Zimmer Biomet Holdings Inc (ZBH) 2009 Q3 法說會逐字稿

Good morning.

I am Paul Blair, Vice President Investor Relations for Zimmer.

I would like to welcome you to the Zimmer third quarter 2009 earnings conference call.

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

This morning we will review our performance for the third quarter 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 review 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 5th, 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, good morning everyone.

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

Our net sales for the quarter were $976 million and that our earnings per share were $0.88 adjusted, slightly above quarterly consensus expectations and in line with our annual guidance.

Let me start by reporting on the progress we're making in restoring growth to our core reconstructive franchises.

We see positive momentum continuing to build in the Knee and Hip franchises globally.

As an example this quarter's results and certain geographic markets, including the US, various European countries and Japan demonstrate the powerful clinical legacy behind NexGen, the world's largest selling knee brand.

These results also demonstrate the broad acceptance of patient-specific solutions which are represented within our Knee and Hip portfolios by products like our gender solutions femoral components and our M/L Taper stems with connective technology.

Knee revenues in Asia Pacific led all geographies up 7.

1% in constant currency with strong sales across the NexGen platform and increased penetration of our uni compartmental knee.

Overall during the quarter we recorded worldwide year-over-year constant currency sales growth of 3.6% reflecting growth in all three of our major geographic segments.

Our momentum is further evidenced by the 4.2% increase in our constant currency sequential growth rate.

Reconstructive sales increased 2.3% in constant currency in the quarter.

Knee sales in the third quarter increased 2.8% constant currency with volume and mix growth of 3.9% offset by negative price of 1.1%.

Hip sales were flat in the quarter in constant currency, reflecting positive volume and mix of 1.2% less negative price of 1.2%.

In the quarter, we saw positive up-take with our new stems, including the M/L Taper with connective technology and the bone conserving Fitmore family of stems, as well as solid results with our Trabecular Metal modular cups.

We're in the initial faces of launching our new Acetabular cup systems outside the US.

Early surgeon feedback on the new cup systems has been very positive.

Extremity products posted outstanding results for the quarter with sales growth reported at 21% constant currency.

Once again, our proprietary Trabecular Metal technology is playing a critical role in addressing previously unmet clinical needs in the expanding extremities market.

Dental sales on a constant currency basis decreased 5.9% for the quarter.

A weak global economy continues to adversely affect market demand for dental implants while revenues in the Americas and Asia Pacific reflected this weakness, dental sales in Europe for the quarter increased 11%.

Trauma sales in the quarter were up over the prior year -- prior period 6% constant currency, with solid results in locking plates and continued uptake of the antegrade femoral nails and tibial within the new Zimmer natural nail line.

Zimmer spine reported 26% constant currency growth in the quarter including $21 million of acquired revenue from the Abbott spine acquisition.

Solid sales of acquired fusion devices as well as legacy interbody devices and bone graft substitutes partly offset a decline in Dynesys revenue.

Because the Abbott spine transaction closed approximately one year ago, future results will more clearly reflect the performance of the combined business, including sales disynergies realized as part of the integration.

Orthopedic product and other sales in addressed 6.8% in constant currency led by the reintroduced wound [debridement] product line.

The realignment actions taken in the second quarter have enabled us to move ahead with a number of important strategic initiatives.

In the third quarter, we bolstered our investments in product development, quality systems, talent recruitment and marketing.

We intend to continue to intensify our efforts in these areas in order to maintain or return positive momentum and achieve sustained growth across all of our product franchises.

We'll manage our spend accordingly.

For example, as we saw business picking up in the third quarter, we cleared the way to accelerate certain key initiatives.

We remain bullish on the opportunities for sustainable long-term growth and demand for our products.

A recently issued research report highlights some significant data points regarding often quoted demographic and usage trends.

I believe they're worth emphasizing.

According to US Census Bureau reports, the segment of the US population between the ages of 65 and 74 is expanding at a rapid pace.

From a growth rate of under 1% in 2003, to a growth rate of over 5% by 2012.

Similar dynamics are in play in markets outside the United States as well.

Just as relevant are the usage statistics which indicate that the rate of joint replacement in the United States increased two and one-half fold from 10 and 10,000 in 1990 to 26 in 10,000 by 2006.

We believe this expansion of the market, which is likely driven by a number of factors, including high long-term success rates, advances in implant designs and materials, and increasing patient awareness, should continue as new innovations are introduced and patient demand and expectations grow.

Beyond these trends, we have great optimism for current or near-term product launches.

We're pleased to be collaborating with some of the most talented surgeon developers in our industry to build out our product pipeline across all of our businesses.

In addition, to our new Acetabular product, we're pleased with the continued buildout of our Ortho Biologics business.

Further, we have more opportunities to leverage platform technology like Trabecular Metal which can provide excellent fixation and stability.

Recent 10-year clinical outcome studies demonstrate exceptional biologic ingrowth and increased bone density around Trabecular Metal implants.

No other porous metal material so closely resembles the structure, function, and physiology of cancellous bone.

This is why we continue to find applications for the technology across our various product franchises.

Now I would like to provide a few thoughts on some of the dynamics at work in our markets.

In the third quarter, price pressure remained a factor in our results with consolidated average selling prices down 0.7% compared to the prior year period.

