Zimmer Biomet Holdings Inc (ZBH) 2010 Q2 法說會逐字稿

Mr.

Blair, you may begin your conference.

Thank you.

Good morning.

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

I would like to welcome you to the Zimmer second quarter 2010 earnings conference call.

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

This morning, we'll review our performance for the second quarter, provide you with an update on certain key matters, present an update on our outlook for 2010 and conclude our discussion with a question and answer session.

We understand that this is a very busy reporting day and we'll do our best to keep today's call close to an hour in length.

Therefore, we ask participants to pose one question with one follow-up to allow as many callers as possible the opportunity to take part in today's call.

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, further 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.

In addition, we routinely post important information for investors on our website in the Investor Relations section.

We intend to use this website as a means of disclosing material, nonpublic information and for complying with our disclosure obligations under Regulation FD.

Accordingly, investors should monitor the Investor Relations section of our website, in addition to following our press releases, SEC filings, public conference calls, presentations and webcasts.

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 5, 2010, and can also be accessed from the Investor Relations section of the Zimmer website.

At this time, I'd like to introduce David Dvorak, President, and Chief Executive Officer of Zimmer.

Thank you, Paul.

Good morning, everyone, and welcome.

We're glad you could join us for today's call.

This morning, I'll review our second quarter and first half 2010 results.

Jim will then provide additional financial details.

Throughout the first six months of 2010, we've continued to perform in line with our expectations entering the year, demonstrating year-over-year constant currency sales growth across all geographic segments.

We've made progress with new product introductions, particularly in our hip business, and we expect these additions, along with our new instrument offerings in knees, will increasingly contribute to revenues in the second half of the year.

Net sales for the quarter were $1.06 billion, an increase of 3.3% on a constant currency basis and our earnings per share were $1.09 on an adjusted basis.

For the quarter, the Americas region grew sales 2.8% constant currency compared to the prior year.

The Asia Pacific segment grew 6.5%, and despite a continued challenging market, our Europe, Middle East and Africa region improved its sales performance with 2.8% growth.

Knee sales for the quarter improved year-over-year 3% on a constant currency basis, reflecting positive volume and mix of 4.5%, less negative price of 1.5%.

To accelerate our growth in the knee franchise, we've launched several strategic initiatives to reinforce the strength and performance of our knee systems, which we believe will also help to gain new customers.

We continue to see growth in our patient-specific instruments, as more physicians seek opportunities to optimize the accuracy of their surgical cases, as well as enhance their operative efficiency with these MRI-based surgical guides.

Along with patient-specific instruments, we plan to deploy our posterior referencing instruments in the second half of this year, following a developer release that took place this past quarter.

Posterior referencing instruments offer physicians, who subscribe to this surgical philosophy, access to our clinically proven NexGen implant.

Early trial results have been encouraging, as these instruments have been favorably received by posterior referencing positions.

Hip sales for the second quarter improved year-over-year 2.6% on a constant currency basis, reflecting positive volume and mix of 4.2%, less negative price of 1.6%.

Adoption of our newly launched Continuum system acetabular products continues to progress and we anticipate sales of these products will positively impact our performance in the second half of the year.

The Continuum system combines the best of Zimmer's proven hip technologies and further reinforces our commitment to providing an integrated line of polyethylene, ceramic and metal bearing options that more closely match the unique needs and lifestyles of patients.

Growth in the second quarter was supported by our Fitmore and M/L taper with connective technology stems, which we firmly believe represent the industry's most versatile hip system.

The Fitmore stem experienced 56% sales growth compared to the prior year as its bone preservation attributes continued to be favored by many surgeons and patients.

Sales of our M/L taper with connective technology grew 31% in the quarter compared to last year.

This product offers the surgeon superior interoperative flexibility with its independent adjustment of leg length, offset and version to match a wide range of patient anatomies.

Positive performance across our hip business is reflected by the 160 basis points of incremental growth over the first quarter.

Extremities posted solid results for the quarter with sales growth of 13% constant currency, due in large part to the success of our Trabecular Metal products sold in the United States.

Noteworthy product lines were the Trabecular Metal Reverse Shoulder with 31% second quarter sales growth and the Trabecular Metal Glenoid, which doubled its sales compared to the same period in the prior year.

Our dental business reported another solid quarter as well, with sales increasing 7.7% constant currency.

Following last year's weak demand fueled by global economic uncertainty, we believe our two successive quarters of growth reflect a stabilizing trend in this sector, as well as a nice performance from our dental team.

The Americas contributed 8.7% growth and sales in Europe increased 10.6% constant currency over the prior year quarter.

Earlier this month, Zimmer Dental launched the Zimmer collagen capsules and wedges, the first-ever bone shaping membranes for dental graft containment during sinus lifts, socket repair and preservation procedures.

Trauma sales in the second quarter were up over the prior year 1% constant currency.

The global rollout of our Natural Nail system continued with our recently released Cephalomedullary nails.

The second quarter also marked the first implantation of our NCB Periprosthetic Plating system, the first comprehensive solution for addressing complex femoral fractures around the area of a knee or hip implant.

The rollout of this product will continue throughout the remainder of 2010.

Our spine business has been through a series of operational challenges over the past few quarters and we recorded a sales decrease of 9.2% constant currency in the second quarter.

As we negotiate a challenging reimbursement landscape and continue to focus on improved sales execution, we anticipate performance will begin to stabilize.

We continue to make steady progress in our orthopedic surgical products franchise.

We reported 14.6% constant currency growth supported by 56% sales growth in wound debridement and 13% sales growth in the bone, cement and accessories categories, both on a constant currency basis.

Before handing off to Jim, I'll briefly touch on a few final topics.

Regarding the overall market, while there did appear to be a modest stepdown in growth during the second quarter, we believe that the broader market dynamics are unchanged.

