史賽克 (SYK) 2003 Q2 法說會逐字稿

Welcome to the Stryker Corporation second-quarter operating results conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. At that time, if you have a question, please press the one followed by the four on the telephone. As a reminder, this conference is being recorded Tuesday, July 15, 2003.

Certain statements made in today's presentation may constitute forward-looking statements. They are based upon management's current expectations and are subject to various risks and uncertainties that could cause the company's actual results to differ materially from those expressed or implied in such statements.

In addition to factors that may be discussed in this presentation, such factors include, but are not limited to, regulatory actions, including cost containment measures that could adversely affect the price of, or demand of, the company's products, changes in reimbursement levels from third-party payers, a significant increase in product liability claims, changes in economic conditions that adversely affect the level of demand of the company's products, changes in foreign-exchange markets, changes in financial markets, and changes in the competitive environment.

Additional information concerning these factors is contained in the company's filings with the Securities and Exchange Commission, including the company's annual report on Form 10K and quarterly reports on Form 10Q.

I will now like to turn the conference over to John Brown, Chairman and C.E.O., with Stryker Corporation. Please go ahead, sir.

Thank you. And welcome, everyone, to Stryker's second quarter earnings report for 2003. With me here today are Steve MacMillan, President, Chief Operating Officer, and Dean Bergy, Vice President, Chief Financial Officer, Secretary.

We're pleased to report that Stryker had a very strong second quarter and first half. For the second quarter, net sales were $892 million, an increase of 22% over the prior year.

Excluding the impact of foreign currency, sales were 16% higher than last year. Net earnings increased 25% to $108 million, and diluted net earnings per share increased 26% to 53 cents per share.

For the first half, net sales were $1.739 billion, which is an increase of 21% over the prior year. Excluding the impact of foreign currencies, sales were 16% higher than last year. Net earnings increased 27% to $212 million, and diluted net earnings per share increased 27%, to $1.04.

We generated $114 million in free cash flow in the first half, allowing us to reduce debt, plus the accounts receivable securitization, by $85 million to 547 million. That's down a little over $1 billion from the December of '98 period when we took on the $1.6 billion of debt to acquire Howmedica.

Domestic sales were $567 million for the second quarter and $1.113 billion for the first half, representing increases of 19% and 18% over the prior year. Substantially all of the U.S. divisions, really, had great first halves and are well-positioned for excellent years to come.

Howmedica Osteonics was up 23% in the quarter and 22% for the half, with extremely strong growth in spine and trauma, and strong growth in the reconstructive implants.

Instrument sales increased 14% in the quarter and 15% for the half, with solid growth in powered instruments, and strong growth in Neptun and operating room waste management systems, Steri-Shield, pain management, percutaneous cement delivery system. Endoscopy sales increased 18% in both the quarter and the half, with strong growth in video, and solid growth in general surgery and arthroscopy.

Medical was up 13% in the quarter and 16 % in the half, with across the board growth in hospital beds, stretchers, and ambulance cots. Leibinger sales were up 4% in the quarter, but declined 5% for the half. Physiotherapy returned, finally, to double-digit revenue growth for the first time since the third quarter of 2002, with sales up 10% in the quarter and 8% for the half, primarily on the basis of new startups and acquisitions.

International sales were $325 million for the second quarter, and $625 million for the first half, representing increases up 27% over the prior year in both periods. Foreign currency comparisons added $39 million to the top line in second quarter and $76 million for the first half. Excluding the impacts of foreign currency, international sales increased 11% for both the second quarter and the first half.

On a local currency basis, most of the international divisions had excellent first halves. Europe grew 13% in the quarter and 14% for the half, with strong performances in the U.K., Benelux, Scandinavia, Spain, and Italy. Japan grew 10% both in the quarter and the half, with strongest performance in orthopedic implants. Pacific was up 11% for the quarter, 8% for the half, the strongest performances in Australia and China. Canada and Latin America were up 7% for the quarter, 5% in the half, with the strongest performances in Latin America.

Orthopedic implant sales were $522 million for the second quarter and $1.013 billion for the first half, representing increases up 26% and 25%, respectively. That's based on strong shipments of reconstructive spine and trauma implants.

Orthopedic implants have now reached an annual run rate exceeding $2 billion, a milestone that we've been pushing for for sometime now. Excluding the impact of foreign currencies, sales of orthopedic implants increased 19% in the quarter and 18% in the half.

MedSurg sales were at $313 million the second quarter and $617 million for the first half representing increases of 17% in both periods, that's based on higher shipments of power surgical instruments, endoscopic systems, hospital beds, stretchers, and craniomaxillofacial implants. Excluding the impact of foreign currency, sales of MedSurg equipment increased 13% in the quarter and 14% for the half.

Commenting on new products, Second quarter introduction of ceramic insert for our Trident ceramic on ceramic hip systems had an extremely positive impact on the domestic hip sales in the quarter. The Trident ceramic system is also selling very well in Australia, Europe, and Canada. In addition, Trident's acetabular cup system continues to be our fastest growing cup system.

System 5 heavy-duty power instrument system was introduced last year. Sold well in the first half. This fifth-generation, battery-powered instrument system is the best ever, and it continues to be extremely well received in the market.

The T2 intramedullar nail system continues to drive our trauma sales. The T2 system provides a wide range of fracture repair options for the tibia, femur, humerus, using a common set of instruments.

The next generation of [INAUDIBLE] implant systems introduced in the fourth quarter of 2002 is off to a very strong start. The new screws are lower in profile, easier to insert, and provide more placement options, and the new instruments are easier to use.

The EIUS [INAUDIBLE] Uni Knee launched at the 2001 is the fastest growing knee product. The Scorpio Flex knee was launched in the U.S. in late 2002, and it, along with our deep flexion knees products in Japan and the Pacific, is doing well in the cranium [INAUDIBLE] flex knee market.

We received F.D.A. clearance to begin selling our Simplex P with Tobramycin bone cement in the United States with certain indications in early May. Acceptance of this preblended antibiotic bone cement met our expectations, and the product sold well throughout the second half of the second quarter. It's been on the market now about six weeks. Simplex P with Tobramycin has been sold in most overseas markets since the mid - 2000s.

