Zimmer Biomet Holdings Inc (ZBH) 2017 Q1 法說會逐字稿

Good morning.

I would like to turn the call over to Bob Marshall, Vice President, Investor Relations and Treasurer.

As a reminder, today's call is being recorded.

Mr. Marshall, you may begin your call.

Thank you, Mariah.

Good morning, and welcome to Zimmer Biomet's First Quarter 2017 Earnings Conference Call.

I'm here with our CEO, David Dvorak; and our CFO, Dan Florin.

Before we start, I would like to remind you that our discussions 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 refer to our SEC filings for a detailed discussion of these risks and uncertainties.

Also, the discussions during this call will include certain non-GAAP financial measures.

Reconciliations of these measures to the most directly comparable GAAP financial measures are included within the earnings release, which is available on our website at investor.zimmerbiomet.com.

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

Thanks, Bob.

This morning, I'll review our first quarter results, including key highlights from our performance.

Dan will then provide additional financial details and our updated guidance.

Zimmer Biomet delivered first quarter top line growth and earnings results that were consistent with our expectations coming into the year.

In concert with our sales execution, we advanced the ongoing commercialization of differentiated technologies, solutions and services across our industry-leading musculoskeletal portfolio.

In March, we showcased several of our most innovative offerings at the Annual Meeting of the American Academy of Orthopaedic Surgeons.

These included solutions from our knee business such as our Vanguard Individualized Design total knee replacement and Persona Medial Congruent Bearing as well as a preview of our future robotics total knee platform.

From our comprehensive hip portfolio, we featured our G7 Dual Mobility Construct and our unique hip preservation offerings.

We also highlighted technologies that address faster-growing categories within the musculoskeletal market such as our Quattro Link knotless anchor for soft tissue repair and our broad range of deformity-correcting foot and ankle solutions.

Additionally, our comprehensive Vault Reconstruction System was very well received.

This advanced shoulder solution features the first commercially available patient-matched glenoid implant and integrates with Zimmer Biomet's unmatched range of intelligent instrumentation options.

Importantly, we capitalized on this global medium by giving our stakeholders an in-depth look at Zimmer Biomet Signature Solutions, our suite of end-to-end clinical services and digital technologies for musculoskeletal practices.

We generated positive feedback from clinicians and representatives from institutions who are interested in pursuing Zimmer Biomet Signature Solutions to drive enhanced patient outcomes, clinical efficiencies and cost savings across the entire episode of care.

We look forward to further developing and commercializing Zimmer Biomet Signature Solutions in 2017 and beyond.

Before turning to our sales performance, I'll provide an update on the product availability of certain legacy Biomet brands as well as our ongoing investments into manufacturing and quality excellence.

First, from a manufacturing perspective, as described on our January call, we have continued to implement operational process improvements at our Warsaw North Campus manufacturing facility as part of our ongoing regulatory compliance-enhancement efforts.

As we implemented these process adjustments during the quarter, we experienced a greater-than-expected number of temporary and occasional production delays.

While our overall production throughput improved during the quarter, these delays resulted in lower-than-expected levels of finished goods and strained inventory availability of key brands throughout the quarter.

While these impacts have been more profound and challenging than initially expected, the dedicated efforts of our team members across multiple functional areas supported steady first quarter sales results and, importantly, resulted in an improved and more consistent production output in recent weeks.

This progress supports our confidence in our ability to restore adequate supply and accelerate growth during the second half of 2017.

As we discuss often, our long-standing commitment to quality is a top priority for our company and the surgeons and patients who rely on our products every day.

Consistent with this objective, during the quarter, we continued to more broadly invest in the harmonization and optimization of our global manufacturing and quality systems.

Against the backdrop of this ongoing work, we achieved net sales of $1,977,000,000, an increase over the prior year quarter of 4.5%, which included approximately 220 basis points of contribution from the LDR acquisition.

Embedded within these global results, our Asia Pacific business delivered a solid 5.9% increase in sales as our Americas region accelerated sales by 4.7% and our Europe, Middle East and Africa region generated 3.1% sales growth over the prior year quarter.

Prior to discussing the performance of each of our product categories, I'll provide a brief comment on market conditions.

During the first quarter, global musculoskeletal markets continued to demonstrate stable growth, in line with prevailing trends we have observed over the past several years.

With regard to pricing, we experienced negative pressure of 2.3% for the first quarter, which was also consistent with our expectations.

Turning now to our knee business.

We increased sales by 0.6% over the prior year quarter, reflecting positive volume and mix of 3.0% and negative price of 2.4%.

Our Asia Pacific business increased sales by 3.1% as our Europe, Middle East and Africa region grew sales by 0.9% and revenues were flat in the Americas compared to the prior year quarter.

