filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following discussion and analysis should be read in conjunction with the consolidated financial statements and the corresponding notes included elsewhere in this Annual Report on Form 10-K. Certain percentages presented in this discussion and analysis are calculated from the underlying whole-dollar amounts and therefore may not recalculate from the rounded numbers used for disclosure purposes. Certain amounts in the 2016 and 2015 consolidated financial statements have been reclassified to conform to the 2017 presentation.
On June 24, 2015, we completed our merger with Biomet and its results of operations have been included in our results starting on that date. The Biomet merger was a transformational event for us and has had significant effects on all aspects of our business. Accordingly, our sales and expenses have increased significantly since the merger date compared to prior periods.
EXECUTIVE LEVEL OVERVIEW
2017 Results
Net sales increased by 1.8 percent in 2017 compared to 2016 primarily due to the acquisition of LDR Holding Corporation in the third quarter of 2016 and solid performance from our Asia Pacific operating segment. In 2017, we experienced challenges across our Knees, Hips and S.E.T. product categories as a result of production delays from our Warsaw North Campus facility. The production shortfall directly impacted our ability to fully meet case demand. Throughout 2017, we worked to improve our production levels at this facility, but we continued to experience insufficient inventory levels across some brands within our Knee, Hip and S.E.T. product categories which impacted our ability to increase revenue.
Our net earnings increased significantly in 2017 compared to 2016 primarily due to a $1,272.4 million income tax benefit we recorded related to the 2017 Tax Act. Additionally, net earnings increased in 2017 compared to 2016 due to a decrease in inventory step-up expense, lower Biomet integration-related expenses, lower performance-based compensation expense as a result of not achieving our 2017 operating plans and the recognition of $111.3 million of tax benefit as a result of lower tax rates unrelated to the impact of the 2017 Tax Act. Partially offsetting these favorable items were $304.7 million of goodwill impairment charges on our Spine and Office Based Technologies reporting units and higher spending on quality remediation at our Warsaw North Campus facility.
2018 Outlook
In December 2017, we announced the appointment of a new Chief Executive Officer (“CEO”). Our new CEO has begun an in-depth review of our business and formulating strategies to improve our performance. His initial review likely will conclude during the first quarter and the implementation of those strategies will likely have an impact on our results in 2018. In the meantime, we have identified several immediate opportunities to improve our operational execution and address certain near-term challenges. We will continue to work toward completing our quality remediation efforts at our Warsaw North Campus facility and continue to invest in best-in-class quality management systems. We will remain focused on fully restoring the supply of certain key brands within our Knee, Hip and S.E.T. product categories. We also have several key product launches planned in 2018 that we believe will be a catalyst for our future performance.
There are a few known items that are expected to impact our 2018 results. Increased manufacturing costs related to quality remediation at our Warsaw North Campus facility in 2017 will be recognized in 2018 as we sell that inventory. We expect ongoing benefits from the reduction of the U.S. corporate tax rate, but we plan to reinvest those savings into the business to drive sales growth. Additionally, due to underperformance against our operating plans in 2017, we expect expenses from our performance-based compensation programs to increase if we are able to achieve our plans in 2018. We also expect our special items expense to decrease as we complete our Biomet integration plans and substantially complete our quality remediation at our Warsaw North Campus facility.
U.S. Tax Reform
2017 Tax Act: The 2017 Tax Act includes a broad range of provisions, many of which significantly differ from those contained in previous U.S. tax law. Changes in tax law are accounted for in the period of enactment. As such, our 2017 consolidated financial statements reflect the immediate tax effect of the 2017 Tax Act.
The 2017 Tax Act contains several key provisions including, among other things:
| • | a one-time tax on the mandatory deemed repatriation of post-1986 unremitted foreign earnings and profits, referred to as the toll charge; |
| • | a reduction in the corporate income tax rate from 35 percent to 21 percent for tax years beginning after December 31, 2017; |
| • | the introduction of a new U.S. tax on certain off-shore earnings referred to as global intangible low-taxed income (“GILTI”) at an effective tax rate of 10.5 percent for tax years beginning after December 31, 2017 (increasing to 13.125 percent for tax years beginning after December 31, 2025), with a partial offset by foreign tax credits; and |
| • | the introduction of a territorial tax system beginning in 2018 by providing a 100 percent dividend received deduction on certain qualified dividends from foreign subsidiaries. |
During the fourth quarter of 2017, we recorded an income tax benefit of $1,272.4 million, which was comprised of the following:
| • | income tax benefit of $715.0 million related to the one-time deemed repatriation of foreign earnings. This is composed of a $1,181.0 million benefit from the removal of a deferred tax liability we had recorded for the repatriation of foreign earnings prior to the 2017 Tax Act offset by $466.0 million for the toll charge recognized under the 2017 Tax Act. In accordance with the 2017 Tax Act, we expect to elect to pay the toll charge in installments over eight years. As of December 31, 2017, we have recorded current and non-current income tax liabilities related to the toll charge of $82.0 million and $384.0 million, respectively. |
| • | an income tax benefit of $557.4 million, primarily related to the remeasurement of our deferred tax assets and liabilities at the enacted corporate income tax rate of 21 percent. |
The net benefit recorded was based on currently available information and interpretations made in applying the provisions of the 2017 Tax Act as of the time of filing this Annual Report on Form 10-K. We further refined our estimates related to the impact of the 2017 Tax Act subsequent to the issuance of our earnings release for the fourth quarter of 2017. In accordance with authoritative guidance issued by the SEC, the income tax effect for certain aspects of the 2017 Tax Act represent provisional amounts for which our accounting is incomplete, but with respect to which a reasonable estimate could be determined and recorded during the fourth quarter of 2017. The actual effects of the 2017 Tax Act and final amounts recorded may differ materially from our current estimate of provisional amounts due to, among other things, further interpretive guidance that may be issued by U.S. tax authorities or regulatory bodies, including the SEC and the Financial Accounting Standards Board (“FASB”). We will continue to analyze the 2017 Tax Act and any additional guidance that may be issued so we can finalize the full effects of applying the new legislation on our financial statements in the measurement period, which ends in the fourth quarter of 2018. See Note 15 to our consolidated financial statements for additional details related to the 2017 Tax Act.
