Zimmer Biomet Holdings Inc (ZBH) 2010 Q3 法說會逐字稿

Mr.

Blair, you may begin your conference.

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

I would like to welcome you to the Zimmer third 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 will review our performance for the third 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 will 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 call contains Safe Harbor statements within the Private Securities Litigation Reform Act of 1995, based on current expectations, estimates and forecasts and projections about the orthopaedics industry, management's beliefs and assumptions made by management.

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

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

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

This presentation also contains certain non-GAAP financial measures.

A reconciliation of such information to the most directly comparable GAAP financial measures along with other financial and statistical information for the periods to be presented on this conference call was included in the press release announcing our earnings which may be accessed from the Zimmer website at www.zimmer.com under the section entitled "Investor Relations".

In addition, we routinely post information on the Investor Relations section.

We intend to use this website as a means disclosing material, non-public information and for complying with our disclosure obligations under 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 November 11, 2010 and can also be accessed from the Investor Relations section of the Zimmer website.

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

Thank you, Paul and good morning, everyone.

We are a he glad you could join us for today's call.

This morning I'll review our third quarter 2010 results and provide some commentary on general market conditions.

Jim will then discuss additional financial details.

We delivered solid earnings and cash flow performance in the third quarter, notwithstanding challenging global economic conditions that negatively impacted procedure rates.

Our performance reflects a focus on disciplined spending and executing our strategic plan.

A core element of this plan involves new product introductions across our businesses.

These introductions will position us for an improved performance in the fourth quarter and accelerated growth beyond 2010 as the economy strengthens.

Net sales for the quarter were $965 million, a decrease of 0.5% on a constant currency basis and our earnings per share were $0.96 on an adjusted basis, an increase of 9.1% over the prior year period.

For the quarter, our Americas and Europe, Middle East and Africa segments experienced constant currency sales declines of 0.4% and 3.8% respectively, while the Asia Pacific region grew 4.2% constant currency.

Knee sales for the quarter decreased year over year 2.7% constant currency, reflecting negative volume and mix of 0.4% and negative price of 2.3%.

Important advances for Zimmer in knees included a broader roll out of our patient specific instruments and a limited roll out of our posterior referencing instruments.

Moving into the fourth quarter and to a greater extent throughout 2011, we expect to see accelerating growth with these knee instruments being deployed broadly.

A number of additional MRI centers have been certified to process our patient-specific instruments and we have had continued commercial success based on the unique and differentiating features and benefits of our system.

Meanwhile, early clinical feedback on our posterior referencing instruments has been very positive.

Recent national joint replacement registry data continues to demonstrate outstanding long-term clinical success of our NexGen and Natural Knee product families and we're confident that our enhanced instrumentation options will drive increased adoption globally.

Our hip business performed above market in the Americas in the quarter with sales improving year over year 2.7% on a constant currency basis.

Overall, our hip sales increased 0.5% constant currency, reflecting positive volume and mix of 2.7% and negative price of 2.2%.

We're encouraged at this volume and mix growth relative to market is verification of increasing momentum we're experiencing in the commercialization of our new hip products.

In particular, the Continuum Acetabular Cup System provides surgeons with the flexibility to select from alternative bearing surfaces to meet the diverse and unique needs of their total hip replacement patients.

The Continuum system has provided an important expansion to our hip portfolio.

As we described before, momentum from a new product introduction generally builds over the course of one or more operating periods as the implants, instruments and related training are deployed.

We are anticipate on track with our expectations for the staged roll out of the Continuum system.

The performance of our hip business in the quarter was also supported by continued strong sales of revision hip products, a category in which Zimmer has achieved overall leading market share.

We also saw growth in sales of our stem products, including the ML Taper with connective technology, which offers a modular adjustable neck system that enables surgeons to personalize fit intraoperatively for each patient.

Extremities products posted sales growth of 3.6% constant currency for the quarter, which compares to a high 20.5% growth rate from the third quarter of last year.

These results were again supported by sales of our shoulder products, featuring Trabecular Metal technology, including the TM reverse shoulder and TM glenoid.

Continuing its solid performance for the year in a market heavily impacted by general economic conditions, Zimmer dental sales increased 4.9% constant currency for the quarter.

Our dental business is generating broad-based sales momentum across implants, restorative components and regenerative products.

