Zimmer Biomet Holdings Inc (ZBH) 2020 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet Third Quarter 2020 Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded today, November 6, 2020.

(Operator Instructions) I would now like to turn the conference over to Keri Mattox, Senior Vice President, Investor Relations, Chief Communications Officer.

Please go ahead.

Thank you, operator, and good morning, everyone.

I hope you are all well and safe.

Welcome to the Zimmer Biomet's Third Quarter 2020 Earnings Conference Call.

Joining me virtually today are Bryan Hanson, our President and CEO; and CFO, Suky Upadhyay.

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

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

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

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

Additionally, the discussions on this call will include certain non-GAAP financial measures.

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

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

Bryan?

All right.

Great.

Keri, thank you.

And here we are now with our third virtual earnings call.

It's hard to believe that so much time has already passed as we live inside the pandemic environment.

But either way, we're here, and I certainly hope that you're listening somewhere safe and socially distanced.

We're clearly taking precautions here.

And we continue to follow our safety protocols.

And that's the reason why Keri, Suky and I are in different locations again for this call.

As we've seen in the past, hopefully, we, again, do not have any tech mishaps, but just know if we do, for whatever reason, we'll push past and make sure that we move forward.

So 2020 has clearly been unlike any other year in ZB's nearly 100-year history, as I'm sure it is for every company that's out there right now.

And as I think we're all probably too aware, it's not over yet.

It's definitely not over yet.

That said, I have to say that I look at how we've managed and just really navigated COVID-19 this year and specifically in the third quarter.

And I'd say that I'm proud of the team.

I am confident about ZB's future, probably more confident now than I ever have been about ZB's future.

I truly believe we are well positioned for success.

And our strategy is absolutely working.

As you all know, we've been acutely focused on transforming ZB since I joined the company.

That's almost 3 years ago now.

We faced challenges before.

And while nothing could have ever prepared us fully for COVID-19, I do believe our ability to rise to those earlier challenges, they truly put us in a stronger position to effectively manage the pandemic situation, the environment that we're in right now.

I actually think it's been a catalyst for ZB.

The team's focus on our mission, our strategy and how we show up and execute every day, it's the strongest it's been since I joined the company.

And the way I look at it is the things we can control, we are absolutely galvanized around and executing flawlessly against.

So it feels good right now.

As much as it's noisy around us with COVID, the execution inside the organization is as strong as I've seen.

And that said, the unpredictability of COVID means there are several variables, and unfortunately, they're pretty big variables that are outside of our control.

And as a result, the pandemic continues to be challenging.

It continues to be fluid.

This requires us to quickly adjust, to change given the changing environment.

So ultimately, we can effectively meet the needs of our customers, and very importantly, our patients at all times.

And that's exactly what we've been focused on.

Along those lines, there are really 3 key areas that I'm going to talk about today that I think are important for you to take away, be aware of and also see the progress that we're making inside of each.

The first one, it should be pretty obvious.

It's our view of the COVID-19 recovery path from here where we see it going.

And I think importantly, inside of that, the areas of concentration or execution that we're going to have inside of the COVID recovery path.

The second is an update on our strategy to drive long-term growth, and through that, value for ZB and for you.

And the third is an update on the ongoing transformation of our business, which I truly do believe we're making great progress on.

And again, I'll spend time on each of these, and then I'll pass it to Suky.

He's going to give you more detail and color about Q3 on the financials and then how we're thinking about and framing Q4 in our minds.

So first, let's talk about the recovery and execution we saw in the third quarter.

Ultimately, the recovery of the elective procedures going from Q2 to Q3 is encouraging.

I would imagine it is encouraging for everybody at this point looking at Q2 to Q3, but it's still difficult to predict from here what's going to happen.

The fact is we've talked about how the key variables impacting procedure volumes needed to remain constant.

Obviously, they can improve, but they needed to at least stay where they were for the recovery to continue and to see sequential improvement from Q2 to Q3, and as you probably remember that we said that these variables included both positive and negative influences on procedure volume.

On the positive side, which would be pretty obvious, we have the new patient volume and in the backlog of patients that have deferred treatment during the pandemic for whatever reason.

On the negative side, we have the effects from economic downturn, but most importantly, surges in the virus that can drive negative policy decisions and/or increased patient fear.

Those would be the negative influencers, obviously.

Now if I look at the combination of those in terms of recovery in Q3, the variables played out in a way that allowed continued improvement over Q2.

So overall, the full quarter was stronger than expected, and we actually returned to growth over 2019 faster than we thought we would.

And this is driven again by these COVID recovery dynamics.

But importantly, our team's strong focus on and probably even more importantly, execution against our strategy.

We've been very focused on moving the strategy forward, regardless of the noise around us.

We saw a steeper rate of recovery in July, followed by a more modest recovery or even a flattening of the curve toward the end of the quarter.

And this was driven by the shift in the recovery variables that I just outlined a minute ago.

We've seen continued increasing surges of the virus, especially in Europe, Middle East and Africa and in the U.S. and this is negatively impacting both patient fear and in certain areas, policy decisions.

And as a result, we exited the quarter with September growth flat versus 2019.

There's not much we can do to stem the virus surges, but we have launched a unique and a very large-scale direct-to-patient campaign focused on patient fear.

So we can't influence the virus, but we can try to influence patient fear.

And the focus of the campaign is to educate and support patients about their options to get procedures during COVID and really even beyond focusing on the fear that patients typically have to come and get a procedure.

And what we're finding early on in this campaign is that the feedback has been very positive.

And in particular, associated with the concept of mymobility and its ability to allow for virtual care capabilities during this challenging time.

All right.

So those are obviously some of the factors surrounding COVID and its recovery dynamics.

But I also want to make sure that we spend time talking about the things that we have more control over, the execution of our strategy and the performance of our business inside the impact of the pandemic.

And even in the midst of this turbulence, we continue to deliver against our goals.

