Zimmer Biomet - Earnings Call - Q3 2020
November 6, 2020
Transcript
Operator (participant)
Good morning, ladies and gentlemen, and welcome to the Zimmer Biomet Q3 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, November 6, 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, 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 the Zimmer Biomet Q3 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?
Bryan Hanson (President and CEO)
All right, great, Keri, thank you. Here we are now with our third virtual earnings call, which is hard to believe that so much time has already passed as we live inside the pandemic environment. 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. 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.
As you know, 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, and I'm 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 three 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 is the strongest it's been since I joined the company. The way I look at it is the things we can control, we are absolutely galvanized around and executing flawlessly against. 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 it.
That said, the unpredictability of COVID means there are several variables, and unfortunately, they're pretty big variables that are outside of our control. 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. That's exactly what we've been focused on. Along those lines, there are really three key areas that I'm going to talk about today that I think are important for you to take away and 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.
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. The third is an update on the ongoing transformation of our business, which I truly do believe we're making great progress on. 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. 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. As you probably remember, 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 then the backlog of patients that have deferred treatment during the pandemic for whatever reason.
On the negative side, we have the effects from the 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. Overall, the full quarter was stronger than expected, and we actually returned to growth over 2019 faster than we thought we would. This was 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. 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. 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. We can't influence the virus, but we can try to influence patient fear.
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. 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. Those are obviously some of the factors surrounding COVID and its recovery dynamics. 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. 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 two quarters versus the overall market. Specifically, if you 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 10% growth in U.S. hips. I got to tell you, these numbers are strong even without the backdrop of COVID. The question's 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 four 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.
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. 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. 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, whatever you want to call it, is higher than I've ever seen.
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. Broadly speaking, over the last year, we've taken a very dismal low single-digit vitality index to a low double-digit number, and that's still not as good as we'd like it to be, but that's a pretty big jump. With our current product pipeline, I could promise you that's only going to continue to move in the right direction. As you know, obviously, vitality index speaks to the percent of sales driven by new product launches. In other words, those products that have been launched within the last three years, the revenue associated with them versus your overall revenue. Again, a real nice jump in the right direction in vitality index and more coming.
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. Importantly, our utilization continues to increase, and the placement pipeline remains very strong. 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.
Revision remains on track, as I said before, to hit $100 million of gross revenue this year, and 40% of that will be new growth. In other words, $40 million of net of cannibalization revenue this year from Persona Revision by itself. This is really exciting, not only because it shows strong momentum for 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. If you know about this marketplace, you would also know that the primary business is usually much larger than the revision business. You can get the order of magnitude of opportunity we have to go after now.
Exciting stuff there on the knee side. Shifting to hips, Avenir Complete is really still outperforming our expectations for 2020. That's even with the pandemic impact. These were the expectations that we had for 2020 before we knew about the pandemic, just to give you some perspective on that, on how well it's doing. This launch has really helped provide a great implant to leverage the high-growth direct anterior 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. 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+% increase in surgeon registrations in Q3, and we already have one in four cases using pre-surgical planning for shoulder replacement. This increased penetration of the system is important in my mind in two very important ways. First of all, there's a real potential for mixed benefit, or maybe said another way, share of wallet gain in each procedure that you use pre-surgical planning in, and it also provides more stickiness with the surgeon. On the surgeon stickiness, it's probably obvious. When a surgeon's using our implant and they're also using the pre-surgical 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 pre-planned procedure versus those without pre-surgical 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 a 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. Very exciting stuff. In short, I would just say that even with the challenges of COVID, we're driving our business forward, meeting our customer needs and improving patient lives as we go. That's the whole mission of this organization.
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. As a team, we've dealt with many challenges over the past three years. What's prepared us for this moment? I've said it before. This is a time when companies and teams can slow down. They can hesitate. They can take their foot off the pedal. Hey, we're being smart and safe, but we are not letting up. It shows. It shows in the ZB performance and in the energy of this team right now. All right, I am 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.
As we've outlined, to drive our strategic pillar of top quartile performance at GSR 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. First, as we've said in the past, the first and foremost area of concentration is above-market performance in knees. Just given the size and the scale of this business, we need to be ahead of market here. We're going to do that by focusing aggressively in the fastest growth submarkets of knee: 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 knees. Next, we've got to drive consistent at-market growth, if not the higher end of market, for our performance in set.
