Zimmer Biomet Holdings Inc (ZBH) 2008 Q3 法說會逐字稿

Good morning.

I'm Paul Blair, Vice President of Investor Relations for Zimmer.

I would like to welcome you to the Zimmer third quarter 2008 earnings conference call.

Joining me today to host this call with David Dvorak, President and Chief Executive Officer; and Jim Crines, Executive Vice President Finance and Chief Financial Officer.

This morning we'll review our performance for the third quarter, provide you with an update on certain key matters.

Present an update to our outlook for 2008, and conclude our discussion with a question and seasons session.

Before we get started, I would like to point out that this presentation contains forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Based on current expectations, estimates, forecast, and projections about the orthopedics industry, management's beliefs, and assumptions made by management.

These statements are not guarantees of future performance and involve risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from those in the forward-looking statements.

For a list and description of the risks and uncertainties, see the disclosure materials filed by Zimmer with the Securities & Exchange Commission.

Zimmer disclaims any intention or obligation to revise or update any forward-looking statements whether as a result of new information, future events or otherwise.

This presentation also contains certain non-GAAP financial measures, a reconciliation of such information to the most directly comparable GAAP financial measures along with other financial and statistical information for the periods to be presented on this conference call was included in the press release announcing our earnings, which may be accessed from the Zimmer website at www.zimmer.com under the section titled investor relations.

A rebroadcast of this call will be available from approximately two hours following the conclusion of today's call through the end of the day on November 6, 2008, and can also be accessed from the investor relations section of the Zimmer website.

At this time I would like to introduce.

David Dvorak, President and Chief Executive Officer of Zimmer.

Thank you, Paul, and good morning, everyone.

You have probably had time to review at a high level our third quarter results and our news release, and now we would like to provide you with some additional detail and context.

Consolidated sales for the quarter of $952 million were up 5.4% over the prior year third quarter, and 2.7% in constant currency, adjusted diluted earnings per share for the third quarter were $0.97, inclusive of a one-time gain of $18 million after tax or $0.08 per share.

Our sales results were led by growth in knee revenues at 7% constant currency.

Hip sales with the interruption of the Durom Cup sales increased 1% in constant currency during the third quarter.

In our remaining business categories for the quarter on a constant currency basis, extremities was up 13% over the prior-year period, trauma was up 7%, spine increased by 8%, and dental was up one 1%.

Finally, our orthopedic surgical products business was down 19% for the quarter, due to the previously announced voluntary suspension of production of certain products at our Dover, Ohio facility.

Some strengthening in the US dollar led to lower than anticipated currency translation benefits in the quarter.

As we discussed before, the top-line impact of currency fluctuations is essentially neutralized on the bottom line due to our hedging program.

During the quarter we generated operating cash flow of $308 million.

Jim will provide more specific details of our financial results and other finance activities in a few minutes.

But reflecting on our performance for the third quarter, we delivered bottom-line results that exceeded Wall Street expectations, albeit with a one time gain that offset certain of the one time costs that are adversely impacting our performance this year.

While our earnings came in above expectations, our sales results were disappointing relative to the estimated market growth.

Over the past year, we set in motion a number of initiatives designed to prepare us for greater success in the future.

Our infrastructure and operating initiatives continue to progress well and we believe these will make us more efficient and effective.

However, a few factors are adversely impacting our sales results, and likely will continue to impact our performance through the first half of 2009.

Let me describe some of the primary factors that are negatively affecting our current performance as well as the aggressive actions that we're taking to improve our future performance.

First, after we entered in to the resolution agreements with the Department of Justice and Office of Inspector General last year, we took steps to enhance our compliance model.

We chose to implement broad changes now rather than incrementalize the efforts.

We believe that it is essential that we continue to collaborate with surgeons and other healthcare professionals and everything we have done from a compliance standpoint is for the purpose of preserving our ability to collaborate in the future.

For instance, no matter how talented our work force, we simply cannot design and development first rate products to address unmet clinical needs without partnering closely with surgeons and other healthcare professionals.

Similarly, in order to meet our obligation to ensure that surgeons are properly trained on the safe and effective use of our products, it's essential that we solicit the help of surgeon collaborators who are highly skilled and experienced in performing the complex procedures.

As we previously disclosed, the transition over the past year has been disruptive to our relationships with consultants.

For instance, we were unable to communicate when development meetings would resume, when educational courses would occur, and when suspended consulting payments would be made.

In other words we weren't able to provide visibility as to how and when these matters would be resolved, and quite understandably that was frustrating to our consultants.

We have been extremely focused on taking steps that we believe will restore these important relationships.

We have conducted development meetings for a number of projects, resumed our Zimmer institute educational courses, begun making overdue consulting payments and made substantial headway on resolving our past due royalty obligations.

Importantly, we have finalized the new royalty payment structure that will be employed for the future development projects.

We continue to believe that royalty payments are the most logical and fair manner in which to compensate healthcare professionals for their valuable intellectual property contributions.

Over the past six months, I have met in person with more than 150 of our consultants all around the world in order to explain what Zimmer is doing and why.

Based upon these discussions we're confident that our direction is the right to ensure that we have the ability to capture the best of the collaborations between surgeons and industry.

Those that provide real solutions to unmet clinical needs while inspiring trust and confidence.

We regret the turmoil created by these circumstances, but we're proud of the efforts our people have made to abide by the resolution agreements and our enhanced compliance program.

I also want to take this opportunity to express my appreciation to our surgeon consultants for their contribution and commitment.

While this transition has been very disruptive, the vast majority of surgeons have exhibited extraordinary patience and expressed a continued interest in collaborating with Zimmer going forward.

These individuals put patient's interest first and they share our belief that conducting business in a compliant and ethical manner is consistent with those interests.

The second set of actions I want to discuss are related to the Durom Cup.

I want to thank the team of Zimmer employees and very importantly, the products' developers and other surgeon collaborators who created a comprehensive training program that enabled us to resume marketing of the product in August.

Within one month of the announcement of a voluntary suspension in the United States.

To date, more than 230 surgeons have completed the requisite training.

As an aside, I want to note that the Durom Cup situation led us to further development and refine our thinking regarding delivery of surgeon training on the safe and effective use of Zimmer products.