This focus and execution against our strategy is the reason we have performed well over the last 2 quarters versus the overall market.

Specifically, if I look at Q3, our performance in U.S. knees and hips is a great example of this underlying momentum.

We grew 3% in the quarter in U.S. knees.

We also saw a 10% growth in U.S. hips.

I got to say these numbers are strong even without the backdrop of COVID.

So the question is going to be what's driving the performance.

I'm sure I'm going to get that right away.

So I'm just going to answer it now.

Our core business is strong really for 4 major reasons in the way that we view it.

The first is pretty obvious.

We have truly shifted from this triaging of execution challenges to launching meaningful innovation.

And I'm going to spend a little bit more time on this one in particular, but that's a big one.

Second, our operating mechanism and really the resulting operational discipline has never been stronger and I'd argue probably as good as I've ever seen it anywhere.

And third, our compensation programs have shifted towards disproportionately rewarding growth, not just paying you for keeping the business you have but truly disproportionately paying and rewarding for growth.

And then finally, and I'm not sure if this is causing it or because of it, but our commercial confidence is higher than I've ever seen in my tenure here at ZB.

The commercial confidence, the swagger or whatever you want to call it is higher than I've ever seen.

So again, those are really the combination of things that has helped create the momentum inside the pandemic, but let's talk specifically about innovation, that as a component of this equation.

And broadly speaking, over the last year, we've taken a very dismal, low single-digit vitality index to a low double-digit number.

That's still not as good as we'd like it to be, but that's a pretty big jump.

And with our current product pipeline, I could promise you that's only going to continue to move in the right direction.

And as you know, obviously, vitality index speaks to the percent of sales driven by new product launches.

So in other words, those products that have been launched within the last 3 years, the revenue associated with them versus your overall revenue.

So again, a real nice jump in the right direction in vitality index and more coming.

But to get a little more specific, I think, go to some of the key launches that you're interested in, and I'll start with our knee franchise.

Our ROSA execution continues.

And I'm very proud to report that we have already passed the 200 ROSA knee placement mark in the worldwide placement strategy that we have.

And importantly, our utilization continues to increase and the placement pipeline remains very strong.

So again, remember, we're way underpenetrated in robotics for our business and across all of orthopedics.

So the tailwind associated with ROSA, in our opinion, is going to be around for a while, and it feels very good right now.

On the Persona Revision side of things, we keep gaining traction in the marketplace with this product launch.

Q3 results were even stronger than last quarter, which had been our best quarter-to-date post the launch.

And Revision remains on track, as I said before, to hit $100 million of gross revenue this year, and that's 40% of that will be new growth.

In other words, $40 million of net of cannibalization revenue this year from Persona Revision by itself.

It's really exciting not only because it shows strong momentum for our Persona Revision, but because it also opens the door to more growth.

Revision system is truly a tip-of-the-spear product.

When we convert a competitive surgeon to our Revision system, we absolutely have the right to hunt for their primary knee business, and that's exactly what we're going to do.

And if you know about this marketplace, you would also know that the primary business is usually much larger than the Revision business.

So you can get the order of magnitude opportunity we have to go after now.

So exciting stuff there on the knee side.

Now shifting to hips, Avenir Complete is really just still outperforming our expectations for 2020.

That's even with the pandemic impact.

These are the expectations that we have for 2020 before we knew about the pandemic, just to give you some perspective on that on how well it's doing.

And this launch has really helped provide a great implant to leverage the high-growth direct interior approach submarket in hips.

That's one of the most attractive submarkets in hips.

And this implant is the perfect opportunity for us to take advantage of that attractive market.

And then one more product I'll highlight in the quarter is in our upper extremities business, our Signature ONE Planner.

I talked about this last quarter as well.

We had another 50-plus percent increase in surgeon registrations in Q3, and we already have 1 in 4 cases using presurgical planning for shoulder replacement.

This increased penetration of the system is important, in my mind, in 2 very important ways.

First of all, there's a real potential for mix benefit, or maybe said another way, share of wallet gain in each procedure that you use presurgical planning in.

And it also provides more stickiness with the surgeon, right?

On the surgeon stickiness, it's probably obvious.

When a surgeon is using our implant, and they're also using the presurgical planning, it's harder for them to want to move away from that environment because they're used to it.

On the share of wallet benefit, this may not be as obvious, but it's a pretty significant opportunity.

It comes because you get a higher utilization in augments and guides when you do a preplanned procedure versus those without presurgical planning.

It's because you know the anatomy before you get in.

And you know that if you're going to have an anatomy issue, you've already got your augments ready to go and your guides ready to go.

That's great for the patient because you're going to get better outcome.

It's great for the surgeon because they have what they need to do the procedure.

And it's great for us because we get more revenue for that surgical procedure.

It's a very exciting stuff.

And so in short, I would just say that even with the challenges of COVID, we're driving our business forward, meeting customer needs and improving patient lives as we go.

That's the whole mission of this organization, right?

It truly is what we do and wake up for every day, alleviating the pain of patients around the world and improving the quality of their life, and we are doing that during COVID.

And as a team, we've dealt with many challenges over the past 3 years.

This prepared us for this moment.

I've said it before, this is the time when companies and teams can slow down.

They can hesitate.

They can take their foot off the pedal.

Hey, we're getting smart and safe, but we are not letting up and it shows.

It shows in the ZB performance and in the energy of this team right now, all right?

So I'm going to move on to cover our strategy to deliver long-term organic growth and ultimately drive more value for ZB and very importantly, for you as well.

And as we've outlined, to drive our strategic pillar of top quartile performance at TSR and truly bring value to you and ultimately to achieve mid-single-digit growth organically, we have got to focus most intensely on driving long-term growth in our key focus areas.

And first, as we've said in the past, the first and foremost area of concentration is above-market performance and needs.

And just given the size and the scale of this business, we need to be ahead of market here.

