Zimmer Biomet Holdings Inc (ZBH) 2009 Q2 法說會逐字稿

Good morning.

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

I'd like to welcome you to the Zimmer second quarter 2009 earnings conference call.

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

This morning, we will review our performance for the second quarter of 2009, provide you with an update on certain key matters, present an update on our outlook for 2009, and conclude our discussion with a question-and-answer 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, forecasts, 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 and Exchange Commission.

Zimmer disclaims any intention or obligation to update or revise 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 entitled "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 August 6, 2009, 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.

We're glad you've joined us on the call today to discuss Zimmer's second quarter results.

Our net sales for the quarter were $1.02 billion, and our adjusted earnings per share were $1.

We believe these results indicate that we are stabilizing our core franchise, and we're moving forward in a disciplined fashion to restore positive momentum in our business.

As we said in our news release, we achieved sequential improvement in revenue on a day rate basis for the quarter in six of our seven product categories, including knees and hips.

We believe that we've held our global market share in knees and hips during the second quarter.

Overall, worldwide reconstructive sales decreased 2% inconstant currency in the quarter.

Knee sales in the second quarter declined 1% constant currency as the result of previously disclosed share losses, negative pricing of 1%, as well as deceleration of procedure volumes as compared to the prior year.

The knee portfolio continues to benefit from our use of Trabecular Metal technology.

We're pleased the clinical data on Trabecular Metal is becoming more accessible.

As an example, the July Journal of Bone and Joint Surgery featured a study that indicates the Trabecular Metal tibia is an effective alternative to standard cemented tibias.

Worldwide hip sales declined 4% in the quarter in constant currency, with negative price of 1% and negative volume and mix of 3%.

Our hip results reflect the impact of market share losses, which again we believe have stopped, and certain product gaps which we've been addressing.

Our hip portfolio continues to benefit from a very strong portfolio of stems.

The Zimmer M/L Taper hip prosthesis family of stems is growing at nearly five times the market procedure rate.

In addition, the Fitmore hip stem is the most frequently requested component for femoral insertion during our MIS Surgical Skills training events.

Extremity sales for the quarter in constant currency increased 13% over the second quarter of 2008, with strong contribution from our new shoulder systems and the launch of the TM Glenoid.

Dental sales on a constant currency basis decreased 12% for the quarter.

The dental market continues to experience significant pressure on a global basis due to the economy.

Trauma sales in the quarter were up over the prior year period 7% constant currency, with strong performance in plates and screws and initial sales coming from the Zimmer Natural Nail.

Zimmer spine reported 23% constant currency growth in the quarter.

This growth is driven by the Abbott Spine acquisition, which was completed during fourth quarter 2008 and contributed $20 million of incremental spine sales in the quarter.

The Zimmer legacy spine business was negatively impacted by competitive pressures and ongoing reimbursement challenges.

Finally, orthopedic surgical product and other sales increased 3% constant currency in the quarter.

We're encouraged that following last year's disruptions, we now have many of the OSP products back on the market.

Looking forward, now that our development teams are reengaged in a significant way, we're really excited about the potential of our product pipeline.

We've historically had substantive releases on a perpetual basis, and you should continue to see such activity from us moving forward.

During the quarter, our development partner filed for US regulatory clearance to market our patient-specific knee instrumentation, which allows for physician preferences and confirmation of implant placement while preserving interoperative flexibility.

Also during the quarter, we filed for regulatory clearance to market multiple new acetabular cups in the US.

Certain of those cups are in the process of being introduced outside the US as we speak.

Among these new products is our continuum acetabular cup, which offers various bearing options, providing surgeons with flexibility to address each patient's needs during the primary replacement or revision procedure.

Another new acetabular offering is our MMC, or metal-on-metal large head cup system.

This is an additional large diameter metal-on-metal hip replacement option which leverages a 20-plus-year history of clinical success with our Metasul technology.

These new cups, once approved in all jurisdictions, should provide opportunity to pull through incremental revenues of our new and innovative stems.

I also want to mention a couple of notable product from our orthobiologics group.

The first is De Novo NT, which we are now rolling out in the US.

De Novo NT is a living tissue graft derived from donor cartilage tissue that is intended to support the surgical repair of damaged articular cartilage.

There's been a great deal of interest in this technology, and it's been a real catalyst for us in terms of engaging with customers about Zimmer innovation.

During the quarter, we also entered into a 10-year agreement for the exclusive distribution rights in the United States for an innovative single injection hyaluronic product.

Our product's Seikagaku Corporation submitted a PMA application for approval of the product in July of last year.

We anticipate beginning to market the product upon approval, which we would expect sometime late this year or next year, barring any unforeseen issues.

These are just two concrete examples of how Zimmer intends to participate in the treatment of arthritis patients earlier in the continuum of care than we have in the past.

While we don't expect significant revenue from these new orthobiologics products in the immediate term, we do believe they will provide compelling expansion opportunities in future periods.

We're also making significant progress in the area of professional education.

Medical education and surgical skills training are vital in our industry.

It's through these programs that our customers become proficient in the safe and effective use of our products.

Providing a quality education experience is among the most important ways we support our customers and build their trust in Zimmer as a valued partner for patient solutions.

As part of Zimmer's effort to provide first-rate medical education, we've made substantial investments to develop a highly interactive education model that we believe sets new standards for the industry.