The DEKOMPRESSOR Percutaneous Discectomy probe for aspiration of herniated disc material was acquired in the fourth quarter of 2002 and generated nice sales in the first half.

Under an agreement with Regeneration Technologies, Stryker endoscopy began distributing human autograft tissue for U.S. sports medicine surgery late in the first quarter. Sports medicine products includes [INAUDIBLE], pre-shaped tendons, precision-tooled anchors, screws, and pins, and [INAUDIBLE] osteocondyle allograft.

The EMS STAIR-PRO evacuation chair is the best-selling product from our medical division in the year 2003.

We believe that -- we'll talk about noninvasive knee and hip procedures which is certainly the rage right now in orthopedics. We believe that Stryker Howmedica Osteonics has a strong position with the development of its Scorpio total knee instrumentation to complement the surgical techniques for less invasive total knee replacement that's been pioneered by Dr. Peter Bonutti.

The multicenter study to validate the safety and reproducibility of this procedure is expected to be completed this summer. We're establishing regional training centers for doctors who wish to learn about these techniques.

In minimally invasive hips, we've designed unique instruments for the use in [INAUDIBLE] incision total hip arthroplasty procedures, and we've been conducting an extensive evaluation of this procedure and the instruments, and plan to begin rolling instrumentation steps out to the field in the third quarter. Our Accolade hip system is an excellent product for use in [INAUDIBLE] many incision procedures because of its simple instrumentation system.

Turning to OP-1,: OP-1 continued to do well in the United States in the second quarter. The number of hospitals using the devices continues to increase. The product is well established in Australia and is doing better in Europe, as they develop a dedicated OP-1 product theme in key countries.

As we evaluate processor improvements to benefit future production of OP-1, we anticipate experiencing some level of supply interruption in the last half of 2003. We have to use our production facilities for both pilot plant work and for production.

We are recruiting patients to the North American uninstrumented posterolateral spine fusion trial, expected to [INAUDIBLE] by the end of this quarter. In Japan, we're enrolling patients in Phase II posterolateral spine fusion clinical trials using OP-1 and expect to complete tests this year.

And with that, I'd like to turn the microphone over to Steve MacMillan to allow Steve to comment on his activities and focus during his first few weeks here at Stryker. Steve?

Thanks, John. Good afternoon.

I've been spending my first few weeks getting to know our businesses, our people, and our customers around the world. My initial primary focus has been with our implant business, which, as John mentioned, is now on track to exceed $2 billion this year.

We are pleased with the progress of the launch of our Trident ceramic on ceramic hip, which saw steady growth from April through June as we wrapped up our instrumentation placement. Trident has breathed new life into our hip business, driving our U.S. and worldwide hip sales for the quarter up 21% and 22%, respectively, a significant acceleration from recent quarters.

We are particularly pleased with the U.S. performance, as international was helped by a strong currency tailwind. On a constant currency basis, hips were up 15% globally in the quarter. Not bad, but always more work to be done.

We've also been focused on boosting our sales and marketing strengths, as well as diving into our product development activities, with an eye on continuing our heritage of innovation. We are rededicating ourselves to strengthening R&D, and expect you will see the results of these activities in future results.

In addition to the Trident ceramic on ceramic launch, we also received approval for the first bone cement/antibiotic combination product in the U.S., Simplex P with Tobramycin. This was approved, as John mentioned, in early May, and is off to a rapid start, driving our bone cement business to double-digit increases in the quarter.

Knee sales were also solid in the quarter, with U.S. and worldwide growth of 14% and 16%, respectively. The U.S. business continues to be driven by strong growth of our Scorpio knee in the U.S., which has now surpassed Duracon as our leading knee system. On a constant currency basis, growth for knees was 10% in the quarter.

We also experienced strong growth in both spine and trauma. On a reported basis, spine was up 97% in the U.S. and 73% globally, boosted largely by last year's SDI acquisition, which has clearly helped us establish a stronger presence in the spine market. Looking forward, our reported growth rate will return to more normal levels at the anniversary of the SDI acquisition, now behind us.

We also continued to make solid progress with our growing trauma business. Led by strong acceptance of the new T2 nail system, U.S. sales were up 17% in the quarter, and global sales up 31% ,or 20% on a constant currency basis.

To summarize, our total orthopedic business was up 26% in the quarter on a worldwide basis, with 7 points of that growth coming from currency, leading to 19% underlying growth. And in the important U.S. market, sales advanced by a strong 24%, a particularly stellar job by our U.S. team.

For more details, we'll now turn it over to our Chief Financial Officer, Dean Bergy, to elaborate further on the quarter's results.

Thanks a lot, Steve.

I'd like to start by talking about the foreign currency impact in the quarter. Obviously, they were, again, very favorable in the second quarter, increasing our international sales by $39.3 million, or 15%, bringing the impact for the total year to $76 million. In the quarter, the euro strengthened 21% and the yen strengthened 4% against the dollar. If currency rates hold, we believe we'll see a positive impact on sales in the third quarter of about $25 million.

Turning to the price-volume analysis impact on sales. U.S. implant prices were, again, up about 5% in the quarter, and that same percentage holds for the first half, as well. Prices in Europe are up slightly for the year, and in Japan, prices declined slightly in the second quarter and are flat for the year. If you look at the overall price-line analysis as a percentage of sales, a price in the quarter contributed 2% sales growth, foreign currency contributed 6 points of growth, acquisitions contributed 2 points, and volume mix was up 12%, or 22% growth.

Turning to the year, price contributed 2 points of growth. Foreign currency was 5 points, acquisitions 2 points, and volume mix 12 points, bringing us to the 21% growth that we're reporting for the year-to-date.

The acquisition impacts here, primarily, relates to the July 1, 2002, acquisition of Surgical Dynamics. As Steve mentioned, that acquisition impact, primarily, will go away in the upcoming third quarter. For the first half, our volume mix is up about 12% in the United States and 10% overseas.

Now turning to the segments of our business, orthopedic implants, I'll remind you, represents about 58% of our sales. As John talked about earlier, orthopedic implant sales increased 26% in the quarter and 25% for the half, on an as-reported basis, and 19 and 18%, respectively, on a constant currency basis. Now I'll give you the breakdown of those sales results by product line, starting with domestic and then working across to international.

