Zimmer Biomet - Earnings Call - Q1 2020

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet First Quarter 2020 earnings conference call. If anyone needs assistance at any time during the conference, please press the star followed by the zero. As a reminder, this conference is being recorded today, May 11th, 2020. Following today's presentation, there will be a question-and-answer session. At this time, all participants are in a listen-only mode. If you have a question, please press the star followed by the one on your push-button phone. I would now like to turn the conference over to Keri Mattox, Senior Vice President, Investor Relations and Chief Communications Officer. Please go ahead.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thank you, Operator, and good morning, everyone. I hope you are all well and safe. Welcome to Zimmer Biomet's First 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 we recently made slight changes to our revenue reporting format, as discussed on our Fourth Quarter call. These changes are designed to further align with the company's recent reorganization and are used in our First Quarter results. Reconciliations are available on our website. Additionally, our comments during this call will include forward-looking statements. Actual results may vary 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 FTC 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?

Bryan Hanson (President and CEO)

Thanks, Keri. I think everybody knows that we're in different locations right now, so I'll just apologize upfront for any of the awkward handoffs that we have between each other for this earnings call and any bad cell phone connection and/or dogs barking in the background. I'm sure everybody's used to that by now. I just also want to say before I get started that I certainly hope that you and your families are healthy and safe and trying to get used to this unusual environment that we're working in and living in right now. I can tell you that I've been home more consecutive days with my family than I have, I'm pretty sure, in the last 20 years. I know for sure that they cannot wait for this to be over because they want me to get out of the house.

Again, hopefully you're managing through this as best as possible. It certainly gives us an opportunity to learn things about ourselves that we did not know before and our families. Given the fact that it is so unprecedented when we think about COVID-19 and really just thinking through it, there really is no proxy that you can look back on that would give you the pathway forward as a result of looking at that historic view. There's nothing that compares to this. I mean, when have we ever seen a global pandemic shut basically the world down? As a result of the significance of it, obviously we want to make sure that we spend a lot of time talking about it today on the earnings call. I'll spend time walking through it. Suky will spend time giving his view of it.

We'll let you know how it's impacting ZB, what we can give you relative to what we think will happen in the future from here. The fact is there's going to be a lot of information moving back and forth, particularly in the Q&A, I'm sure. I just want to make sure that you walk away from the call with at least these five key points because at the end of the day, I truly do believe these will be the most significant and meaningful points that we have throughout the call. The first one is really that Zimmer Biomet, myself included, have been very focused on ensuring that our number one priority through all of this has been the safety of our team members.

I'll talk more about this in a minute, but I'm very happy with the momentum that we've picked up here very early to make sure that our team members are safe and the amount of energy that we've put behind this. The second thing is that we have a high level of confidence that we have adequate liquidity and financial flexibility to manage through this storm. I would tell you that I'm very proud of the work that Suky and his team did to make sure that we backstopped the organization aggressively right out of the gate. We do have a high level of confidence in our liquidity and financial flexibility as a result. Number three, we also have a very high level of confidence in the recovery. I'm very sure that a majority of these patients will come back into the funnel.

The biggest variable right now is just the timing of that. Just know that we have a high level of confidence the recovery will happen and many, many of the patients that are being deferred now will come back in the funnel. The fourth thing is that we will continue as an organization to invest in our key strategic areas in research and development and commercial projects. This will not deter us from continuing to double down in those key areas. I will talk more about that in a minute. It does not mean that we will not save money because we have aggressively, but we will be committed to spending money in these key strategic areas.

The fifth thing is that we are, just given the work we have done over the last two years to reshape the company, better prepared right now to deal with this challenge than we would have if it was two years ago. As a matter of fact, we feel confident that given that reshaping of the company and the position we are in, we can not only come through COVID-19, we will come through in a better position as a result of the work that we have done. Really, those are the five things. Safety is our number one priority. We feel confident in the liquidity and financial flexibility of the company. We have confidence in the recovery. We will continue to invest in key strategic areas.

We are very confident we will come out the other end of COVID-19 in a better position than when we started. Let's start with safety. I'll just give you an overview of why I feel so confident here. Interestingly enough, last year, as a part of a broader risk mitigation kind of a planning process that we were going through, a crisis management planning process, we actually did put together a comprehensive global pandemic plan. I know it sounds inconceivable that we did this literally months before the pandemic occurred, but we did have it in place. As a result of that, to the extent possible, we were as ready for COVID-19 as you can be. We mobilized that plan and the multiple work streams right away, very early on in January, actually.

That has been, from my perspective, a significant game changer for us. I also think it's our ongoing transformation of ZB that has really been key in this whole process. We already had the means to tackle this because we had a stronger team. We've been able to put a stronger team together over the reshaping over the last two years. We have a very active and engaged business right now. We have a very supportive culture. All those things are paramount to being able to get through a challenge like this. We moved to put new policies in place even before the COVID-19 reached pandemic status. Very early on in the process, we began to shift immediately to work-from-home policies, no travel policies. We did not allow visitors in our distribution sites or our manufacturing facilities.

We did not want visitors entering the sites where our essential workers were. That just does not make any sense, right? We want to keep them as isolated as possible. We did that right out of the gate. We had no large meetings. We had broader social distancing practices in those sites that we were continuing to work. I really do think that we moved aggressively and took a very proactive stance because we had the roadmap already laid out through that planning process. I also want to just thank all of our team members and especially our manufacturing, distribution, and commercial teams who have gone just truly above and beyond during this challenging time. We still have team members who have been out in the hospitals every day.