Officially launched on July 1st, the new Zimmer Institute redefines industry training, providing a broad spectrum of customized courses spanning medical education, surgical skills training, and personalized surgeon to surgeon training.

This model was developed in conjunction with adult education and subject matter experts.

The key to its success is a focus on individual surgeon needs.

Surgeons move through customized programs that incorporate four levels of education: Knowledge acquisition, skill development, skill enhancement, and refinement.

This customization requires that we provide training using a variety of different modalities to assure that we meet surgeons' needs.

So far, the feedback we've received about this approach from participants has been excellent.

They appreciate that our training is more personal, interactive, and convenient, thanks especially to regional locations.

The faculty to participant ratio provides physicians with meaningful access to expert trainers.

We believe all these attributes distinguish the Zimmer Institute from other industry offerings.

While many of the aspects of enhanced Zimmer Institute offerings may seem somewhat intuitive, the logistics involved and the resources required for investments in curriculum, course materials, and locations are substantial.

Overall during 2009, we expect to train approximately 20,000 medical and dental professionals worldwide across all of our businesses.

In closing, I would like to provide our view on some of the more macro trends that relate to our business and industry.

Based on reported results to date, we now believe knee and hip procedures have slowed somewhere between 3 to 4% when compared to the prior year, with a more pronounced slowdown in knees.

As the economy improves, however, the procedures that were deferred in the interim are expected to come back.

Note that this is our opinion based on our analysis of market data from a variety of sources; but given the interest in the topic, we thought it would be useful to provide our sense of the situation.

Another closely watched market dynamic is pricing, and it is our view that pricing pressures have been persistent for some time and will continue.

With the first half of 2009 behind us, we now anticipate worldwide pricing for Zimmer to be down about 1% for the full year.

We report pure price, not price and mix.

If we were to combine price and mix, the metric would be more positive.

We're currently underpenetrated in higher priced segment of the hip market, for instance, although going forward we intend to address that with new product introductions.

One factor that some believe may indirectly influence pricing is the rates of reimbursement from Medicare.

The rates proposed by CMS for most procedures in our markets show reimbursement as slightly positive for 2010, similar to increase in recent years.

Again, there is no proven correlation between those rates and overall pricing, but it doesn't add any additional pressure to pricing.

We believe this reflects the US government's recognition of how cost-effective these procedures are for society.

One final point I want to touch on is healthcare reform.

I think we're still some time away from having a great deal of clarity on how these efforts will eventually play out.

As such, we don't think it's particularly useful to speculate on how the proposals made to date might affect Zimmer or the medical device industry in general.

I can tell you, though, that Zimmer is appropriately active in the healthcare reform discussion.

In the [beltway], we're working to disseminate our key messages that patient access to the most effective treatments must be maintained, and that what constitutes medically appropriate care should be determined by healthcare professionals.

We'll continue to advance these positions and respond to healthcare reform proposals through AdvaMed, the US Chamber of Commerce, and in coordination with Congressional contacts through our Washington, D.C.

Government Affairs Office.

Before I turn the call over to Jim, I'll summarize by saying that we're confident that our second quarter performance is indicative of stability and positive momentum in our business.

We continue to believe that Zimmer is well-positioned for long-term success in an industry that has demonstrated great value and continues to have extremely bright prospects.

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

Jim?

Thanks, David.

I will, as David said, review our performance in the quarter in more detail, then provide some additional information related to our guidance.

While the dollar strength subsided during the second quarter relative to the first quarter 2009, compared with the prior year, foreign currency translation decreased revenue by 4.9% or $53 million in the quarter.

Consolidated pricing was down .7% for the quarter.

In the Americas, price was negative .9% for the quarter, while Europe average selling prices were flat compared to the prior year.

Asia Pacific results include negative price of .6%, and have improved compared to recent quarters as we have anniversaried out of the April 2008 reimbursement price cuts in Japan.

Our adjusted gross profit margin of 77.1% for the quarter is up 130 basis points over prior year second year quarter.

Foreign currency hedge gains as compared against prior period hedge losses, offset by inventory charges and higher unit manufacturing costs, largely account for the improvement in gross margin in the quarter relative to prior year.

Gross profit margins are expected to be lower by approximately 200 basis points in the second half due to higher per unit manufacturing costs associated with reduced production volumes.

Moving down the income statement, R&D expense as a percentage of sales increased to 4.9%; and at $49.9 million for the quarter is 3.1% above prior year.

We continue to expect our R&D spend to trend higher and average just over 5% of sales for the full year.

Selling, general, and administrative expenses decreased to $432 million in the second quarter and are down 3.5% compared with the prior year.

At 42.4% of sales, SG&A expenses are 90 basis points above prior year and down 30 basis points when compared to the first quarter of this year.

In this challenging economic environment, we are carefully managing our SG&A spend, reducing expenses in certain areas in order to fund growth and productivity initiatives.

Areas of continued investment focus include marketing and promotion.

As David noted, we are also investing significantly in our global medical education programs.

Acquisition, integration, realignment and other amounted to $36.5 million in the quarter and include severance expenses associated with the global workforce realignment, contract termination costs, and litigation related charges.

Also reflected in our results in the quarter is a net curtailment in settlement gain of $32.1 million resulting from the termination of a legacy retiree medical plan.

Adjusted operating profit in the quarter decreased 5.8% to 303.7 million.