Looking at the first half of the year, based on a majority of the market having reported second quarter results, it appears that worldwide reconstructive growth is actually up about 1% compared to the full year growth in 2009.

Moreover, the fundamental drivers for attractive growth within the musculoskeletal markets have not changed.

Turning to the European market, our performance in this geographic segment remains in line with our expectations coming into the year.

Although government spending controls continue to contribute to challenging market conditions in Europe overall, we're not seeing further market deterioration and we're encouraged by our performance during the quarter.

With regard to pricing, consolidated average selling prices in the second quarter were down 0.9% compared to the prior year period.

We experienced negative pricing of 1.1% in the Americas, positive pricing in our Europe, Middle East, and Africa region of 0.4%, and negative pricing in the Asia Pacific region of 2.4%, driven largely by the price cuts in Japan.

Consolidated pricing for the second quarter was consistent with our expectations and we continue to anticipate moderate price erosion of negative 1% to negative 2% for the year.

With respect to guidance, as we discussed in our earnings release this morning, we're reaffirming our outlook for 2010.

Finally, we announced this morning that Zimmer has entered into a definitive agreement to acquire Beijing Montagne Medical Devices Company, Limited.

The agreement contains certain closing conditions and we anticipate consummating the acquisition in late 2010 or early 2011.

Montagne is a China-based manufacturer and distributor of orthopedic implants with annual revenues of approximately $10 million.

This acquisition would make Zimmer the leading provider of reconstructive orthopedic solutions in China.

We're excited about this opportunity to expand our presence in a vital emerging market for the industry.

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

Jim?

Thanks, David.

I will review our performance in the quarter in more detail and then provide additional information related to our 2010 guidance.

Our total revenues for the quarter, as David mentioned, were $1.058 billion, a 3.3% constant currency improvement compared to the second quarter of last year.

A tailwind from the Australian Dollar, Canadian Dollar and Japanese Yen offset a headwind from the Euro in the quarter resulting in a slightly positive impact from foreign currency translation, which increased revenues by 0.4% or $4 million in the quarter.

Our adjusted gross profit margin of 76.3% for the quarter reflects improvements in operating efficiency and the recognition of gains on currency hedge contracts.

The margin ratio is down 70 basis points compared to second quarter 2009, but increased 140 basis points compared with the first quarter.

We are now expecting our gross margin ratio to be between 76% and 76.5% for the full year.

These expectations include an assumption that foreign currency exchange rates remain near recent levels.

Moving down the income statement, R&D expense as a percentage of sales was at 5.2%, and at $55.1 million for the quarter is 10.5% higher on a total dollar basis when compared to the prior year.

This increase is in line with our plans for the year, as we began to accelerate our new product development programs in the second quarter.

Selling, general and administrative expenses were $437 million in the second quarter, and at 41.4% of sales are 100 basis points below prior year.

SG&A as a percentage of sales is now anticipated to be approximately 42% for the full year, as our outlook is negatively impacted by a change in foreign currency exchange rates and the higher product liability expenses incurred in the first quarter.

We expect SG&A expense to increase to around 43.5% of sales in the third quarter due to seasonality.

Typically, the third quarter SG&A expense as a percentage of sales represents the high watermark for the year, due to the summer slowdown and procedure volumes.

During the second quarter, the company recorded a provision of $75 million for known and anticipated claims related to the Durom Cup.

Zimmer's estimate for these claims now includes worldwide revisions associated with surgeries predating the 2008 temporary US suspension.

Adjusted 2010 figures exclude the impact to this provision.

The total provision for all claims to include those that were expensed in the normal course is now $222 million.

This estimated contingent liability is based on a two-year pattern of claims made.

Prior estimates were necessarily based on a smaller data set of claims made in a shorter time series.

An independent actuarial model was also used to assist in determining an appropriate level of accrual for these claims.

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

Continuing down the income statement, acquisition, integration, realignment and other amounted to $11.5 million in the quarter, and includes one-time costs for realignment of our global IT infrastructure and other charges related to prior period acquisitions.

Adjusted operating profit in the quarter increased to $315 million, or 29.7%.

Our adjusted operating profit to sales ratio is 10 basis points lower than the prior year second quarter, as the anticipated decrease in gross margin was offset by leverage in SG&A.

Net interest expense for the quarter amounted to $14.3 million compared to $4 million in the prior year quarter.

Similar to the first quarter, the change is primarily due to the $1 billion senior unsecured notes offering we completed in November of 2009.

Adjusted net earnings were $221 million for the second quarter, an increase of 2.6% compared to the prior year.

Adjusted diluted earnings per share increased 9% to $1.09 on 203 million average outstanding diluted shares.

These adjusted earnings per share are inclusive of approximately $0.06 of share based compensation.

At $0.82 reported diluted earnings per share, which include the items reflected in certain claims and acquisition integration realignment and other decreased 16.3% from the prior year second quarter reported EPS of $0.98.

Our effective tax rate for the quarter was 26.4%, slightly below the first quarter as a result of the favorable resolution of certain tax positions.

We still anticipate a 2010 full year tax rate of approximately 27%.

During the quarter, we repurchased 1.4 million shares at a total purchase price of $85 million.

As of June 30, 2010, approximately $32 million remained authorized under a $1.25 billion repurchase program, which expires at the end of 2010.

The Company had approximately 201 million shares of common stock outstanding as of June 30, 2010, down from 204 million as of December 31, 2009.

Our board has approved an additional $1.5 billion stock repurchase program, which expires December 31, 2013.

We continually review the best utilization of the cash that we generate.

Our intentions with regard to use of free cash flow remain the same, as we have indicated for sometime.

Our first priority is external development, when and if the right opportunities arise, to add technology, product, or businesses that strategically align with our focus on musculoskeletal health.