This moderate change in price is consistent with the trends that have emerged over the course of the year.

While we believe pricing pressure will continue, we don't expect to see any dramatic changes for the balance of the year.

Turning to procedure volumes, we believe there are early signs of some improvement.

The third quarter competitor results reported to date and our internal reports suggest a bit of an easing in the procedure deferrals we've seen over the past year.

This improvement appears to be more pronounced in Knees globally and in Hips outside of the United States.

Although there continues to be some uncertainty about the rate at which procedure volumes will return, we believe this quarter's results suggest the early indications of stabilization and potential trends towards more normalized growth rates.

Finally, I want to briefly mention healthcare reform.

On our last call, I said there really wasn't enough clarity to engage in useful forecasting about the impact of healthcare reform, and I think that's still true.

We will continue to voice our opposition to the proposed $40 billion industry tax, which is part of the Senate finance committee healthcare reform bill.

We also continue to communicate our strong concerns on this matter to our elected representatives in Washington, including members of the Indiana congressional delegation.

We have been and will remain quite active through [Avamed], the US Chamber, and with our congressional representatives to assure Zimmer's concerns are understood and represented as the healthcare reform debate continues to play out.

We remain supportive of constructive healthcare reform and we believe patients should have access to the most effective treatments as determined by healthcare professionals.

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 additional information related to our guidance.

Our total revenues for the quarter, as David mentioned, were $976 million, a 3.6% constant currency improvement compared to the third quarter of last year.

Dollar weakness in the quarter resulted in lower than anticipated head wind from foreign currency translation which decreased revenues by 1.2% or $11 million in the quarter.

As David also indicated, consolidated pricing was down 0.7% for the quarter, pricing in the Americas and Europe was negative 1.1% and negative 0.5% respectively while Asia Pacific results include slightly positive average selling prices compared to the prior year third quarter.

Our adjusted gross profit margin of 74.7% for the quarter is down 50 basis points from the prior year third quarter and in line with the comments made on the second quarter call.

Foreign currency hedge gains as compared against prior period hedge losses were more than offset by higher unit manufacturing costs, inventory charges, and idle plant costs.

Moving down the income statement, R&D expense as a percentage of sales increased to 5.3%, and at $52.1 million for the quarter is 8.8% above prior year.

We expect our total dollar R&D spend to trend higher in the fourth quarter and average just over 5% of sales for the full year.

Selling, general, and administrative expenses increased to $413 million in the third quarter, and are up 2.3% compared with the prior year.

At 42.3% of sales, SG&A expenses are 10 basis points below prior year.

We expect SG&A expenses as a percent of sales to moderate going forward.

During the third quarter, the Company recorded a provision of $35 million for known and anticipated claims related to the Durom cup.

This brings the total provision for Durom related claims to $104 million.

As previously disclosed, our estimate for these claims is limited to revisions associated with surgeries that predate the 2008 temporary US suspension and which also occurred within two years of the original surgery date.

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

Any claims received outside of the defined parameters are managed in the normal course and reflected in our standard quarterly product liability accruals.

Acquisition, integration, realignment and other amounted to $22.2 million in the quarter and are comprised of costs pertaining to prior period acquisitions including facility consolidation costs, litigation related charges, and termination payments.

Adjusted operating profit in the quarter was flat at $264.1 million, and at 27.1% our adjusted operating profit to sales ratio is 70 basis points lower than the prior year third quarter.

Net interest expense for the quarter amounted to $4.2 million on $600 million of outstanding net debt.

As a reminder our third quarter 2008 net interest and other income of $28 million included a pretax gain of $30 million from the sale of certain assets.

Adjusted net earnings decreased 13.9% compared to prior year at $188.3 million and adjusted diluted earnings per share decreased 9.3% to $0.88 on 214.5 million average outstanding diluted shares.

These adjusted earnings per share inclusive of approximately $0.06 of share-based compensation at $0.70 reported diluted earnings per share which include the nonrecurring items reflected in certain claims and acquisition, integration, realignment and other decreased 26.3% from prior year third quarter reported EPS of $0.95.

Our effective tax rate for the quarter was 27.6%, and our anticipated full-year tax rate remains around 27.5%.

During the quarter, we repurchased 1.5 million shares at a total purchase price of $67 million.

Approximately $730 million remain authorized under a $1.25 billion repurchase authorization which was set to expire at end of 2009.

Also in the third quarter, the Board of Directors approved an extension of this authorization through December 31st, 2010.

The Company had approximately 213 million shares of common stock outstanding as of September 30, 2009 down from 214 million as of June 30, 2009.

Operating cash flow for the quarter amounted to $352.3 million, up 14% from $307.9 million in the third quarter of 2008.

An increased focus on working capital management contributed to the improvement.

Our most significant improvement in the quarter among all the critical financial metrics we track was in free cash flow defined as operating cash flow less cash outflows for instruments and property, plant, and equipment.

At $303.4 million in the third quarter, free cash flow is more than two times higher than the trailing six quarter average.

This demonstrates meaningful progress and represents an important source of leverage going forward.

At more detailed level, adjusted inventory days on hand finished the quarter at 353 days down 22 days from the second quarter.

This is well ahead of our expectations coming into the quarter.

We made more rapid progress on inventory reductions, in part, through stronger top-line performance.