And we're going to do that by focusing aggressively in the fastest-growth submarkets of need: robotics, data and informatics, cementless, and for us, revision.

These are the areas of concentration and investment that are going to allow us to sustainably perform above market in these.

And next, we've got to drive consistent at-market growth, if not the higher end of market for our performance in S.E.T.

And that's focusing on the most attractive sub-elements of S.E.T.

For us, that's going to be sports, and it's going to be extremities.

Also, we've got to make sure that we have a consistent at-market performance in hips.

That's in the short term, right?

In the longer term, when we launch into robotics, we absolutely expect above-market growth in hips well.

And then finally, while our other businesses, at least at this point, we'll not receive the same level of investment and will be managed differently, we still expect these businesses to drive in line to the lower end of their market growth.

And that's our pathway.

That's our pathway for long-term durable 4% to 5% organic growth rates in this business, okay?

So next, I want to talk about ZB's transformation.

You probably heard me outline the 3 phases of our ZB transformation, but I'm just going to go over them again just quickly here.

Phase 1, capturing the hearts and minds of the team, truly capturing the hearts and minds of the team and addressing our execution challenges.

That was really phase 1. And with this in mind, we've aggressively shifted to the One ZB mission, the One ZB culture.

We've added new and very diverse executive talent, and we've stabilized the business across all key areas.

So good progress in phase 1.

Phase 2 was really around shifting to a disciplined strategic clarity for the organization that's more focused on long-term success, not solving problems but truly long-term success.

This is where ZB shifts to innovation, drives our strategic plan, has our pillar priorities that are very clear to the organization, locks in our operating mechanisms and evolves organizational structure to ensure that we can drive a focused approach to execution of this strategy.

And phase 3 is where we transform for the future.

Through active portfolio management, we look to change the portfolio complexion accelerate growth, right?

So we've made pretty significant and really durable progress in phase 1. We've laid the foundation for and are absolutely executing against phase 2. And now we're moving squarely into phase 3 of the ZB turnaround.

And so for us, when I think about phase 3 and I think about that active portfolio management, it includes 3 main components and really should include these same 3 for anyone who's looking at active portfolio management.

But the first one is disproportionately investing in our priority businesses, in our priority markets.

And that would be across research and development, commercial infrastructure, just mind share, being disproportionately invested in those areas.

For number two, being selective in M&A, prioritizing opportunities that are accretive to our weighted average market growth and aligned to our strategy.

So selective M&A.

And the final one, when appropriate and in line with our overall strategy, divesting noncore assets that are financially less attractive than our core businesses, right?

So those are the 3 components of active portfolio management in a way that we see them.

Now as we manage the ZB portfolio, we're going to continue to focus on high-growth areas and areas where we truly believe we have a right to win.

Now size is going to be a factor here, particularly in the short term.

And out of the gate here, we're going to have a preference towards smaller tuck-in deals that could be easily integrated and operationalized while also maintaining, very importantly, our investment-grade rating.

And I really do believe this philosophy is apparent when looking at the recent transactions we just highlighted in our earnings press release.

Again, while these deals are not material in terms of acquired revenue, they're absolutely instrumental in filling some of the product gaps we have at ZB in our ASC and sports portfolios.

And really, they add to our pipeline of new technologies and product launches in markets that are accretive to our growth rates.

And these deals are small, so they're going to be easily integrated.

And we're going to be able to validate our new deal process, our new team, the integration playbook that we now have in place.

So I think great first step in the M&A side of things.

From a -- looking at the individual deals, if I look at the acquisition of Incisive, now this is an OR solutions company in the $1.2 billion integrated OR market.

And this is going to provide ZB with a soon-to-be-launched, it's not launched yet but a soon-to-be-launched surgical booms and lights portfolio that will help us push more aggressively into the attractive ASC market, which is clearly an area we want to go.

We also see some real differentiation.

It's not just filling the gap of the portfolio, it's truly bringing differentiation for really 2 reasons.

Now first of all, they have a smaller footprint.

And this focuses on reducing the acquisition costs but also the construction cost, which we know is a pretty important aspect of the ASC market, looking at controlling these costs.

And the second reason why we think it's differentiated is they've really done a really interesting job in incorporating an innovative and automated way to capture data in the operating room that ultimately leverages artificial intelligence.

And that helps us in the operating room drive efficiency and productivity and potentially even better outcomes.

Again, this is really lending itself to the needs of the ASC setting.

So again, pretty excited about this portfolio opportunity.

This idea of a smart OR and really leveraging data to drive decision support and efficiency is also reflected in our exclusive relationship with Canary Medical.

Through this partnership, we actually see the opportunity to further differentiate our knee ecosystem, which is a major focus of ours right now.

Our goal is to launch an intelligent Persona total knee implant that incorporates Canary's smart sensor technology.

We feel a combination of active data capture from the smart implant that we already have from mymobility and we already have from ROSA.

It's going to provide an unmatched data set that ultimately could be leveraged through AI for decision support related to how best to treat and care for the patient.

And this will give us a unique opportunity, we feel, to create an intersection between the $4 billion total knee market and the telehealth solutions space, which is growing somewhere north of 15%.

So a very attractive area for us to differentiate the ecosystem and kind of enter into an adjacent space in telehealth.

And the last deal I'll talk about is our acquisition of Relign.

And this is focused on the sports medicine market, which we know is a $5 billion market and it's growing 5% to 7%.

So again, accretive to our overall weighted average market growth.

And this deal clearly helps fill our gaps in arthroscopy capital.

Now the capital makes up about 30% of the sports market.

Until now, we had absolutely no offering in the space.

With this acquisition, we've not only filled the gap, we also see some real differentiation in the portfolio.

They've done a nice job of, again, innovatively consolidating 3 tower components into a single comprehensive system, both at the equipment side and on the end defector side.

So this is a first in the industry.

This system is very early in commercialization stage, but I would say it's getting very positive feedback early on.