We balance this priority with maintaining strong liquidity and continue to believe that share repurchases are an efficient and effective way to return excess free cash flow to our shareholders.

Operating cash flow for the quarter amounted to $273 million, up nearly 40% from $195 million in the second quarter of 2009.

Our focused efforts on managing our working capital have allowed us to offset significant investments to build out the inventory pipeline for Acetabular Cup and Intermedullary Nail new product launches.

This quarter we continued to carefully manage inventory levels with our global distribution network.

Inventories were $10 million below first quarter at $886 million.

As a consequence, adjusted inventory days on hand finished the quarter at 318 days, a decrease of 57 days compared to the second quarter of 2009.

Our adjusted trade accounts receivable day sales outstanding finished the quarter at 61 days, a decrease of 2 days from the second quarter of 2009.

Depreciation and amortization expense for the second quarter amounted to $81 million.

Free cash flow in the second quarter was $214 million, $73 million higher than the second quarter of 2009.

We defined free cash flow as operating cash flow, less cash outflows, for instruments and property, plant and equipment.

Capital expenditures for the quarter totaled $58.9 million, including $43.7 million for instruments, and $15.2 million for property, plant and equipment.

We expect capital expenditures to be higher in the second half of the year as we make significant investments in our new posterior referencing knee instrument, continue to deploy instruments in support of our previously mentioned new product launches and replace machinery and equipment in the normal course.

Cash outlays associated with divesting activities during the quarter include $4.1 million for certain international distributor acquisitions.

I'd like to turn now to our guidance for 2010.

In our earnings release this morning, we reaffirmed our full year constant currency sales and adjusted earnings per share guidance.

Full year revenues are expected to increase between 3% and 5% on a constant currency basis.

Assuming foreign currency exchange rates remain near recent levels, we estimate that foreign currency translation will decrease revenues by 0.5% for the full year 2010, resulting in expected revenue growth on a reported basis between 2.5% and 4.5%.

For the third and fourth quarters, we anticipate foreign currency translation will decrease revenues by approximately 2% and 5% respectively.

Adjusted diluted earnings per share are projected to be in a range of $4.15 to $4.35 for the full year 2010.

Additionally, with respect to the third quarter, we believe, based on a review of published independent analyst earnings models for Zimmer, that seasonal revenue and expense patterns are not fully reflected in those models.

Also, new product and instrument deployments will progressively ramp up and are expected to have a greater impact on revenues in the fourth quarter than in the third quarter.

Taking into account the anticipated effects of seasonality and other factors, we expect that our third quarter adjusted diluted earnings per share will be between $0.93 and $0.98.

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

Thank you, Jim.

Our performance in the second quarter and year to date has been in line with our expectations coming into 2010, reflected by top line constant currency growth across all three of our geographic segments.

We continue to progress on operational improvements, as reflected in our higher gross margin and lower SG&A ratios compared with our first quarter results.

This allowed us to accelerate R&D spending and still deliver solid earnings and strong cash flow.

As the year progresses, further penetration of recently launched products will complement our established key product lines.

We're encouraged by early adoption rates and clinical feedback for our new Acetabular Cup offerings, patient-specific instruments, and Natural Nail line.

Further, we're confident that the actions we're taking will accelerate our short-term performance and build upon the foundation for our longer term strategic plans.

And now, I'd like to ask Regina to begin the Q&A portion of our call.

(Operator Instructions) We ask that you please limit yourself to one question and one follow up.

Our first question comes from the line of Adam Feinstein with Barclays Capital.

All right.

Thank you.

Good morning, everyone.

Hi.

Just wanted to get some more thoughts here.

Obviously, you guys showed some stable trends.

The market was very concerned about Europe during the quarter, but seems like things were fine there.

You provided some comments before that you feel comfortable with it.

Can you just give us some more specific feedback in terms of just whatever your analysis is not telling you and just curious in terms of specific countries and such.

But just wanted to see how you guys get comfortable and just so we could better understand the trends.

Thank you.

Sure, Adam.

I'll start off and Jim, you can add any color that you want to.

What we're seeing, Adam, is consistency in those markets.

And as we said before, when you concentrate on the five major markets there, they are flat.

I mean some of them are a couple points down.

Some of them are maybe a couple of points up, but they wash out to being relatively flat within that space.

That isn't as descriptive of the other markets, the more developing markets, where there is more attractive growth presently.

So, we do think that this is a continued trend .

It's a relatively stabilized trend over the last several quarters and as you can see over the last few quarters and we produced positive results in that context.

So, I think that our performance is improving in Europe at this point in time.

I think that the market is relatively stable and we still firmly believe that the long-term growth prospects of those developed markets, the larger ones, will improve over time with greater economic

Okay, thank you very much.

I'll get back in the queue.

You're welcome.

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

Hi.

Good morning, everyone.

Thanks for taking the question.

Jim, can you maybe just walk us through in a little bit more detail on the gross margin the sequential uptick from the 74.9 to the 76.3?

How much of that is related to product mix versus FX hedging gains?

Can you quantify the breakout of the two?

Sure.

With the FX, basically the gains that were recognized on hedge contracts contribute about half of the improvement in margin quarter over quarter, and the balance of that improvement really comes from the improvements that we've seen in operating efficiency.

So in the first half of this year, our manufacturing facilities were operating at or near optimal levels of capacity utilization, in contrast to what we were talking about in the back half of last year.

So, this has allowed us to put lower cost inventory to the shelf in the first half.

In addition, our efforts to reduce core inventories, as we build out the pipeline of new product inventory, has resulted in lower obsolescence charges.

Okay.

So--

As we look at the balance of the year, currency has a relatively modest positive impact.

It's really these other factors that are the principal driver to the anticipated improvement.

So if I take out FX from here, gross margins were about 75.6 in the quarter.

