Zimmer Biomet Holdings Inc

NYSE:ZBH

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet Second Quarter 2019 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded today, July 26, 2019. Following today's presentation, there will be a question-and-answer session. At this time, all participants are in a listen-only mode. [Operator Instructions]

I would now like to turn the conference over to Cole Lannum, Senior Vice President, Investor Relations and IRO. Please go ahead, sir.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thank you, operator, and good morning. Welcome to Zimmer Biomet’s second quarter earnings conference call. I'm joined by Bryan Hanson, Suketu Upadhyay, and Dan Florin.

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 forward-looking statements due to a variety of risks and uncertainties.

Please note that 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.

Also, the discussions on this call will include certain non-GAAP financial measures. Reconciliation of these measures to the most directly comparable GAAP financial measures is included within the earnings release found on our website at zimmerbiomet.com.

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

[Bryan Hanson, President and Chief Executive Officer]

Thanks, Cole. Before we actually get into the quarter and any news of the back half of the year or beyond when don’t we just go ahead and address the elephant in the room. I'm sure we have had a lot of people talking about the CFO transition. People have been writing quite a bit about it, even some people thought that may be the CFO transition might signal that we didn't have confidence in our guidance. This morning has already proven that's not to be the case.

This truthfully is just Dan's intent to spend more time with his family and who are we to get in the way of that aspiration, really that truly is what it is. Dan was kind enough to give us enough notice, me specifically, to be able to really set this up in an orderly way. Without that time you can't have a proper transition. You can't plan to organize this thing in a way that is not disruptive, and Dan gave us that opportunity. That's really what this is all about.

You know, the good news is, because we have done this an orderly fashion, I get the great opportunity to have an earnings call with two CFOs by my side and my IR guy. So I'm pretty much don't even need to be here today. So I'm looking forward to this call. I think I can actually relax on this one.

Suketu, I just want to say to you, welcome to the team, brand-new on the team. This is your first call obviously as CFO of Zimmer Biomet. Important day for us and important day for you. I can tell you that Suketu I had a feeling he would during the interview process, but the guy's jumped right in. It's just been a handful of weeks, but he is already getting to know the finance team and the broader leadership team. He is digging into the short-term financials to make sure that he feels comfortable with where we are, so a lot has been done in a very short period of time. I'm pretty confident the guy doesn’t sleep.

I know that he is going to be a great cultural fit as a result of that, fitting in quite well with leadership team. I know that through the interview process and it's playing out already. Again, early days, but strong so far, and I think everybody knows that this guy brings a wealth of experience to our organization. He has been a finance leader and just general leader for many years and clearly has a lot of experience in the healthcare space, which is going to be extremely applicable Zimmer Biomet.

Given that you've had a few weeks, why don’t we give you an opportunity maybe to just say a few words on your first impressions and that will start the business.

[Suketu Upadhyay]

Thank you, Bryan. I'd like to thank you and the rest of the team for all the introductions over the last couple of weeks and all the support in bringing me up to speed. My early observations are all very positive and if anything I think surprises to the upside. One, I think we've got a leadership team and more broadly than that an organization that has an aligned view of the strategies and the priorities of the company. Two, I've seen an organization that has a bias for action and that's really around patient centricity and value creation. And I think third, what I've seen is we clearly have a very strong corporate conscious to do things the right way operationally, from a compliance standpoint, and with the patient always in the center of deal.

So far the transition with Dan is going really well. I want to thank him for his counsel and his support. He has built some very high quality teams within the company and beyond that he is leaving a very positive and enduring legacy in many areas and many aspects of the company. I look forward to reconnecting with many of you and for those of you that I have not had the chance to work with me yet I hope to do that in the very near future. And all I can say is, I really look forward to driving value and being part of the team.

[Bryan Hanson, President and Chief Executive Officer]

Excellent, first words spoken as CFO is a [indiscernible] to the investment community. Welcome again to the team and we're looking forward to some big things from here. And it would remiss if I didn’t say a few words about my man Dan sitting across me right now. I'd just say first of all this guys, I think everybody knows is a phenomenal leader. He has done so much for this organization over the years and truthfully from the very beginning, even in the interview process quite frankly, this guy has been there for me. Truly has been what I would just define is my right hand from the very beginning.

I think it's important not just to look at the capability as the finance leader and the leadership that he has provided ZB, but also the fact that this guy has high integrity. He is an authentic leader and he proves that to me every day. I would say Dan, we've made some pretty difficult decisions over the past year and a half, anywhere from talent decisions to structure, to culture, I mean you name it across the board some of these quite frankly were not easy decisions, not for me and certainly not for you. I know that they were probably more personal for you than they were for me because you've been with the business longer, but what I would say is you never let that get in the way.

This guy through and through has made the right decisions for the right reasons for the organization and I am 100% confident we would not be where we are today without your leadership. So I want to thank you again on behalf of all of ZB for your leadership over the years as CFO, as interim CEO and I want to personally thank you for the counsel that you provided me over the last year and a half. This is officially, I'll put in here quotes "your last call as CFO of Zimmer Biomet." I'll be a little emotional for you, it is for me, and I want to give you an opportunity to say a couple of words.

[Daniel Florin, Outgoing Chief Financial Officer]

Thank you, Bryan and really thank you for your kind remarks, very humbling. And I really want to thank you for your friendship and your incredible leadership of this great company. It is palpable [ph] the difference that you have made and your leadership has made. And it's evident in the turnaround progress that we're making. So thank you for all that you have done for me and for the broader ZB community. It's been a real privilege working side-by-side with you over the past year and a half and I look forward to helping you and the management team in the coming months on some critical projects. So thank you from the bottom of my heart, thank you. I appreciate it man.

[Bryan Hanson, President and Chief Executive Officer]

And the good news is, just to make sure we calm everybody down, although Dan does want to spend time with his family and again I'm very supportive of that, he is being gracious enough to give us time to make sure this transition goes well, the pass off responsibilities in an orderly way to Suketu and to stay on and as you just said, work on some key projects that we have. So anyway, again Dan, thanks so much, I appreciate it.