At 29.8%, our adjusted operating profit to sales ratio is in line with the prior year's second quarter.

Interest expense for the quarter amounted to $4 million, principally resulting from financing the Abbott Spine acquisition and share repurchases.

Adjusted net earnings decreased 9% compared to prior year at $215.5 million, and adjusted diluted earnings per share decreased 2.9% to $1 on 215.5 million average outstanding diluted shares.

These adjusted earnings per share are exclusive of approximately $0.08 of share-based compensation.

At $0.98, reported diluted earnings per share -- which include the nonrecurring items reflected in acquisition, integration, realignment and other, and net curtailment and settlement, decreased 1% from prior year's second quarter reported EPS of $0.99.

Our effective tax rate for the quarter was 28.1%, and our first half 2009 adjusted effective tax rate was 27.5%, in line with our anticipated full-year rate.

During the quarter, we repurchased .8 million shares at a total purchase prize of $36 million.

Approximately $797 million remain authorized under a $1.25 billion repurchase authorization which expires at the end of 2009.

The Company had approximately 214 million shares of common stock outstanding as of June 30, 2009, down from 215 million as of March 31, 2009.

Operating cash flow for the quarter amounted to $195.1, million, down from $280.6 million in the second quarter of 2008.

In the quarter, we continued to resolve outstanding payments to healthcare professionals and institutions, resulting in substantial cash outflows compared to the prior year.

Adjusted inventory days on hand finished the quarter at 375 days, up two days from the first quarter.

Over the past two years, we've made investments in response to growing demand for systems that provide more versatility and better fit for patients.

Our gender solutions femoral components, connective technology, Fitmore stems, contoured plates, and new intramedullary nails are all examples.

This trend has and will continue to put pressure on inventory days.

We intend to rationalize the inventory investments over time through reductions in field-based consignments and through the use of new inventory management tools, including RFID technology to speed returns and redeployments.

Offsetting reductions in field consignments will be the continued buildout of pipeline inventory for the new acetabular cups and the new nail line for trauma.

Our adjusted trade accounts receivable days sales outstanding finished the quarter at 63 day, an increase of two days over the first quarter.

Depreciation and amortization expense for the second quarter amounted to $81.8 million.

Capital expenditures for the quarter totaled $54.4 million, including $30.6 million for instruments and $23.8 million for property, plant, and equipment.

This is down substantially from prior year levels, as our European distribution center and (inaudible) manufacturing projects are mostly complete and we adjust spending for lower production volumes.

Cash outlays associated with divesting activities during the quarter also include $18 million for acquired intellectual property, and another $17 million for certain international distributor acquisitions.

Finally, free cash frow was $140.8 million for the quarter.

And I will turn now to our guidance.

We are reaffirming our sales and EPS guidance, expecting full-year revenues to increase from 1 to 3% in constant currency when compared to 2008.

With first half behind us, we see clear indications that our share position in our core reconstructive business has stabilized.

However, we also acknowledge a more pronounced temporary slowdown in the global market for knee and hip procedures than we estimated coming into this year.

Based on current projections, we now believe that foreign currency translation will reduce our reported 2009 revenues by an estimated 2.5% for the full year.

Therefore, on a reported basis, our revenues are projected to be in a range of negative 1.5% to a positive .5% compared with 2008.

For the third and fourth quarters, based on current projections, foreign currency translation is expected to reduce our third quarter 2009 revenues by an estimated 2% and increase our fourth quarter 2009 revenues by just over 2%.

Full-year adjusted diluted earnings per share are projected to be in a range of $3.85 to $4.

Third quarter adjusted diluted earnings per share are projected to be below prior year by approximately 12%, due principally to the significant gain recognized in the third quarter of 2008 on the sale of certain investments.

Fourth quarter adjusted diluted earnings per share are expected to be in line with or above the current consensus estimate of $1.07.

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

Thank you, Jim.

Once again, we're pleased with the progress we've made in the first half of the year, and we believe that Zimmer is positioned for sustained growth in attractive markets.

With that, I'd like to open the call to your questions.

(Operator Instructions).

Your first question comes from the line of David Lewis with Morgan Stanley.

Good morning.

Good morning, David.

Jim, I want to clarify some of your comments on gross margin.

You've been saying throughout the year you'd expect a gross margin kind of deceleration in the back half of the year.

If you take the average back half gross margin compared to the first half, is 50 or 60 basis points reduction on a reported basis a reasonable assumption?

Go back to the comment I made in -- the scripted comments just I made, David, and you -- it's -- the step-down that we're anticipating in the second half of the year is more like 200 basis points.

On a year-over-year basis?

I was speaking more sequentially.

So you're -- tell me again.

You're comparing back to what period?

I'm just rolling off your first and second quarter and trending through the remainder of the year.

Yes, so the gross margins we saw in the first half of the year averaged around 77%, and we're anticipating gross margins for the back half of the year to come in at around 75%.

Okay, and then maybe moving on to SG&A here for a second, you did pretty stellar SG&A here in the second quarter.

So in terms of your ability to hold SG&A at current levels, given -- so the gross margins are probably incrementally lower than we would have expected, can you kind of talk about your visibility and expectations there?

Yes.

We talked about our expectations for the full year on SG&A to be in absolute dollar terms -- on the first quarter call -- to be in line with our slightly above prior year, and that remains the case.