They're still there, making sure that the healthcare professionals that we have that are out there doing procedures still have what they need to be successful in those surgeries. It is just impressive, really, truly on the front line to make sure that we move patient care forward. Our team has also adhered to new safety protocols and has made changes to our sites and production lines. Where possible, obviously making sure that we are doing the work that we do in a safe and effective manner given the guidelines that we have right now for COVID-19. They have also managed temporary facility shutdowns to basically proactively modulate production where we need. All the while, they have done all of this without disrupting our overall supply chain.

Needless to say, I'm really proud of how the ZB team has taken safety so seriously out of the gate and has worked to achieve goals to keep not just our team members safe, but also our customers, our partners, and our patients safe as well. Okay, moving on to number two and our confidence around the adequate liquidity for the business and financial flexibility. I would tell you just right out of the gate, as we saw the challenges associated and disruption associated with COVID-19, we took very aggressive measures to contain costs and also, obviously, to support the liquidity of the company. One of the first things that we focused on was making sure that we refinanced our $1.5 billion of debt that came due on April 1 of this year. Then Suky and team went to renegotiating our $1.5 billion revolver.

Shortly after that, secured an additional $1 billion credit facility as an additional backstop. Again, just kudos to Suky and his team to make sure they got right out ahead of this and made sure that we had that financial flexibility and liquidity strength in the organization. Additionally, we've continued to execute on our previously announced restructuring program. As you may remember, this program was focused on streamlining our structure and just driving efficiency throughout the organization with the ultimate intent to allow for margin expansion over time, which we committed to, while also allowing for investment for growth. Really, the only way that we could have both those things happen in tandem was to be able to put this restructuring plan in place.

Actually, having the restructuring plan and the working group in place to move it forward actually helped us to quickly pivot and aggressively cut costs as a result of the COVID-19 challenges using the very work streams and really the mindset that we had in place for this program. We have also modulated the schedules and the output across our manufacturing facilities, keeping an eye on cash consumption with inventory while also positioning the business for business continuity. We need to make sure that we have the inventory that is needed today. Also, we have the inventory for the recovery when it comes. Finally, we implemented temporary base pay reductions for all of our salaried team members of about 20%. We did 25% cuts for executive teams and then up to 100% reductions to the annual retainer of our board of directors.

As you probably have heard, I've taken personally a 100% reduction in my pay during this period. Moving on to number three, our confidence in the recovery. What I'll tell you just first and foremost, the momentum that we had coming out of 2019 absolutely carried into the early part of the first quarter, obviously pre-COVID-19. We were performing at or above our expectations pretty much across all businesses and regions. There is no doubt that the pandemic has absolutely changed the landscape for everyone. For Zimmer Biomet specifically, it has significantly impacted our business, probably more than most, just given our dependence on elective procedures. We have 80+% of our global revenue that comes from elective procedures. That's the bad news. The good news is, as I said, our business was strong before the pandemic.

The good news is we do believe that these patients will, in fact, come back into the funnel. The fact is you can certainly delay these procedures. There's no question about that. The critical and really often life-changing nature of a knee procedure, a hip procedure, back surgery, or other bone and joint procedures makes us confident that these patients will ultimately return to the healthcare system. The fact is we've seen that. It's not an exact proxy, but we have seen when natural disasters occur or other market disruptions occur and patients get deferred, they do, in fact, come back. The large majority of those do come back into the funnel. This is obviously significantly different than what we've seen in the past, just given the volume of deferred procedures.

There are other variables that make it harder to determine when they're going to come back. The fact is even OR capacity will have to be something that we consider in the short term with bringing these patients back, just given the number of patients. We're going to have to think about the access to PPE and/or testing kits. We're also going to have to think about the psychological viewpoint of a patient on when they're ready to come back. I can tell you right now, as we've done our own analysis and we've done extensive outreach to our customers, the one consistency is that everyone does believe the majority of these patients will come back. The question just becomes over when that's going to happen.

Based on our modeling right now and really our Q1 performance and our April performance, what we would say if we're trying to put some color to this is that clearly Q2 is going to be the most challenging quarter. April, as a month, will be the most difficult month. We truly do believe after April, we're going to see sequential improvement on a month-to-month basis and on a quarterly basis until we get back to normal. We definitely see April as the most challenging month and then sequential improvement from there. Okay, moving on to number four. As I said, we're going to continue to invest in a dedicated and disciplined way in key R&D and commercial projects. We're highly focused on the high-priority, high-growth areas of our business. We're making investments to continue to drive innovation in those areas.

The fact is, when we look at ROSA and/or any other robotics-related initiatives that we have, these are key priorities. Our investment, if anything, will accelerate right now and certainly the focus on these projects. We are going to continue to build out our dedicated specialty sales teams and other high-value commercial programs. These things will not stop during this time. In terms of supporting innovative commercial initiatives, we have launched recently the MyMobility LE, which is a change to MyMobility to make it a more limited edition, lower-cost version of MyMobility, but really built for rapid deployment to help customers and patients respond to the needs of the COVID environment right now. MyMobility LE and our exclusive partnership with Apple can be used by surgeons and care teams to actively, but importantly, virtually support and guide patients preparing for the procedure and recovering from the procedure at home.

This is an innovative and really alternative solution to continue delivering pre- and post-op care and reduce unnecessary in-office and hospital visits. It was perfect for this particular time. Providing all the while through this mechanism, MyMobility LE, providing real-time data on patients' progress so that surgeons know how that patient is doing. It offers education. It offers video-guided exercises for rehab programs to be able to do that at home, to not have to have that personal contact with rehabilitation. It provides direct video, picture, and text-based messaging right to the patient. Again, allowing that patient and surgeon connection to be there, but also allowing that to happen with the new social distancing policies that are in place.

