript 2023-Q1

[Operator]

Good morning, ladies and gentlemen. And welcome to the Zimmer Biomet First Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded today May 2, 2023. Following today's presentation, there will be a question-and-answer session. At this time, all participants are in listen-only mode. [Operator Instructions].

I would now like to turn the conference over to Keri Mattox, Chief Communications Officer. Please go ahead.

[Keri Mattox, Chief Communications Officer]

Thank you, operator and good morning, everyone. We're joining you from our Warsaw Indiana headquarters and are happy to be with you today. Welcome to Zimmer Biomet's first quarter 2023 earnings conference call. Joining me are Bryan Hanson, our Chairman President and CEO; EVP and CFO, Suketu 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 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 Q1 earnings release, which can be found on our website, zimmerbiomet.com.

With that, I'll turn the call over to Bryan, Bryan?

[Bryan Hanson, Chairman President and CEO]

All right. Thanks, Keri. And thanks to everyone for joining us on the call this morning. We don't get the opportunity to do this too often. So I'm going to take advantage of it. And I'm just going to start the call by simply saying this was a phenomenal quarter, where pretty much everything went better than expected. And importantly, as a result of that momentum, we are significantly raising our full year top and bottom line outlook, which Suke Upadhyay is going to talk about in just a minute.

With that said, and maybe taking a step back, for today's call, I'll talk more about our Q1 performance and the drivers of that performance. And then Suke will get into more details for the quarter and importantly, also our financial guidance for the rest of the year. And then we'll make sure that we save plenty of time for your questions which we look forward to addressing.

But before we do any of that, I just want to take a minute to speak directly and personally to the ZB team. And it really just say thank you, truly say thank you. For yet again, you have delivered beyond our expectations. And I'm very proud of what this team is doing to navigate an environment that while improving, there's no question it's improving, it is still fluid. And it presents us with challenges that quite frankly seem like daily challenges. And it is truly impressive how you're navigating that environment right now.

And I'm very proud of the dedication, the resilience and the innovative thinking that you're bringing to your roles each and every day. It is truly making a difference. But I'm most proud of how together and I do mean together, we are living the ZB mission to alleviate pain and improve the quality-of-life for people around the world. And as we know, we do that every eight seconds, 24 hours a day, seven days a week, which is really what it's all about in the first place. So thank you. Thank you for what you do for ZB, thank you for what you do for our customers and most of all, and most importantly, what you do for our patients, the patients that we serve every day.

Okay, so let's take a look now at the first quarter. And as some of you may recall coming into the year, our guidance assumed that Q1 would have the easiest comp of the year, but also experienced some headwinds from both staffing and COVID-related challenges that we felt would put pressure on elective procedures during the quarter. We also assumed that there would be a pretty high level of supply pressure in the first quarter.

Our assumptions also believed that all three of these headwind variables would then improve throughout the year providing less impact to the business. But then outside of the easy comp, Q1 would be pretty bumpy.

Okay, so what actually happened in the quarter? And why was it considerably stronger than we expected? Well, first and foremost, procedure recovery was much better than we anticipated, really having almost no material or meaningful impact from COVID or staffing challenges in the quarter. And second, we manage the supply constrained environment better than we originally anticipated. Make no mistake, supply is a real problem. And it's putting pressure on the business. But this team has done an excellent job managing that environment, probably leveraging some muscle memory from the past.

And then third, and I think really importantly, our team's execution and traction with our new product innovation is even stronger than we anticipated. And that's important because it's going to continue to provide benefit to the rest of the year. And so because of this, we saw another quarter of very positive year-over-year momentum in large joints, with our global hip and knee businesses growing approximately 13% and 18% on an ex-FX basis.

Our overall S.E.T. category grew more than 6%, driven by strong low-double-digit performance in our growth drivers in S.E.T. which we've talked about before being sports, CMFT and upper extremities. And then this was partially offset as expected, from headwinds from our restorative therapies business, where these headwinds will anniversary, and as you remember, these are reimbursement change headwinds that we have in that business, they should anniversary by the back half of this year.

And then finally, our other category grew 11% in the quarter. So needless to say it was a pretty strong quarter. And the momentum is real in this business and our confidence is extremely high. And there's good reason for this competence. If we just think about this quarter alone, we officially launched our new cementless knee form factor Persona OsseoTi, and this is adding to the Persona family and really strategically rounding out that portfolio. And this new keel design tray is extremely versatile, it's anatomic because it is the Persona family and it's stable. And it's the only knee that you can do a cemented or cementless procedure with an inter operative decision possible for the surgeon.

And that's a big deal. We believe that this will enhance the potential for cementless penetration, because surgeons can go into a questionable bone quality procedure with the intent to use cementless, but then they have the ability to pivot back to cement it as the bone quality isn't there. And for this reason, and a lot of other reasons, customer feedback so far has been extremely positive, as we've launched this product.

And as you may know, our cementless penetration is already in the mid-teens. But we believe that this can get to 50% or higher penetration. And we're excited about that. And we truly do believe that this premium product can accelerate that growth for ZB and is already doing so.

It's still early days. Our full launch is planned for the middle of this year as more sets become available. Make no mistake, this is a real driver for not just our knee franchise, but for the overall company. So we're very excited.

As you remember, back in February, we also closed our acquisition of Embody, which is providing access to differentiated products and an innovative pipeline for our sports medicine business. And this investment helps expand ZB's presence in this very attractive high growth market, while also in that market, serving our customers and our patients better. And this combined with a very strong innovation pipeline that we have in sports, and this dedicated commercial channel that we put into place gives us continued confidence in our global sports franchise.