Why don’t we go ahead and jump into the quarter now? So looking then at Q2, the team delivered another quarter of improving financial results with revenue growth driven by better performance in all geographic regions, as well as across most of our businesses. This morning we updated our guidance to reflect our increasing confidence in the ZB turnaround and our commitment to investing for growth.

Our people are focused and engaged at a level that I personally haven't seen since I joined the company. We're seeing real progress in the business and while we still have work ahead of us, I'm truly excited by our momentum. In terms of supply, we continue to drive efficiency throughout our supply chain to ensure that we meet increased demand for our products and drive confidence in our sales team. Our quality remediation efforts at our Warsaw North Campus remained on track and we continue to keep the FDA updated on our progress. We are highly confident in our progress and path to full remediation.

Additionally, we have now rolled out our culture program called "Quality Begins With Me" at all of our sites and we are building a sustainable quality culture as a result. We're excited by several key new product introductions this year and we are seeing the benefits of our engineering teams turning from quality remediation back to innovation to support what is becoming a robust pipeline in 2020 and beyond. Inside of these new product introductions, we are executing against our strategy to deliver an ecosystem of customer centric solutions, including our ROSA robotics platform and mymobility our digital health platform developed in partnership with Apple and our flagship Persona Partial and Cementless, as well as Knee System offering a more personalized solution for our patients.

We've also increased accountability and strengthened ZB spirit across the organization as a result of our new structure, new leadership team, and through our relentless focus on culture and connection to our mission. This is evidenced by a recent team member survey were more than 80% of respondents feel confident or very confident in Zimmer Biomet's future, strategy and leadership and feel the company is much better positioned today than a year ago.

Moving to our second quarter results, we benefited from continued strength in the Asia-Pacific region, another solid quarter in EMEA and improved performance in Dental, S.E.T., in the Americas particularly in the knee business. We are excited to report the best growth rate we've had in knees in the last three years. This is the result of continued strength in Asia-Pacific and improving growth in EMEA and most notably in the Americas. We are beginning to see the benefits of increasing confidence from the sales organization, better sales execution driven by more disciplined and rigorous operating mechanisms and our new product launches, particularly with critically with persona partial and Cementless, as well as ROSA Knee.

Specifically related to ROSA Knee even though we are in limited launch, system revenue did provide a benefit in the quarter, which we are confident will be further enhanced as we enter Q3 and beyond. Importantly, even when excluding ROSA sales in the quarter, our global knee business delivered positive growth, accelerated growth sequentially, and further narrowed our gap to market and it did all of this despite a tough comp in the quarter.

Speaking of new product launches, all the launches are delivering as planned or better. Since everyone is highly interested in ROSA, I'd like to take a minute to tell you how the limited launch is progressing. The ROSA knee system is receiving very high marks out of the gate and feedback from surgeons is very positive. While the overall number of placements in the second quarter remained relatively small, it's clear we have a solution that is attractive to our surgeon partners as evidenced by the surgeon feedback we received from the hundreds of procedures that we've performed since launch.

Most importantly though, demand is strong and it is growing daily. As expected, the internal and external energy around robotics is clear and as a result we intend to increase our investment in robotics as it relates to both research and development and commercial infrastructure. This increased investment will begin in the second half of the year which Dan will discuss later in the call.

Our S.E.T. business showed solid growth in the quarter as a result of supply stability which continues to grow sales force confidence, increased traction in the specialized sales channel that we've invested in and new product launches across the business. Moving into the back half of 2019 we will accelerate the expansion of the investment in our specialized sales channel in order to further increase our focus on these high-growth S.E.T. markets.

We also saw continued improvement from our dental business which has been gaining traction over the last few quarters. In fact, this is the best quarter for Dental since the Zimmer Biomet merger four years ago. Though there is still much work to accomplish, the focus on strategy, investing resources in priority areas, operational improvements and enhanced culture, have brought new energy to this business. While we saw broad improvements across our organization, we continue to see pressure in Bone Cement in line with our expectations, albeit at the lower end of the 10 million to 15 million per quarter we referenced in the past.

We also experienced growth deceleration in our Spine & CMF business in the quarter. Although we're not happy with our growth rate here, much of the sequential deceleration from Q1 is due to difficult comps. As we begin to retire some of the comp challenges, work through the final steps of our channel consolidation in spine, and fully launch a number of new products including ROSA spine and Walter, which will occur in the first half of 2020, we certainly expect to see improvement across this business.

So as you can see, we have a lot going on and we are making strong and steady progress. We have built a solid foundation over the last 18 months and have dramatically reduced the risk in the business. As a result, we have updated our 2019 full-year financial guidance to reflect our believe that we will achieve our weighted average market growth rate six months ahead of schedule beginning in the third quarter of this year. We intend to build on the momentum and execute against our plan to accelerate revenue growth, drive margin expansion and increase free cash flow, all with an eye toward significantly increasing shareholder value.

And with that, I'll turn the call over to Dan to go through the numbers.

[Daniel Florin, Outgoing Chief Financial Officer]

Thank you, Bryan. I will provide highlights on our second quarter financial results and go into a bit more detail on the updated 2019 guidance provided in this morning's press release. Net sales totaled $2 billion in the quarter, a decrease of 0.9% from the prior year period with an increase of 1.2% on a constant currency basis. As we noted previously, while there is no impact on our growth rate from billing day differences for the full-year, there was about a day of headwind in the first half which was spread fairly evenly across the quarters.

During the second quarter, we have solid results across all geographic regions. Our Asia-Pacific team delivered strong performance with 4.7% sales growth, while our Europe, Middle East, and Africa team increased sales 1.9%. Americans increased 0.1% reflecting improved performance across the majority of our product categories. Importantly, despite tougher comps, this represents sequential improvement of 100 basis points compared to our first quarter growth rate in the Americas region.

As Bryan noted, we saw improved performance in several product categories during the quarter. Our Knee franchise grew 2.5% on a constant currency basis with solid performance across all geographic regions. In addition, S.E.T. and Dental businesses on the same basis grew 4.3% and 1.7% respectively.

