史賽克 (SYK) 2005 Q3 法說會逐字稿

Welcome to the Stryker third quarter 2005 operating results conference call. During this 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, simply press the one followed by the four on your telephone. As a reminder this, conference is being recorded Tuesday, October 18, 2005.

Certain statements made in today's conference call may constitute forward-looking statements. They are based upon management's current expectations and are subject to various risks and uncertainties that would 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 conference call, such factors include, but are not limited to, regulatory-- not limited to regulatory actions, including costs containment measures that could adversely effect the price of or demand for the company's products, unanticipated issues arising in connection with clinical studies and eventual United States Food and Drug Administration approval of OP-1, the Flexicore and Cervicore spinal implant product, or other new product introductions, changes in reimbursement levels from a third party payors, significant increase in product liability claims, changes in economic conditions that adversely effect the level of demand for the company's products, changes in current interpretations of the law relative to the repatriation of undistributed foreign earnings, 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 10-K, and quarterly reports on Form 10-Q.

Today's conference call will also include a discussion of adjusted net earnings, excluding the impact on the three months and nine months ended September 30 of charges to record income tax expense associated with the planned repatriation of foreign earnings in the third quarter of 2005 and to write off purchased in-process research and development in the third quarter of 2004. Further discussion of this non-GAAP financial measure, including a GAAP reconciliation appears in the company's Form 8-K filed today the with the Securities and Exchange Commission, which may be accessed For Investor page at the Company's website at www. stryker.com.

I would now like to turn the conference over to Mr. Stephen MacMillan, President and Chief Executive Officer of Stryker Corporation. Please go ahead, sir.

Thank you, Duane, and good afternoon, everyone, and welcome to Stryker's 2005 third quarter earnings report. With me today is Dean Bergy, our Vice President and Chief Financial Officer.

We are pleased to report another solid quarter of delivering on our commitments. In a nutshell, sales were up 14%. Earnings before repatriation up 21%, and R&D spending, up 29% in the quarter. So while investor concerns are clearly building over a slowing reconstructive market, we feel better than ever that the broad strength we have across a number of our franchises and geographies will allow us to continue to deliver strong earnings growth in the quarters ahead and we continue to invest heavily in our future.

Net sales for the quarter were $1.172 billion, an increase of 13.9% over the prior year and up 13.5% operationally. Adjusted net earnings increased 21% to 163 million and adjusted diluted net earnings per share increased 21% to $0.40, consistent with our guidance. Now, we know that the First Call consensus was $0.41, so we would like to address this head-on. Quite simply, more of the estimates were in fact $0.40, but some outliers pushed consensus figure up just enough to round up to 41. So, again, we delivered on what we said and in line with many analysts expectations. We generated strong 263 million in cash flow from operations in the quarter, bringing the first nine months total to 482 million.

In many ways, our third quarter was a repeat of our healthy second quarter. Some of the reported numbers look a little soft, however, and the third quarter had one less selling day than last year, while second quarter had one more day than last year. Essentially, a 3-point swing in this quarter's numbers.

To summarize the quarter, eight of our nine major franchises again generated double-digit operational growth on a global basis, with hips being the only lagger. Our instruments, endoscopy, medical, biotech, spine, and trauma franchises again delivered strong growth. And our international businesses are really humming. Specifically our MedSurge business posted another 20% growth quarter and achieved 428 million in sales, while orthopedic implants grew 10% operationally to 678 million.

Internationally, we continue to see great strength as Europe, Japan and Latin America all posted double-digit growth again this quarter. We continue to be particularly pleased with the breadth and depth of our European business, which was up 15% operationally and once again posted double-digit growth in each of the five major Europe countries. We are seeing solid growth across all franchises, and each of the five major markets have also posted double-digit growth on a year-to-date basis. This is not just a good quarter or two by one or two countries. This is sustained across the board growth. Japan also had another exceptional quarter, up 13%, posting double-digit operational growth for the second straight quarter. With 9% operational growth, our Pacific business came in just shy of double-digits for the quarter, but is still solidly on track for double-digit growth for the full year.

Regarding our U.S. recon business, growth rates on an average daily sales basis in third quarter for both hips and knees were equal to second quarter. We had hoped for a modest uptick and are not yet satisfied with these results. However, we do feel good about a number of things going in that division under the new leadership we put in place earlier this year. Unfortunately, a softer than expected elected surgery schedule in the third quarter and the difference in the number of days did not yet help our turnaround efforts.

Now, for a quick run-through of our various franchises. We'll start with our soft spot, our hip franchise, which grew 2% in the quarter on a global basis with essentially flat or single-digit growth in each region. We were encouraged in the quarter by the continued strength of our Accolade line and the Restoration Modular System, both of which generated double-digit growth in the U.S. Unfortunately, this growth was offset by the soft surgery schedule, a poor performance in the hip fracture area and some lingering softness from the loss of some customers late last year and earlier this year.

Apart from that disappointment, the other eight of our nine global franchises turned in very good results, all up double digits in the quarter. Here we are.

Knees were up 12% globally with all regions in double-digit range except Pacific and Latin America. Surgeon reaction to our Triathlon knee has been very favorable and the bulk of our instrument sets have now been deployed, which should lead to continued growth in the quarters ahead. We also began to roll out Triathlon in Europe, leading to very healthy growth in our European knee business, while Japan was also strong due to the success of our Scorpio and our G knee.

Trauma had another nice quarter, up at least 15% globally for the fourth straight quarter, driven by double-digit growth in every region. Behind the strength of our new Gamma 3 system and enhancements to the T-2 line. In addition to the progress we are making in the U.S., we are also very pleased with the renewed strength in our European trauma franchise this year.

Spine also continues to emerge as a major franchise for us, achieving 19% global growth in every key region over 10%. In the important U.S. market, sales were up 22%, marking our sixth consecutive quarter of 20% or greater sales growth. Strong new product flow drove very strong growth in our emerging inter-body franchise, while cervical and thoracolumbar sales else experienced strong growth. We also filed a cervical disk ID in the quarter and hope to begin enrollment before year end.

Our micro implant business also maintained its double-digit growth globally and the U.S. business accelerated to 11% growth, up from 7% last quarter. As an interesting reminder, this business was negative in 2001 and 2002, but is now generated double-digit global growth in seven of the last eight quarters.