That is focusing on the most attractive sub-elements of set. For us, that is going to be sports, and it is going to be extremities. Also, we have to make sure that we have a consistent at-market performance in hips. That is in the short term. In the longer term, when we launch into robotics, we absolutely expect above-market growth in hips as well. Finally, while our other businesses, at least at this point, will not receive the same level of investment and will be managed differently, we would still expect these businesses to drive in line to the lower end of their market growth. That is our pathway. That is our pathway for long-term, durable 4%-5% organic growth rates in this business. Okay, next I want to talk about ZB's transformation.
You've probably heard me outline the three phases of our ZB transformation, but I'm just going to go over them again just quickly here. Phase one, 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 one. 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. Good progress in phase one. Phase two 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. Phase three is where we transform for the future. Through active portfolio management, we look to change the portfolio complexion to accelerate growth. We have made pretty significant and really durable progress in phase one. We have laid the foundation for and are absolutely executing against phase two, and now we are moving squarely into phase three of the ZB turnaround. For us, when I think about phase three and I think about that active portfolio management, it includes three main components and really should include these same three for anyone who is looking at active portfolio management.
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. Selective M&A. The final one, when appropriate and in line with our overall strategy, divesting non-core assets that are financially less attractive than our core businesses. Those are the three components of active portfolio management in the 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. Size is going to be a factor here, particularly in the short term.
Out of the gate here, we're going to have a preference towards smaller, tuck-in deals that can be easily integrated and operationalized while also maintaining, very importantly, our investment-grade rating. 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. They add to our pipeline of new technologies and product launches in markets that are accretive to our growth rates. 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.
I think great first step in the M&A side of things. From looking at the individual deals, if I look at the acquisition of Incisive, this is an OR solutions company in the $1.2 billion integrated OR market. 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 two reasons. First of all, they have a smaller footprint, and this focuses on reducing the acquisition cost, but also the construction cost, which we know is a pretty important aspect of the ASC market, looking at controlling these costs.
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. 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 this smart implant that we already have from mymobility and we already have from ROSA is going to provide an unmatched data set that ultimately can be leveraged through AI for decision support related to how best to treat and care for the patient. This will give us a unique opportunity, we feel, to create an intersection between the $4 billion total knee market and the telehealth solution space, which is growing somewhere north of 15%. A very attractive area for us to differentiate the ecosystem and kind of enter into an adjacent space in telehealth. The last deal I'll talk about is our acquisition of ReLign. This is focused on the sports medicine market, which we know is a $5 billion market, and it's growing 5%-7%.
Again, accretive to our overall weighted average market growth. This deal clearly helps fill our gaps in arthroscopy capital. The capital makes up about 30% of the sports market. Until now, we had absolutely no offering in this 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 three tower components into a single comprehensive system, both at the equipment side and on the end effector side. 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. 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.
I would just say that, hey, we've got other portfolio management opportunities in the near-term funnel. 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. 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. 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. That was what the whole idea behind the restructuring plan was. 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 of the COVID recovery trends. That said, 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. As a result of that, the value creation opportunity we have as a company. With that, I'm going to turn the call over to Suky again for more financial details for the quarter and looking forward. Suky?
Suky Upadhyay (CFO)
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+ 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 progressed throughout the quarter.
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. 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. 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 continued to significantly underperform 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 have continued at about 70%-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. Finally, our other category was down 11.1%. I will 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 the year. Moving on to the P&L. As we 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 flows 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 diluted earnings per share of $1.81. GAAP earnings per share versus the prior year were lower, primarily due to a sizable one-time 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.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Thanks, Suky. Before we start the Q&A session, a reminder to please limit yourself to a single question and one follow-up 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. One moment, please, for the first question. Our first question comes from Ryan Zimmerman with BTIG.
Ryan Zimmerman (Managing Director and Medical Technology Analyst)
Great. Thank you. Good morning, everyone. Bryan, I want to start on the backlog and the commentary about the September exit rates, and then I have one on ROSA. You know, if you call back to the last quarter, you talked about a $700 million backlog for ZB. I am 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 are talking about.