RESULTS OF OPERATIONS
We analyze sales by three geographies, the Americas, EMEA and Asia Pacific, and by the following product categories: Knees, Hips, S.E.T., Dental, Spine & CMF and Other. This sales analysis differs from our reportable operating segments, which are based upon our senior management organizational structure and how we allocate resources towards achieving operating profit goals. We analyze sales by geography because the underlying market trends in any particular geography tend to be similar across product categories and because we primarily sell the same products in all geographies.
As previously disclosed, sales increased significantly in 2016 when compared to prior years due to the inclusion of Biomet sales for the entire year. Therefore, we analyze 2015 sales on a pro forma basis because it represents how the Zimmer and Biomet underlying businesses may have performed on a combined basis. Pro forma sales assume the Biomet merger occurred on January 1, 2014 and therefore include the net sales of Biomet in 2015 prior to the closing of the merger.
Net Sales by Geography
The following tables present net sales by geography and the components of the percentage changes (dollars in millions):
| Year Ended December 31, | Volume/ | Foreign | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | % Inc | Mix | Price | Exchange | ||||||||||||||||||||
| Americas | $ | 4,865.6 | $ | 4,802.2 | 1.3 | % | 3.7 | % | (2.5 | ) | % | 0.1 | % | ||||||||||||
| EMEA | 1,745.2 | 1,730.4 | 0.9 | 2.1 | (1.9 | ) | 0.7 | ||||||||||||||||||
| Asia Pacific | 1,213.3 | 1,151.3 | 5.4 | 9.4 | (3.1 | ) | (0.9 | ) | |||||||||||||||||
| Total | $ | 7,824.1 | $ | 7,683.9 | 1.8 | 4.3 | (2.5 | ) | - |
| Year Ended December 31, | Volume/ | Foreign | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | 2015 | % Inc | Mix | Price | Exchange | ||||||||||||||||||||
| Americas | $ | 4,802.2 | $ | 3,662.4 | 31.1 | % | 33.4 | % | (2.1 | ) | % | (0.2 | ) | % | |||||||||||
| EMEA | 1,730.4 | 1,417.8 | 22.0 | 26.1 | (0.7 | ) | (3.4 | ) | |||||||||||||||||
| Asia Pacific | 1,151.3 | 917.6 | 25.5 | 24.5 | (2.5 | ) | 3.5 | ||||||||||||||||||
| Total | $ | 7,683.9 | $ | 5,997.8 | 28.1 | 30.3 | (1.8 | ) | (0.4 | ) |
“Foreign Exchange” used in the tables in this report represents the effect of changes in foreign currency exchange rates on sales.
The following table presents our 2016 net sales, and our 2015 pro forma net sales, by geography and the components of the percentage changes (dollars in millions):
| Year Ended December 31, | ||||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | Pro Forma 2015 | % Inc/(Dec) | Volume/ Mix | Price | Divestiture Impact | Foreign Exchange | ||||||||||||||||||||||
| Americas | $ | 4,802.2 | $ | 4,685.2 | 2.5 | % | 5.2 | % | (1.6 | )% | (0.9 | )% | (0.2 | )% | ||||||||||||||
| EMEA | 1,730.4 | 1,767.9 | (2.1 | ) | 1.9 | (0.6 | ) | (0.8 | ) | (2.6 | ) | |||||||||||||||||
| Asia Pacific | 1,151.3 | 1,064.7 | 8.1 | 8.0 | (2.1 | ) | (0.7 | ) | 2.9 | |||||||||||||||||||
| Total | $ | 7,683.9 | $ | 7,517.8 | 2.2 | 4.9 | (1.5 | ) | (0.9 | ) | (0.3 | ) |
Net Sales by Product Category
The following tables present net sales by product category and the components of the percentage changes (dollars in millions):
| Year Ended December 31, | Volume/ | Foreign | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | % Inc/(Dec) | Mix | Price | Exchange | ||||||||||||||||||||
| Knees | $ | 2,737.1 | $ | 2,752.6 | (0.6 | ) | % | 2.2 | % | (2.8 | ) | % | - | % | |||||||||||
| Hips | 1,879.1 | 1,867.9 | 0.6 | 3.6 | (3.0 | ) | - | ||||||||||||||||||
| S.E.T. | 1,709.1 | 1,644.4 | 3.9 | 6.0 | (2.0 | ) | (0.1 | ) | |||||||||||||||||
| Dental | 418.6 | 427.9 | (2.2 | ) | (0.3 | ) | (2.3 | ) | 0.4 | ||||||||||||||||
| Spine & CMF | 759.5 | 662.0 | 14.7 | 15.8 | (1.4 | ) | 0.3 | ||||||||||||||||||
| Other | 320.7 | 329.1 | (2.5 | ) | (0.9 | ) | (1.7 | ) | 0.1 | ||||||||||||||||
| Total | $ | 7,824.1 | $ | 7,683.9 | 1.8 | 4.3 | (2.5 | ) | - |
| Year Ended December 31, | Volume/ | Foreign | |||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | 2015 | % Inc | Mix | Price | Exchange | ||||||||||||||||||||
| Knees | $ | 2,752.6 | $ | 2,276.8 | 20.9 | % | 23.6 | % | (2.0 | ) | % | (0.7 | ) | % | |||||||||||
| Hips | 1,867.9 | 1,533.0 | 21.8 | 24.6 | (2.6 | ) | (0.2 | ) | |||||||||||||||||
| S.E.T. | 1,644.4 | 1,214.6 | 35.4 | 36.9 | (1.4 | ) | (0.1 | ) | |||||||||||||||||
| Dental | 427.9 | 335.7 | 27.5 | 25.7 | 2.1 | (0.3 | ) | ||||||||||||||||||
| Spine & CMF | 662.0 | 404.4 | 63.7 | 66.7 | (2.9 | ) | (0.1 | ) | |||||||||||||||||
| Other | 329.1 | 233.3 | 41.1 | 43.4 | (1.8 | ) | (0.5 | ) | |||||||||||||||||
| Total | $ | 7,683.9 | $ | 5,997.8 | 28.1 | 30.3 | (1.8 | ) | (0.4 | ) |
The following table presents our 2016 net sales, and our 2015 pro forma net sales, by product category and the components of the percentage changes (dollars in millions):
| Year Ended December 31, | ||||||||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2016 | Pro Forma 2015 | % Inc/(Dec) | Volume/ Mix | Price | Divestiture Impact | Foreign Exchange | ||||||||||||||||||||||
| Knees | $ | 2,752.6 | $ | 2,735.9 | 0.6 | % | 4.2 | % | (1.6 | )% | (1.4 | )% | (0.6 | )% | ||||||||||||||
| Hips | 1,867.9 | 1,842.6 | 1.4 | 3.7 | (2.1 | ) | - | (0.2 | ) | |||||||||||||||||||