In our April 17, press release announcing key enhancements that we're making to our compliance model, we indicated that we'll cease using physicians to train and educate on products for which they may receive royalty-based compensation connected with the Company's sale of the products; however, the Durom experience led us to conclude that there are instances in which it is necessary and advisable to use the product designers to train other surgeons on the safe and effective use.

At Zimmer, we're now managing these potential conflicts of interest through other important enhancements we have made to our compliance program.

While the Durom matter presented one situation where we needed to use royalty bearing surgeons to facilitate effective training, there will be other instances where we will continue this practice based on our training needs.

The third set of actions I want to highlight involve our OSP business, where we're upgrading quality systems to enable us to fully return the affected OSP products to market.

The remediation efforts are continuing and we now expect to have a significant portion of the suspended OSP products back in production by the end of this year with the balance of the effective products back in production by the end of the first quarter of next year.

Fourth, our other infrastructure and operating investments continue on track.

Our new plant in Shannon, Ireland will be ready to commence operations toward the end of this year.

We're making significant expansions in our Winterthur, Switzerland operations, we're installing a new state-of-the-art foundry in Warsaw, and very importantly, we're continuing the expansion and strengthening of our corporate-wide quality systems.

Finally, as one contemplates our business prospects within the core reconstructive market, it is important to note that our knee franchise remains among the strongest and most comprehensive portfolios of clinical solutions in the industry.

That offering begins with our new patella femoral joint for partial knee replacement for patients with early stage optiarthritis, and advances through our primary knee systems to our new segmental system for complex revision arthroplasty for those patients with significant bone loss.

Our knee systems including NexGen, Natural and Innex offer multiple options to appeal to various and discriminating preferences.

Our NexGen system with approximately 2 million implantations globally since its introduction is reported to have the lowest rate of revision among many knee systems followed within certain national registries.

On the hip side, we already possess an extremely comprehensive line of stems with track records of outstanding clinical performance.

We have recently added the bone conserving Fit More prosthesis and ML taper with connective system.

We're working diligently to complete development and introduce new technologically advanced acetabular systems during the second half of 2009.

Although these systems will not address our hip resurfacing gap in the US market, our product position in the US should be significantly enhanced.

I'll conclude by briefly commenting on our near-term prospects.

While we have made substantial progress on many important initiatives in 2008, and have responded to additional challenges along the way, the factors I have described collectively led to the loss of some customers across our geographic sales channels in the third quarter.

We believe the knee and hip market on a global basis continues to grow at mid-single digits and units, and when combined with mix-benefit opportunities in high single digits on a dollar basis, our knee and hip results lag market growth in the quarter.

As a result, we have adjusted our full year 2008 sales guidance as outlined in our press release, and as Jim will discuss in more detail.

We also anticipate that the factors I have discussed will create headwinds for us going in to 2009, and that our overall revenues are likely to grow below market at low to mid-single-digits in the first half of 2009.

We expect improvement in the second half of 2009, as we launch new products, and as the disruptive events of 2008 anniversary out of our results.

We're working through the 2009 planning process, and intend to provide 2009 earnings guidance on our fourth quarter investor call, but on a preliminary basis, given the headwinds we face on our top line and the dilution associated with the Abbott Spine transaction, we're now an anticipating more modest leverage in earnings most likely resulting in high single-digit growth and adjusted, diluted earnings per share for 2009.

Jim will now provide further details on the quarter and our guidance.

Jim?

Thanks, David.

I will review our performance in the quarter in more detail and then provide some additional information related to our guidance.

Sales of $952 million for the quarter represent an increase of 5.4% reported, and 2.7% constant currency.

These results include the effect of one extra billing day in the US in the quarter and reflect lower than anticipated benefit from foreign currency as well as lower reconstructive sales relative to expectations.

The US dollar strengthened as compared to many foreign currencies during the quarter and while the impact was lower than in recent quarters, foreign currency still increased revenue by 2.7% or $25 million in the quarter.

Consolidated pricing was down 0.5 percentage point for the quarter in both the Americas and Europe price was flat for the quarter, while Asia Pacific results include negative price of 3.9% driven by negative 4.8% in Japan and negative 4.7% in Australia where changes to certain implant prices took effect as of the beginning of the quarter.

Turning to our revenue growth by major product category, worldwide reconstructive sales increased 7.3% reported, 4.4% constant currency.

Knee sales in the third quarter improved 6.9% constant currency, reflecting slower unit growth in certain segments combined with slightly lower net pricing on a global basis, knee pricing on a global basis was down 1.2 percentage points in the quarter compared with negative 0.6% in the second quarter principally as a result of the lower prices now in effect in Australia.

Flex knees accounted for 54% of our new unit sales on a global basis in the third quarter, showing modest but continuing increases in levels of penetration relative to prior quarters, against the backdrop of the disruptive factors that David described, our geographic operating segments reported certain customer losses in any quarter which in the aggravate reduce our base of global knee revenues by approximately 3%.

Countering the effect of those losses, our natural knee sales increased over 40% in the quarter on a dollar basis following the recent introduction of the Gender Solutions thermal component for that system with the launch of our new segmental knee, sales of hinged knees increased over 15% on a small base.

Now, with the introduction of the mobile bearing knee in the US our LPS mobile bearing knee units increased over 25% on a global basis.

In the third quarter, knee sales in constant currency increased 6.8% in the Americas, 9.3% in Europe, and 3.6% in Asia Pacific respectively.

The Asia Pacific results reflect a 5.9% reduction in average selling price.

Hip sales increased just under 1% in the quarter reflecting interruption in Durom Cup sales as well as some customer losses, which, similar to knees, lower our global base of hip revenues by approximately 3%.

While we are working through final stages of development on projects that will strengthen our acetabular cup portfolio, we have significantly enhanced our stem offerings this year with the launch of the ML taper with connective technology, our [Abeneer] stem for the European market and the recently released Fit More bone conserving stem.

The ML taper, the Abeneer, and the Fit More all experienced solid growth in the quarter offset in part by lower sales by VerSys fiber metal mid coat, (inaudible) six inch full coat and other cemented stems.

On a geographic basis and in constant currency hip sales increase 2.4% in the Americas, 0.7% in Europe, and decreased 3% in Asia Pacific, which includes negative pricing of 4.6%.

Extremity sales for the quarter in constant currency increased 13.4% on a challenging comp of 33% in the third quarter of 2007.

Extremity sales increased 19.3% in the Americas, 3.6% in Europe, and decreased 15.1% in Asia Pacific on a small base.