On the domestic line for the quarter, hips were up 21% -- actually, I'll go down. 21% domestically, 22% internationally, or 22% total growth in hips. Knees were up 14% domestically, 19% internationally, for 16% reported growth. Trauma was up 17% in the U.S., 40% internationally, for 31% total reported growth. Spine was up 97%, 46% internationally, and 73% total. And then the total for orthopedic implants, 24% domestically, 28% internationally, to get to a 26% reported number.

On a constant currency basis for the quarter, the domestic numbers are, obviously, the same. The international numbers I'll give you, then I'll give you the totals with the blended rates on a constant currency basis.

So on constant currency internationally, hips were up 7 for a total of 15. Knees were up 4 internationally for a total of 10, when you add in domestic. Trauma was up 21 internationally for a total of 20. Spine was up 30 internationally for a total of 66. And orthopedic implants were up 12 internationally for a total of 19%.

Now I'll comment on the individual product lines. Hips -- hip growth in the second quarter was very strong, led by the introduction of our Trident ceramic on ceramic hip system in the United States. We rolled out sets to the field throughout the second quarter and believe we now have enough inventory and instrumentation in the field to meet demand.

[INAUDIBLE] stems, which are used in the higher end ceramic on ceramic procedures continue to lead the growth in hips, driven by our [INAUDIBLE], the Accolade TMZF, Citation TMZF, and Secur-Fit HA. Revision stems continue to do well, led by our T3 modular revision hip system.

Sales of acetabular cups are solid, driven by our Trident acetabular system for polyethylene and ceramics. I'll remind you that the Trident acetabular system utilizes the same cup and shell locking mechanism for the polyethylene and ceramic lines.

In Europe, Trident and Exeter are doing well, and ABG, too, is steady. Japan, Super Secur-Fit, Super EON, and ABC ceramic on ceramic hips are doing well. In addition, our new [INAUDIBLE] HA coated Trident cuff was launched in limited quantities in the second quarter.

Knees were up 16% in the second quarter, 17% year-to-date. And another good quarter in knees was Scorpio, providing excellent growth in the United States. DuraconTS and Scorpio TS revision systems are doing extremely well.

The Scorpio flex knee for patients requiring an extended range of motion was launched in the U.S. last year, and it's growing rapidly. The modular rotating knee hinge has also been well accepted in the United States. Our posterior, stabilized deep flexion knee products, Scorpio Super Flex PS, continues to do well in Japan, and a similar deep flexion knee product is making inroads in the Pacific.

EIUS, our new minimally invasive Uni Knee continues to be our fastest growing knee product. In Europe, Kinemax is doing extremely well in the UK. We also introduced a mobile bearing Scorpio knee in Europe last year, and we have a U.S. mobile bearing knee clinical trial underway.

Trauma, as Steve commented on, has done extremely well for the quarter and the year, up 31%, continuing a great growth trend in the U.S. and overseas. The second-quarter growth was stronger overseas, when you put more recent emphasis on dedicated sales organizations.

The T2 intramedullary nail system, which was launched the U.S., Europe, and Japan in 200, continues to drive our trauma growth. The T2 system was completed in 2002 with the introduction of the T2 humeral nail. This was Stryker's best performing new product in 2002, and continues to set new sales records.

Again, hip fracture devices and external fixation products also did very well in the first half, particularly in overseas markets. Growth in external fixation devices continues to be helped by military sales.

Spine was up 73% in the quarter, as you know, and 76% year-to-date. The ZF thoracolumbar systems are growing nicely, with the introduce of SF2 late last year. That system, as you know, offers lower profile screws and improved instrumentation.

A reflex material cervical plate also continues to do well. Last year's addition of spinal implant products from Surgical Dynamics helped round out the Stryker spine lineup by adding interbody cages in the U.S. market, as well as other cervical and thoracolumbar systems. The additional thoracolumbar products are doing very well.

We lost some interbody cage sales in the transition, but believe that this business has stabilized. We are committed to growing U.S. interbody cage sales through training and the natural maturation of our U.S. spine sales force.

Now I'll turn to our MedSurg group. That represents 36% of our sales. I'll remind you that MedSurg is comprised of four operating divisions; Instruments, which makes up 41% of that sales total, endoscopy 31% of sales, medical 20%, and Leibinger 8%. Our MedSurg group sales were up 17%, as recorded for the quarter and the half, and 13% for the quarter and 14% for the half on a constant currency basis.

Turning to instruments, the instruments line had a great quarter, growing 22% in both the quarter and the half, and 17% for the quarter and 18% for the half on a constant currency basis.

Turning to those -- their product lines in the quarter, powered instruments were up domestically 10%. Internationally, 34%, for a total growth in the product line of 16%. And other OR equipment was up 18% domestically, 69% internationally, and 29% in total. And then the totals for instruments, 13% domestic growth, 37% international growth, and 22% total growth.

Now the instruments division had an excellent quarter, based on steady growth in card instrument systems and strong shipments of other OR equipment. Neptune Operating Waste Management system, Steri-Shield, pain management, and percutaneous cement delivery were especially strong in the quarter.

Growth outside the United States, as you can see by the number, was very strong. I'll remind you that we have lower market penetration than in those markets. An important sales driver, as John mentioned, continues to be Systems 5. And also, we've had nice sales from the addition of our DEKOMPRESSOR discectomy probe in the quarter.

Now turning to endoscopy. Endoscopy was up 19% in the quarter, 18% for the half, as reported. And on a constant currency basis, 17% in the quarter, 16% for the half.

Looking at their product lines, arthroscopy was up 17% domestically, 26% internationally, for 19% total growth in the quarter. General surgery was up 8% domestically, 20% internationally, 10% total. Video was up 26% domestically, 21% internationally, and 25% in total. In total, endoscopy was up 18% domestically, 21% internationally, bringing them to the 19% reported third quarter growth.

As you've heard from the numbers, endoscopy had another great quarter based on strong growth in video and arthroscopy, and solid growth in general surgery. The camera sales have been very strong, and there continues to be a lot of activity in the Endosuite and communications area.

Turning to Leibinger, Leibinger was up from the first half, as you recall. Leibinger total growth in the first quarter was 2%, the line increased to 11% in the second quarter, and 7% for the half.