And if you're at the AAOS meeting, you would have seen that we previewed our Hammer product, which is designed to ensure consistent and reproducible compaction for hip procedures, while allowing the surgeon to dial up or dial back the force of the strike, depending on the individual patient need. And this ability to be more personalized, actually differentiates Hammer versus other compaction devices on the market. So needless to say, we're excited about this differentiated product. We believe this could actually increase not only the consistency for surgeons, but also the procedure efficiency, which is really important right now. And our current expectation is to launch Hammer in the third quarter of this year.

And if you just look at these combined products, this is actually building on other launches that we've talked about the Persona IQ, Hip Insights, the Identity Shoulder system, and in total, we've introduced more than 50 new products from 2018 through the end of 2022, with the majority of those products coming in markets growing 4% or faster. And we're geared to continue that momentum, doesn't stop here with another 40 planned product launches between this year and the end of 2025, again, with the majority of those products to be launched in 4%-plus growth markets.

And this shift not only continues to transformation of our product portfolio, because the short term revenue growth, but it also improves our weighted average market growth. And ultimately, as a result of that gives us more confidence that our markets and our portfolio mix positions to company for sustainable mid-single-digit growth.

And with this kind of traction around our product pipeline, increasing strength of our balance sheet, and our team members' ability to execute, ZB continues to be well positioned to deliver value today and in the future and achieve our mission as a company.

And with that, I'm going to turn the call over to Suke to take a closer look at Q1 and our latest expectations for 2023. Okay, Suke.

[Suketu Upadhyay, CFO]

Thanks, and good morning everyone. As Bryan mentioned, we had an excellent quarter with better than expected results. As a result of continued market normalization and the strength of our performance, we are increasing and narrowing our full year financial outlook.

With that, let's turn to our results in updated full year guidance. Unless otherwise noted, my statements will be about the first 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 $1.831 billion, an increase of 10.1% on a reported basis and an increase of 13.2%, excluding the impact of foreign currency. As we noted on our last call, we had a selling day tailwind of about 100 basis points this quarter. Overall, the business back from faster than expected recovery of elective procedures driven by the easing of staffing related headwinds, normalization of cancellation rates, and some backlog recapture. Also, we've benefited from lighter comps, strong commercial and supply chain execution and new product uptake.

While we continue to face macro supply headwinds, our teams have been doing a great job mitigating these challenges. U.S. growth of 12.7% was well ahead of our expectations with elective procedure volumes recovering and procedure cancellation rates returning to pre-pandemic levels.

International sales grew 14%, EMEA growing ahead of expectations, driven by faster recovery and strength across both developed and emerging markets. And in APAC, we saw some pressure in China as anticipated, but results were generally in line with our expectations.

Turning the business category performance, global knees grew 18.2% with us growing 18.1% and international growth at 18.2. Specifically, we saw strong uptake across the full Persona product portfolio and traction in all regions. We now have the Persona, Primary, Partial, Revision and OsseoTi cementless options rounding out our full product line. And we are seeing very encouraging results across that new cementless form factor.

This full Persona product line not only improves and enhances our product mix benefit, but also supports the continued utilization of Rosa and associated pool through.

Global hips grew 12.9% with U.S. hips up 12.3% and international up 13.5%, driven by continued traction across the Avenir and G7 product lines, along with ongoing uptake of Rosa hip. And we are encouraged by the early impact of the Hip Insight launch.

The S.E.T. category grew 6.4% driven by continued strong performance across our key focus areas of CMFT, sports medicine and upper extremities, all of which grew in the teens. This was partially offset by lower growth in other parts of S.E.T., which includes the reimbursement changes in restore therapies that will anniversary mid this year.

Finally, our other category grew 11.1% partially driven by some larger orders and surgical products which may not repeat over time.

Moving to the P&L. For the quarter, we reported GAAP diluted earnings per share at $1.11, compared towards GAAP diluted earnings per share of $0.35 in the prior year. While investments in R&D and commercial infrastructure increased, net earnings were higher this quarter driven by revenues improve gross margins and losses in the prior year related to ZimVie.

On an adjusted basis diluted earnings per share was $1.89 represents a 17% increase from $1.61, in the first quarter of 2022. Adjusted gross margin was 72.8%, up 220 basis points from the prior year. These results were positively impacted by favorable mix related to large joints performance and foreign currency hedged gains. Excluding these items, underlying gross margin was broadly in line with our expectations related to inflation.

We're seeing some incremental pressure from spot buying and contract manufacturing pricing, but overall inflationary pressure has largely stabilized. Our adjusted operating margin for the first quarter was 28.4%, up 200 basis points primarily driven by revenue better gross margin and continued discipline around our investment profile.

Interest in non-operating expenses of $46 million and our adjusted tax rate of 16.3% were broadly in line with our expectations.

Turning to cash and liquidity. Operating cash flows were $308 million and free cash flow totaled $178 million. We ended the quarter with cash and cash equivalents of approximately $330 million.

And moving to our updated financial outlook for 2023. Based on strong Q1 results and our ongoing strong execution, we are raising and narrowing our full year 2023 outlook. Constant currency revenue growth is now expected to be 6% to 7% versus 2022, with an expected foreign currency exchange headwind of 100 basis points. We're also updating our adjusted EPS guidance range now expecting $7.40 to $7.50. While we initially gave color that adjusted operating margin would be flat to slightly better in 2023, or Q1 results in tandem with an improved rest of your outlook gives us the confidence that we will expand operating margins this year. We continue to expect interest and other non-operating expenses, along with our tax rate to be in line with our previous commentary.

Finally, we now expect free cash flow for the year to increase to a range of $1 billion to $1.1 billion.

In terms of quarterly cadence throughout the year, our expectations remain unchanged. Q1 will be the highest revenue growth quarter followed by Q4, which should benefit from improving supply and contribution from new and innovative products, as well as a selling day tailwind of about 100 basis points. Q2 and Q3 are expected to be lighter growth quarters given tougher comps and a net selling day headwind of about 100 basis points. Again, selling days will have a net neutral impact for the full year. We expect adjusted operating margin to largely follow revenue with second half operating margins being slightly better than the first half.