Our adjusted trade account receivable day sales outstanding finished the quarter at 63 days consistent with historically strong performance on the collection and application of cash.

Depreciation and amortization expense for the third quarter amounted to $88.2 million.

Capital expenditures for the quarter totaled $48.

9 million including $26.8 million for instruments and $22.1 million for property, plant, and equipment.

As indicated in our second quarter call, this is down substantially from prior year levels as our European distribution center and Shannon, Ireland manufacturing projects are mostly complete and we adjust spending for lower production volumes.

Cash outlays associated with investing activities during the quarter also include $7 million for acquired intellectual properties and another $17.7 million for certain international distributor acquisitions.

I'd like to turn now to our guidance.

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

This is consistent with our expectations throughout the year.

Based on current projections we now believe that foreign currency translation will reduce our reported 2009 revenues by an estimated 1.6% for the full year.

Therefore, on a reported basis, our revenues are projected to be in a range of negative 0.6% to a positive 1.4% compared with 2008.

For the fourth quarter 2009, foreign currency translation is expected to increase our revenues by an estimated 4.4%.

In our earnings release this morning, we reaffirmed our full-year adjusted diluted earnings per share guidance to be in a range of $3.85 to $4.

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

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

Thanks, Jim.

Through three-quarters our 2009 performance has unfolded largely as we had expected, and we're fully focused on moving forward.

We understand that improved top line performance is the key to progress.

We're pleased to have stabilized our business and established new momentum.

Moreover, we expect to he restore adjusted earnings per share growth in the fourth quarter and regain leverage in 2010.

Our optimism for Zimmer's long-term success is based on the solid foundation we're creating and on the hard work and dedication of our employees and representatives.

Our strategic plan is in place.

We'll continue to make growth oriented investments to support our innovation and commercialization priorities.

We believe our long-term outlook and opportunities are compelling.

Demographics and clinical success in our established markets should drive growth and expansions into new product categories and emerging markets provide even greater potential.

Zimmer is well positioned to focus on realizing these opportunities.

And now I'd like to ask Celeste to begin the Q-and-A portion of our call.

(Operator Instructions) Your first question, Derrick Sung.

Good morning.

Thank you for taking my question.

If I could start on the Hip and Knee broad markets, it looks like the Knee markets did pick up this quarter versus last quarter.

I think our numbers have, at least in the US, growing at perhaps 6% versus 4%, and I was wondering if you could comment on whether what you are seeing is less deferral of procedures there, or if you think we're actually starting to see moving of pent-up demand working through the system already.

I think that when you reference the improvement, it looks to us to be more of a quarter -- I'm sorry, of a point as opposed to two points within that US market, Derrick.

But I do think that you are just seeing stabilization.

The economy broadly on a variety of fronts begins to stabilize, people feel like they have more predictability in their futures and start to make decisions to move ahead, so, whether it's deferrals or a quicker turnaround of that individual it's come to the point where they need to have a replacement in either the Knee or the Hip category.

They're moving forward with those procedures more rapidly.

But again, this is a step.

We have said all along that there was going to be no permanent solution.

These were deferments.

We weren't going to miss these procedures ultimately, so this is a step towards a more normalized growth rate.

You're really looking at a point recovery of the three to four points decline in procedure rates that we saw earlier in the year.

If I could ask to you give us a status on the regulatory filings for the new Acetabular hip cups that you have currently filed.

Are you seeing any signs of any potential delays or are those on track from your perspective?

Those are 510K filings in the United States, so the filings have been made.

As is usual we respond to questions as those filings progress through.

That's the current status of it.

I don't know that there's anything that looks all that unusual about those filings at this point in time, but, of course, because of the 515 request that went out earlier in the year there's some potential that those filings could take on a different form or the requests that come from the FDA could take on a different form as well.

So there's no absolute assurances to timing on those clearances.

Okay.

Last, just a question on your guidance.

You're reaffirming the same Q4 guidance at $1.07, I think is where consensus is that you had reaffirmed or guided us to last quarter despite kind of the $0.02 beat in the third quarter.

Is that the way to be looking at this, and if so why not raise expectations for Q4?

I think that is the right way to be looking at it at this point in time.

As I stated in my prepared remarks, we want to make sure we do is fund all the strategic initiatives that are going to be important to positioning the Company for long-term and sustained growth.

We've got some initiatives underway that we think are the right ones.

It's a well developed plan.

There's a lot of clarity as to where we think there are opportunities going forward.

So to the extent we were to see any additional pickup, we're going to be accelerating the investments in those strategic initiatives.

Great, thank you very much.

Your next question comes from the line of David Roman with Goldman Sachs.

Good morning and thank you for taking the question.

Could you highlight for us on the gross margin line, Jim, you talked about improvements in inventory levels in your discussion about cash flow.

Can you give us ways to think about the gross margin going forward, maybe some gating on as volume increases a certain percent we can start to see stabilization in the gross margin?

I think that is.

We talked obviously on the last quarter call about the step-down that we anticipated coming into this quarter.

And you are seeing that obviously reflected in our results at 74.7%.

To your point, I would acknowledge that there's some head wind going into 2010 as we begin to sell off that higher cost inventory that's sitting on the shelf.

And that is the principal contributor to the step-down in margin relative to what we saw in the first half of this year.