Dental sales on a constant currency basis were flat for the quarter on a challenging prior-year comp of 17%.

Dental sales decreased 1.8% in the Americas.

As indicated in our second quarter call compliance related disruption as well as economic conditions were expected to have a negative impact on dental revenues through the second half of this year.

The results in dental are in line with what we had expected for the quarter, in addition, we recently have worked through many of the issues in applying our enhanced compliance model to our dental business and activities are backed up and running.

We remain committed to our strategy to seek to expand our presence in the dental market as we believe the commercial opportunities remain very attractive longer term.

Dental sales increased 3.7% and 4.4% in Europe and Asia Pacific respectively.

Trauma sales in the quarter were up over the prior year quarter 6.6% constant currency, our plate and screw lines as well as bone graft substitutes continue to lead our growth in trauma.

We look forward to the 2009 release of an upgraded nail line in order to fill a current gap in our growth potential.

On a constant currency basis Trauma sales in the quarter increased 3.3% in the Americas, increase 5.3% in Asia Pacific and increased a very strong 18.1% in Europe.

Zimmer Spine reported 7.6% constant currency growth in the quarter, with the consummation of the Abbott Spine acquisition, we look forward to realizing the full market potential of the combined Abbott spine and Zimmer spine business.

Spine sales in the Americas were up 2.2%, Europe increased 19.1% and Asia Pacific was up over 100% on a small base.

Finally, orthopedic surgical products and other sales declined 18.6% constant currency in the quarter as a result of the volunteer suspension in sales of certain patient care products partially offset by cement and accessory sales which grew over prior year.

The OSP and other category was down 16.6% in the Americas, declined 34.7% in Europe, and was down 12.9% in Asia Pacific, compared with the prior-year period.

We are encouraged that the remediation efforts at our Dover facility are progressing, and as we move into 2009, we look forward to stocking shelves and putting the OSP products back in the sales bag.

Now I'll focus on the rest of the income statement.

Our adjusted gross profit margin of 75.2% for the quarter is down 270 basis points from the prior year third quarter, foreign currency hedge losses accounted for the majority of the decline in gross margin with idle plant cost, and excess and obsolete inventory charges making up the balance.

Compared to last year, R&D expense decreased 11.9% to $47 million for the quarter as a result of lower spending on consulting services and delays in new product development activities.

At 4.9% of sales, R&D spending is just below our targeted and historical range of 5 to 6%.

Collaborative development activities are expected to ramp back up and we anticipate spending will return to that stated 5 to 6% range in the near term.

Selling, general and administrative expenses increased to $405 million, up 14.8% over prior year, and include monitor fees as well as consulting and legal fees associated with the global implementation of the enhanced compliance model as we discussed during last quarter's call.

Also included in SG&A for the quarter is a favorable adjustment to reduce performance-based share compensation accruals by approximately $7 million.

At 42.5% of sales, SG&A expenses are 350 basis points above prior year, inclusive of the significant one-time fees and expenses associated with compliance.

Acquisition, integration, and other amounted to $5.6 million in the quarter, comprised of cost pertaining to current and prior-period acquisitions, including facility consolidation costs, legal fees and retention and termination payments.

On July 22, we announced a voluntary temporary suspension of marketing and distribution of the Durom acetabular component in the U.S.

That announcement followed reports of Cup loosenings and revisions of the acetabular component used in total hip arthroplasty.

During the third quarter, the Company recorded a provision of $47.5 million for known and anticipated claims related to the Durom Cup.

Our estimate for these claims is limited to revisions associated with surgeries that predate our voluntary suspension and which also occur within two years of the original surgery date.

This is consistent with our data which indicates that Cup loosenings associated with technique are most likely to occur within that time frame.

This provision is classified as a nonrecurring item and is therefore excluded from our non-GAAP earnings measure.

Alternatively, any claims received outside of the defined parameters will be managed in the normal course and reflected in our standard quarterly product liability accruals.

Adjusted operating profit in the quarter decreased 11.2% to $264.8 million, at 27.8% our adjusted operating profit to sales ratio decreased by 520 basis points from prior year as a result of the lower gross margin and the significant but temporary step-up in SG&A costs.

Interest, and other income for the quarter amounted to $28.2 million, including a one time pre-tax gain of $29.8 million on the sale of 5.2 million shares of RKI Biologics which shares the Company had originally obtained through the acquisition of Centerpulse.

Adjusted net earnings increased 1.4% compared to prior year at $218.5 million, and adjusted diluted earnings per share increased 6.6% to $0.97 on 225.6 million average outstanding diluted shares.

These adjusted earnings per share are inclusive of approximately $0.04 of share-based compensation.

At $0.95, reported diluted earnings per share increased over 400% on prior-year third quarter reported EPS of $0.19, which included a $169.5 million settlement charge.

Our reported earnings for the third quarter include the provision for certain claims as well as a one-time tax benefit associated with the DOJ civil settlement paid in 2007.

This previously disclosed in our periodic filings, no tax benefit was recorded related to the settlement expense due to uncertainties to the tax treatment.

We submitted a prefiling agreement to the IRS in order to make a final determination of the deducibility of the settlement payment.

As a result of reaching agreement with the tax authority during the third quarter we have recorded an estimated current tax benefit of $31 million.

Consistent with the treatment of the 2007 settlement charge, this tax benefit is classified as a nonrecurring item, and is therefore excluded from our non-GAAP earnings measure.

At 25.3% adjusted for the quarter, our reflected tax rate reflects a favorable year to date adjustment to bring the effective tax rate for the nine-month period ended September 30, to 27.2%.

This is below our first half estimates and 30 basis points below our full year 2007 ETR due to favorable geographic mix of earnings and profits.

During the quarter we repurchased 720,000 shares at a total purchase price of $48.6 million, or an average price per share of $67.50.

We used cash to acquire the shares under a $1.25 billion repurchase authorization which expires at the end of 2009.

Our decision to pursue and ultimately acquire Abbott Spine business for $360 million resulted in our share repurchases in the quarter being lower than in the first two quarters of the year.

Approximately 1.18 billion remains under this program, the Company had approximately 225 million shares of common stock outstanding as of September 30, 2008, down from 226 million as of June 30, 2008.

Turning to cash flow.