We would expect with the seasonal slowdown in revenues in the third quarter that the variable component of SG&A expenses will come down in the third quarter; so you'd see sort of a modest sequential step-down in total in SG&A spend in the third quarter, and then an increase in the fourth quarter with higher procedure volumes that we would expect to see in the fourth quarter.

And maybe lastly, I'll jump back in queue, here -- David, just talking about share in the marketplace, you've been sort of hesitant to talk about share gains.

You've focused more on stabilization.

And clearly, you've got two quarters where we seem to have some sort of relative stabilization.

Are you any more confident, given the training initiatives that should be increasing here in the back half of the year, to kind of make a statement that share gains may be more possible in hips and knees than you would have expected, let's say, six months ago?

Well, I think that we're reaching that level of stabilization, so obviously that's step one, David, to the process of picking up share.

That's going to be dependent on a lot of things.

In addition to training and education, some of these new product approvals being cleared within the US market, and then the ramp-up times.

So I think the important thing for us is that stabilization in the first instance, and then doing all the things that are necessary to get back into the share gain mode in the future, and that's really our objective for the year.

As we exit 2009 and enter 2010 with everything coming together, we'd expect to be in that kind of a position.

I'm sorry, just Jim, one last question.

I apologize.

Just heading into the back half of the year, price has been stable, at least what you're reporting as true price for the first half.

And given you're anniversarying pressure you were seeing in the Asian RIM, should we expect true price to improve here in the back half of the year, or is that too much to hope for?

Well, I would -- as David indicated in his comments, we would anticipate pricing to be down about a point for the full year, and that's really consistent with what we saw in the first half.

Okay, thank you very much.

Thank you.

Next question comes from the line of Bruce Nudell with UBS.

Thanks, good morning.

Good morning.

Looking at the market so far, it looks like -- based on what you've reported, it seems like US hips and knees are around mid-single digits, and -- but ex-US hips and knees are 1% or flat.

First of all, could you comment on your perception of, is anything going on ex-US that is like to persist?

What's the source of the downturn?

And within the US market, of the 5% -- if we're, in fact, correct -- how much of that do you think is volume?

Okay.

Hey, Bruce this is Jim.

Just to comment on the market, on the slowdown we're seeing in markets outside the US, it is the case that that slowdown is really hitting in the major markets in Europe.

So in the UK, Germany, France, Spain, Italy, much like we've seen here in the US, we believe that's associated with the economic climate that we're in.

And we would expect the patients that are deferring these procedures in Europe in these major markets to eventually come back, so we would expect to see a rebound eventually in those major markets in Europe.

I would tell you that getting outside of the major market in Europe that we believe there are significant opportunities still in the emerging markets.

In Eastern Europe, as an example going forward, there are underpenetrated markets in places we've mentioned, if you go back to the comments I made about cash flow, that we spent some money in the quarter on distributor acquisitions.

We are in the process of building out a direct presence in some of those emerging markets, and believe there's some significant opportunity there going forward.

And then just coming back to the question on the US, it is the case, we believe, that the slowdown that we've seen is in procedure volumes.

Okay.

And just to push on the European major markets -- and this is actually a point of clarification that would help certainly me -- our pre-existing belief was that most of these patients were kind of insured by national health services, and hence should be less susceptible to economic pressure.

What's wrong with that scenario?

Or are the governments, in fact, just pulling back?

I think it's probably more the latter than a flawed assumption, I guess, fundamentally.

But I think it's early to start to predict that that's going to be in any type of a prolonged trend at this point, Bruce.

So we'll keep our eye on it, obviously, and give you as much of an update as we can in subsequent calls.

Thanks so much.

And I guess the only other question I have is, one of the subtleties of measuring share is you may not gain back new surgeons, but you may be able to have have better mix in the surgeons -- in the volume controlled by the surgeons who are affiliated with your products.

Could you just comment on that idea and whether it's valid?

I think it is valid, Bruce.

And in my prepared remarks, I highlighted one of the principal areas where we do that have opportunity, and that is on the hip side.

We're underpenetrated in some of those technologies that do draw price premium; and as you say, if you have the relationship and come out with innovative products in that area, you ought to be able to take advantage of those opportunities, and that's what we intend to do.

Thanks so much.

You are welcome.

Your next question comes from the line of Bob Hopkins with Bank of America.

Thanks, and good morning.

Just a quick question for David and one for Jim.

First for David, just following up on Bruce's question on mix.

You guys highlighted a nice stream of new product flow into the marketplace going forward, and I'm just wondering, as you're launching new products, what are you seeing from the marketplace in terms of your ability to get mix out of a new product launch?

Is it -- has it change at all?

Are you still able to get the ASP bump-up from launching a new product at a higher price?

It's early for us on these launches, Bob; but our view of it at this point is the mix opportunity still exists.

As we progress through the back half of this year and have more success with product launches in the US markets in particular, as well as the acetabular cups in the large markets throughout Europe that are already launching just this week, we'll be able to come back to you and confirm that our assumption is accurate here.

But all the early signs are that that mix opportunity is still out there.

And then specifically on the MMC, can you talk about the timing of that launch in the United States and when you expect to see an impact?

Well, as we said, we are anticipating a launch of MMC in the second half of the year.

We're on pace with the development of the product.