In summary, we delivered excellent top-line results, beating internal expectations in nearly every category while posting very strong adjusted earnings performance. Our business is executing well our pipeline is delivering and our momentum is real. We feel very confident as we move forward.

With that I'll turn the call back over to Keri to start the Q&A.

[Keri Mattox, Chief Communications Officer]

Thanks, Suke. 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?

[Operator]

We'll take our first question from Steve Lichtman with Oppenheimer.

[Steve Lichtman, Oppenheimer]

Good morning, guys. And congratulations on the quarter. I guess, first one, I want to start on the knee and hip market. Obviously, very strong for ZB and for the market. As you noted comps play a part. I was wondering if you could talk about what you think sort of underlying market growth here is, and maybe talk a little bit about procedure growth and where sort of pricing stands as well?

[Suketu Upadhyay, CFO]

Sure, Steve. Thanks for the question. This is Suey and hello to everyone on the call. The first thing I'd just step back, overall, we had a very good first quarter, as you can see from the results. And it was really across all of our business segments, including all of our regions, and that flowed through all the way through the P&L. So really happy about the quality and the execution of the entire team.

We did always think that Q1 would be our strongest growth quarter. We talked about that when we gave our initial guidance for the year. That was really two key drivers. One is you had a strong comp benefit versus the first quarter of 2022. Clearly, we were still dealing with Omicron back in 2022.

Secondly, we talked about a day rate tailwind of 100 basis points. So we knew year-over-year that we would see strong growth. But we achieved better than that and really across every one of our business segments, as I pointed out earlier.

But recall where our expectations were before. We thought we would continue to see some procedural volume challenges and staffing challenges and also supply chain headwinds. So that underpinned our previous guide. But we actually overachieved relative to those macro factors. Where we just didn't see as much staffing or COVID pressure. We also saw some backlog come into the marketplace. And so from a macro standpoint, it was better than we expected. And then also our execution was incredibly strong. Our innovation was very strong across commercial but also supply chain. So really happy with where everybody sort of executed for the quarter. And we think that, that store will going forward.

Relative to your specific question on the overall market growth rates. I would just say, look, we're not yet in normal market growth. You clearly continue to have some choppy comp comparisons versus the prior year. We do still think we're going to continue to face some headwinds relative to staffing and of course, supply chain continues to be a very real challenge out there, partially offset by some backlog tailwinds. So again the markets, I think, are anything but normal yet. But I would say they're very strong, they're improving and normalizing, and we're very encouraged about where they're going.

Pricing in the quarter was a little bit, I would say, kind of in line with where we expected it to be. We always talked about this year being a bit better than the traditional 200 to 300 basis points that we've seen historically. And at 140 basis points of erosion that was right in line with where we expected to be.

[Steve Lichtman, Oppenheimer]

Great, thanks. And one product on the new side that is yet benefiting you is on a Persona IQ. I was wondering if you could give us your updated thoughts on that, how the limited launch is going and maybe your latest thoughts on the outlook for that product, particularly after the NTAP proposal. Thanks.

[Ivan Tornos, COO]

Thank you, Steve, Ivan here. So lots of excitement as of late on Persona IQ. As of late, obviously, we got the NTAP indication that we're kicking October of 2023, were featured in the Wall Street Journal that got a lot of attention. We've signed additional contracts all over the U.S. with advancing rapidly in our limited market release, which as we said in the past, is more clinical in nature than commercial. We got now north of 500 million data points. And again, that's gained a lot of excitement.

In terms of where we are, I'll tell you nothing has changed. We believe we'll be in a position to launch speed product by the end of 2023. We're working on four key things when it comes to this limited market release. Number two is understanding the clinical value proposition as well as the commercial value proposition. What do we do with all this data? What is the best way to position this product in the marketplace?

Number two, as you can imagine, with the data component, there is a bit of a back and forth ownership, how do we utilize it, how do we make the best out of all this data. So we can act on it. And I would say with that tends a lot in this regard.

Number three, is making sure that, overall, the customer experience is seamless. This involves patient education, this involves caregiver education. We're going to make sure that this is a best-in-class experience. And then number four, is how do we monetize the device. So in those four key areas, we've made tremendous advancements. And I do believe we're going to be in a position to launch at the end of the year.

The NTAP is not going to impact every single patient, but it's a sizable amount of patients that are going to benefit from the additional reimbursement. And again, it's just another reminder that this is breakthrough technology, first to market, new to market that will make a difference. So the exigent is high, and we look forward to updating you guys down the road.

[Steve Lichtman, Oppenheimer]

Thank you, Ivan.

[Keri Mattox, Chief Communications Officer]

Thanks so much, Steve. Operator, can we go to the next question?

[Operator]

We'll go next to Shagun Singh with RBC.

[Shagun Singh, RBC Capital Markets]

Great, thank you so much for taking the question. And congratulations on a really strong print here. I guess just a question around guidance and Q2 trends. So your guidance is about 6% to 7% ex FX in 2023. Can you just walk us through expectations around cadence, perhaps shed some light on April trends for your business? How you expect that to stack up versus Q2. I think prior to the call, consensus was looking for sales and EPS of 1.79 and 1.77, respectively, your guidance obviously implies strength beyond Q1. So any color there?

And then longer term, what does it mean for the growth profile for Zimmer going forward really versus consensus? I believe for 2024 is around 4.5%. So any color there would be great. Thanks so much.

[Suketu Upadhyay, CFO]

Yea. Shagun, it's Suke. Thank you for the question. We definitely saw a very good quarter in the year in the first quarter, and we're expecting that momentum to carry through. And I think you would see that in our rest of year guide coming up to 6% to 7% ex FX.