| S.E.T. | 1,644.4 | 1,571.8 | 4.6 | 6.1 | (1.1 | ) | (0.4 | ) | - | |||||||||||||||||||
| Dental | 427.9 | 454.8 | (5.9 | ) | (7.2 | ) | 1.5 | - | (0.2 | ) | ||||||||||||||||||
| Spine & CMF | 662.0 | 583.5 | 13.5 | 15.5 | (2.0 | ) | - | - | ||||||||||||||||||||
| Other | 329.1 | 329.2 | - | 7.7 | (1.2 | ) | (6.2 | ) | (0.3 | ) | ||||||||||||||||||
| Total | $ | 7,683.9 | $ | 7,517.8 | 2.2 | 4.9 | (1.5 | ) | (0.9 | ) | (0.3 | ) |
The following table presents net sales by product category by geography for our Knees and Hips product categories, which represent our most significant product categories (dollars in millions):
| Year Ended December 31, | |||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | 2015 | 2017 vs. 2016 % Inc/(Dec) | 2016 vs. 2015 % Inc | |||||||||||||||||
| Knees | |||||||||||||||||||||
| Americas | $ | 1,660.2 | $ | 1,688.6 | $ | 1,391.5 | (1.7 | ) | % | 21.4 | % | ||||||||||
| EMEA | 644.2 | 637.8 | 535.2 | 1.0 | 19.2 | ||||||||||||||||
| Asia Pacific | 432.7 | 426.2 | 350.1 | 1.5 | 21.7 | ||||||||||||||||
| Total | $ | 2,737.1 | $ | 2,752.6 | $ | 2,276.8 | (0.6 | ) | 20.9 | ||||||||||||
| Hips | |||||||||||||||||||||
| Americas | $ | 975.6 | $ | 987.5 | $ | 789.7 | (1.2 | ) | % | 25.0 | % | ||||||||||
| EMEA | 518.6 | 522.4 | 455.2 | (0.7 | ) | 14.8 | |||||||||||||||
| Asia Pacific | 384.9 | 358.0 | 288.1 | 7.5 | 24.3 | ||||||||||||||||
| Total | $ | 1,879.1 | $ | 1,867.9 | $ | 1,533.0 | 0.6 | 21.8 |
The following table presents our 2017 and 2016 net sales, and our 2015 pro forma net sales, by product category by geography for our Knees and Hips product categories, which represent our most significant product categories (dollars in millions):
| Year Ended December 31, | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | Pro Forma 2015 | 2017 vs. 2016 % Inc/(Dec) | 2016 vs. 2015 % Inc/(Dec) | ||||||||||||||||
| Knees | ||||||||||||||||||||
| Americas | $ | 1,660.2 | $ | 1,688.6 | $ | 1,684.6 | (1.7 | )% | 0.2 | % | ||||||||||
| EMEA | 644.2 | 637.8 | 649.5 | 1.0 | (1.8 | ) | ||||||||||||||
| Asia Pacific | 432.7 | 426.2 | 401.8 | 1.5 | 6.1 | |||||||||||||||
| Total | $ | 2,737.1 | $ | 2,752.6 | $ | 2,735.9 | (0.6 | ) | 0.6 | |||||||||||
| Hips | ||||||||||||||||||||
| Americas | $ | 975.6 | $ | 987.5 | $ | 980.3 | (1.2 | )% | 0.7 | % | ||||||||||
| EMEA | 518.6 | 522.4 | 537.2 | (0.7 | ) | (2.8 | ) | |||||||||||||
| Asia Pacific | 384.9 | 358.0 | 325.1 | 7.5 | 10.1 | |||||||||||||||
| Total | $ | 1,879.1 | $ | 1,867.9 | $ | 1,842.6 | 0.6 | 1.4 |
Demand (Volume/Mix) Trends
Increased volume and changes in the mix of product sales contributed 4.3 percentage points of year-over-year sales growth during 2017. Volume/mix growth was driven by acquisitions in 2016, recent product introductions, sales in key emerging markets and an aging population.
We believe long-term indicators point toward sustained growth driven by an aging global population, growth in emerging markets, obesity, proven clinical benefits, new material technologies, advances in surgical techniques and more active lifestyles, among other factors. In addition, demand for clinically proven premium products and patient specific devices are expected to continue to positively affect sales growth in markets that recognize the value of these advanced technologies.
Pricing Trends
Global selling prices had a negative effect of 2.5 percentage points on year-over-year sales during 2017. In the majority of countries in which we operate, we continue to experience pricing pressure from governmental healthcare cost containment efforts and from local hospitals and health systems.
Foreign Currency Exchange Rates
In 2017, changes in foreign currency exchange rates had a minimal effect on sales. We address currency risk through regular operating and financing activities and through the use of forward contracts and foreign currency options solely to manage foreign currency volatility and risk. Changes in foreign currency exchange rates affect sales growth, but due to offsetting gains/losses on hedge contracts and options, which are recorded in cost of products sold, the effect on net earnings in the near term is reduced. If foreign currency exchange rates remain at levels consistent with the end of 2017, this will have a favorable effect on sales in 2018 due to the weakening of the U.S. Dollar versus the Euro and other currencies.
Sales by Product Category
Knees
Knee sales declined in 2017 compared to 2016 after growing in recent years due to the previously mentioned supply issues, a price reduction mandate in India and continued pricing pressure. Knee sales volume/mix growth was led by Persona® The Personalized Knee System and the Oxford® Partial Knee.
Hips
Hips sales continued to experience year-over-year sales growth driven by volume/mix growth primarily resulting from strong performance in our Asia Pacific operating segment. Volume/mix growth was partially offset by the previously mentioned supply issues and continued pricing pressure. Hip sales volume/mix growth was led by our Taperloc® Hip System, Arcos® Modular Hip System and G7® Acetabular System.
S.E.T.
Our S.E.T. sales have continued to increase driven primarily by a growing emphasis on sales force specialization, strong performance by key brands and 2016 acquisitions, partially offset by the previously mentioned supply issues and continued pricing pressure.