Operating cash flow for the quarter amounted to $308 million, up from $167 million in the third quarter of 2007, which included the civil settlement with the US Department of Justice.

Inventory days on hand, finished the quarter at 321 days, a decrease of 9 days from prior year third quarter, reflecting higher cost of goods in the quarter.

Our trade accounts receivable days outstanding finished the quarter at 59 days.

An increase of 1 day over the prior year third quarter.

Depreciation and amortization expense for the quarter amounted to $67.4 million.

Capital expenditures for the quarter totaled $135 million, including $67 million for instruments and $68 million for property, plant and equipment which includes $25 million related to infrastructure initiatives.

Finally, free cash flow was $173 million for the quarter.

Now I'll turn to our update on guidance for 2008.

Our press release this morning stated that we have adjusted our top-line sales growth and adjusted diluted earnings per share guidance for the full year 2008.

For 2008 we expect to deliver top-line sales growth of 7 to 7.5% compared to the previous guidance range of 8.5 to 9% and adjusted diluted earnings per share, including $0.02 of dilution related to the Abbot Spine acquisition of $4.03 to $4.08.

The adjustment to our sales guidance now includes an estimated $20 million of revenue from Abbott Spine and anticipates approximately 3.3 points of growth to come from foreign currency versus the previous 4 points.

Our revised sales guidance now assumes a constant currency growth rate of 3.7 to 4.2% as compared to previous constant currency growth of 4.5 to 5%.

Adjusted estimates also exclude one-time charges related to the Abbott Spine purchase price allocation for acquired inventory, restructuring and integration charges, as well as an in-process research and development charge anticipated in connection with the transaction.

The definitive purchase price allocation will be completed during the fourth quarter.

To arrive at our projected GAAP earnings per share for the full year, you should assume subtracting an estimated in process research and development charge of $50 million, the certain claims provision of $47.5 million, the tax benefit on the 2007 civil settlement of $31 million, amortization of step ups and inventory value of $8 million, and acquisition, integration, and other expenses of approximately $37 million, for an estimated total of $0.37 per share.

As always our guidance and assumptions exclude the effect of potential future acquisitions or other unforeseen material business events or litigation matters.

Turning to cash flow, we anticipate capital expenditures to be around $500 million for the full year, reflecting the capital components of many of our 2008 infrastructure and operating initiatives.

Also for some time now we have discussed how we will use our free cash flow to fund strategic acquisitions and our share repurchases.

Earlier in the year we also explained our intent to draw up to $500 million on our credit facility to fund share repurchases under approved repurchase programs.

Year to date, we have used $469 million in available cash and have borrowed $220 million to fund the repurchase of 9.5 million shares.

David, I'll turn the call back over to you.

Thank you, Jim.

We have recently completed our strategic plan and such an exercise provides for the opportunity to review and appreciate the potential our industry promises, as we move beyond the issues of defining surgeon collaboration and the format of ongoing surgeon relationships, we're now able to focus our attention on working with surgeon collaborators to develop the best products for patients.

We're excited about the underlying fundamentals of our business, and what is on the horizon for us in the area of new products and technologies.

We're in enviable position as a $4 billion global corporation generating over $500 million of free cash flow annually.

Even in a year when we're making significant investments, overcoming extraordinary events, and implementing a more sustainable business model, we believe Zimmer's business is on track for a bright future.

Finally, we're delighted to welcome Abbott Spine into the Zimmer family of businesses.

Abbot Spine will allow us to continue to build toward critical mass in the spine market.

We're gaining access to new products and talented employees and are increasing our sales coverage as a result of this combination.

We announced last week that we have closed the transaction and teams from both organizations are working very diligently to assure that we can equip the expanded Zimmer Spine organization to serve our collective customers.

As we entered 2008, we indicated this would be a year of transition and investment for us.

The Abbott Spine acquisition is an example of our continued financial strength and willingness to invest for future growth.

And now I would like to open the call to your questions.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Raj Denhoy of Thomas Weisel Partners.

Good morning.

Good morning.

I was wondering if I could ask about the surgeon relationships you spent some time talking about.

I think this is probably the first time you've actually mentioned that you've seen some dislocation because your compliance activities, your heightened compliance activities.

'm curious, what gives you confidence that those relationships will come back?

In a sense that these surgeons will -- because I guess you have mentioned that you have lost some customers; that these will return at some point?

The customer losses are a combination of the fact theirs mentioned, not only the enhanced compliance program implementation but obviously the disruption that was created by the Durom Cup matter and some of the other things that we faced including OSP, so when I speak about our surgeon collaborators, I'm quite confident after having over 150 conversations with these individuals that they understand what we're trying to accomplish with this enhanced compliance program.

They frankly, see the proof points developing all around them that these relationships have got to be managed in a very careful way.

And as we explain the rigors of our program, they subscribe to that model and express a continued interest to work with us, so I'm quite confident that we're going to have the ability to attract the talent that we need to develop great products and to train and educate in a first-rate fashion going forward.

Having said all of that though, I think if, unless I heard incorrectly, you mentioned that the hip and knee businesses were both impacted by about 3% because of some lost customers.

Did I misunderstand that?

No, that's correct.

On the customer side of those relationships it is also true that the disruptions that we faced this year have caused some displacement of that customer base and I can't give you any absolute assurance that that business is going to come back our way, that could be the cost of implementing the program and going through the transitions that we have this year.

What I can tell you is that we're taking the steps to make sure that we remain the existing customer base going forward, and we're quite confident that as we enter into the second half of 2009, we're going to be able to put ourselves on a nice growth track.

Just one last one on the Durom training, I think you mentioned that there was a -- looking back at my notes 230 surgeons had been retrained on that product.

What percentage of the users does that represent?

Well, it's probably about a quarter of the -- of the exhaustive list of users, but I will tell you it is greater than 50% of the active users at the point of the -- the pullback of that product.

Okay.

Thank you.

You're welcome.

Your next question comes from the line of Tao Levy of Deutsche Bank.

Good morning.

Good morning.

As -- my question -- maybe it's a clarification.

You mentioned 2009 revenue guidance, I think in the low single digits, sort of as a ballpark, does that include, headwind from currency, or does that include constant currency?

Our -- just to talk for a minute about currency, assumptions that we have, the forecast that we have for the fourth quarter and then as we look at 2009, and we'll give more specific guidance on 2009 on our fourth quarter call.