From a quarterly cadence standpoint, I would expect the overall growth rates in each quarter from here to step down from the first quarter. And it really goes back to that one that comp benefit I talked about in the first quarter on Steve's question, but also we have that day rate tailwind of about 100 basis points in the first quarter. So that you should think about, again, the first quarter being the highest fourth quarter being the second highest from a growth perspective and the second and third being a little bit lighter just based on tougher comps and a net day rate headwind. And so that's how you should think about cadence.

But definitely, we're lifting our guidance by more than just the first quarter outperformance. We're actually pulling that momentum through the rest of the year as part of that raise. Maybe Bryan, do you want to talk about the underlying growth as we move forward.

[Bryan Hanson, Chairman President and CEO]

I mean, we've stated it before. And obviously, just based on our performance today, our confidence level is even higher. We do believe that we're 4%-plus grower in a normal market. It's not exactly normal right now, as Suky talked about before, but our confidence continues to grow that we're in the right markets. We continue to build scale in more attractive submarkets and our confidence design.

[Shagun Singh, RBC Capital Markets]

And just any color on April trends?

[Suketu Upadhyay, CFO]

I would say, continue to support our increase in guidance. So things continue to -- our guidance initially showed or had an assumption of improvement throughout the year. Our current increase in guide assumes that as well in the early days in April continuing to prove that out.

[Shagun Singh, RBC Capital Markets]

Thank you.

[Keri Mattox, Chief Communications Officer]

Thanks, Shagun. Operator, can we go to the next question, please?

[Operator]

We'll go next to Matt Taylor with Jefferies.

[Matt Taylor, Jefferies]

Hey, guys. Can you hear me okay?

[Keri Mattox, Chief Communications Officer]

We can.

[Matt Taylor, Jefferies]

Great. So Suke, I want to ask you a question about margins. Because to your point, you're fortunate now you have this maybe excess growth. We don't know exactly. But that gives you a lot of margin to work with. And so I think, ultimately, that's what people care about is how our margin is going to progress. And I know you've talked a lot about it. But if you enjoy this excess growth for a while, how are you going to use that? Are you going to reinvest? Or are you going to let it drop through? What are you thinking about in terms of how to use the excess margin?

[Suketu Upadhyay, CFO]

Yeah. I'd say the first thing is that it feels good to be in a position where you have the optionality, right, of deciding where you're going to put that additional growth in the margin or the profitability upside that comes from that.

We continue to have a very strong, robust and innovative pipeline. We're going to continue to invest against the business in the right way, in a disciplined way. We're going to continue to be focused and make choices about, continue to expand in faster-growth submarkets that have good profitability profiles.

We believe we can do that while still expanding margins over time. And that really comes from the strength and the discipline of the overall team in driving efficiency and mix shift in that investment profile to make sure that we're growing the top line while still growing the bottom line. So we think we can do both over time.

[Matt Taylor, Jefferies]

Great. And one follow-up. So no one quite knows what's going to happen here, right? But it seems like there may be some excess demand for a while. And the best type of margin is that, that comes from excess organic growth, right? And so you may have that for a while. So how are you thinking about that? You talk about yourself as a 4% grower, but I mean clearly, you just outperformed that by a lot. And I guess, a, how long can that last? And then b, if it does last longer, then how does that change how you run the business?

[Suketu Upadhyay, CFO]

Yeah. Just going back to your point there, remember the comp benefit in Q1 was a key driver beyond underpinning that large overperformance relative to sort of that 4% to 5% we've been talking about. So just want to make sure that we've got good clarity around that.

Having said that, as Bryan talked about, we do think and have even more confidence now based on our execution, based on the normalization of markets based on our pipeline, that 4 to 5 is a durable number, and we'd be disappointed again if we weren't able to achieve that in normalized markets. So we think that, that's sustainable over time.

And then as we talked about, if that provides profitability upside that can be reinvested back into the business while still driving margin expansion. I mean that's where we want to be, right? That was the story underpinning our margin expansion all the way back to the beginning a few years ago, which is to be able to do this through revenue leverage, and do it in a high-quality way while investing back to the business.

[Matt Taylor, Jefferies]

Yeah, guys. Thank you.

[Keri Mattox, Chief Communications Officer]

Thanks so much. Operator, can we have next question please?

[Operator]

We'll take our next question from Vijay Kumar with Evercore ISI.

[Vijay Kumar, Evercore ISI]

Thank you, guys. Congrats on really strong. I'll start here. My first one here, Bryan, there is some debate on perhaps demand being pulled forward here. Do you see this also in market growth as perhaps a catch-up of backlog as against a pull forward of demand and do you feel like with your product portfolio that you have, is Zimmer now gaining share in the market versus the industry?

[Bryan Hanson, Chairman President and CEO]

Well, maybe I'll just quickly talk about what I see from a market standpoint, us versus market. And then maybe you could speak to, which I think when you say pull forward you talked about backlog consumption. So maybe you could talk about backlog.

From us versus market perspective, it felt pretty good in the quarter. Obviously, we look at this on a year-over-year basis, a stack basis, a sequential basis versus our key competitors. But we try not to get overexuberant about any specific order or too depressed about any specific quarter. What we do look at, as I've always talked about, is an eight-quarter trend across those three vectors.

If I go all the way back to Q2 of 2020, and I look at that consistent order trend, I feel very good about our position versus market. And I truly believe we're just getting started. So from us versus market perspective, I feel good, and I think it will only get better over time. If you think about the backlog, maybe you could speak to what we saw in the quarter.

[Suketu Upadhyay, CFO]

Yeah. So there are a lot of factors inside the quarter that drove the outsized performance. I talked about year-over-year our original expectations, but we were above that, again, for a number of variables, including less pressure than we expected. We saw some backlog. I talked about, and we were able to navigate supply chain and good commercial execution.

