Zimmer Biomet Holdings Inc (ZBH) 2018 Q2 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet Second Quarter 2018 Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded today, July 27, 2018.

(Operator Instructions)

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

Please go ahead, sir.

Thank you, and good morning.

Welcome to Zimmer Biomet's second quarter conference call, Friday edition.

Joining me this morning is our President and CEO, Bryan Hanson and our CFO, Dan Florin.

Before we get started, I'd like to remind you that our comments during this call will include forward-looking statements.

Actual results may differ materially from those indicated by forward-looking statements due to a variety of risks and uncertainties.

Please note that we assume no obligation to update these forward-looking statements, even if actual results or future expectations change materially.

Please refer to our SEC filings for a detailed discussion of these risks and uncertainties in addition to the inherent limitations of such forward-looking statements.

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

Reconciliation of these measures to the most directly comparable GAAP financial measures is included within the earnings release found on our website, zimmerbiomet.com.

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

Bryan?

Thanks, Cole, and thanks, everyone, for joining us this morning.

Before we get into specific updates on our short-term initiatives, our Q2 results and updates to 2018 expectations, I'd like to just spend a minute on my view regarding our progress as a company and team.

As you may remember, during our fourth quarter call, I described the business as having more risk than opportunity due to the status of our supply recovery efforts and quality remediation work as well as our culture-building process.

On our first quarter call, I changed my perspective to a more balanced view of risk and opportunity.

Thanks to the early progress we made on the supply recovery milestones and meaningful engagement with the broader organization focused on culture building, including very specific interactions with the field sales organization.

As we come into Q3, my current position is one of cautious optimism, fueled by further progress on supply recovery, field execution improvements as reflected by the team's overall Q2 revenue performance and continued traction around the one mission, one culture focus of the Zimmer Biomet team.

It's important to recognize that my current sentiment takes into account the headwinds of FX pressure we need to offset and the continued heightened state of risk we must manage while executing our quality remediation efforts.

There's clearly much work to be done, but I like the progress that has been made and look forward to the team driving toward continued traction.

With that said, let me provide a bit more detail for each of our previously stated short-term priorities, which are the ongoing quality remediation, our supply recovery efforts, new product introductions and our culture enhancement activities.

Turning first to the status for our quality remediation.

As we communicated previously and also shared publicly, we submitted our comprehensive response to the FDA's 483 observations, stemming from the reinspection of the Warsaw North Campus.

Although we currently have no additional information to share, I want to reiterate that none of the FDA's observations identified a specific issue regarding the performance of any particular product.

As a result, the facility continues to manufacture its full range of products at this time.

At Zimmer Biomet, patient safety is our first and guiding priority.

Completing our quality remediation to the highest standards is a matter of utmost importance that we take very seriously.

Execution of our remediation plan is progressing with a sense of urgency.

However, fixing these issues in the right way takes time.

I remain confident in the people and the processes we have in place, and I can assure you that we will continue to appropriately resource and staff this important work.

And we'll keep the FDA updated on our progress.

With regards to supply, we are happy with our progress, but we are not completely satisfied with where we are versus our internal steady-state goals.

We still have important work to do with regard to manufacturing and quality remediation, which is why we are going to stay diligent in these efforts.

That said, our progress toward a steady-state supply environment is real and contributed to our performance in Q2 and increases our confidence that supply will not be a barrier to accomplishing our 2018 guidance and the turnaround time line we previously communicated.

Now turning to our new product launches.

We continue to have confidence in the products we have already launched and the time lines for the pipeline product still to come.

For example, we're very excited about our most recent additions to the Persona family, including the Partial Knee System and our most recently launched TM Tibia system, which will be in full launch later this year.

Both of these new offerings have garnered very strong clinical feedback from surgeons thus far.

We also look forward to products launching at the end of the year, including the limited launches of the Persona Revision System and the total knee application for ROSA robotics platform.

As a reminder, the combination of steady-state supply and the full launch, and importantly, stating the full launch of these differentiated technologies, will allow our sales organization to truly go on full offense.

In addition to positioning our organization to deliver sustained organic growth, we are committed to active portfolio management to drive diversified growth and enhanced shareholder value.

Zimmer Biomet's trusted brand, scale and expertise afford us an opportunity to build leading positions in faster-growth subcategories.

On the culture front, we continue to strive for higher levels of engagement with Zimmer Biomet's team members worldwide.

As part of that effort, over the last quarter, I've held several mission ceremonies with thousands of our team members to share with them our new mission and guiding principles.

Our plan is to reach every team member with this important message regarding the one mission, one culture focus of this organization.

We also recently completed a comprehensive employee engagement survey, which has provided us with a clear picture of our strengths and opportunities for improvement within our workplace as well as a baseline for measuring the progress of our future culture-building initiatives.

What encouraged me most about our results is that our team members are overwhelmingly ready and willing to go above and beyond in their roles to build a stronger, more innovative company.

As CEO, I am energized by their personal commitment as we work together on the path to future success.

With that, I'll turn it over to Dan to go through our financial results in more detail.

Thank you, Bryan.

Before we get started, I'd like to note that this quarter, we are changing the presentation of our GAAP income statement to provide additional transparency.

We no longer will use the special items operating expense category.

Instead, we will now provide more specific details on the items formerly in that category.

Importantly, there is no change to our historical or future GAAP or non-GAAP earnings per share.

Turning to our performance.

Net sales totaled $2,008,000,000 in the second quarter, an increase of 3% over the prior year period, which represents an increase of 1% on a constant currency basis.