OP-1 continues to deliver well and we are completing the two-year follow-update take for our pivotal U.S. spine study. We plan to submit our PMA by the end of first quarter next year.

Moving to our MedSurge businesses, which, again, posted great results. Instruments had another strong quarter, with both global and U.S. sales up 18%, marking the 14th consecutive quarter of double-digit growth globally for this franchise, and, again, our strength was broadly based here, as every region posted double-digit sales growth behind our strong power tool and operating room solutions offerings.

Our Endoscopy business continues to be strong with U.S. sales up 20% in the quarter. This also makes the sixth consecutive quarter of better than 20% growth in the U.S. for this franchise, and the ninth straight quarter of global sales at or above 20% growth.

Our medical business continues to defy gravity, as global sales were up 24% and U.S. sales were up 30% in the quarter. This is our seventh straight quarter of medical sales at or above 20% growth, so we continue to deliver here even against tough comparables.

Finally, our service business, physio therapy, showed a modest uptick in the quarter, growing at its best pace in the last five quarters with sales up 9%.

In summary, we continue to feel good that the strength of our broadly-based businesses allowed us to deliver another good quarter, while also positioning us for continued success. Hips were a little soft, but every other franchise and geography delivered great results.

I will now turn it over to Dean for more details.

Thanks, Steve.

I'll start with the foreign currency comparisons in the quarter. You can see they were slightly favorable in the quarter, increasing sales by $4.1 million, bringing us to favorable impact year to date of 38.8 million. If currency rates hold at the current levels, we expect the impact of currency on fourth quarter 2005 sales to be unfavorable by about $20 million.

Next, turning to the impact of price volume on sales in the quarter, price was up just slightly, but we round that down to zero. Foreign currency had about a one-point impact, again, rounded acquisitions about 1 point on the quarter volume mix, 12%, adding up to our 14% sales growth in the quarter. Summarizing that pricing in a little more detail, U.S. implant prices were up slightly in the third quarter and are up approximately 1% for the first nine months. Prices in Europe and Japan were down slightly in the quarter, and for the first nine months, volume mix was up about 12% in both the U.S. and overseas markets.

Now, turning to our very exciting sales, orthopedic implant represents 59% of total sales for the company. Sales of orthopedic implants increased 11% in the third quarter and 13% for the first nine months as reported and 10% and 11% respectively on a constant currency basis. To give you the sales growth rates within orthopedic implants by-product line, for the first quarter, hips, domestically were actually down 1%, internationally up 6% and in total, up 2%. Knees were up domestically 11%, international, 14%, and in total, 12%. Trauma up 12% domestic, 17 international and 15 in total. Spine, up 22 domestic, 14 international, 19 in total. Leibinger, up 11 domestic, 13 international, and 12 in total. And then for the total orthopedics implants line, 9 domestic, 11-- 12 international, 11 in total.

Now, turning to our constant currency results, obviously the domestic numbers I was saying for the third quarter, so I'll give you the international and total line. For hips, international is up 5 and up 2 in total. Knees up 13 international and 12 in total. Trauma up 17 international and 15 in total. Spine, up 14 international and 19 in total. Leibinger up 12 international, 11 in total, and for the total orthopedics implant line, again, constant currency, international up 11, total up 10.

Now for a little bit more detail on the individual products lines, hip sales growth slowed to just 2% in the quarter and it was up 6% year to date. In the U.S., our Accolade [Cement Mix] products had a strong quarter and we generated nice growth in Revision hips with our new rEstoration Modular System. Upward growth in these areas was offset by a slight decline in sales of our Trident ceramic on ceramic hip system and a decline in sales of hip fracture products. In Europe, hips posted mid single digit constant currency growth led by Trident, Exeter and Restoration Modular. Japan local currency hip revenues grew at mid to high single digits and were led by our Secur-Fit and [INAUDIBLE] stems.

Turning to knees, they were up 12% and up 14% year to date. Knee growth was solid in the quarter, in the United States our primary revision businesses posted low double-digit growth. Our new Triathlon knee had another good quarter, but competitive gains are still very small with this product, as we continue to roll out Triathlon posterior stabilized sets. European knee sales grew at low to mid single-- mid double-digits in constant currency led by Scorpio. Japan, excellent sales of our Japanese market dedicated Scorpio NRG product helped the division to post better than 15% operational growth. Pacific generated mid to high single digit operational knee growth led by Triathlon.

Turning to trauma, they were up, that product grouping was up 15% in the third quarter and is up 19% year to date. U.S. trauma business grew 12% on the quarter, 14% of military sales are excluded. U.S. growth was led by excellent results in hip fracture devices and internal fixation and solid growth in entrumentulary nails. Our gamma 3 product line had an excellent quarter. International trauma sales were strong in the quarter, with substantially all geographies and all product categories contributing to the results.

Spine, turning to that product category, was up 19% on the third quarter and 18% year to date. Spine had an excellent quarter in the United States, as Steve said, posting 22% growth. This growth was led by inner body devices with great acceptance of our ABS-EL ABS-TL spacer products. Sales of cervical and thoracolumbar products were also very solid in the quarter. International spinal also had a good quarter with every product category producing double digit growth. Performance was strong across most geographies, most impressive growth in the Pacific and Europe.

Finally, Leibinger was up 12% in the quarter and 13% year to date and they had another double-digit sales growth quarter with U.S. sales up 11% on the strenth of neuro and hand products and growth in these categories also led our international sales growth in the quarter.

Now turning to our MedSurge group, that group represents 36% of the company's total sales, as comprised as three significant product categories. Instruments represents 43% of the group and endoscopy, 35% and medical, 22%. MedSurge group sales were up 20% for the quarter and 22% for the first nine months on a reported basis and 20% and 21% respectively on a constant currency basis.

Turning to instruments, sales of our instruments product line increased 18% for the third quarter and 19% for the first nine months as reported and 18% for both periods on a constant currency basis. Breaking down that growth by domestic and international, we were up 18% domestically and 19% international for that 18% reported sales growth in the quarter. In addition to the benefit, business another strong quarter with excellent growth in powered instrument systems and very good growth in other OR equipment. Instruments generated another quarter of strong sales growth in the U.S. and international sales also grew at a healthy 18% on an operational basis. Our System 5 heavy duty power systems posted exceptional sales growth in the quarter and micro powered tool sales grew at high teens levels. Growth in other OR equipment was led by interventional pain and Neptune operating room waste management system, irrigation products and Steri-shield.