We -- there -- there is always a little bit of a lag on the development of these forecasts, so the rates that we have used in the development of the guidance we have provided for the fourth quarter, were the rates come in -- in effect coming out of the quarter, and -- and those are the same rates that were used to develop the, sort of general guidance that David described for 2009.

So to the extent -- if you look at where rates have traded over the last couple of weeks, to the extent that the dollar continues to strengthen, there could very well be some further adjustment to the currency assumptions as we complete the 2009 plan, and ultimately provide more specific guidance on that fourth quarter call.

I would keep in mind Tao, that that currency effect on the top line has minimal effect on the bottom line as we look out over the next 12 months because of our hedging program.

Okay.

Essentially it was a reported number that you were talking about, not necessarily constant currency?

No.

I -- the 2009 number that we're talking about -- the right way to think about that as is a constant currency number.

Okay.

And then just on -- turning back to the customers and sort of the transition, did things -- it seems like based on your tone, your second quarter it didn't seem like there was maybe that much disruption and here in the third quarter it seems like things have progressively worsened and now as you talk about the fourth quarter and 2009 -- at least the first half of 2009, that you have gotten some pretty strong indications that the customers are frustrated.

It is going to take some time to come back.

Did anything happen specifically between the -- sort of the third quarter and what you are seeing now to kind of make your a little bit more concerned about those relationships?

Well, the passage of time.

I think that we're taking a lot of steps to catch up on payments, to get our design meetings back up and running to fully ramp up training and education, so with every passing month, I think that frustration grows.

The reason that we're confident that this is going to turn for us is our activities are really coming together in those areas, so, I just think that we started to see some customer displacement in the third quarter, and, that's not going to go away in the fourth quarter, but as we take the corrective actions, we see that remedying itself as we progress into 2009.

So there is just going to be a lag in the activities that we're taking to take care of these subject matters, and then the performance of the business, and also to follow up on the comment, someone mentioned that the low single-digit to mid-single-digit we do see that top-line growth rate on a constant currency basis accelerate in the second half of 2009 as a consequence of all of these actions.

Great.

Thank you.

You're welcome.

Your next question comes from the line of Matt Miksic of Piper Jaffray.

Hi, good morning.

Can you hear me okay?

Good morning, Matt.

We can.

Thanks for taking the questions.

One just clarification on Durom you mentioned 230 surgeons having taken the training.

I think that was the number.

Any sense of how that compares to the total number of surgeons who are using the cup prior to the hold that you put on the product cast quarter?

Yes, Matt, I think it is in excess of half of the active users as of the point of us pulling the product back or the capability to use that product back earlier in the year.

Okay.

And just looking forward, we hear about another cup that you have coming.

It potentially is something that could be used for metal on metal as well.

Are you seeing that as you get into next year, that you may, in fact, be transitioning some of these folks to a next generation product?

That's one possibility.

Okay.

And more about that at AOS, maybe?

Maybe so.

All right.

The question on this gross margin, maybe my numbers were just off here in the quarter, but it looked like I would have expected less FX impact, maybe a little benefit to gross margins since those things kind of move in opposite directions.

Was there anything else in the quarter that may have hung on the gross margin a little bit more than you would have expected?

Well, the couple of things that I mentioned, Matt, one are still some plant costs with the Dover facility, and -- as well some inventory charges, which, on the base of revenues in the third quarter, tend to be a bit higher as a percentage of sales and have more -- sort of more of an impact, I guess on the margin in the third quarter.

Okay.

Okay.

That's helpful, and then just one more here, and I will get out of the way, just on the economic backdrop, everyone keeps asking it seems the same question over and over again, but have you seen anything on the private payer side?

Anything that would suggest that patients are opting to defer procedures, or is that part of your business -- you still look pretty solid, and then on a capital side, I don't think there's much exposure that you have, but if you could call out anything that you might think could be affected if capital budgets come under scrutiny the end of the year and in to next year?

We hear some -- to pick up on the initial part of your question, Matt, we here some rumblings but they are very anecdotal as far as the general economic trends having impact on the business.

To date we haven't really seen a measurable impact, and frankly, don't anticipate in the core reconstructive business, of course the dental business sees that kind of on impact because of the payer model.

Jim, do you have anything to add to that?

No, we have gotten a lot of questions about this, Matt, as you know, and we're paying careful attention to unit volumes across all of our accounts both on the Medicare side and the private pay side.

We're not -- at least at this stage we're not really seeing it have any effect I have seen reports that argue on the one hand the economy may cause a bit of a slowdown on the private pay side, on the other hand I have seen reports that would argue just the opposite with people in some situations displaced and taking advantage over that period of time while they have things like cobra benefits to get there down through the rehab before they get through back in to the work force.

I think the key is, that at this point at least, we're not seeing it.

Thanks very much.

You're welcome.

Your next question comes from Bruce Nadol of UBS.

Good morning.

Thanks for the question, and pardon my voice.

In '07 you guys had about 23% unit share in hips, about 30% in knees.

Are you saying that you basically lost 3 points of unit share?

And I guess my question also with regards to losing those high-volume surgeons who were your consultants.

They are still active.

They have obviously continued putting in hips and knees, which means they are using other peoples products, and perhaps, picked up consultancies from other firms, so why should they come back?

And I have a follow-up?

Yes, again, it's 3 points of our base.

So it's not 3 points off of the total market, Bruce.

And -- and I would tell you that the guidance with respect to the full year 2008, does not assume that they would come back, nor does the guidance with respect to 2009 assume that those that we have lost would come back.

But what it does at this point indicate, that we -- as David indicated, we would see our performance improving in the back half of next year as we anniversary out of these losses, and as we enter in to a period where we're going to be introducing some new products, one of which was touched on earlier on the hip side.

Okay.

But does that mean that most of this loss is on the unit side as opposed to the mix side?

That's -- yes.

Yes.

Okay.

And could you explain what happened in, ex US hips?

On the last call you guys basically pointed us to our -- and frankly our field check suggested that this was really -- Durom was a US problem, but clearly ex US hips for the companies that have reported to far, constant currency was around 8%.

And so what happened there?

Yes, well we had a significant adjustment effect I guess if you look at the pricing in Asia Pacific in particular, that had sort of a significant impact on performance with respect to the Asia Pacific results.

In Europe, clearly kind of a stepdown in what we were experiencing the first half of the year, and in large part due to the losses that we described.