Another great commercial initiative that was put into place was to make sure that when AAOS conference was canceled in March, that we immediately got to putting together a virtual kind of a virtual reality AAOS experience where healthcare partners can actually come into the booth, again, virtually. Through that virtual experience, they can learn about the products that we would have shown at AAOS. They can talk directly with our commercial teams through that virtual experience. They can even sign up for the trainings that would have been there or other trainings that we are doing online as well. I can tell you that out of the gate, this has been very well received by our surgeon partners. We have had over 7,500 site visits in the first two weeks alone.

We are going to continue to stay focused on investing in those areas that are important and strategic to the organization. We are going to make sure that we continue to bring innovations that matter right now during the pandemic. Finally, moving on to the fifth takeaway, we truly do believe that the work we have done over the past two years to reposition the company for success absolutely better positions us to be able to not just get through COVID-19, but to be able to emerge on the other side in a better position than when we started it. This is clearly a challenging time that will test, I think it is obvious, even the best teams and the most innovative companies.

What I know for sure is that over the past two years, we have made real progress in transforming our culture, evolving our business strategy, improving our financial performance. We have vastly improved our manufacturing supply and inventory management. Our base business is strong. We have a talented and dedicated global team that positions us very well for this challenge. We believe that this progress and truthfully our proactive stance and our financial stability also give us key competitive advantages right now during this challenging time that could open up new opportunities not just to drive innovation, but also grow our business and our share position in the near term. With that, I'm going to turn the call over to Suky to get into more financial details.

Suky Upadhyay (CFO)

Thank you, Bryan. Good morning, everyone. I hope that you and those close to you are healthy and remain safe. I'd like to start by saying that our underlying fundamentals remain strong. Recall that in February, we announced a strong close to 2019 with top-line results ahead of expectations, leveraged earnings, robust cash generation, and continued deleveraging of our balance sheet. While COVID-19 has had and will continue to have a significant unfavorable impact in the near term, we remain confident in our ability to navigate these challenges and to return to a positive trend over time. Let me turn to first-quarter revenues. Net sales were just under $1.8 billion, a reported decrease of 9.7% from the prior year, and an operational decrease of 8.9%, excluding the impact of foreign currency changes. Moving forward, unless otherwise noted, my commentary will be on a constant currency basis.

Prior to COVID-19 reaching global scale late in the first quarter, most of our businesses and markets were trending at or ahead of expectations. However, the deferral of elective procedures as a result of hospitals redeploying resources to COVID-19 had a meaningful negative impact on our first-quarter performance. Across Zimmer Biomet, this impact became most pronounced in mid to late March. Again, revenues for the first quarter were down 8.9% versus the prior year and down approximately 60% in the last two weeks of March. That trend extended into the first part of Q2, with April revenues down about 70% versus the prior year as we observed the impact of the pandemic intensify in some markets. I'll break down the overall revenue trends I just mentioned, starting with regional performance and then move to our businesses. Beginning with Asia-Pacific, the region decreased 9.5% in the quarter.

We began to see procedure deferrals in early February at varying levels across the region and at varying times during the quarter. Since it was one of our first markets to be impacted, I'll provide more color on China, which represents about 20%-25% of the region's revenue. Here, we observed the largest and earliest decline, with procedures down 75%-85% from early February to mid-March. This six to eight-week period represented the peak of deferrals. Since then, procedures in China have steadily increased, exiting the last weeks of the first quarter at about 40% down. We saw some positive trends in China in the later part of the quarter. In April, China continued to improve and is averaging procedures being down about 25% with steady weekly improvement.

While China experienced some deep declines, Japan, our largest market in Asia-Pacific, did not see a material impact from COVID-19 in the first quarter. However, there has been a modest decline in procedures since the country announced the state of emergency last month. In April, procedures and revenue in Japan are down about 15% and have been stable at that level. We remain cautiously optimistic that deferrals will not approach the levels of China as the Japanese government has not announced, nor have we observed or seen a widespread deferral of surgery in the four or so weeks since the state of emergency was put in place. Across all of Asia-Pacific, in April, the deferral of procedures led to revenue being down about 25% versus the prior year. Moving to EMEA, the region decreased 11.7% in the quarter.

Across EMEA, we saw some variability in the onset and timing of COVID-19, with two profiles emerging. One, countries impacted more severely, which represents more than half of the region, including countries like Italy, Spain, France, the U.K., and others, where we saw a significant reduction in procedures starting in mid-March and exiting the final weeks of the quarter down about 80% versus the prior year. Two, countries with a more moderate impact. This represents the remaining portion of the region and includes countries like Germany, Austria, Switzerland, among others. There, we saw reductions of about 50% in the final weeks of Q1. The level of impact in these markets continued into April, with both groups observing further declines. Overall, in April, we saw EMEA procedures or revenue down about 75% versus the prior year.

While we've seen some recent encouraging policy actions in many parts of EMEA, it's still too early to tell what level of impact this will have on revenue uptake in these markets. Lastly, the Americas decreased 7.7%. Here, the COVID-19 impact ramped up materially in mid-March with the U.S. shutdown and with federal and state governments' guidance to defer elective procedures. In the final two weeks of the first quarter, the region saw procedures or revenue decline about 70% versus the prior year. Within the U.S., states were broadly impacted at about the same level. Through the month of April, we continue to see a decline in procedures with deferral rates of about 75%-85% and revenue being down about 80% versus the prior year. Most recently, many states are taking policy steps to reopen elective procedures, with the vast majority expected to do so by mid-May.