Is that the right number off of which to build the go-forward gross margin assumption, if we want to make estimates with respect to volume and mix going forward from here?

Should we view that as -- that 75.6 as a baseline?

On an operational basis?

I tell you what, there are a number of factors that impact on gross margin, including product mix, currency, inventory obsolescence, capacity utilization just to name a few.

I would say that's something we'll certainly have a more studied view on as we close out 2010 and be prepared to discuss that on our fourth quarter call.

Okay, and David, maybe you could follow up on your comments with respect to the market.

Just doing some math, looking at who's reported so far, it looks like the US market (inaudible) hips and knees slowed about 300 basis points sequentially and international slowed between 150 and 200 basis points.

Can you address the US in a little bit more detail?

J & J talked a little bit about increased pricing pressure.

Could you maybe help us gauge what you think is happening there?

We didn't see much change in the way of pricing pressure, David.

But clearly there was a stepdown in both hips and knees in the reported second quarter numbers.

I think that there could be some billing day impacts across the other companies within the industry that contributed to that, that may have led people to believe that the first quarter market numbers were a bit higher than they actually were.

And from my perspective, I think you really want to look at the first half of the year as opposed to isolating the second quarter on a stand-alone basis.

A little bit more profound of a stepdown on the US side in knees and I think that there was a bit of a procedural stepdown.

I will tell you that very anecdotally, we saw a bit more of that in the earlier interventions.

So, the Unis and the cruciate retaining knees as opposed to the posterior stabilized knees, so that might be indicative of people in that younger category deferring the procedures at this point a year or making some decisions as impacted by the health of the economy in general.

But very an anecdoctal at this point in time and I wouldn't read too much into that one-quarter result.

Okay.

That's helpful.

Thank you.

You're welcome.

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

Hi, thanks for taking the question.

Dave, just following up on David's question, when we look at the ex-US market, Q1 to Q2, there were differences between hips and knees across the quarters, but in aggregate on a constant currency basis, it looked pretty similar.

What's your sense of that?

Consistent with what you just described, Bruce.

I think that there's -- there looked like a little bit of an [OUS] stepup in hips and a little bit of a stepdown in knees and they largely washed one another out.

That's logical in the sense of everyone has described in the industry.

There was a more significant price cut in Japan applicable to knees than there was to hips and so that can be part of the explanation for that.

Okay, and, Dave, just thinking about spine, and I know you're not a huge player in spine, just to get a little more granular on the nature of the pressure in the market, is it more about surgeries being denied or delayed or not approved quickly, or rather per case reimbursement at the payor level?

Or just the hospitals are negotiating harder with unchanged commercial reimbursement because it's largely a commercially insured population?

If you could just give us some indication of what your sense of what's going on there, it would be great.

Sure, Bruce.

The dynamics you described are all in play, and I think that there are different elements that would apply to a greater or lesser extent to the different companies dependent upon their market positions.

As it applies to us, obviously the reimbursement issues are much more profound with respect to our US Dyneses business at this point in time, and so that's where we're seeing the most pressure.

In the general market, we're seeing some of what you described, but I don't know that I would describe that as being profoundly impacting our results as opposed to what's happening with Dyneses there.

And then when it comes to pricing, we're not seeing as much pressure as some of the others are discussing, but, again, I think that's that probably consistent with our market position.

And, again, all of those comments are -- need to be interpreted and read in the context of a company with far less market share than some of the others that you're talking to.

Thanks so much.

You're welcome, Bruce.

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

Thanks, good morning.

Good morning, Mike.

Okay.

First question, I just want to clarify on the commentary on the SG&A line for third quarter, Jim.

You're looking -- it's looking like you're expecting after getting a really good quarter of leverage, that you're expecting that to go the other way in the third quarter and you tied it to seasonality.

But there seems to be a bit of a disconnect there.

Could you explain it?

Sure.

I think if you go back, Mike, over the last several years, you would see that, that's pretty consistent with the seasonal patterns that we've recorded in the past.

Because those costs are largely fixed over the short run, with some limited exceptions to where we have sales organizations that are fully commissioned.

The SG&A expenses did not drop at the same rate as our sales tend to kind of decline relative to the first quarter as procedure volumes slow down and surgeons take vacations over those summer months.

So really is a of seasonality and it's -- what we're projecting is very consistent with what we've reported in the past.

Okay, and, Jim, the decision to maintain the guidance, you had some EPS upside this quarter and your guidance is still pretty wide range in the bottom line for the year.

Why not narrow that down a little bit at this point?

Well, I think we've, as we've said before, we come into the year with a range.

We feel very comfortable operating within that range and as far as the bottom line goes, it's very dependent clearly on what happens on the top line.

We're in an operating period where we see significant opportunities around these new product launches.

The timing, the ramp up, all of that is obviously not all that predictable.

So, that sort of leads us to the range that we provided as we indicated, or I indicated in my prepared remarks, that ramp up really just begins to take effect in the second half of this year.

So, we feel it's still appropriate to maintain the range that we're operating with and came out with and came out with in the beginning of the year.

Okay.

Last question, David, how would you describe where you think you are in the rollout of the new hip lines?

Do you feel like -- at what point do you feel like -- at what point do you feel like you are in the full rollout of those products and the timing of us seeing the impact on the business?

It's a good question, because it's so important, as Jim described, to the expectations for the second half of the year performance, Mike.

And I will tell you that I believe that we're just entering the traction period with respect to the rollout of the Acetabular Cups.

We're six months into it, so there are enough sets that are deployed in the key markets, at least at this point in time, to where we're starting to see traction.

You actually saw a point and a half of improvement in our hip performance in the second quarter.

So, we're just entering the period.

And, you have great visibility and a lot of conceptual understanding for what these rollouts look like and the time horizons to look at these things and say first six months, you shouldn't expect much.