Now, turning to endoscopy, endoscopy was up 21% in the third quarter and 26% for the first nine months as reported, and 20% and 25% respectively on a constant currency basis. Breaking down their growth in the quarter by domestic and international, domestic up 20, international up 23, total up 21. Endoscopy posted another quarter of 20% or more sales growth with reported growth at or above the 20% mark in video systems and general surgery. Endoscopy's quarterly growth was led by video sales, which were boosted by the first quarter of the trauma acquisition and continued strong sales of the 1088 high-definition camera. General surgery product sales were strong across the board and entroscopy internationally, but were soft in the U.S., partially as a result of the discontinuance of sales of RTI caligraph products.

Then last, but certainly not least, our medical business was up 25% in the third quarter and 23% for the first nine months as reported and 24% and 21% respectively on a constant currency basis. Domestic growth was 30% of its business. International was 7, for that total of 27% reported growth. Medical division also delivered another 20% or better growth quarter. U.S. sales surpassed 20% growth for a fifth consecutive quarter. As expected, international sales growth was, again, depressed by difficult comparables in Canada, but very strong quarter in Europe helped to blunt this impact. That and EMS shipments were extremely strong in the quarter, stretcher sales were very soft.

Physio therapy, the last of our franchises represents 5% of our sales. They recorded 9% growth in the third quarter, bringing the first nine months revenue growth to 8% for that business. Start-ups and acquisitions have generated all of our growth this year.

And then just to report on a number of PC centers, we ended the quarter with 475 such centers.

Now turning to the, the rest of the P&L, gross profit margins in the quarter were flat compared to the prior year, and down sequentially. The sequential decline was expected as a result of the normal summer slowdown in orthopedic implant surgeries, which usually causes our third quarter to reflect our higher proportion of lower gross margin MedSurge equipment sales. Compared to 2004 we benefited from lower excess obsolete inventory costs and flat royalty costs, partially offset by the higher sales growth of MedSurge products. R&D spending was up a very healthy 29% in the third quarter and is up 27% for the first nine months, as we continue to put increased focus on our development efforts, including added year-over-year spending for the development of our acquired spine core product.

SG&A costs were up 10% in the quarter and 12% for the first nine months, with sales commissions driving a significant portion of the increase. Instrument amortization costs associated with new product rollouts were also higher in the quarter and first nine months. These increases were partially offset by lower advertising costs. In addition, insurance premiums are growing slower than sales, contributing to the decline in SG&A costs as a percent of sales.

Operating income adjusted to remove the purchase in-process research and development charge from 2004, increased 19% on the quarter, was up 22% for the first nine months, and operating margins are up nicely from last year, ending this quarter at 19.8% of sales and 20.6% of sales on the year to date basis.

Now breaking down real quickly our other expense for the quarter, that was expense of $600,000. That consists of interest expense of 1.6 million, offset by investment income of 2.4 million and we had a foreign currency transaction loss of 1.2 million in the quarter and minority interest of 200,000 adding up to that $600,000.

Income tax expense in the third quarter, first nine months includes the $31.3 million charge associated with the plan to repatriate $722 million of undistributed foreign earnings under the American Jobs Creation Act. The repatriation will occur in the fourth quarter of 2005. The underlying effective income tax rate of the charge related to the repatriation of foreign earnings is excluded for both third quarter and first nine months of 2005 was 29.5%. This compares to 2004 annual underlying tax rate if the spine core purchased in-process research and development is excluded from consideration of 30.0%.

As you can see, the balance sheet is in great shape and asset management continues to be very good. Accounts receivable days ended the quarter at 57 days, four days below the prior year. Inventory days finished at 128 days, eight days below last year.

At September 30, 2005, we have no amounts outstanding under our credit facility and have about $9 million in remaining legacy debt, which we expect to pay off as it matures. We plan to borrow approximately $200 million overseas when we repatriate foreign earnings in the fourth quarter and we expect to repay this in about six to eight months. Then finally, cash flow, we had good operating cash flow in the quarter and in the first nine months.

Operating cash flow for the quarter finished at $263 million. Our year to date free cash flow after adjusting for accounts receivable securitization reductions in 2004, which we consider to be a financing-type activity is about on par with last year, which is primarily attributable to the higher level of 2005 investments we are making in loaner instruments, facilities, and ERP systems.

With that, I will turn it back over to Steve.

Thanks, Dean. In summary, we feel very good that our broadly-based business model again delivered strong sales and profit growth. Despite the loss of the foreign currency gains which we've all benefited from over the last few years, and a more challenging pricing environment. As we have been indicating over the last year, we have been anticipating this more challenging environment and have been investing across the range of our franchises and geographies in order to allow us to continue to deliver on the very high expectations that the investment community has for us. And frankly, we have for ourselves.

We should note that we not only delivered 20% earnings growth again this quarter, we also did it while continuing to accelerate our R&D spending and while absorbing a slightly higher tax rate than anticipated at the start of the year.

Although the strengthening dollar will likely reduce reported fourth quarter sales growth and we will again have one less day in the quarter versus last year, we expect 2005 annual sales to finish somewhere between 4.86 and $4.89 billion. This represents reported growth in the range of 14 to 15%, or operational growth of about 14%.

Third quarter adjusted net earnings of $0.40 per diluted share were at exactly in line with our guidance. We are maintaining our 2005 full year adjusted net earnings guidance at $1.75 per diluted share. This represents a 22% increase on 2004 adjusted net earnings. On a reported basis, we expect EPS to be $1.67, which would be up 46% from 2004.

Now I would like to turn for a moment to our first look at our 2006 outlook. As you know, we anticipate facing a much tougher pricing environment in the U.S. and Japan and a continued tough environment in Europe. We also do not expect the positive currency gains that have helped us in the last few years and we will be investing in advance of the expected 2007 U.S. launch of OP-1. Against this headwind, we continue to feel very good about the breadth and depth of our underlying business and therefore again set a goal to increase earnings by 20% over adjusted net earnings for 2005. This leads us to adjusted net earnings of $2.10 per share before the impact of expensing stock options. On a reported basis, that will be up 26% due to the cash repatriation charge incurred this year.

Now we'll open it up for question and answer session. Duane, we're ready for questions.