It's too early to determine the ramp of procedures in those states, but this is an encouraging sign. Let's turn to our businesses for Q1. Our global knee business declined 8.3%. Prior to the impact of COVID-19, we saw strong performance in the category driven by improved operational execution and the continued positive launch of Persona Revision. ROSA contributed to sales early in the first quarter, but COVID-19 negatively impacted overall capital sales. Our hips business declined 9.7% in the first quarter. Underlying performance in hips prior to COVID-19 was solid, due largely to continued launch traction for Avenir and Complete. Sports, extremity, and trauma sales declined 5.8% in Q1. The first quarter decline was not as pronounced as in knee and hips, primarily due to the trauma division, which is less elective by nature.

However, we did experience a softer trauma market due to a generally mild winter and lower activity as a result of the global quarantine. Looking beyond Q1 for revenue, as you know, we withdrew our 2024 year guidance on April 6th. The impact of COVID-19 continues to be fluid, and there are multiple market dynamics and variables that we're unable to quantify at this time. Given the current environment, we will not be providing updated financial 2020 guidance. We do want to share information and insights into our business that might provide shaping of our revenue expectations for the remainder of the year. We expect to see a sequential deepening of procedural deferral rates in the second quarter relative to the first quarter. As I mentioned earlier, we observed a consolidated revenue decline of about 70% in April when compared to the prior year.

To recap, in April, by region, we saw declines of about 25% for Asia-Pacific, about 75% for EMEA, and about 80% for the Americas. Within April, we observed fluctuations by market throughout the month, with many remaining stable and some slightly improving their revenue ramp. As a result, we project May to be similar or slightly better than April, with an improving trend in June as countries and states reopen and begin to ramp up elective procedures. We currently anticipate that the sequential improvement will continue into Q3 and then again into Q4 as procedures return. The rate and level of improvement remains fluid. Also, we do not assume a significant recurrence related to COVID-19 later this year. While we are encouraged by the recent leading indicators, our revenue trend could vary materially from the profile I just provided.

Turning to our P&L and liquidity, we're taking a disciplined and proactive approach to mitigate the earnings impact of the pandemic and to enhance our liquidity profile. However, COVID-19 will continue to put pressure on our earnings and free cash flow profile through the year, driving significant deleveraging versus our prior expectations. In terms of our first quarter results, we reported GAAP diluted loss per share for the quarter of $2.46 compared to diluted earnings per share of $1.20 in the prior year period. Adjusted diluted earnings per share were $1.70 compared to $1.87 in the prior year. In addition to the operational drivers that I'll speak to as part of our adjusted results, GAAP earnings per share in the first quarter were negative and lower than the prior year due primarily to goodwill impairment charges related to operating segment changes and to lower future cash flows due to the pandemic.

In addition, GAAP results were impacted due to higher litigation expenses and restructuring charges related to the restructuring program we announced earlier this year. For additional commentary on GAAP results, please refer to our first quarter 10Q to be filed later today. Turning to our adjusted results for the quarter, earnings per share were lower than the prior year, driven by decreased revenue. Adjusted gross margin was 72.7%, or 60 basis points higher than the prior year. While gross margin was higher in the first quarter, as previously guided, we expect pressure on overall gross margins in 2020. Gross margins were not significantly impacted in the first quarter by COVID-19, as the most pronounced impact was not felt until late in the quarter.

However, COVID-19 will put additional pressure on gross margins for the remainder of the year due to less favorable mix and lower fixed cost absorption as a result of decreased revenue. Adjusted operating expenses were $831 million, or a decline of 7.6% versus the prior year. Key drivers of the lower spending were reduced variable selling expenses related to lower revenues, the early impact of our restructuring program announced earlier this year, and additional cost reductions as a proactive measure to deal with the pandemic. We were able to flex quickly on COVID-19-related cost reductions in the first quarter by leveraging the restructuring program already in place. Incremental cost reductions we took in March to deal with the pandemic will have an even larger impact into Q2. Overall, adjusted operating margin for the quarter was 26.1%, 50 basis points lower than the prior year, again driven by lower revenues.

Moving beyond operating margin, interest expense of $51 million was down versus the prior year due to debt paydowns through 2019. Our adjusted tax rate was 15.7% in the quarter, lower than expected due to the impact of certain favorable discrete items that we do not expect to repeat through the rest of the year. Moving to cash and liquidity. Given the unprecedented challenges facing us, we have taken a number of steps to enhance our liquidity profile, including securing an additional credit facility backstop, amending covenants for greater operating flexibility, and moderating cash expenditures in the near term. We ended the first quarter with cash and marketable securities of about $2.4 billion, and we generated approximately $325 million in free cash flow in the quarter. Our ending cash position was higher than normal due to the execution of $1.5 billion of new senior notes in early March.

Those funds were used to term out a $1.5 billion senior note maturity early in the second quarter. To neutralize for this timing difference, underlying ending cash and marketable securities was about $900 million at the end of the first quarter. In April, we secured an additional $1 billion credit facility that will be in place through this calendar year. We have our existing $1.5 billion credit facility that was in place prior to COVID-19. Combining cash and our available credit facilities, we have over $3 billion of immediate liquidity available to us in the near term. The credit facilities will have a gross leverage covenant of 5.75x through 2020 instead of the 4.5x covenant in place prior to COVID-19. Also, both facilities remain untapped.