Moving to the income statement, we reported a GAAP diluted earnings per share for the quarter of $0.65. After adjusting for special items, our non-GAAP adjusted diluted earnings per share were $1.93. Reconciliation of reported earnings per share to adjusted earnings per share is included in this morning's press release.

Included within special items, we recorded a $70 million one-time non-cash charge in the quarter related to the termination of certain in process R&D projects. This reflects the progress we are making to prioritize our internal R&D portfolio and focus our engineering resources on the opportunities that are most closely linked to our mission and have the greatest market potential with the highest financial return.

Adjusted operating margin was 27.4% for the quarter and in line with our expectations. The adjusted effective tax rate for the quarter was 17.5% as expected. Operating cash flow for the quarter amounted to $301 million and our free cash flow was $161 million. During the quarter we paid $49 million in dividends and paid down $115 million of debt.

Moving to our updated 2019 full-year guidance, starting with revenue, we now expect 2019 reported growth to be in a range of flat to positive 0.5%. Included in our reported growth range is a negative impact of foreign exchange which we now expect will reduce reported sales between 125 and 175 basis points at current rates. The impact of FX on sales should be much smaller in the second half compared to the first half of 2019. We expect to deliver growth in line with our WAMGR on a constant currency basis during the second half of this year which is six months ahead of schedule and we also expect to see sequential improvement in every product category versus the first half of 2019.

To help you with your models, there are two factors that will impact the quarterly revenue phasing for the second half of 2019. First, the majority of the headwind from billing day differences in the first half which was about a day will be offset in the third quarter of 2019. Again, there is no impact from billing day differences on the full-year. Secondly, remember that in the fourth quarter of 2018 we received a one-time revenue benefit from a rebate adjustment in our EMEA region which creates a tougher comp for overall revenue growth in the fourth quarter of this year.

Turning to EPS we are narrowing our full-year 2019 adjusted diluted earnings per share expectations to a new range of between $7.75 and $7.90 per share. Included in this updated range we now expect our adjusted tax rate to be between 16.5% and 17.5% as we continue to execute on certain tax planning activities. The upside from tax will allow us to increase our investments in the areas that Bryan highlighted during his prepared remarks. Specifically, enhance sales specialization in our S.E.T. business, expanded and accelerated commercial infrastructure to support the launch of ROSA Knee, as well as additional investments in R&D.

As you look to update the components of operating margin for the second half, while operating expenses will increase for these investments, you should expect our gross margin rate in the second half to step up in over the first half. This improvement in gross margin was assumed into our original guidance and is driven primarily by anticipated refunds of prior period medical device excise taxes which will impact the third quarter. Therefore we are updating our operating margin for the full year 2019 to be between 27% and 27.5%.

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

[Bryan Hanson, President and Chief Executive Officer]

All right, thanks Dan. And before we move into Q&A, I want to say again that I'm pleased with the significant progress the team has been making. Compared to early last year when we began this journey, Zimmer Biomet truly feels like a different company. The energy inside of our organization is real. I'm excited that our second quarter results, as well as our updated 2019 guidance demonstrates the progress of our turnaround and our enthusiasm for the future.

And with that, I'm going to turn it back to Cole to get into the questions.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks Bryan. Before we start the Q&A session I want to remind you again to please limit yourself to a single question with a brief followup if and only if needed. Feel free to put yourself back in queue afterwards. I promise we'll get through as many questions as possible that way. With that operator, may be please have the first question?

[Operator]

Thank you, sir. [Operator Instructions] We'll take our first question from Raj Denhoy with Jefferies.

[Raj Denhoy, Jefferies]

Great, thank you and good morning and Dan I just want to add my congratulations on the next phase here. You know, I want to focus on the U.S. Knee growth if I could. You know, obviously it was the best growth we've seen in a couple of years here. You mentioned a couple of drivers there, ROSA, some mixed benefit from new products, but what I wanted to get at was underlying volumes and where you think you are from a share perspective and have you sort of stemmed the share losses you've seen or where is that tracking in your mind?

[Daniel Florin, Outgoing Chief Financial Officer]

Yes, Raj. So what I would say is we definitely closed the gap to market in the quarter. You know the momentum was real pretty much across the board and we're excited about closing that gap and at the same time we still feel like we've got real headroom here. You know, 2.5% may be the best we've had in a few years, but we really do believe there is even more potential in the knee arena. So we had a number of things go right. I mean I just kind of walked through them.

You know, we don’t want to discount the value of increasing confidence and morale in the commercial organization. When I think about supply, if you look at our current position in supply, it's significantly better than when were at our worst. I would say we had somewhere in the neighborhood of four days of backorder at the worst of this supply issue, we're down to a day. And as I said in the past, the organization would have a delayed response to getting back to steady-state supply would take a while for the organization to feel confident after some of the posttraumatic stress disorder they had at the beginning, but I do believe we're there.

The organization confidence level is high and their posture around offenses is good as I've seen. So that was a major contributor in the quarter and that's the gift that keeps giving, so that's an important one. Also we're seeing increased discipline in the way that we manage the commercial focus of our organization, particularly in the Americas. We're really making sure that we have an increased operating mechanism discipline focusing the organization around segmentation better than we have in the past, really being data-driven as a result of that and driving increased accountability. That also played a role and that is also a gift that will keep giving.

And there's the new products as you mentioned, I mean obviously we've got ROSA Knee coming out of the gate pretty strong, still limited launch, but feeling really good about it. Persona family of launches is doing quite well also. So it's a combination of those things that that are really driving the momentum and that is allowing us as a result to close the gap to market, but we may be happy about that, but we're not going to be satisfied until we're above market.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Raj. Next question please?

[Operator]

Our next question comes from Joanne Wuensch with BMO Capital Markets.

[Joanne Wuensch, BMO Capital Markets]

Good morning and thank you for taking the question. Your commentary on the second half of the year would imply increased confidence. What is giving you that increased confidence and how do we think about that then rolling into 2020?