We continued to successfully drive the growth of Persona The Personalized Knee System, our flagship total knee, that has now been utilized in more than 500,000 procedures since its commercial introduction in 2012.

We also achieved noteworthy sales of our trusted Oxford Partial Knee system, which leverages more than 4 decades of clinical success.

Our knee team is currently focused on transitioning our new Persona partial knee into full commercial launch during the second half of the year.

This latest addition to the Persona product line will complete our partial knee portfolio with a fixed-bearing design that incorporates anatomic compartment-specific solutions and precise efficient instrumentation.

Our hip business increased first quarter sales by 2.4%, including positive volume and mix of 5.6% and negative price of 3.2%.

Our Asia Pacific region led hip sales growth with a strong 8.9% increase over the prior year quarter as we grew revenues by 2.7% in the Europe, Middle East and Africa region and sales were flat in the Americas.

Our Taperloc complete hip system drove steady growth as well as our G7 Acetabular System and our recently launched G7 Dual Mobility Construct.

We also increased sales of the Arcos femoral revision system and premium constructs, leveraging our proprietary 3D-printed OsseoTi Porous Metal Technology and vitamin E-infused advanced bearing materials.

During the quarter, our Europe, Middle East and Africa hip team hosted over 1,000 orthopedic hip surgeons and leading clinicians at a premier event held by the Zimmer Biomet Institute.

This global congress was an invaluable opportunity to present the full breadth of our best-in-class hip portfolio while reaffirming our commitment to offering world-class medical education and surgical training.

As we look to the balance of the year, we remain fully confident in the opportunities for growth within our knee and hip businesses while we continue to focus on supporting these trusted brands with greater supply readiness.

Turning to our S.E.T.

product category.

We delivered a solid 6.5% increase in sales, including good performances from each of our geographic segments.

During the quarter, we generated strong growth with our differentiated surgical portfolio, highlighted by the sales of our IntelliCart system, which significantly advances fluid and smoke waste management technology in the OR suite.

Within our sports medicine business, we continue to drive the growth of our proprietary Gel-One Cross-linked Hyaluronate injection and Subchondroplasty Procedure.

From our extremities portfolio, we've enjoyed the benefit from strong demand for our market-leading comprehensive total shoulder system.

And the ongoing success of our trauma business was reinforced by noteworthy sales of our A.L.P.

S. Proximal Humerus Plating System as well as steady demand for our NCB Periprosthetic femur plating system and DVR cross-linked distal radius plating system (sic - DVR Crosslock Distal Radius Plating System).

We believe our diversified S.E.T.

offerings, supported by our specialized commercial organizations, position this important category for ongoing sustainable growth.

Our dental sales growth was flat compared to the prior year quarter.

This stabilizing performance was supported in part by the sales acceleration of our hybrid surface T3 implant.

We remain confident in our ability to optimally position our broad dental portfolio of advanced implant technologies, regenerative solutions and multitiered offerings for this evolving global sector.

Turning to our spine, craniomaxillofacial and thoracic category.

We increased sales by 32.1%.

Building on our progress from recent quarters, we remain focused on executing our spine sales force integration, which will position this business to meaningfully contribute to our consolidated top line growth as 2017 progresses.

Our success in these ongoing efforts can be seen in the continued sales acceleration of our Mobi-C Cervical Disc prosthesis, a leading offering for a growing global market.

We also capitalized on the demand for our innovative new spine offerings such as the Vitality Spinal Fixation System for degenerative and complex thoracolumbar procedures.

Importantly, during the first quarter, our spine portfolio continued to garner clinical validation and industry recognition.

The International Society for the Advancement of Spine Surgery recently awarded its Best Clinical Paper for 2017 to a 7-year study on the Mobi-C Cervical Disc prosthesis.

This study demonstrated that Mobi-C patients experience less radiographic adjacent segment pathology compared to those receiving traditional cervical discectomy and fusion.

Outcomes such as these further validate our ongoing confidence in the future of our spine business.

Among our craniomaxillofacial and thoracic offerings, we achieved another strong quarter of growth with the SternaLock Blu and SternaLock 360 primary closure systems as well as the RibFix Blu Thoracic Fixation System.

We look forward to the continued positive performance of these differentiated clinical solutions.

With that, I'll turn it over to Dan.

Thank you, David.

I will review our first quarter performance in more detail and then provide additional information related to our second quarter and full year 2017 sales and earnings guidance.

Our total revenue for the first quarter came in at $1,977,000,000, an increase of 4.5% constant currency compared to the first quarter of 2016 and 2.3% constant currency excluding acquired revenue from the LDR transaction.