And we see this as another great opportunity to drive a successful product launch, leveraging our ZB commercial infrastructure, which we absolutely know we can do.

So I would just say that, hey, we've got other portfolio management opportunities in the near-term funnel.

And we're not ready to talk about those yet, but we've got other ones in the funnel, and we will continue to keep you up-to-date as we make progress here.

And finally, we are fully committed to our margin expansion goal of at least 30% operating margin by the end of 2023.

Suky is going to talk more about this, but our restructuring plan is on track.

And the cost savings we're delivering will help drive margin expansion, which has got to be there, but also support reinvestment in the business for growth.

It's got to be able to do both.

And that was what the whole idea behind the restructuring plan was.

So again, Suky will give more detail on that, but it's on track so far.

Overall, we are clearly watching the COVID recovery trends closely and completely realize, as everybody does, the short-term market performance, and I want to reiterate market performance, is out of our direct control as a result the COVID recovery trends.

That said, and I hope it is very clear, we feel confident in ZB.

We feel confident in our business strength and our execution and the long-term growth prospects we have as a business, and as a result of that, the value creation opportunity we have as a company.

Okay.

And with that, I'm going to turn the call over to Suky, again, for more financial details for the quarter and looking forward.

Suky?

Thank you, and good morning, everyone.

To echo Bryan's comments, ZB's underlying fundamentals remain strong.

Overall, our Q3 performance was better than expected.

Revenue was ahead of expectations as we posted operational growth due to faster market recovery across most developed markets in tandem with strong commercial execution.

Improved revenue performance drove better margins and a solid quarter of free cash flow.

I have a genuine feeling of pride in how our 20,000-plus team members have responded to a very challenging environment.

Net sales in the third quarter were $1.9 billion, a reported increase of 2% and constant currency increase of 1.1% versus the same period in 2019.

Sequentially, Q3 improved over Q2, as expected.

In spite of that, we continue to see variability in recovery by market and region as we progress throughout the quarter, and we did see a flattening of the recovery curve with September effectively flat versus the prior year.

I'll talk about performance across our regions and then move to our business segments.

And moving forward, unless I note otherwise, my comments will be on a constant currency basis.

Beginning with Asia Pacific, the region returned to growth, increasing 0.7% versus Q3 2019.

We saw strong performance in China with results well ahead of normal levels.

And while Japan has not yet returned to prior year volumes, the market continues to show stability.

Australia and New Zealand made steady progress in Q3 but were negatively impacted by surges of the virus late in the quarter.

Finally, India and other small Southeast Asian countries continue to significantly underperform in the broader region.

EMEA decreased 5.7%.

While we saw recovery from Q2, the region did not return to growth in any part of the quarter, and we observed a slowing in September due to recent COVID-19 surges and corresponding policy actions.

Developed countries, excluding the U.K., showed the strongest signs of recovery but decelerated in the latter part of the quarter.

The U.K. and emerging markets continue to be a significant drag on overall regional growth and are lagging developed markets recovery.

Lastly, the Americas region continued to grow, increasing 3.3% with strong growth of 5% in the U.S. While the recovery was robust in the U.S., we observed the same flattening in the recovery curve due to increases in virus surges in September.

Similar to Q2, caseloads and elective procedures in hard-hit regions are continuing at about 70% to 90% when compared to 2019 volumes.

Outside of the U.S., the rest of Americas continues to lag with numbers well below normal levels.

Turning to our business performance for Q3.

The global knee business declined 1.4% versus Q3 2019, a marked sequential improvement from the 47% decline we saw in Q2.

The U.S. knee business returned to growth, increasing 3% in the quarter.

Overall, execution was strong with continued momentum for ROSA.

Additionally, our Persona family of primary, revision and partial knee continues to get great traction with existing and new customers.

Our global hip business increased 4.4%, another big sequential improvement from the 31% decline we saw in Q2.

I do want to call out that U.S. hips increased about 10% in the quarter, strong market recovery for sure but also a great illustration of our commercial team's execution in the backdrop of new product introductions.

Sports, extremities and trauma sales grew 2.5% over Q3 2019.

Notably, the Americas grew about 6%, but that growth was offset by softness in EMEA and Asia Pacific.

Also, strength in upper extremities was partially offset by slower growth in sports and trauma due to lower social activities as a result of COVID.

Dental, spine and CMFT increased 6.5% due to strong execution, new products including robotics and market recovery.

And finally, our other category was down 11.1%.

I'll now walk through our third quarter P&L and liquidity and then share more color and insights that may provide shaping of our expectations for the remainder of year.

So moving on to the P&L.

As we've previously discussed, we moved quickly and have taken a disciplined, proactive approach to mitigate the earnings impact of the pandemic while also enhancing ZB's liquidity profile.

Results in the third quarter were better than we expected at the time of our second quarter call as we saw margins, earnings and cash flow sequentially improve versus the second quarter, consistent with our revenue improvement.

In the third quarter, we reported GAAP diluted earnings per share of $1.16 and adjusted earnings per share of $1.81.

GAAP earnings per share versus the prior year were lower primarily due to a sizable onetime Swiss tax credit that the company realized in 2019.

For additional details on GAAP results, please refer to today's press release and our 10-Q, which will be filed later today.

On an adjusted basis versus 2019, earnings grew in line with revenue growth as lower SG&A spending offset lower gross margins and a higher share count.

Adjusted gross margin was 70.6% for the third quarter and as expected, results were sequentially better than Q2 but lower than 2019.

Versus the prior year, pressure from prior period deferred costs and lower volumes due to COVID were partially offset by a favorable regional mix tailwind as we saw stronger recovery in the U.S. and developed markets in the quarter.

Adjusted operating expenses increased sequentially over Q2 driven by commissions related to higher revenues and increased commercial investments.

Expenses were lower than prior year due to the early impact of our restructuring programs and due to moderated investment levels as we continue to navigate pandemic uncertainty.