For more details about the new credit facility and the amendments to the existing credit facility, please refer to our Form 8-K filed on April 29th. The steps we have taken should position us well to deal with the near-term challenges and set us up for strength through the recovery. Related to liquidity, our capital allocation priorities remain consistent with what we outlined earlier this year. In the near term, we will focus our energy on navigating the challenges of the pandemic while strategically preparing to meet demand as end markets recover. In terms of our P&L for the remainder of 2020, we do want to provide some broad insights to help you think about the rest of the year. Moving forward, the majority of our remaining cost base is fixed in the near term.

As a result of deeper revenue erosion, we expect margins will be significantly impacted the next few quarters, down from Q1 and negative in the second quarter. If the revenue trajectory improves in Q3 and Q4, as we project, we anticipate that margins and earnings will also improve. Earnings improvement may lag revenue improvement as we plan to increase our investments to prepare for market recovery. Free cash flow should have a similar profile to earnings. We do want to remind you that the situation remains fluid, and these comments represent our best estimates at this time. To summarize, our underlying financial fundamentals remain strong, and we have taken prudent steps to enhance our financial flexibility and liquidity profile. I'm proud of how the ZB team has responded to the crisis.

We believe we're well positioned to address this challenge, lead in the recovery phase, and accelerate our growth profile over the long term. With that, I'll turn the call back over to Bryan.

Bryan Hanson (President and CEO)

Thanks, Suky. In closing, it's clear that the impact of COVID-19 is real and obviously material for Zimmer Biomet. We do think it's also clear that Zimmer Biomet is positioned to address the challenge. Again, if I can leave you with those same five things, I just want to make sure that we get these points across. As I think you've been able to hear, we absolutely feel confident in our ability to keep our team members safe and that will remain our number one priority as an organization. We have a very high level of confidence in our liquidity and financial flexibility to manage through this challenge. We have confidence in the recovery.

is just a question of the timing of that recovery, but a high level of confidence in the patient tunnel being there. We will continue to invest in key R&D and commercial projects. The fifth piece is that we truly do believe that given some of the changes we have put into place as an organization over the past two years, we will come through COVID-19 stronger than when we entered it. What we know is we have the absolute right team at Zimmer Biomet, and I want to thank each and every one of them for the amazing job they are doing right now. We are highly confident that we are positioned to deliver value to our customers, our patients, and importantly, to our shareholders. With that, I am going to turn the call back over to Keri to move into the Q&A portion of the call.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Bryan.

Before we start the Q&A session, a reminder to please limit yourself to a single question so that we can get through as many questions as possible during the call. With that, Operator, may we have the first question, please?

Operator (participant)

Thank you. Ladies and gentlemen, at this time, we will now begin the question and answer session. Once again, please limit yourself to one question if possible to allow everyone an opportunity to ask their question before we end at 9:30. One moment, please, for the first question. We'll take our first question from Chris Pasquale with Guggenheim.

Chris Pasquale (Director and Senior MedTech Analyst)

Thanks. Appreciate you taking the questions. Bryan, I want to start off with, obviously, not a surprise that the business was weak given everything that happened late in the quarter.

It does look like you lost a little bit of ground in hips and knees this quarter, which really reverses a recent trend of narrowing that gap versus peers. Can you talk a little bit about how you thought the quarter turned out from a competitive standpoint?

Bryan Hanson (President and CEO)

Yeah. Yes, Chris. I'll tell you, I don't know that I would agree with the statement, to be honest. I think that you've got such a confusing quarter given day-rate differences, given a mix of business in certain parts of the world that may or may not have been hit as hard as other parts of the world from the COVID-19 issue. I think it's really challenging to look at this quarter in particular, truthfully any quarter, but this quarter in particular, and try to draw too much conclusion about either share gain, share loss, that type of thing.

What I would say, though, is that we were feeling actually very good about our performance in both hips and knees before COVID-19. Again, pretty much in every region. I was actually looking forward to this earnings call before COVID-19 because I was pretty confident based on the trend that we were seeing, everyone was going to be very happy with the performance that we had. It is very difficult for me to know exactly what is going on with my competitors. I would say, almost across the board, the performance is a little better than I expected. Pretty much everybody in their earnings call did reference the fact that they were feeling confident about their business. Now, again, it is one quarter, but that would indicate that everybody felt that the momentum in Q1 was good, that ultimately bodes well for all of us.

I'd like to see us do well, and I'd like to see our competitors do well. That's actually a good thing. All boats rise in those situations. Again, very difficult to be able to draw a parallel to what our numbers look like versus somebody else for all the reasons that I mentioned. The general momentum and the feedback and the messaging that I'm hearing bodes well for the market, at least pre-COVID-19.

Chris Pasquale (Director and Senior MedTech Analyst)

That's helpful. Thank you. Could you just give us a little bit more color on when you think recon volumes return to year-over-year growth? Should people be thinking about pre-COVID expectations as still being a reasonable proxy for where recovery ends up? Or are you baking in some lingering impact from the economic fallout or from your patients perhaps not wanting to engage with the healthcare system? Thank you.

Bryan Hanson (President and CEO)

Absolutely, Chris.