These losses do cut across all geographic segments.

And if I -- with the regard to the Durom Cup our sales outside of the US did grow in the quarter.

They grew at a somewhat slower rate than we saw in the first half of the year, but we did have growth in Durom Cup sales outside of the US in the third quarter.

Thank you.

Your neck question comes from the line of Bob Hopkins of Banc of America.

Good morning, and thank you for taking the call.

Good morning.

I just wanted to get some clarification on the '09 thoughts.

You have given '08 guidance of $4.03 to $4.08, is the high double digit earnings growth in '09 estimate off that $4.03 to $4.08?

High single digits, you mean, Bob, right?

Yes, sorry, high single digits.

That is correct.

It is off that base.

And does that also include $0.10 of dilution from Abbott?

Yes.

Okay.

And lastly on the '09 guidance just in terms of how you wow characterize it, is this sort of your best estimate at this point, as you look at all the puts and takes, or given what has gone on over the last six to twelve months, should we assume that there is a fair amount of cushion built into this just given all the changes that you've been through?

We're just giving you the best viewpoint that we can at this state, , Bob.

And obviously we're going to come back with a much more refined view and specificity when we give you the detailed guidance in the fourth quarter call.

But this is the way we see it at

Okay.

And then just following up on the -- your comments about disruptions from the consultant base and losing some physician customers.

Is it -- just -- could you just provide a little bit more granularity there, in terms of is it just doctors moving around to competitors, or is there an aspect to this that involved your sales force?

And I have asked this question on the last couple of calls.

I'm just curious if you could give us a sense as to the turnover in your salesforce during the third quarter?

And nothing material has changed from the responses that we gave in the last quarterly call on that point.

We're seeing stability, nothing unusual going on with the salesforce.

These customer relationships have moved, due to reasons that are unrelated, generally to both the sales force as well as the products, subject to those gaps that we've been very open in discussing.

Just lastly, real quickly, can you give us your latest updated thoughts on the outlook for pricing in the United States?

Yes, we saw a little bit of a stepdown this past quarter, but as we look forward, Bob, we don't really see that environment changing from the way that we have talked about it in the past.

It's both -- in the US, flat to slightly up.

As we look to pass along increases in list prices, we look to pass along the increases that are embedded, in a lot of the multi-year arrangements that we have with hospitals that are tied to some index of inflation, and -- I know you didn't ask about internationally, but with respect to the international markets we have -- going into 2009, anniversary out of an adjustment, and reimbursement prices in Japan, don't expect there to be another one next year, and then, would expect to see some pressure in Europe in the same markets where we have been experiencing some pressure and have experienced some low single-digit adjustments downward and -- in prices.

And that is on a worldwide basis going flat to slightly down, is that--?

I think that's a fair way to think about it, yes.

Thanks.

You're welcome.

Your next question comes from the line of [Michael Youngling] of Merrill Lynch.

I've got a couple of questions.

The first one is for Dave.

You try to set up Zimmer for best practice with respect to compliance, but I'm just wondering whether the pendulum has swung too far the other way.

I guess you also have to balance shareholder interest and if you keep on losing market share, that may not be the right balance.

The first question is why do you think you have got the right balance when you lose about 2 to 3 points of top-line growth in hips and knees?

Yes, and we are making these decisions, Michael, consistent with the shareholders interest.

We -- we believe that we're in the initial stages of what is going to be a fundamental change in the industry, and how these relationships are structured and managed, and as we've said repeatedly we're not going to incrementalize this change process within our business.

We're doing that because we want to make sure that we get access to the best design surgeons, the best trainer and educators, et cetera, and so we're going to take the bold steps that need to be taken now to preserve our ability to get that input.

We think that if one were to pursue this in a manner where they were to incrementalize those efforts, they are going to go through continued disruption over the course of a long period of time.

As enforcement actions continue to play out, as legislators continue to promulgate further enforcement of these ethical principals, and try to police these relationships in a more aggressive manner, so it's early in this change process.

We think that we have got the right approach.

It never was an approach that by definition was going to prove out in the short-term to be beneficial, but it's completely consistent with the shareholders longer-term interest, and I think you are going to see that in the coming periods.

So, again, all of these decisions are driven towards ensuring that we have the ability to continue to innovate and to provide solutions that address unmet clinical needs and train and educate in the best manner possible, and so these decisions are going to get made with patient's interests in mind and it will go down to the shareholders benefit.

At what point in time would you recognize perhaps that maybe we'll lose too much market share and we need to change things?

How long would that be away before perhaps management does, maybe (inaudible)?

No, we're on the right track, Michael.

Okay.

The second question is on the spine acquisition, I'm just curious what the rationale was?

If you look at the sales in the EBIT it seems that Abbott Spine was highly profitable.

$40 million of restructuring charges, we'll probably need a payback period of 10 years.

Can you give us an indication why Abbott Spine was so important to you?

For all of the reasons we have articulated.

We pick up a great base of products with a nice pipeline.

That was not a basis that on a stand-alone business was highly profitable.

It was marginally profitable.

But again, that business allows us to establish critical mass on a lot of important fronts that will enable us to participate in a meaningful way in that growing market.

Okay.

Final question is on the SG&A, maybe this is a question for Jim.

I think the point that was made was that the SG&A costs have increased temporarily?

I'm just curious what you mean by temporarily?

Will they decrease in 2009 or does temporary mean maybe 2010?

Yes, well, certainly we're going to have the opportunity as we talked about going into 2009 to save the one time fees.

You had third-party fees and expenses that we have incurred in 2008 with respect to the implementation of the compliance initiative across all our business units and around the globe.

Some of that may very well get reinvested in other areas, but, again, we are going to have the opportunity to save those third-party fees and expenses going into 2009.

That would mean -- so it's okay to say that after Q1 of 2009, SG&A costs will decrease because the monitoring costs will go away?

Well, as I said the opportunity is there, and we'll -- as David said on our fourth quarter call, come out with more specific guidance with respect to SG&A, and other, parts of the P&L on our fourth quarter call.

So it's quite possible that you will reinvest that and perhaps SG&A does not change in 2009 materially?

It's possible, yes.

Thank you.

Your next question comes from the line of Kristen Stewart of Credit Suisse.