Overall, adjusted operating margins for the quarter was 26.3%, better than expected and driven by the favorable geographic mix and gross margin and a slower ramp on spending.

Moving beyond operating margin.

Net interest expense and adjusted other income totaled $52 million and the adjusted tax rate at 16.6% was slightly better than expected due to some modest discrete benefits in the quarter.

Turning to cash and liquidity.

We returned to positive free cash flow earlier than expected, totaling $287 million.

This is lower than the prior year as we used a portion of our better-than-expected operating cash performance to reduce our AR securitization program.

We ended Q3 with cash and cash equivalents of just under $1 billion, and our $2.5 billion of credit facilities remain untapped.

Relative to the deals that Bryan referenced earlier, we expect the cash call to be approximately $80 million in the second half of this year, and that will be funded through existing cash balances.

Turning to Q4.

Our consolidated revenue outlook for the remainder of the year has a heightened level of uncertainty, given recent COVID surges that we have seen in a number of markets.

And due to that backdrop, we will not be providing financial guidance for the fourth quarter.

So far, through October, regional trends have been similar to what we saw for the full third quarter except for EMEA.

That is, Asia Pacific and the Americas continue to grow in line with full Q3 growth rates albeit with more pressure or risk in the U.S. due to increased virus surges.

On the other hand, EMEA has worsened due to surges in the virus as declines have accelerated in October with some governments in the region taking new policy actions to limit elective procedures.

We expect consolidated Q4 revenue performance to continue to be fluid based on the major variables impacting the recovery, which include the rate of pull-through on the backlog, patient anxiety and elective procedure capacity constraints due to COVID surges and/or resulting policy actions.

While market dynamics remain uncertain, what I do know is that our commercial and supply execution combined with our innovative new product introductions will continue to drive strong performance relative to the market.

Looking ahead on gross margin, we expect sequential improvement but continued year-over-year pressure due to the same drivers we saw in Q3.

Adjusted operating expenses are expected to be sequentially higher in Q4 but down versus prior year as we also saw in Q3.

Interest expense will be stable to Q3, and we expect that our tax rate will be slightly higher than Q3 2020.

Lastly, fully diluted shares outstanding are expected to step up in Q4 due to the exercise of options as a result of the acceleration of stock price we saw in the third quarter.

Longer term, we remain committed to our target of at least 30% adjusted operating margins by the end of 2023.

Our near-term initiatives relative to reorganization, consolidation and zero-based budgeting, as examples, are complete or near completion.

And we're steadily advancing our longer-term structural initiatives around supply and G&A efficiency.

To summarize, our underlying business performance is strong.

Our execution is on point and ZB's transformation is delivering positive proof points even in the midst of a challenging pandemic.

We continue to believe that ZB is well positioned to address near-term challenges and to accelerate growth over the long term.

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

Thanks, Suky.

(Operator Instructions) With that, operator, may we have the first question, please?

(Operator Instructions) Our question comes from the line of Ryan Zimmerman with BTIG.

Great.

So Bryan, I want to start on the backlog and the commentary about the September exit rate and then I have one on ROSA.

If you'd call back to the last quarter, you talked about $700 million backlog for ZB.

And I'm just wondering if you could comment a little bit around that backlog in terms of what you feel like you achieved against that in the third quarter and how we should think about that maybe refilling back up in light of some of the dynamics with COVID in the fourth quarter here that you're talking about.

Yes.

I appreciate the question.

So what I would say is that the -- we saw in Q3 because we actually saw a positive growth relatively in line, if not a little above, say, for instance, in hips in like a typical market growth.

That would indicate that we did not build further backlog or deferred patients in a way that I calculated in Q3.

That said, we still have hundreds of millions of dollars of deferred patients that will eventually come back in the funnel.

So I still feel very bullish about the fact that we have these deferred patients.

There are patients, as we know, for most of our business that have a disease that progresses.

It does not get better by itself.

And as a result of that, those patients typically come back in the fall.

So I wouldn't say that we built more backlog in Q3, but we certainly still have quite a bit of backlog to go through.

So that's my view of where we are from a backlog standpoint.

And again, I think eventually, when we get to the point where we have a vaccine that people have confidence in or treatment that people have confidence in, we're going to have that backlog of patients begin to come through in concert with new patients, and that should be a really nice headwind for our business.

I'm looking forward to that day, for sure.

Understood.

And then just a second question, ROSA, really nice number there on the 200 -- exceeding the 200 placements on ROSA.

Can you just talk a little bit about the visibility on the order book and your expectations for '21?

Is it unreasonable to believe that you can accelerate beyond that 200 to 300 placement rate you're expecting this year?

Just a clarification just to make sure, that 200 to 300 is what we've done from a placement standpoint since the launch.

That wasn't 200 to 300 that we would expect just in 2020, but it would be since launch, which is -- it's called about a little over 1.5 years now since full launch of the ROSA system.

But I'll tell you that, hey, I'm pretty enthusiastic as is the team around the ROSA placements that we saw in Q3.

It was the best quarter that we've had relative to the number of installations we did in a single quarter.

And I can tell you that, that momentum is continuing into Q4.

And even though I think it will be slightly better, it is still slightly better than what we did in Q3.

That's what our expectation will be in Q4.

And so that pipeline of what I'm just going to call future customers is robust as it's ever been with our product.

And as I mentioned before in the prepared remarks, I really do believe the underpenetration of robotics is at such a point that this is a tailwind for the organization for a long time to come.

And it's a very exciting tailwind, no question about it, because not only is it for us, it's for the patient.

It really is providing a level of accuracy in the operating room that you can see when you're in the operating room with the surgeon.

Forget studies, we've got those coming.

But when the surgeon uses the robotic system in the operating room, you can see the lights go up -- I mean go on.

They clearly understand that they have an opportunity to get better cuts, more accurate cuts but also, and very importantly, feedback right away in the operating room around tissue balancing.