As you know, Leibinger split its sales organizations at the beginning of this year to bring more focus to the CMF and navigation businesses. The CMF business was stronger this quarter, and the international business continued to show nice growth. Domestic sales were up 4% in the quarter, international 20%, for the 11% growth. And we continue to believe that the sales force changes we've made here will make a difference as this year goes on.

Turning to medical, the medical line was up 10% in the quarter and 13% for the half on an as-reported basis. 8% for the quarter and 11% for the half on a constant currency basis. As you recall, this is primarily a North American business for us. Domestic sales were up 13% in the quarter, international sales, on a very small base declined 2%, for the 10% growth. Medical had another very good quarter, and the U.S. hospital bed, stretcher, and ambulance cot sales were strong, based on new products and a stronger sales force.

Physiotherapy revenue growth was 10% in the quarter, bringing first half revenue growth up to 8%. As John talked about, physiotherapy's sale growth came back in the quarter as it continued to adapt to the clarification in Medicare coding guidance that was effective July 1, 2002. Startups and acquisitions have contributed most of physiotherapy's growth this year. Same store sales are up 1%. PT now has 362 centers, up from 350 at the end of the first quarter.

Turning now to the other parts of the P&L. Looking at margins, as you saw from the press release, margins in the quarter were 63.3% versus 63.6% last year. They're down slightly, primarily as a result of some duplicative costs from plant production moves and higher excess and obsolete inventory reserving. The transition out of our Rutherford orthopedic implant manufacturing facility is pretty much complete, and the good news here is that it's gone off, really, without a hitch. It's been extremely well executed.

Turning to R&D, you can see that that ratio increased from 4.7% of sales in 2002 to 5% of sales in 2003. And that increase is, primarily, the result of us putting increased focus on our development efforts.

Selling, general and administrative expenses, were pretty flat in the quarter versus the prior year of 39.2% in 2002, 39.1% in 2003, as strong sales have allowed us to grow our dedicated sales forces and absorbed higher insurance costs.

Operating income increased 19% in the quarter. Operating margins were down slightly from last year, primarily from the increase in R&D spending and the little falloff in margins that we saw.

Looking at interest expense, you know that here we include, we look at interest expense, the total cost of our debt, as including our accounts receivable securitization program. When we look at the numbers, we include the accounts receivable securitization discount, which was 0.7 million in the second quarter and $1.2 million year-to-date. So total interest, including that, is $7.1 million in the quarter, bringing it to $14.6 million year-to-date. Its down 34% in both quarter and the year.

Intangibles, amortization increased $4.3 million in the quarter and $7.3 million year-to-date. That's primarily as a result of the Surgical Dynamics acquisition.

Other income, I'll give you the breakdown here. It's a small number. But it's made up, really, of three components. The components in the quarter, interest income was $1.6 million. The foreign currency loss was a loss of $600,000. And we had minority interests up $200,000, bringing us to the $800,000 of income that we had in the quarter.

We saw for the second quarter in a row our income tax rate has declined to $31% from 33%, primarily as a result of tax benefits from manufacturing in Ireland and Puerto Rico. As you know, the annual income tax rate in 2003 -- or 2002 was 31.8%.

Turning to the balance sheets, the balance sheet continues to look very good. The one thing I'll tell you about, or remind you about here, is you do have to, for our receivables and debt, adjust those numbers for the impact of our cost receivable securitization program, which was expanded during the quarter. It had been at $130 million, and we've now increased the maximum to $200 million, and currently we have out on that program $181.5 million. You have to add that number back to both receivables and debts to get to the adjusted numbers.

Accounts receivables, days after having made that adjustment, are up one day from the prior year at 63 days, primarily as a result of increased sales overseas.

Inventory days are down nicely compared to the second quarter of last year. They finished this quarter at 128 days. That's a decline of 21 days from 149 last year at the same time, and is just two days above our record low that we've set at the end of 2002.

Our total debt plus accounts receivable securitization declined $32 million in the quarter. As John mentioned, that number is now $547 million, which includes the AR securitization, plus the long-term debt, and we dropped that number by $85 million in the first half. Our debt ratio has continued to improve, with debt to EBITDA down to 0.68, and the interest coverage ratio up over 22 times.

And the good news is the rating agencies have continued to recognize our progress here. Moody's upgraded our rating in June from BAA-2 to BAA-1. That's still one step behind Standard and Poor's, which has us at an A-minus.

In our operating cash flow, turning to the cash-flow statement very briefly, was very strong in the half, finishing at $225.3 million. If you adjust that for the accounts receivable securitization proceeds that you see there, that number is $173.8 million, and that's flat from the prior year. And that's actually very good, considering the fact that we've had much heavier tax payments in 2003.

With that, I'll turn it back over to John for some final comments.

Okay. Thanks, Dean, and thanks, Steve, for your comments.

Just some comments on the 2003 outlook. We really had an excellent first half, and we continue to be very optimistic about the markets that Stryker's participating in. We lose the incremental growth from the SDI acquisition effective at the end of the second quarter, and the foreign currency tailwind is going to be a little less in the second half, particularly as the yen, we won't get any help from the yen in the second half, we don't think. It hold around 118 to 120.

But we're still pushing for $3.6 billion in sales for the year, that's still our goal. It's our internal goal, it's our external goal. And that would put us up about 20% over 2002. And based on strong first half performance, in our projections for the remainder of the year, we're increasing our net earnings goal for 2003 from $2.15 to $2.18 per diluted share, which will be a 25% increase on net earnings before nonrecurring items.

Now I hasten to add here, we're not just trying to inch up quarter by quarter, but this goal is our internal goal, and again, it's our external goal, so we're not holding anything back from you.

With that, you've probably heard more prepared statements than you wanted to hear, so we'll be delighted to open it up for Q&A.

Thank you. Ladies and gentlemen, if you'd like to register for a question, please press the one followed by the four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the one followed by the three. If are you using a speaker phone, please lift the handset before entering your request. One moment, please, for the first question.

Our first question comes from the line of Katherine Martinelli with Merrill Lynch. Please go ahead with your question.