Consistent with our guidance, we recorded slightly less than half of an extra billing day in the quarter as compared to the first quarter of 2016 due to the timing of Easter, which added approximately 70 basis points to the growth rate in the quarter.

Net currency impact for the quarter decreased revenues by 0.7% or $12.6 million.

The negative currency impact for the quarter was related to the ongoing relative strength of the U.S. dollar versus the euro and the British pound.

Our adjusted gross profit margin was 75.2% for the quarter and 50 basis points lower when compared to the prior year due primarily to the impact of price declines and lower gains from our cash flow hedging program, particularly associated with the Japanese yen.

R&D expense was 4.6% of revenue at $91.1 million, 10 basis points higher than the same period in the prior year.

This added expense reflects the inclusion of pipeline activities from acquired companies such as LDR and Medtech, partially offset by a shift of quality and regulatory experts to ongoing remediation efforts at our Warsaw manufacturing facilities.

Adjusted selling, general and administrative expenses were $760.8 million in the first quarter or 38.5% of sales, 80 basis points higher than the comparable period in the prior year.

The negative variance was driven by increased freight costs due to expedited product shipments and the ongoing absorption of acquired business expense infrastructure as well as investments in our specialized sales force, offset in part by continued savings in SG&A expense categories stemming from our synergy capture initiatives.

In the quarter, we recorded pretax charges of $287 million in special items, which include $169 million of noncash amortization and inventory step-up charges as well as $35 million of quality remediation and $83 million of integration and other items.

Our diluted earnings per share were $1.47, an increase of 172% from the prior year.

Our current year earnings benefited from a onetime $70 million tax item related to an internal restructuring.

Adjusted first quarter 2017 figures in the earnings release exclude the impact of these special items, including the onetime tax benefit.

Adjusted operating profit in the quarter amounted to $635.7 million or 32.1% of sales, which was 150 basis points lower when compared to the prior year period.

Our adjusted effective tax rate for the quarter was 21.5%, a decrease of 430 basis points from the first quarter of 2016.

The reduction is related to the favorable resolution of various international tax matters, which will have ongoing benefit to our effective tax rate.

Adjusted net earnings were $433.4 million for the first quarter.

Adjusted diluted earnings per share increased 6.0% or 11% excluding the impact of foreign exchange to $2.13 on 203.1 million weighted average fully diluted shares outstanding.

A full reconciliation of reported net earnings to adjusted net earnings is included in this morning's press release.

Operating cash flow for the quarter amounted to $275.4 million, which included $109 million of cash expenditures for our synergy program and quality remediation initiatives.

Capital expenditures for the quarter totaled $129.5 million, including $86.4 million for instruments and $43.1 million for property, plant and equipment.

Free cash flow in the first quarter was $145.9 million, which was essentially flat with the first quarter of 2016 and in line with our expectations when adjusting for the timing of certain working capital initiatives.

During the quarter, the company repaid $150 million on our term loan.

Also during the quarter, the company borrowed $400 million from our senior credit facility to bridge the retirement of a $500 million senior note which matured on April 1. Therefore, gross debt reduction during the first quarter and the first week of April amounts to $250 million.

I'd like to now turn to guidance.

As a result of lower-than-expected manufacturing output of certain legacy Biomet brands during Q1 that David described and taking into account the resultant diminished product availability entering the second quarter, we are adjusting our view of the second quarter and full year revenue and earnings outlook.

We expect to have sufficient inventory as we progress through the second half of the year to enable our commercial teams to drive accelerated growth, albeit with a slight downward adjustment of 25 basis points to our previously guided second half growth rate, which now approximates 3.5% constant-currency growth.

For the second quarter, we expect revenues to be in a range of $1,940,000,000 to $1,960,000,000, which reflects a negative impact from foreign exchange of 2.2%.

On a constant-currency basis, our growth rate is expected to be in a range of 2.4% to 3.4%, inclusive of a 240 basis point contribution from LDR as well as approximately a negative 100 basis point impact from fewer billing days compared to the prior year.

Therefore, the midpoint of our Q2 guidance range is similar to our Q1 performance on a billing day adjusted basis.

For the full year 2017, our estimated revenue growth is now expected to be in a range of 2.0% to 3.0%.

Foreign exchange is now expected to decrease revenues by 1.2%, which is a 30 basis point improvement from our previous guidance as the dollar has weakened modestly versus many currencies.

Taken together, constant-currency revenue growth is expected to be in the range of 3.2% to 4.2%, inclusive of 120 basis points of acquired revenue from the LDR transaction.

In dollar terms, revenues are now expected to be in a range of $7,835,000,000 to $7,915,000,000.

Our expected range is down slightly from our previous guidance range of $7,855,000,000 to $7,930,000,000, which -- with favorable foreign exchange partially offsetting the reduction in our constant-currency growth rate.