We're on pace with the clearance of that product in the European markets, and that clearance is pending within the US right now.

Okay.

And then for Jim, you guys had had commented, I think, in the last quarter that your EPS guidance for the year was somewhat predicated on an assumption that the hip and knee market growth rate would be in the 6% year.

And looking at that time first half results so far, it doesn't look like 6% is a conservative estimate at this point -- maybe something in the 3 to 4% range.

So you're -- but you're obviously maintaining your EPS guidance here.

Are there extra spending cuts that are beg assumed to get to that rate, or was there just enough wiggle room in the 6% number that 3 to 4% isn't enough to really offset on the EPS side?

The other thing we pointed out, Bob, when we came into the year with respect to our guidance on the top line, was that we could see up to another 50 basis points of share loss in hips and knees; and looking back now at the first half of the year I would tell you we're not seeing that, not seeing me of that.

So the fact that we're not seeing any of that really offsets the fact that we now would acknowledge the markets are growing at a slower rate, maybe somewhere on the order of 4% as compared to the 6% we anticipated coming into the year.

So we're not having to save in expenses to get to that bottom line.

That's very helpful.

Jim, just lastly, can you just give us your sense as to where your -- what the market share change has been since the end of 2008 here at the halfway point in 2009, exactly what incremental share you've lost or gained in hips and knees since year end '08?

Yes -- and understand, we measure it quarter over quarter.

So when we -- after the fourth quarter of last year, we came out, we looked at fourth quarter of '08 versus fourth quarter of '07, and that indicated that at that time, we felt we had lost about two points of share in hips and a point and a half of share in knees.

Admittedly, we're sort of at a point where not everybody has reported here in the second quarter.

But we're looking at our performance in the second quarter against those that have released, and putting in some estimates into our own models for those that have yet to release.

And our view of it is that we have not lost any incremental share in either hips or knees in the first half of this year.

Great, thanks very much, Jim.

You're welcome.

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

Thank you.

Good morning.

Good morning, Mike.

I wanted to start by making sure I understood your guidance.

It sounds like, just based on your comments, Jim, that your guiding the Street to an $0.85 number for third quarter.

Is that right?

That's right, Mike.

That's on target with obviously the down 12% versus prior year.

Okay.

And then the commentary for the fourth quarter was that you expected diluted earnings per share to be in line with or above the consensus of $1.07.

That would imply that you'd be somewhere for the year in the $3.85 to $3.90 range.

Is that basically what you're trying to imply for the year?

Yes, I think that's fair.

I think there may be opportunity beyond that, particularly in the fourth quarter, but some of that would depend on where things shake out in the market and whether or not we see any rebound at all in the fourth quarter.

But I otherwise would tell you that that's a fair assessment.

Okay.

Did you think at all about narrowing the range?

I mean, it sounds like basically that's what you were doing.

Instead of saying the $3.85 to $4, you're saying $3.85 to $3.90.

Well, the range is the range for the full year.

It's $3.85 to $4.

And the possibility still is there, and the opportunity is still there to get to the high end of the range, but it would depend, admittedly, on a couple of things.

One would be some rebound in procedure growth -- and understand we do get into somewhat easier comps across the market in the back, particularly in the fourth quarter -- and then timing of some of these new product launches.

If they were to hit sooner than we're anticipating, that would obviously provide with us some opportunity, in the fourth quarter in particular.

The inventory issue still is a concern of mine.

You did guide to lower gross margins over the back half of the year.

That 75% second half gross margin guidance, what does that assume in terms of improvement in your inventory levels?

Well, we would anticipate, if we are talking about days, first of all that we would see an increase in days in the third quarter relative to the first and second quarter, and that has a lot to do with the seasonality that we always see in this business.

So we see a slowdown and somewhat of a stepdown in revenues in the third quarter due to the summer holidays; and as we continue to build -- produce inventory through the third quarter, we would anticipate seeing an increase in days in the third quarter, and then a pretty significant stepdown in days going into the fourth quarter.

In absolute terms, our expectation is that inventory investments will remain at around current levels as we get towards the end of the year.

We've got some reductions in our field consignments being offset by the buildout of pipeline for the new acetabular cups and the new Natural Nail.

Okay, last question, and I'll let some others jump in.

The change in the post retiree benefits got a lot of attention last month, and I was just hoping you could give us a sense of all that trauma, noise, relative to your retirees and your employee base.

How much does that save you?

I'm just trying to get a sense.

Are the savings worth the noise and negative publicity?

Well, the savings on an annual basis admittedly are not all that significant.

Because our liability has such a long tail, the savings over time are significant, and why we have a $32 million gain -- net gain -- reflect in the results for the quarter.

But that admittedly was not an easy decision for us.

A difficult decision, but it was made after a careful and very thoughtful analysis of our total comp and benefit packages and how that compares with our peer group.

Okay, thanks, Jim.

Sure.

Your next question comes from the line of Matt Dodds with Citigroup.

Good morning, couple of questions.

Good morning, Matt.

First on ASPs, since you didn't give the level of detail you've given in the past, hips have generally come down more than knees, at least the last couple quarters for you.

Is that more of an industry trend?

Is your thinking -- because I know you're talking about potentially you see a little more issue there; but is there maybe a growing sense that hips see more price pressure than knees, based on maybe their premium or less differentiation across classes?

