Zimmer Biomet Holdings Inc (ZBH) 2017 Q3 法說會逐字稿

Good morning.

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

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

Mr. Abernethy, you may begin your call.

Thank you.

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

I'm here with our Interim CEO 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 to these measures to the most directly comparable GAAP financial measures are included within the earnings release found on our website.

In addition to the earnings release issued this morning, we have also posted the quarterly presentation on our website at investor.zimmerbiomet.com to supplement the content we will be covering this morning.

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

Thank you, Matt.

Our third quarter results fell short of our expectations, driven by external and internal factors.

These factors included softened domestic market conditions, the impact of the hurricane and the Indian knee price reduction as well as the pace of our supply recovery and the related delay in sales recapture within our U.S. business.

We know that Zimmer Biomet can and must perform at a higher level, and significant work continues to ensure that we deliver on our commitments to our customers and our stockholders.

During today's call, we will provide our insight into what drove the sales and production shortfalls within our U.S. business, in addition to our detailed plans to get our performance back on track.

We will also provide an update on our production and sales recapture initiatives to improve our near- and long-term results with respect to our U.S. business.

Finally, we will discuss U.S. market conditions and our global performance by product category.

First, I want to take a moment to acknowledge the communities affected by the devastation of Hurricanes Harvey, Irma and Maria.

We're thankful to report that all of our team members in the affected regions are safe.

During the third quarter, our revenue was impacted by these storms, resulting in approximately $5 million of headwind.

Regarding our production at our Puerto Rico facilities, where we primarily manufacture some hip and trauma products, like many, we have encountered problems obtaining consistent power, causing a more gradual return to full production than originally anticipated.

Given the continued instability of infrastructure in Puerto Rico and current safety stock levels, we now expect some minor sales disruption in the fourth quarter and into 2018.

Additionally, the government of India initiated a significant knee price adjustment during the quarter.

This action has caused much disruption in the Indian market, resulting in a headwind of $5 million for the third quarter.

Turning to our results.

We achieved net sales of $1,818,000,000.

Excluding approximately 30 basis points of contribution from the LDR Holding Corporation acquisition, third quarter 2017 revenues decreased by 1.1% from the third quarter of 2016, representing a decrease of 1.5% on a constant currency basis.

Our results were negatively impacted by approximately 130 basis points due to having one less billing day through the quarter.

On a constant currency basis, our Asia Pacific sales increased by 5.2% while sales in the Europe, Middle East and Africa region decreased by 0.4% and sales in the Americas decreased by 3% compared to the prior year quarter.

Let me now take you through our plans in greater detail.

During the third quarter, we made good progress in the execution of our quality remediation plan at the Warsaw North Campus, and we remain on track to achieve the key milestones laid out in our Form 483 responses provided to the FDA in December of 2016.

These efforts will continue through 2018, as we have previously highlighted, and will remain a key focus of our entire company.

On the production front at our Warsaw North campus, we achieved lower-than-anticipated production output of several key brands due to inconsistent yields from certain, more complex manufacturing processes as well as increased attritions, beginning in August, among our temporary direct labor workforce in Warsaw.

This resulted in third quarter output being below our targeted level.

Reaching targeted and consistent output for certain manufacturing processes has proven difficult due to the added quality compliance measures, including in-process monitoring implemented as part of our remediation plans.

Given these challenges, we have accelerated our planned dual-sourcing strategy for the previously mentioned manufacturing processes, which we expect will provide additional capacity starting in the second quarter of 2018.

Within the current manufacturing environment, we continue to make ongoing engineering process improvements, including targeted investments into equipment and key technical expertise, to improve process consistency and output.

As it relates to the staffing, we have implemented new strategies to provide resource stability for the Warsaw North plant, including temp-to-direct hiring, to ensure we attract and retain the required skilled labor in Warsaw.

We remain intensely focused on resolving these challenges.

For brands not impacted by the previously described process complexity, we expect to clear back orders and replenish safety stock, consistent with prior expectations, resulting in full supply by the end of the fourth quarter.

For those brands attached to the more complex processes, we expect both back orders and safety stock levels to improve over the coming quarters, achieving full supply on all products during the second quarter of 2018.

I'd now like to turn to our sales recapture program in the United States.

The production shortfall is directly impacting our ability to fully meet case demand and go on offense.

During the third quarter, we continue to experience low inventory levels across key brands within our knee, hip and S.E.T.

categories.

Supply is the foundation to enable our sales recapture program.

And as supply improves, we expect the logistical burden on our sales forces to decrease, allowing us to better serve all of our customers and go back on offense.

During the interim, our sales forces have focused on products that have not been impacted by temporary supply challenges, such as our market-leading Persona Knee System, which recorded strong growth during the quarter.

We also launched our Persona Partial Knee System, which is realizing positive momentum due to encouraging market acceptance.

In addition, we have enhanced our customer engagement and responsiveness with chartered internal teams to ensure customers are being appropriately communicated with as we work through production and supply initiatives.

We also continue to make investments into our specialized sales forces and sales rep incentive programs to accelerate growth.

Our global commercial organization and team members worldwide have shown tremendous resiliency, and I am proud of their hard work and dedication.