I would say backlog was probably the smaller component of the overall change our performance relative to expectations in Q1. We do expect that to continue for the rest of the year. That's built into our guidance as we move forward. And so yeah, it's good to have that a bit of an offset or tailwind relative to some of the other challenges we're seeing in the marketplace.

[Vijay Kumar, Evercore ISI]

Understood. And Suky, one on margins for you. Gross margins up 100 basis points sequentially. Can you just remind us on what was the impact of inflation, China BP, et cetera, in Q1? And what drove this sequential gross margin expansion? And when I look at your guidance, revenue raised by 250 basis points at the midpoint, EPS up by 6%. Clearly, that implies operating margin expansion I think, north of 50 basis points. Is it all coming from gross margins versus operating leverage?

[Suketu Upadhyay, CFO]

Yeah. So thanks for the question -- second question here, Vijay. The first thing is I'm just going to step back a little bit. As part of the overall margin expansion story, the Zimmer Biomet, we talked about ability to stabilize gross margins from '22 out for the next few years. Side of that on better revenue growth, we would leverage SG&A, which would give us the platform to then expand margins increase our earnings balance as a company. So that continues to be the strategy and story, and I think you're just seeing that play out here to 2023.

Remember, as we came into '23, we talked about 100 basis points roughly of inflationary pressure in '22. That was going to capitalize in our P&L this year. That still remains true. In fact, probably seeing a little bit of additional incremental pressure on some areas of supply chain and inflation. I talked about contract manufacturing supply prices. We're still doing some spot buys for certain raw materials. It's putting a modest amount of incremental pressure.

Nothing significant, but something we just want to keep our eyes on for the rest of this year and into 2024. But again, inflation has largely stabilized. So that 100 basis points is definitely coming in year-over-year. But despite that, we said that 22% on gross margins would be relatively in line, excuse me, '23 versus 2022, right? So the teams are going to be able to find a way to offset that incremental headwind and we've largely done that.

Now in the first quarter, we did see exceptional growth sequentially, but also year-over-year. There are a number of variables that drive that. But I'd say the three biggest are around volume gains, right, that led us year-over-year but also versus expectation. Saw some FX hedge gains in the quarter and also a pretty pronounced mix benefit, especially given the outsized performance of our large joints versus our S.E.T. and other category and also U.S. versus the rest of the world. So those are kind of the three dynamics that are going on.

In the first quarter, we -- as we go through the rest of the year, we still expect those three variables to play a positive impact, but not at the same level, okay? So the way to think about this is gross margin for the rest of the year will step down versus Q1, but still for the overall year will be higher than it was in 2022. So you should think about it on an underlying basis, '23 being still in line with 2022, okay? So gross margin is definitely a tailwind, underlying still consistent with prior year.

The operating margin that you're implying off of our EPS guide is I think the directionally right way to think about that, and that upside is coming primarily from gross margin. So those are some of the building blocks that underpin our EPS raise for the year.

[Keri Mattox, Chief Communications Officer]

Operator, can we have the next question?

[Operator]

We'll take our next question from Robbie Marcus with JPMorgan.

[Robbie Marcus, JPMorgan]

Great. Thanks for the question, and congrats on a nice quarter. Maybe to start, I was hoping maybe you could dive into some of the drivers behind the knee growth rate. It was really impressive, definitely better than market growth and was just hoping you could help us understand how much is coming from robotics, from mix of new products and really dive into some of the growth drivers there? Thanks.

[Ivan Tornos, COO]

Hey. Thank you, Robbie. Good talking to you this morning. I will probably bucket the performance in two key areas: commercial execution and innovation. And maybe I'll start with Slide number two, and I won't break down all the details on what's driving what. But clearly, new product introductions had to do a lot with the performance.

As you know, during Las Vegas, we launched Persona OsseoTi, that is our cementless new form factor platform, and that is gaining traction. I'll tell you, roughly one third of all customers for Persona OsseoTi are competitive accounts. We've seen that with Persona OsseoTi with increasing also the penetration robotics. And again, I won't break down the size of that increase. But we've seen an increase in robotic cases done in combination, personas and ROSA. So definitely a driver there. Persona iQ, obviously, too early but ROSA overall, with Persona primary is gaining traction across the globe.

The ecosystem, the interconnectivity of implants and CV is gaining momentum. And that's the momentum whether you hit in the U.S. or you're in Europe or Asia Pacific. So again, a lot to unpack when it comes to innovation.

On commercial execution, we navigated supply challenges, I think, very effectively, very proud of what the team has done in that regard. And we're executing flawlessly. We got new incentive plans in place in '23 that were not around in 2022. Around making sure that people are growing in knees and hips, while pulling asset. We have new incentives in other geographies around EMEA and APAC. And I would say, again, the commercial execution is going very well.

The last thing I'll talk about is the ASC. This is one area where in the past, we're not doing other grade. We have three major gaps, people, contracts and portfolio. The portfolio is definitely there. We added a lot of people in our contracting group and the number of people they're thinking about ASCs in the hundreds. So today, around 10% to 15% of our sales come from the ASC and that's growing very nicely.

So again, commercial execution and innovation are the two key buckets when it comes to this level of performance.

[Robbie Marcus, JPMorgan]

Really helpful. And maybe for Bryan and Suke, we've heard you talk in the past about using M&A to maybe diversify into faster-growing parts of the market. There's a lot of talk from your competitors about M&A, some of them more specific than others. I thought it would be great to just get your latest thoughts on M&A for Zimmer, how you're thinking about it in terms of size and ability to diversify away from your core markets and your thoughts on valuations out there right now. Thanks.

[Bryan Hanson, Chairman President and CEO]

Yeah. So maybe just quickly before I get into our focus areas. I'd say in valuations, I still think -- see things as being pretty expensive. I look at assets that are out there today. We're not seeing as much downward pressure on valuations as we certainly were hoping for. Maybe a little better recently, but not as good as we would have expected. And then that, combined with the fact that capital is a little more expensive to come by is not necessarily a great combination.