Matt, I would tell you we looked back over the past several quarters, and I would tell you that sort of the reductions that we've seen in ASPs in hips and knees have been pretty consistent actually, so -- and was also the case this quarter.

And I'll tell you more precisely that ASPs for knees on a consolidated basis were down 1.3% and for hips were down 1.3%.

And then sort of those reductions in ASPs were offset by some increase in some of the other product franchises.

That's how we netted out to a .7% reduction across all franchises on a consolidated basis.

And then one follow-up on your comments on OUS recon.

When you are talking about building out more direct in some of these emerging markets, where do you think Zimmer is relative to the competition in the footprint in those emerging markets?

Are you ahead, behind?

Is the distribution going direct -- is that a normal move for this industry?

I think it is a normal move for the industry.

As those markets begin to mature and people view those opportunities more precisely, I think that it's quite natural, and I think it's consistent with what the competitors are probably doing or have already done in different markets.

People are probably at different places, depending upon the company and the particular market.

And then, where do you think you are today relative to your big competitors?

Any idea?

We're with the rest of them in the process.

All right, thanks, Dave.

Thanks, Jim.

You're welcome.

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

Hey, good morning.

Thanks for taking the questions.

So I had one clarification on the margins, and then I just had a couple of quick ones on sort of the business trends.

You talked, Jim, about this sort of less favorable absorption rising per unit costs from lower production volumes.

Just want to make sure I'm looking at this the right way.

This is from lower production levels earlier this year that flow through the second half of this year through the P&L and into next year?

Is that the right way to look at it?

That's right.

Okay.

Second, on hips, just obviously still under pressure, still -- but a bit better than we were expecting here, and maybe a bit better than we were expecting in the US in awhile.

I think it's been awhile since we've been able to say that.

Can you talk at all about the dynamics you're seeing there?

Competitive landscape, maybe the change -- if there is any changes -- in demand for advance bearing surfaces or the demographics of the patients that you're seeing?

Well, I think that on that front, Matt, probably the biggest dynamic is we feel like we have some innovative offering on the stem side; and as the training and education ramps back up, our ability to help train and educate the surgeons on the benefits of those stems and the safe and effective use is obviously enhanced.

And so I think you're starting to see us realize some of those opportunities that were pending for us through 2008 but we really weren't in a very good position to take full advantage of, and we are now.

Okay.

And I guess part of it is having a new product.

How much of it is -- I think you talked earlier in the call -- is sort of getting back out in front of these folks, getting reengaged with the surgeons?

Absolutely.

I mean, I think that that is a big part of it.

It's something that the management team and the field organization is focused on every day as we need to be, and you are going to see continued emphasis that regard.

So the tone of those conversations, the frequency of the contacts, are all on positive trends at this point for us.

Okay.

But no change that you're seeing in the marketplace, or maybe mix in the marketplace for advanced bearing surfaces?

I'm just trying to dig down into maybe where the deferrals have been.

Metal has ramped here pretty significantly, up to maybe 30% of the market.

Is that starting to slow now for incremental penetration?

Anything like in that hips that you're seeing?

Well, yes, I understand the question; and we aren't seeing that, but we don't have the best visibility to that either, with our current offering.

I think that as the new acetabular cups get cleared, we'll be able to provide you better feedback on that, okay?

Okay.

Last thing here on spine.

Still kind of bumping along, hasn't really turned the corner.

What do you have to do, or how long do you think it will take, to sort of absorb the acquisition and start to regain momentum here?

Well, it's work that will continue for some number of quarters, not years.

At this point, Matt, we are making a lot of progress.

We've done a good job of cross-training the salesforce.

Again, training and education on the Zimmer Institute side is still ramping up in that particular sector; and beyond that just the building blocks of putting the organization together on a combined basis, we are making good progress.

That management team is working very hard.

They're doing good things.

It will pay off for us.

But it just is going to take some more time.

I think that on top of those integration challenges, as we've talked about, we've had some headwinds, particularly in the area of (inaudible) on the legacy Zimmer business because of some of the reimbursement challenges.

It's a product that we very much believe in.

We're going to continue to emphasize that as an important part of our portfolio, but we want to move forward with getting the broader regulatory claim and then being able to address those reimbursement challenges in that particular franchise.

So those are the types of things that will make a difference in our performance going forward.

Anything you can see to sort of integrate Pathfinder, or anything you can see to sort of put a product out that would sort of show the strength of the new platform with the products you already have?

Absolutely.

I think that you named one of the key areas.

We have a very broad and extraordinarily competitive MIS offering within spine at this point in time, and so that is something that we clearly will be able to take advantage of.

Okay.

Thank you again for taking the questions.

Thanks, Matt.

Thanks, Matt.

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

Good morning.

Good morning.

Good morning.

I had a quick question on inventories again.

I'm just trying to make sure I understand what's going on.

When I looked at your prior comments from last quarter, you're somewhat comfortable with inventory levels having gone up so you could get more instruments out in the field for your distributors; and now it seems like you want to reign those back in again.

So I just wanted to get that dynamic.

I think, Tao, it represents an opportunity for us.

I think as we -- it is going to require that we invest in some technology -- and I reference the RFID technology and the way that that can be used in the field to speed returns and redeployments.

So we don't want to simply, obviously, pull the inventory out of the field and go back to putting a lot of pressure on our independent distributor network in terms of what it takes for them to service the demand to get the inventory and instruments sets in hospitals day in and day out.