Trauma sales in the quarter were up over the prior year period by 0.5% constant currency.

We recently announced the 1,000th US implantation of our Cephalomedullary Nail, a key component of the Zimmer Natural Nail System.

Continued success in the commercialization of this new product bodes well for the rest of the Zimmer Natural Nail System, which features a wide range of lengths and diameters and an innovative anatomical design.

We also announced the first implantation of the NCB Periprosthetic Plating system, a first of its kind for addressing complex femoral fractures that can occur around a knee or hip implant.

While Zimmer spine reported an overall decrease of 7.4% constant currency in the quarter, European spine sales experienced strong growth of 21.1% constant currency.

In our spine business, we continue to drive operational changes and pursue an aggressive new product development pipeline.

In the third quarter, Zimmer surgical, formerly known as orthopedic surgical products, experienced a solid 8.2% constant currency growth.

We continue to see strong sales of our wound debridement devices and bone cement products.

I'll now touch briefly on some operational developments and other topics.

Operationally, we improved our sequential gross margin and cash flow to support corporate investments, including new product development initiatives designed to accelerate our growth.

While we increased spending on product development, our margins remain strong with operating margins improving 160 basis points in the third quarter, compared to the prior year.

Cash flow remains at a high level, a point on which Jim will provide more detail.

Consolidated pricing for the quarter was consistent with our expectations, decreasing slightly from the second quarter.

Consolidated average selling prices in the third quarter were down 1.4% compared to the prior year period.

We experienced negative pricing of 1.6% in the Americas, flat pricing in our Europe, Middle East and Africa region and negative pricing in the Asia Pacific region of 2.9%.

We continue to anticipate consolidated price erosion of between 1% and 2% for the year.

In the third quarter, the market experienced a slowdown in procedure volumes due to global economic conditions, unemployment and other factors.

High unemployment has resulted in expiring health insurance and Cobra subsidies in the US as well as enrollment and plans.

Demographic analysis suggest that these have had a particular impact on the non-Medicare potential patient base for joint procedures, those between 45 and 65 years of age.

The balance of the slowdown in the US is attributed to seasonality effects which include a combination of slower surgery schedules and patients delaying care until high deductibles are met.

Similarly, austerity measures are contributing to the overall slowed procedure volumes in Europe.

Now, long-term indicators still point towards sustained growth and we continue to believe that the knee and hip market should grow in the mid-single digits.

That outlook is based on anticipated growth in developed markets with aging populations, as well as higher penetration rates in emerging markets in which increasing numbers of patients are gaining access to health care.

Even with the economic pressures that we've seen over the last 18 to 24 months, health care providers and third-party payors recognize that these replacement procedures are cost effective.

They take costs out of the system as opposed to continuing to manage the chronic conditions to which patients would otherwise be exposed.

We remain committed to executing our strategic plan with a focus on disciplined financial performance.

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

Jim?

Thanks, David.

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

As David mentioned, our total revenues for the quarter were $965 million, a 0.5% constant currency decline compared to the third quarter last year.

Net currency impact for the quarter was slightly negative, decreasing revenues by an additional 0.5% or $5.2 million.

The unfavorable currency impact from our Euro denominated sales in the quarter was partially offset by a favorable currency impact from our Japanese yen and Australian dollar adjusted revenues.

Our adjusted gross profit margin was 77.3% for the quarter, the margin ratio was up 260 basis points compared to third quarter 2009, and increased 100 basis points compared with the second quarter 2010.

Improved management of our global up inventories has resulted in lower excess and obsolescence expense compared with the third quarter prior year.

Additionally, prior year results reflect certain charges for scrap, idle plant and cleanup activities following the 2009 fire in our Warsaw manufacturing plant.

Lastly the improvement in gross margin also reflects it's manufacturing network operating at higher levels of efficiency in 2010 compared with prior year.

As outlined in the second quarter call, we expect our gross margin ratio to be between 76% and 76.5% for the full year, assuming the foreign currency exchange rates remain near recent levels.

This includes a lower gross margin ratio in the fourth quarter due to less favorable hedge results.

R&D expense as a percentage of sales was at 6% and at $57.6 million for the quarter, is 10% higher on a total dollar basis when compared to the prior year.

This increase is in line with our strategy to focus more investment into new product development activities and clinical programs.