Dental
Dental sales continued to decline. In 2017, the decline was driven by the restructuring of our dental organization in certain European markets.
Spine & CMF
Spine and CMF sales continued to increase, due to the full year impact of the LDR acquisition and continued strong performance of our Thoracic products. However, sales were lower than expected due to sales force integration issues and additional complexities of merging the Zimmer, Biomet and LDR supply chains.
The following table presents estimated* 2017 global market size and market share information (dollars in billions):
| Global | Global | Zimmer Biomet | Zimmer Biomet | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Market | Market | Market | Market | |||||||||||
| Size | % Growth** | Share | Position | |||||||||||
| Knees | $ | 7.7 | 2-3 | % | 36 | % | 1 | |||||||
| Hips | 6.0 | 1-2 | 31 | 1 | ||||||||||
| S.E.T. | 15.7 | 4-5 | 11 | 5 | ||||||||||
| Dental | 4.7 | 5 | 9 | 4 | ||||||||||
| Spine & CMF | 10.1 | 1 | 8 | 5 |
| * | Estimates are not precise and are based on competitor annual filings, Wall Street equity research and Company estimates |
|---|
| ** | Excludes the effect of changes in foreign currency exchange rates on sales growth |
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Expenses as a Percent of Net Sales
| Year Ended December 31, | |||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | 2015 | 2017 vs. 2016 Inc/(Dec) | 2016 vs. 2015 Inc/(Dec) | |||||||||||||||||
| Cost of products sold, excluding intangible asset amortization | 27.3 | % | 31.0 | % | 30.0 | % | (3.7 | ) | % | 1.0 | % | ||||||||||
| Intangible asset amortization | 7.7 | 7.4 | 5.6 | 0.3 | 1.8 | ||||||||||||||||
| Research and development | 4.7 | 4.8 | 4.5 | (0.1 | ) | 0.3 | |||||||||||||||
| Selling, general and administrative | 38.0 | 38.2 | 38.1 | (0.2 | ) | 0.1 | |||||||||||||||
| Goodwill impairment | 3.9 | - | - | 3.9 | - | ||||||||||||||||
| Special items | 8.1 | 8.0 | 14.0 | 0.1 | (6.0 | ) | |||||||||||||||
| Operating Profit | 10.3 | 10.7 | 7.8 | (0.4 | ) | 2.9 |
Cost of Products Sold and Intangible Asset Amortization
The following table sets forth the factors that contributed to the gross margin changes in each of 2017 and 2016 compared to the prior year:
| Year Ended December 31, | ||||||||
|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | |||||||
| Prior year gross margin | 61.6 | % | 64.4 | % | ||||
| Lower average selling prices | (0.6 | ) | (0.6 | ) | ||||
| Average cost per unit | (0.1 | ) | (0.7 | ) | ||||
| Excess and obsolete inventory | - | 0.4 | ||||||
| Discontinued products inventory charges | 1.0 | (1.0 | ) | |||||
| Foreign currency hedges | (1.1 | ) | (0.9 | ) | ||||
| Inventory step-up | 3.8 | 1.2 | ||||||
| U.S. medical device excise tax | 0.7 | 0.3 | ||||||
| Intangible asset amortization | (0.3 | ) | (1.6 | ) | ||||
| Other | - | 0.1 | ||||||
| Current year gross margin | 65.0 | % | 61.6 | % |
The increase in gross margin percentage in 2017 compared to 2016 was primarily due to a decrease in inventory step-up charges. The reduction in inventory step-up charges resulted from the Biomet inventory that was stepped-up to fair value having been fully recognized by June 30, 2016. In 2016, we recognized significant excess and obsolete inventory charges for certain product lines we intend to discontinue, but did not recognize significant charges in 2017, resulting in improvement to our gross margin percentage. Additional favorability was driven by lower medical device excise tax expense due to the two year moratorium on the U.S. medical device excise tax and a favorable resolution on past excise taxes that were paid. Under the applicable accounting rules that we apply to the U.S. medical device excise tax, we had a portion of the tax paid prior to the moratorium included in the cost of inventory and recognized expense through the fourth quarter of 2016. In January 2018, the moratorium on this tax
was extended through December 31, 2019. These favorable items were partially offset by lower hedge gains of $5.1 million in 2017 compared to $87.7 million in 2016 and the effect of lower average selling prices.
The decrease in gross margin percentage in 2016 compared to 2015 was primarily due to increased intangible asset amortization from the 2016 acquisitions, excess and obsolete inventory charges for certain product lines we intend to discontinue, lower average selling prices and lower hedge gains from our foreign currency hedging program in 2016 compared to 2015. These unfavorable items were partially offset by lower inventory step-up charges from the Biomet merger and lower expense from the U.S. medical device excise tax, in each case in 2016 compared to 2015.
Operating Expenses
After taking into consideration an increase in expenses related to the Biomet merger and other 2016 acquisitions, research and development (“R&D”) spending has remained generally consistent as a percentage of sales, as we continue to invest in new technologies to address unmet clinical needs.
After taking into consideration an increase in expenses related to the Biomet merger and other 2016 acquisitions, selling, general and administrative (“SG&A”) expenses as a percentage of sales have remained generally consistent. In 2017, we recognized increased freight costs due to expedited product shipments and increased investments in our specialized sales forces. These increases were partially offset by continued savings in various SG&A expense categories stemming from our synergies initiatives and lower performance-based compensation expense as a result of not achieving our 2017 operating plans.
In 2017, we recognized goodwill impairment charges related to our Spine and Office Based Technologies reporting units. For more information regarding these charges, see Note 9 to the consolidated financial statements.
We recognize expenses resulting directly from our business combinations, employee termination benefits, certain R&D agreements, certain contract terminations, consulting and professional fees and asset impairment or loss on disposal charges connected with global restructuring, quality and operational excellence initiatives, and other items as “Special items” in our consolidated statements of earnings. We recognized significant expenses in 2015 due to Biomet merger-related expenses, such as the acceleration of unvested LVB stock options and LVB stock-based awards, retention bonuses paid to Biomet employees and third-party sales agents who remained with Biomet through the Closing Date, severance expense and contract terminations. Expenses declined in 2016 due to the absence of certain of these expenses. In 2017, Biomet-related integration expenses continued to decline, but we have incurred additional costs related to quality remediation at our Warsaw North Campus facility. See Note 2 to the consolidated financial statements for more information regarding “Special items” charges.