Thank you, sir. [OPERATOR INSTRUCTIONS] One moment please for our first question. Our first question comes from the line of Katherine Martinelli at Merrill Lynch. Please proceed with your question.

Thanks, good evening, everybody.

Hello, Catharine. You got in this time.

I got in this time. I've been on hold for a long time. Couple of questions, first of all on the reconstructive side, recognizing you guys were facing a fewer selling days, but J&J put up some pretty strong numbers overall, suggesting we'll see how things shake out that, they grabbed market share and they really started their direct to consumer advertising, which they have indicated they expect to continue doing. They are doing it now in both hips and knees. So just wondering against that backdrop, does the SG&A investment you guys need to make to sustain competitiveness or build awareness need to increase and how we should be thinking about that going forward.

Great question, Catharine. We are continuing to assess whether we start to get back into the DTC game and we may well do that. I would say that we would look to be able to fund that out of our existing by re-allocating our existing SG&A spending.

And by re-allocating corks you just give us a little bit of color on that? I was actually surprised your SG&A as a percent of sales was as low us a it was in a sequentially weaker quarter. Are you rethinking some of the compensation or how you structure your recon sales force against the fact that pricing's more difficult?

At this point we're not looking into commission, you know, anything out of the usual in terms of commission cuts or any of that stuff. I think it's more just tightening up on some of the other parts of the SG-- particularly the G&A line more than just the selling line, but we will continue to invest in our sales forces. But over time, might be something we need to look at in terms of other re-allocations. Be we have been saying all along that we see a little bit of leverage we can get out of SG&A and probably continue to increase the R&D spending as a percent of sales and therefore still being able to deliver the 20% as we go forward here.

And then just one follow-up and I'll get back into the queue. Can you just give us any sense for what you've seen in elective procedure growth? Has that market snapped back now that we're into October, assuming that was kind of a summer phenomenon, that gives you some confidence about both the hips and knees both rebounding in the fourth quarter?

I think we'll feel better about fourth quarter. Clearly we didn't want to put the hurricane word into the thing, but we were effected by the hurricane and we personally were probably hit more by Rita than we actually were by Katrina in the quarter. Now, Rita will bounce back. Katrina, you know, will not. So our Texas business, which is very strong for us, you know, took a bit of a hit there. I think we're seeing some-- we would expect fourth quarter to definitely see a bounceback from third.

Can you quantify Rita at all?

You know on the grand scheme, not material, but for the U.S. hip and knee franchises it, probably nicked us by, you know, a touch.

Katharine, one thing I would say about the fourth quarter, we are going to have one less selling day again though, too. So I think that needs to be factored into the way that we look at this quarter.

Okay, great. Thank you.

Great, thanks, Catharine.

Thank you. Our next question comes from the line of Milton Hsu at Bear Stearns. Please proceed with your question.

Hi, guys.

Hi, Milton.

Could you just talk about the European business. Over the last couple quarters, that's been pretty strong for you guys. Are there any changes you're making, market share and which particular markets have been stronger than the others?

I tell you, Milton, if you go back a couple years ago, it was primarily the UK that was driving it. I think what we've been really impressed with is it's just been broad based. Really over the last four quarters or so. You know, it's funny, if you think back, last year at this time we weren't feeling as good about Europe, but clearly we had put-- we had made leadership changes in a few of the countries. We also had Mike Mogul, as you notice, running Germany and our German business is just on fire right now and Mike had run that business for four years, left it early this year and we've brought him back to work his magic now in the U.S. And he left that business in very good shape.

So it's really across the board and it's every single franchise. If we look back last year, had you a couple of countries performing well and couple of franchise. I think what we're doing is firing a little bit better, trauma country by country, recon, country by country, and also our MedSurge businesses that we have seen some nice growth in those businesses and that have really been underdeveloped there. And I think that's what gives us reason to believe we can continue to do pretty well there.

Just turning to the UK, the backlog, the wait list gets worked down from 18 months to something about 7 now. Do you anticipate that buying will revert back to a more normalized rate?

I think we do. we are seeing the UK slowing down a touch this year. Which is where -- it had been really hot. Really '02, '03, '04, our growth rates there this year a little bit softer than previous years, but it's been offset by the rest of the countries really coming up. It's still healthy, but we would expect that to continue to ease up over the next couple of years.

Okay, and just one last question on acquisitions. You have a very strong balance sheet. Does that change your appetite compared to last six months, last year about how you looking, how aggressively you're looking?

You know, it gives us the ability, but we're still going be pretty disciplined and focused. And if you see-- frankly we still believe one of the great ways to generate shareholder value is the internal investment. I think that's where if you look at our R&D spend, you know, we're clearly putting a lot right back into the business because we've seen a lot of ideas that we have internally that can start to pay off in the years ahead and have really made a conscious decision in to invest there right now. Obviously we have increasing ability to go after something bigger, but we're going to just continue to be disciplined and focused.

And think, too, Milton, within that R&D line, there is a little bit of in-licensing and some small bits of in-process R&D that are kind of small that don't get called out that are a little bit a part that have line, too, not a major part, but some portion of that growth is in those kinds of things that we're looking at externally, as well as to supplement what we're doing internally.

Okay. Thanks a lot.

Thanks.

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

Thank you. Good evening, guys.

Hi.

A few questions, I wanted to make sure we heard your commentary first relative to Trident sales, which I think you said was negative in the quarter. I wondered if you could clarify that and if that was the case, what's going on, is it volume, is it price pushback, is it competition?

Yeah, it was done very slightly in the quarter and I think it's a little bit of both. You know, we're seeing a little bit of, you know, slide back in terms of our penetration rate, just a touch, and there's probably a little bit of price in there, too. But, you know, again it, is a slight, very slight decline year-over-year.

Okay. When you're looking at '06, and you guys made enough references there to pricing and the environment could be more challenging, what are you assuming in terms of, as you guys start to think about modeling next year in terms of the pricing environment and the U.S. and globally?

I think globally we're probably assuming about zero, and if you recall, we've historically over the last few years, we've been capturing about 2% globally in price so. We see that as zero and depending on where things shake out in Japan and ultimately where some of the contracts might shake out in the U.S., could it go marginally negative, we're actually prepared that it could. So think we would see more of a downward bias than an upward bias at this point.

You think even if that occurred, you would still feel comfortable with the 20% bottom line target?