After six months, you should start to expect something, and you're really in that traction point, I would say, from six to 18 or 24 months of rolling these things out.

So, we're just entering the period where we should start to see some traction and pickup.

Great.

Thank you, David, thanks, Jim.

You're welcome.

You're welcome.

Our next question comes from the line of Bob Hopkins with Banc of America.

Thanks.

Can you hear me okay?

We can, Bob.

Good morning.

Great, good morning.

So, just to follow up on Mike's question, as it relates to your global hip growth over the next couple of quarters, is it fair to say, then, that you think you will see accelerating constant currency growth trends in Q3 and Q4 relative to the 3% that you saw here in the second quarter?

We do think that we're going to make progress on the hip side on the second half of the year.

I will tell you that I think that more of that progress on the hip side is going to come from the Americas and Asia Pacific geographic market initially, just because some of the environmental circumstances affecting the European market.

And it's also important to note that you lose a billing day in Europe in the third quarter, so subject to those comments, yes, Bob, we'll see a pickup in our hip growth.

And then same kind of question on the knee side.

You made some comments about knees in your prepared remarks and I'm just curious, do you have confidence in where you are right now, that we should expect, again, an uptick in constant currency growth rates in the back half of the year relative to what you saw in the second quarter?

We do.

And I will tell you that in that circumstance in particular, the opportunities geographically are a little bit flipped.

I think that there's a bit more momentum and opportunity to improve in Europe in Q3 than some of the other geographic segments.

And I think as we get into the fourth quarter, we're going to see more significant ramp up due to the deployment of those new instruments in markets that would include the United States.

So, that's the pattern.

The deployment, as it applies to hips, are not at the same stage sitting here today as they are on the Acetabular Cups for hips.

So, I think our knee instrument growth, driven growth is going to be a little bit more back end loaded in the year than hips.

Okay, and thank you for that.

And then just for Jim real quick, regarding the third quarter, you gave some specific guidance on EPS.

If you said it on top line, I missed it.

I know consensus I think is a little over a billion.

Was there a specific number you had in mind for the third quarter?

I did not provide a specific number or guidance on third quarter revenues, Bob, other than to provide some color around what the effect of the change in our currency outlook is going to be on the third quarter, where we indicated that we expect that to be minus 2% in the third quarter and minus 5% in the fourth quarter.

But beyond that, we have not provided specific revenue guidance for Q3.

Okay, and then just finally real quick, on the SG&A leverage side, I understand dynamics about what's going on in the third quarter, but from a longer term perspective, is there any change to the comments you've said historically about the potential over time to get back down to normalized SG&A levels when you look at Zimmer historically?

Has there been any change in your mind on that thought?

Yes, and I'll respond to that.

It's a very good question.

It's indicated in my prepared remarks our SG&A expenses for the quarter were 100 basis points below prior year, so clearly we showed some progress in the quarter.

And this is in an operating period where, as you know, we are investing the support of significant new product launches.

So, we are making progress.

But from this point, a stronger dollar relative to prior operating periods does create a headwind for the SG&A ratio, because a significant portion of our expenses are dollar-based.

So, as for the outlook for SG&A longer term, we obviously have more work to do.

As we acknowledged on the first quarter, we don't consider 42% to be a structural norm.

We're not happy with those expenses being at that level, and our plans over the long term are to bring that down through a combination of business process, re-engineering, and through leveraging our fixed costs as our top line grows.

Thank you so much.

You're welcome.

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

Thank you very much for taking my questions.

I have two of them.

The first one is, as we've heard a number of companies and managements talk about the hip and the knee market growth rate in the mid-single digits, could you toss your hat in the ring and comment on what you think, not just this year or even maybe next year, but longer term, the overall health and growth rate this market could look like?

Well, I think that that is the right way to think about the market, Joanne, in the current context.

We exited the year right at that point, say 5% in the fourth quarter.

The full year 2009 looked like it was a point lower than that, and so now if you look at the first half of this year on the large joint side, again, it looks dead in the middle of that, that range.

So, mid-single digits, right at 5%-ish.

But I think the thing that is important to remember is you have some big markets that are suppressing that number, primarily those developed markets in Europe at this point in time, and significant price pressure as it applies to Japan in particular at this point in time.

And so these procedures are getting deferred in Europe and the developed markets to be sure, and those are going to come back at some point in time and so you will see some procedural uptick from that dead middle single digits.

Furthermore, I think that we continue to believe that there is mix opportunity on top of that procedural growth and we think that that mix opportunity as we discussed in the past, if you want to put numbers to it, is in a range of say 1% to 3%.

So right now, we would expect that in general those mix opportunities are washing out the downward price pressure, pure price pressure.

And so the economy stabilizes and improves in the long run, you build up from that mid-single digits to something above that number and potentially high single digits again.

That's helpful.

My second question is with the purchase of the Beijing manufacturing that you announced this morning, couple of the medical technology companies have already hit upon the opportunities in China.

Could you extrapolate what you see opportunistically there?

Thank you.

You're welcome.

This is one of the important markets clearly going forward.

It's a market that is expected, if its round number is $1 billion today, that within the next three years it's going to be $2 billion in size.

There's a significant hip and knee business already developed there.

And we have a significant hip and knee business in the context of that market already.

So, this acquisition, when and if consummated, would add to our product offering.

It would add to our local research and development capabilities, as well as manufacturing and greatly broaden our distribution channel.

So, we have specific plans, I will tell you, for each of the important emerging markets.

Globally, we think it's going to be an area that will drive future growth and so this is just a step in executing a rather comprehensive plan to make sure that we're in leadership positions in the key markets that are going to drive a lot of growth in the future.

Terrific.

Thank you.

You're welcome.

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

Hi.

Good morning.

Good morning.