[Bryan Hanson, President and Chief Executive Officer]

Well, it’s a number of things actually that I just talked about. I mean, if I'm going to break it down into its simplest form, the thing that gives me most confidence and the things we need to see happen in the back half and beyond, I really - I’ll make very simple, two things, we need to see the knee franchise continue to improve, you know that is the number one most important thing. But we also need to make sure that if that occurs we don't let things slip from our focus perspective and S.E.T. So if we get the knee franchise continuing in the progress that we've got and we make sure S.E.T. continues with the traction it’s getting, those are the things that need to happen to have the confidence we do in the back half and into 2020.

Couple of the sub-elements of that that make me confident that we're positioned well, for both of these, whether it be knee or S.E.T., one of the primary things is this confidence that I just talked about. The confidence level is high in the organization, supply is where it needs to be, people are more confidence that if they need a product they are going to get it. And again, as I said before, that hasn’t always been the case in this organization and it means a lot.

The second one is that, discipline. You know that operating mechanism discipline that we have to drive accountability. You say something, you will do something in this organization, you will accomplish it and that operating mechanism also ensures that we have the discipline to stay focused in S.E.T. even when large joints start to do well. And the final thing which is kind of obvious for both of these is new products.

We have new products across both platforms and we are going to take advantage of those and then the thing in S.E.T. that is different is we are increasing or doubling down in our specialization in sales organization. And you know, on top of that you've got to be more than just specialized. You also have to make sure that you have the compensation structure to ensure that the focus remains in S.E.T. even when large joints takes off.

And so, those are the things that need to happen in the back half. We have confidence they are going to happen and those will be the areas that we focus most heavily on, both in the back half of 2019 and into 2020.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Joanne. Operator, next question please?

[Operator]

We'll take out next question from Matthew O'Brien with Piper Jaffray.

[Matthew O'Brien, Piper Jaffray]

Good morning, thanks for taking the question. I’m sure you’ll get a bunch of ROSA questions here in a minute, but I was curious about the commentary on investments in the back half. I think beyond which you had been anticipating, can you, without giving away too much to your competitors, talk a little bit about where that may be allocated between maybe more sales reps, more marketing and R&D, and are those incremental investments designed to get you above the WAMGR in 2020 and beyond? Thank you.

[Bryan Hanson, President and Chief Executive Officer]

Yes, you know, it's interesting because when we think about increasing our weighted average market growth, you know, we've talked a lot in the past and people always asked questions about when are you going to do active portfolio management to drive your weighted average market growth up? What we’re saying is, eventually we'll get to that, but right now there are opportunities for us to do that in the businesses we are playing in by shifting resources. As an example, if you look at overall knees it's not that exciting of a growth business or growth market. But when you look at the sub-elements of certain categories like robotics, like cementless, there's clearly opportunity for outweighed growth.

So we want to make sure that revising our investment to those areas, that’s number one, right? So the whole goal of this is, choose those submarkets that are most attractive, bias investments to those which would be R&D, commercial investments and others, and that’s exactly what we’re doing. The second piece of it is though, we’re actually getting better feedback even than what we expected.

And as a result of that, we want to lean into the investment and make sure that we are increasing investment in research and development, to be able to fill some of the gap areas that we have in robotics, but I think more importantly to move ahead. You know, we don't want to just fill gaps that exist in robotic applications today. We want to be able to bring a more integrated ecosystem of robotics that will differentiate us beyond what other players have. And so that’s where some of that R&D money is going.

In addition to that, to be able to be prepared for the demand that we’re seeing, we want to make sure that we have the right commercial infrastructure. That’s not just sales teams, that service, that’s education, that’s everything that we need to be able to rollout ROSA in an effective manner. That’s what we’re seeing, we’re seeing an opportunity to invest in a higher growth submarket, and we’re seeing an opportunity to respond to better demand than what we expected.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that, Matt. Next question please?

[Operator]

Our next question comes from Matt Miksic with Credit Suisse.

[Matt Miksic, Credit Suisse]

Hey, good morning. Thanks for the question. I just wanted to followup on the Raj’s question on the knee business in the quarter if I could. You mentioned a lot of things went well and the numbers clearly, you know the best you've delivered in a long, long time. But just a couple of things in that list of things that went well is, maybe just clarification on closing the gap versus narrowing the gap to market, and you know where you wound up with press fit [ph] mix that was a bigger driver you talked about the past, and then just this 8% average of that you’ve been delivering in APAC growth has been very, very strong and just in the overall knee business if you could maybe elaborate on those that would be super helpful?

[Bryan Hanson, President and Chief Executive Officer]

Yes, so I'd just first say on Asia-Pacific, it is a juggernaut in our business for sure and the thing is every time I get out to the Asia-Pacific region and spend time with that team, they continue to give me confidence that they can continue that type of performance. So I truly do feel that that is in fact the case. They’ll continue to drive strong performance in their business. But we’re also seeing and probably most importantly, when you look at the knee franchise the Americas pick up you know, we’re seen some good life in the Americas and that needs to continue. It needs to actually grow, but we haven't been able to say that for a very long time and that's an important part of this equation. And same with EMEA, I mean, right now we've got all of our regions improving. Asia-Pacific is staying where they have always been and I would assume that all three will continue that momentum.

When I look at cementless, clearly this is a focus for our organization. Robotics and cementless, two of the most important areas of focus for us in knee, they are great because they give us an opportunity to be able to get a mixed benefit as you referenced. I’m not going to get into the specifics about the percentage that we think we’re going to get penetration of cementless or robotics, I’m not going to get into specifics relative to how much of our growth is going to be dependent upon that. But guaranteed we will be heavily focused on making sure that we get that mix benefit leveraging those technologies.

And not just those, mymobility fits into that category as well. So we have cementless, we have robotics, we have mymobility. These are all technologies that are very attracted to our surgeon partners and our providers. And as a result of that, we can get an up-sell in the procedure without having to get a new customer, a new patient and truly just upgrading the procedure. So we bring real value to the patient and the surgeon and we get to get the uptick and mixed benefit for the organization.