We know what we need to do, and our team is working diligently to achieve our objectives.

While the pace of our production and sales recovery has not met our expectations, I am encouraged by my interactions with many of our surgeon customers, who continue to place their confidence in our portfolio, our pipeline and our people.

As I alluded to earlier, a number of factors in the musculoskeletal market have impacted our results, including the previously mentioned effect from the hurricanes and the knee price actions by India.

Further, we saw a moderate step-down in knee and hip procedural volume in the United States.

Based upon those who have already reported, we estimate the third quarter U.S. knee and hip market to be flat to positive 1% on a day-adjusted basis, which was lower than our expectations.

These quarter-to-quarter market fluctuations appear to have been driven by U.S. insurance dynamics, causing more variability in the timing of procedural volumes and contributing to our lower-than-anticipated third quarter sales.

We view these market fluctuations as temporary and believe underlying market demographics point to a sustainable global knee and hip market growth rate of between 2% and 3%.

With regard to pricing, we experienced negative pressure of 2.1% during the third quarter.

Turning now to our performance by product category.

As a reminder, the growth rates I quote are on a constant currency basis and have not been adjusted for the 130 basis point impact from one less billing day during the quarter.

Our third quarter knee sales decreased 1.7% from the prior year quarter, reflecting positive volume and mix of 0.8% and negative price of 2.5%.

We continue to drive strong knee growth in the Asia Pacific region, where we generated approximately 4% constant currency sales growth, inclusive of the effects of the price actions in India.

We were also pleased with our sales results in the Europe, Middle East and Africa region.

In the Americas, our knee franchise was impacted by a softened U.S. market as well as the headwind I mentioned earlier related to supply shortfalls, which limited our ability to accelerate revenues.

As we continue to work aggressively on resolving these near-term challenges, we remain focused on a number of important development projects to drive future growth.

As I mentioned earlier, in September, we announced the launch of the Persona Partial Knee System, which provides us with the ability to participate in the important fixed-bearing segment of the partial knee market and complements our clinically trusted mobile-bearing Oxford Partial Knee.

The Persona Partial Knee also represents our first significant jointly developed new product since the Zimmer Biomet combination.

We also continue to make steady progress towards the planned launch of our Persona TM Tibia cementless knee and the clinical evaluation of our Persona Revision system in the second half of 2018 as well as the clinical evaluation of our ROSA robotics platform for knee replacement applications.

In addition to these development projects, after reaching the milestone of over 500,000 Persona Knee procedures, our knee teams showcased the clinical success and versatility of our Persona Knee System to hundreds of surgeons at a globally webcast surgical education event.

The webcast was very well received and provide a continued optimism for the future success of our Persona platform.

Third quarter hip sales decreased 1.7%, reflecting positive volume and mix of 0.8% and negative price of 2.5%.

While we continue to achieve solid sales of our G7 Acetabular System, our Taperloc Complete Hip stem and Arcos Modular Femoral Revision System, our hip performance remained challenged by supply constraints.

As we focus on fully restoring production levels and closely engaging with accounts impacted by the temporary supply disruption, we will continue to pursue improved growth across our comprehensive hip portfolio, along with several important development projects.

Now turning to our S.E.T.

product category.

Revenue increased by 1.1% over the prior year quarter.

Our specialized sales forces delivered solid sales of our Gel-One and subchondroplasty treatments as well as our Quattro Link knotless anchors, the A.L.P.

S Total Foot System and our IntelliCart System for fluid waste management.

Our surgical team had another quarter of strong execution and sales growth as a result of their dedicated sales channel and broad product offering.

However, our overall S.E.T.

sales growth was challenged due to supply constraints that limited our ability to drive offense within our sports medicine, extremities and trauma portfolios.

We remain focused on restoring supply levels across the entire range of our S.E.T.

offerings.

In addition, we plan to introduce several new products in 2018, including our Comprehensive Shoulder augmented baseplate as well as the stemless shoulder offering, which we expect to be important growth catalysts.

Our third quarter dental sales decreased by 4.4%.

We continue to restructure our dental sales organization, specifically in some key Western European markets, which we expect to positively impact sales performance in 2018.

Our dental business remains focused on executing both commercial and portfolio initiatives to shape the business for sustainable long-term growth.

Revenue from our spine, craniomaxillofacial and thoracic category increased by 0.3% over the prior year quarter.

We continue to benefit from sales of our market-leading Mobi-C Cervical Disc.

However, our spine performance came in below our internal expectations due to near-term revenue dissynergies related to the commercial integration of our U.S. spine sales force.

We are working diligently to mitigate these disruptions and to enable optimal cross-selling through increased training and investments into working capital.

Among our craniomaxillofacial and thoracic offerings, we achieved another solid quarter of growth, supported by sales of our TraumaOne Plating System and our SternaLock Blu and SternaLock 360 Primary Closure System as well as our RibFix Blu Thoracic Fixation System.

I'll now turn to our third quarter financial details before providing additional information related to our fourth quarter sales and earnings guidance.

Our adjusted gross profit margin was 73% for the quarter and was 210 basis points lower than the prior year period due primarily to lower gains from our cash flow hedging program, additional manufacturing costs at our Warsaw North Campus manufacturing facility and the impact of price declines.