On a similar basis, in the Asia Pacific region, our sales increased by 5.4%, while our America sales increased by 0.9% and our Europe, Middle East and Africa sales decreased by 1.8%.

Our adjusted gross profit margin came in at 71.9%, reflecting a benefit from mix, offset by continued incremental manufacturing and inventory costs as well as the impact of price decline.

Our GAAP diluted earnings per share for the quarter were $0.90.

Our adjusted results exclude $265 million of expenses in the quarter, approximately $110 million of which are cash outflows for quality remediation, business integration and other items.

The noncash charges are primarily related to intangible amortization.

Adjusted operating profit in the quarter amounted to $562 million or 28% of sales.

Our adjusted effective tax rate for the quarter was 18.9%.

Adjusted diluted earnings per share for the quarter were $1.92.

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 $393 million, and our free cash flow was approximately $300 million.

Our year-to-date free cash flow totaled $704 million.

I'd like to now turn to our updated 2018 guidance.

We now believe that our organic revenue growth for the year will be slightly better than discussed last quarter.

However, we are updating our revenue growth guidance to a new range of between 1% and 2.5%.

This new range assumes an annual positive impact from foreign currency of between 100 and 150 basis points.

This is less of a positive impact than our previous estimates due to the recent strengthening of the U.S. dollar.

Given the modest improvement in our base business, we should be able to largely offset the earnings impact of foreign currency, which is about $0.10 per share in the second half of 2018, without affecting our ability to continue making focused investments into R&D and our commercial organization to help accelerate future revenue growth opportunities.

Therefore, our original 2018 adjusted earnings per share guidance of $7.60 to $7.80 remains unchanged.

It's important to also remind you that we continue to expect the third quarter to be hit fairly hard by normal business seasonality.

Due to continued strong cash flow performance, primarily attributable to increased accounts receivable collections, we are updating our free cash flow guidance to a new range of between $1.2 billion and $1.35 billion.

With that, let me turn the call back to Bryan.

Before we go into Q&A, I just want to reiterate the fact that our second quarter results reflected improved overall performance as well as continuing progress on our operational and manufacturing goals.

I want to emphasize that our second quarter achievements strengthen our confidence that we are focused on the right immediate priorities and that over the long term, we are well positioned to climb back into positive market share growth.

As I said before, our turnaround will take time to complete, and we won't declare success until we are consistently delivering top line growth at or above market rates with a competitive operating margin.

From where we stand today, I can tell you we still have a lot of work to do to achieve these goals.

But as we enter the second half of 2018, I'm encouraged by the progress we are making.

And I'm confident that we are building a strong foundation to deliver sustainable long-term growth and ultimately, value creation.

With that, I'm going to turn it back to Cole so we can enter into the Q&A.

Thanks, Bryan.

We try to reserve the majority of the time on the call this morning for your questions.

(Operator Instructions)

With that, Lauren, may we please have the first question?

(Operator Instructions) Our first question comes from Mike Matson with Needham & Company.

Bryan, it sounds like you're planning to take sort of a portfolio management approach here at Zimmer similar to what you did at Covidien.

And I guess, what I'm wondering is, Covidien had a kind of a much wider mix of businesses when you look at growth and margins and things like that.

And at Zimmer, it seems like there's more consistent margins and growth rates across the various businesses.

So that's the first part of my question, if you could just maybe comment on how you can implement that here.

And then the second thing would be just with regard to M&A.

Are you looking at opportunities more within the existing markets?

Or would you consider going more of a diversification route similar to what Stryker has done over the recent years?

Yes.

Absolutely, Mike.

Hey, would you do me a favor?

I just want to make sure the first part of your question I understood.

Could you just give me a little more color around what you're referencing there?

Yes.

So I mean, you've talked about portfolio management.

In other words, shedding maybe lower-margin, lower-growth businesses while you're looking to acquire things that are higher growth and higher margin.

And when you look at a business like Covidien, there was more of a mix of you had some really low-margin, low-growth businesses and really high-margin, high-growth businesses.

So it's a little easier to do that, but it seems like the businesses here are more similar.

So that's my question essentially.

I got you.

Understood, understood.

Yes.

So the way I think about active portfolio management, I guess, first and foremost is, that it is another opportunity for us to be able to drive consistent shareholder value.

Clearly, organic growth is the primary focus of the organization, and we have to get to a place where we're at market or better.

But I want to be able to complement that by ensuring that we're wading into businesses and markets that are more attractive than the spaces we're in today.

And let me just kind of really put a -- an exclamation mark on that.

First and foremost, I'd like to get scale in some of the areas that we already play in that have better growth profiles than some of our larger businesses.

Some of that would be in the S.E.T.

businesses obviously.

So our first area of focus will be to add scale in areas where we already play in faster-growth submarkets, where we have an opportunity to take advantage of the brand that we have and the commercial organization to be able to drive traction in those spaces.

And ultimately, as a result of that, bring our weighted average market growth up.

So that will be the first kind of leg of this process.

We really want to make sure that we're doubling down in spaces we already play in, build more scale and make sure that we increase the weighted average market growth.

And there's plenty of opportunity to do that.

I'm not at all opposed as we go into the active portfolio management process and we have more firepower to do so in diversifying the business even beyond some of the areas that we currently play, again, with an eye towards driving the mission of the organization, making sure that it's economically attractive for us to do so and it drives shareholder value with an eye towards that increased weighted average market growth.

So that's kind of the phased approach that I would see.

Let's double down in areas where we already play, drive scale, drive weighted average market growth up and then potentially, diversify outside of those spaces as well.