Turning now to full year 2017 earnings.

Although our expected dollar revenue range has decreased slightly, the mix impact of operational growth versus foreign exchange impact has a negative impact on our profitability.

Additionally, we are incurring incremental manufacturing and distribution costs to maximize production flow while, at the same time, maintaining critical investment in sales channel specialization, innovative research and development programs and medical training and education.

Special items for the year are now estimated at $550 million, an increase of $20 million from previous guidance.

This includes a $40 million increase in quality remediation costs, which are now estimated at $210 million.

Notwithstanding these items, we are increasing our earnings per share guidance due to the onetime benefit of the previously mentioned tax item recorded in the first quarter.

We now estimate our reported earnings per share to be within a range of $4.68 to $4.88.

However, excluding the impact of inventory step-up and these special items, we are revising our 2017 adjusted earnings per share guidance to a range of $8.50 to $8.60.

This EPS range represents 7% to 8% growth over the prior year or 12% to 13% excluding the negative impact of foreign exchange.

Our estimated free cash flow range remains unchanged at $1,250,000,000 to $1,400,000,000.

Finally, our Q2 expected EPS is in the range of $0.95 to $1.05.

After the elimination of inventory step-up and special items, our adjusted EPS range is in the range of $2.08 to $2.13.

Our Q2 guidance contemplates the resolution of certain tax matters, which drives a 100 to 200 basis point improvement in our Q2 ETR from Q1.

We still expect our full year adjusted ETR to approximate 22.5%.

Finally, please note that our guidance does not include any impact from other potential business development transactions or unforeseen events.

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

Thanks, Dan.

Our achievements during the first quarter have built on the foundations we've laid for improved supply chain throughput and enhanced manufacturing systems.

These efforts, along with the contributions from our expanded global spine business, are positioning Zimmer Biomet to deliver stronger, broad-based sales acceleration in the second half of the year.

We remain confident in the promising opportunities within the global musculoskeletal market.

As we look to the balance of 2017, we'll remain focused on driving sustainable growth through innovation at every level of our global business, guided by our long-standing framework for value creation.

And now I'd like to ask Mariah to begin the Q&A portion of our call.

(Operator Instructions) And we'll take our first question from Bob Hopkins with Bank of America.

Can you hear me okay?

We can, Bob.

Great.

So first question is I just want to make sure I have a good understanding of what's driving the change in guidance.

So I guess, for Dan, first of all, it looks to me like organic revenue growth guidance is coming down by about 50 basis points.

Is that all due to these production delays related to the supply issues?

Yes, it is, Bob.

Okay.

And then same question on the earnings side.

The change in earnings -- on adjusted earnings, is that all related to the increased costs associated with this?

The adjustment to earnings is a combination of the revenue reduction, so the earnings drop-through impact of the revenue reduction combined with the incremental production costs, particularly in the North Campus.

Okay.

And then, David, I just wanted to kind of ask a bigger-picture question on the production delays.

So can you just take a step back for us and give us a sense as to what really is the root cause of these issues on the legacy Biomet side and just on the supply side generally?

And I just would love it if you could give us a little bit better understanding of what also the incremental issue is this particular quarter and how long is this going to take to resolve.

So I think it'd be really helpful just to give people some perspective as to kind of how we got here.

Sure, Bob.

Well, as we explained in the last call, we have been working through the integration process to harmonize and optimize our quality and manufacturing systems as part of the integration.

Those efforts as it relates to the Warsaw North Campus were greatly accelerated as a consequence of both internal audit findings as well as the FDA's inspection that concluded in the fourth quarter of last year.

So we had a pretty fluid situation in the fourth quarter leading into the beginning of this year.

We've made accelerated changes to those operations.

And obviously, in addition to implementing operational improvements at the facility as part of these regulatory compliance enhancement efforts, we were focused on ensuring that the production was coming back up to satisfy, in a prioritized way, existing customer demand and then working towards replenishing safety stocks that would allow us to go back on offense.

Because some of these key brands that come out of that facility provide us with some of our best competitive opportunities, so they're a very important set of brands and strategically relevant to the acceleration of the top line.

And so it really is a matter that is focused on that facility.

And as we got into the beginning of the year and production began to accelerate back up, it just took us longer to ramp that production back up.

You can understand why we'd be operating with an abundance of caution, most importantly, with the interest of the patients that are served by these products in mind.

These are high-quality products.

We want to make sure that we're putting them out without any compromise, and so the monitoring processes are very sensitive.

The implementation of these processes, as I said, this was done on a very accelerated basis for obvious reasons, and it just took us longer to ramp up that production in the first quarter than we originally anticipated.