That said, we still think there's opportunities that we're going to try to pursue. We are absolutely in Phase 3 of the transformation. As we said many times, Phase 3 is focused on portfolio transformation using capital to be able to acquire technologies that are attractive to the organization.

And we're very focused on this and extremely disciplined, number one, we're not going to look at a target if it's not mission centric. That's very important to the organization. We are a mission-driven organization, and that target needs to move our mission forward. We need to see a path to leadership at some point if we move into that space or we're already in that space. We need to see a WAM accretion, so increasing our weighted average market growth and as a result of that, our revenue growth and then ultimately helping us drive faster EPS growth. So those are the types of deals.

And then inside of that, we're looking at enhancing our position through acquisitions in fast growth subcategories of recon, which may not seem super exciting, but the fact is there's some fast growth subcategories that we want to build scale in so that we can grow faster than the overall market in a consistent way.

And then we're also going to look to diversify. So looking at acquisitions, which we've already shown in other parts of orthopedics that are faster growth, that's mainly in our set category for us. Eventually looking to diversify outside of orthopedics to diversify outside of electric procedures and give us other forms of opportunity to grow the business again outside of orthopedics. And we would say most likely in the near term, we would look at smaller to midsized deals, and we would kind of quantify that to say about $1 billion in revenue or less would put us in that category.

And we would probably stay a little closer to the vest in Orthopedics in the near term. So that's the way we're thinking about it right now.

Anything else you want to add to that?

[Suketu Upadhyay, CFO]

I would just say all the hard work that the team has done in improving financial performance, paying down debt over the last few years, even through a challenging period to COVID. We've really strengthened the balance sheet. And so the great thing is our capital structure can support everything that Bryan spoke about. Right now, we're traveling somewhere around the mid- to high-2s from a net debt to leverage ratio perspective.

So if you took turn, turn and half on that relative to $2 billion to $2.5 billion of adjusted EBITDA, you would see that there's a substantial amount of M&A firepower available to us. And those numbers would only be augmented by the EBITDA from a target. So a long way of saying that we've got the capital structure, we've got the balance sheet to support what Bryan talked about.

[Bryan Hanson, Chairman President and CEO]

And what's key about that, we were very disciplined about this. It's who we put phases into the organization transformation. We wanted to make sure that the base business was humming. That the organization was executing just like Ivan spoke to, we have. Our confidence level is very high. So not only do we have the balance sheet to move into that Phase 3 transformation. We now are ready to do it. We have the capability. We have the right team in place and we have the execution of the base business. So we're excited about Phase 3.

[Robbie Marcus, JPMorgan]

Thanks for the question.

[Keri Mattox, Chief Communications Officer]

Yeah. Operator, can we get the next question in the queue.

[Operator]

We'll go next to Matthew O'Brien with Piper Sandler.

[Matthew O'Brien, Piper Sandler]

Thanks for taking the question. Brian and Ivan, you talked a lot about new product introductions. And I think you said 40 through the next three years. How does that compare to the number of products you've introduced over the past three years?

And then I know you've got your competitors listening probably don't want to give us too much. But just can you give us a general sense of where those are going to go? Are they going to go into set specifically? And are you going to start touching maybe some areas kind of outside your traditional power alleys, I guess, with those new product introductions.

[Ivan Tornos, COO]

Yeah, thanks for your question, Matthew. So first things first, it's not just the quantity, it's also the quality. Not every new product is created equal. But I think we referenced in the past, we launched around 50 new products from 18 through 22. And the commitment is to do at least 40 new product launches over the next 36 months.

And again, what excites me about this launch is, Matthew, is the type of products that they are. They're differentiated. In many instances, they are first to market. And most of them are in growth areas that are going to drive WinGuard accretion for that, so 4% or above.

In terms of where they're going, it will take me about an hour to go through everything in the pipeline. I'll keep it to maybe three minutes or less, but I'll tell you excited about where we are in is with a full portfolio, things that are already -- we already spoke about cementless or Persona OsseoTi new to market as of two-three months ago is getting up on traction. Our cementless penetration is at 15%, 1-5. We deserve to be in the 50% range, and that is definitely the goal.

Excited about ROSA partial or robotic parcel system that is next generation is getting relaunched summer of 2023.Persona IQ, I think, we spoke plenty about that. As you look at the next 12 to 14 months, we will have Oxford Partial cementless here in the U.S. That is a legacy product that has gained a ton of markets in Europe. Persona Revision I didn't comment on that one, Robbie asked about performance. In Q1 Persona Revision saw tremendous growth again. That is a product that is only available in the U.S. I can hardly wait for 2024 when it gets into all U.S. markets.

Shifting to hips, we launched ROSA Hip on the direct interior category, posterior to come at some point. In the market, we are the only mixed reality company with hip insights. That is something that is gaining tremendous traction. You can see the hologram of a patient anatomy. It drives efficiency and accuracy in a case with a lower instrumentation. Bryan, in the opening remarks spoke about HAMR or surgical impact. That is also a device that is driving efficiency in an operating room, frankly, taking an existing product. Product that is in market and making it better. It drives variable energy control. It's got better accuracy. It has the ability of actual implanting the cap. Again, I can spend an hour in that regard.

On [Indiscernible], we got a sizeable of products inset through acquisitions and organic. We recently announced that we closed the Embody deal. That is giving us a competitive advantage in soft tissue repair, whether it's tendon injury or whether it's rotator cap that is performing very well. We got everything that we need in Sports medtech. We have a new product introduction in Shoulder.

Again, I think three minutes are almost done, but I will tell you, there is a lot that is happening and it's happening both from an implant standpoint happening from a technology data solutions standpoint. So we look forward to updating you at an upcoming product fair, but I will tell you, innovation is truly now a competitive advance seat at Zimmer Biomet.