Bryan Hanson (President and CEO)
Yeah. Appreciate the question. What I would say is that 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 the typical market growth, that would indicate that we did not build further backlog or deferred patients in the way that I calculate it in Q3. That said, we still have hundreds of millions of dollars of deferred patients that will eventually come back in the funnel. I still feel very bullish about the fact that we have these deferred patients. There are patients, as we know from most of our business, that have a disease that progresses. It does not get better by itself. As a result of that, those patients typically come back in the funnel.
I would not say that we built more backlog in Q3, but we certainly still have quite a bit of backlog to go through. That is my view of where we are from a backlog standpoint. Again, I think eventually, when we get to the point where we have a vaccine that people have confidence in or a treatment that people have confidence in, we are 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 am looking forward to that day, for sure.
Ryan Zimmerman (Managing Director and Medical Technology Analyst)
Understood. And then just the second question, you know, ROSA, really nice number there on the 200, exceeding the 200 placements on ROSA. You talked a little bit about the visibility on the order book and your expectations for 2021. Is it unreasonable to believe that you can accelerate beyond that 200-300 placement rate you're expecting this year? Thank you for taking the question.
Bryan Hanson (President and CEO)
Just for clarification, just to make sure, that 200-300 is what we've done from a placement standpoint since launch. That was not 200-300 that we would expect just in 2020, but it would be since launch, which is, you know, it's called about a little over a year and a half now since full launch of the ROSA system. I'll tell you that, hey, I'm pretty enthusiastic as to 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. Even though I think it will be slightly better, it is still slightly better than what we did in Q3. That is what our expectation will be in Q4.
You know, that pipeline of what I'm just going to call future customers is robust as it's ever been with our product. As I mentioned before in the prepared remarks, I really do believe the under-penetration of robotics is at such a point that this is a tailwind for the organization for a long time to come. It's a very exciting tailwind, no question about it, because not only is it good for us, it's good 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. You know, we've got those coming, but when the surgeon uses the robotic system in the operating room, you can see the lights go off, 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. It is really neat to see, actually. To have an opportunity to go in and see that kind of light bulb go off in a surgeon's mind when they're using it is pretty amazing. Relative to 2021, I do not 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 if that level of placement did not continue into 2021, right? That would indicate if, in fact, that does happen, that 2021 should have more placements overall than 2020 did.
I think real positive momentum, great feedback from our customers, and a really strong pipeline of future customers that are out there right now.
Ryan Zimmerman (Managing Director and Medical Technology Analyst)
Thank you.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Thanks, Ryan.
Ryan Zimmerman (Managing Director and Medical Technology Analyst)
Sure.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Lauren, can we go to the next question, please?
Operator (participant)
Our next question comes from Bob Hopkins with Bank of America.
Bob Hopkins (Managing Director)
Hey, good morning. Thanks. Can you hear me okay?
Bryan Hanson (President and CEO)
Yep. You hear me great.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
You can, yep.
Bob Hopkins (Managing Director)
Good morning. Thanks, Keri. First, quick question. I appreciate, Bryan, your comments on deals and divestitures and the two deals you announced. Quick question there is, one, you know, 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, you know, kind of how would you characterize how likely divestitures might be in 2021? Thank you.
Bryan Hanson (President and CEO)
Okay. What I would tell you is that the deals that we just talked about, obviously, are not super accretive relative to acquired revenue growth. There's just not much there. Think about it more as product launches, you know, that we have, you know, facilitating product launches in these very attractive spaces: ASC. It would also be in sports, which is kind of a combination ASC, you know, impact, and then also in the data and informatics portion of things. I would absolutely expect revenue growth to be driven in 2021. I wouldn't say 2022. I definitely believe that the portfolio being, you know, 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.
We talked about that new ecosystem. It is all three of the things that we just, you know, 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, you know, clearly, I would not talk about a timeframe. I do not want to give anybody any expectation here. The fact is, is when we think about active portfolio management, that is one of the vectors. You know, one of the obvious ones is M&A. For us, M&A that we are 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. 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 do not really see a clear pathway to leadership. You know, those would be the things that we would look at when we think about, you know, shedding the business. I just do not want to give you a specific timeframe because I do not 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, right? That is the intent. If we are going to be a top four top performer in total shareholder return, we have to have more of our revenue in higher growth markets.
I'm just talking about the single-digit to upper single-digit growth markets. That is the intent of the active portfolio management process.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Thanks so much, Bob. Lauren, can we go to the next question in the queue, please?