I wonder if I could ask questions on the decision to expand Durom liability reserve -- well, a couple questions first.

In the first quarter there was about $9 million of expenses that flowed through the P&L that fell outside the parameters of that reserve.

Was there any similar expense that flowed to the P&L this quarter?

There were not, Raj.

So, with this provision, we've done a couple of things.

We've expanded the definition of what we were calling certain claims to include all revisions worldwide that related to surgeries that predated the suspension in 2008.

So, we broadened the definition of certain claims and that therefore picks up what was otherwise running through SG&A expenses on a quarterly basis.

Okay.

So we shouldn't expect to see any more of those claims hit your P&L then?

None of those claims as they relate to revisions for surgeries that occurred prior to the suspension.

So, what will still run through SG&A expenses is any revisions associated with surgeries post the suspension and after the product was relaunched into the market.

But I would tell you, as you well know, that market has shrunk and sales for us, sales of the Durom product are very modest relative to our total hip business.

I think you also implied that perhaps the revision rate was higher than maybe you initially thought.

Is that true?

Did I interpret that correctly?

That's certainly one of the things that's leading to us having to increase the provision.

And we start out in the beginning with the very limited data set.

These estimates are based on claims at the time that they were made on claims that have been received at that particular point in time, up to that point in time.

So, we obviously have at this point a much richer data set.

We're looking at two years worth of claims that have been made and that gives us a lot of confidence that at this point we feel we have an estimate that will cover, as I said, all revisions that predate that, the suspension.

Okay.

And just one additional one on -- you're one of the many companies that have now mentioned these patient-specific knee guides as potential growth driver going forward.

Have you quantified what percentage of knees you're currently seeing using guides right now and where you think that's going to go over time?

How big of an opportunity you really think this is?

It's, it's a relatively low penetration rate within the industry at this point in time.

But, I think that it's the beginning of a broader trend.

I think that the technologies will advance.

I think that these technologies will merge into other areas that have been worked on in the past, and including navigation broadly.

So, I think that in the intermediate and longer term, the penetration rates could get quite high.

But this is really a first generation offering within the industry that we're talking about now, with these custom cut guides or pin guides.

So, is it well less than 5%, then, at this point?

For us, clearly.

Okay, very good.

Thank you.

You're welcome.

Our next question comes from the line of Derrick Sung with Sanford Bernstein.

Hi, good morning.

Thanks for the question.

Good morning.

So in the US, especially in the knee markets, but also in the hip markets, it looks like the broader markets clearly slowed around you, but you kind of maintained constant growth rate on a sequential basis.

What I'm wondering here is did you also see a slowdown in your procedures and are you basically making up in this quarter that difference with mix perhaps that the other companies aren't seeing?

Or did you see your procedures steady, and perhaps your mix steady which would then suggest moving forward you would then see greater opportunity to drive mix in the upcoming quarters?

Derrick, this is Jim.

We did see what I would describe as a modest stepdown in procedure growth on the knee side.

When you look at our recon results in the aggregate, we certainly did see and experience an improvement in results on the hip side and some of that is mix related as we launched the new Continuum Cup system.

Okay, so on the knee side, then, what drove the mix then?

It looks like your knee growth still stayed relatively steady.

Sure.

It would be the same new products that have driven some mix benefit within that knee franchise over the past several quarters.

So, Trabecular Metal tibial trays, highly crosslinked polyethylene liners, prolonged liners for the knee system, those are just a couple of the products that continue to drive some positive mix benefit for us in knees.

Okay, thank you.

And then just really quickly, going back to the China market, can you give some specifics on how big the market as a whole for hips and knees right now is in China and what kind of growth rates you've been seeing historically and you expect to see moving forward?

Sure.

Yes, as David indicated, the size of the musculo -- we would define as the musculoskeletal market in China right now, we see it around $1 billion.

About a third of that is hips and knees, and there's a fairly sizable trauma market in China, actually largely than the hip and knee market right now.

And then spine would principally make up the balance of that $1 billion.

That's a market that, as David said, we think will more than double in size over the next three years.

So, you're looking at very significant growth rates.

And this is the market where the government has committed to invest somewhere on the order of $125 billion in providing better access to care and that better access to care will drive, we think, more significant growth in elective hip and knee procedures.

Great.

Thank you very much.

You're welcome.

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

Hey, guys.

This is Rich in for Rick.

How are you?

Hello, Rich.

I just wanted to -- maybe just follow up on that question on China.

Did you guys say when the deal -- if the deal closed or when it's expected to close, and also what -- when can we start to expect some sort of meaningful revenue contribution and increased share of that $1 billion market?

We expect the deal first of all to close either the fourth quarter of this year or the earlier part of next year.

And obviously, this is part of a broader strategy on our part, so in the go-forward periods, we would expect to enjoy a significant portion of that growth within the large market.

We think that the deal really accelerates some of the things that we'd like to do within that market.

But, again, we have a great group in China presently with a significant market position in both knees and hips and we're growing that business currently at very attractive rates.

So, this is just an accelerator for us that's consistent with part of a broader strategy within that marketplace.

Thanks.

And then maybe just switching gears for a [sec] to spine, it looks like the growth deceleration or the year-over-year growth rates, the deceleration is stabilized.

And I was just wondering, are we kind of at a turning point here?

And what sales or marketing or new products are on the horizon?

What initiatives get that growth rate going again?

Well, we have, I think, done a good job of expanding the product portfolio.

Particularly in the core fusion market, so that is going to help us stabilize the business, Rich, and in the intermediate term within the United States market.

OUS we have a really nice offering in the current bag because some of the non-fusion products are marketed presently there and we're already seeing an uptick in growth OUS.

So, I think that as we get into the second half of this year, we're going to see relatively attractive growth rates coming from our spine business outside the United States.