I think that is fully reflected, I would tell you, in this quarter's results, and provides some indication of what would you expect to see going forward from here.

And then as we look to next year to some of the moving parts on gross margin, currency is a negative, as the dollar weakens, if I'm correct, in that at some point you work through the underabsorption but certainly FX is an issue to think about for the first half of next year.

It is.

One of things I would point out about currency.

And we provide a fair amount of detail on the impact that it's having in the year-over-year comparisons in the margin ratio, which has been pretty significant this year.

But in absolute terms, the hedge gains that are running through cost of goods this year are not as significant.

So when we take into account all the things that are going to impact margin going into 20 10, that's certainly one of them.

But there will be some other things that will potentially be going in the other direction.

Lastly, by my math this is the first quarter in seven or eight or so where SG&A has grown at a slower rate than sales, albeit modestly.

Can you talk to us about what's going on there and how to think about it on a go-forward basis?

Yes, I would tell you it's as we have talked before.

As we restore growth to the top line, and made this comment in my prepared remarks, we would expect to see some moderation in SG&A spending as a percent of revenue.

Okay.

And then maybe just one more on volume.

You talked about, just looking at reported numbers and seeing a stabilization this quarter, but could you give us maybe some of the other factors you're looking at as you talk to your surgeon customers and sales reps, whether it's waiting lists, referral trends, operating room schedules, et cetera?

It's all of those things at this point, David, and those are meaningful data points, they're anecdotal really in their nature, and so we are seeing some stabilization on those various more subjective factors.

Overall, though, I think what we're looking at is a point improvement in the quarter over quarter numbers, and I think that that's a fair estimation as to what one might see for the balance of the year.

I just don't think that you are going to see anything turning negative from that improvement.

And then you get into debates about how quickly you are going to see the market restored to normalized rates and some theories about whether it's going to come in the form of a bolus or not.

We personally don't believe that it's going to come in the form of a bolus.

But we think that over time you are just going see a continued progression towards a more normalized procedure rate.

Thank you very much.

Thank you.

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

Thanks.

Can you hear me okay?

Yes.

Good morning.

Great, good morning.

Jim, first, for you, I think David mentioned that 2010 was a year where you felt you could return to some more significant operating leverage.

I was wondering if you could just remind us of the various moving parts in terms of some of the spending that's going on in 2009 that won't materialize and in 2010, or is that comment just strictly a function of improving top line?

It's principally a function of improved performance on the top line, and as I just pointed out a minute ago, we are going to be managing the SG&A spend as a percent of revenue, so that -- you can expect to see SG&A spending grow at a slower rate than the top line, and that's principal source of operating leverage.

Then, of course, there's the leverage as we get down below the line that we can also deliver by use of putting our free cash flow to use through our share repurchase program.

Are there any of the quality initiatives that have trued up some spending in 2009 that you have quantified, ending in 2010?

Are those any specific numbers that you can talk to there?

Well, one of the things that I will tell you helps us, or puts us in a position where we can leverage that SG&A spend, as an example, the investment that we've made in a centralized distribution hub in central Europe.

In Germany, we've invested in highly automated facility, and we've worked through the process of closing down a number of forward stocking points, and that part of Europe, and have eliminated redundant positions and spending on headcount and have also been able to reduce the cost of moving inventory in and out of hospitals in that part of Europe.

So that's just one of the investments that we've been able to make over the past 18 months that we're going to be able to leverage going forward.

And there are others as well.

Okay.

Great.

Two other really quick follow-ups.

One, do you guys have any visibility on the potential Japanese pricing changes in April?

And secondly, for David, could you just give us some comments on the state of business in Europe?

It seems like growth there is a little bit lower than other geographies still.

What are you seeing in Europe?

Are there signs of real stabilization there as well?

Just any comments there would be helpful.

Thanks.

Sure.

Bob this is Jim.

First of all, on the Japan adjustments and reimbursement prices, we would expect there to be some adjustment in reimbursement prices in April of next year.

We do not have visibility to what those adjustments are going to look like at this point.

And then if I can just take a stab at the question on Europe, I would tell you as we look at this quarter's results and what we believe, based on the data that we have, is going on in the major markets in Europe, and the five major markets we define as the UK, Germany, France, Italy, and Spain, we see market growth, basically flat in the third quarter, and that's consistent with what we saw as well in the second quarter.

We would expect and that's funding for single payer systems for elected procedures, is maybe less available in this economic environment than it was prior to this economic downturn.

I would tell you these are life changing procedures, as we talked about, and as waiting lists grow, political pressure builds to provide ultimately put some funding back into the healthcare system there to address those patient needs.

So we would expect over time to see those markets recover back to mid single-digit growth and demand.

Now, those five markets, as we look at it, represent about two-thirds of the total market as we define Europe.

There are another 15 or 16 markets in Europe as we look at them in that the aggregate are growing at around mid single digits, continue to grow at mid single digits.

So in total, having the five big marks flat, and then the other 15 or so markets growing in mid single digits we're seeing low -- very low single digit growth in those markets in the aggregate.

Great, thanks for the color, Jim, I appreciate it.

Your next question comes from the line of Adam Feinstein with Barclays Capital.

Great, thank you, good morning everyone.

Good morning, Adam.

Maybe one quick housekeeping question, then a couple follow-ups.