Great. Thank you. Just a question first on the Trident rollout. I assume it's too early to break out the percent that it was for hip sales in the U.S. in the quarter. But have you changed your expectations for what you think the penetration rates might be for the full year, and where they could be over the next 12 months?

I would say if anything, we're becoming more and more bullish about it. Steve has become my main hip man. Steve, you're welcome to comment on this if you want.

Yes, Katherine. I think we're still cautiously optimistic. It's hard to tell how much has been pent up demand yet, and how much is real, sustaining demand. But we would say that we're feeling very optimistic from a lot of the physician, feedback we're getting so far.

Does it appear you're primarily upgrading existing customers, just given where are you in the rollouts? Or have you seen some market-share gains from typically non-Stryker accounts?

No. Really in the first two months, April and May, was virtually all upgrading. In June, we started to just begin to feel the effects of some surgeons converting over. And frankly, we've been a little bit supply constrained in terms of getting the instrumentation out. We think there may be some more demand out there. But we're cautiously trying to get it.

And then just lastly, do you realize higher operating profit on that? I know the selling price is higher. But since you're not manufacturing it, or I assume the manufacturing costs are higher, does that still have a net positive from the operating line?

Katherine, I would say that the gross margin as a percentage of sales is probably a little bit less because it is a supply product. Given the selling price, it's certainly getting a little bit of operating profit uplift. But nothing that could be that significant to us.

Okay. And then just lastly, a clarification, Dean. Your comments about the higher inventory reserves -- I apologize. I just missed it and wanted to make sure I got what you were saying.

What I was basically saying is that our margin, when you look quarter on quarter, our inventory reserving was just a little bit higher this year versus last year. And we have a consistent methodology that we use for that. And it really is dependent on just what's going on with our product lines. So, you know, the results of that formula, basically, just end up a higher number this year vis-a-vis last year.

Okay. So there wasn't some particular area that suddenly became a trouble spot?

No. Not at all.

Okay. Great. Thank you.

Thanks, Katherine.

Our next question comes from the line of Bill Plovanic of First Albany. Please go ahead with your question.

Thank you. I'd like to tag onto Katherine's question. In regard to ceramic on ceramic, I understand the supplier has had some issues supplying -- I don't know, one of your competitors -- I was wondering if you've seen an impact from that?

Secondly, that was a great number on the U.S. hip increase year-over-year, and I was wondering, how much of that is volume, and how much of that is pricing due to the increased price point on the ceramic product?

In the accounts --

Yes.

Well, as you know, our U.S. implant pricing is up about 5%. And I think on hips, it's probably a little bit more than that, as a result of ceramic. But it's not double digits.

Okay. Great. And then on the supply, have you had any supply issues?

Well, we are constrained right now, and we are, shall we say, all over our supplier here to help us get out of this, to speed up their plant and give us better supply. But I think that's probably going to wear on, probably the rest of the summer before we can really get total control of it.

Okay. So you're saying by the end of July or August, you think that will be resolved?

By the end of summer. I'm thinking sometime in September to October.

Bill, it depends on demand a little bit, obviously. We hope we can keep our suppliers as busy as possible, run right out of supplies.

Okay. Fantastic. Thanks a lot. Great quarter.

Thanks, Bill.

The next question comes from the line of Rick Wise of Bear, Stearns. Please go ahead with your question.

Good afternoon, John.

Hi, Rick.

A couple of questions. First, you all talked about the Rutherford Plant, basically, being closed. Can you write that back to gross margins? Shouldn't we see gross margins trend higher from here? And maybe you could expand a little more on the comments about the inventory drag on gross margins in the quarter.

Okay, Rick. The -- I mentioned that there are a couple of impacters on gross margin. One is duplicative costs from some plant movements. Rutherford is certainly a part of that. I think, as we get through this Rutherford transition, which is still, as I said, it's pretty much complete. But there's still some work to be done on the other side of the transition. I think we'll have a better sense of it when we report next quarter, and I think it's possible that we could see a little uplift this year. But most of that impact will be in 2004.

Relative to the inventory reserving, that's pretty normal. And, you know, the change here is only 0.3 of a margin point. It's not a lot year-to-year. So there's not a lot to that. But it is a little bit of a factor in that change.

Okay. On the -- your lapping the SDI acquisition, as you indicated, should we assume more normal spine growth is in the mid-20% range? How should we be thinking about that?

Well, you know, what's normal? We're never happy with our growth here. But I would think that it would be in the 20% or better area, 20, 25% area.

Okay.

We're not going to be happy unless we're gaining market share.

I can believe that. And last, you talked about working to strengthen your R&D. Can you discuss the implications of that, both in practical terms, is it more people, is it focusing on new areas, does it suggest accelerating R&D spending?

Well, we're not so much accelerating spending, Rick, as just putting more focus on managing the R&D process and giving a lot more visibility to our R&D people, particularly the people who come up with good ideas.

We, for the first time, had a worldwide meeting with our major R&D folks back in April. And it was the first time that we had really recognized people, these people, publicly, for what they had done. And this is self-serving, I guess. But it really was a great success. And one that we want to build on.

Now one of the things that Steve is doing is starting to focus on this, and I'll let Steve just comment.

Yeah, Rick, I think when you really look at it, Stryker's been a phenomenal sales and manufacturing organization. We started with a history in innovation from Homer Stryker. We really are trying to pick up on a little more focus on what else we can do to dial up the invented part of the equation.

I'm spending time with each division, reviewing in probably more detail than we have historically, what are we really working on, are we working on the focus areas? It's less about necessarily about spending more, more about the same accountability that we hold the sales forces to and deliver on timely new product developments. So I think we're just turning up the visibility within the organization. And the accountability.

Okay. Thank you, very much.

Thanks, Rick.

Our next question comes from the line of Larry Keusch for Goldman Sachs. Please go ahead with your question.

Okay. Great. Thanks. Dean, I just -- I don't want to beat a dead horse on the gross margin. I'm just trying to understand one thing. If I could here -- I'm just trying to understand, I know that comparisons year-over-year are just 0.3 of a percent, but they -- the GM comparison is down more substantially, sequentially, despite the fact having, you know, approximately $50 million in higher revenues. So I'm trying to understand what changes, sequentially, as you think about it, I guess your manufacturing or your inventory levels, etc. Particularly with inventory going down.