As we exited the quarter and in most recent weeks, those production levels have been brought up to a point where we're going to be able to begin to more fully satisfy existing customers and, as the second quarter progresses, work towards replenishing those safety stocks.

So in the summer months, we expect, in particular, to make a lot of progress on that front and to put ourselves in a position then to not only fully satisfy existing customer demands but then to go back on offense.

From where you sit right now, when do you think this is completely behind you?

No, I wouldn't say that it's completely behind us, but I think we have better visibility, Bob, on the matter than we did 3 months ago.

As I said, the output has risen to levels that allow us to work down the back orders.

As those back orders are brought down, some of the cases with existing customers that we're currently missing, we will regain.

That will take us through the second quarter.

But then as we exit the second quarter and work into the second half of the year, we do believe that we'll be putting this behind us.

And we'll take our next question from Matthew O'Brien with Piper Jaffray.

Just to follow up a little bit on Bob's question.

As far as your customer base goes, have you seen -- at this point, there's a couple of quarters where you've had some of these manufacturing issues.

Do you have any sense for your ability to retain share within your customer base given the shortfall in terms of product availability?

And what are some of the programs that you're putting in place in order to retain some of these customers as you work through these issues?

Yes.

I would tell you that the teams have done an excellent job of moving product around and being very responsive to the customer demands.

There are instances where we aren't able to satisfy those demands in particular cases, but you should think about it predominantly as instances where we're missing cases with existing customers.

But the larger relationship is maintained, and that is part of the reason we have such a high degree of confidence that, as these production flows begin to replenish stocks out in the field, that we'll be regaining those cases.

So that's more the matter that's in front of us.

And we think it's very achievable to regain those cases, and we'll begin to do that here in the latter part of the second quarter.

Okay.

And then the follow-up question.

In looking at -- it looks like in the knee and the hip business that the pricing pressure you saw this quarter is the highest that I can find over the last kind of 5 quarters.

Understanding Q1 of last year was a little bit lighter than you've been seeing.

So are you -- that modest elevation in some of the pricing pressure you're seeing in hips and knees, is that a direct result of this manufacturing issue, you're having to give up a little bit more price?

And do you think you'll -- this will be a level that you may have to continue to deal with over the next couple of quarters?

It really isn't related.

The slight uptick in price pressure was more geographically focused out of the Europe, Middle East and Africa businesses and, in particular, 2 or 3 countries where we have large share.

And those are market-driven priced-down efforts in those markets, and so that was really the dynamic that led to the incremental price pressure sequentially.

Okay.

Should we expect this level of pricing pressure for the next couple of quarters?

Well, I think that this is really consistent with our guidance, so nothing's changed for 2017 on our perspective as to what price is going to look like.

And we'll take our next question from Mike Weinstein with JPMorgan.

My question relates to Lotus and (inaudible).

So when Lotus relaunches later this year, you're going to have the challenge of bringing a product back to market that's been off the market for 6 months.

Can you just give us your thoughts on where you think the balance between the 2 settles out for you as it relates to 2018?

What do you think respective positions are of those 2 products in Europe?

Mike, it was difficult to make out your question if you were directing that our way.

(technical difficulty)

Hearing no response, we'll continue to David Lewis with Morgan Stanley.

Can you hear me?

We can, David.

Okay.

A couple quick questions here.

Dan, I want to start with you on margins.

Can you give us a better picture of the factors sort of weighing on margins here both for the quarter and the year?

And I guess, I'm trying to better understand the dynamic of synergy progress relative to remediation.

And sort of what is your confidence for the balance of the year that we have a good handle on these remediation costs given they sort of accelerated here in the quarter?

Sure, David.

First, with respect to the integration synergy program, that remains solidly on track.

We have described that as an incremental $85 million of benefit in 2017.

So that continues to be on track, and the Q1 installment, very consistent with our expectation.

The incremental production costs and I also mentioned in my prepared remarks some incremental distribution costs as we've expedited shipments around the world, the combination of those 2 is the big change.

Keeping in mind we're still delivering very strong ex-FX earnings per share growth on an adjusted basis.

So I'd say what's changed, consistent with the commentary on the production throughput, it's just costing us more to produce those products out of the North Campus.

That will change over time.

As we continue to make progress on these operational process improvements, there's no question that the cost to produce product out of the facility will normalize out over time.

But we have dialed that in for the remainder of 2017.

We've dialed in the incremental distribution expenses, and then we've gone back through and looked at some other productivity initiatives and looking to tightly manage discretionary spending.

And you put all of that together, and that's where we landed on earnings guidance.

Okay.

You remain confident that these remediation issues at this elevated level represents the ceiling on the costs for this year?

Yes, David.

And keep in mind -- so what I just described is included in our adjusted earnings per share, the incremental production costs.