We feel very good about the ability to deliver that. I mean is it going to be harder? You bet. You know, don't make any mistake about it, but we've been looking forward and frankly part of the increase in R&D, you know, there's some things going in there that we don't talk a lot about, but we've been gearing for an environment that was going to get a lot tougher and frankly, it's where we're glad we're not dependent on any one or two franchises because we've got a lot of cylinders to count on in terms of delivering both geographically and product lines. So it's going to stretch us and push us more, but we wouldn't be saying it if our team wasn't committed to it.

When you talk about pricing going from 2% to zero, you're talking about your recon business, right?

That's really global. That's all in.

Okay. So you're--

If you were to talk recon, we're probably seeing that going from year or two ago, more like 3 or 4 in the U.S., Dean, call it zero to potentially down a point or two.

In 2006?

Mm-hmm.

Okay. OP-1, will we see that data at AOS?

Probably not. We want to make sure we deliver to our primary audience on this one, which is the FDA. But as you know, we will-- we anticipate filing the PMA probably right around the time of the Academy. As we get closer to it, we'll assess what kind of date it we might be comfortable sharing, but I think we're really going to focus that data with the Agency at this point as opposed to the external world.

So you're not sure when you would be showing it to surgeons?

Correct.

Okay.

You know, at the end of the day, until it's approved, that data is not going to do us a lot of good to get out too far in front of it and frankly we're going be going up against a heck of a competitor there and we're not sure we want to clue them into exactly what we're going to be doing.

Last question, then I'll hop here. If next year if you're taking a more conservative stance on pricing as you model out the year and you think you can still deliver your 20% target, in '07, let's assume you hit OP-1 and then '08 you get your lumbar basic, maybe '09 the cervical disk, how sustainable is the 20% target and beyond '06, how should we be thinking about the bottom line?

A lot of the investment we're doing in R&D now, you know, you go back over the quarters this year and you see what we're doing in R&D, candidly, Mark, a lot of that's not going to hit until '07, '08. We're taking on -- If you look at our R&D portfolio today, I would tell you it probably has a longer timeframe in terms of some of the portfolio products against the exact goal. We always figured that '06 was probably going to be a pretty challenging year for us to fight through '06 and then I think frankly the product flow in '07 and '08 and '09, that's where we've been placing some of these bets. So that's where I think, you know, who knows what's going to happen in the environment and everything else, but we've been gearing up very much for those years to have some nice growth. Now, between now and then, does everything we're working on come through? You know well enough that not necessarily, but we think we've been loading the bag a little bit better at this point in time than probably at any point in our company history.

Good. Thank you, guys.

Thanks, Mike.

Our next question comes from the line of Jason Wittes at Leerink Swann. Please proceed with your question.

Thank you. Just following on Mike's question, so should we assume that most of the growth for next year or more of the growth is kind of come from the MedSurge business? How would you characterize the investments you've made for '06 and how they are going play out on the top line?

I think probably what we'll see, if anything, is the MedSurge business, as you know, Jason, have been delivering even above our expectations this year and candidly speaking our U.S. recon business has been lower and I think our hope is that even though the environment in U.S. recon will get a little tougher next year, it will be executing a lot better and so we should actually see an acceleration in our recon business next year, particularly in the U.S. relative to what we had this year and MedSurge will probably just soften up a touch, but that overall, again, we'll do well. We expect to see obviously some pricing pressures in Japan, but continue to expect Europe and Latin America and Pacific and some of the other regions to pick that up.

And I guess just focusing a little closer on the recon business, there's-- I guess you're pretty clear stating that pricing pressure is increasing, but how about mix pressure? I mean obviously you've had some-- you've come back a little bit on ceramics. Are you seeing also pressure on some of the mix items as well to accompany that, or is it all just price at this point?

A little bit. They are kind of intertwined, but mix is actually holding up pretty well. As long as we're bringing a product that's meaningfully different, we think we're still able-- the market will still allow some better products in.

And I think a perfect example of that is our X3 poly that we just introduced. It's still very early, but I think the reception to that has been very good at this point in time and that will definitely drive some mix benefit.

Are you getting a premium-- I guess you're implying you're getting a premium at this point on the X 3 poly?

Yes, we are and we think there's good reason for that given its characteristics.

Just to wrap up this questioning, what type of top line should we be modeling for for 2006 at this point?

You know, we haven't finalized our budgeting, so we wanted to give you an earnings guidance because there shall the last time we're scheduled to speak to you till January, but I think we would have to get back to you with that. As you know, the way we try to run the business here is we set a goal internally. That's our goal, and we communicate it externally. We don't low ball our estimates and everything else. So I just would rather hold off on that, Jason, at that point.

Fair enough. Thank you very much.

Thank you.

Our next question comes from the line of Stephen Vice at Mindflow Capital Investments. Please proceed with your question.

Yeah, thanks very much. Nice job guys. Couple of questions for you to provide color. Stephen, a lot of your competitors over the last year have recently been implementing new strategic initiatives to boost their raw material costs by establishing a better line of communication with their supplier base to overall look at their supply chain and improve efficiency. I'm interested in some color to what you guys are planning on doing from an overall perspective to reduce raw material costs by working better with your supplier base to overall improve your supply chain and reduce overall costs.

You know, I think it's fair to say that we consistently work with our supplier base and we have over time delivered reasonable cost reductions, although I think it's also fair to say that in the last several years, because of pricing environment has probably been a little bit better in the U.S., we probably haven't focused on that as much as we had in some past years. I think as I look forward and look at what's coming into our planned standard cost reductions in 2006 and look at what people are planning as they go forward there, will be more effort put into that area.

What are some of the raw materials that still concern you?

Well, we use a fair number of metals and things like that, you know, we use titanium in our products and things like that. So there's a fair number of things that we look at.

One thing I've noticed over the past couple of years is quality's always been a key metric in your company, certain goals by compared to other companies. What are you looking to do to improve your quality standards and make sure your suppliers meet those quality standards? Are you score carding your suppliers? Are you meeting them through global supply forums? How do you make sure they are meeting your strict guidelines?

We're dealing with them in different ways by division. Frankly we're not going get into the level of detail on that.

Could you provide any color on some of the things you're doing?

That's really proprietary.

Okay, and what's been your supplier feedback? Are they open to a lot of different collaborative tools you're working with? What's been their feedback? Obviously they feel like they are probably being squeezed in this high, intensive--

They are working with us.