At the same time, I’m feeling more confident that those same values that we can bring to the surgeon also give us an opportunity to take competition as well right? To truly take competitive share. So I’m going to go after that mixed benefit for sure with friends and family, but I truly do think we’ve got an opportunity to leverage those same technologies to be able get competitive share as well.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Matt. Next question please?

[Operator]

Our next question comes from Matt Taylor with UBS.

[Matt Taylor, UBS]

Hi, thank you for taking the question. I just wanted to ask about your decision here to reinvest or double down in S.E.T. and make some investments with the savings that you got from tax. And the question I want to ask is, is this just something that we’re going to see in the second half or can you talk a little bit about how those investments will play out into 2020, and when do you start to see more of the payoff from them? Any color on those investments and what we should expect from them would be super helpful?

[Bryan Hanson, President and Chief Executive Officer]

Yes, it’s - they’re really, most of the investment on the S.E.T. side will be around commercial infrastructure, specialization of the sales organization, not as much in this situation on the R&D side of the equation. We do feel like we've got a good portfolio of products being launched in the category, but we want to make sure that we have that disciplined specialization to help drive it. So that’s; where you’re going to see most of the investment.

Now the good news is, that type of investment typically has a much shorter turnaround from a payback perspective. So I would say relatively quickly we could start to see the dividends associated with that investment and we’re already seeing it with the specialization that we have. The key piece to this though and I referenced it a little bit, is we need to make sure that we also have the compensation structure and the operating mechanisms in place to ensure that the 'specialized resources' don't all of a sudden do a stage left and go to large joints when that business is taking off.

And I seen that, but we've put specialization in place and we find whenever large joints moves that specialization starts to move towards large joints, because that’s where the money can be made. We have to make sure that we don't just put phase 1, specialization in place, we have to put the operating mechanisms in place to hold that group accountable and we got to put the compensation scheme in place to make sure that they're dedicated to that specialization.

So, net-net, when you put an organization in place the expense doesn't go away. I mean, it’s going to continue into 2020 obviously. But the dividend associated with that expense should also come pretty quickly.

[Daniel Florin, Outgoing Chief Financial Officer]

I would also add Bryan that the improvements in supply that we have had in S.E.T., you know, S.E.T. was hit pretty hard with supply as well, gives us confidence that the supply will be there. So it’s the right time to add to that specialized sales force. You combine that with the new products that are coming and it is the right time to do that.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Matt. Next question please?

[Operator]

Our next question comes from Ryan Zimmerman with BTIG.

[Ryan Zimmerman, BTIG]

Thank you, can you hear me?

[Coleman Lannum, Senior Vice President, Investor Relations]

Yes Ryan, go right ahead, we can hear you.

[Ryan Zimmerman, BTIG]

Thank you. So you’ve changed over, I wanted to talk about spine for a second, you’ve changed over the sales force a little bit within spine and recognizing that you anniversary in the fourth quarter Bryan, what is your assessment of that spine sales force today and how do you see that segment performing upon the completion or the lapping of those comps? And you know if spine is going to be dilutive to your WAMGR over time and how should we think about that? Thank you.

[Bryan Hanson, President and Chief Executive Officer]

Well, what I would tell you is, I feel good about the leadership team changes that we've made in spine. I feel good about the decisiveness of that newer organization relative to what we should do on channel, those are tough decisions. I think anybody who knows this space, when you're making a significant decision to consolidate channel there's always risk associated with that, but truthfully I’d rather take the risk, do the right thing for the channel and make sure that we take advantage of it in the future. So I feel good about all the decisions that have been taken. I feel good about the fact that we’ve moved through a lot of the channel consolidation. Now it’s just making sure that that channel jells and ensuring that we’ve chosen the right distributive partners to double down on and that will just take some time to determine whether that is in fact the case.

The bigger things from my perspective to be able to see a change in momentum in this business is as I referenced, we really do need to get past some of the tough comps that we have. We've got to see this channel begin to jell. And I think that's going to take another couple of quarters for that to happen and we got to launch, from a full launch perspective some of the key products. You know, ROSA Spine is there, but to be honest we put that a little bit on the backburner to make sure ROSA Knee is ahead of the game. But now we've got to redouble our efforts to get ROSA Spine moving in the first part of 2020.

Walter, I think is a great application that we can use to complement ROSA or by itself for spine applications which is a bionic arm that is independent of ROSA, but allows a kind of a mini robotics platform for spine procedures. And then we've got some gap filling products that we’re going to be launching as well that will come into full launch in the first part of 2022.

So to me, do I feel good about the decisions and the team? I'm going to need to see the results as we get into 2020. You know, the variables are in place for a successful equation. If they can deliver on that equation and solve the equation, we should see positive momentum in 2020. I fully expect that that business can absolutely be a positive to our growth rate, but they have to prove it and until they do, it’s still a – you know we’re still testing it.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Ryan. Next question please?

[Operator]

Our next question comes from Larry Biegelsen with Wells Fargo.

[Larry Biegelsen, Wells Fargo Securities]

Good morning, thanks for taking the question. Dan, congratulations on your retirement and Suke, I look forward to working with you. So I’ll ask a ROSA question. Bryan, maybe if you could give us some color on some of the early feedback on ROSA total knee, who were the early adopters, the demand of that you're seeing, and your ability to meet that demand? Thanks for taking the question.

[Bryan Hanson, President and Chief Executive Officer]

Yes, it’s, you know, I’ll tell you, part of the equation of having the confidence now to say that we’re going to be at that weighted average market growth six months early does come from the feedback that we’re receiving on ROSA. It is one variable in the equation. I don't want to put everything on ROSA, but it's a pretty big variable in the equation. And it’s early. We've had, as I said, hundreds of procedures that have been completed and the feedback that we’re getting from those procedures is very positive. So, I would just say the people that are actually using this system are feeling very good about the capability of the system and reliability of the system. That to me is one of the most important inputs that we’re going to get.