Relative to divestitures, which I think is really the first part of your question there, it isn't just the margin profile that we would look at.

It would be really mission alignment.

It would be our ability to win in the space given our capabilities versus maybe others that might find our businesses more attractive.

The fact is, we love all of the businesses that we have, but not all of them are going to be invested in equally.

And not all of them have the same opportunity for us.

And if any of our businesses are attractive to others, other third parties that see more value in them than us and they're not critical to our mission, we would contemplate divestiture, assuming that we could take those proceeds and apply them to the areas that I talked about in the beginning here.

So that's the way we're going to take the approach.

It will be a similar playbook to what we have done previously at Covidien, what we've done at Medtronic as well.

But ultimately, as you said, we don't have that real difference in margin profile in our businesses so the margin profile won't be one of the primary things we look at.

We'll take our next question from Bruce Nudell with SunTrust.

Bryan, just looking at major joint market year-to-date, it looks like it's around 1%.

Last year it was around 2%.

And historically, people have thought of major joints as 3%.

Is there something secular going on?

And if there is, is that putting more alacrity in your diversification efforts?

Sure.

First of all, nothing that's happening right now would change our opinion or aggressiveness or stance on diversification.

So I wouldn't read anything into what you may be seeing relative to large joints market growth.

And to be honest, as we said in the first quarter as well because there was a lot of discussion around, are you seeing pressure on volumes in the first quarter?

We really aren't.

I mean, the fact is, when you work the numbers based on everybody's performance over the last 2 quarters, clearly, what you're saying about growth rates is accurate.

But what's interesting about it is, you're not really hearing any companies complaining about this market growth.

And what's interesting for me, too, is I'm not hearing my own organization complaining about volumes out in the marketplace as a reason why they can't attain or drive past the goals that we've set.

So that tells me that even though we're seeing maybe a little more pressure than normal, at least based on the math, we're not actually seeing an impact in our ability to drive the goals that we had for the year.

So again, I don't want to read too much into the market growth over the last 2 quarters.

I think there's not a perfect science in the first place associated with looking at these things.

So even if you add up the major players, there's day rate differences and a lot of things that go into those numbers that I don't always say that there are perfect science on this.

But at the end of the day, what -- it's not going to change our opinion on how quickly we're going to look to diversify.

The diversification is a strategy that we had and will continue to move forward.

And again, anything that we've seen relative to market growth in large joints does not change our opinion on what we're going to be able to accomplish this year or beyond that.

Our next question comes from Chris Pasquale with Guggenheim.

Bryan, can you give us some more color on the supply situation and where things stand today relative to what you're hoping when you talked about being back at full capacity by the start of 3Q?

Are there particular categories where you're in good shape today, but others where you're still having issues?

Or is it broader than that?

Yes.

Thanks, Chris.

I'd say, I don't want to speak to specific categories just for competitive reasons.

But I'm just going to -- I'm a pretty transparent person.

I'm pretty happy with progress, but we didn't hit all the goals that we had set for the first part of Q3.

Some of it slid, and so I just want to be transparent with that.

That said, we've obviously made great strides in making progress here.

And ultimately, we're seeing that reflected in the results in Q2.

And we're going to -- obviously, we're seeing it in our cautious optimism here because we're saying supply is not going to be a barrier for us to accomplish what we said in 2018 and the turnaround itself.

But before I get into any more detail, I do want to just call out a couple of groups of team members that we have that have made this a reality.

Again, we're not where we want to be, but the progress is real.

And our manufacturing team has done a yeoman's work here.

I spent a lot of time on the floor talking to folks that are actually working on the manufacturing floor.

I've got to tell you, these people are putting in a lot of time, a lot of extra hours to get this company back to where it needs to be.

There's still work to be done, but the attitude and the work ethic of these folks is absolutely inspiring.

When I'm having a bad day, I'll go out to the floor, talk to some of those folks, and it turns my day around.

So I want to make sure that I call them out because they've been a big part of the progress that we've made.

And the other group is our sales organization.

I spend a lot of time in the field talking not just to the territory leaders and not just to the reps, but also the folks that are running the operations in the field.

Again, all of these individuals are doing significant work to make sure that the product that we do have gets to surgeons, fulfills the cases and takes care of the patients.

And that is extra work that they're doing every day in a supply-constrained environment.

So I appreciate what they're doing.

And that was a big part of why we were able to get the performance we did in Q2.

But here's the thing that I really want to concentrate on.

Steady state in our supply is the first step, and we are making progress towards it.

Certain brands that are lagging behind, we'll catch those.

The most important thing, though, is to be able to get to steady state and sustain it.

Because at the end of the day, steady-state supply has to translate into incremental revenue, accelerated revenue.

And one of the things that we've been doing now is to really define, internal to the organization, what do we mean by steady state and beyond the obvious stuff, back order recovery, safety stock levels, those types of things, we're also starting now a sentiment survey from our commercial organization.

How do they feel about where we are with supply?

Because ultimately, until they feel confident, we're not going to get the revenue acceleration that we're looking for.

This is part and parcel to me saying we're not where we want to be yet.

In the Q2 survey that we did, just 3 very simple questions.

First one is, did we make progress from the previous quarter?

The second one is, do you feel confident now with the supply you have to service your current customers?

And the third one is, are you ready given the supply situation to go after competitive surgeons?

And in this Q2, we've got a pretty good response on, was there improvement?

We've got a neutral response on, can I supply my current surgeons?

Which tells me that they feel like they can, but we haven't been doing it long enough for them to feel comfortable yet.