Selling, general and administrative expenses were $412 million in the third quarter, and at 42.7% of sales, our 40 basis points above prior year.

SG&A spending for the third quarter of 2010 in absolute dollar terms is slightly below the third quarter of the prior year.

Acquisition, integration, realignment and other, amounted to $5 million in the quarter.

These expenses include integration costs from our pending acquisition of Beijing Montagne and one time costs stemming from distributor acquisitions in our Europe, Middle East and Africa segment, realignment of our global IT infrastructure and other prior period acquisitions.

Adjusted operating profit in the quarter increased to $277 million, a 28.7% or adjusted operating profit to sales ratio is 160 basis points higher than the prior year third quarter due to improvements in gross margin that are partially offset by increased research and development expense.

Net interest expense for the quarter amounted to $14.2 million, compared to $4.2 million in the prior year quarter.

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

Adjusted net earnings were $192 million for the third quarter, an increase of 2.2% compared to the prior year.

Adjusted diluted earnings per share increased 9.1% to $0.96, on 199.7 million average outstanding diluted shares.

These adjusted earnings per share of inclusive of approximately $0.05 of share based compensation.

At $0.96, reported diluted earnings per share which include acquisition, realignment and other, increased 37% over the prior year third quarter reported EPS of $0.70.

Our adjusted effective tax rate for the quarter was 26.7%, we anticipate the 2010 full year tax rate will be approximately 27%.

During the quarter, we repurchased 4.2 million shares at a total purchase price of $225.6 million.

As of September 30, 2010, approximately $1.3 billion remained authorized under a $1.5 billion repurchase program, which expires at the end of 2013.

The Company had approximately 197 million shares of common stock outstanding as of September 30, 2010, down from 204 million as of December 31, 2009.

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 some time.

Our first priority is external development, when and if the right opportunities arise, technology products 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 effective way to exercise free cash flow to our shareholders.

Operating cash flow for the quarter amounted to $320 million, down 9% from $352 million in the third quarter of 2009.

Net inventories were $923 million at the end of the third quarter, $44 million less than third quarter prior year.

Adjusted inventory days on hand finished the quarter at 380 days, an increase of 27 days compared to the third quarter of 2009.

This increase in days on hand is largely driven by the sensitivity of the calculation of year-over-year improvements in cost of goods sold.

Our adjusted trade accounts receivable days sales outstanding finished the quarter at 67 days, an increase of four days over the third quarter of 2009.

Net receivables increased $14 million or 2% over prior year.

Depreciation and amortization expense for the third quarter amount to $84 million.

Free cash flow in the third quarter was $256 million, $47 million lower than the third quarter of 2009.

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

Capital expenditures for quarter totaled $64 million, including $50 million for instruments and $14 million for property, plant and equipment.

Cash outlays associated with investing opportunities in the quarter include $2.5 million for certain international distributor acquisitions.

I'd like to turn now to our guidance for 2010, in our earning release this morning we provided fourth quarter revenue and adjusted EPS guidance and updated our full year guidance.

Fourth quarter revenues are expected to increase between 0% and 2% on a constant currency basis as we continue to gain momentum with new products and instruments.

As a result, the Company now expects 2010 full year revenues to increase approximately 2% on a constant currency basis, which compares with prior guidance of between 3% and 5%.

Assuming foreign currency exchange rates remain near recent levels, the Company estimates the foreign currency translation will decrease revenues by approximately 1% in the fourth quarter, and increase revenues by 0.5% for the full year 2010.

Fourth quarter adjusted diluted earnings per share are projected to be in the range of $1.17 to $1.22.

As a result, adjusted diluted earnings per share are projected to be in the range of $4.24 to $4.29 for the full year 2010.

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

Thank you, Jim.

In summary, our third quarter performance reflected solid bottom line performance in a climate of macro economic pressures.

The outlook for the remainder of the year anticipates continued progress with recent product and instrumentation launches, supported by a full offering of medical, education and training programs.

Our organization retains a broad sense of optimism about the potential for our industry.

The long-term positive indicators for our sector are compelling.

In the face of heightened scrutiny about health care costs, our increasingly diversified portfolio of early and late stage intervention musculoskeletal products provide cost effective solutions for the patient and global healthcare systems we serve.

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

(Operator Instructions).