Gross margin was lower than anticipated due primarily to regional and product mix of our third quarter revenues.

Our R&D expense was 5% of revenue at $91 million, a slight decrease from the same period in the prior year.

We continue to prioritize R&D spending on what we believe are the most impactful programs, including our important knee programs, our robotic applications, novel case fulfillment approaches and Zimmer Biomet's Signature Solutions, among others.

SG&A expense was $695 million in the third quarter or 38.2% of sales, 150 basis points lower than the comparable period in the prior year and consistent with 2017 trends.

In the quarter, we recorded pretax charges of $328 million in special items, which include $188 million of noncash amortization, inventory step-up and a goodwill write-off related to one of our small noncore businesses.

Special items also included $50 million of quality remediation expense and $90 million of integration expense and other items.

Our diluted earnings per share for the quarter were $0.48 versus $0.78 in the prior year period.

Adjusted third quarter 2017 figures in the earnings release exclude the impact of the special items that I just mentioned.

Adjusted operating profit in the quarter amounted to $542 million or 29.8% of sales, which was 40 basis points lower when compared to the prior year period, driven by the previously described gross margin decline, partially offset by SG&A improvements.

Our adjusted effective tax rate for the quarter was in line with our expectations at 23.2%, an increase of 210 basis points from the third quarter of 2016.

Adjusted diluted earnings per share for the quarter decreased 3.9% from the prior year period or negative 0.6%, excluding the impact of foreign exchange, to $1.72 on 204 million weighted average fully diluted shares outstanding.

A 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 $463 million, which reflects $111 million of cash expenditures primarily for quality remediation initiatives and integration activities.

Free cash flow in the third quarter was $344 million, $142 million higher than the third quarter of 2016.

During the third quarter, the company paid down $490 million from our term loans and increased our borrowings by approximately JPY 21.3 billion for our Japanese loan vehicle.

Therefore, when combined with our activities for the first half of 2017, gross debt reduction during 2017 has been $950 million.

I'd like to turn now to our updated guidance.

As a result of the previously described pace of supply recovery of certain key brands manufactured at our Warsaw North Campus facility and the related impact on sales recapture, primarily in the U.S., we are adjusting our fourth quarter and full year revenue and earnings outlook.

For the fourth quarter, we expect revenues to be in a range of $2,010,000,000 to $2,050,000,000, which includes approximately 175 basis points of favorable foreign exchange impact.

On a constant currency basis, our growth rate is expected to be in a range of negative 1.8% to positive 0.2%, inclusive of a 20 basis point contribution from selling day impact compared to the prior year period.

Therefore, our billing day adjusted constant currency growth rate is now expected to be in the range of negative 2.0% to 0%.

For the full year 2017, our estimated revenue growth is now expected to be in a range of 1% to 1.5% over the prior year.

Foreign exchange is now expected to increase revenues by 0.1%.

Taken together, constant currency revenue growth over 2016 is expected to be in the range of 0.9% to 1.4%, inclusive of 120 basis points of acquired revenue from the LDR acquisition.

In dollar terms, our full year 2017 revenues are expected to be in a range of $7,760,000,000 to $7,800,000,000.

Our expected dollar range is down from our previous guidance range of $7,800,000,000 to $7,870,000,000 with favorable foreign exchange partially offsetting the reduction in our constant currency growth rate.

Turning to EPS.

The earnings flow-through from our lower sales expectation will again have a disproportionately negative impact on our fourth quarter profitability due to the regional and product sales mix, which is only partially offset by favorable currency adjustments versus our previous outlook.

Additionally, we continue to invest in critical areas, such as specialized sales forces, sales incentive programs, core R&D initiatives, including the knee and robot projects previously mentioned, and sales support costs to maximize customer engagement.

We will also continue to incur incremental manufacturing and distribution costs, primarily in the Warsaw North Campus facility.

These increased manufacturing costs are expected to continue to have a negative impact on gross margins throughout 2018 until we implement our dual-sourcing strategy and more efficient and automated manufacturing and quality control processes.

Our fourth quarter projected EPS is in the range of $0.94 to $1.08.

After the elimination of amortization, inventory step-up and special items, our adjusted EPS is expected to be in the range of $2.08 to $2.14.

This guidance assumes a fourth quarter effective tax rate of approximately 23.5%.

As a result, full year earnings are now estimated to be within a range of $3.80 to $3.93.

Special items for 2017 are estimated at approximately $1,260,000,000.

This is an increase of $25 million from our previous guidance, which is driven by the previously mentioned goodwill write-off, partially offset by lower integration costs.

We expect investments in our quality remediation program for 2017 to be consistent with previously stated amounts.

We expect our full year adjusted effective tax rate to be approximately 22% as we continue to execute important initiatives that will benefit our future effective tax rate.

Excluding the impact of amortization, inventory step-up and special items, we are reducing our full year 2017 adjusted earnings per share guidance to a range of $8.01 to $8.07.

This EPS range represents approximately 0.5% to 1.5% growth over the prior year or 4% to 5% growth when excluding the impact of foreign exchange.

We expect free cash flow to be in a range of $1,125,000,000 and $1,225,000,000.