I just want to go back to your level of confidence with respect to the fact that you have lost some surgeons now, and I can appreciate that you are not including regaining that business in the '09 forecast, but what really gives you the confidence that this isn't just the beginning of additional market share losses and losses of surgeon contacts?

And can you just put this into in context in what has been at least characterized as an industry where market share shelfs and surgeons moving to other manufacturers is not very likely?

Yes, and again, we have undergone some pretty significant disruption because of the variety of subject matters that I talked about earlier in the call, Kristen, so it isn't just the compliance program, but the confidence level is really derived by a lot of conversations that we have had, and day-to-day contact with people, and the advancement that we're making in implementing this program as well.

The program structure is the right track for the future.

We firmly believe that.

We're in an execution mode, and as we continue to progress through this we're going to see some stabilization on that front.

That doesn't mean that there won't be additional customer losses, but we have characterized those losses, and that's the basis for believing that come the second half of 2009, we're going to see our top line begin to accelerate.

So we think that the fourth quarter is likely to be the high watermark for that activity, and will stabilize in the first half of the year, 2009, that is, and then begin to improve our top line thereafter.

Okay.

And just the playing field here just seems to be level, I guess with respect .to what the DOJ has mandated.

So do you feel that it is truly just the fact that you are going to a more conservative model and that's the reason for some of the losses?

I guess I'm just having a hard time understanding why these customers are going to other companies.

Well, we're going to any place that we think we're going to need to be for the next five, eight, 10 years at this point in time, so we're not going to undergo disruption in the future on the same basis.

I think that if people try to incrementalize this change they're going to subject themselves to further disruptions.

So we think that this is the right long-term solution.

Thanks very much.

You are welcome.

Your next question comes from the line of Mike Weinstein of JPMorgan.

Good morning.

Thank you for taking the questions.

Good morning.

Just to clarify on the preliminary '09 commentary on the bottom line, you have had the last two quarters about $0.12 of gains from your investment sales, so if you are talking high single digits off of your adjusted $4.03 to $4.08 number, if we backed out the gains you do have in 2008, it does end up becoming more like 10 to 12%.

So if you were at 7 to 9 before in terms of the how you were thinking about '09 EPS growth, but backing that $0.12 out would get you nor a 10 to 12% growth rate?

I just wanted to make sure we are all on the same page.

Mike, that's fair, but I think you also have to consider the one time costs that are running through the P&L this year.

Oh, absolutely.

Yes.

And all of the other stuff, yes.

Just wanted to make sure we're just talking apples to apples.

Sure.

I -- I do understand on the third quarter, if we look at the performance -- I think we would find that most people are probably surprised on the O-US business more than the US business in terms of how sales growth came in.

And the surprise that everybody does think of everything that is going on in the industry is primarily a US event because it was the US Department of Justice, and it was a US agreement.

But is it your view that it's the compliance programs you are putting in place globally that are impacting your non-US businesses?

Is that what you are saying?

It's had an effect, sure.

And so what -- what else is having an effect on the non-US businesses?

Well, I -- I mean the most significant other factor that I don't know if which have highlighted heavily enough is the pricing changes in Asia Pacific.

That had a dramatic effect on our growth rate.

Probably 6 points worth of growth taken away by virtue of the price impact in Japan and Australia, primarily.

And Japan, starting in April?

That's correct.

So if we looked at -- maybe Asia Pacific was much stronger in the second quarter than it was in the third quarter.

So the delta from 2Q to 3Q wouldn't have been in Japan, but you said the price cut in Australia?

That is correct.

Okay.

Anything else that played out between Q2 and Q3 that you would highlight?

Nothing else of significance, Mike.

Okay.

And then as we -- as we think about your mix right now, you haven't been able to execute on your product launches the way you would have liked for 2008, and you have commented on that.

I would like to get just a better read on, if we looked at your revenue growth right now?

Where would volumes be and where would mix be?

I think we have a sense of where price falls out right now but where is your mix today, because obviously the implication from everything that you have said and what we've seen in the business is that your mix benefit has been greatly diminished here because of the lack of product launches.

Yes, I -- without getting too specific, we talked about that mix benefit opportunity being in the 1 to 3% range, across the market.

And we would expect typically to be at the high end of that range.

I think it's fair to say that we're not quite at the high end of that rage, but there is still mixed benefit reflected in our results coming from products that were launched in 2007, and those that we put out this year.

I talked about the growth, we saw for example, in the natural knee gender flex product in the third quarter, at 40%, 15% growth in hinged knees, so we are still, Mike, getting some mixed benefit.

And the more -- at least with respect to this quarter -- the more significant factor, kind of impacting on the difference between our performance and the market is -- has more to do with these customer losses in the quarter.

Got you.

Okay.

Listen, thanks for taking the questions.

You're welcome.

Your next question comes from the line of Ben Andrew, William Blair.

Good morning.

Maybe just one more question on the compliance issues.

I guess maybe some of the hangup here is that it seems like you guys are taking the pain now by getting out in front of what may be more substantial congressional action in the next couple of years, at which point the whole industry would convert and effectively relevel the playing field without share losses on the part of the competitors that you are taking.

Is that a fair characterization of how you expect this to play out?

Or do you think that as the rest of the industry goes through this same transformation in the next two or three years, that you are going to substantially take share?

Well, it is tough to say what competitors are doing with respect to implementing programs and what their practice is at this point in time.

What we're staying focused on is the right program for this Company, and to ensure that we get the input that we need from surgeons and have the relationships structured and managed in the right way.

So that's going to prevail over the course of this, and I don't think it will just be legislative branch.

I think that you're going to have continued enforcement actions, I think that the public is going to pay a lot of attention as these transparency initiatives take hold.

So on a variety of different fronts this is going to be a topic that is going to accelerate from hearing something about it every month in the past to daily proof points that one has to manage these relationships in a very careful manner.

So that is what we are establishing in our practices.

It is what we're establishing in our culture, and we think that it is going to be a prevailing view in the long term, but if we implement this program the right way, and we are able to innovate, and to train and educate in the right manner, we're going to have the right model to succeed in the future market.

So that's what we're doing.

If you think about having begun to reengage with doctors, can you put it on a scale of your 20% are we reengaged 10%, 50?

In terms of trying to quantify or at least characterize the potential future, kind of share losses here?

Yes, I think that engagement level.

I would say woe oar at the 50%-plus mark, and by the time which exit this year, we'll be at the 75% plus mark.