Any time you launch a new product, you are going to get feedback. You are going to get positive feedback and you're going to get constructive feedback. I would just say that the positive is significantly outweighing the constructive in this situation. And any of the things that we’re seeing relative to constructive are more around training, making sure they have a more robust training platform so that people are ready to use this system. That's why you do a limited launch right? To learn these things, get the feedback, and adjust. But pretty much across the board every day that goes by the more feedback that we get the higher the confidence level is that we have the right system.

So, again I feel, I feel very confident that we're heading down the right path and that the things are moving in the right direction. Ultimately, we still have to make sure that we commercialize effectively and move from this limited launch to full launch, but all our systems are positive at this point.

[Unidentified Analyst]

Thank you.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thank you, Larry. Next question please?

[Operator]

Our next question comes from David Lewis with Morgan Stanley.

[David Lewis, Morgan Stanley]

Good morning. Maybe just a question for Dan. Dan, there was - two dynamics have been weighing on investors here the last couple of quarters. One is obviously growth and we clearly gained growth acceleration this morning. The second is actually earnings. So I guess, Dan, when I think about reinvestment in 2019, how does that alter the picture for '20 can you deliver leverage earnings next year or are there additional investments not captured by Street numbers needed to get to that 2% to 3% top line number next year? And congrats as well to both of you.

[Daniel Florin, Outgoing Chief Financial Officer]

Thanks David. Well first, if you just look at our performance on gross margin in the second quarter, the second quarter gross margin was in line with our expectations, a little bit better than the first quarter. I've talked about the foreign currency hedging gains that are in the P&L this year. In 2018 we had FX hedge losses. We got gains this year, so that creates a tailwind here in 2019. We're obviously, Dave we're not going to give guidance for 2020.

We've talked in the past qualitatively that gross margin in 2020 will remain under pressure and when you think about what the manufacturing and quality teams have been through over the past two or three years, the focus clearly has been on quality remediation and supply recovery and you're seeing the benefits of that focus as we're describing on the top line acceleration.

So the offset to that is, that same team has not been as focused on cost takeout in COGS. So the good news is, we're now pivoting towards that and going to sustain quality remediation and service of course. We've built a very strong operational excellence team in the manufacturing organization. Ken Tripp and his leadership team are doing an excellent job of implementing much more rigorous operating mechanisms through the plants.

All of that says, we're starting to build up the momentum to get after cost reduction in gross margin, but that will take some time to materialize and then come through the P&L. So again gross margin, the takeaway is, it's going to remain under pressure.

Now the flip side is, as that revenue accelerates, it does give us the opportunity to make the investments that we're describing, but that incremental growth, particularly in Knees is a very positive mix and we believe creates enough dry powder to help us think about 2020. And as we've said in the past, sitting here today, we remain committed to some level of operating margin expansion in 2020.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that, David. Next question please?

[Operator]

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

[Bob Hopkins, Bank of America]

Oh great, thanks and hi, good morning. I wanted to ask my question about U.S. knee growth, such a critical driver and obviously nice to see the improvement. And I realize that both capital and volumes contributed this quarter, but I'm just curious to hear whether the improvement in U.S. Knees in Q2 over Q1 was driven more by capital or by volumes? I'm just wondering, directionally, can you give us a sense as to which was the bigger contributor?

[Bryan Hanson, President and Chief Executive Officer]

Well, I don't know that I'm going to get into specifics about the percentages or anything else, but as I said, ROSA is still in limited launch. So, we only placed a limited number of systems in the quarter, but it did play a part in the performance. But I think probably the most important takeaway Bob on this one is, even though it did play a part in the overall growth, even if I took it completely out, this was a really strong quarter in knees.

It really was, and the fact is we accelerated versus Q1 even with the tougher comp. We definitely had positive growth and as I mentioned before we closed the gap without capital to the market growth and again this is all despite a tougher comp coming into the quarter.

And I think most importantly on the ROSA side is, the fact is, our confidence in the system as I said, is growing and I fully expect because of that confidence in what we're seeing from our customers that it's going to play a bigger part, more material part in Q3 and Q4.

And I think you know this, Bob because you asked the question before, the real benefit of the ROSA placements isn't necessarily the capital injection you get in that moment, it's the revenue annuity that you get as a result of the disposables, the service arrangements that we have, and also the implant pull-through.

And so, as we begin to place these, we're going to be able to put more of an algorithm around net revenue annuity and build our confidence in what the future revenue growth of knee should look like. And so, that's the thing that gets me most excited about this. We can bring real value to our customers and patients and obviously increase the ability for us to get that revenue annuity as a result of placing ROSA.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Bob. Next question please?

[Operator]

Our next question comes from Amit Hazan with Citigroup.

[Amit Hazan, Citigroup]

Good morning. Thanks very much. I wanted to maybe kind of focus a little bit more on specific surgeon feedback. You talked about it in general a couple of times, but I'm curious what aspects are doctors most interested in so far on ROSA? And where are the areas of push back, if you can be honest about that from a surgeon perspective on the technology side, so far in the learning curve that would be - some color on that would be great? Thanks.

[Bryan Hanson, President and Chief Executive Officer]

So what I would say, I'll start with the areas of pushback, which we have been relatively limited. They've been around the education needed to ensure that somebody understands how to get the registration correct on the patient, right? So you've got to get the patient registered to the system. So the system knows where the patient is and we need to make sure that the training allows people to do that effectively. Where we've had slip ups is where that training wasn't effective enough and as a result of that, someone didn't understand how to do the registration and because of that they had to go back to doing the procedure, the good old-fashioned non-robotic way, that's an easy fix for us truthfully.

On the positive side of things, we knew out of the gate was that people would like the fact that they can use our implants. We are the preferred implant of any other company. We have the number one share position. Persona is a very attractive implant and people want to gravitate to it. So being able to use the implant, they know and love with the robotic system is very important to them and it is meaningful in the decision that they make on which robotic system, they're going to buy.