Operator (participant)
Our next question comes from Josh Jennings with Cowen.
Josh Jennings (Managing Director)
Hi, good morning. Thanks for taking the questions. One on ROSA and then just one on your upper extremities business. Just on ROSA, I was wondering, just trying to parse out just the implant performance in these in the quarter. Was there a headwind from third quarter 2019 ROSA upfront purchase revenues versus the placement dynamic that's been happening over the course of the pandemic? Can you help us as we think about modeling these ROSA placements out in 2021 and just all robotic solutions out there in the North Big marketplace? I mean, do you think the percentage of systems that are placed that will drive an upfront capital purchase and that upfront revenue, is that a 50% bar? Is it a 25%?
Anything you can help us just in terms of modeling out that system revenue as we think about 2021 and beyond would be helpful.
Bryan Hanson (President and CEO)
Okay. Maybe I'll hit that piece first. What I would tell you is 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. That almost seems like it's already starting, although not nearly at the pace that it was, let's say, last year. I would guess, you know, it's purely a guess, but I would, you know, again, based on that, assume that as we move into 2021, you might see more of a shift in that direction. 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, you know, 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 builds that relationship in a more stable way. I would assume that as, you know, 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 try to give you a sense for what the percentage would be. 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, you know, base knees, we actually grew closer to four, you know, even a little better than 4% in base knees in the U.S. It was almost 100 bps of, actually a little more than 100 bps of headwind from ROSA in the quarter. Hopefully, that answers the question.
Josh Jennings (Managing Director)
That's very helpful. Thanks for those details. I heard Suky call out 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 a pandemic. I also just wanted to get your thoughts on, you know, the opportunity with the integration next year from, you know, see second biggest competitor and what that opportunity represents in your mind for the upper extremities business. Thanks for taking the questions.
Bryan Hanson (President and CEO)
Yeah, absolutely. I mean, you know, if, you know, the fact is, you know, when we look at the performance in Wright, they had a pretty good quarter. You know, clearly, at least based on that performance, one would indicate that it's not disruptive yet. You know, always hoping for things to happen, you would be very, I'd be very happy if there was disruption when you try to bring those two organizations together finally. The fact is, most of the time in our industry, when you're bringing two organizations together, there is dysynergy risk. There just is. That is why I like some of the small deals that we just did. It really eliminates that dysynergy risk because they're really more product launches versus bringing two sales organizations together.
I would expect at some point, just given historical views of acquisitions in our space, that you are going to see some level of dysynergy. And, you know, the hope is that we have an opportunity to take advantage of that. That said, the hope is not a strategy. We have a very clear strategy in our extremities business, and we're executing against that. 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 coming from our competitors.
Josh Jennings (Managing Director)
Thanks, Bryan.
Operator (participant)
Thanks. Our next question comes from Vijay Kumar with Evercore ISI.
Vijay Kumar (Senior Managing Director)
Hey, guys. Thanks for taking my question, and congrats on the footprint here. Bryan, maybe a big picture question. If I look at 2021, Street's modeling earnings about 2019, I'm just curious, a couple of your peers of Cargill, you know, gross margin, manufacturing variance, et cetera, is there anything we need to be aware from a margin perspective? And I, you know, should Street perhaps, you know, are you guys comfortable with the Street EPS numbers?
Bryan Hanson (President and CEO)
Yeah, maybe what I'll do for that one is just 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.
Suky Upadhyay (CFO)
Yeah, sure. You know, we're not obviously giving guidance on 2021, and I'm not going to speak to, you know, Street numbers. What I would say is, you know, 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. You know, from a top-line perspective, if we saw a situation where the recent surges we've been experiencing begin to abate or moderate and then stabilize, you know, there could be a pathway to seeing a 2021 revenue profile that's in line with the 2019 revenues. If, you know, we got into next year and saw that stabilization, moderation, but also on top of that, saw a vaccine or credible treatment in tandem with a vaccine, you could potentially see volumes or revenues ahead of 2019 levels.