Included in that would be some incremental quality inspection.

In addition to that, with respect to the remediation activities of the 483 observations, we've also increased that estimate, and that's included in the special items.

And our prior estimate was $170 million, and we've increased that by $40 million to reflect the additional work that's taking place there.

That's included in the special items in our GAAP P&L.

Okay.

And David, just a follow-up question for you, if I could.

The thesis for most investors on Zimmer is they want to see that steady incremental organic acceleration.

I think, to be fair, over the last few quarters, there's a bit of a "1 step forward, 2 steps back" effect.

So I think -- what I think most investors would really like to hear is a couple things: number one, this really is about manufacturing and it has nothing to do with sales attrition and nothing to do with competition.

Maybe you could comment on that.

And then, once again, I think what they really want to hear is your confidence that when the company says, "We're going to be making these slow steady progress forward," it's now going to be steps forward and not steps back.

And maybe you could help us with your conviction on that as we head over the next 2 or 3 quarters.

Yes.

First, to confirm, David, it is all about that production facility.

We have -- we believe that even within the first quarter to second quarter, you can think about that production facility impacting the top line growth at an estimated 150 to 200 basis points.

And so quite literally, as those products roll out, everything that we make is going to get sold, and you're going to see the elevated top line off of that.

There is no under -- any other underlying root cause of the top line performance that we've been discussing.

And I would tell you that not only are we confident based upon the progress that we're making on the production side in the recent weeks that we're going to be able to fulfill that demand to a much greater extent by the end of Q2 and moving into the second half of the year, we're really optimistic about some of the other growth drivers that we've been working hard to create, including the integration of the spine sales channel and great success with the Mobi-C product.

So our vision for the second half of the year is you're going to see this work through.

Our large joint business is going to be positively impacted by our progress in this regard.

We'll continue to perform well on the S.E.T.

category, and we're going to be adding another cylinder to that growth with an integrated spine channel with the best-in-class cervical disc product, Mobi-C.

And we'll take our next question from Mike Weinstein with JPMorgan.

Sorry about that earlier.

I was trying to jump back and forth between the 2 calls.

So I think David asked the right question there.

It does feel to everybody like it's 1 step forward, 2 steps back.

So what -- how do we get to a point where, from an investor standpoint, we have enough confidence that these issues are going to be behind you in 3 months and that you really will get the second half reacceleration that you're talking about?

What can you do from -- for the investor base here to give us some confidence that these issues at Warsaw and the issues before them are going to be a thing of the past?

Mike, I would just reiterate that the visibility that we have exiting the quarter and in the most recent weeks as to those production levels, the solutions to that, it's really as simple as once the field inventory gets bled down and they're -- even with extraordinary efforts, there is no ability to move product around to cover cases with existing relationships, you're going to start missing some of those cases.

And that's what transpired in Q1, and we're going to be working our way out of that issue as we exit Q2.

So we have very good line of sight as to the product that's flowing out of that facility now, and we can map out precisely what cases we're missing and the status of those relationships.

And when you bring those lines together, you see this problem resolving as we exit Q2 and move into the second half of the year.

Thereafter, it's a dynamic of not only fulfilling existing customer demand by virtue of the enhanced production levels that we're seeing currently but then rebuilding safety stocks that allows us to go back on the offense and compete very effectively with this great product portfolio for competitive business.

Mike, this is Dan.

I would also add that the Q1 -- I think the right way to think about this is that the Q1 production throughput delays has pushed our time horizon out by approximately 2 months in clearing back orders and replenishing safety stock and getting back on offense.

And importantly as David said, in recent weeks, we've reached production throughput out of that campus to levels that are necessary to fuel that.

So we've already demonstrated in the past couple of weeks the level of output necessary to fuel that growth.

Now there's a time lag between it coming out of the facility, getting through terminal sterilization and pushed out to the field, having complete sets and then going on offense.

Those are the -- that time lag.

But I think it's really important that we have, in fact, been performing, from an output perspective, to the degree that we need to, to fuel the second half growth.

And David, where does the FDA fit in on all this?

I assume the FDA hasn't yet been back in the Warsaw facility for reinspection.

Yes.

As we provided the update during the last call, we obviously take these matters, as evidenced by everything we're doing, very, very seriously.

And we've developed a comprehensive remediation plan to fully address the issues cited by the FDA, and we're going to continue to communicate with the Agency as we execute that plan.

We're going to take the necessary steps to address these gaps in that operation.

And I would tell you we also would express that we remain confident in the quality and safety efficacy of these products.

So it just is an ongoing process, Mike, at this point in time, and we'll keep everyone up to date with any appropriate disclosures as that process unfolds.

And we'll take our next question from Larry Biegelsen with Wells Fargo.