But we do believe there's opportunity there.

We've got to make the investment in the technology and in the training and education; and over time, really would like to reduce what we have invested in field consignments.

Okay, great.

And on the operating margin side in the back half of the year, you gave some good visibility on sort of where you thought the gross margins were going to go -- down a couple hundred basis points -- and then mentioned that SG&A and R&D were going to stay at a healthy clip.

Should we just assume between 100, 200 basis points of operating margin declines here in the back half?

Well, you see more of that clearly if you sort of go through the guidance we provided on the third quarter on the bottom line.

Probably a more significant step down than that in the third quarter, and fourth quarter more in line with what we are reporting here in the second quarter.

Okay.

And then the last question, on the 3 to 4% that you now are indicating you think the orthopedic market may have slowed down versus the 2% in your prior comments, I didn't catch it.

Is that main change -- is that US, Europe, worldwide?

Is there something that may be different in this quarter?

That's consolidated, Tao.

But as we pointed out in the discussion with Bruce earlier in the call, it looks like in the second quarter the step down was more significant OUS.

(Inaudible) in Europe then?

Yes.

Okay, great.

Thanks a lot.

You're welcome.

Okay.

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

Hi, thanks for taking my question.

Hi, Kristen.

You were talking about ASPs, and I believe that you were giving them on a global base.

Would you be willing to share, like you have in past quarters, what the US ASPs were?

Because it seems that we have -- or I guess we're starting to anniversary some of the price cuts in Asia Pacific that may be -- look like that might help upward bias, kind of global ASPs.

Yes, Kristen, I will provide you at least for the core franchise.

For the second quarter, our ASPs on knees in the US were down 1.4%, and on hips were down 1.8%.

In Asia Pacific, our ASPs on knees were down 2% and that continues to reflect the adjustments we saw that took place in Australia July -- beginning from July of last year.

Hips, on the other hand, in Asia Pacific were flat.

In Europe, knee pricing was down seven-tenths of a percent, and hip pricing was down 1.2%.

I mean, it seems that there's a pretty dramatic change between -- at least, from what I recall with the US business -- this quarter relative to last.

Is this something that we should continue to see more of a deceleration trend with pricing here?

Is it possible that for the US we could start to see down 2%, as some of your GPO contracts start rolling off and new contracts are entered into?

It is the case that we're seeing some increased pressure in the US; and as you pointed out, kind of reflected in those numbers that I just quoted for the US on hips and knees.

And that -- on a global basis, it's being offset to a degree by less -- lower headwinds as we anniversary out of the Japan price cuts that took place in April of 2008.

Does your 1% price assume further degradation in price in the US for the second half?

It assumes that pricing dynamics globally are going to be in line with and consistent with what we saw this quarter.

Okay, so it sounds like US might get worse, because I think Japan rolls off -- coming off -- so that should be more of a positive.

Yes, and as you pointed out, Kristen, that is obviously reflected in the pricing dynamics for the US this quarter relative to the first quarter of this year.

Okay, and then just with respect to just some of the, I guess, reconciliations to GAAP, it looks like now your GAAP net guidance has remained the same, but you are now including a $0.15 benefit from this net curtailment in settlement.

So it looks like you're anticipating higher than what you had last quarter acquisition, integration and realignment costs.

What is prompting that change, and does that -- are some of those costs being taken out to help kind of get to the adjusted numbers for the back half, given the lower gross margin assumptions?

Is that some of those additional restructuring maybe helping the SG&A line be a little bit lower than what you would have anticipated in the first quarter?

Well, the way I would characterize it, Kristen, that we did incur higher than anticipated costs on that line of the P&L relative to what our expectations were coming into the year, and that's -- almost all of that is associated with the workforce realignment that took place in the second quarter and the severance and related costs associated with that.

It is the case that within the quarter, that cost is being offset by the curtailment and settlement gain.

I would tell you with respect to the savings that come following that, the changes we've made -- the adjustments we've made in the second quarter -- that those savings are being sort of reinvested.

The savings are going to allow us to go forward and execute on our plans to invest in the areas that I mentioned -- in marking and promotion -- and also to move forward with the investments that we're making in the medical education program, all of which are going to help us restore growth and reestablish momentum across all of our product franchises.

I guess I'm just still struggling with the kind of change in gross margin guidance, but yet your constant currency growth rate still remains kind of the same.

So what's really different helping you to still get to the numbers that you're expecting for the full year?

Well, if you go back, I think will you find that the gross margin guidance for the full year really hasn't changed.

So the gross margin came in a little stronger than we anticipated in the first half of the year, and it's coming in a little weaker than we anticipated in the back half; but on balance, it's in line with our expectations for the full year.

Okay.

Thanks very much.

Okay, you're welcome.

Your next question comes from the line of Raj Denhoy with Thomas Weisel Partners.

Hi, good morning.

Hi, Raj.

Good morning.

I wonder if I could just ask a little bit about the complexion of the share losses we experienced last year.

Could you remind us when those started occurring and when they sort of hit in earnest?

And it sounds like you haven't seen anything this year.

Is that correct?

No, I think that, as we described in prior calls, those share losses on the customer loss side were primarily in the third and the fourth quarter of last year.

And that's not to say that there wasn't some activity at the beginning of this year, but I think that that activity was offset by some of the offensive efforts that were put in place.