Your first question comes from the line of Derrick Sung with Sanford Bernstein.

Hi, good morning, thanks for taking the call.

Good morning.

I wanted to start by asking you a little bit about the European dynamic in hips and knees.

So it looks like Europe, perhaps, took another step down, maybe in the market as a whole, certainly for your sales this quarter after seeing a couple quarters of somewhat weak, but stable growth.

Was there anything -- two questions related to changed over this past quarter to result in that?

And then secondly, as you think about the budgets getting reset for 2011 and austerity measures being put in place, what in your mind is the risk of kind of another step down in procedure volumes or another step down in sort of health care spending pressure that would pressure procedure volumes coming from new budgets being put in place in 2011?

Derrick, we did see a slower market with respect to procedures in Europe.

For us, the pricing environment didn't change much from the second quarter to the third quarter.

So I think that some of the austerity measures and the macro economic conditions created an environment where there was a more profound element of seasonality to the business.

It's always a slow market in the third quarter within Europe due to the holiday schedules, but it was exacerbated by the economic conditions.

I would tell you with respect to looking forward in that market, I think that one of the limitations as to how aggressive people can push in managing these procedure rates down is a political one.

At some point the known success of these procedures among the patient base and the recognition by the payors with these national health care systems is that it's not a cost effective move to defer these procedures in any extended form and frankly, it becomes politically untenable at some point and I think that you have to bear that in mind as you look forward and anticipate what those markets would look like in the future.

Now, the majority of our business is in the five or six most developed markets and those slowdowns that we saw were more profound marketwise, it seems, in hips than in knees and we obviously have a significant market share in those European markets and so that impacted the quarter to an extent.

And then finally, if you're looking at our performance within Europe sequentially, you'll note that we picked up a billing day in Q2 and lost a billing day in Q3 and so that explains a bit of the sequential performance difference from Q2 to Q3 for us.

Okay.

Thank you.

And then just a follow-up on pricing.

So it looks like pricing in hips and knees decelerated further from, I believe you said it was last quarter in the 1.5% to 1.6% range, specifically in hips and knees to 2.2% to down 2.3% range this quarter.

Sounds like most of that came from the US if you're saying that Europe pricing held pretty steady.

Can you provide further color on that and kind of where you see that pricing trajectory going?

That pricing performance is consistent with what we expected to see coming into the year.

We anticipated a 1% to 2% element of price erosion in our business and that's exactly what we're seeing.

It is true that the price erosion in the US for the third quarter was a bit more significant than in the second quarter, but it's also the case that Japan, because that -- that price decline hasn't anniversaried out yet impacted our overall step down from 1.9% to 1.4% in the quarter.

I don't think that the dynamics, Derrick, have changed much in the US.

Those discussions are similar to what's taken place in the past quarters and I think you could anticipate that they're going to continue to be similar with respect to pricing discussions going forward.

Great.

Thank you very much.

You're welcome.

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

Good morning.

Thank you for taking the questions.

I wanted to touch on a couple areas.

And, David, I appreciate it's very hard to try and make sense of the market off of one difficult quarter for the Company, but you expressed your confidence in what you think is a sustainable mid-single digit growth market for hips and knees and I just wanted to maybe just get your view that within that, how do you view price and mix (inaudible) component in order to do mid-single digit revenue growth, what do you think volume growth would need to be?

Again, we still think that there's an opportunity with respect to mix and, Mike, that's just going to be dependent upon where we are within each product category on new product roll outs.

If you've anniversaried out of that mix benefit and you're not introducing something else within that category, you're probably going to see a bit of negative impact between price and mix at that particular point in time.

On the other hand, if you're ratcheting up a launch and it's a significant launch to provide you with mix opportunity, you could see some positive impact is between price and mix at that point in time.

So, I think it's just going to be dependent upon where you are in the product roll out cycle, but if you have a healthy flow within this marketplace and you're addressing unmet clinical needs, I still do think that you can -- you can see either a wash in those categories or some modest positive impact as between price and mix going forward.

If we start to think about 2011, I noted in your comments earlier that price had gotten a little bit worse in the quarter, I think across the Company, I think you guys said it was down 1.7% this quarter, how should we be thinking about it for 2011?

Well, we're not going to give 2011 guidance, but as far as the market goes, I think you have to look at price in a similar fashion to 2010 at this time.