It's tough because, as I said in my prepared remarks, I have a high level of confidence. Not just me, by the way. This isn't my assumption. This is us talking to literally thousands of surgeons around the world on a weekly basis to find out how they're feeling about it as well. There's clearly a lot of confidence around the large majority of patients coming back. There's a lot of question marks on when it's going to happen. As I referenced before, there's a lot more complexity to this particular situation just given the volume of patients that are being deferred. As I mentioned, OR capacity will absolutely be something that we're going to have to consider, particularly in certain parts of the world. This access to PPE and test kits will be a factor, there's no question.

Really just when the patient's going to be ready to come back in. To be able to put a specific time frame in place is challenging. What I would tell you is that my confidence level is high. They're going to come back and will not only get to pre-COVID revenue numbers, I believe we'll surpass that. We'll see a positive tailwind come when these patients come back in the funnel, and we'll see extraordinary growth at some point. I just can't give you the specific time. Generally speaking, as we think about it, as we provided in the script, we would say April is the most difficult, for sure, month that we're going to see. We're going to see sequential improvement from there until we get back to normal.

At some point, I would expect, again, extraordinary revenue numbers coming in as that patient funnel comes back into the mix.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Bryan. Lauren, can we go to the next question, please?

Operator (participant)

Our next question comes from Kyle Rose with Canaccord.

Kyle Rose (Managing Director)

Great. Thank you very much for taking the question. I just wanted to see if we could get some thoughts on the potential to move cases to the ASC in an effort to increase capacity over the near term from a recovery standpoint, I guess. What types of cases do you see moving there? When you're talking to your physicians, when they're thinking about putting or where it's appropriate, when they're thinking about scheduling cases again, what types of cases are being scheduled? Are there any different dynamics that you're seeing? Are things being prioritized, complex versus relatively simple procedures?

Just the overall timing of that return to volume, specifically in the Q2.

Bryan Hanson (President and CEO)

Yeah, yeah. I think, again, it's very difficult to say because there's so many moving pieces and parts. Just logical extension argument would suggest that patients may feel—I want to make sure that I say that—may feel more comfortable coming into an ASC setting versus an acute setting like a hospital. Again, we won't know that for a fact until we actually see the patients come back and get a true assessment of how much of those patients are coming back to the ASC versus the hospital. One could assume that there would be some desire to not go into an acute facility and feel more comfortable in an ASC setting. Again, we'll know that when it happens.

What I would say is that pretty much across the board, most of the procedures can be done in an ASC setting where our big volume comes in. What we're seeing out of the gate, to be honest, is a higher volume of recovery in revision cases versus your standard knee cases or hip cases. Clearly, those patients that have a desire to get in, given kind of air quotes, a more acute issue, seem to be coming in first. Again, it's very difficult to say. It's pretty fluid, as I've suggested. I would expect, generally speaking, that momentum towards ASC to continue. We'll see whether it accelerates or not. I would expect those patients that are more acute and have a higher level of desire to get back in to come into the funnel first.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Bryan.

Lauren, can we move on to the next question, please?

Operator (participant)

Our next question comes from Kayla Krum with SunTrust.

Kaila Krum (Managing Director and Equity Research)

Hi, guys. Thanks for taking our question. Can you just speak to any updates on the strategy with your large joint robotics system? You mentioned that you're still investing there, but I'm just curious how or if your commercial approach may have changed for 2020, just given the current backdrop.

Bryan Hanson (President and CEO)

Yeah. What I'll tell you is, first of all, thanks for the question. We remain very excited about ROSA and just overall robotics and the desire to bring robotics into orthopedics. There is nothing that we've seen in the short term that at all, in any way, shape, or form, changes that viewpoint. We truly do believe robotics is going to be the future of orthopedics.

What I would tell you is just honestly, as Suky mentioned, it had a very little impact for us anyway in Q1. That is not surprising. It is not even concerning. The fact is most of the sales of a robotics program or capital program in general comes towards the end of the quarter. I think, as everybody knows, a lot of our robotic sales have been in the U.S. When the U.S. got hit so hard in the back half of the quarter, it is not surprising that a lot of those opportunities that we had got deferred. The good news is that we are not seeing cancellation of any of the deals that we had in place. We are seeing deferment of those.

We are continuing to see very strong demand for robotics overall, still seeing people trying to get queued up for training, which is a very good leading indicator of where robotics is going to go. We feel good about it. We will absolutely flex with our customers. If customers are in challenging situations, remember, we have different ways, as we have said from the very beginning, of placing robotic systems. The real goal for us is to get them placed. We will work with our customers if they need flexibility in the way they acquire those systems and place those systems to make sure that we are flexing for their needs. The fact is that we have to remember that the major benefits associated with ROSA or robotics placement are not necessarily the capital sale upfront. It is nice to have, no question about it. It is really more around the annuity.

Quite frankly, when you do place these systems with the right type of contracting strategy, you also see kind of a byproduct effect of better pricing stability because you typically get longer-term contracts in place. If I just look at the annuity revenue associated with it, you get disposable revenue that is an uptick to the share of wallet you get in every procedure that is dedicated and needed for a ROSA procedure. You get the pull-through of competitive volume, which just kind of naturally occurs when you get a ROSA system in place. You also get the service agreement. For us, this idea of flexing to help our customers in a time of need is real. We're willing to do that. The strategy holds.

We've got to make sure that we're getting ROSA placements in, getting more robotics out so it can help the patients with better accuracy. It certainly helps the overall market growth as well.

Kaila Krum (Managing Director and Equity Research)

Thank you.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Bryan. Lauren, can we go to the next question, please?

Operator (participant)

Our next question comes from Joanne Wuensch with Citibank.