You gave some detailed pricing data.

Just want to make sure I got that.

You went through it fast.

Just want to make sure that I had the pricing data for the US for Hips and Knees.

Adam, we did give pricing data for Hips and Knees in the aggregate.

Knees were down 1.1% in the quarter.

Hips were down 1.2%.

That's very consistent with what we saw in the first half of the year.

Sure.

Okay.

Great.

And then as we look at your recon business here, comps get very easy starting in the fourth quarter, and I'm referring to constant currency basis, so distributing out the impact from FX.

So just as we think about that, do you think we can see a more normalized type of growth number coming off of these easier comps, or are there other things we have to keep in mind as you guys think about the overall industry environment and pricing and what's going on there?

Just curious to get your thoughts how we should interpret the growth rate for the quarter just with the comps from the price levels.

Thank you.

Sure.

I think we would expect that -- as David has talked about before, to see continuing improvement in our performance in our core Hip and Knee franchises.

I will tell you one of the things you have to obviously keep in mind with respect to the fourth quarter is the fact that we anniversaried the lift we've been getting from the Abbott Spine acquisition, which was adding about two points of growth per quarter to our top line in the first three-quarters of the year.

And then with respect to the pace at which we see that momentum picking up in the core hip and knee franchise, some of that is going to be dependent on where we are with these new product launches.

So we're -- as we said is in our prepared remarks, we're in the early stages of launching the new Acetabular cups outside the US, regulatory clearances are still pending for the new cup systems here in the US, and the regulatory clearances are still pending with respect to our patient-specific instruments on the knee side as well, which once we get there, would be, we believe will be a catalyst for improved performance going forward.

Okay, great.

One more question.

Just maybe -- you mentioned the Spine business.

Can you give us an update there, how things are going, where we are in the process?

Just curious as you think about the growth rate of your legacy Zimmer spine business relative to the Abbott Spine business, just wanted to get a sense of the trends in the quarter.

Sure, glad to give you an update on that.

I think that we continue to make good progress.

I will tell that you over the course of the last quarter in particular a lot of progress o-US on the integration efforts, so that's going to serve us well as we progress into 2010.

Sales training, the surgeon training programs as well continue to get spun up, and I think we're making good progress on that front.

You end up with a lot of head wind in that type of a deal and revenue dissynergies.

So that's principally what we're facing on the avid spine side.

On the Zimmer spine side, the majority of the head wind comes in the form of Dynesys performance.

And as you probably are aware we're heading for a panel review of the Dynesys product with the broader indications coming up next month.

So that's going to be telling to the future of that product line, but we are big believers in the clinical success of that product and believe that it's really a product that can make a big difference for patients.

So we're quite optimistic about the future of Dynesys.

So this is a work in process.

I think you can look for the next couple quarters to be continued work in progress, then we're going to have more clarity as we work towards the next year on the spine business.

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

Thank you, good morning.

Good morning, Mike.

First, Jim, let me clarify, your inventory math always throws us off a bit.

The map we had had was less profound than I think your inventories have come down by 8, 9 million in the quarter.

You said that your inventory days came down by 23 days.

Can you just walk me through real quick your math?

Inventory on a cash basis came down closer to $30 million in the quarter.

So what's netting out the decrease in inventories on a cash basis is effective currency translation on the inventory balances that are reported, particularly our yen-based inventories, given the size of our business in Japan.

So that's really the most significant thing that would you not obviously have visibility to, and how we get to the 22-day increase on a day basis.

Okay.

I want to make sure I was understanding some of the comments you were making earlier just about operating leverage.

In 2010, given the pushes and pulls, with what you have said about how you you've run the facilities, and the expectations that inventories will come down, then the rollover of the FX hedges on the gross margin, do you think you generate operating leverage in 2010?

I would tell that you we're going to have head winds in 2010, but I think those head winds are getting fully reflected in our gross margin this quarter, and what we guided to for the second half of this year.

You're saying that -- I'm making sure I understand what you're saying.

So you're saying you think you have worked through your inventory issues in the back half of this year, or the degree of degradation that we're seeing on the back half of the year is consistent with what you're assuming for 2010?

I think the gross margin at this level is reflective of the head winds, and the principal head wind being the higher unit cost inventory that we're selling through, and we'll continue to sell through as we go into 2010.

Okay.

But the net picture of where you're coming at it, you don't necessarily generate operating leverage, but you generate earnings leverage based on your usage of your cash?

Well, that and I did talk about generating some operating leverage through the SG&A line.

Yes, I'm netting the out SG&A and gross margin.

Okay.

David, I want to get your thought process.

If healthcare reform goes forward, and there is an excise tax on medical device companies, or US class 2-3 medical device sales, how will you manage the business differently for 2010?

Have you thought that through yet?

Sure.

We have scenarios that we're building out, Mike, and there are questions about the amount, the existence of the tax, first and foremost, which as you can guess we're not supportive of.

We think this is bad policy.

We do think that on a broad basis, it's going to hurt innovation, and you are going to find that patients get access to life changing technologies much later than they otherwise would as a cobs questions of that.

So that's the first place to start the discussion.

We think that this is bad policy.

If something goes through the magnitude of such an excise tax as well as the timing are going to be the first factors that are going to have to be developed out and built into plans.