The other pieces is, as we've said before, we've really wanted to in the design characteristics of the system to be able to allow people to really keep the surgical flow that they're used to. And so, as a result of the way we set the design of the system up, we were able to keep a very similar surgical flow and as a result of that in very short order, be able to do a robotic procedure in the same time that they were able to do a non-robotic procedure. That's really important for high volume surgeons. And by the way, that's exactly who we want to go after. The highest volume surgeons you could get on robotics is better for everybody.

The other thing is, we have this dynamic tracking, which once you do have the patient registered with the system, if for whatever reason that patient or robotic system moves, our system can actually track the movement and keep you in line with where you need to be. Other systems can't do that. That's a really important feature.

And then the final one is, a lot of the surgeons, don't want to have to do CT scans to be able to do the pre-surgical plan. It's more radiation than is needed for the patient. It's another step that isn't typically needed and it's costly for the system. We don't have to have that when we do pre-surgical planning for our robotic system. You can use regular 2D x-rays. We then use an algorithm and turn it into a 3D image and as a result of the 3D image you can do your pre-surgical planning with typical x-ray.

So, those are pretty big differences that we have that the competition doesn't have. I've heard a lot of people say, and it does frustrate me that, well, it's not quite as good as the market leader, but it's a good enough system. I think it's completely the opposite. The feedback that we're getting is that it is a better system than what's out there and people are excited about that. And so, I truly do believe these variables that I just referenced do absolutely put us in a position to compete well.

[Dan Florin]

Yes. There will be an opportunity over time for more of you to see ROSA in action and then you will be able to draw your own conclusions about some of the things that can really do it. I'm looking forward to that timing.

[Bryan Hanson, President and Chief Executive Officer]

Yes. And I would just say one other thing too is, people are questioning whether or not with x-ray technology using this algorithm for 3D presurgical planning, so that we get the accurate cuts without controlling the saw-blade and in fact we're seeing is, we're getting more accurate cuts and people are pretty excited about that. At the end of the day, again traction feels very positive right now, and it gives me more confidence that even though we're going to have a great opportunity to get this mix shift in our own swim lane with surgeons that are using our implants today, I also truly believe that ROSA gives us an opportunity to go after competitive business. So we're going to get that mix benefit. We're going to make sure that our surgeons have access to robotics, but 100% guarantee we're going to go after competition here as well.

[Coleman Lannum, Senior Vice President, Investor Relations]

Next question please?

[Operator]

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

[Mike Matson, Needham & Company]

Good morning, thanks for taking my question. Bryan, you've talked about your desire to pursue M&A to increase your WAMGR over the longer term, but it just seems like given the growth in a lot of the orthopedic markets and segments, there may be sort of a limit to how fast you can really grow if you still stick within orthopedics. So I guess I just wanted to take your temperature on your willingness to diversify and maybe do deals that are outside of orthopedics? Thanks.

[Bryan Hanson, President and Chief Executive Officer]

Quickly, I would say on that, and then I'll get into little more of this, my preference would be to stay into the categories we already play and begin to try to double down in near adjacencies type plays, tuck-in type acquisitions to be able to build scale in areas we already play that are faster growth. So, I would be less interested at least in the short term to completely get into a new space right now. I think we have plenty of opportunity to be able to build scale in areas that we already play in and have a right to win and improving ourselves.

So that will be the first thing. But just before I even get into to this idea of M&A, we will stay focused and I'd just say, yes I would like to use the word maniacally focused on ensuring that we do drive the near-term priorities. We are beginning to see stabilization in the base, we cannot lose that, as stabilization in the base has to be, there has to be our number one priority. But we're feeling better about that, there's no question.

We are also working down our debt leverage now as we said that we would. We're being very focused on getting that debt leverage in the right place. Combination of those two things, more confidence in the core, getting the debt leverage where it needs to be, gives us better position now to be able to think about active portfolio management than in the past. But I don't want people to think that we're waiting to go buy companies to be able to drive our weighted average market growth up.

As I've said before, we're already doing this. We're selecting the fastest growth submarkets that we play in today and we are systematically moving dollars to those growth drivers. That means, research and development, that means patient education, that means commercial infrastructure, and eventually when the time is right and asset is attractive from a returns perspective and it fits our strategy BD&L will file that as well.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks Mike. Next question please?

[Operator]

Next question comes from Richard Newitter with SVP Leerink.

[Richard Newitter, Leerink Partners]

Thank you. I just wanted to ask another followup on ROSA, but more specifically what exactly is the - I don't want to use the word delay, I'm not sure if you had always intended to move into a full launch more in the first half of '20. But it feels like the ROSA one Spine product is getting pushed out a little further. Can you elaborate on what exactly, the prioritization issue was there and how we should be thinking about that rollout from either a sales force expansion ramp or is there a technological component to this that you need to redo on the system? Thanks.

[Bryan Hanson, President and Chief Executive Officer]

Yes, it's a good question. What I'd say, first of all, is that we, from a commercial standpoint, we're leveraging the same commercial organization. So, we're building this robotics sales organization, it would have a component of it that would sell spine, brain or knee. So, we're able to leverage some of the brain infrastructure that we already had in robotics and we're just expanding that to be able to service each of these platform, so it's not so much on the commercial side.

But the fact is, we did the, the limited launch, we came out with ROSA Spine and in that feedback process we received information on things that we could do to enhance the system, not necessarily the system itself, but the instruments around the system, and so we've been working on those enhancements and that's part of the reason for the delay.

The other part is, when you're looking at getting these off the line, it's one line, whether it's a ROSA Brain, or ROSA Spine or ROSA Knee, it's coming off the same manufacturing line and we have biased our focus and resources to ensuring that ROSA Knee gets out of the gate strong. So that's just, we really have, we made sure that we, for all the right reasons focused a lot of our attention and getting those systems out first,

But believe me, we have every intention of taking advantage of ROSA Spine and we truly do believe ROSA Spine is going to be an element of the turnaround of that Spine business, and we look at the first part of 2020 to start to move into that full launch.

[Richard Newitter, Leerink Partners]

Thank you.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thank you, Rich. Next question please?