We expect to continue prioritizing our free cash flow in the fourth quarter towards debt repayment, continuing our path towards reduced leverage.

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

Before we move on to our Q&A, I want to provide an update on our board search to select our next CEO.

The process is ongoing, and our board continues to make good progress as it is committed to a thorough and timely search process.

In closing, I'd like to reiterate that we are not satisfied with our current results.

Looking forward, we are focused on addressing our production challenges to allow for greater sales recapture and to enable our sales teams to go back on offense.

We will also continue to leverage Zimmer Biomet's diversified portfolio and a strong pipeline.

The new products scheduled for release over the coming 18 months provide further optimism for getting our performance back on track and improving our growth profile.

With that, I'll open it up to questions.

(Operator Instructions) Our first question comes from Bob Hopkins with Bank of America.

So it seems to me, looking at this release, there's sort of 2 big changes, one is the remediation supply issues taking longer and the second one is just that the U.S. market is weaker.

Before I get to those 2, which will be my 2 questions, I just want to clarify.

In the third quarter, what was your organic growth, organic revenue growth adjusting for selling days, LDR and weather?

I just want to make sure I have that number because it's not 100% clear from the release.

Sure, Bob.

So on a constant currency day-adjusted basis, backing out the LDR contribution, it's negative 0.2%.

And we described in the release or on my prepared remarks, rather, that the impact of the India knee price cut and the hurricane impact is about, call it, 50 basis points.

So adjusting for that, call it, a 0.3% Q3 performance.

Okay, great.

I'm sorry if I missed that in a slide or something.

So the key things I really want to focus on was, one, on the remediation supply side.

You're pushing back your guidance for when you think it'll be completely behind you.

What is the one main reason why you're doing that, one main reason for the adjustment?

And can you quantify what you think the supply issue -- how much it's impacting growth right now?

Bob, as I said in my prepared remarks, the production output in the third quarter fell below our expectations, which means we did not make progress on reducing the back order that we expected to, and really, as I said, the drivers being a level of process inconsistency in certain core manufacturing or complex manufacturing processes as well as the increased attrition in the temporary workforce.

So combination of those 2 factors led to the shortfall in production output.

So I described what we're doing about that.

And in terms of the impact of that on the Q4, the point I would make is that our prior Q4 guide assumed we'd be entering the quarter in a healthier supply situation.

And we had, order of magnitude, 200 to 250 bps of comp-adjusted acceleration in the fourth quarter, really, predicated on the assumption of having the supply to go on offense.

That's the biggest driver of the takedown in Q4.

Okay.

And then I'm sure someone will follow-up on the attrition question, but I wanted to get your views on the U.S. hip and knee market.

Most of the folks that have reported so far have seen a little bit of weakness, but you're calling out a couple of specific things and reasons why you think the market is slowing.

I was wondering if you could just develop that a little bit more because some of the growth rates we're seeing are growth rates that are the weakest we've seen in some time.

So could you just kind of go into little more detail on what you think is going on with the U.S. hip and knee market?

Sure.

So based on what's been reported, we estimate that the Q3 U.S. knee and hip market was somewhere between flat to 1% on a day-adjusted basis in Q3, which was below our expectations.

Our expectations had been more in the 2% to 3% range.

Q3's always the slowest from a seasonality perspective and has been the least predictable over the past several years.

So we view this as more of a quarter-to-quarter demand dynamic as opposed to any systemic change in the outlook for hip and knee performance and market growth in the U.S. So we continue to believe that a 2% to 3% global knee and hip market growth rate is sustainable and based upon underlying demographics.

So we're not concerned about the ebb and flow quarter-to-quarter.

We still believe in the long-term tail of demographics and 2% to 3% global U.S. or global hip and knee market growth rate.

Our next question comes from Mike Weinstein with JPMorgan.

And maybe I'll just pick up where Bob left off there.

So the comment in the prepared remarks about U.S. insurance dynamics impacting market growth, what are you referencing there?

Well, I think it's just what we've seen, Mike, is a lot of volatility quarter-to-quarter, and I'm referring to the higher prevalence of high-deductible plans, which tends to cause people to have elective procedures on later in the year, which is more difficult to predict.

I don't think we have enough data point...

But nothing -- but, Dan, nothing impacting the third quarter.

That's correct.

Okay.

And then could you spend, Dan, just couple of minutes on the dual-sourcing strategy and what you're doing there?

Sure.

So I'm referring to a number of more complex manufacturing processes that are in the North Campus, where despite a lot of excellent work by the engineers, and that work continues, it's obvious that we need more capacity on these particular production lines.

I -- for obvious reasons, I don't want to get into the weeds on what exactly those processes are.

But in fact, what we are doing, in addition to optimizing inside the 4 walls of North Campus, which we'll continue to do, we're also looking on the outside, a combination in our current network or with vendors to add capacity for those particular production activities.

So that's what we mean by dual-sourcing.

So we're accelerating that time line to look for additional capacity that we need, and that increased capacity should also, as we continue to make improvements on the processes, lead to more process and output consistency.

Okay.

Then last item on your comment on the CEO search.

I recognize the limitations as to what you could say.

You want to add anything relative to your thoughts on timing.

No, Mike.