I think, Larry, you see the same thing most every year, it started to become a trend in the business. I talked about this a little bit, as I answered some questions at the end of the first quarter. I think what you see is -- it really hasn't started that much. But sometimes you see the factory start to slow down. I wouldn't say that's happened a lot here. The other thing you see start to see happen is our product inventory reserving does go up throughout the year, or seems to.

And I think that is just as much as anything else a result of the fact that we start to introduce new products. Many of them are introduced in the first quarter, and that, as products start to get phased out, as we look at the reserve needs for those products, we just end up tending to build those reserves as we go throughout the year.

Okay. That's helpful. We should be thinking about it as this may be sort of a seasonal effect here. Maybe next year we get some offset from Rutherford. But certainly thinking about it that way.

I think that's fair. Certainly if you look at the trends, that's what's happened in the last several years.

Okay. Perfect. And then just two other questions. John, maybe you'll take this one.

Just trying to get a sense of, you know, sort of, what type of patients the ceramic on ceramic is actually going into. I know what you talked about prelaunch, and sort of, talking about the younger patient. I wonder if you could touch on what you've seen this far?

The second question is, any sort of color from the hospital, you know, we definitely have seen a reduction in admissions. The comps get tougher in the second half the year. I'm looking to see if there's anything that suggests they may be looking a little bit more, pushing back on some of the cap spending that they had planned?

Well, I'll answer the second question first. On capital spending, hospitals are continually having to upgrade. They're very competitive. They've got to have new equipment to attract patients, and also to attract surgeons and physicians to refer patients to their facilities. So the capital spending, based on what I'm seeing with powered instruments, if anything, it's popped up a little bit this quarter.

And the U.S. bed structure business, which is another good surrogate for capital spending, I say it's still pretty robust. I would admit that I think we're growing faster than the market in both cases. So it may not be a total -- totally good correlation with the market. For us, capital spending is not -- not particularly [INAUDIBLE] right now. Same thing with the endoscopy. That continues to do well.

And on the issue of ceramic on ceramic, clearly this product, is being positioned with clinicians, and I think, rightfully so, that this is a product for the baby-boomer with a hip problem. That's where the product is going to be used. And that's the patient that's more concerned about the quality of the implant and expected life of the implant than they are with the cost of the implant.

A couple of hundred dollars in price here is not going to affect that decision at all. It's going to be more and more on what is the expected outcome, and how long, Dr., is this going to last. Steve might want to add to that.

I think John hit it well. Clearly, that's the initial market . Where it goes from here, it might creep up a little bit in agewise.

Okay. Great. Thanks, guys.

Thank you.

Our next question comes from the line of Ben Andrew with William Blair. Please go ahead with your question.

Good afternoon. You mentioned you wouldn't be happy with spine growth, kind of, at the market rate, which again, doesn't surprise anybody. What mechanisms do you think you'll work at to drive that higher? You talked a little bit about maturation of the sales force. But do you see throwing more resources at that business, generally?

You know, the maturation is a key issue. I don't see us throwing a lot of financial resources at it, too much at this point, Ben. We did lose gain reference, we lost some cage business in the integration. There was a little bit of a learning curve here for us. I think we're seeing the cage sales picking up, sequentially, over the last few months. Still nowhere near where we want to be.

I do think we've been doing a lot more focused training. And we've hired a lot of new folks into the sales organization, dedicated spine reps. Really, toward the end of last year, and really brought them on, many of them, in the first half of this year. As you know, spine, a little more complicated. The learning curve a little bit longer. We think that's going to start to come through. But it is more focused on that than additional money or resources.

Is there anything you're keeping your eye on in the pipeline that could help move the needle in the next 12 months in that space?

We've got some things that we're working on. That's part of our dedicated review, I'm going to be going next week with that group.

Okay. Finally, John, you mentioned MIS training that you're going to start instituting some regional centers. Can you talk a little bit more about that, and how you'll roll that out? And when you think that might begin to impact the business?

I -- there's not a whole lot more I can add to it. It's just one of the things that the guys mentioned to us the other day that they're going to be doing. So I can't give you a lot more detail.

Okay. Thank you.

Okay.

Our next question comes from the line of Rob Faulkner with Prudential Securities. Please go ahead with your question.

Thank you, very much. Good afternoon.

Hi, Rob.

How are you? Just a couple of points here. I'm focusing on volume. As many investors look at hospitals, they've noticed a sharp decrease in growth and admissions. And they're wondering why we're not seeing that in hips and knees. And I guess the question is, are we seeing it in hips and knees? Doesn't look like we're seeing it in yours. So if you've seen any of that, from that trend, that would be interesting.

And also, what are your thoughts, in terms of focus on cost containment and implications for pricing, in obviously, not in '03 but in '04, for reconstructive surgery implants?

In general we're not seeing any sign of the market -- the market is slowing down. Clearly, the reconstructive market is like any other part of the medical market. People want high quality, high technology, at affordable prices. And we're trying to be a responsible company in that area.

Okay. And for the pricing environment in 2004?

I would say it's a little bit early to talk about that right now.

Okay. Have we seen a big change in the last six months? In discussions around price or cost-containment efforts in hospitals, in your perception?

Not that I know of.

No. I don't think so, Rob. Not that I've heard from -- coming up from our guys.

Good. Great. Thank you.

Thanks, Rob.

Our next question comes from the line of Matthew Bratten with Argus Partners. Please go ahead with your question.

Good afternoon. A couple of questions. One, on the ceramic on ceramic, I guess I wanted to try to understand a little more, kind of, what kind of penetration you did experience, and maybe what kind of ASP's you're receiving, and what premium that is over the hip products that might have otherwise been used for some of the younger patients? I know John you mentioned a couple of hundred dollars premium. It sounded like there was a bigger ASP increase.

Then I had a question about the DSOs, which I think you mentioned were up to around 64 days. Maybe if you could comment, sequentially, that's up about 5 days. And how much was attributable to international sales? You know, that's a little bit of a higher increase than we're used to for you guys.

Yeah. Matt, on the receivables, clearly, we are seeing the impact of some over -- the faster growth in our business in overseas. I would also tell you that we're not as happy as we would like to be with where that number has gone to. And we're going to make it a focus going forward here.