And then by the time we exit this year, we would expect to see a more stabilized US business and then we'll continue through our internal development to fill in some of the existing product gaps.

But I will tell you, they're far less profound than they were a couple of years ago, prior to the Abbott spine acquisition.

Great.

That's helpful.

And then maybe just one last quick one on hips.

As you launch your new products, the Continuum and MMC, I know metal on metal is a capability that these products enable you to address.

Just wondering, given what seems like accelerating pushback or dropoff on metal to metal use, does this in any way impact your projected sales from these products, the mix opportunity, if you could just comment there.

Thanks.

Sure, Rich.

It doesn't at all.

These are -- we have the industry leading in growth technology with Trabecular metal and that's really the premise of the Continuum system, but there are integrated taper systems that are designed for O-US markets that are part of this broader Acetabular launch.

And the bearing surfaces that we have to offer are clinically proven first-rate bearing surfaces, both polyethylene and ceramic.

Ceramic O-US at this point in time.

So, we have a very low market share of the metal on metal offering and yet these alternative bearing surfaces that are clinically proven, very well received in the marketplace, and these new Acetabular cups will just allow us to leverage our polyethylene technology, as well as our metal on metal technology, as well as the Delta BIOLOX has on the ceramic on ceramic side.

So, anything that a surgeon or patient could be looking for, we believe we can offer with these integrated taper systems that are coming out right now in the form of Continuum and the others.

Thanks a lot.

You're welcome.

Our next question comes from the line of Doug Schenkel with Cowen and Company.

Hi, good morning.

Good morning.

Let me just rattle through a few loose ends.

So, since you guys finished up your prepared remarks, I've already heard a few folks comment to me that your pricing commentary sounded a bit worse than last quarter.

And I think this is because you guys basically said that knee pricing and hip pricing was down about 30, 40 basis points relative to what you said last quarter.

But I, I think this is probably largely attributable to the price cuts that occurred in Asia, really in Japan.

Is that the right way to think about it, that basically pricing is essentially stable in hips and knees, with the exception of the biannual price cuts?

That is exactly the right way to think about it.

And that is precisely the reason for the slight sort of negative increase in hip and knee pricing as between the second and first quarter.

Okay.

The actual price -- the price performance within the Americas division is dead on in the second quarter what it was in the first quarter, and so the incremental 2-point decline in price within Asia Pacific is driven by the cause that you just articulated.

Okay.

Thank you for that.

Going back to an earlier question from, I think it was from Mike about you guys not narrowing the EPS range.

We heard your explanation, but I'm just curious whether you would be willing to share exactly what scenario at this point you have modeled out that would lead you to get into the low end of the EPS range and maybe how likely that is, given the strength that you've demonstrated over the first half of the year?

Well, we don't think that it's likely to end up at the lowest end of the range or below that level of the range.

If there was a double dip in the economic recession and we found no traction for the new product launches and whatever else you want to put on that list, I suppose that could drive that type of performance.

But that's not what any of us is believing will occur and certainly not what we're striving to do in the way of our business performance at this point in time.

Okay.

But I think that the premise to that decision really is the one that Jim articulated earlier, and that is we're at a point in time where we're ramping up these new product launches.

That traction cannot be predicted with absolute certainty down to the week or even the month as to when you're going to start seeing progress.

We have absolute confidence that we're going to see progress because of the clinical feedback that we're getting on these new product launches.

So, depending upon the pace of that ramp up, you're going to end up somewhere within that top line guidance range for the year and I think that's one of the most significant drivers obviously in addition to what happens externally with respect to the broader market.

Okay.

That's helpful.

And then maybe building off of that last point, when we aggregate what we've heard from you and others who've reported already, it actually looks like you guys may be doing a little bit better in hip, a little hips, a little bit earlier than at least I had expected.

I know it may be premature to reach any conclusions based on just one quarter, but are there any signs that you are actually gaining traction here a little bit ahead of plan, given you are in the very early stages of the new product rollouts?

I think it's consistent with what we expected to have occurred.

We did make some progress and it's a fairly long time in the coming from our perspective.

We're working hard.

We think that we have a great portfolio at this point in time.

We've said all along that as we got these new Acetabular Cups out, coupled with our already very strong portfolio of stems, we should be able to make good progress within the marketplace and I think we're just beginning to see that at this point in time.

So, it's relatively consistent with what we anticipated coming into the year, Doug.

Okay, great.

And if maybe I could just try to squeeze in one more, your gross margin guidance implies that in the second half, you're going to see I think about 100, 150-basis point improvement relative to the, I think it's 75.6% you did in the first half.

This is clearly better than street models and clearly better than what you guided us to earlier.

How much of this is FX?

And separate from FX, where are you tracking ahead of plan?

Sure.

So, as I indicated for the second quarter FX ended about 70 basis points.

I would tell you as we look at the back half of the year, the FX contribution is positive, but it's much more modest than that.

So, the real driver is the improvements in operating efficiency and the fact that we're at or above our planned capacity utilization in the first half of the year.

So, as I said, we've been able to put lower cost inventory to the shelf over the first half of the year.

So, we have very good visibility to what this is going to look like in the second half of the year.

And the other thing, as I also indicated is that the better job that our operations people are doing working together with our people in the field on managing inventory.

So, as we've been able to bring inventory days down and bring them down even more profoundly than is reflected in our numbers, because as we bring down the core inventory sets, that's being offset by the investments we're making in the pipeline, we're seeing much lower excess and obsolescence charges run through cost of goods.

So, another thing that we have I think good visibility, too, and that's really what's leading to the improvement.

Great.

Thanks again for taking the questions.

You're welcome.

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

Hello, Matt.

Hi, Matt Miksic, thanks for taking my questions.

So, couple follow-ups.

One, Jim, just to understand the comments you made on the gross margin.