You're going to have a similar environment, I would believe, in the United States.

I think that Europe may get a little bit more aggressive, on the other hand, Asia Pacific, you're going to anniversary out after the first quarter of the Japan adjustments that took place and those were significant for most of the competitors and certainly that's the case for us because of the size of that business relative to our overall Asia Pacific business.

So just -- last question.

Even with the kind of deterioration we saw from 2Q to 3Q in price in the Americas, and it looks like a little bit in Europe, too, that you think that 2011 pricing looks similar to 2010?

Yes.

I mean, I think that coming into the year we said minus 1% to 2% and that's right where we're tracking.

We're minus 1%, but that range, I think, is as good of one as I can give you at this particular point.

Okay, thank you.

Thanks, Mike.

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

Good morning.

Thanks for taking my questions.

Dave, if you kind of look from, January '09 through the first quarter of 2010, the combined markets, constant currency were probably a little less than 5% and based on what we saw in the United States in '09, ASPs were probably in positive territory, so it's kind of like a 4 point unit market or 3 point unit market in the US, I don't know, and I don't think anybody knows, but what -- and so going forward, we're modeling 4%, you say 5, who knows, but just to your comment on hips, and product mix, you guys have new products and, I think you said volume mix was 2.7%, but price was minus 2.2.

Should we -- is it just a safer assumption to assume net zero ASP going forward?

Net zero ASP, so a wash between price and mix?

Yes.

Yes.

I think that that's a reasonable assumption, but I think that you're going to have points in time where there's some head wind in that category, Bruce, and then some other opportunities to show some modest positives as between those two.

But I guess just at this instant in time, you do have new hips and hips should be -- this would be one of those times or is there something that makes that more complicated than meets the eye?

No, you're right and, again, you have to factor in where you are in the launch of those products.

So we're really just beginning to hit the traction point.

There's a lot of emphasis on the US market and so you saw some improvement in our performance relative to the market within the US on the hip side.

The penetration is continuing.

Within that particular market right now, you have to remember that there's a bit of head wind on the metal on metal mix and that's an element of that continuum set.

So but for that head wind, we'd be seeing a lot more mix benefit coming from Continuum, but that's the reality of the market that we're launching the product into.

And then just strategically let's say it's a -- could be anywhere from a 4% to 5% kind of steady state market but that -- there is probably a risk of deflationary pressures worsening on the net of price and mix.

What sort of things could Zimmer do strategically to kind of diversify away from this sector where you've got reasonable but not great volumes and some potential increase in deflationary pressure?

Well, I mean, take market share in the core business is first and foremost, but when you look at our existing portfolio as it sits today, Bruce, there are big opportunities for us in those smaller product categories.

So spine, dental, trauma, surgical products, we have less than 10% market share and instances less than 5% market share in each of those categories and if you look at what we're experiencing there oftentimes because of that market position, you don't have as much price pressure as you do in an instance where you have 30% or 40% market share and have had that market share historically.

So we're running this business and investing in these global businesses in a manner where we expect to outpace market growth, take market share and those are going to be big opportunities for us.

Furthermore, the continuum of care that we've been talking about, both earlier interventions and late interventions puts us in a position to move upstream in the treatment of these patients and intervene with biological solutions.

So Pyeloronic acid is a interesting one for us.

We have great set of relationships that we can push that kind of a product through our existing distribution channels and there are a lot of opportunities for us to broaden the business and expand our growth rates in those categories as well.

Thanks so much.

You're welcome, Bruce.

Your next question comes from the line of Bob Hopkins with Banc of America, Merrill Lynch.

Hi.

Thanks for taking the question.

Hello, Bob.

Hey, good morning.

So just on the pricing front again and the sequential down tick in hips and knees.

That's not all Japan sequentially, I would assume.

As specific as it relates to hips and knees; is that correct?

It's more than just the sequential down tick in Japan?

That's correct.

If you're talking about the step down from the second quarter to the third quarter, that would principally be the Americas.

Okay.

And so any further color on that dynamic away from what you've said already?

I think, Bob, when you look at what's happening with procedure volumes our sense is that the slowdown is really happening on the private pay side.