If it ended up impacting 2010, obviously you'd have to overlay that on to a developed operating plan and figure out where you are going to take out and what you are going to reposition.

So you are going to look at every line of the P&L if that thing comes through, and it's going to affect jobs, it's going to affect the pace of innovation within our R&D portfolio as well as the ramp-up some of some of the other opportunities, but obvious it would affect the industry broadly, sought wouldn't be anything unique to our particular Company.

Okay.

I'll let some others jump in.

Thanks, Mike.

Your next question comes from the line of Bruce Nudell with UBS.

Good morning, it's Eric Schneider for Bruce.

A couple questions.

As you noted on Knees and Hips, the pricing pressure that you are seeing there, was that pure price, or was that ASP, so price net of mix and pure price?

That for us is pure price.

And would -- are you still this year able to offset that with mix?

There is -- there's certainly mix benefit reflect ed we report out as volume mix.

But were net ASPs up or down?

We are generally able to, much like others have reported, generally able to offset -- may not be an exact offset, but generally able to offset the erosion in ASPs with positive mix benefit.

As we see increased penetration, particularly with the Trabecular metal-based implant devices.

Dave, as you noted the potential consequences of the max tax potentially going through in D.C.

, you didn't note an ability to pass any of those costs on to customers.

Do you think there is an option for that?

Due think it's just too rough a pricing environment to do

Well, that is certainly an option that would be fully explored.

I think right now, with the number of moving pieces in the overall makeup of such a proposal, it just is difficult to speculate further, Eric.

And then given the clear poser demographics, in terms of aging and obesity, are you still at the mid single 5% to 6% expected mid to long-term unit growth for major joints?

I think that's the right way to characterize the broader market demand in this area, Eric, that's right.

Okay, great, thank you very much.

You're welcome.

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

Thanks for taking my question.

I was wondering if could you just dive a little deeper on the pricing side.

I think you guys had had anniversaried some of the price cuts in Australia in July so can you break out just the Hip and Knee pricing in Americas and Europe?

In the Americas, looks like the past two quarters there's a little bit of decline in pricing.

I guess -- could you just help us fill in the pieces there?

Sure.

Kristen, in the Americas, Knee pricing was down 1.5 points in the quarter.

Hip pricing was down 1.7%, and I think you will find that is very consistent with what you saw in the first half of the year.

Asia Pacific, where we saw some improvement in price trends in the quarter, given that we anniversaried out of both the April Japan price adjustments and the July Australia price adjustments, we had positive price on Hips, about half a point.

Still negative price on Knees of about half a point.

Then in Europe, Knee pricing was down just 0.2 of a point, and hip pricing was down 1.4%.

Thanks.

And then I guess just in terms of how we should think about just the pricing, I know you guys generally do in some instances multiyear contracts, so can you help to -- it seems that the incremental new contracts, particularly in the Americas, may be down, obviously much larger than your balance of your book of business.

So what does that really tell us about trends going forward?

How confident are you that we won't see further pressure in the Americas?

Yes, what I would tell you, what we've seep in the Americas, over the past three-quarters has been very consistent.

With Hip and Knee pricing down about a point and a half, or a little more than a point and a half.

And when we talk -- I guess one of the things you have to understand, when we talk about increased pressure on pricing is that the price adjustments do not always coincide with contract renewal dates.

So we have -- we've seen broadly and have had to deal broadly with requests for proposals from many of our hospital systems, and that is really what's getting reflected in the trends that we've seen over the past three-quarters.

So we think it is very representative of what's going on more broadly across the entire US market.

And then just looking at, I guess, the hip business, particularly within the Americas, can you remind us again what the impact last quarter was with the Durom suspension in terms of how we should think about an apples to apples growth rate within the business?

Kristen, I have to say I don't have that right here in front of me.

Off the top of my head, I'm not going to be able to answer that question.

Okay, no problem.

I'll take that off-line.

Last question would be, you obviously had had very strong cash flows in the quarter, only repurchased 67 million in terms of shares.

How are you thinking about the use of cash moving into 2010, and what will the role of acquisitions play?

Do you still feel comfortable getting to a double-digit earnings growth rate absent any acquisitions?

Yes, I would tell you as I have said before that our first priority for use of free cash flow would be focused on our strategic -- any strategic opportunities that we would identify where -- particularly where he would would have the opportunity to continue to build out the other musculoskeletal franchises outside of our core Hip and Knee franchises where we have smaller market share position.

Talked about the interest that we have in spine, the Abbott Spine deal is representative of the kind of deal that would look very attractive to us.

Certainly continue to have an interest in building out our Ortho Biologics portfolio and do that through a combination of potential acquisitions or licensing, like the licensing arrangement we've entered into with [Sacagacu].

So that will remain our priority with respect to use of free cash flow To the extent that there are no immediate opportunities in front of us, we would otherwise put it to use through our share repurchase program.

We have over 700 million remaining over the share repurchase authorization that, as I pointed oint my remarks, has now been extended out through December 2010.

And then just the confidence in 10% growth absent acquisition earnings growth?

We'll talk very specifically about what our expectations are for 2010 on our fourth quarter call.

Thank you very much.

Thank you.

Your next question comes from the line of Rick Wise with Leerink Swann.

Turning back to trauma, we've seen stable growth year-over-year in the first three-quarters.