[Matthew O'Brien, Piper Sandler]

Thank you can hear the enthusiasm there. I appreciate it. A question for Suke. On the pricing side, I think you said down 140 bps in Q1. You had a competitor report last night, and they said more like neutral this year, they're more diversified. I know it's a little different. But are you guys a little bit more on the stream side as far as pricing concessions at this point in the marketplace? Is that part of the strategy? And can pricing actually be a little less of a headwind for you guys over the next maybe year or two versus what you've seen historically? Thanks.

[Suketu Upadhyay, CFO]

Yeah. Hey, Matt, so I definitely think that pricing will be less of a headwind than we've seen historically. I do think that pricing pressure in the overall market will remain it could potentially intensify over time. But I will tell you, our performance, so idiosyncratic to Zimmer Biomet is that we're putting things in place to ensure that we don't have pricing erosion at the same level that we've had historically. Even if the market worsens. So we think that we can continue to travel less than 200 basis points here in 2023 and at least for the near term beyond that.

[Keri Mattox, Chief Communications Officer]

Thanks, Matt. Can we go to the next question, please?

[Operator]

We'll take our next question from Joanne Wuensch with Citi.

[Joanne Wuensch, Citi]

Good morning. And very nice quarter. Just summing back just a little bit. I don't think anyone expects these kind of growth rates to go on forever that it's a new normal. But it does give you what I would call, breathability to make some strategic decisions as you get these really strong quarters on a cash flow basis and on a revenue basis. What changes and maybe the way you approach your strategy given it?

[Bryan Hanson, Chairman President and CEO]

Yeah. Probably no major change, to be honest. To your point, it will create some headroom and it gives us that optionality as referenced before to let it flow through, which, as you can tell by our guide, we're going to let some of this flow through, but also to invest, and we are highly focused on driving revenue growth.

We've done a lot of research in the med tech space. And it's very clear that those companies that are consistently top quartile performers in TSR, grow faster than those companies that aren't. And the second leading thing behind that is EPS growth. So make no mistake, when we get this headroom, we're going to be focused, first and foremost, on investing in the business to continue to drive sustained revenue growth that ultimately as a result of that drives EPS growth as well.

So it's going to be the balance that we've always had with maybe a little more optionality than we would have otherwise.

[Joanne Wuensch, Citi]

And then as my follow-up. You did mention that there are some, we'll call it, niggling supply chain issues that are out there. Is there a way to put some color around that, what those issues may be? Are they easing? Or are they staying the same, intensifying -- and just sort of maybe give us a line of sight on what would make those go away.

[Ivan Tornos, COO]

Absolutely. I wish I will tell you when they are going to go away. What I will say is that we're navigating those very effectively. There are three key areas that I would say, account for 90% of the problem: Material shortage, labor issues and sterilization issues.

On the materials situation is better. We have validated second sources. We've come out with new materials. So I would say that it's probably better than it was, let's say, six to 12 months ago. On the labor here in Warsaw, we constantly continue to hire people. So again, I would say we're in a much better position than we were six-12 months ago. Sterilization is also getting better, but make no mistake, it is a bottleneck. We could definitely be in a much better position. It will have more capabilities.

That said, as reflected in the quarter, supply has been what it needed to be. It's put us in a position that we can continue to manage the business and grow the business. In terms of when this goes away, I have no idea. But I do think that it's well managed as of today.

[Bryan Hanson, Chairman President and CEO]

Yeah. The other factor that's impacting it is you've got all these negative pressures that Ivan just referenced. And then, of course, our demand is going up pretty substantially. So the demand signal is coming in much higher than we expected in the face of that environment that's pretty challenging. And I just want to -- again, I know I said it in my prepared remarks, but I want to compliment the team.

I've been with the commercial teams around the globe. And they're just doing an excellent job. These guys are really fighting 24 hours a day to make sure that we get product to the cases where they're needed. And trust me, it's a lot of work. It's a lot of effort. It's a lot of frustration I'm positive of that, but the team is doing a wonderful job indeed.

[Joanne Wuensch, Citi]

Bryan, thanks for the question.

[Operator]

We'll take our next question from Lawrence Biegelsen with Wells Fargo.

[Lawrence Biegelsen, Wells Fargo]

Good morning, guys. I'll echo my congratulations. A really nice quarter here. Just one for Ivan person, one big picture, one for Bryan. So Ivan, on Persona IQ, can you put the NTAP into context for us into context for us, what percent of knee patients are Medicare. What do you see happening with reimbursement for commercial payers? Do you expect them to follow? And have you guys filed for a pass-through payment in the outpatient setting? And I had one follow-up for Bryan.

[Ivan Tornos, COO]

Thank you. I'll keep it short, so you can continue with Bryan. But first things first. NTAP, new technology add-on payment enables an additional payment of around $150 per additional knee, so up to $1,700 for both knee. The decision kicks in, in October or actually the indication. The approval kicks in, in October '23 and the last for 30 years. So it's pretty material.

In terms of -- and by the way, it's not done. So we're going to be requesting these additional payments for the base station and other components. So there may be some additional upside to these numbers that I just quoted. In terms of the percentage of patients, this is for Medicare inpatient. We estimate that to be between 15% to 20%.

Relative to the second part of the question, do we think that commercial payers will follow. I think that comes down to the data to the clinical data. As we expand the number of patients that benefit from this technology, we're able to validate the clinical claims that we think that we're going to able to validate, of course, this will become a new standard of care, and this will impact not just Medicare patients, but also commercial patients. So I think you had a follow-up question for Bryan.

[Lawrence Biegelsen, Wells Fargo]

And just Ivan, on the outpatient setting, did you file for pass-through payment?

[Ivan Tornos, COO]

We're in the process of evaluating that, but we have not done that as of right now, no, we don't have any.