So that perhaps at a hospital level, the hospitals are looking at a somewhat unfavorable trend in payer mix and we know for a fact that if you go back to 2008, 2009, Medicare enrollment was already increasing at a faster rate than enrollment in a private health plan, so that's some of what has created this pressure and I think it's fair to say that that pressure has intensified somewhat.

But again, we continue to manage through that pressure and believe average selling prices across our franchises globally, as David said, will be down in the range that we guide to at the beginning of the year, 1% to 2%.

And then the one follow-up I have is on the knee franchise.

You guys have talked about Europe and the issues there, but in the US it looks like on the knee franchise you saw a deceleration.

I was wondering, do you think you're losing share in knees, are you losing some surgeons or just talk about the knee dynamic in the United States in Q3 versus what you saw in the first half of the year?

Yes, we -- we think that we need to improve on the execution front to be sure, Bob, because the performance that we saw come out of our business in the third quarter on the US side wasn't at market growth rates and so there's some loss of business there.

I think that we have the right plans in place and we're executing those plans and most importantly, those initiatives are around these instruments to augment our already existing excellent clinical performance with the NexGen of the Natural Knee systems, so that's a big opportunity for us, because those are instrument sets that are differentiated in the case of PSI and accommodating in the case of PRI of surgical philosophies that many competitive surgeons come to the table with.

So we have one of the best performing knee systems and now a set of instruments that's going to accommodate that particular surgeon customer, I think it's going to be a great growth opportunity for us.

But the third quarter marked the point where we introduced those PRI instruments only on a limited basis and again, it takes some time for those sets to get deployed, for surgeons to train, to trial and us to work through the sales process and we're optimistic that as these months progress, you're going to see an improved performance driven by that initiative as well as others.

Great.

Thank you very much.

You're welcome, Bob.

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

Yes, thank you.

Good morning, everyone.

Good morning.

I guess just a question about new products.

Maybe you could just quantify how much of your revenues came from new products in the quarter and just trying to think about just opportunity there and just trying to think about the outlook in terms of that being a catalyst for growth, so we are in a slower market environment.

I guess one could argue that new product launches are more important than ever.

So just trying to understand what sort of impact that may have had in the quarter and how you're thinking about that over the next 12 months.

Sure.

We've said historically that we look to -- with what we spend on R&D, we look to be in a range of 15% to 20% of revenue with new product revenues and we define that as products that have been released in the last 36 months.

I would tell you with respect to the hip franchise we're within that target range, but outside of that range when you look at the knee franchise.

And as you -- you think about what we have going on with knees with the launch of these new instruments that's where we're seeing the competitive pressure on knees.

There are competitive systems out there with new, more modern instruments and our response to that is the -- both the new PSI instruments as well as the posterior referencing instruments and as David indicated, we're still early into the launch of those instrument systems.

The fact that those are instruments will not really have -- necessarily have an impact on that metric, so we -- until we launch new devices within the knee franchise, we're not likely going to see much of an increase in new product revenues within the knee franchise.

What we're really looking for to drive performance there, again, is the launch of the new instrument systems.

Okay.

Great.

And then just one quick follow-up.

I guess, as you guys just think about deploying your free cash flow and thinking about opportunities there and for the conservative balance sheet, just any thoughts in terms of I guess the ability to take on additional leverage to buy back stock or do any acquisition opportunities?

So I guess what are your most current thoughts there?

Thank you.

Well, as I indicated in my prepared remarks, Adam, we will continue to deploy free cash, excess free cash flow in the way we have historically.

That is as a first priority we'll look for business development opportunities that, as I said, strategically align with our focus on musculoskeletal health.

We'll otherwise continue to return excess cash to shareholders through the share repurchase program.

As you know, we did issue $1 billion in notes, long-term notes in 2009.

So we have levered up to some degree and that's helped us in some respects be more aggressive in terms of returning cash to shareholders.

As we indicated we spent $225 million in the third quarter on share repurchases and as we've said before, we're going to continue to target somewhere in the order of returning a third to a half of our net income on an annual basis through that share repurchase program.

All right.

Thank you.

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

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

Jim, can you just talk a little bit about SG&A spending?

I think on last quarter's conference call you had guided us to a number somewhere in the 43.5% of sales range.

In David's opening remarks, he referenced tight cost containment measures.

I assume some of that had to do with the revenue trends you saw throughout the quarter.

Can you maybe just help us understand in the quarter how much of the SG&A relative to your guidance was natural leverage versus proactive measures that you took?