[Operator]

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

[Robbie Marcus, JPMorgan]

Thanks for the question. Maybe just to followup on Richard's question here on Spine, this was one area of the business that came in a little weaker than expected this quarter. Can you help us understand some of the trends that are going on there, geographic differences, and how you expect this to trend for the balance of the year? Thanks.

[Bryan Hanson, President and Chief Executive Officer]

Yes, truthfully, when I look at the overall Spine & CMF business, no one can be happy with the growth rates that we saw in the quarter. The only thing that gives me a little solace on this and should you as well, is that that deceleration as I've said from Q1 to Q2, was really a big portion of it was comps. I'm certainly not happy with the performance. We need to make sure that we do a better job there, but comps did play a pretty big role in that deceleration from Q1.

That said, the thing that I would be most concerned about and I'm sure you are is, when are we going to see this thing turnaround. And as I've said before, I think first and foremost, we have to make sure that that commercial organization is gelling and that we have selected the right distributor partners. We made – we know the algorithmic decision and tribal knowledge decision on which distributors should be the ones that we land on, now we've got to make sure those are the right ones, and that's going to, that's going to take a little bit of time.

Second piece is, we just talked about ROSA Spine, but we have applications in Walter, which is a mini robotic solution that can be by itself or it can be a complement to ROSA. We need to make sure that we launch that effectively as well and then we have some gap filling technologies, that we just haven't had in the bag, which has hampered our ability to be successful here that we're going to be launching as well towards the back half of 2019 and full launch into 2020.

So, those are the things that need to come together for us to have success. And we're making the investment to do these things. We've got the team in place that says they can get it done. I've got to see it happen. And I wouldn't expect to see any inflection in this business that would necessarily say that you should expect as negative as Q2, but I wouldn't expect to see any inflection in this business until we get into that first part of 2020, probably even into the second quarter.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks for that Robbie. Operator, we're going to try to get two or three more questions in for the part of the hour. Next question please?

[Operator]

Up next we have Rick Wise with Stifel.

[Rick Wise, Stifel, Nicolaus & Company]

Good morning, everybody. I have a question for Suke. Good to speak to you again, welcome. Dan is a tough act to follow. He has done a lot of the heavy lifting in this initial turnaround phase. Maybe Suke you could just talk to us, one about to your initial impressions coming in? But more importantly, your priorities, the opportunities for this next phase, if you will, of the relay race to turn them around, get them up back on track, whether it's growth, or margins, or cash, what are your priorities? What should we be looking for from you as you stepped into the job? Thank you so much.

[Suketu Upadhyay]

Yes, good morning, Rick. Thanks for the question. It's good to hear from you again, and you're right, there are big shoes to fill with Dan. He has done a lot as part of the overall turnaround and I feel fortunate to be joining at this inflection point. And as you said, Dan, along with the rest of the team under Bryan's leadership they have done a lot of heavy lifting already, but there is more work to do. And if I think about where the priorities are going forward, for me, just very tactically and acutely, there is a lot to learn about this business as well.

It's a complex business with a lot of moving parts, especially in the backdrop of continuing to move beyond stabilization to growth. Two, I've got to get deeper into the organization to learn more about the teams and continue to build that relationship with the leadership team and more broadly into the organization, and really start to understand the culture, but then start to shape the culture as Bryan has been doing for the last several months.

From a priority standpoint, the company has already gotten a number of initiatives in flight, and those initiatives, as Bryan has talked about, are hyper-focused on what I see is the key value driver of the company. One is around revenue growth across all the franchises. Two, it's around driving a leveraged P&L and margin expansion. Three, I think it's around making sure we have a top quartile free cash flow margin, as it relates to sales over time. And fourth, continuing to prioritize things that drive a very high and improving return on invested capital.

So, I'm going to be spending my time on those initiatives that are aimed towards those four key metrics and we'll continue to evolve those as the market evolves and as our priorities evolve. But, I'm really excited and that's kind of how I see it, it's pretty basic, it's about blocking and tackling, and as I said, I think many of these things are already in flight, and that's where I'm going to spend my time.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thanks, Rick. Operator, I know all the attendees have to get off at the bottom of the hour, they probably have a lot of oars to put in. So, let's just have one more question please and then we're going to wrap up.

[Operator]

Up next we have Vijay Kumar with Evercore ISI.

[Vijay Kumar, Evercore ISI]

Congrats guys on a nice quarter. A quick one from me, the investments that you've mentioned on the capital sales force, can you maybe qualitatively comment on is that, is that capital of sales force, is it doubling or tripling from these levels? Thank you.

[Bryan Hanson, President and Chief Executive Officer]

I wouldn't get into specifics there, but I would just say that it's a significant increase in commercial infrastructure to make sure that we feel that we have the capacity, not from a manufacturing standpoint, but the commercial capacity to handle demand. And we will - again the beautiful thing about adding commercial infrastructure, if you've got your demand signal, right, which we think we do, there is a very quick payback on that. Also I want to make sure that I clarify that the capital sales organization is solely focused on getting the capital sold and placed and they are not going to have to be on an ongoing basis in the procedure.

We truly believe that through the design requirements of our system that we have a system that does not have to have a separate representative in the operating room to run the system. We can use the implant rep to be able to do that. So the capital organization will be expanded to be able to drive the capacity for supporting the demand of the capital and our implant rep will be the one that will take over once the capital has been placed to make sure that this system runs well inside the procedure.

[Vijay Kumar, Evercore ISI]

Thanks, Bryan.

[Bryan Hanson, President and Chief Executive Officer]

Yes, thank you.

[Coleman Lannum, Senior Vice President, Investor Relations]

Thank you, Vijay. And with that, we're going to cut it off. I know there are number of other people in queue. As we've always done, if you didn't get a question in today because of lack of time we'll get to you at the top of the list for next time.

Really, I want to appreciate your joining us. I know it's a Friday and it's been a long earnings week. As a reminder, you can listen to a replay of this call. It will be available later today for review. You can see that or listen to that on our website at zimmerbiomet.com. Have a great day. We will be talking to some of you later on today. Have a great weekend. Bye-bye.

[Operator]

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