But clearly, the international piece is a impacter, because the domestic days are all in the 40s and the international days are higher than that. We're going to keep working at this. But -- and we want to do work in the international business as to bring the days down there where we can. As our international business grows faster, that does make it harder to contain the number.

Relative to the ceramics and Trident, you know, we're definitely seeing a price premium here. I think you would say that it's probably in the range of where metal on metal is, you know, maybe for a total product, maybe 20% higher. And you know, that would be a traditional procedure, probably using Crossfire, because many of these products -- many of these patients would get a very high-end implant, as it is.

And in terms of the penetration? I know there's some really pent-up demand. Where --

We're hesitant to comment on that. I would tell you that overseas it's probably been at 15%. I think that we're definitely, probably moving at, or a little above that range in the U.S. right now. But until we see it shake out and know where we're at with any demand that might have been pent-up in this quarter, I think we'd be better prepared to comment on that later on in the year.

Great. Thank you.

Thanks, Matt.

Our next question comes from the line of Greg Halter with Lynch, Jones, and Ryan, Incorporated. Please go ahead with your question.

Good afternoon, gentlemen. I would like to add my congratulations to a very good quarter. Relative to the R&D focus, any particular area you're looking at, either on the MedSurg side or on orthopedic implant side?

I would say just about everything. We think, particularly in endoscopy and our instrumentation, there's still a significant upside. Clearly, the implant business, which is where, you know, we've been an innovator. We want to continue to innovate. It's great to have the ceramic, we've got to find the next winner beyond that. And then, continuing to look at OP-1, as well.

Okay. And for the year, Stryker's capital expenditures should be around what level?

Greg, I would say it will be, probably, in the range of somewhere between $120 million to $140 million, in that range.

Okay. And finally, do you have any internal targets for where you would like to see your debt in '03 and '04, or any kind of rating targets?

Well, lower and higher. I mean, we're paying down the debt as fast as possible. I think that our cash flow will be stronger in the second half of the year, as I mentioned. We did have some pretty heavy tax payments in the second quarter. I think you'll see our cash flow come back up in the second quarter, which will allow us to take another nice chunk out of debt.

And, you know, obviously we think given the dynamics of our business and what we're doing here, that, you know, we'll be talking to the rating agencies about bringing our rating higher, even though Moody's just moved us up. They're still a notch below S&P and we'd like to, at least, get them on par, because we think that's warranted.

Is there any sort of limitations on the reduction? The prepayment penalties, or so forth?

No, none whatsoever.

Okay. Thank you. Great quarter.

Thanks, Greg.

The next question comes from Bruce Jacobs with Deutsche Banc Alex Brown. Please go ahead with your question.

Thank you, very much. Congratulations, as well, guys. John, can I just ask you to comment on your comments about your goal of $5 billion in sales by 2005, which if I do the math, even off of a big number this year in the 3-6 range, I think is still high teens growth, which might be faster than some would have otherwise expected. Is that a target, is that a stretch goal? How should we all interpret that?

Well, I hope you interpret it the same way I expect the employees to interpret it. We're going to do better. Now, granted it may be a little bit of a stretch, goal. But I believe we can do it. We may have to fill in a few acquisitions. We've been able to do that for the last two or three years. I have pretty strong feelings that we can do it, and I would say that it's really gotten strong endorsement from the management team, pretty much across the board.

I don't know, Steve, do you want to comment on it or--

Yeah --

Would you rather avoid that question?

Oh, well, I would suspect that John announced it just before they announced I was coming on board.

But it is -- you know, I view it very much as the 20% goal that we've always had as a company. Which is trying to inspire our folks to achieve things that are well above and beyond what anybody average would achieve. And I think there is a real spirit within the company, that we want to try to achieve this. Can we promise it? No. Are we shooting for it, do we expect to try to get there? Absolutely.

And can I just ask one followup, if I could? I'm not going to ask you for specific numbers here. But the volume mix analysis that Dean takes us through. How should we think about each of those categories as a contributor in terms of directionally, do you expect the volume mix levels to stay the same, to perhaps, rise a bit?

Obviously -- maybe not obviously, but it would seem foreign currency would fall. Does price stay strong? How should we just think about the composition of growth? I know we're looking on the long-term here, but just directionally over the next couple of years?

Well, in general, why don't I take a stab and aim at telling you, you know, the volume of mix piece has got to be the key driver. And if anything, we probably want to try to boost that. Let's face it, the FX, wonderful tailwind right now, but as you point out, probably not going to happen. The ability to get much more price is probably going to be limited. We'll be looking primarily volume mix, and see what we can do on the acquisition front.

Fair enough. Good. That's all I had, guys. Thanks, very much. Congratulations on the quarter.

Thanks, Bruce.

The next question comes from the line of Bob Hopkins with Lehman Brothers. Please go ahead with your question.

Thanks, very much. Just a quick clarification. One quick question on the clarification side. In response to Matt's question, did I hear you correctly that you're, as a percentage of hip sales, that ceramic on ceramic was somewhere in the neighborhood of 15%? Did you say that?

I don't think so.

Yeah. No, I did.

I thought that was for international.

That's internationally.

Okay. And then did you say what it was, kind of, U.S. or worldwide?

Well, I think it's -- you know, it's certainly in that range.

So U.S. is also, you know, above 10% of the hip mix?

It's definitely double digits. And, you know, it's -- real honestly, I think in June, you know, it was higher than 15%. Again, you know, we're looking at the fact that there may be some pent-up demand here, too, as we got everything into the field.

Yeah. And just to follow up on that, and on the conversion question. Can you, sort of, talk qualitatively about, you know, a Stryker surgeon that's using ceramic on ceramic today? What is he converting from, specifically?

And then, you mentioned in June that you're also having some preliminary success in, perhaps, you know, working with nontraditional Stryker docs and getting them to switch over to ceramic on ceramic. What are they, you know, what were they previously using? What are they, you know, is it metal on metal or other categories? Just a little bit of qualification there would be great.

You know, I don't have any real knowledge as to what they're switching from for competitive docs. As Steve mentioned, you know, we've made very small in-roads there, at this point in time, Bob.