They are working with you?

Yeah.

How are they working with you?

You know what, I would like to move on here.

You don't want to tell me, or--

This feels like we're getting a little too detailed in certain areas.

If I recall you're publicly traded, right, so I was just asking a basic question.

And our quality systems are proprietary. Duane, can we move on, please.

Certainly. Our next question comes from the line of Bill Plovanic at First Albany. Please proceed with your question.

Great. Thank you. Good evening.

Hi, Bill.

Hi, Bill.

Just a couple questions. First of all, you mentioned that there are at the end of the last year, and I'm just trying to quantify this or get a little better understanding, you mentioned there was a loss to customers in the U.S. I was wondering if you could quantify or kind of walk me through that. And then secondly, as we talk about pricing going forward, is this a concentrated number of customers that are high volume that are kind of getting away with the lion's share of the pricing reductions, or is this something that's more broad-based?

Sure, Bill. You know, the loss of customers, what we would say is candidly throughout '04 and probably even into the first quarter of '05, we lost a few surgeons along the way. It's one of the reasons our hip business particularly has been a little softer in the U.S. and we're feeling much better over the last four to five months. We've stopped any losses and if anything are starting to claw back and seeing much more new users starting to creep in. But the new users to some degree at this point are smaller volume, not fully up to speed as much as some of the ones we lost. So that's part of what we're doing in terms of climbing out of that hole in the U.S.

Regarding the pricing, we're kind of seeing it across the board. Clearly the big guys, the HCA's of the world have pressure, but even some of the smaller hospitals, they are out there trying to manage their supply chain a little bit tighter than probably what we've seen. You know how these things go in some cycles, so we don't want to say it's just the large customers. We're prepared and dealing with it pretty well across the board, but the degree to which it gets dealt with, you know, does vary a little bit.

Okay. And then on the customers, I'm just going back there because I don't truly understand it, but is there a certain event or reason that you had some challenges there?

There were some fairly agressive tactics by some of our competitors that particularly I think over the course of last year and we have a certain way we do business and there were probably a few surgeons that we lost. Again, nothing we're not going to fight through and come back on.

Okay, and then lastly, you kind of covered this, but you're upping the R&D spend. Is this-- you mentioned that the artificial disk and the OP-1 are a big piece of that. If you took those out, is the R&D spending increasing as a percentage of revenues as much, so I guess the question is more are we just seeing more early stage or later stage kind of development projects and how much, if you can quantify, or just kind of cut it out for us, what the OP-1 and the disks are doing. Thank you.

Sure, Bill. If you pulled OP-1 and the artificial disks out, you would still see a healthy increase in our R&D spending because you're pretty much seeing it across virtually every division. So it's not just those two items. It's a more concerted effort to dial up our new product activity across the board.

If you look at what's really been driving our MedSurge business so well over the last year or two, especially, they have probably had a better new product flow than truthfully what we've had in the recon side and we've had frankly great flow in our spinal business and we've been spending a higher percent to sales there and our trauma business as well so. I think where we've been, where we've had the better products flow and the better R&D, we're clearly seeing those returns. So we're just trying to extend that a little bit more and frankly, where we were probably a little slower was our orthopedics division for a couple of years. So that's where some of that investment is going as well.

Great. Thank you very much.

Great. Thanks, Bill.

Our next question comes from the line of Larry Keusch at Goldman Sachs. Please proceed with your question.

Yeah, thank you. Couple questions. First on the Triathlon knee, it sounds like things are going a bit slower than you would have anticipated. Has there been some trouble getting out the instrument sets and loaner sets for the posterior stabilized product? Because I think you would have thought that you probably would have been in the U.S. up more than you were.

Fair point, Larry. We were, we were slow. That was part of the additional changes we made at our orthopedics division earlier this year because we were behind. I would tell you they are now out and I think we feel good about where we should be going. We got a lot out in the third quarter and have pretty well caught up to where we wanted to be at this time. If you look at it, it was clearly a slower rollout than what we had hoped to be at in September. But bit end of September, we're now where we want to be. It just-- it got there in a lot lumpier fashion.

I would else tell you there are some small things. From the time we initially developed that system, our instrumentation for Triathlon was probably not as MIS friendly as it needed to be. We've been in the process of making some tweaks and changes, so we continue to feel great about the implant itself. The feedback we're hearing from the surgeons are just outstanding, but our own instrumentation has probably let us down a here a little bit. We're making those changes and that's-- you'll seen to see the impact I think on triathlon well into '06 as we adapt to some of the changes that have happened in the marketplace from when this system was first conceived.

Okay, great. Then two other questions for you. First, just coming back to this notion that you think you'll see an acceleration in your U.S. recon business, it sounds obviously like it will be up volume and perhaps some share gain. It sounds like you're clawing back on some of these surgeons that you lost, you know, sort of late last year, and certainly Triathlon has to be a part of it. X3 poly has to be a part of it. But from an execution perspective, what are you doing differently? I feel like I asked this question sort of every quarter, but I'm really trying to get my arms around how the execution is improving and what we can really see there that would suggest that that's happening and I guess I've been hearing that you're actually hiring additional sales reps. Are you cutting territories or doing anything else to kind of increase the coverage?

Yes, very much so. If you really look at it, Larry, really from about 2002-2004, we had stopped growing our recon sales force and we think we have been paying for that a little bit more frankly over the last year or so. We were growing or sales forces almost around the company and we had slowed it down in the U.S., particularly U.S. recon, and what we are doing now is dialing it back up. We are trimming some of the territories and going back to a lot of the blocking and tackling that's made us good, as well as greater performance management. We would tell you I think the other thing that happened is as we stopped turning some of those territories a little bit, you know, we probably stopped serving some of the customers and lost a little of the fire in some of our folks and I think we're getting that back right now. Mike Mogul is really reenergizing and rebuilding that U.S. business for us. Go ahead, Dean.

I was going to say, Larry, the other thing I would say is I think we all sort of had a lot of focus inside the organization on the R&D part and how we deliver new products. You know, we have been pretty candid in saying we've not been happy with how we've approached that and one of the things I think sometimes that causes a little bit of loss in confidence with the sales force as well, and one of the things that Mike is doing is really reinvigorating that part of the organization and looking at our approaches there so that we can deliver products to appeal to much more timely fashion and put out much more efficient launches and that as a sales force starts to see that, they will gain some of that confidence relative to the way the inside of the business is functioning as well.