[Lawrence Biegelsen, Wells Fargo]

Okay. And Bryan, people have asked this question. I'm going to ask a similar question in a different way. So the recon market is clearly running hot now, 13% by our math in Q1. Pre-COVID, the recon market grew 2% to 3%. So a, do you expect the recon market to eventually return to its historical growth rate at some point in the future? I'm not asking you for a date. And b, does that create more urgency for you to do some M&A to increase your [Indiscernible] and diversify while things are good. Thanks for taking the question.

[Bryan Hanson, Chairman President and CEO]

Yeah. I think it's important to go back to the first quarter and just say, hey, that's not indicative of recon market. That is an easy comp for everybody, not just us, but across the board. So you have to look at that outsized performance and kind of haircut it by the comp. But even without that, it's a very hot market, to your point right now.

And there are certain things about that, that you might think would be for just a period of time. Backlog recovery should be here for a while. But that will eventually go away. But there are some things associated with Recon that we think are sustainable. And we've talked about these in the past. I don't know that everybody connects with what we're saying. But here's what I see.

If I think about market in total, there's a pretty significant technology shift that's occurring in Orthopedics at a very rapid pace. And by the way, we're just really getting started with that technology shift. That has a mixed benefit associated with it. So you don't need one new patient. You just need that technology to come in and that lifts the overall market growth and creates because of the innovation, better pricing stability. So the combination of those two things, in my view, is durable and sustainable to elevate the overall recon market growth, and we're certainly going to take advantage of that.

The other benefit that we have in this area for us specifically is that we're investing very disciplined in areas in recon that are faster growth. So our weighted average market growth will be better than the overall market growth in Recon. That creates more sustainability for fast growth and above-market growth for the company. And then outside of that and specific to us, as Suky said, we're doing a much better job on pricing. And that's a big benefit.

So if we can stay below our historical average in pricing that does also elevate our Recon business. And then finally, if I think about our innovation, we do believe it's differentiated. So we have an opportunity to also take market share through that innovation. So we really do believe Recon is attractive and sustainable. It's not going to be first quarter type of growth. That's abnormal because of the comp. But we do believe it could be elevated.

We're also looking into some patient behavior potential changes that we're seeing through COVID. This is early days. We're kind of analyzing it right now, but the feedback is that there's really three things that may be changing the perspective of a patient on whether they do or don't get a procedure. Which would be positive for us because we think that we're going to make the decision to get the procedure.

The first one is the technology advancements are giving people confidence that the outcome of the procedure is going to be good. A lot of people don't get the procedure because they're afraid the procedure is not going to do what they wanted to do. If that fear goes away, you may see more people enter the funnel. The second is that you're getting out of the hospital or the ASC faster. So that turnaround for the procedures 24 hours a lot of times used to be dates. So that also then is less inconvenient for the patient.

And then the ASC setting by itself is attractive. I mean we don't want to go to a hospital to get a knee procedure where a bunch of sick people are. The ASC setting is less overwhelming, feel safer. And I think people are more attracted to it.

And the final thing is you've got flexwork right now. That's pretty rampant out there. And so people feel more comfortable, more confident rehabbing and also staying in work. So we think those three things really have the opportunity to continue to elevate the recon market. And we're going to continue to look at it and take advantage of it.

[Lawrence Biegelsen, Wells Fargo]

Thank you.

[Keri Mattox, Chief Communications Officer]

Thanks, Larry. I think we have time for one more question in the queue.

[Operator]

We'll take our next question from Travis Steed with Bank of America.

[Travis Steed, Bank of America Merrill Lynch]

Hi, thanks for taking questions. I guess I hear you on all the strong momentum to carry through post Q1 and improvement throughout the year. And so maybe given the funky comps on Q1. Maybe think about Q2 in dollars, like hips and knees before the pandemic were typically flat to slightly down. And so I don't know if you think on a dollar basis, Q2 hips and needs would still be flat or if it can actually go up sequentially. Just kind of thinking about the momentum you have going through the year?

[Suketu Upadhyay, CFO]

Yeah. I think on an absolute dollar standpoint, you should expect to see a step down in Q2. That's typical seasonality. So growth rates yet are going to be wonky sequentially or year-over-year between 1Q and 2Q, but you should expect to see the traditional sort of historic step down in absolute dollars for Q2.

[Travis Steed, Bank of America Merrill Lynch]

Okay. Appreciate that clarity. And then I did want some clarification. I think I heard you say gross margin for the full year would still be flat year-over-year. I wanted to make sure I understood why it was still flat every year given the momentum on Q1. And then it looks like you bought back $268 million of stock in the quarter. I don't know if there was any color on that, if that's kind of a new use of capital for you. Thank you.

[Suketu Upadhyay, CFO]

Yeah, thank you. Thanks for the question on gross margin, Travis, because actually, I intended to say that gross margin would be higher this year versus 2022, primarily driven by that mix component and FX hedge gains. But if you thought about neutralizing those because they may not continue beyond 2023 at the same level, the underlying gross margin will be equivalent to 22%. But in absolute terms, it will be higher this year versus last year on gross margin. I just want to make sure that's clear.

Very perceptive on the share buyback. We did buy back, I think, about $250 million of shares this year, $150 million in Q4 of last year. That gets split between the Embody transaction, where we structured that with some equity to be advantageous from a deal structuring standpoint. So we bought those shares back, so to avoid any dilution on that deal from shares. And then the second is our more normal cadence going forward will be to buy back equity dilution from annual brands.

[Travis Steed, Bank of America Merrill Lynch]

Perfect, thanks so much.

[Keri Mattox, Chief Communications Officer]

Thanks so much for the question. Yeah. And I think that wraps us up through the queue, and we're at 9:30. So thanks, everyone, for your comments and your questions. The IR team is obviously available today, and we'll continue the conversations as we go through the day. Please feel free to reach out with any others.

[Operator]

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