And there was a negative response knowing the scale that we had in being able to go after competitive surgeons.

And again, that tells me we're not where we need to be.

Because what they're telling us is, until I know, for a fact, that I can supply my current surgeons, I'm not going to take on the additional risk to go after material new business.

And that's where we've got to get.

So when I say, we've still got to make progress here, it's just not getting to steady state.

It's maintaining it and getting the sentiment of the sales organization to shift to move to revenue acceleration.

Our next question comes from Glenn Novarro with RBC Capital Markets.

Bryan, a question on the North facility observation.

So fewer observations this inspection relative to the last, but there were 8 repeat observations.

And this has made some investors worry that the North facility could receive a warning letter.

So could you provide your view on the repeat observation?

How fixable are these observations and your confidence that the remediation plan on their observations will be acceptable to the FDA?

Well, what I would say first is I don't want to get into any specifics relative to any of the observations, how I feel about the observations.

We've been pretty transparent in the entire process here relative to our quality remediation and any interaction that we've had with the FDA.

And so everything that we provided in our responses to the observations is public.

We made sure that you could see that.

Not every company would do that, we did it.

And so I think you've got what you need in the public domain on how we feel about the observations and our responses to those.

What I would tell you is -- and I think this is really important, I just want to reinforce that ZB, as well as myself, we take our commitment to quality and ultimately, patient safety very, very seriously.

It is a commitment that we make as an organization.

As a matter of fact, the new mission that we created, and I'm on a tear right now around the world, communicating this mission, live and in color to our team members isn't just an inspirational mission.

There are principles inside the mission that define who we are going to be, who we are and who we are going to continue to be.

One of the primary principles talks about quality, patient safety and conducting ourselves with integrity period.

These are not just words in a mission statement.

These are things that we will actually define ourselves by.

And when I present to the organization in these mission ceremonies, we talk extensively about what that means to each and every one of us.

So I just want to make sure that that's clear.

Relative to where we are right now, I feel good about the responses that we've had to these observations.

I am 100% committed as is the team to resourcing appropriately the quality remediation in the North Campus.

I do not like to have an open checkbook policy on anything, but in this particular situation, it is an open checkbook.

If resources are needed, the resources are attained, and we're going to move this thing forward.

So again, I don't want to comment on anything specifically.

We've done what we can relative to responding to the observations.

And now it's just the process has got to unfold.

Our next question comes from David Lewis with Morgan Stanley.

Bryan, I wanted to ask about the state of share across the business and specifically, where is share better?

Where is loss more pronounced?

I wonder, how is it trending at customers that have historically been sort of higher Zimmer customers versus where your share has been lower?

And at this point, how much of your share loss do you think is supply-related versus product positioning?

I'll tell you, it's always tough to actually speak specifically to the reasons where we have deficiencies in share.

When I say share, I think what you're talking about is just growth versus market growth and not specifically where our current state is relative to overall market share.

But in a lot of our categories, let's face it, we have been growing below market.

And that's the very thing that we're concentrating on.

As a matter of fact, we defined the turnaround in this organization as overall getting back to market or above-market growth in a sustained way.

That will require us in our major categories to be able to get to market growth and sustain it.

Now we've made some progress, and I think some of the progress that we've made in certain categories has everything to do with the fact that we have a great sales organization that is prepared to sell.

We have a combination of Zimmer portfolio and the Biomet portfolio, which is second to none.

We've been saying that all along.

We just got to be able to supply it.

And the fact is, we've had the manufacturing team increase the capability in supplying that product.

So all of those things coming together and some of the culture building as well has been able to help us start to close the gap where we've had gaps in our performance versus market.

We're not there yet.

We're clearly not there.

I mean, let's face it, even though we beat our expectations in the second quarter, we're far from being at overall market growth.

We need to get there.

That's the goal.

The things that need to happen for us to feel confident that we can do it is that steady-state supply, we maintain it and we get that sentiment of the sales organization up and translate it into revenue growth.

If we got to launch the new products where we have product gaps as we've talked about in the past and get those into full launch, that needs to happen.

And then ultimately, we got to continue to drive the culture of the organization to make people believe we can win.

Those are the things that we have to accomplish to be able to ensure that when you ask this question in the future, we can confidently and comfortably say we are at market or better in the major categories that we have.

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

Bryan, there's been a lot of discussion on the call about diversification or moving into the faster-growth areas.

You've got very good free cash flow.

The leverage ratio, I think, is less than 3x now.

But you've got this manufacturing issue.

So is that the biggest gating factor to you going out and doing some more deals to either get you into faster-growth areas that you're already in or other areas?

And is that something where we should think of you getting more aggressive, maybe 6, 9 months after you feel better about where manufacturing's at?

First of all, just maybe a quick correction.

We're not yet, from a leverage perspective, under 3. We're still 3, slightly above 3. The goal would be to be below 3, and we expect to be able to do that in 2019.

But what I would say is, in a perfect world, if you were sequencing this, we would do exactly what you just said.

We would focus first on our short-term priorities, as we previously stated.

Those short-term priorities would get us to the point where we were steady state as a business, which would mean in the spaces that we already play with the businesses that we already have, in our major segments that we're growing at or above market.

Once that stabilized, then you would start to get into more active portfolio management.

But in reality, what we know is, you could put -- the best laid plan never survives first contact with the enemy, right?

And so that plan, in a realistic world says, if there are opportunities in spaces that we know are attractive to us become available and opportunistically, we can wade into those, we're not going to ignore them.

And we do have the firepower now to do smaller tuck-ins.