I guess heading into the back half of the year, I think I understood half the improvement in Q2 sequentially was, it sounds like, roughly was driven by FX.

In the back half of the year, is that a contributor to your sort of stepping up your view on gross margins for the full year, or is it -- how would you split out operational versus FX in terms of that stepup in your outlook?

Sure, Matt.

And I just went through this with Doug and you may have dropped off there for a minute and missed it, but I'll just go quickly.

The currency, while it's positive in the back half of the year, is much more modest than the 70 basis points that we picked up in the second quarter.

So, what's really driving the improvement is the improved utilization across our manufacturing network in the first half of the year.

So, we've been putting lower cost inventory to the shelf over the first half of the year.

We have good visibility as to what that looks like and what impact that's going to have on margin in the second half.

And the other thing is lower excess and obsolescence charges running through cost of goods, as we do a better job of managing our field based inventory deployment.

Great.

Sorry to take you through it again.

On -- a couple of just quick ones on smaller businesses, and I hope that these haven't been asked, as I've been hopping back and forth between a couple of calls, so I apologize.

Dental and spine, you showed a nice stepup in dental sequentially.

Maybe if you could talk a little bit about what you think the market is growing there at the moment and what you've been doing there that's been improving your business.

And then on spine, the other side of that I guess, still challenged.

Is it new product flow, is it distributor network, or the way it's structured with your ortho distributors, maybe talk about what you need to do on that side of your business?

Sure.

I'll take those questions, Matt.

I think on the dental side, it just is fundamentals coming together.

With respect to the performance, we've got a nice cadence, new product flow.

We have a really good leadership team in place that understands that business and is making great progress in strengthening the depth of knowledge throughout all levels within that division.

They're very focused on growing their business.

They see a great opportunity in that market, as we do.

Notwithstanding what's transpired over the last couple years.

And so it's a stabilizing market.

At this point in time, I wouldn't describe our performance as probably being market level performance.

I would suspect that our growth rate is above market growth rate.

I would suspect that market growth rate is probably flat to slightly positive, a couple three points of growth that we'll see as much larger players report out what their results look like and gain greater visibility to that.

So, again, the fundamentals, we've got a good leadership team, a good product cadence a focused sales force and they're executing quite welcoming out of a difficult time period.

So, we're really optimistic about what we're going to be able to do with that business going forward.

Spine, we're a click or two behind in those categories, but working in the right direction to be able to talk to you about our spine performance in the same way that we sit here and talk to you about the dental performance in due time, making good progress on ramping up sales OUS.

We think that we're sorting out the right priorities for our internal development product pipeline and we've got a lot of good talent in the distribution network.

It is not largely integrated in any significant way, Matt, with our reconstructive distribution channels.

So, it's quite independent of that, focused on spine, and I think we have some good people there and we need to give them a good opportunity with a full product bag to go out and compete.

And so that's what we're working on.

And I would expect to see our performance OUS improve within that spine market in the second half of the year and then begin to stabilize at the end of the year within the United States market.

And head into 2011 with good prospects to see some growth come out of the spine division.

Great.

Very helpful.

Thank you.

And in the interest of everyone's time, let's take one more caller, please.

Our final question will come from the line of David Lewis with Morgan Stanley.

Hi, good morning.

It's Steve [Bushaw] in for David.

Thanks for taking the question.

Hi, Steve.

One quick one on inventory.

Can you -- we were a little bit surprised by the level this quarter.

Can you comment on the underlying drivers between the balance of input costs, market dynamics, and then maybe your expectations for the balance of the year?

Sure.

First of all, we, as we indicated, or I indicated in my prepared remarks, Stephen, the inventory days on hand, which is how we measure inventories and we calculate that using a quarterly cost of goods, so it's somewhat sensitive to quarter to quarter changes and cost of goods.

It came in 57 days below where we were in the second quarter of last year at 866 million or 886 million, rather.

The total investment in inventory dollars is down $10 million from the first quarter of this year.

And that's in spite of significant pipeline buildout for the new product launches.

So, I would tell you that, if anything, we're kind of ahead of where we would have expected to be at this point of the year in terms of making progress on better managing our field inventory deployments.

And it's one of the things, as I indicated, that's contributing to a stronger outlook for gross margin in the back half of the year.

I would tell you as far as the balance of the year, we typically see an increase in inventory days in the third quarter because of the slowdown in procedure volumes.

And so we build -- as we continue to build inventory through the summer months, in advance of what ends up being a busier surgery schedule -- busier schedule for surgeries in the fourth quarter, we would expect to see a bit of an increase in days on hand in the third quarter and then have it come back down in the fourth quarter.

Great, thank you.

And then a question on the move into China.

Clearly a significant and fast-growing market.

But I wonder if you could comment on the balance of factors that drive the appeal of moving into the market, between that top line, sizing growth opportunity, and the opportunity to leverage a low cost manufacturing out of that market.

Could you give us your thoughts there?

How you balance the two?

In this step that we announced today is really driven towards better positioning us to compete effectively in that market.

Again, we pick up some great capabilities on the product development side, a broader distribution channel, a broader portfolio of products that are designed for that specific market at this point in time, and that's really the principal driver for that transaction.

A collateral benefit, to be sure, will be enhancing our capabilities on the manufacturing side within that jurisdiction and that is one that I would think of as more an intermediate or longer term objective and strategic rationale for the deal.

So, the principal driver is to position us to compete effectively within China itself.

Great, thank you very much.

You're welcome, Steve.

Thank you all, again, for joining us this morning, and for your continued interest in Zimmer.

We look forward to speaking to you on our third quarter conference call at 8:00 AM on October 28, 2010.

So, with that, I'll turn the call back to you, Regina.

Ladies and gentlemen, this does conclude today's conference call.

Thank you all for participating, and you may now disconnect.