I would just say that, as you can appreciate, I'm not going to provide specific detail on the board's process, just that the process is ongoing and our board continues to make good progress.

And as we've always said, we're committed to a thorough and timely search process.

Our next question comes from David Lewis with Morgan Stanley.

Dan, just a few quick ones here.

So just starting with kind of fourth quarter guidance and getting a sense of how conservative you think that number is.

It still implies, by our math, some acceleration in the momentum in the business into the fourth quarter, and that has not happened in several quarters.

So can you just give us a sense of what drives that underlying momentum acceleration into the fourth quarter?

And I have a couple of quick follow-ups.

Well, as I said before, David, the prior guidance assumed much more significant acceleration predicated on full supply.

What our Q4 guidance is not assuming is any of the Q3 market softness spilling into Q4.

In other words, our Q4 guidance is assuming a U.S. hip and knee market based upon historical seasonality Q3 to Q4.

So we've not layered that expectation on top.

So I think the underlying guide in Q4 is assuming similar production levels to Q3, a market that's tied to historical seasonality and the type of progress on these non-affected brands that I described in my prepared remarks.

In other words, we are making progress on certain products coming out of the North Campus, which helps put that into the hands of the sales force to drive some growth.

And then the last part would be we're very excited about the Persona Partial Knee, and that will continue to have impact in the ensuing quarters.

Okay.

But if the market does not get better in the fourth quarter, this guidance theoretically could be at risk, said another way.

Well, our assumption about the U.S. hip and knee market for Q4 is a 2% to 3% type year-on-year market growth.

Okay, that's very helpful.

And then, Dan, just 2 questions around earnings.

The first question is cost dynamics in the quarter.

If I take your revenue reduction for the fourth, and I assume a pretty good drop-through, you get kind of -- $0.20 is the reduction for the fourth quarter, roughly.

I get kind of half that from a high-margin product sales drop-through.

Is the other half coming from the cost of higher employee wages to keep them in their seats and the dual-sourcing?

Is that a decent way of thinking about it, it's sort of half increased costs and half about the top line drop-through?

The drop-through on the sales is more than what you're modeling because the takedown from the prior guidance is focused on the U.S. market.

So that EBIT drop-through on the mix of sales is more significant than the half that you're describing.

By -- I'd probably put, of the takedown, between the organic sales and the FX change, inclusive of the mix I just described, that's about in the neighborhood of $0.12 of the takedown and the balance being tied to incremental cost of goods, a combination of higher production costs and inventory charges tied to the North Campus performance.

Let me clarify the organic component of the takedown, David.

It's around $65 million with the offset of the FX benefit around $20 million.

Okay.

That's very helpful.

And then, Dan, I know it's early, but if we think about -- there's a lot of consternation about what the 2018 numbers could be last quarter.

And is it a decent way of thinking about next year?

Do you still believe this business, a, can grow modestly in 2018?

Can you leverage -- if the business grows 1% next year, is that a decent way to think about core earnings growth?

One way I'm thinking about it is if the core business grows 1%, you lever earnings 1% and you get currency, you kind of come out at 8 20, 8 30 for next year.

I just wondered if you just think about how this business can grow over the next 12 months.

David, I'd say that we're going to provide 2018 guidance in early 2018.

We have to see how the year closes and then go through our normal process, taking into account production, sales trends, gross margin, et cetera, and the investment needs to inform our thoughts more fully on 2018.

I think it's important to point out that gross margins will continue to be pressured until we increase our U.S. sales growth and optimize the production of the products that are currently produced in the North Campus.

So we have plans to do both of those things.

But in terms of the gross margin profile, if you look at the gross margin profile in the back half of this year, as revised, I think that's the right way to think about gross margin rate for next year.

We'll continue to drive value-creation programs across the enterprise.

First and foremost, top line growth is at the top of the list.

We'll go to Chris Pasquale with Guggenheim.

Dan, you anniversaried the close of the LDR deal during the quarter, but the legacy Zimmer portfolio continues to struggle.

But they're -- how close do you think we are to seeing that segment turnaround?

Is it just a matter of lapping the impact of some rep turnover?

Or do you need something else, like new product flow, to get it going again?

Sure, Chris.

First, we're very excited and continue to be very excited about the Mobi-C product line.

In addition, we expect the recent enhancements to our Vitality System and the future robotic spine application to be key enablers to future spine momentum.

Certainly, the recent results have been impacted by the market on the one hand, but probably more so the sales disruption and the channel integration.

So at this point in time, we continue to evaluate and, I would say, fine-tune our sales structure to make sure that we're positioned for long-term spine success.

I think we have the portfolio that we need.

We have a lot of talent in the sales channel, and we're going to continue to look to fine-tune that to make sure that we're getting the type of performance that equals the potential that we have.

Okay.

And S.E.T.

was such a bright spot last year, and it's taken a couple of steps back.

I know that the Warsaw North issues are a big piece of that.

But can you talk about the outlook for that business heading into next year and maybe, in particular, focus on that stemless shoulder launch, how that compares to the competitive product that's on the market today and how you think about that market opportunity?

Sure.

So year-on-year growth -- slowdown was attributable to more difficult comps but also, really, for the first time, seeing the cumulative impact on momentum due to supply constraints.