One of your competitors reported yesterday, one of the bigger players, very strong results.

I'm trying to gauge just your thoughts about how, when and where Zimmer might start to gain share in trauma.

You've highlighted your new nail line.

When do we start to see the impact of that and other new product?

We expect to show the impact of that in some of the investments we've made strategically as we progress into 2010, Rick.

And so is it too much to think we might see accelerating growth rate as we get into 2010 helped by the new products hopefully?

Yes, that's exactly what we expect to be able to produce in the way of results.

And I know you're not going to give us 2010 guidance, but just thinking conceptually about gross margin, looking at the year ahead, I'm wondering whether 2010 gross margin flow might be the reverse of what we've seen in 2009 with a weaker first half as you've suggested, a rebound in the second half as the higher cost inventory works through, volumes continue to grow.

But just in general, ending up with gross margin much like the 76% kind of range we're talking about for this year.

Is that the right kind of thought process?

Well, that is getting into 2010 guidance, Rick.

I think at this stage, I would just repeat what I've said earlier, and that is that the head winds in terms of the higher unit manufacturing costs that we're going to -- we are currently dealing with and going to continue to deal with going into 2010 are fully reflected in our results this quarter.

We have still a year's worth of inventory on hand.

So it will take some time before we're able to benefit from the increased leverage that we will eventually get as we sigh more volume running through our facility.

Dental still is weak, as you've suggested.

Maybe any additional color you can give us there, any signs of stabilizing, or anything that might change the outlook for that business in coming quarters?

Well, I think that you're just looking at that time macroeconomic factors.

The unemployment rates, the consumer confidence levels, the financial community getting back in order and providing capability for these people to secure the resources that they need for the broader procedures, especially in the private pay markets.

So those are all the broad factors.

But I would tell that you that's a market that we don't have double-digit market share in, and I'm not sure that we're the ones to provide with you much more color on that at this point, Rick.

Okay.

Two last questions.

Maybe just a little more color on your comments about going back to the recon market.

The growing and building sales momentum.

Is this more in existing accounts or are you at the point now where you feel like you're winning competitive accounts as you move past issues of the last couple of years?

I would describe it as stabilization of the customer base, Rick.

Driving things more.

On the shorter term basis, just thinking about SG&A, clearly you're getting the positive SG&A leverage.

Clearly you are getting the positive SG&A leverage.

I'm guessing currency helps a little bit.

But to get to the consensus numbers, we'd have to see a pretty strong step up, something approaching $40 million sequential increase plus or minus, depending on other numbers.

And appreciating the seasonal nature of SG&A, is it possible that there might be a little more leverage as we look ahead to the fourth quarter than those numbers might suggest?

I think it's fair to say that just given the seasonality in the business, it's fair to expect that we're going to see some significant improvement going from the third to the fourth quarter.

Okay, thank you very much.

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

first question on inventories.

Just a few follow-ups on some things that I think folks have touched on, on the call, then I had a broader question for you Jim, and one for David.

The follow-ups here, inventories, as you talked about, were down.

I wish I could get a sense of where you are in terms of capacity utilization as you think about your current production levels versus a year ago.

And maybe if you could just talk about when you think you're going to get back to sort of a normalized rate, because that seems to be of the predictive element of when gross margins will start to track off from prime levels.

Well, of course, a lot of that, Matt is going to be dependent on the momentum on the top line as well as whether or not we see some recovery and when we will see a recovery and the five major markets in Europe.

We talked about earlier.

Some of that will depend certainly on getting the 510K's that we have in cleared.

But we would expect the utilization from current levels will improve in a linear fashion from here.

And then it's just a question of how steep that improvement is going to be.

And as I said, all that is going to depend on when we would -- couple things I mentioned when we would see a recovery in those major markets in Europe, and when specifically we would be able to get clearances, particularly for the new Acetabular cups here in the US.

Just on that, you do have through products filed.

I'm assuming that you don't wait for approval before you start ramping production.

We have seen slight improvement here in terms of deferrals in the third quarter.

So have you started to get to a point where you've eased back into some production level higher than -- because you took it down pretty significant in the first half, is that correct?

We did.

It does increase from here for the sort of very reasons that you stated.

And these new -- some of these new products, as we pointed out, were in the early stages of launching those products outside the US.

So the production volumes, there's the opportunity, obviously, for those production volumes to increase once those products are cleared and out in the marketplace, and you're not just building the pipeline, but the facilities are responding to the demand for replenishment once those products have been commercialized.

Okay, that's helpful.

Another follow-up.

I think there were some questions on the European market.

It looked like they have improved on a constant currency basis.

Is there anything there that's changed, and also, is there any difference that you see there in terms of Hips and Knee performance?

You mentioned a bunch of markets that are still growing, and the major markets are maybe stabilizing, but anything in terms of competition or your product that would drive the recovery in Knees before Hips?

Well, I would tell you where we saw the significant improvement in performance on the knee side was not so much in Europe as it was more for us in our case, at least, it was more Asia Pacific, and specifically Japan.

What we saw in Europe in the quarter was we think fairly consistent with what we saw in the second quarter.

Okay.

And then lastly, the follow-up, then I do after couple of questions, but on spine, you talked about Dynesys, David, and annualizing some of the synergies here heading into fourth quarter.