Okay, great. Then just the last question, you know, relative to this softness in the third quarter, I guess two questions, was it concentrated in any portion of the third quarter, and assuming that it wasn't all Rita-related, what do you read into going on out there?

You know, I think we would be honest with you, Larry, saying we still don't have a complete answer to the third quarter. It just overall was softer and I think we saw it -- August particularly, but it didn't bounce back quite as quickly as we probably would have hoped in September, and it happened, I would say pretty well across the geography. I mean, you know, the reason we didn't mention Rita and Katrina is because they are only a small piece of it. Overall, they are just-- it looked like there were more surgeons on vacation and other things that we saw and I think based on what we saw in terms of a lot of earnings warnings and people taking down guidance in early September from our competitors, it looked like something was going on there. Having said that, obviously our friends at J&J had a very nice quarter. They are doing a lot of things well. We know we can do a few things better as well.

Granted, I understand there's one less day in the fourth quarter, but as you look at your fourth, 4Q sort of daily run rates there, are the surgical procedures starting to come back?

I think we would expect to see better numbers certainly on an ADS basis in fourth quarter than third.

Okay, great. Thank you very much.

Thank you, Larry.

Our next question comes from the line of Raj Denhoy with Piper Jaffray.

Thanks, I won't take too much time. I was just curious how much of your guidance or even what your expectations for hip resurfacing. I guess you signed a contract or a distribution deal not too long ago. Does that factor pretty heavily into your plans for next year?

Not for '06. That's the Corrine deal you're speaking of. We see it more likely in '07. If it comes in '06, that's an upside, but we're really figuring that's an '07 launch.

That's our planning and obviously we hope things go quicker with the FDA. We're not going to speak on Corrine's behalf, but that's the way we're planning for it.

Just one broader one on the pricing front, you know, it sounds like you're obviously rhetoric has gotten more negative there. I guess what I'm curious, what are you actually seeing out there? Are you starting to see uptick with the HCA contract? Are you starting to see hospitals starting to push you on price, I guess some of the concerns with Japan have really yet to play out. I guess I'm trying to get a better sense on what has caused you just over the last three months to suddenly get much more negative on the pricing environment?

I don't think we've gotten significantly more negative over the last three months. I think we signalled this a year ago. If you actually go back in July of '04, I think we were the first company out there saying we see the pricing environment getting much tougher going forward and I think were a number of other folks saying we don't see that, we don't see that yet. We continue to see what we've been saying all through that time period and it's why we're very focused on frankly not just being a recon company, but being much more broadly based and firing across all of our cylinders. I think we do see a more difficult pricing environment in the U.S., but that is not any different than I think what we've been talking about for well over a year now.

I think Japan is a little bit of a shift. Again, we're in the early stages of the discussion there, and that's a little bit newer news as you look at the global numbers, but on U.S., I don't think we're significantly more downbeat than we have been.

And even Japan, we knew coming '06, it would have been targeted for one of its biannual price reductions, so our strategic pricing there called for price cuts next year. It may be just a little deeper than what we've been expecting. We've been saying for quite sometime we see pricing going away. We're trying to continue to figure out how we continue to deliver our 20% without doing that. We continue to feel very good about underlying volume growth across all the franchises, hips, hips may be a touch slower, but knee growth is still going be good. Spine, we feel great about our investments there. Trauma continues to be very healthy with a lot of upside for us, and certainly the MedSurge business is continuing to deliver.

Okay. Fair enough. One last one on OP-1 since you had mentioned spine, I understand that trial was an uninstrumented fusion trial. As we're now starting to get to the data coming out and going in front of the FDA, I'm curious your thoughts around the construct for the trial and whether you think that might be an issue going forward.

We think it was certainly the acid test, and if you can prove success in an uninstrumented trial, it will clearly show how strong OP-1 is as a product because it's not going to be in there with a crutch. It's going to be purely OP-1 delivering. So, and we feel very good about OP-1. We think we've got a great molecule and a great formulation there.

Fair enough. Thank you.

Thanks, Raj.

Our next question comes from the line of Ben Andrew at WM Blair and Company. Please proceed with your question.

Curious on a couple things. It occurs to me that a lot of the pressure on the reimbursement side is, on the pricing side is because you're not getting the kind of reimbursement increases on alternative bearing products that you might. Are there things that you can do clinically with CMS or with physicians to try to develop studies to get that sort of data to drive reimbursement higher, which might take some of the pressure off hospitals for mix?

Ben, that's a great question. I think that is a competence see that we've not historically had and are developing. I think we are realizing that to bring premium products to market, we're going to probably have to have a little more economic data behind it to help us sell these things in in the future.

Any sort of timeframe when we could even begin to see some data along those lines to justify the higher prices and therefore drive reimbursement?

You know, probably not quite, quite ready to start giving out dates on that stuff. Think it will be more as we bring newer products to market.

Okay, and can you talk about-- can you even directionally, where you would see volume and mix for hips and knees next year and your perspective either for the market or for your business?

I think we've done the exact volume mix by-product line. We're in the process of pulling together our final budgeting right now. I think we see knees beg a little bit stronger than hips. Go ahead, Dean.

I was going to say I don't know that we see it much different than it is right now as we look at it.

Yeah.

The previous question was trying to kind to get at, not that you didn't see this coming, but the directional shift from '05 to '06 from 0 to 1% to 0 to minus 2 I think is quicker than most people have anticipated on the street. And I guess the question is specifically what activities at the hospital level are driving that? Is it just greater demand for price and the company's suddenly being willing to give that to get volume, or is there something else going on here?

Hospitals in part being a little more demanding and there will be-- in some cases, there are discussions about some possible volume offsets. Certainly the HTA contract, you know, if they deliver what they have committed to in terms of the additional volume gains, that will end up being fine for us. So in some cases we are willing to trade off some volume for some price and I think we're seeing that from a few, few of the other Big Boys. So it's-- I would say that's probably the overall take. Dean, I don't know if you have anything to add to that.

No, think that's fair. I mean obviously those are situations that we have agreed to live with and I think can live with if we can get more volume out of the deal, it's probably a win-win.