Yes.

So as you pointed out on our second quarter call we indicated that SG&A was expected to be approximately 42% for the full year.

At the time we had projected approximately 43.5% for the third quarter.

We clearly came in below that level and since our third quarter SG&A expenses came in lower than we had projected and historical trends tell us that seasonality should have a favorable impact on the ratio for the fourth quarter, we would now expect the full year SG&A to be lower than our prior guidance of 42%.

This is an area, David, that we continue to focus on.

We've acknowledge that at 42% our SG&A ratio is out of line with industry benchmarks and I would tell you as we develop our operating plans for 2011, that is something that will get a fair amount of attention.

We have opportunity here, we would acknowledge, to drive more leverage through the P&L by taking that SG&A ratio down and bringing it more in line with industry benchmarks.

Okay.

And then on the gross margin this quarter that you called out the drivers of the year-over-year improvement primarily being efficiencies and lower excess and obsolete inventory costs.

Did foreign currency gains contribute at all to the year-over-year improvement?

They did, net hedge gains in the third quarter account for approximately 40 basis points of our gross margin and I would tell you that assuming currency rates remain near recent levels, the effect of hedge gains and losses on gross margin in the fourth quarter, that will be lower.

So--.

Okay.

For the fourth quarter, we're projecting losses, for example, on the yen, Aussie dollar, Canadian dollar, and British pound hedge contracts that's given away the dollars traded against us currencies.

That will be partially offset by what we would predict at this point would be modest gains on euro hedge contracts.

But that does create a bit of a head wind going into the fourth quarter.

Okay.

And then lastly, for David, obviously you've been stepping up R&D in absolute dollars pretty consistently over the past two quarters.

Can you maybe just help me understand where that incremental R&D spending is being focused?

Is that on the core businesses, the hip and knee franchises or are you dedicating an increasing percentage to those noncore businesses and should we start to see the relative pace of new product introductions be more significant in your peripheral businesses rather than hips and knees?

Sure.

It's broad based across all the product categories.

I think that if you look at a longer term trend as to where we were, say, five -- five years ago or so, though, David, it is broader based.

There's been greater emphasis in the global businesses than there was that five-year time period previous and I think that you're going to start to see some of the benefits of those investments in the coming quarters.

Notably we've emphasized a great deal of investment in the trauma area and the Natural Nail line that is rolling out now, that we're seeing some good early clinical success with is an example of what we intend to do in those product categories.

Again, those are markets that are very attractive markets, the skill set that it takes to compete effectively in those markets are very transferable from the core recon business and in instances, the distribution channels overlap as well, so we can create a lot of value with growth in those global businesses and going back some time, we started to enhance our investment to drive that opportunity.

Great.

Thank you very much.

You're welcome.

Your next question comes from the line of Kristen Stewart with Deutsche Bank.

Thanks for taking my question.

I just wanted to go back to the pricing commentary about kind of Europe and as, I guess you're seeing obviously more pressure from the austerity measures from a procedure basis and I'm just wondering do you expect as some of the tenders come up to see greater pressure on price and maybe some alleviation on some of the procedure side?

That is potentially the case, Kristen.

I think that some of that depends on the jurisdiction and the structure and how centralized those systems are versus the more regional systems and so there are jurisdictions where their lever is more procedure level and others where their lever is more of a price level.

So we have a pretty significant market share in most of those developed jurisdictions across Europe and what we reported out as being essentially flat pricing in Europe is indicative of what we're seeing right now, but it could be the case that in some of those jurisdictions, price gets pushed a bit harder as they free up the procedure rates.

Are some of the tenders that you've gone through more recently suggesting that pricing could get worse going forward?

And--?

No.

I wouldn't say that.

Because I think that that tender business always had that character to it.

Those are typically not the highest margin opportunities, but they're volume opportunities and so they can make some economic sense on a couple of fronts.

For one thing, if you're absorbing overhead, the marginal profit can still be an acceptable one.

On another front, it could be that you'll want to participate in those tenders because that's an emerging market that's going to continue to grow, so getting in at this point in time is strategically consistent with your plans.

So either way, those are elements of the business that we want to be very engaged in and have been historically.

Okay.

And then you said Americas pricing was down 1.6%.