So when we're trying to sort of look out into next year and building models, your growth -- there's really no reason your growth should be below the market rate, whatever that is next year, at some point in the first quarter?

Not due to those customer losses.

That's fair.

Okay.

Is there anything else we should think about there?

I mean, I guess you've talked about new products and getting a bit more offensive; but it sounds like, again, we should be through this period, and next year we might see more market-type growth rates for the balance of the year?

Yes, that's -- everything that we're doing is positioning the Company to restore growth and reestablish that momentum; so the customer focus that we've been talking about, our relationships with the customers, the time we're spending in the field, the emphasis on surgeon training and education through the Zimmer Institute, as well as you referenced the new product launches on acetabular cups, the knees with patient-specific instruments, Natural Nail within trauma -- those are all keys to the future.

And then on the deferral side, have you given a lot of thought to when we might see these patients come back?

I mean, is there a period at which you feel patients can delay, but then they must return or have to return, or is this really something that could rail for a year plus and we might not see a bolus of patients at one point come back?

The reference that you make -- you say a half year to a year.

I think that that's a range of what's reasonable to expect.

But the other big dynamic is just the stabilization of the economy, and obviously that's a more difficult one for anyone to predict; and I think that it's going to happen at different rates across the globe, and with the geographic diversity of our business, we'll see pickups in certain places and probably some geographic segments lagging that pickup.

But I will tell you, again, that we're very confident that it is a deferral as opposed to a permanent loss of those procedures.

They'll come back and we'll be well-positioned to help those patients get the right solution.

So when you look out to 2010, though, do you anticipate sort of an above trend year in recon volumes?

Well, I would think that you have to look at what's happening now as a baseline; and as the second half of the year rolls out, you are going to have a greater capability to read what 2010 is going to look like.

Okay.

Fair enough.

And then just on the margin side, we have the last year-plus talked about incremental spending on your part for a lot of initiatives, and then there was at one point a promise of some of that flowing through so that we might see kind of better leverage at some point.

It sounds like that a lot of that has kind of been reinvested; and again, when we look out into 2010, are we anticipating really sort of more natural leverage coming from your model, or is it a case where we might see kind of additional incremental leverage because of some of the initiatives that you've been spending on for the last two-plus years, or two years or so?

Well, I think the way you characterized it is fair that we would see more natural leverage in 2010, particularly given the fact that we are and have been able to push ahead this year with getting the spend back into the P&L, for example, on the training and education and some other areas, where we are -- here on the other hand, I suppose that spending is sort of ramping up over the course of the year, that may -- we haven't done a plan for 2010.

That may sort of present a bit of a headwind in the first couple of quarters of the year, but we are going to be -- as we develop our operating plan for 2010, we are certainly going to be looking to restore that kind of natural leverage.

And the other thing, frankly, that is going to help to restore that is getting the growth back on the top line.

Sure, sure.

But your comment about how some of this incremental spending might bleed now again into 2010, I mean, should we then not think about real kind of leverage until the second half of 2010 at this point?

I would tell you we'll have more to say about 2010 on our fourth quarter call.

Okay, fair enough, thanks.

Okay.

Thank you.

Celeste, in the interest of everyone's time, let's take one more question.

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

Thank you very much for taking my question.

Can we switch to the legacy spine problems that you were talking about?

I'm a little unclear of what's going on there.

And then if we can assume that that weighed down the quarter, what would spine growth have been without the Abbott acquisition?

Yes, I will address that with you, Joanne.

I think that the biggest couple of areas to focus on are first of all in the integration of those salesforces.

In each of those geographic segments, we were choosing those distributors and the salesforce channel that we thought was strongest and most consistent with our ability to build that business going forward.

And so in some instances, the legacy Abbott spite people were chosen, and so there were going to be revenue [dissynergies] on the legacy Zimmer side; and so those were, in fact, incurred.

I think that the second major factor is the one that I already pointed out [Venysis], which has been a significant growth driver for our business, and there have been some non-coverage decisions that have mounted against that product.

That product is marketed as an adjunct to fusion as it's been cleared within the United States.

We have a PMA that is pending at this point in time, and and we believe that after we receive the approval, we'd be able to go back and start working through those non-coverage decisions.

We really feel strongly about the clinical benefits of the product.

So that's created some pretty significant headwind in the year-over-year comparisons.

And can we assume that without Abbott we would be seeing negative growth?

Yes.

Okay, and one of the more interesting products I saw showcased at your AAOS booth was the patient-specific products for -- I think it was both hips and knees.

What kind of market opportunity do you think that holds?

We think that there's a significant market opportunity for the patient-specific instruments.

As we've said, the regulatory filing has been made there, and we're awaiting clearance at this point in time.

It is a patient-specific instrument technology that applies to knees -- not hips as well at this stage.

But there's been some pretty significant interest shared by community hospitals, as well as larger volume surgeons, and so we think it's going to be more broad-based than one might have initially anticipated.

Very helpful.

Thank you.

Thank you, Joanne.

With that last question having been addressed, I just want to thank everyone again for joining us today and for your continued interest in Zimmer.

We look forward to speaking to you on our third quarter conference call at 8:00 a.m.

on October 22nd.

I will now turn the call back to you, Celeste.

Ladies and gentlemen, this concludes today's conference call.

You may now disconnect.