I think a key point that we would want to make here there, have been a lot of companies riding the market the last few years and think what we want to remind, and those of you who have been around for a while understand Stryker's delivered in good times and in bad times, and we have a commitment to delivering and even if the market slows down a little bit we're not one posting numbers that match the marketplace.

You clearly see a whole bunch of folks running for cover here every quarter here, and saying the sky is falling and taking down guidance. We're not taking down guidance. We've been putting together plans to continue to deliver. We want to make sure that that's what you take away, but is it a more difficult environment? Yes.

Sure. And then just one final question and I'll hop off. Take the example of the ACA contract, but it sounds like it's happening in other big hospital groups. If you don't get volume, can you claw back the price or have you set a new benchmark that you just cannot come back with your original price ever again?

Our intention is clearly to be able to get it back, you know. If we're in these negotiations and two sides are committing to certain things and we sure hope that the other side will live up too.

Okay. Thank you.

Thanks, Ben.

Ladies and gentlemen, as a reminder, to register a question, you may press one-four. Our next question comes from the line of Stephen Lichtman at Banc of America. Please proceed with your question.

Thanks. Hi, guys, just to follow up just relative to the last question, in particular relative to HCA, when do you expect to get some of that visibility as to whether the volume requirements are being met?

That will really be year end, Steve.

Okay, and to be clear, did you guys give up price in anticipation of that volume?

Absolutely.

Yes, we did.

So, again, if, if those levels aren't met, then you go back to the table?

Correct.

Okay, and then just in Japan, can you talk about sort of where we're at, what you're hearing today and when you expect to get really good visibility as to what's going to happen April 1?

You know, there is a lot of activity going on and I can tell you even through our industry association, we are doing a lot to try to bring some more reasonableness to the table there. There is so much going on that I don't think we'll have a real good handle until certainly November and it will probably be early next year, I would say, given the magnitude of some of the discussions.

When you talk about worldwide price for next year flat, what do you build in for Japan?

We're probably in the minus 6 to minus 10 range.

Okay, so you're building in tough case scenarios?

Yes.

Okay, and then just flipping back to HCA, what are you seeing out there in terms of, so far in terms of the volume shifts?

At this point, it's -- we're not probably fully seeing what we committed, to but we expect them to get there. They have committed to get there. I think they realize they are not quite delivering yet. I think they are developing plans to get there.

Okay. Great. Then lastly, Dean, the tax rate going forward, what should we build in?

I think we're good at 29 1/2 for the rest of this year, but there's definitely a downward bias there. I certainly would expect as we go into '06 and the way we built our plans that that rate will be coming down at a reasonable pace.

So we all stick to that 20% growth that building in a lower rate to next year?

We definitely are.

Okay, great. Thank you, guys.

Thanks, Steve.

Thanks, Steve.

Our next question comes from the line of Tao Levy at Deutsche Bank. Please proceed with your question.

Good afternoon, everyone. Thanks for taking the question. Just two quick questions. I wondered if you could provide us with a little bit of visibility into the order pipeline for MedSurge. I think did you that last quarter. You said it was really strong and you came through with that. I was just wonder if you could update us on the order pipeline.

I think it's probably just, it's probably just a tad softer than it's been, which is in line with kind of what we've been saying we do expect as we go forward here, MedSurge products to slow down a bit and the recon business will, and implants will pick up. But it's still pretty healthy. Probably just a tad softer.

Okay. And on the clients with HCA, someone had asked that earlier on, but is there any reason that, because one of your competitors, Zimmer specifically is saying that by the October timeframe, they will know whether HCA is hitting their compliance numbers or not. Any early read on that?

As we said, we think they are a little bit behind right now, but we continue to have faith that they will deliver against their commitments.

And just lastly, you know, with the stock trading where it's at in your strong, healthy balance sheet, any thoughts on share buybacks?

Not at this -- oh go ahead to, Dean.

Well, I think it's something we could look at, but there's no particular plans right now at this level, but if the stock continues to be weak, it's something we could look at.

Great. Thank you very much.

Thanks.

Your next question comes from the line of Pat Pace at UBS Securities. Please proceed with your question.

Great. Good afternoon.

Hi, Pat.

Just a question on your spine business, it looks like for several quarters, you guys in the U.S. have been much stronger than the competition, or at least most of the other players. Can you just talk a little bit more detail about what's going on there?

We think we're doing a pretty nice job there. Admittedly, off, against some of the biggest competitors, we've got a slightly smaller base that we're operating, but we've got a pretty good size base right now. We have had really good new product flow. This is one of the divisions about two years ago we got a lot more serious about and have had great new product flow coming through, both in terms of the spacers that Dean mentioned, as well as some nice minimally invasive systems coming out and we have been beefing up that sales force. We have really been going from what we call a Tier 2 spine competitor to clearly into the top tier over the last year or two. I would say that's allowed to us attract much better sales people and it's that combination of better sales execution and better product flow that really have us humming right now. Because as you also realize, our numbers are all hardware numbers, so over 20% for five straight, I guess, what, six straight quarters now, we feel pretty good about.

Excellent. And just on the, I guess on the pricing side and when you talk about the negotiating table with the hospitals, do you guys -- I mean I know you talk about the diversity of our revenue base, but your strength in MedSurge, how does that effect you or position you when you talk to hospitals on a local basis?

You know, it helps us have broader discussions and frankly open up more avenues and sometimes you might be talking about an implant price and you might end up getting a bed order out of it as well. So we think there's volume trade-offs that accrue to us because of our more broadly-based business, that probably do help our MedSurge businesses, some of which come out of the tougher discussions we have on the implant side.

Okay, great. And then just on your results, can you guys break out volume mix and price for hips and knees in the U.S.?

You know, we really don't give that level of granularity, Pat.

Okay, that's fine. Great. Thanks a bunch.

Thanks, Pat.

Thank you, gentlemen, there are no further questions at this time. I'll turn the call back over to you.

Great. Thanks, Duane. Obviously as we wrap up here, the environment a little tougher, but we continue to feel very good about our ability to continue to deliver here. Our fourth quarter 2005 operating results conference call will be, if you want to mark this on your calendars, set for January 26 of 2006. So thanks, everybody, and we'll talk to you soon. Bye-bye.

Ladies and gentlemen, that does conclude the conference call for today. We thank you very much for your participation and ask that you please disconnect your lines. Thank you, and have a good day.