So it's really neat to see, actually, to have an opportunity to go in and see that kind of light bulb go off in the surgeon's mind when they're using it is pretty amazing.

Relative to 2021, I don't want to give specifics there.

But what I would tell you is that I would be disappointed if the level of placements that we saw in Q3 and Q4, which were better than the first half of 2020, I would be disappointed that, that level of placement didn't continue into 2021, right?

And that would indicate, in fact, that it does happen that 2021 should have more placements overall than 2020 did.

So I think real positive momentum, great feedback from our customers and a really strong pipeline of future customers that are out there right now.

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

Can you hear me okay?

Yes.

First quick question.

I appreciate, Bryan, your comments on deals and divestitures and the 2 deals you announced.

So a quick question there is, one, are those deals that could start to have an impact from a revenue perspective more in 2022?

Just kind of how should we be thinking about those launches?

And then on the divestiture side, kind of how would you characterize how likely divestitures might be in 2021?

Okay.

So what I would tell you is that the deals that we just talked about obviously are not super accretive relative to acquired revenue growth, just not much there.

I think about it more as product launches that we have, facilitating product launches in these very attractive spaces, ASC.

It would also be in sports, which is kind of a combination ASC impact and then also in the data and informatics portion of things.

But what I would absolutely expect revenue growth to be driven in 2021.

I wouldn't say 2022.

I definitely believe that the portfolio being provided by these acquisitions will immediately give us traction to be able to go out and hunt in the ASC marketplace, in the sports marketplace and continue in 2021 to provide more unique offerings inside of our new category when we talked about that new ecosystem.

So it's all 3 of the things that we just talked about in the prepared remarks, will provide revenue growth, just not acquired revenue growth in 2021 and well beyond, by the way.

As far as divestitures go, clearly, I wouldn't talk about a time frame.

I don't want to give anybody any expectation here.

But the fact is, is when we think about active portfolio management, that is one of the vectors.

One of the obvious ones is M&A.

And for us, M&A that we're going to focus on will always be to build scale and/or innovation that matters in markets that are accretive to our ZB weighted average market growth.

And very importantly, where we think we have a right to win and we see a clear path to leadership in those categories that would potentially be on the docket for divestiture, it would be in those areas that are not as financially attractive to the business, are not as core to our strategy and where we don't really see a clear pathway to leadership.

Those would be the things that we would look at when we think about shedding the business.

But I just don't want to give you a specific time frame because I don't want to set that expectation.

But just know that, that is part of the equation as we think about active portfolio management with the intent over time to move more of our revenue in higher growth markets.

That's the intent.

If we're going to be a top quartile performer in total shareholder return, we have to have more of our revenue in higher-growth markets.

I'm just talking about mid-single digits to upper single-digit growth markets.

And that's the intent of the active portfolio management process.

Our next question comes from Josh Jennings with Cowen.

One on ROSA and then just one on your upper extremities business.

Just on ROSA, just wondering, just trying to parse out just the implant performance in knees in the quarter.

Was there a headwind from third quarter '19 ROSA upfront purchase revenues, again, versus the replacement dynamic that's been happening over the course of the pandemic?

And just can you help us as we think about modeling these ROSA replacements out into '21 and just all robotic solutions out there in the orthopedic marketplace?

I mean do you think the percentage of systems that are placed that will drive an upfront capital purchase in that upfront revenue, is that a 50% bar?

Is it 25%?

Anything you can help us just in terms of modeling out that system revenue as we're thinking about 2021 and beyond would be helpful.

Okay.

Maybe I'll hit that piece first.

So what I would tell you is it's -- we're definitely seeing -- it's not dramatic.

But we're already seeing a slight shift back towards customers having a desire to acquire, either lease or acquire the robotic systems.

It almost seems like it's already starting, although not nearly at the pace that it was, let's say, last year.

And so I would guess, it's purely a guess, but I would, again, based on that, assume that as we move into 2021, you might see more of a shift in that direction.

But I just don't have a good sense for where it's going to land.

I would tell you that right now, it's definitely the larger portion of installations are these placement programs, which is truly what we would prefer.

I really like having that longer-term contract and relationship with the customer that does require a certain volume commitment to the company and just build that relationship in a more stable way.

But I would assume that as our customers get more confidence in the market that they may want to shift back to where they were before, which is maybe acquiring more.

I just don't want to kind of give you a sense for what the percentage would be, but it is moving slightly back in that direction.

Relative to Q3, interestingly enough, even though there were some sales of ROSA in Q3, on a relative basis, it was actually a headwind for us.

If I think about U.S. knees, particularly, I talked about 3% growth in U.S. knees.

If I eliminated ROSA as a part of that and just looked at core knees, base knees, we actually grew closer to 4%, even a little better than 4% in base knees in the U.S. So it's almost 100 bps of -- actually a little more than 100 bps of headwind from ROSA in the quarter.

So hopefully, that answers the question.

That's very helpful.

And then just I heard Suky call out the strength in upper extremities in the quarter.

Are you seeing any disruption from the Stryker Wright combination maybe hard to parse out in the middle of pandemic?

But I also just want to get your thoughts on the opportunity with the integration next year from your second-biggest competitor and what that opportunity represents in your mind for the upper extremities business.

Yes, absolutely.

I mean the fact is when we look at the performance in Wright, they had a pretty good quarter.

So clearly, at least based on that performance, one would indicate that it's not disruptive yet.

The -- always hoping for things to happen.

I would be very -- I'd be very happy if there was disruption when you try to bring those 2 organizations together finally.

The fact is most of the time in our industry when you're bringing 2 organizations together, there is dyssynergy risk, there just is.

That's why I like some of the small deals that we just did.

It really eliminates that dyssynergy risk because they're really more product launches versus bringing 2 sales organizations together.

So I would expect at some point, just given historical views of acquisitions in our space, that you are going to see some level of dyssynergy.