There's a lot of moving parts there.

Dynesys seems to be currently challenged, but then you have this new indication, new data that could drive further adoption.

What's the strategy there for returning the core business to growth post the comps?

Is it penetration of Pathfinder?

Do you need the new indications for Dynesys to grow that business?

Yes, good question.

And the strategy for growth there is we really have a broad foundation of fusion offerings at this time, post integration of the Abbott Spine deal, so you have everything that you need on the outer body and the inner body side within the fusion market.

As well, we have a strong MIS offering between Pathfinder and the technologies and products we picked up through the (inaudible)acquisition.

It is the case, as you suggest that the broader indication on Dynesys is going to be very important to restoring the right trajectory on that franchise.

And the path there is the broader claims allow us to go back and address the non-coverage decisions.

.

I don't think anyone either among the surgeon users or within our business has question about the clinical efficacy of that product and the solution that it provides for patients.

So we need to get the broader indication so that we can address those noncoverage decisions over time and get that important franchise that truly is a differentiator for us, back on track, and then continue to emphasize the MIS

Jim, on the P&L, just a broad question as you look forward, and I'm not trying to pin you down here for 2010 growth or anything like that.

But I think, if I understand, the goal is to sort of restore some level of sales growth, then to achieve some acceleration to the bottom line, in very sort of rough terms.

But what level top-line growth is enough to give you some meaningful leverage to the bottom line, putting aside year-over-year comps that you're facing now?

On a go-forward basis is low to mid-single-digit enough?

Do you feel like you need to break the mid-single-digit level, given your margin structure, to show acceleration?

Well, that is a tough question to answer at this point, Matt.

We'll be able to respond to that very specifically when we come without guidance for 2010.

Certainly the opportunity is there longer term, at least in terms of how we think about it with the market longer term on a unit basis growing mid single digits, and an opportunity beyond that with some positive mix benefit, net mix benefit coming from the introduction of new innovative devices.

Thanks, Matt.

And last one here, for David, on healthcare reform, just a broad question, David, about this element of comparative effectiveness.

You've talked about the great success life restoring benefits of joint replacement, which I think a lot of folks would agree with.

But is there any strategy to put data on the board that would help position you in the new world of clinical evaluation that we may be facing from payers?

I think it's going to become more and more important.

Not only the clinical efficacy, but the economics of these solutions, and we have have such a great story to tell within our space in particular.

You look at these procedures, and over half the people that have a hip or knee replacement are returned to work, that were out of work previously.

If you look at it from the the individual's perspective, the cost of managing these chronic conditions, this replacement will lead to savings of anywhere estimated from $68,000 to $180,000 per individual.

So whether you're looking at the broad system cost or the individual cost, these procedures, with 90-plus percent success rate 10, 20 years into the replacement, after great story to tell.

And the economic development of that story and communication of it we need to do a better job on that front.

And I think that that's true for the broader industry, too, when you start talking about healthcare reform.

I mean no one argues with the desirability of getting more access to patients.

It's a matter of how you do it and how you build greater efficiencies into the system without inhibiting the innovation that leads to these better outcomes for individuals and greater efficiencies and economies in a broad sense.

So those are the points that we make in these discussions.

I think a crude and material excise tax that's currently being proposed cuts very much against the core substance that is trying to be repaired with healthcare reform.

So comparative effectiveness makes sense.

A $40 billion tax does not.

That's helpful, thanks.

Sure.

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

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

Two quick questions.

One, given that some of the regulatory of the new product haven't come through how much of the inventory improvement that we saw in the quarter was somewhat related to not having to build for those new product, and how much was real work-down of products?

I don't think, Tao, the improvement in the quarter was at all material.

To some extent, you end up with these pending approvals, then you're going ahead with build plans in anticipation of the approvals.

So I don't think that you would see anything other than a modest impact on the deferral of those clearances.

And on the -- I was actually going after the inventory levels that you have.

I don't know if you're starting to build up already for them, or in the last quarter you alluded to inventories potentially either staying flat with the second quarter because of these new products that you're going to be manufacturing.

I think that what we talked about in the past is just that there's a little bit of a washout effect.

We're doing a better job of managing our inventory more efficiently and more effectively, and at the same time we're starting to ramp up the production for these new product launches in anticipation of those clearances and finding some traction with the commercialization of the new product.

And so there's a washing out as between the two, but net we still saw improvement in the quarter, obviously.

Perfect.

And on the Hip side, when I look at the numbers from the companies that have reported, it looks like maybe you lost a little bit of share sequentially.

Is that more related to these new products that you're expecting?

Yes, I think that we don't believe that we're losing customers at this point in time.

We may be losing some cases because of those gaps that we talked about extensively in the past, and these product launches that are underway right now.

O-US, fill those gaps and then some.

We have some very differentiated technology built into the Acetabular cups, for instance, so we're really optimistic about the future there.

Then, of course to get after those same opportunities within the US market is going to require these clearances coming through.

Thanks a lot.

Okay, thank you, Tao.

And thanks again everyone for joining us today and for your continued interest in Zimmer.

We look forward to speaking to you on our fourth quarter and year-end conference call at 8:00 a.m.

on January 10th, 2010.

I'll now turn the call back to you, Celeste.

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

You may now disconnect.