And so if those opportunities come available to us, even if we haven't gotten to the place where we're defining our business as steady state, we would take advantage of those opportunities if, again, they made economic sense and we thought they could drive shareholder value and importantly, it could drive the mission forward of the organization.

So if we can sequence it perfectly, it would be the way you said.

But in the real world, it doesn't always happen that way.

Our next question comes from Larry Biegelsen with Wells Fargo.

So by my math, the guidance implies about 1% to 1.5% constant currency growth in the second half.

The question is, do you expect a sequential improvement in the constant currency growth rate in Q3 and Q4?

And what are you assuming now for resolving the supply constraints?

I'm not sure I heard that in your response, Bryan, to Chris's question earlier.

Dan, why don't you take the first part of the question, and then I'll handle the second.

Sure, sure.

So Larry, the second half implied constant currency growth rates about 1%, as you're suggesting.

The Q3 to Q4, we've not given specific guidance on the phasing of Q3 to Q4.

The comps are different.

The seasonality has been difficult to nail precisely Q3 to Q4, but feel good about that about 1% second half constant currency growth that's implied in our guidance.

Yes.

One obviously, would expect that given typical seasonality, Q3 would be more pressured than Q4.

What I would say on the supply recovery, I think the way I want to answer it is, there's work to be done in certain brands.

But we feel confident given where we already are and where we know we're going to exit in Q3 that this is not going to get in the way of us delivering what we just said in 2018 and will absolutely not get in the way of the turnaround time line that we've communicated in the past.

To me, the most important thing at this point is to get the sentiment of the organization up, particularly the sales organization so that they're translating that supply into revenue acceleration.

But again, I just want to reiterate, we do not see supply as being a barrier to our ability to deliver what we said.

Our next question comes from Richard Newitter with Leerink Partners.

Just wanted to focus on the S.E.T.

business.

This was a little bit -- represented an area of underperformance relative to our forecast, whereas, obviously, your recon was better.

I'm just curious, with respect to an earlier question that was asked on how much is supply versus product gaps driving that within the S.E.T.

business, can you talk a little bit about whether that's more impacted perhaps from a supply issue relative to recon?

And I'm also going to just ask if you can comment on the stemless shoulder launch.

I would have thought if it's not supply, that might have helped that division.

Yes.

Thanks, Richard.

Yes, it's -- so first of all, stemless shoulder is going well.

As a matter of fact, I was just talking to a shoulder surgeon last night at a dinner, and he was commenting how excited he is about the launch.

He's using the product already, and he's had very good results.

So I would just tell you that we remain confident and comfortable with our expectations around our stemless shoulder and just the shoulder space in total.

What I would say is, you're accurate.

The S.E.T.

business -- first of all, not all of our brands are impacted equally relative to the speed at which we're recovering supply.

And in the second quarter, the S.E.T.

business was pressured a little more than the large joints when it comes to supply recovery.

So that was part and parcel to some of the performance of the business in the quarter.

But the other thing, too, is we just had some timing, quite frankly, of capital that will benefit us in the back half of the year that just didn't translate into the second quarter.

So that was some of it as well.

And the final piece is, we've actually had some good conversions in the S.E.T.

business.

I'm not going to speak specifically to where, but across the S.E.T.

business.

And a lot of that is not going to translate until Q3, Q4.

So I feel good about our progress in S.E.T.

I feel good about the supply recovery as we come into Q3.

And I think what you're going to see in S.E.T is our ability in the back half to have better performance than we did in the first half.

Our next question comes from Rick Wise with Stifel.

Maybe highlight some -- if you would, give us a little more color on the challenges you're facing in the EMEA region.

You called out the weakness there.

Maybe help us understand some of the softness drivers.

Is there a specific geography?

What's the pathway time line for recovery?

Is it a small fix?

Is it portfolio?

Is it people?

Anything to help us understand and frame that would be helpful.

Yes.

No problem, Rick.

So what I would say is, [framing it if I may], it was a little lighter than what we had contemplated for the second quarter.

Not dramatically so, to be honest, but a little lighter than what we had thought.

And a few reasons that I would point to.

I think, first of all, supply constraint was real in Q2.

It probably impacts Europe a little more than other areas just given the tendering process that occurs to be able to get in certain tenders and win those tenders, you have to have the full portfolio available.

It isn't always the case in other regions in the world.

So it does impact them maybe a little differently, particularly depending on where you are in Europe.

So that's one thing.

The other thing is, we have some tender timing, not lost tenders, but just tender timing that's going to push us towards the back half of the year where we thought we're going to get those earlier in the year.

And that's real.

And then just being honest, we had Katarzyna leave the organization.

She's been in place for a long time.

Whenever you have a senior leadership shift like that, there's always risk for some level of disruption.

And so I don't want to say that there isn't that.

I don't see it as being material.

But the fact is, that when you have a leader leave, there's some level of disruption that you've got to assume is happening.

At the same time, I've spent a lot of time in Europe with the team underneath Katarzyna, and we have strong players.

I have a lot of confidence in the team.

I feel very confident they're going to continue to be able to steward the business.

And I don't see us having a falling knife situation here at all.

At the same time, I don't necessarily believe you're going to see a quick turnaround either.

I would say that the back half of the year would look pretty similar to the first half of the year when we're talking about that region of the world.

So again, not a major concern.

It's not far off of our expectations in the -- what we assumed so far in the year.

And the performance of EMEA throughout the rest of the year is already contemplated in the expectations that we just provided.

Our next question comes from Isaac Ro with Goldman Sachs.