And the hope is that we have an opportunity to take advantage of that.

That said, and the hope is in the strategy, we have a very clear strategy in our extremities business, and we're executing against that.

And I feel very confident in the commercial infrastructure we're putting together, the product pipeline that we have and the traction that we're getting in the marketplace right now with or without disruption from our competitors.

Our next question comes from Vijay Kumar with Evercore ISI.

Congrats on a good print here.

Bryan, maybe a big picture question now.

If I look at 2021 Street's modeling earnings about 2019, I'm just curious.

A couple of your peers have called out gross margin manufacturing variance, et cetera.

Is there anything we need to be aware of from a margin perspective and Street perhaps?

Are you guys comfortable with the Street EPS numbers?

Maybe what I'll do for that one is just to pass it over to Suky to provide a little more color there.

I know you had some of that in your prepared remarks, Suky, but maybe you can comment on that one.

Yes.

Sure.

So we're not obviously giving guidance on 2021, and I'm not going to speak to Street numbers.

What I would say is next year's profile obviously is going to be driven by revenue, and a large component of that is going to depend on what happens relative to COVID-19.

From a top line perspective, if we saw a situation where the recent surges being experienced begin to abate or moderate and then stabilize, there could be a pathway to seeing a '21 revenue profile that's in line with the 2019 revenues.

And if we got into next year and saw that stabilization moderation, but also on top of that saw vaccine or credible treatment in tandem with a vaccine, you could potentially see volumes or revenues ahead of '19 met.

So that's kind of how we're thinking about it from a broad strokes perspective, but there's a lot of runway between here and there relative to COVID and how that's going to play out.

So we're going to pause on giving too much additional color beyond that.

From a margin perspective, it's really going to fall in line with overall revenue and volumes, right, as you would expect.

Volumes and revenues better, so will margins.

That's intuitive.

I would say, as we think about our margins going into next year, there are a number of headwinds and tailwinds that we have taken into consideration using sort of second half this year as a starting point or as a run rate.

First, on gross margins, we've actually had a pretty good quarter in Q3.

We expect to sequentially step up in gross margin into Q4 based on overall volumes and seasonality that we typically see in the fourth quarter.

But as we move into next year and as overall regional mix starts to stabilize with the stabilization of COVID, we're seeing a mix tailwind right now that may abate into next year.

So that could be a slight headwind as we go into next year.

And then we have had some pressure on the overall COGS this year because of lower volumes, because of prior year deferred costs.

Those are going to continue into next year.

So there are a couple of headwinds in gross margin that we're closely watching.

Now having said that, we're also very aggressive on our cost down opportunities and cost of goods.

So that could be a tailwind to next year.

But we've always talked about coming out of 2020 as part of our broader restructuring program, a 30% operating margin aspiration that you should expect to start to see a stabilization from 2020 as you move out to '23 when it comes to gross margin.

And then within operating margin, I'll tell you we're going to continue to ramp up investment.

I think what you see over the last 2 quarters is our performance relative to market has been strong.

One of the reasons behind that is because we've been making really smart investments and our commercial teams have been optimizing those investments and getting quick ROI on those.

And so we're going to continue to ramp up that spending because we've got a lot of great products.

We've got great execution in very strong end markets.

And so we're going to see a step-up in investment as we move into 2021.

Having said all that, we're consistent with where we were before, that if we saw revenues at '19 levels, we would expect we'd be disappointed if operating margin within 2021 didn't reach those levels.

Maybe not for the full year but within 2021, we would expect to get to those margin levels.

So hopefully, that gives you a little bit more perspective on how we're thinking about '21.

But again, a lot more to play out yet with COVID.

That's extremely helpful, Suky.

And Bryan, one for you on -- thanks for all the color on Persona Revision.

I guess when you look at next year, as you guys gain traction on the Revision side, should those, I guess, gains accelerate as you gain a beachhead into the primary side of EMEA as well?

I'm sorry.

Could you repeat that?

I missed part of -- the first part of your question.

You went out a little bit for me.

Could you repeat that?

So on that, the Persona Revision knee side, I think the commentary you made was that should allow you guys to go after primary implant side as well.

So when you think of like $40 million of net gains on the Revision side, should we perhaps be looking at accelerating share gains for next year as you gain share into -- on the primary side?

Yes.

I'd say it's -- that's the most exciting thing for me on Persona Revision.

It probably was a little lost on me, to tell you the truth, in the beginning because I assumed a better connection between revision sets and primary.

But what we're finding is that a good portion of that $40 million or so of competitive conversions are competitive conversions where we have the primary business already, we did not have the Revision system.

But a lot of them are the other way around, where we didn't have the primary or the revision.

And so when we pick up that Revision business, it absolutely, as I said before, gives us a right to hunt for the primary business.

And it's in order of magnitude, larger than the Revision business.

So if you just look at the market differential, let's call Revision somewhere in the neighborhood of 10% to 15% of the overall knee market.

The rest of it is really primary uni that are out there.

And that -- again, once we get the Revision business, we then can go after that primary or the uni that the surgeon is doing.

And it doesn't mean you're going to naturally get it or automatically get it but you, again, have a right to go after it.

And you build the trust and you build the relationship with the surgeon, and it gives you that chance.

So I absolutely expect 2 things in 2021: continued competitive conversions with primary, with revision but also that opportunity to pull in the primary business as well.

And it will clearly be one of the catalysts that we use to continue to drive towards above-market growth in knees.

Just as we've been saying, it will absolutely be one of the variables that will drive us in that direction in 2021.

And our next question comes from Raj Denhoy with Jefferies.

A couple of questions, if I could.

So I'm just trying to put a finer point on your comments around the fourth quarter.

So it sounds like you're suggesting that Asia Pacific and the Americas perhaps in line with the third quarter.

But given that EMEA is worsening, I guess we should assume that the growth rate in the fourth quarter will be below what you posted during the third quarter.

Is that a fair way to think about that?