It's Craig on for Larry.

Can you hear me?

We can.

I guess, David, for you, just given some of the commentary about rebuilding the safety stock and going back on the offensive, I wanted to ask about -- when looking at '18, is it fair to assume that you guys can accelerate on the 3.5% growth you expect in the second half?

I would think that, that -- you should think about that as a base as we exit 2017 and move into 2018.

No doubt, there are opportunities to go beyond that.

But obviously, work to do and operating plans to be developed before we get specific about that, Craig.

Okay, that's helpful.

And I wanted to ask on -- with the display of ROSA at AAOS, I wanted to get your view on the place robotics will have in the overall hip and knee market for the next couple of years.

I mean, if you step back from the competitive dynamics, just robotics in general, is it going to be a tool just for surgeons that may be placed in a niche market?

Or do you see it as a bigger treatment shift?

Yes.

I think consistent with our discussions and our innovation strategies over the past decade, I would maybe start by characterizing robotics in a broader way into intelligent instrumentation.

And I would tell you that as it relates to intelligent instrumentation, more broadly defined, we believe that it's going to be the predominant way, ultimately, that these procedures are done and, frankly, the standard of care.

And that includes everything that we've been doing from a navigation platform through custom jigs, the Signature offering, the legacy Zimmer PSI offering.

We've done this across various anatomical sites, knees most extensively.

We have the iASSIST technology in that space, eLIBRA for soft tissue balancing, preoperative planning systems.

And these technologies are going to converge in ways that satisfy 3 conditions: improve the quality of care, take costs out of the procedure and enhance the throughput of patients.

So I think, again, those are the key value drivers as we develop those technologies in a portfolio fashion that we're focused on, we think that robotics can have an appropriate place within that.

I don't think that that one tool out of the box is going to be the total answer, rather I think it's going to be a portfolio of technologies that address the needs and create value across those 3 dimensions.

And so we're really enthusiastic about the broad portfolio that we've assembled.

We've been at it for 10 years, and I think it's one of the reasons that as we previewed the potential opportunities to bring the ROSA platform into a knee procedure, we think that we can go at that in a differentiated way and leverage all the work that we've done over the last decade, along with our new team members from Medtech, to make a difference in that space.

And so I don't know how to break robotics out of a broader portfolio of intelligent instrumented solutions that will become the future.

But a decade from now, I think that these procedures are going to predominantly utilize these intelligent instrumentation procedures, and I suspect, across various anatomical sites, robotics can be part of that portfolio.

And we'll take our next question from Joanne Wuensch with BMO Capital Markets.

Can you hear me now?

We can, Joanne.

At one stage, you had put up a slide that showed sort of an aspirational growth of 4% organic revenue.

Do you believe that that is still attainable with the current product of portfolios that you have?

And can you give us an idea of what your time frame might look like to reach that?

Yes, we absolutely are confident in that capability.

We -- you reflect back on each of these entities on a stand-alone basis, and for the prior 2 years, before any deal work began, they were performing in the mid-4s on a standalone basis.

And the portfolio has been greatly enhanced by virtue of the combination.

So we're very confident in being able to achieve that goal.

And look, our expectation is going to be to exit the year consistent with what we're forecasting, in kind of that midpoint of 3.5% in the second half of the year, and that puts us on a nice path towards the number.

Okay.

And my second question has to do more with expenses.

Obviously, there's a lot in getting everything sort of fully on track.

I'm going to assume most of that's running through SG&A.

Should we think of your 38.5% in the first quarter as a go-forward rate?

Or will you be able to manage that down throughout the year?

Joanne, first, most of the incremental costs that we're incurring beyond our original guidance is actually up on the gross margin line.

So the incremental production variances flow through cost of goods sold.

The distribution expense that I referred to is in SG&A.

But essentially, our gross -- or SG&A profile remains on track to migrate back towards the original guidance levels that we had provided.

So we'll -- that's where a lot of the installment of the synergy capture is flowing through, and that enables us to move closer towards 37.5% on a full year basis.

And we'll take our next question from Glenn Novarro with RBC Capital Markets.

Can you hear me okay?

We can.

I just had a follow-up on ROSA and then a question on free cash flow.

So at AAOS, you talked about ROSA being launched at AAOS in 2019.

But in 2018, I think we're all assuming that the Mako launch is in full swing.

So what keeps the Zimmer surgeon from migrating to the robot?

I know, Dave, you talked a lot about you offer more than the robot.

But I'm curious, does the promise of the robot in 2019 keep the Zimmer surgeon from migrating?

And are you still confident that ROSA could be launched at AAOS in 2019?

Sure, Glenn.

That is the track that we're on.