Other Expense, Interest Income, Interest Expense, and Income Taxes
In 2017, other expense, net, primarily included the net expense related to remeasuring monetary assets and liabilities denominated in a foreign currency other than an entity’s functional currency, partially offset by foreign currency forward exchange contracts we enter into to mitigate any gain or loss. In 2016, other expense, net, primarily included a $53.3 million loss on debt extinguishment. It also included losses on the sale of certain assets and the net expense related to remeasuring monetary assets and liabilities denominated in a foreign currency other than an entity’s functional currency, offset by foreign currency forward exchange contracts we enter into to mitigate any gain or loss. In 2015, other expense, net, included a $22.0 million loss on debt extinguishment, debt issuance costs that we recognized for a bridge credit agreement that we entered into in May 2014 in connection with the Biomet merger, the net expense related to remeasuring monetary assets and liabilities, partially offset by a gain related to selling certain product line rights and assets.
Net interest expense decreased in 2017 compared to 2016 primarily due to our issuance of Euro notes in the fourth quarter of 2016 and lower average outstanding debt balances due to debt repayments. We used the proceeds of these Euro notes, which have a lower interest rate than most of our other debt, to repay certain senior notes with higher interest rates. In 2016, net interest expense increased compared to 2015 due to the issuance of the debt in connection with the LDR acquisition in July 2016 and the Biomet merger in March 2015.
Our effective tax rate (“ETR”) on earnings before income taxes was negative 290.3 percent, positive 23.8 percent and positive 4.6 percent for the years ended December 31, 2017, 2016 and 2015, respectively. We have incurred significant expenses associated with the Biomet merger and other acquisitions, which were generally recognized in higher income tax jurisdictions. Accordingly, our ETR was reduced, as our earnings were lower in these higher
income tax jurisdictions. Additionally, other discrete adjustments have occurred that have significantly affected our ETR. The 2017 ETR was driven by the provisional income tax benefit we recorded of $1,272.4 million from the 2017 Tax Act, as well as $111.3 million of tax benefit we recorded from lower tax rates unrelated to the impact of the 2017 Tax Act. In 2016, we recognized $40.6 million of tax benefit from the favorable resolution of certain tax matters with taxing authorities, which was partially offset by $27.6 million of additional tax provision related to finalizing the tax accounts related to the Biomet merger. The 2015 tax rate resulted from operating losses in the U.S. caused by significant expenses incurred in connection with the Biomet merger.
Our future ETR is expected to be favorably impacted by the 2017 Tax Act as a result of a reduction in the U.S. corporate income tax rate from 35 percent to 21 percent partially offset by a new U.S. tax on certain off-shore earnings, referred to as GILTI, at an effective tax rate of 10.5 percent for tax years beginning after December 31, 2017 (increasing to 13.125 percent for tax years beginning after December 31, 2025), with a partial offset from foreign tax credits. See Note 15 to our consolidated financial statements for further details related to the 2017 Tax Act. Our ETR in future periods could also potentially be impacted by changes in our mix of pre-tax earnings; changes in tax rates, tax laws or their interpretation, including the European Union rules on state aid; the outcome of various federal, state and foreign audits; and the expiration of certain statutes of limitations. Currently, we cannot reasonably estimate the impact of these items on our financial results.
Segment Operating Profit
Similar to our consolidated results, our segment operating profit has been significantly impacted by the addition of Biomet sales and expenses to these segments. In the Americas, operating profit and operating profit as a percentage of sales in 2017 were similar to 2016. The Americas segment was unfavorably impacted in 2017 compared to 2016 by price declines, higher contribution of sales from products with lower gross profit margins and higher freight costs. These unfavorable impacts were offset by lower U.S. medical device excise tax expense and continued savings from our SG&A synergies initiatives. In EMEA, operating profit and operating profit as a percentage of sales decreased in 2017 compared to 2016, primarily due to price declines and a reduced impact of hedge gains. In Asia Pacific, operating profit and operating profit as a percentage of sales decreased in 2017 compared to 2016 due to price declines and a reduced impact of hedge gains.
Non-GAAP Operating Performance Measures
We use financial measures that differ from financial measures determined in accordance with GAAP to evaluate our operating performance. These non-GAAP financial measures exclude the impact of inventory step-up; certain inventory and manufacturing-related charges connected to discontinuing certain product lines, quality enhancement and remediation efforts; intangible asset amortization; “Special items;” goodwill impairment; financing and other expenses/gains related to the Biomet merger and other acquisitions; debt extinguishment costs; the interest expense incurred on the senior notes issued in connection with the Biomet merger during the period prior to the consummation of the Biomet merger; any related effects on our income tax provision associated with these items; the effect of the 2017 Tax Act; and other certain tax adjustments. Other certain tax adjustments include internal restructuring transactions that provide us access to cash in a tax efficient manner, resolution of certain matters with taxing authorities, favorable tax rate changes, adjustments to deferred tax liabilities recognized as part of acquisition-related accounting, the resolution of unrecognized tax positions established through goodwill as part of acquisition accounting and any tax item that would otherwise be distortive to the expected future tax rate. We use these non-GAAP financial measures internally to evaluate the performance of the business and believe they are useful measures that provide meaningful supplemental information to investors to consider when evaluating our performance. We believe these measures offer the ability to make period-to-period comparisons that are not impacted by certain items that can cause dramatic changes in reported operating results, to perform trend analysis, to better identify operating trends that may otherwise be masked or distorted by these types of items and to provide additional transparency of certain items. In addition, certain of these non-GAAP financial measures are used as performance metrics in our incentive compensation programs.
Our non-GAAP adjusted net earnings used for internal management purposes for the years ended December 31, 2017, 2016 and 2015 were $1,636.4 million, $1,610.8 million, and $1,310.5 million, respectively, and our non-GAAP adjusted diluted earnings per share were $8.03, $7.96, and $6.90, respectively.