Joanne Wuensch (Managing Director)

Good morning. Thank you very much for taking my question. Could you please spend a minute on what it takes to roll out MyMobility and how you plan on or how you expect on seeing this in action as we get back to sort of a new normal? I'm going to sneak a second question in, which is, when you think about that new normal, when do you think procedures will be back to sort of a stable or relatively normal run rate?

This year, next year, or if you can get more granular than that, that would be great. Thank you.

Bryan Hanson (President and CEO)

Yeah. I do not have—I will just hit the second question first. I do not have specifics on the normal timeline as we referenced. I would say it is more likely next year, though, if I was just going to give you a very broad view of when I think it is going to come. It could be earlier than that, but it is very difficult to say. There is just a lot of moving pieces and parts right now. When I talk about MyMobility, I tell you, in any crisis situation, there is this opportunity to move away from crisis management to crisis optimization. MyMobility is a platform that we have had out for a while that has had good traction.

I can tell you the interest in an application like MyMobility that allows for virtual interaction with the patient has gone up fivefold since this whole thing has started with the social distancing requirements. People really have a significant interest to get it out. That was the reason why we came out with the LE. How do we do this in a way that allows for absolute rapid deployment while still giving most of the characteristics of MyMobility to the patient and to the surgeon so they can enjoy it while they're in this unnatural kind of COVID environment? The positive news is demand for this type of technology has gone up dramatically.

Our team is pivoting very quickly to make sure that we have the right launch of MyMobility to be able to take advantage of that and to make sure that we're deploying it in those accounts that are interested as quickly as possible. I'd rather not have this situation happening right now. The fact is, it is opening up people's eyes to this type of technology. That benefits us because we already had it.

Joanne Wuensch (Managing Director)

Thank you.

Operator (participant)

Absolutely. We'll take our next question. We'll take our next question from Amit Hazan with Goldman Sachs.

Amit Hazan (Managing Director)

Oh, thanks. Hey, good morning. Thanks for all the color. I want to come back to China. They're obviously a couple of months ahead of us in this whole thing. They've got a patient backlog there too, of course.

Utilization seems to kind of still be stuck around down 25% through April. I'm wondering if you can help us if this is explained better in your view through the lens of hospital capacity issues or through the patient demand side factors like psychology. If that at all helps to color what we should expect in the rest of the world. Thanks.

Bryan Hanson (President and CEO)

Yeah. I'll take a shot at this just maybe topically. Then, Suky, if you have anything to add, feel free to do that, obviously. What I would tell you is that Suky was referencing what we had seen so far through April in China. I would say I'm actually very pleased with the recovery. I would be happy to see every other market that's being impacted by COVID-19 respond in the same way with the same level of exuberance in the recovery.

If we look past April, just to give some more specifics, and I think it's warranted here just because it is our longest-standing proxy of what could happen. I'm not saying this will happen. The fact is, we're already suggesting that as we get into June, China could be at 100% of what they were doing prior to COVID-19. Post that, there's folks there on the ground that would expect us to be above 100%. Again, to start to see some of that extraordinary growth come from patients coming back in the funnel. I have not heard from the China team a lot of concern around the specific concern of a patient coming back into the funnel. Whether that applies to other markets or not, who knows? I'm not hearing that as a specific issue, at least so far, in the China market.

Again, I do not want to read too much into what we are seeing in China because there are a lot of differences that occur in other marketplaces. I am pretty pleased, actually, with the recovery that we are seeing in China and the timing of it. I do not know, Suky, if you had anything additional to add.

Suky Upadhyay (CFO)

No, I think that is a good summary, Bryan. Really no color to add on top of that. In the midst of those numbers, at the deepest part, China was doing about 25% of their normal run rate. Within two months, they are up to 75% in April. We are seeing a pretty steep V there. As Bryan added, we expect that trend to continue over the near term. It is too early to tell if that same shape and pace of recovery will extend into other markets. We are encouraged by what we saw in China.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks.

Lauren, we can go to the next question, please.

Operator (participant)

Our next question comes from Larry Biegelsen with Wells Fargo.

Larry Biegelsen (Senior Medical Device Analyst)

Good morning. Thanks for taking the question. Bryan, one on pricing. One of your competitors called out the potential for increased pricing pressure given the situation that hospitals are in. Can you comment on that? What is your expectation going forward? Thanks for taking the question.

Bryan Hanson (President and CEO)

Yeah. What I'd say, Larry, is that from my view anyway, I don't see any real difference in pricing pressure. I mean, the fact is, we've had austerity measures in the past. We have constant bombardment on pricing pressure every day of our lives. I could certainly see where people might be looking for more. The fact is, there are competitive forces in place that would pricing doesn't go down unless somebody gets the pricing.

I truly do believe in this situation, you're going to find that pricing will continue to be similar to what we've seen in the past. It's still not an attractive pricing environment. 2-3% is what we've always said. I'd be surprised in the short term if we see anything deviate dramatically from that. As a matter of fact, as I said before, what we're really focused on right now is leveraging broader contracting, either in concert with ROSA placements or robotic placements or just cross-business contracting using multiple categories with the idea that we would be able to help our customers in the time of need, have longer-term contracts, and as a result of that longer-term contract, actually have more pricing stability. That will be our focus.

I do not want to predict better pricing, but I also do not want to predict worse pricing in the short term here.

Larry Biegelsen (Senior Medical Device Analyst)

Thank you.

Sure.