A quick question, just as a follow-up to the last topic on team.

Bryan, can you talk a little bit about how much time you're spending when it comes to recruitment, whether it'd be in sales force or in leadership team?

Just kind of interested in the progress there and some of the things that you're doing that put into place the people that you want that are maybe harder for us to see on the outside.

Yes, absolutely.

For me, it's a big part of what we need to do in the organization is just to increase this kind of one Zimmer Biomet mission culture.

And I don't want to -- I know sometimes people put this as a secondary thing.

But to me, culture and mission in an organization is absolutely critical.

It's absolutely critical.

We have great people in this organization.

I don't need a wholesale change of leadership or folks in the organization.

I have confidence in the team.

What we need to do is to create a framework and an environment where these individuals can perform in the way that I know they can.

And talking about the mission of the organization, getting people excited about the culture of the organization, the fact that it's one team, one fight goes a long way to unleashing the capability of the people we already have on this team.

So I just don't want there to be a sense out there in the investment community or anywhere else that we don't have the team members needed to be able to make this business turn around.

I feel confident that we do.

We just got to create the environment that allows them to do it.

At the same time, in certain critical areas, we have added talent from outside the organization that I think will help increase the capability of the organization to turn things around.

Our Head of Operations, as I've said in the past, is new.

That individual is bringing additional people in that I think will help us in capabilities where we have certain gaps today.

Again, not that we don't have a great team already, but we're adding additional capabilities that I think will only help.

We've done the same thing in our portfolio management and strategy area.

We've upgraded talent there.

We're going to continue to do that.

And my sense is, we'll continue to see additional folks come on board underneath Rachel, and that gives me more confidence that we're going to have a sound strategy and even more focus in this organization to ensure that we're applying our resources to the areas that's going to bring the most value to the organization and ultimately our shareholders.

So we're making changes and additions where we need to.

But make no mistake, we have a very good team, and we're creating the environment where that team can be unleashed.

Our next question comes from Robbie Marcus with JPMorgan.

Dan, 2 very quick financial questions for you.

One on EPS phasing for the back half of the year.

Historically, Zimmer had a drop of 15% in the EPS from second quarter to third quarter.

How are you thinking about that for this year?

And then maybe just give us an update on -- I know your FX hedges flow through gross margin.

What are you thinking of the impact to gross margin in '18 and '19?

And any color on EPS impact from FX for next year would be great.

Sure, Robbie.

So first, on phasing Q3 to Q4, it's certainly appropriate to look back over the past number of years and look at that seasonality.

It's significant in our business, and you see it every year.

In particular, when you look back at Q3 of last year, from an earnings perspective, recall that we made some bonus accrual adjustments in Q3 of last year, which was a benefit to the P&L as we trued up those bonus accruals.

So we came into this year from a full year guidance perspective and talked about that as a significant year-over-year headwind.

And there's a significant item in Q3 that's a headwind.

So I think as you model Q3 versus Q4, just know that inside of Q3, you've got this big credit in Q3 of last year that won't be there in Q3 of this year because thus far, we're performing.

So while I'm not going to give you the precise phasing Q3 to Q4, I would just remind you to look back at revenue seasonality of the corresponding OpEx that is fixed versus variable.

And then just know that the prior year Q3 had that credit inside of it.

With respect to hedges, in my prepared remarks, I talked about a total FX headwind to earnings of about $0.10 in the second half of the year.

Given the sharp move in the U.S. dollar since our call in April, so that movement is about 5% strengthening of the U.S. dollars, while we have a very robust hedging program, the sharpness of that move really prevents us from completely offsetting that in the P&L.

So the $0.10 headwind would have been significantly worse if we didn't have a hedging program.

And the offset to the hedging program will flow through 2019 as well.

So last piece would be, when you think of gross margin 2018 to 2019, we've talked a lot about the headwinds in 2018.

We've talked about the incremental production costs that we're still incurring, the capitalization policy that's associated with that.

And therefore, when you think about '19 versus '18, you're still going to have a bit of a headwind on the gross margin rate due to pricing and then also that incremental COGS that will still be flowing through the P&L.

Robbie, let me add one more thing on the sequencing thing.

You mentioned the 15% number.

I want to be clear, and Dan definitely said this as well.

That doesn't mean that necessarily, we're going to have an exact 15% kind of impact.

As Dan said, we're not going to talk about specifics there, it could be higher than that, it could be lower than that.

I think the reason why it's important that we point it out is a lot of people on The Street have got that right.

It's very, very straightforward.

It happens every single time.

A lot of surgical-oriented companies see that seasonality shouldn't be a big deal.

And if you're one of those people, then you're in good shape.

There are 2 or 3 people out there, though, that may have not fully understood this SG&A dynamic that Dan was talking about.

And we just want to highlight it so that as you -- when you do your models, you go back, you take a look at that, you understand that, that SG&A, in particular comp, has a real impact there.

And of course, happy to go through all of this off-line with anyone if there's any confusion on that, okay?

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

I wanted to fast forward to a year from today.

And I think everyone on this call understands that this is a shift, a progress, a gradual improvement, pick any adjective that you want.

But a year from today, what is a win?

And what will you be saying or could be saying that will be deemed a disappointment?

And the sister question to that is, when do you think you stop losing market share?

Well, the sister question is kind of buried in the first question anyway.

So what I would say is, a year from today, I hope we're not saying anything that's a disappointment to where we thought we would be.

And here's the perfect timing actually to be a year.