The following are reconciliations from our GAAP net earnings and diluted earnings per share to our non-GAAP adjusted net earnings and non-GAAP adjusted diluted earnings per share used for internal management purposes (in millions, except per share amounts).
| Year ended December 31, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | 2015 | ||||||||||
| Net Earnings of Zimmer Biomet Holdings, Inc. | $ | 1,813.8 | $ | 305.9 | $ | 147.0 | ||||||
| Inventory step-up and other inventory and manufacturing related charges | 84.6 | 469.1 | 348.8 | |||||||||
| Intangible asset amortization | 603.9 | 565.9 | 337.4 | |||||||||
| Goodwill impairment | 304.7 | - | - | |||||||||
| Special items | ||||||||||||
| Biomet merger-related | 248.0 | 487.3 | 619.1 | |||||||||
| Other special items | 385.1 | 124.5 | 220.4 | |||||||||
| Merger-related and other expense in other expense, net | 2.6 | 3.6 | 1.0 | |||||||||
| Debt extinguishment cost | - | 53.3 | 22.0 | |||||||||
| Interest expense on Biomet merger financing | - | - | 70.0 | |||||||||
| Taxes on above items (1) | (421.5 | ) | (449.0 | ) | (487.6 | ) | ||||||
| Biomet merger-related measurement period tax adjustments (2) | - | 52.7 | - | |||||||||
| U.S. tax reform (3) | (1,272.4 | ) | - | - | ||||||||
| Other certain tax adjustments (4) | (112.4 | ) | (2.5 | ) | 32.4 | |||||||
| Adjusted Net Earnings | $ | 1,636.4 | $ | 1,610.8 | $ | 1,310.5 |
| (1) | The tax effect for the U.S. jurisdiction is calculated based on an effective rate considering federal and state taxes, as well as permanent items. For jurisdictions outside the U.S., the tax effect is calculated based upon the statutory rates where the items were incurred. |
|---|
| (2) | The 2016 period includes negative effects from finalizing the tax accounts for the Biomet merger. Under the applicable U.S. GAAP rules, these measurement period adjustments are recognized on a prospective basis in the period of change. |
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| (3) | The 2017 Tax Act resulted in a net favorable provisional adjustment due to the reduction of deferred tax liabilities for unremitted earnings and revaluation of deferred tax liabilities to a 21 percent rate, which was partially offset by provisional tax charges related to the toll charge provision of the 2017 Tax Act. |
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| (4) | In 2017, other certain tax adjustments related to tax benefits from lower tax rates unrelated to the impact of the 2017 Tax Act, net favorable resolutions of various tax matters and net favorable adjustments from internal restructuring transactions. The 2016 adjustment primarily related to a favorable adjustment to certain deferred tax liabilities recognized as part of acquisition-related accounting and favorable resolution of certain tax matters with taxing authorities offset by internal restructuring transactions that provide us access to offshore funds in a tax efficient manner. The 2015 amount related primarily to adjustments to deferred tax liabilities recognized as part of acquisition-related accounting and other integration related items. |
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| Year ended December 31, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2017 | 2016 | 2015 | ||||||||||
| Diluted EPS | $ | 8.90 | $ | 1.51 | $ | 0.77 | ||||||
| Inventory step-up and other inventory and manufacturing related charges | 0.42 | 2.32 | 1.84 | |||||||||
| Intangible asset amortization | 2.96 | 2.80 | 1.78 | |||||||||
| Goodwill impairment | 1.49 | - | - | |||||||||
| Special items | ||||||||||||
| Biomet merger-related | 1.22 | 2.40 | 3.26 | |||||||||
| Other special items | 1.89 | 0.62 | 1.16 | |||||||||
| Merger-related and other expense in other expense, net | 0.01 | 0.02 | - | |||||||||
| Debt extinguishment cost | - | 0.26 | 0.12 | |||||||||
| Interest expense on Biomet merger financing | - | - | 0.37 | |||||||||
| Taxes on above items (1) | (2.06 | ) | (2.22 | ) | (2.57 | ) | ||||||
| Biomet merger-related measurement period tax adjustments (2) | - | 0.26 | - | |||||||||
| U.S. tax reform (3) | (6.25 | ) | - | - | ||||||||
| Other certain tax adjustments (4) | (0.55 | ) | (0.01 | ) | 0.17 | |||||||
| Adjusted Diluted EPS | $ | 8.03 | $ | 7.96 | $ | 6.90 |
| (1) | The tax effect for the U.S. jurisdiction is calculated based on an effective rate considering federal and state taxes, as well as permanent items. For jurisdictions outside the U.S., the tax effect is calculated based upon the statutory rates where the items were incurred. |
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| (2) | The 2016 period includes negative effects from finalizing the tax accounts for the Biomet merger. Under the applicable U.S. GAAP rules, these measurement period adjustments are recognized on a prospective basis in the period of change. |
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| (3) | The 2017 Tax Act resulted in a net favorable provisional adjustment due to the reduction of deferred tax liabilities for unremitted earnings and revaluation of deferred tax liabilities to a 21 percent rate, which was partially offset by provisional tax charges related to the toll charge provision of the 2017 Tax Act. |
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| (4) | In 2017, other certain tax adjustments related to tax benefits from lower tax rates unrelated to the impact of the 2017 Tax Act, net favorable resolutions of various tax matters and net favorable adjustments from internal restructuring transactions. The 2016 adjustment primarily related to a favorable adjustment to certain deferred tax liabilities recognized as part of acquisition-related accounting and favorable resolution of certain tax matters with taxing authorities offset by internal restructuring transactions that provide us access to offshore funds in a tax efficient manner. The 2015 amount related primarily to adjustments to deferred tax liabilities recognized as part of acquisition-related accounting and other integration related items. |
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LIQUIDITY AND CAPITAL RESOURCES
Cash flows provided by operating activities were $1,582.3 million in 2017 compared to $1,632.2 million and $849.8 million in 2016 and 2015, respectively. The decline in operating cash flows in 2017 compared to 2016 was driven by additional investments in inventory, additional expenses for quality remediation and $30.5 million in penalties paid to resolve previously-disclosed FCPA matters involving Biomet and certain of its subsidiaries as discussed in Note 19 to our consolidated financial statements included in Item 8 of this report. These unfavorable items were partially offset by an estimated $174 million of incremental cash flows from our sale of accounts receivable in certain countries. The increased operating cash flows in 2016 compared to 2015 were primarily from the inclusion of Biomet cash flows for the entire year. Operating cash flows also increased by an estimated $103.1 million due to our sales of accounts receivable in certain countries in 2016. Conversely, in 2015 we had various significant cash outflows, including a $97.6 million loss on our forward starting interest rate swaps we settled and expenses related to completing the Biomet merger.