And by the time we complete the first quarter of next year, we should be at full speed.

Okay.

Great.

And just one quick numbers question, maybe for Jim.

If currency holds steady from where we are today, even as best as you can, I know it's changing daily, what would be the top line headwind and the gross margin headwind, understanding, of course, that you are hedged to the bottom line.

Yes.

I don't know that I'll be able to answer at this point, Ben.

That's something we'll have to get into when we come out with more specific guidance on the fourth quarter call.

Okay.

Thanks.

Your next question comes from the line of David Roman or Morgan Stanley.

Good morning, everyone, and thank you for taking the question.

Just on the guidance for 2008 -- this is the second time we have seen a reduction in guidance, due to the, I guess compliance initiative programs.

What gives you confidence in the numbers this time around?

Where does the 60 million to $80 million reduction come from, and why should we see that number not be worse in the fourth quarter?

Yes, David, you can look at where that puts us relative to the -- the market, and where it puts us relative to our -- either the third quarter or for that matter year to date growth rates, for our core franchises hips and knees.

And it's principally hips and knees where we're experiencing the customer losses.

I think you'll find what we have forecasted for the fourth quarter is -- on a constant currency basis our overall revenue is relatively flat slightly up compared to prior year.

I think we're very comfortable with this adjustment with what we have forecasted for the full year.

When you sort of embarked on this new compliance initiative in April, what sort of surprised you over the past six months?

Was it the customer response?

Was it the level of, sort of investment needed to bring this compliance program to fruition?

What sort of changed over the past couple months?

Just the excuse time, it's a significant amount of work, and we're dragging this out in simultaneous fashion across all of the business units and all the geographic segments, so that's a lot of work for the organization to push through, and we're making a lot of progress.

And did you find surgeons to be less collaborative in the process than you expected?

I think that the vast majority of is surgeons have responded very favorably.

Except those obviously are no longer, sort of -- the ones that you mention as sort of defecting this quarter.

But I guess one other question, on -- David, just a comment you made earlier about making steps now as to not have to revisit the compliance issues later.

Is there a sense that companies that might have been less thorough in the compliance process are going to need to step up investment in compliance sometime down the road?

It is tough for me to comment on, David.

I think that's a question that you are just going to have to pose to the other companies, and we'll have to watch and see how things play out.

I don't think that this is going to be an area that is unique just to our sector.

I think you are going to see this is a significant issue across a broad array of medical device companies in the coming months and years.

It's the same challenge that exists in those different contexts, and I think that the orthopedic sector is probably out ahead of some of the other sectors in that regard.

But longer term, I will tell you that my view is that these compliance programs are going to be thought of as being a significant and required piece of infrastructure just as quality systems are seen that way because of what has been focused on in the proceeding years in that area.

That makes perfect sense and then just lastly for Jim.

On the share buyback and the Abbott deal is the Abbott deal a signal that you are starting to pull back on share repurchases going forward?

Given where the stock price is, and the level which you had bought back shares is there any change with respect to your capital allocation plans?

No, there are no changes.

That was clearly the case in the third quarter, but that deal is now closed and as we generate free cash flow and have cash available on hand, and are not otherwise, looking at anything on the immediate horizon in the way of further investments, we would look to put that cash to use through the share repurchase, the authorized share repurchase program that we now have in place.

Great.

Thank you very much

Your next question comes from the line of Joanne Wuensch of BMO Capital Markets.

(Inaudible) for Joanne, can you hear me?

Yes.

Hi, guys.

I just had a couple of questions about the Abbott acquisition, given the $20 million that you are putting in your guidance, how does that break out geographically?

It is about three-quarters US based and the balance outside of the US.

And how should we think about the run rate or the contribution to your top line next year?

Is that 80?

This transaction closed in mid-October, so it's -- they did a little over $100 million in revenues in 2007, and, again, we'll continue to spike out what it is contributing on a quarterly basis, but I would reference at this point back to the slightly more than $100 million in revenue that they did in 2007.

Okay.

Fair enough.

And of the non-dilution, how does that hit the P&L?

They are spending a fair amount of money on R&D as a percentage of their total revenues, so it -- if some of that would come through in higher R&D costs as a percentage of total revenue, and then the balance of that could come through in intangibles, amortization and the interest cost on the deal.

And just switching gears, you have talked about having a stronger second half of '09 and highlighted a new hip product.

Are there other areas that you would highlight that you think you will come back strong in the second half?

On the product introduction side the new nail offering is another contributor for that growth.

And then obviously we're going to be picking up the OSP revenues as well as those products become available again.

Right.

Okay.

Fair enough.

Thank you guys.

You're welcome.

In respect of our attendee's time, let's take one more question.

Your next question come from the line of Michael Matson of Wachovia Capital.

Hi.

Thanks for taking my question.

I know you mentioned that you had done some work on the future structuring of your royalty agreement, but I was wondering what we can expect around the royalty agreements that have already been in place?

I know there has been some rumblings that you are looking at sort of buying those out or something?

Is that something is still potentially going to happen, and if so, when and what would the P&L impact be?

That is happening.

Some of that take place in fact, in the third quarter and will continue on into the third quarter and fourth quarter of next year.

And I would tell you you that, the P&L impact at this point is expected to be neutral.

Now those, those arrangement would cause us to buy out rights to technology and in doing that recognize an intangible asset on the balance sheet that would be amortized over the life of that technology, and that's -- that sort of, as we look at it at this point at least, sort of lines up with what we would otherwise be incurring in royalty expenses.

Okay.

Then.

Just any impact on your gross margin as you bring the new Ireland plant online?

No, again, we -- in getting that plant up and running, we're taking the processes, that have been -- the manufacturing processes that have been developed in Warsaw, and, transferring those into that facility.

I think initially, we may see some slightly higher unit costs on those thermal components, just given the amount of time that it takes, to get up to the point where they are operating at sort of full capacity, but otherwise, no, we would not expect that to really have much of an impact on our gross margin ratio in the aggregate.

Thank you.

I will now turn the call to David Dvorak for closing remarks.

Thanks, again, everyone for joining us today, and for your continue interested in Zimmer.

We look forward to speaking to you on our fourth quarter and year-end conference call, will be l be held on Thursday January 29, at 8:00 a.m.

I'll now turn the call back over to you.

Thank you for participating in today's conference call.

You may now disconnect.