So we've been describing that.

From the North Campus, there's certain Biomet sports medicine, upper extremities and trauma products that come out of the facility.

Importantly, Chris, S.E.T.

remains a strategic growth driver for the company.

It's a very important, exciting market for us.

We're clearly focused on improving supply, first and foremost, in shoulder, sports med and trauma.

We're continuing to invest in specialized sales forces in the S.E.T.

category.

I think the results of surgical are an excellent proof point of what that can do from a performance perspective.

And then you're right, the launch of the new products in 2018 that include the stemless shoulder as well as the comprehensive augmented baseplates.

So we're the market leader in shoulders and getting the comprehensive augmented baseplate out into the market is an important addition, and we're very excited about the stemless shoulder.

We think that's going to compete very nicely with the other stemless products that are out in the market.

We'll take our next question from Kristen Stewart with Deutsche Bank.

Just going back to the gross margin question and go and looking ahead to 2018.

How long do we think that -- or how long do you think that the gross margins will continue to be pressured by some of the costs?

Is that all...

Kristen, sure.

The gross margin pressure, the 2 contributors here in 2017 relative to prior guidance are the sales mix that I was describing earlier, less U.S. sales than expected, and then secondly, the production costs and related inventory costs out of the North Campus.

So the sales mix will improve as we accelerate U.S. growth.

The cost of goods from the North Campus, as I described, is going to persist through 2018 and, frankly, until we're -- as I described, until we're into a more automated environment with validated processes and more process consistency, in combination with the added capacity, those are the elements that are needed, really, to drive improved costs and more consistent output.

And to add on that, our expectations and what we've communicated previously that, that program and the positive benefit on gross margin would start translating into benefit in 2019 and 2020.

Okay.

And I appreciate you don't want to give any sort of color on 2018 in terms of specific guidance, but are there any other puts and takes that you can give us just to help frame 2018 at this standpoint?

Kristen, as I said, I really want to see how we close Q4, see what kind of momentum we have exiting the year and then monitor the progress that we're making on our dual-sourcing strategy and the engineering improvements inside the North Campus, that will inform our view on production output, which is so critical to getting full supply into the hands of our great sales force to drive growth.

So I'd rather wait until our guidance early next year.

Our next question comes from Steven Lichtman with Oppenheimer.

First of all, I was wondering if you could just frame for us about what percent of the recon business falls into the more complex products that are still supply constrained versus those that you feel that you are in a better position from a supply perspective.

Steve, I -- without getting into the exact quantification of that, I would tell you that a lot of the brands that come out of the North Campus, which, of course, is a Biomet facility, a lot of those brands were, in fact, faster-growing product lines, and it spans knees, hips, sports extremities and trauma.

So it's a significant facility for Zimmer Biomet.

The complex processes, without getting into the weeds on what those exactly are, do impact a significant number of those brands.

And I think that the quantification of that is apparent in the impact it's having on our performance and our revised guidance.

Okay, got it.

And then, Dan, just a couple of products for next year.

Can you talk to how much you think not having cementless has also impacted knee growth, and how that may be important for the back half of next year?

And then I know on ROSA, obviously, a lot of talk about getting into knees, but you're not really fully rolled out in spine yet.

Is that also targeted for mid to back half of next year?

Sure.

We're very excited about the pipeline for 2018.

We're excited about what Persona Partial Knee will do for us in 2018.

We're excited about getting the cementless Persona out.

We've had a competitor talk about cementless being as much as 20% of their knee mix.

That comes at a nice price point.

So we're very excited about getting that out into the market middle of next year, and we think that product will perform very well.

And then we've also talked about getting the Persona Revision System out into the market.

So a lot of really important Persona product launches next year.

On the ROSA side, we're -- on the knee application, continue to make progress in accordance with the time line that we've described before.

And then keep in mind that the Medtech ROSA platform is currently approved for brain, and we're very excited about that opportunity.

So our craniomaxillofacial business, which is one of our best-performing divisions in the company, continues to drive good growth.

It's under very capable leadership, and that same leadership is overseeing the brain and spine ROSA development program.

So on the ROSA spine, the expectation is middle of next year to be out in the market with that.

We think that product and application will compete very favorably with the other spine robotic systems that are currently in the market.

Our next question comes from Matt Taylor with Barclays.

So I guess the first thing I wanted to circle back on was when you're talking about kind of normalized 2% to 3% market growth here in Q4.

Can you comment on whether you're seeing that through the first month of the quarter?

Or are you seeing any continued insurance dynamics or other soft spots that would cause the Q4 market growth to be lower?

Matt, our 2% to 3% U.S. market assumption is based upon historical norms.

So what I was describing before is that we stuck with that assumption about the market and did not add, on top of that, the softness in Q3.

So I'm not going to comment on intra-quarter months.

But I'd say, at this point, the 2% to 3% U.S. knee and hip growth is the right way to think about it based on historical norms.

Yes.

And just to add to that, Matt, is usually the big bolus of procedures push into November and December.

So a near-term read is obviously difficult.

But there's no indication, that we're aware of, that's pointing to something other than what we've communicated.

Okay.