A year from today, what we need to be saying, and this is our short-term objectives, is number one, we have gotten to the place where steady state in our supply is -- has been maintained and the sentiment of our organization, particularly the commercial organization, realizes this and does not have concern with pursuing new business as a result of supply constraints.

That has to be in place.

The second piece that we talked about, we've got to launch the products that we've been openly communicating are important to the portfolio to get our reps back on full offense.

And we need to get them into full launch, which, by the way, around a year from now, would be the time frame that we should be in full launch of that full portfolio.

So if we're at that place with supply recovery and we continue to make progress on the culture of the organization, particularly again around our commercial organization, I think we're in a position to begin to go on true offense.

Now what I do know about being in a position to go on true offense and actually realizing it, there's typically some period of lag between that, where you've got to build up your bull pen of offensive opportunities and ultimately, translate that bull pen into converted business.

So my feeling is, as we're coming into a year from now, those 3 things will be happening.

And we'll be able to talk to you about the offensive position that we're in.

And then ultimately, as we've talked about the turnaround for the business, we want to be at or above market growth in a sustained way, and we truly do believe that can happen in 2020.

Our next question comes from Vijay Kumar with Evercore ISI.

So maybe going back to the guidance question.

So I just want to understand the 3Q and '19 comments, right?

So 3Q, obviously, there's seasonality.

But I think there's also days impact, right, the comps get easier, supply is coming back up online.

I just want to understand how all of those things fit in together.

And I think relative to that, the FX impact for '19, at current levels -- I think on the last call, we said that we expect that operating leverage.

I just want to understand that is still intact, right, given where rates are currently.

Sure.

I would just say that our guidance for the second half of the year takes into account everything that you just said.

Now it takes into account the comps from the prior year.

It takes into account the improving supply situation that Bryan is referring to and the FX movements.

So that's all factored into the second half guidance.

With respect to 2019 operating margin, and Bryan probably wants to comment on this as well, we're going to stay focused on delivering what we're talking about here in the back half of 2018, first and foremost.

We're going to see how that goes, and we will continue to have a bias for investment in areas that deliver a return from a growth profile perspective.

So when we look out to next year, as we go through our budgeting process and see how the year is progressing, we'll look for additional opportunities to invest to drive growth.

And I think it's fair to say that if we see opportunities to do that, we will put a priority over that relative to driving operating margin expansion.

Yes.

I don't know if I have anything material to add.

Well said.

I mean, to me -- I think to us, as an organization, and probably to you as well, the primary goal in this organization has got to be to get revenue growth up and get it up in a sustained way.

That will be the primary focus, and that will be our North Star.

When we accomplish that, then we can truly look at operating margin expansion.

But I would give up on operating margin expansion in the short term to be able to drive revenue growth.

And when we do see those opportunities where we're getting traction in areas where we're making investment, we will double down on those areas and continue to push, even if it impacts our ability to get that modest expansion we've been talking about in 2019 for margin.

That's a good point.

I'm glad you brought it up, Vijay.

Our next question comes from Raj Denhoy with Jefferies.

Anthony on for Raj.

Maybe a 2-part question, Bryan.

The first will be on new products.

You mentioned the importance there.

But you did have some launches in the quarter, Partial Knee, the Tibia was out there and then you have 2 slated for year-end.

So what is now baked in there just from, let's call it, the partial launch of those products, in guidance?

And the second question would just be on portfolio management.

Dental was below our expectations.

Just wondering what the strategy is there and would the company contemplate potentially a spin or a divestiture of that asset going forward.

Yes, absolutely.

So first of all, when I think about the new product launches, I think the primary thing that I'm looking for here, just across the board, forget for a minute new products, but just across the board.

We, as an organization, doing what we say we're going to do.

It's very important to me.

It's one of the culture pieces that we want to have as one Zimmer Biomet.

When we say we're going to do something, we do it.

And if we get new challenges in the process, we pivot inside of those, and we make sure that we ultimately accomplish what we set out to accomplish.

And that's one of the things that I'm really concentrating on in the organization, and we're sending that message loud and clear.

What I'm happy about on the new product side is we are delivering on what we committed.

We've been hitting pretty much on target all product launches that we have committed to.

And I'm talking about internal commitments, the time lines, not just the external commitments that we've made to you.

And we're delivering on the expected revenue growth associated with those new products.

I'm not going to get into specifics, but just know that the revenue growth that we expect from those products is coming to bear.

And ultimately, it is built into the guidance and expectations that we set for the back half of the year and beyond.

So I feel really good about it.

I feel solid about where we are.

Relative to specific new products, across the board, where we've launched, the response from surgeons is extremely positive.

I just can't wait on the cementless side to get to full launch because the response associated with that product so far is extremely positive.

And full launch will be coming at the end of the year.

And it's not remember, just about the revenue associated with that individual product.

It's the potential pull-through of other categories and our ability to get back to market using other categories.

Because new products gives energy to the sales organization, and ultimately, gives energy to our surgeon partners.

So again, I'm very happy with what we've seen thus far, and we probably still have a lot to do.

We get major products we still have to launch, but every indication is that we're still on track to delivering those limited launches as we've been communicating.

Specific to dental, I would agree.

The dental market, it's a tough market for us right now.

It remains very competitive, and we've been, as we've previously stated, making changes within the dental organization to senior management.

We're continuing some of those changes within the dental organization to try to position us to be able to compete in a more holistic way.

The key thing that we put into place was stabilize.

We've got to stabilize.

It was dropping pretty quick.

We want to at least stabilize that drop and then try to move into a position of growth.

Clearly, we haven't gotten to the second phase of that plan.

We have stabilized.