Yes.

So maybe, Suky, I'll start.

If you want to provide any more color, feel free to do so.

I would say, generally, what you're saying is accurate.

I would say that Asia Pacific, which is clearly being less impacted by surges in the virus, seem to be relatively consistent.

Again, it's early in the quarter, but based on what we've seen so far, pretty consistent with the growth rates that we saw in Q3, overall Q3.

The Americas, even though it's a positive growth, it has slightly decelerated versus Q3.

But the good news is even with the surges that we're seeing in the U.S., we're still seeing positive growth.

And it's close relative to what we saw in Q3.

Again, it's early and the risk feels a little more tenuous right now because the surges are so much more prominent than they were in Q3.

But the fact is that U.S. is hanging in there and still has positive growth.

But in EMEA, to your point, we are seeing more pressure.

The policy decisions and the reaction to the virus surge is more acute in Europe, Middle East and Africa.

No question about it.

And I would expect Q4 to be slower growth.

And it was already negative in Q3 than Q3 was.

And so we're really watching this everywhere, obviously.

But right now, Europe, Middle East and Africa is a key area of focus for us to understand what's happening in that region and then importantly, inside of that storm, if you will, what are we going to do to make sure that we stay ahead of the competition while it's occurring.

Okay.

So maybe just...

Suky, do you have anything else you want to add?

No.

I think you summarized it really well, Bryan.

All right.

Thanks.

And maybe my second question is to get somewhat related.

I think Suky made a comment that, that demand in some areas is still at 70% to 90% of normal.

And I guess I'm curious how to think about that.

Is that a kind of broad statement that you're still more than 10% below what you would consider normal demand and that it's going to take something like a vaccine or better treatments ultimately to get that to 100% and beyond?

Well, let me clarify what he's saying there is -- what he's saying is that -- so take the U.S., for instance.

If you look at specific state or a county inside the U.S. that is being very hard hit by surges, what he was referencing is that even in those very hard-hit areas, the county or the state, you're still seeing 70% to 90% of procedure volumes that you would typically see, say, versus 2019.

So that doesn't necessarily mean that broad-based, we're seeing 70%, 90% of demand.

It just would say that in that hard-hit area, you're still seeing 70% to 90% of typical procedure volume.

So that was what he was referencing.

Yes.

I think -- Raj, I think the extrapolation from there is even in the very acute second surges, we're not seeing anything that resembles what we saw in April and May, right?

So clearly, the end markets, the hospital systems with decisions, more deference being provided to them, they're better prepared to deal with COVID.

They have better protocols and they triage their patients.

And they've got incentives to get some elective procedures through.

So that's really the key point of that statement of 70% to 90%.

We'll take our next question from Matt Miksic with Crédit Suisse.

I have one on S.E.T.

and one on -- just a follow-up on Raj's question there on trends.

So on sports medicine, extremities, trauma, you provide a global reporting line here.

It's 20% or so of your business.

I was wondering if you could maybe expand a little bit on how the major moving parts of that business are performing and maybe proportions or geographic color would be helpful.

And then I actually have one quick follow-up.

Okay.

We don't really provide a breakdown beyond the S.E.T.

overall category.

But what I would tell you is that the U.S., and I think that Suky, you referenced this in your prepared remarks.

Just I think that the overall S.E.T.

category, the U.S. was definitely the strongest performer in the world.

I think we had somewhere in the neighborhood of 6% in U.S. S.E.T.

performance from a growth standpoint.

So that would indicate that we clearly had lower growth in other parts of the world, which isn't surprising.

When you think about our S.E.T.

category, say, for instance, in Asia Pacific, a bigger part of that category would be trauma in that region for several reasons, just given the dominance or the significant portion of revenue in Asia Pacific that China has.

And even though we're seeing less surges of the virus in that part of the world, we still are seeing less activity.

And that typically would drive lower volumes and -- or lower revenue growth in sports.

It would drive lower revenue growth in trauma.

So just when people aren't moving as much and they're not doing as much, we typically see those 2 businesses inside of S.E.T.

get hurt.

And I would tell you that as we talked a lot about, we've had pretty significant focus in extremities.

Obviously, upper extremities is one of the key areas of focus for us.

And I would just say our growth rate there is promising.

And that's probably all the detail I'll provide below S.E.T.

But overall, if I look at the category, the U.S. region, the U.S. or the Americas was definitely the strongest growth region.

And then just on -- Suky, your comments just now on trends and what we could expect and not expect potentially around the surge.

Is there anything -- there was a pretty tight period, I guess, this summer in Arizona and Texas when there were some very narrowly focused constraints like county and other.

And I'm just wondering if you could talk a little bit about what you saw there, how quickly it bounced back and sort of what we might learn from that as it pertains to maybe the next few months in some other areas.

Yes.

I think we actually commented on that on our second quarter call and some of those very hard-hit counties within the States that you mentioned.

We're operating somewhere in that 80% to 90% range.

So we've seen a very consistent pattern now for a few months where we've seen heightened surges.

So I think that's, again, another positive inflection that we're not going to return back to those periods of April and May even with acute surges, at least based on what we're seeing today.

The time to abate, it really -- it's variable, right?

There is no broad statement.

It depends on the specific market, the specific submarket that you're talking about, the territory and the number of surges and how quickly -- how big that population is and how quickly that -- those surge rates come back down.

So it's tough to say, but in some of those hardest hits where we were at 80 to 90, we've seen a path in some of those where they've gotten back to normal or perhaps a little bit above normal within a few months.

But again, it's really variable from market to market.

And that concludes today's question-and-answer session.

I'd like to turn it back to Keri Mattox for additional or closing remarks.

Thanks so much.

And thanks, everyone, for joining us.

I know we'll be in touch today.

If you have questions, please don't hesitate to reach out to the IR team, and we look forward to continuing the conversation.

All right.

Great.

Thanks, everyone.

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

You may now disconnect.