Cash flows used in investing activities were $510.8 million in 2017 compared to $1,691.5 million and $7,557.9 million in 2016 and 2015, respectively. Instrument and property, plant and equipment additions reflected ongoing investments in our product portfolio and optimization of our manufacturing and logistics network. The 2015 and 2016 periods included cash outflows for the Biomet merger and LDR and other business acquisitions. Additionally, the 2017 period reflects no investing activity related to available-for-sale debt securities because as investments matured we used the cash to pay off debt.
Cash flows used in financing activities were $1,210.5 million in 2017. Our primary use of available cash in 2017 was for debt repayment. We borrowed amounts under a new Japan Term Loan B and used the borrowings to pay down a portion of our U.S. Term Loan A. Overall, we had approximately $1,250 million of net principal repayments on our senior notes and term loans in 2017. Additionally in 2017, we had net cash inflows of $103.5 million on factoring programs that had not been remitted. Since our factoring programs started at the end of 2016, we did not have similar cash flows in prior periods. 2015 and 2016 financing cash flows reflected borrowings necessary to complete the Biomet merger and LDR acquisition.
In February, May, July and December 2017, our Board of Directors declared cash dividends of $0.24 per share. We expect to continue paying cash dividends on a quarterly basis; however, future dividends are subject to approval of the Board of Directors and may be adjusted as business needs or market conditions change. As further discussed in Note 11 to the consolidated financial statements, our debt facilities restrict the payment of dividends in certain circumstances.
In February 2016, our Board of Directors authorized a $1.0 billion share repurchase program effective March 1, 2016, with no expiration date. The previous program expired on February 29, 2016. As of December 31, 2017, all $1.0 billion remained authorized for repurchase under the program.
We will continue to exercise disciplined capital allocation designed to drive stockholder value creation. We intend to use available cash for reinvestment in the business, debt repayment, dividends and opportunistic share repurchases. If the right opportunities arise, we may also use available cash to pursue business development opportunities.
As discussed in Note 15 to our consolidated financial statements, the Internal Revenue Service (“IRS”) has issued proposed adjustments for years 2005 through 2012 reallocating profits between certain of our U.S. and foreign subsidiaries. We have disputed these proposed adjustments and continue to pursue resolution with the IRS. Although the ultimate timing for resolution of the disputed tax issues is uncertain, future payments may be significant to our operating cash flows.
As discussed in Note 19 to our consolidated financial statements, as of December 31, 2017, a short-term liability of $78.0 million and long-term liability of $121.4 million related to Durom Cup product liability claims was recorded on our consolidated balance sheet. We expect to continue paying these claims over the next few years. We maintain insurance for product liability claims, subject to self-insurance retention requirements. We have recovered insurance proceeds from certain of our insurance carriers for Durom Cup-related claims. While we may recover additional insurance proceeds in the future for Durom Cup-related claims, we do not have a receivable recorded on our consolidated balance sheet as of December 31, 2017 for any possible future insurance recoveries for these claims. We also had a short-term liability of $36.0 million recorded on our consolidated balance sheet as of December 31, 2017 related to Biomet metal-on-metal hip implant claims.
At December 31, 2017, we had eleven tranches of senior notes outstanding as follows (dollars in millions):
| Interest | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| Principal | Rate | Maturity Date | |||||||
| $ | 1,150.0 | 2.000 | % | April 1, 2018 | |||||
| 500.0 | 4.625 | November 30, 2019 | |||||||
| 1,500.0 | 2.700 | April 1, 2020 | |||||||
| 300.0 | 3.375 | November 30, 2021 | |||||||
| 750.0 | 3.150 | April 1, 2022 | |||||||
| 600.4 | * | 1.414 | December 13, 2022 | ||||||
| 2,000.0 | 3.550 | April 1, 2025 | |||||||
| 600.4 | * | 2.425 | December 13, 2026 | ||||||
| 253.4 | 4.250 | August 15, 2035 | |||||||
| 317.8 | 5.750 | November 30, 2039 | |||||||
| 395.4 | 4.450 | August 15, 2045 | |||||||
*Euro denominated debt securities
We also had four term loans with total principal of $1,801.1 million outstanding as of December 31, 2017.
We have a five-year unsecured multicurrency revolving facility of $1.5 billion (the “Multicurrency Revolving Facility”) that will mature on September 30, 2021. There were no outstanding borrowings on this facility as of December 31, 2017. We also have other available uncommitted credit facilities totaling $58.4 million.
For additional information on our debt, see Note 11 to our consolidated financial statements.
We place our cash and cash equivalents in highly-rated financial institutions and limit the amount of credit exposure to any one entity. We invest only in high-quality financial instruments in accordance with our internal investment policy.
As of December 31, 2017, $382.2 million of our cash and cash equivalents were held in jurisdictions outside of the U.S. Of this amount, $81.9 million is denominated in U.S. Dollars and, therefore, bears no foreign currency translation risk. The balance of these assets is denominated in currencies of the various countries where we operate. We intend to repatriate at least $3.6 billion of unremitted earnings in future years.
Management believes that cash flows from operations and available borrowings under the Multicurrency Revolving Facility are sufficient to meet our working capital, capital expenditure and debt service needs, as well as to return cash to stockholders in the form of dividends and share repurchases. Should additional investment opportunities arise, we believe that our earnings, balance sheet and cash flows will allow us to obtain additional capital, if necessary.
CONTRACTUAL OBLIGATIONS
We have entered into contracts with various third parties in the normal course of business that will require future payments. The following table illustrates our contractual obligations (in millions):
| 2019 | 2021 | 2023 | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| and | and | and | ||||||||||||||||||
| Contractual Obligations | Total | 2018 | 2020 | 2022 | Thereafter | |||||||||||||||
| Long-term debt | $ | 10,172.3 | $ | 1,225.0 | $ | 3,439.1 | $ | 1,941.2 | $ | 3,567.0 | ||||||||||
| Interest payments | 2,208.4 | 297.4 | 487.9 | 332.0 | 1,091.1 | |||||||||||||||
| Operating leases | 311.3 | 66.7 | 100.0 | 62.7 | 81.9 | |||||||||||||||
| Purchase obligations | 265.1 | 152.3 | 75.2 | 4.9 | 32.7 | |||||||||||||||
| Toll charge tax liability | 466.0 | 82.0 | 61.4 | 61.4 | 261.2 | |||||||||||||||
| Other long-term liabilities | 372.8 | - | 256.5 | 33.7 | 82.6 | |||||||||||||||
| Total contractual obligations | $ | 13,795.9 | $ | 1,823.4 | $ | 4,420.1 | $ | 2,435.9 | $ | 5,116.5 |
$67.1 million of the other long-term liabilities on our balance sheet as of December 31, 2017 are liabilities related to defined benefit pension plans. Defined benefit plan liabilities are based upon the underfunded status of the respective plans; they are not based upon future contributions. Due to uncertainties regarding future plan asset performance, changes in interest rates and our intentions with respect to voluntary contributions, we are unable to reasonably estimate future contributions beyond 2017. Therefore, this table does not include any amounts related to future contributions to our plans. See Note 14 to our consolidated financial statements for further information on our defined benefit plans.