That is kind of how we're thinking about it from a broad strokes perspective, but there is a lot of runway between here and there relative to COVID and how that is going to play out. We are going to pause on giving too much additional color beyond that. From a margin perspective, it is really going to fall in line with overall revenue and volumes, right, as you would expect. Volumes and revenues better, so will margins. That is 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, you know, we have 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. As we move into next year and as overall regional mix starts to stabilize with the stabilization of COVID, you know, we're seeing a mixed tailwind right now that may abate into next year. That could be a slight headwind as we go into next year. We have had some pressure on overall COGS this year because of lower volumes, because of prior year deferred costs. Those are going to continue into next year. 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. That could be a tailwind to next year.
You know, we've always talked about coming out of 2020 as part of our broader restructuring program, our 30% operating margin aspiration, that you should expect to start to see a stabilization from 2020 as you move out to 2023 when it comes to gross margin. Then within operating margin, I'll tell you, you know, we're going to continue to ramp up investment. I think what you see over the last two 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. 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 and very strong end markets.
We are going to see a step up in investment as we move into 2021. Having said all that, you know, we are consistent with where we were before, that if we saw revenues at 2019 levels, we would expect we would be disappointed if operating margin within 2021 did not reach those levels, maybe not for the full year, but within 2021, we would expect to get to those margin levels. Hopefully, that gives you a little bit more perspective on how we are thinking about 2021. Again, a lot more to play out yet with COVID.
Vijay Kumar (Senior Managing Director)
No, that's extremely helpful, Suky. Bryan, one for you on that. Thanks for all the color on that. Persona Revision, I guess, you know, when you look at next year, as you guys are getting traction on the revision side, should those, I guess, gains accelerate as you gain a beachhead into the primary side of knee as well?
Bryan Hanson (President and CEO)
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?
Vijay Kumar (Senior Managing Director)
On that, the Persona Revision Knee side, I think the comment you made was that should allow you guys to, you know, go after primary implant site as well. When you think about $40 million of net gains on the revision side, should we perhaps be looking at an actual rating share gain for next year as a gain share into on the primary side?
Bryan Hanson (President and CEO)
Yeah, I'd say that's the most exciting thing for me on Persona Revision. You know, and it probably was a little lost to me to tell you the truth in the beginning because I assumed a better connection between, you know, revision sets and primary. What we're finding is that a good portion of that $40 million or so of competitive conversions are competitive. Some of them are competitive conversions where we have the primary business already and we did not have the revision system. A lot of them are the other way around where we didn't have the primary or the revision. When we pick up that revision business, it absolutely, as I said before, gives us a right to hunt for the primary business. It's an order of magnitude, you know, larger than the revision business.
If you just look at the market differential, let's call revision somewhere in the neighborhood of, you know, 10%-15% of the overall Knee market. The rest of it is really primary or uni that are out there. Again, once we get the revision business, you know, we then can go after that primary or the uni that the surgeon is doing. It doesn't mean you're going to naturally get or automatically get it, but you, again, have a right to go after it and you build trust and you build a relationship with the surgeon and it gives you that chance. I absolutely expect two things in 2021: continued competitive conversions with primary and with revision, but also that opportunity to pull in the primary business as well.
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.
Vijay Kumar (Senior Managing Director)
Understood. Thanks, guys.
Bryan Hanson (President and CEO)
Sure.
Operator (participant)
Our next question comes from Raj Dienhoy with Jefferies.
Raj Denhoy (Equity Research Analyst)
Hi, good morning. A couple of questions, if I could. I'm just trying to put a finer point on your comments around the fourth quarter. It sounds like you're suggesting that Asia-Pacific and the Americas perhaps in line with the third quarter. 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?
Bryan Hanson (President and CEO)
Yeah. Maybe, Suky, I'll start. If you want to provide any more color, you know, 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, seemed 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 positive growth, it has slightly decelerated versus Q3. The good news is, even with the surges that we're seeing in the U.S., we're still seeing positive growth. It's close, you know, to what we saw in Q3. Again, it's early. The risk feels, you know, a little more tenuous right now because the surges are so much more prominent than they were in Q3.
The fact is that, you know, the U.S. is hanging in there and still has positive growth. In EMEA, to your point, we are seeing more pressure. You know, the policy decisions and the reaction to the virus surges is more acute in Europe, Middle East, and Africa. No question about it. I would expect Q4 to be slower growth, and it was already negative in Q3 than Q3 was. You know, we're really watching this everywhere, obviously. Right now, Europe, Middle East, and Africa is a key area of focus for us to understand what's happening in that region. 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? If you have anything else you want to say?