We're a little under where we want it to be in the second quarter, but it's not inconsistent with previous quarters.

The real goal for us, though, is to use the momentum of that new team and begin to get traction in the dental business.

That's where we are with the dental business.

Thanks, Anthony.

Although I would note that sounded suspiciously like more than one question that you asked.

But I'll note that to you after the call.

I'm doing a time check real quick.

We're going to have time for maybe 2 or 3 more questions and then we're going to try to get them through if we can.

Our next question comes from Craig Bijou with Cantor Fitzgerald.

I wanted to ask on the Spine & CMF business.

You guys obviously saw a pretty good step-up there in the quarter, so just wanted to see what the driver was there.

And then maybe your overall thoughts on the spine market and the growth profile of your specific business going forward.

Yes.

So I would say, I'm again, pretty happy with where we are right now with that segment of our business.

A big part of it is, we've made -- I just talked about the dental business, we've made some management changes and some structural changes to that segment of our organization.

We've got some new team members in, almost across the board in spine, but also in other categories of our business that I think are setting a really strong strategy.

They've begun to implement a channel strategy that provides risk because there's change in the channel strategy that is needed, but they're aggressively moving that's forward and having good success so far, as indicated by the Q2 number.

And we continue to feel confident that we're going to be able to deliver what we expect in the back half.

So I'm excited.

It's some combination of a new team, new products that we're launching and the channel strategy that we're putting into place that's all coming together to be able to allow that business to perform at plan or even slightly better.

Our next question comes from Kyle Rose with Canaccord.

Earlier in the call, you talked about the ROSA knee application coming on track for launch.

Just want to see if you can frame that out in terms of how you really define a controlled launch.

Is it 10 robots?

Is it 20 robots?

Is it Zimmer customers?

Is it competitive customers?

The de novo robot users versus experienced robots users?

And then just the second part, from a ROSA perspective, is when you anticipate reengaging the spine market with a robotic application.

I'll start with that one first.

The goal would be to have a limited launch, either right at the time or just right behind the ROSA knee application for spine.

So spine would follow directly the ROSA knee application.

And when we define limited launch, we don't get into specifics about how many robotic systems, what kind of revenue are we talking about in the limited launch.

The whole idea behind limited launch is to learn.

Particularly when we're talking about a robotic system, we want to roll this out in a safe and effective manner.

We want to make sure that we have the right training that goes along with it, and we want to learn as we go.

Are there any mishaps associated with the product launch that we have?

And if so, how do we correct those on a go-forward basis?

That usually takes us 5 to 6 months, and that's what we would expect probably the further out piece of that and we're talking about robotic systems so let's call it, 6 months post the time that we limited launch.

And to me, again, I'd like to concentrate on individual products because they're important.

And certainly, when we talked about robotics in knee, it is an important area for us.

But most importantly for me is to have that full portfolio that allows us to go on full offense and to have a robotics platform that then complements what I truly believe is the best knee system in the marketplace allows us now some differentiation versus everybody else.

So others may have a robotic system but they certainly don't have the Persona Knee System that we have with the personalized capability that, that brings to the table.

And it also differentiates us because with robotics and the segmentation we have in knees is kind of a good, better, best, also provides us with some differentiation at that time.

But as much as I like the ROSA platform, I like the fact that we're going to have robotics.

I think the bigger story is, it is a piece of the puzzle that will allow us to be differentiated versus our competition.

Thanks for that.

We are coming up at the bottom of the hour.

I'm going to try to squeeze one more quick question in and then we're going call it.

Our final question comes from Jeff Johnson with Baird.

I'm in a car.

Hopefully, the background noise isn't too bad here.

Bryan, that was helpful to comment on the timing around the robot.

But wondering, on Sidus, just when do you think full launch there?

When will instrument sets be built up, things like that on that?

And then on the Revision Knee, same question.

Is it about a 6 months after late year prelim launch that we should expect instrument sets and kind of a full commercial launch then on the Revision Knee as well?

Sure.

Okay.

So on Sidus, we're already in full launch.

We've entered full launch.

And again, as I've been out, I've been lucky enough to be with a couple of really exceptional shoulder surgeons and have seen shoulder procedures.

I have not yet seen a Sidus procedure, but I just got the offer last night from a surgeon that I talked to, to visit his site and see a Sidus procedure.

But I can tell you that each of the shoulder surgeons that I spent time with in the operating room are excited about the technology.

So we're in full launch, and it is being accepted well.

As far as Revision goes, again, as we've referenced, we're looking at a limited launch at the end of the year.

I would give that same time line when we build up our capabilities to go on full launch, learn as much as we can, build the supply that we need to be able to go to full launch.

And that will be towards the middle of 2019.

And I'd say it again, the folks that have seen the Revision System really like it.

We haven't gotten to limited launch yet, but people who have had exposure to it, and the exposure to that system is garnering very positive responses.

And remember, when we do launch Revision, it's an important category for us that, that product is an important product for us.

But ultimately, there are folks that are sitting on the sidelines that would like to use Persona but are waiting for a Revision System.

So not just the importance of launching Revision, but it's also getting some of the folks on the sideline into the Persona game.

And we're going to wrap it with that.

Really appreciate the vast majority of you keeping to the one question on the call.

We got through a bunch of you, and I hope this has been helpful.

Really appreciate you joining us on the call.

A replay of the call will be available later today on our website.

And of course, the IR team will be available throughout the day to answer any follow-up questions you may have.

Have a great Friday and a great weekend.

Take care.

Bye-bye.

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

You may now disconnect.