We expect to move into a clinical evaluation state in the second half of 2018 that would lead to the achievement of that objective of a 2019 academy launch in earnest.

But in the meantime, we're excited about continued penetration with our intelligent instrumentation offering.

We did almost 100,000 cases, as I rattled off just a bit ago, the various technologies within our current portfolio, and that continues to grow.

We had a great receptivity on the Signature Solutions front to help better manage the end-to-end episode of care.

And again, back to the 3 value drivers of enhanced clinical outcomes, workflow efficiencies and then increased patient throughput, that's what that program is all about, and that's what our intelligent instrumentation offering is all about.

So all of that, in addition to the fact, Glenn, that we have some exciting product introductions within that category that are going to make a difference, some of which we discussed, such as the Persona partial knee that moves into a full release in the second half of this year, and others that we haven't discussed at this point in time but are going to be highly relevant to that same time period that you referenced.

And in the aggregate, it puts us in a position to be very comfortable that we're going to compete effectively in our market-leading knee space.

Okay, great.

And just, Dan, on the free cash flow, the guide there is unchanged even though we're taking down adjusted sales and EPS.

So can you maybe talk through the puts and takes in the free cash flow for 2017?

Sure.

So the free cash flow guide of $1.25 billion to $1.4 billion, as you said, we're retaining that.

And really, despite the earnings takedown, as we look at other working capital and operational levers we have available to us at this point in time, remain confident that we can deliver free cash flow within that range.

I think it's important to just remind you that in the current year, there are still significant special items.

We've increased the quality remediation spend up to $210 million.

In addition to that, there's incremental Biomet integration expenses and other integration activities.

So we're still committed to our long-term goal of $2 billion of free cash flow.

So within our 2017 guide, there are still hundreds of millions of dollars that should dissipate over time as we work towards that $2 billion long-term goal.

And we'll take our next question from Steven Lichtman with Oppenheimer & Co.

First question is just on the specialized sales forces.

How much are you looking to grow that overall footprint in 2017?

And maybe just an update on how you're seeing the development of the specialized sales forces as a driver of S.E.T.

Yes, we haven't disclosed the specific numbers, but it's a key area of focus for us.

I mean, as between the large joint business versus the other categories, our sales adds are predominantly focused on the non-large-joint categories because we have such a large footprint and an existing capability on a global basis within the large joint section.

So it's substantial.

We made a lot of progress in the design of the organizational structure at the time of the integration and had a lot of success last year with adds and expect to make another meaningful installment in 2017.

Okay.

And then -- and just a second question, Dan, just to further clarify your comments about a couple-month delay in terms of the ramp.

So it sounds as though you are seeing the acceleration in ramp of production over the last several weeks.

It's just simply a couple of months later than you would have thought, and that's what's sort of pushing it out a little bit.

Is that the way to think about your 2-month comment?

That is exactly the right way to think about that, that, importantly, we're currently -- in the past couple of weeks, we've seen throughput out of the facility at the levels necessary to clear back orders, to meet existing customer demand, replenish those safety stocks and then get back on offense.

And we'll take our next question from Kyle Rose with Canaccord.

Can you hear me all right?

We can.

Great.

So I just wanted to ask about the pipeline.

Obviously, you showcased a lot of products at AAOS.

But there's -- with the manufacturing and some of the remediation plans going on, I just wanted to understand what, if any, impact the work on that side of the house has impacted some of the timing and cadence of product development launches over the coming 12 to 24 months.

Yes, it has caused a reprioritization, but there -- the key products that are in the pipeline now move forward.

Many, many products are either in early launch or about to get launched, and I would tell you that, notwithstanding the reprioritization, we still have a very robust pipeline.

The expectation is still approximately 40 new product launches within fiscal year 2017.

Great.

And then just one housekeeping question.

I know you disclosed the pro forma growth number excluding the contribution of LDR, but just wondering if you could give us the overall underlying organic growth number for the quarter, excluding all acquisitions.

So the -- we'll start with, in my prepared remarks, described the constant-currency all-in number of 2.4% to 3.4%, with LDR contributing 2.4%.

So ex FX, ex LDR, 0% to 1%.

And then we had the billing day headwinds of 100 basis points.

This is in our Q2 guide.

So that 1% to 2% is indicative of the organic growth rate.

The other acquisitions are having some impact.

We're very pleased with how those products are performing, but I think the right way to think about our organic growth is as we're disclosing it.

With that I'd like to -- I'm sorry.

With that, I'd like to thank everyone for joining the call today and for your continued interest and support for Zimmer Biomet.

We look forward to speaking with you on our second quarter conference call.

I'll turn it back to you, Mariah.

Ladies and gentlemen, that concludes the Zimmer Biomet, Inc.

First Quarter 2017 Earnings Conference Call.

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