Under the 2017 Tax Act, we recorded a $466.0 million income tax expense related to the toll charge liability for the one-time deemed repatriation of unremitted foreign earnings. This amount is recorded in current and non-current income tax liabilities on our consolidated balance sheets as of December 31, 2017. We expect to elect to pay the toll charge in installments over eight years.
Also included in long-term liabilities on our consolidated balance sheets are liabilities related to unrecognized tax benefits and corresponding interest and penalties thereon. Due to the uncertainties inherent in these liabilities, such as the ultimate timing and resolution of tax audits, we are unable to reasonably estimate the amount or period in which potential tax payments related to these positions will be made. Therefore, this table does not include any obligations related to unrecognized tax benefits. See Note 15 to our consolidated financial statements for further information on these tax-related accounts.
We have entered into various agreements that may result in future payments dependent upon various events such as the achievement of certain product R&D milestones, sales milestones, or, at our discretion, maintenance of exclusive
rights to distribute a product. Since there is uncertainty on the timing or whether such payments will have to be made, we have not included them in this table. These payments could range from $0 to $61 million.
CRITICAL ACCOUNTING ESTIMATES
Our financial results are affected by the selection and application of accounting policies and methods. Significant accounting policies which require management’s judgment are discussed below.
Excess Inventory and Instruments - We must determine as of each balance sheet date how much, if any, of our inventory may ultimately prove to be unsaleable or unsaleable at our carrying cost. Similarly, we must also determine if instruments on hand will be put to productive use or remain undeployed as a result of excess supply. Accordingly, inventory and instruments are written down to their net realizable value. To determine the appropriate net realizable value, we evaluate current stock levels in relation to historical and expected patterns of demand for all of our products and instrument systems and components. The basis for the determination is generally the same for all inventory and instrument items and categories except for work‑in‑process inventory, which is recorded at cost. Obsolete or discontinued items are generally destroyed and completely written off. Management evaluates the need for changes to the net realizable values of inventory and instruments based on market conditions, competitive offerings and other factors on a regular basis.
Income Taxes - Our income tax expense, deferred tax assets and liabilities and reserves for unrecognized tax benefits reflect management’s best assessment of estimated future taxes to be paid. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments and estimates are required in determining the consolidated income tax expense.
We estimate income tax expense and income tax liabilities and assets by taxable jurisdiction. Realization of deferred tax assets in each taxable jurisdiction is dependent on our ability to generate future taxable income sufficient to realize the benefits. We evaluate deferred tax assets on an ongoing basis and provide valuation allowances unless we determine it is “more likely than not” that the deferred tax benefit will be realized.
The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations. We are subject to regulatory review or audit in virtually all of those jurisdictions and those reviews and audits may require extended periods of time to resolve. We record our income tax provisions based on our knowledge of all relevant facts and circumstances, including existing tax laws, our experience with previous settlement agreements, the status of current examinations and our understanding of how the tax authorities view certain relevant industry and commercial matters.
We recognize tax liabilities in accordance with the FASB’s guidance on income taxes and we adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the tax liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which they are determined.
Commitments and Contingencies - Accruals for product liability and other claims are established with the assistance of internal and external legal counsel based on current information and historical settlement information for claims, related legal fees and for claims incurred but not reported. We use an actuarial model to assist management in determining an appropriate level of accruals for product liability claims. Historical patterns of claim loss development over time are statistically analyzed to arrive at factors which are then applied to loss estimates in the actuarial model.
In addition to our general product liability, we have recorded provisions totaling $489.7 million related to the Durom Cup. See Note 19 to our consolidated financial statements for further discussion of the Durom Cup litigation.
Goodwill and Intangible Assets - We evaluate the carrying value of goodwill and indefinite life intangible assets annually, or whenever events or circumstances indicate the carrying value may not be recoverable. We evaluate the carrying value of finite life intangible assets whenever events or circumstances indicate the carrying value may not be recoverable. Significant assumptions are required to estimate the fair value of goodwill and intangible assets, most notably estimated future cash flows generated by these assets. As such, these fair value measurements use significant unobservable inputs. Changes to these assumptions could require us to record impairment charges on these assets.
We have six reporting units with goodwill assigned to them. In the fourth quarter of 2017, we determined our Spine, less Asia Pacific (“Spine”) reporting unit’s carrying value was in excess of its estimated fair value. Fair value was determined using income and market approaches. Fair value under the income approach was determined by discounting to present value the estimated future cash flows of the reporting unit. Fair value under the market approach utilized the guideline public company methodology, which uses valuation indicators determined from other businesses that are similar to our Spine reporting unit. As a result, we recorded a goodwill impairment charge for the Spine reporting unit of $272.0 million in 2017. As of December 31, 2017, $421.5 million of goodwill remains for this reporting unit.
Also, in the third quarter of 2017, we recognized a goodwill impairment charge of $32.7 million on our Office Based Technologies reporting unit using a market approach. The $32.7 million impairment represented the entire goodwill balance of the reporting unit and, therefore, no goodwill remains.
See Note 9 to our consolidated financial statements for further discussion and the factors that contributed to these impairment charges and the factors that could lead to further impairment.
For our other five reporting units that have goodwill assigned to them, their estimated fair value exceeded their carrying value by more than 10 percent. We estimated the fair value of those reporting units using the income and market approaches. If we do not achieve our forecasted operating results or if market valuation indicators decline, we could be required to recognize additional goodwill impairment charges in the future.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 2 to our consolidated financial statements for information on how recent accounting pronouncements have affected or may affect our financial position, results of operations or cash flows.
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