And then when we think about the improvements that you could make going forward to your ability to produce some of these key brands, you talked about 2Q '18 as being really the turning point when you'd be able to have full supply.

So can you just clarify?

Does that mean that it's going to really take until the third quarter for you to go back fully on offense?

Or do we see that kind of early in the second quarter?

Just wanted to get a little bit more specific on the timing.

Yes.

Matt, from a timing and recovery perspective, it's a rolling recovery, okay.

So during Q4 here, we'll be making continued progress on certain brands.

Q1, Q2, we'll continue to make progress.

And that incremental progress is critical and meaningful because what that means is that our sales force can then gradually move away from being the case logistics people that they have been to more higher trust that the products will be there and then going on offense and not only servicing existing accounts, but going after new business that we know is out there for us.

So it's a rolling improvement.

Some brands will continue to get healthy through Q1.

My comment about Q2 was in the vein of having a full supply, ready to go on offense across all brands with our engineering improvements and dual-sourcing strategy contributing to that pace of recovery.

So that's the comment relative to Q2, and that sets us up well for thereafter.

Our next question comes from Kaila Krum with William Blair.

So first, I guess just to start off, what percentage of your surgeon customers today would you say are waiting on the sidelines sort of prior to a complete supply recovery here?

Is it 20%?

Is it 1/3?

Is it as much as half?

Just any sense for that would be helpful.

Sure.

I've spent a fair bit of time in the field over the past quarter and continue to be impressed by the talent of our sales force, the belief of our sales force and our surgeons with respect to Zimmer Biomet.

That's critical and gives me confidence that over time, as supply recovers, that we're going to get the accelerated growth that we know is out there, and I'm confident that we're going to deliver on that.

It is the case that surgeons are frustrated.

They believe in Zimmer Biomet.

They believe in their sales rep.

And you do have instances where we're able to fully supply surgeons, and it is the case that you have other surgeons that are sitting on the sidelines waiting for the full range of SKUs available across a product family before they entrust their business back to us.

So that's where our focus is.

I'd also add that the lack of full supply hampers our ability to bring on new surgeons at the top of the funnel, so to speak.

So we know the ticket is full supply.

That's why we're focused on it.

And as that supply picture improves, I've no doubt that our sales team will run with that and make good progress.

Okay, that's helpful.

And then I guess just -- I mean, you've said we're going to reach supply stability by the end of this year with a portion of your products and the rest by the second quarter of '18.

I guess what sort of visibility do we have into that recovery at this time?

And what gives you confidence in that statement?

Well, with the guidance takedown that's embedded in our Q4 tells you that production is the biggest barrier.

So our assumption about production output for Q4 is that production is similar to Q3 levels.

And what gives us confidence on the recapture, which again is more of exiting this year and gradually through next year, is tied to what I was describing before in terms of the interactions with surgeons and our sales force and their belief in the portfolio.

So we know what we need to do.

It's tied to production of the North Campus, but it's also -- our team is executing very well with Persona.

And I mentioned good growth in the quarter on Persona.

I mentioned the educational event that we did on Persona, where we had hundreds of surgeons attending that, demonstrating the versatility of both the implants and the instrumentation of Persona.

So I know that our sales team is going to make a lot of progress with the Persona platform.

And then on the production side of the house, the key is really, as I described, process consistency, so reducing the variability in those processes, getting redundant capacity out to either vendors or elsewhere in our network as dual-sourced capacity.

So it's a combination of those 2 areas.

Our next question comes from Matthew O'Brien with Piper Jaffray.

Just for starters on the guide-down for Q4, by my math, net of currency, it's about a $40 million guide-down.

I'm assuming a majority of that is related to these complex products that you can't manufacture.

So is -- first of all, is that math about right?

And then secondly, is that roughly what we should expect in Q1 as far as the headwind that you'll face in that business maybe tapering down a little bit and then tapering down even more into Q2 next year?

So Matt, the Q4 takedown, you have the right net number.

I think organically, the number's north of that.

The organic takedowns, as Matt mentioned before, is more like $65 million with some favorable currency in the range of $20 million.

So it's -- the organic takedown is north of the 200 basis points.

And I'd say the organic takedown of 300, call it, call half of that being tied to supply and lack of offense.

We also had dialed in Q4 guidance, prior guidance, an acceleration in spine.

And as I mentioned before, we've removed that from the guidance based on current performance as we need to drive improved performance in the sales channel and then, to a lesser extent, the impact being the India knee price, which we expect that to be a drag on Q3 as well.

And then as far as the manufacturing pushout goes, Dan, how comfortable are you with the time line that you laid out now of Q2 next year being completely finished with this issue?

And how all-inclusive or how broad is the plan that you put in place to ensure that, that will be the definitive moment where all this issue is behind you from a production perspective, be it the dual-sourcing, et cetera?

And then how does FDA fit within that timing?

So Matt, we -- as I said in my prepared remarks, we continue to make good progress on the quality remediation in the North Campus.

So we're very much on track with the remediation plan that we laid out for the FDA at the end of last year.

So I feel really good about our progress there.

It's been roughly a year since the FDA inspected the facility.

We don't know exactly when FDA will come back in, but we'll be prepared for them when they do.