Relative to, you know, Stryker docs. There's definitely some cannibalization of our other business here. As I mentioned, many of these people would be getting a pretty high-end product to start with. So --

Uh-huh. Then, just one last question, then. You know, spine with the acquisition anniversarying, you know, are you comfortable that this is the right, you know, scale or the right size for you to realize scale benefits at this point? Or do you think you need to be, you know, bigger in order to compete with the Medtronics of the world? Or is their organic growth pretty much what we should look to here over the next couple of years?

We think we probably ought to focus on organic growth. Digest this thing. We're big enough and of a scale enough and a product line that's now broad enough that we should be able to be a reasonable player here. We think we've got to continue to consolidate. We've actually seen some nice growth in some of the areas we didn't fully expect. We disappointed ourselves a little on cages, but doing better on the rest of the line. And we think there's still opportunity to be had there in the short term.

Okay. Great. Thanks, very much.

Okay. Thank you, Bob.

Our next question comes from the line of Dolfini Delvinco of Fulcrum Global Partners. Please go ahead with your question.

Good evening. I was wondering if in terms of constant currency, hip and knee growth overseas, at 7% and 4%. Would you, in the past I believe you've done a breakdown of price volume and mix for Europe. Or even more broadly for overseas. Does the 7% and 4% suggest that perhaps you're working through the patient backlog overseas? And I think you commented that price was up slightly in Europe. If you could just flush that out a little bit, that would be great.

Well, you know, we've not given a lot more color than what I gave you, Dulcini. Prices are up slightly in Europe. You can interpret that as 1% or 2% max. Europe is not a market where prices have traditionally grown very much.

Right.

I think that continues. As I said, our volume mix is up 10% overseas. Which would tell you that, obviously, our volume is higher than the other product lines, other than hips and knees.

You know, we could be working through the patient backlog a little bit overseas. And in Europe specifically. I think another quarter will tell us more on that. I think, you know, we're also, you know, not as happy as we'd like to be with those numbers. I think that, you know, there's room for us to do a little better there.

Okay. And then just one clarification. Tax rate of 31%, is that what we should be thinking about going forward? I know you had said something less than 31.8, 31 seems quite a bit less --

Well, yeah. We're, you know, we're at 31. Obviously, we've been moving some of the operations to Ireland. We think that as we go forward, there is an opportunity to bring this rate lower. We're very comfortable with 31% for the year right now.

Obviously, we'll be looking at that every quarter. And you know, if and when the time comes that our operations overseas are, you know, generating the requisite amount of profits and to reduce that rate, we'll do so.

Okay. Thanks very much.

Thanks.

Our next question comes from the line of Michael Weinstein of J.P. Morgan Securities. Please go ahead with your question.

Hi, this is actually Raj Stenhoy for Mike. I was wondering if I could ask a couple on the trauma field? I guess by our measure, you guys have moved into the second spot, or are close to being in second in the market now. I'm curious, what your plans are to continue to grow there? Will you be adding to a dedicated sales force, building it in the U.S.? Are there next generation products that are set to come out here soon?

We have been boosting our dedicated reps, both in the U.S., as well as internationally. Where we can, we've tried to pull the business away from some of the full line folks and dedicate the trauma reps at it.

In terms of additional products, there's a lot of good product activity going on. Nothing that we're ready to really talk about at this point.

Have you guys said how many dedicated reps you now have in the U.S.?

Right now, Raj, we have about 50. But we're looking at growing that.

Okay. Then just on the RTI deal, I'm just been curious how that's rolling out? We've heard about it coming, and I haven't got an update on where that stands. You know, how much revenue you're generating from that, or even if it's a big component of the business at this point.

Raj, it's pretty modest now, as you might suspect, but the growth on a month-to-month looks pretty good. And we'll just go forward with it. We think it will work out fine.

Okay. Thank you.

Thanks, Roger.

Our next question comes from the line of Scott Davidson of Piper Jaffray. Please go ahead with your question.

Hi, good afternoon.

Hi, Scott.

John, can you update us as to your thinking in terms of a highly cross linked poly in your knee line. Is that something you might think about doing?

Scott, that is something that we're looking at. But you know, that's all I'll say right now. Something that we are thinking about.

Okay. And looking longer term, just back to the whole notion of cash generation, the business seems to be throwing off more cash debt balances going down. There have been some changes to the tax laws. Have there been changes to your thinking in terms of how you might use cash going forward? And specifically, you know, how are you weighing off debt pay-down acquisitions, dividend policies, things like that?

I say first, it's not affecting our dividend policy. I mean, you know, we pay a modest dividend, and we'll continue, in my opinion, to pay debt as we go forward. We pay an annual dividend, and I don't see making any major change there.

We are opportunistic in the acquisition area. If we see something that would complement what our major product lines are now, we will obviously go for it. So I think it just depends on what the guys turn up.

Thanks. And lastly, can you update us as to your thoughts in terms of the timing of a mobile-bearing knee launch in the U.S.?

Well, you know, right now, we have a critical trial going on. And obviously, we're constrained by that. Now, you know, the F.D.A., as we understand, is being petitioned to look at a down classification of that. Obviously, that will change things.

We think we have a good product here, and we'd, obviously, welcome the opportunity to start selling it in the U.S. But as it stands right now, you know, with a PMA, we're a couple of years out, at least.

Okay. Thank you.

Thanks, Scott.

There are no further questions at this time. Please continue with your presentation or any closing remarks you may have.

Okay. Well, Lena, we appreciate all of your help in this. And we're getting about ready, I think, to wrap up.

As you know, as you heard, it was a good quarter. We're delighted with the way Steve is getting up to speed very quickly. He's focusing, I think, on the major part of the business, the one that really counts as far as our long-term growth. They all count. But clearly, the implant business is the one that will make us or break us. And he's focusing on that. We like that. He's focusing on making sure we've got good development programs in mind. And we think that's appropriate.

We're delighted that you are with us today. We would invite you to put on your calendar October 16. That's on a Thursday, October 16, and we will plan on reporting to you at 5:00, then, Eastern time, the third quarter results.

We wish everybody a good day. Thank you.

Ladies and gentlemen, that does conclude your conference call for today. We thank you for your participation and ask that you please disconnect your lines.