Operator (participant)

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

Bob Hopkins (Managing Director)

Thank you. Good morning. Bryan, Suky, to the whole team, thanks for the details on April. It was very helpful. Would love to just get your thoughts on two things as it relates to expenses. Could you just clarify what percentage of your costs you consider to be fixed? As we look forward, maybe hypothetically into next year, if revenues get back to something that approaches 2019 levels, would margins also get back to 2019 levels? Is there a reason why the recovery in margins may take longer than a recovery in revenues? Thank you.

Bryan Hanson (President and CEO)

Hey, Suky, why do you not go ahead and tackle that?

I've got some color commentary afterwards. I'll provide it.

Suky Upadhyay (CFO)

Yeah. As we said in our earlier remarks, or I said in my earlier remarks, first of all, thanks for the question. We said more than half of our cost base is fixed in the short term. That breaks out a little bit differently across cost of goods and within OpEx. In cost of goods, it's probably much less than half is fixed. As you get into OpEx, I'd say a little bit more than half is fixed. The weighted average then takes the overall cost structure as more than half being fixed. That's how we think about our overall cost base. We did implement a number of cost preservation activities in Q1 that will extend into Q2 to help with overall liquidity and earnings.

You will get a full quarter of those into the second quarter. We do expect that to be a bigger impact. Having said that, if we do see a solid ramp here in May and into June, we may elect to start to invest even sooner than Q3 against the business to ensure that we are ready from a supply standpoint, from a channel standpoint, from a commercial standpoint to meet the end market recovery. Relative to margins, we do think it could be slightly delayed versus revenue uptake, primarily because of some of those spending reductions we are taking that we are deferring. We may catch up on those in the rest of the year. In addition, within cost of goods, some of the fixed overheads that might fall out as unfavorable variances because of lower revenues could get deferred and be recognized over time in the future.

Those are two factors that could lead to margins ultimately lagging slightly behind the revenue uptake as we go forward. It's too early to tell as to when margins could get back to 2019 levels. As we said, Q2 is probably the low watermark. We would expect margins to improve as revenue improves.

Bryan Hanson (President and CEO)

Hey, just one additional comment on that. I think Suky is right on the money. Also, it's very clear when revenue comes back, that obviously has a direct and almost immediate impact to margins in a positive way. As we have some deferred expenses hit that, it could delay it a little bit. The fact is, nothing is better than increased revenue growth to enhance margins.

Remember, as I mentioned in the prepared remarks, and I believe Suky did as well, we do have our restructuring program in place, live and well. The whole intent behind that restructuring program was to be able to continue to invest for growth but do so while expanding margins. We were pretty explicit the last time that we had talked about our goals associated with those margins. The hope is this gets behind us and we get right back on track with what we had predicted the last time.

Bob Hopkins (Managing Director)

Thank you very much.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Bryan. Lauren, I think we have time for maybe one or two more questions.

Operator (participant)

Thank you. Our next question comes from David Lewis with Morgan Stanley.

David Lewis (SVP and Financial Advisor)

Good morning. Bryan, just maybe one broad comment, one related question.

The dynamic of the economy, this kind of consensus view that orthopedics is sort of more economically sensitive relative to other elective procedures across broader medical devices. We did not hear a lot of talk about economy on this call. Do you accept that view that recon is sort of more economically sensitive and sort of related to that? I think about your unique businesses, dental, recon, and trauma. They are all very different. How do you see the recovery across those three different businesses? Thanks so much.

Bryan Hanson (President and CEO)

Yeah. I would hit the second one first. I think trauma obviously would be the one to rebound more quickly. It has been down, obviously. Everybody knows. People just are not out. As a result of not being out, not being active, trauma business just gets hurt.

The fact is, as people start to hit the street again and start to move again, we would clearly expect trauma to be the thing that recovers the fastest. Recon would be next for us. Even the acuity level of those recon patients would kind of dictate who comes first into the funnel. Dental would clearly be the cleanup in the way that I would look at it, be last to recover for obvious reasons associated with the dental marketplace. When I think about the impact that an economic downturn has on ortho, I think in the past we have seen that it can have an impact. What we are doing when we are modeling this out, David, when you just think about the number of moving pieces and parts, we are assuming that the natural business, the natural growth of the business remains pretty consistent.

That you're going to see the typical patient flow that would have been coming in over the rest of this year, over next year when things recover. You are going to see that incremental patient flow come because of those deferred patients. If anything, for me, when I think about 2021 and potentially even beyond, I think we could have an opportunity as a market, which would be a false positive. I think we could have a situation where you're seeing extraordinary growth during that time rather than depressed growth because of any kind of economic recovery issue. That is just, again, just my view based on data points that we're getting from folks that are out there in the world and what they're seeing and then also our own teams.

I would just tell you too, right now, we have an unprecedented amount of outreach to our customers. This is not just us sitting in a room thinking about what's going on. We literally have thousands of touch points every week to surgeons and customers around the world to get insights. We're loading that through our Salesforce program. And we're able to use those insights to be able to give us a view of what we should expect. But that's just my personal overview based on those insights that I have right now.

Operator (participant)

Thank you. That concludes today's question and answer session. At this time, I will turn the conference back to Keri Mattox for additional or closing remarks.

Keri Mattox (SVP of Investor Relations and Chief Communications Officer)

Thanks, Lauren. Thanks, everybody. I know there were some other questions in the queue. Unfortunately, it is right up at 9:30. We are going to wrap here.

Of course, the IR team is available all day today. We will be speaking to many of you. If you have additional questions, please do not hesitate to reach out. Thank you so much for joining us today. Stay safe and be well.

Operator (participant)

That does conclude today's conference. Thank you for your participation. You may now disconnect.