Suky Upadhyay (CFO)
No, I think you summarized it really well, Bryan.
Raj Denhoy (Equity Research Analyst)
Thanks.
Really, my second question is, I guess, somewhat related. Thank you for Suky made the comment that demand in some areas is still at 70%-90% of normal. You know, I guess I'm curious how to think about that. You know, is that a kind of broad statement that you're still, you know, 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, you know, to 100% and beyond?
Bryan Hanson (President and CEO)
Let me clarify what he's saying there. What he's saying is that, so take the U.S., for instance. If you look at a 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, you know, the county or the state, you're still seeing 70%-90% of procedure volumes that you would typically see, say, versus 2019. That does not 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%-90% of typical procedure volume. That was what he was referencing.
Suky Upadhyay (CFO)
Yeah, I think, Raj, I think the extrapolation from there is even in these very acute second surges, we're not seeing anything that resembles what we saw in April and May, right? Clearly, the end markets, the hospital systems, the physicians, more deference being provided to them. They're better prepared to deal with COVID. They have better protocols and are able to triage their patients. They've got incentives to get these elective procedures through. That's really the key point of that statement of 70%-90%.
Raj Denhoy (Equity Research Analyst)
Definitely. Thanks for the clarification.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Thanks. Lauren, it looks like we have time for at least one, maybe two more questions.
Operator (participant)
We'll take our next question from Matt Miksic with Credit Suisse.
Matt Miksic (Director)
Hi, good morning. Thanks for taking the questions. I have one on S.E.T. and one just to follow up on Raj's question there on trends. On sports medicine, extremities, trauma, you provide a global reporting line here. It's a 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. I just had one quick follow-up.
Bryan Hanson (President and CEO)
Okay. We do not really provide a breakdown beyond the S.E.T. overall category. 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. That would indicate, you know, that we clearly had lower growth in other parts of the world, which is not 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 versus other regions, just given, you know, the dominance or the significant portion of revenue in Asia-Pacific that, you know, China has.
You know, even though we're seeing less surges of the virus in that part of the world, we still are seeing less activity. That typically would drive lower volumes in or lower revenue growth in sports. It would drive lower revenue growth in trauma. Just, you know, when people aren't moving as much and they're not doing as much, you typically see those two businesses within the side of S.E.T. get hurt. I would tell you that, you know, as we've 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. I would just say our growth rate there is promising. That's probably all the detail I want to provide below S.E.T.
Overall, if I look at the category, the U.S. region, the U.S. or the Americas was definitely the strongest growth region.
Matt Miksic (Director)
Thanks for that. Just on Suky, your comments just now on trends and what we could expect and not expect potentially around the surges, is there anything, you know, there was a pretty, you know, tight period, I guess, of this summer in Arizona and Texas when there were some, you know, very narrowly focused constraints by county and other. I'm just wondering if you could talk a little bit about what you saw there, how quickly it rebounced back, you know, and sort of what we might learn from that as it pertains to maybe the next few months in some other areas.
Suky Upadhyay (CFO)
Yeah, I think we actually commented on that on our second quarter call. Some of those very hard hit counties within the states that you mentioned were operating somewhere in that 80%-90% range. You know, we've seen a very consistent pattern now for a few months where we've seen heightened surges. I think that 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. You know, the time to abate, it really, it's variable, right? There is no broad statement. It depends on the specific market, the specific sub-market that you're talking about, or territory and the number of surges and how quickly, how big that population is and how quickly those surge rates come back down.
It's tough to say, but in some of those hardest hits where we were at 80, 90, you know, 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. Again, it's really variable from market to market.
Matt Miksic (Director)
Thanks.
Operator (participant)
That concludes today's question and answer session. I'd like to turn back to Keri Mattox for additional closing remarks.
Keri Mattox (SVP of Investor Relations and Chief Communications Officer)
Thanks so much. Thanks, everyone, for joining us. I know we'll be in touch today. If you have questions, please do not hesitate to reach out to the IR team. We look forward to continuing the conversation.
Bryan Hanson (President and CEO)
All right. Great. Thanks, everyone.
Operator (participant)
Thank you again for participating in today's conference call. You may now disconnect.