With respect to the production recovery and the time line, operating this plant under the manual interim process control environment leads to greater variability and inherent risks that's associated with the output, and it is what it is.

What I am confident about is that the engineers are focused on the right areas for improvement.

We brought in technical experts from the outside to help in that regard, and we're also working closely with outside vendors, who have certain capabilities that give us confidence that they're going to be able to help drive that added capacity.

So that's what gives us the confidence to lay out the time line that I just laid out, Matt.

Our next question comes from Bruce Nudell with SunTrust Robinson Humphrey.

(technical difficulty)

Dan, could you hear me now?

Yes, Bruce.

Post the ZUK divestiture, you had about 39% less in share.

It looks to be about 36% now.

Just given any lingering issues with supply that's caused current -- customer defections and perhaps sales force defections as well as the lack of a robot, where do you think you guys will asymptote?

And how much of that is due to the lack of a robotics solution?

Bruce, I would say that based on the early -- well, both the limited release and now the full release of the Persona Partial Knee System, we're extremely confident in that platform.

And I've personally talked to surgeons who have used the Mako for uni knees and are excited to use the Persona Partial Knee System.

They've -- those are surgeons that have had excellent success with the Persona primary system and are excited about using the Persona Partial Knee.

So we believe that we will win back market share that we lost as a result of the divestiture.

And -- but just more broadly, where do you think knee share will stabilize?

And where will you kind of -- how high -- how much of that 39% could you get back?

Well, our efforts -- I -- we have internal goals to recover all of the lost business of ZUK.

We have -- again, the feedback is very positive on the Persona Partial Knee.

So as we have full supply across all of our knee systems, we're in a good spot with Persona primary.

But as we get healthier on Vanguard and as we launch the cementless Persona and the revision knee, our goal is to, first and foremost, get back to market growth.

We've been ceding share.

That needs to stop.

Supply in the pipeline into the hands of the sales force will enable that.

And first and foremost, we're focused on closing the gap to market then putting up a string of quarters at market growth and then above-market growth thereafter.

So it's a whole string of things that we know we need to execute on better, and that will lead to market share gains.

Then I guess my follow-up is -- this is the first time I've heard the company talk about expectations for the worldwide major joint market of 2% to 3%.

It was always closer to 3%.

I'm sure that, that wasn't taken lightly.

And how does that impact the board's perception of the necessity to move away from hips and knees?

Well, to win, Bruce, for Zimmer Biomet, we need to perform in hips and knees, and that -- our performance in hips and knees in the Asia Pacific region has been excellent.

And that performance in Asia Pacific is really driven by the team, and they've not been as dependent on the North Campus products as much as the U.S. market.

So the team has done extraordinarily well, and we expect them to continue to do so.

The EMEA growth in the quarter for knees was quite good.

So the 2% to 3%, I would just tell you that we're still of the belief this is an attractive market.

The demographic tailwinds are real.

So we're committed to growing hips and knees.

For us to win, we need to perform really well there.

At the same time, we've talked a lot about the S.E.T.

category, 21% of our sales mix today, why we're very excited to continue to perform there.

It was hampered by supply this quarter.

That will improve over time.

And we'll look to continue, both organically and inorganically, to add to the S.E.T.

bag, it's a critical driver for us, and last piece being spine.

So my comments about spine and our potential to drive accelerated performance there.

So it's really across the portfolio where we need to perform.

We'll go to Joanne Wuensch with BMO Capital Markets.

Could you qualitatively discuss what's going on with the sales force, how you're thinking about keeping them in place, motivated and making sure that they see that there is a turning point in this process?

Absolutely, Joanne.

I mentioned the amount of time that I've personally been spending in the field, and that includes direct time with our sales leadership for the orthopedic business and as well as a good piece of our spine sales force.

So in a nutshell, we continue to post them regularly on the updates with respect to supply.

On top of that, we're placing a tremendous focus on all of our team members on supporting our sales channels globally.

I think importantly, we've seen relatively stable levels of attrition, so a net neutral performance from a headcount standpoint of the channel in the United States here in Q3.

So I think that is indicative of a sales force that continues to believe in Zimmer Biomet, continues to believe in our products, in our pipeline, and a lot of high touch with them and communication will be necessary as we continue to move forward.

So I believe we've got the best sales force in the industry.

We need to fully equip them with all the tools they need to win.

That's where our focus is.

Okay.

And then as my second question, it's going to sound sort of mundane, given everything going on, because SG&A was nicely down as percentage of revenue year-over-year.

Are there still expense synergies to be had by the combination of these 2 companies?

Joanne, we've described here in 2017 synergies in the neighborhood of $225 million and leading to $310 million cumulative, okay?

So that -- the integration synergies are on track through 2017.

So as I described, we'll continue to look at other value-creation opportunities across the enterprise.

We know that it, first and foremost, starts with top line performance and acceleration and then the last bit on SG&A.

Our SG&A percentage includes the depreciation of our instrument placements, which is part of, obviously, a growth investment for us.

So we continue to invest in the working capital and instrumentation necessary to drive growth.

So thank you, everyone, for your attendance today, and we look forward to speaking with you on the fourth quarter call.

Thank you.

Thank you, again, for participating in today's conference call.

You may now disconnect.