What was it last quarter again, I'm sorry, in Q2?

It was 1.1% in the second quarter.

Okay.

And then just as we think about that dynamic, I mean, as I've always kind of looked at things, you guys have locked up contracts with DPO, it's usually for an extended period of time.

So what really is explaining such a dramatic or what seems to be a dramatic down tick sequentially?

Are hospitals kind of breaking old contracts, are the net new contracts that you're signing just suggesting that price is materially down?

Can you help us just kind of understand why it's just down a significant degree on a sequential basis?

Kristen, I would tell you that -- and we've pointed this out on prior calls, that we no longer would rely on, broadly speaking the contracts that are in place at a given point in time.

We've seen a lot of churn over the past few years and it continues to be the case that many of our individual hospital pricing agreements are often getting renegotiated somewhere in the middle of their term or prior -- certainly prior to the end of the their term and that continues to be the case.

Okay.

So I guess, then, suffice it to say certainly as this continues, then pricing is likely to get worse, based upon kind of where we're heading certainly and the ability of hospitals to renegotiate in the middle of contracts would suggest that you guys have less of a bargaining position?

Is that fair to say?

Well, I would say just what we said before.

We continue to manage through the pressure.

It's been around.

It's been around for some time.

And we, I think -- our contract management people working together with our independent distributors in the US, our sales management teams outside the US have done a pretty effective job of managing the pressure, so that we're able to provide the kind of guidance that we provided coming into the year and we're seeing results that are right in line with where we told people they would be for the year.

Okay.

Thank you.

You're welcome.

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

Thanks for taking my question.

Sure.

Can you give us an update on the sales force at this stage in terms of turn over and also in terms of sentiment given that the market is going through this transition?

I would say that the sales force continues to be very engaged.

I don't think that there's been turnover that's been out of line with any historic averages, Joanne, either.

Then, there were some new products that you launched in the last 12 to 18 months in the hip Continuum and the MMC.

Could you please give us an update on how those products are tracking?

Thank you.

Sure.

And some of those new product launches are what's driving the continued engagement within the sales force obviously.

On the hip side, as you mentioned, the Continuum System as well as the MMC system were launches that were initiated at the very end of last year and so those launches are under way.

We're starting to see the productivity of those launches particularly on the Continuum side.

I will tell you that the MMC Cup is a less significant launch in light of what's happened in that metal on metal category.

I think that there's going to continue to be a market out there for the metal on metal, but it's going to be less significant and that was not a segment that we were heavily penetrated in prior to the market turning the way that it has.

So we didn't have much business in that category and I think that those that had a lot of business in that category are seeing the mix of that business turn probably likely more towards polyethylene solutions at this point in time.

But the Continuum System is a very encouraging launch for us.

You can see what it's allowed us to do in even a down market over the course of a slow summer within the US business and step up to above market growth rates.

So continue to be very encouraged and I think that there is more run way out in front of us on that launch.

Thank you.

You're welcome.

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

Mr.

Lewis, your line is open.

We'll take the next question, please.

Okay.

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

Good morning, everybody.

Good morning.

Let me start back on the procedure volume side.

Several companies this quarter have already given us some sense that the third quarter seasonally weak, of course, but the second half of the quarter was better than the first or they saw some signs of rebound in September and into October.

Can you give us any color about the directionality?

Do you just feel like things are sort of dead flat in a broad sense or are we trending a little better?

Any perspective will be welcome.

Thanks.

Sure.

There have been obviously a lot of questions to try to break these quarters apart and even anticipate the current quarter and obviously that's a place that we can't go just as others went.

I'm not familiar with people coming back and providing color along the lines of what you articulated, but I'm sure that you have heard something from people, Rick, to give you a basis for making that statement.

In our case, I would tell you that the procedural slowdown was relatively consistent through those summer months.

So I can't really look at the performance on a procedural basis and disaggregate the quarter in a way that can offer you any better understanding.

I think that what you see in our results was pretty consistent through the entire third quarter.

Okay.

And to be fair, just for your information, it was a bunch of smaller companies and some non-ortho companies just for your perspective.

Just a follow-up question.

Maybe some updated portfolio strategy thoughts and specifically as it relates to spine and maybe more broadly on the spine side, continue on where you are from here, and again, any updated thoughts on can you do it internally or are you going to look outside?

And maybe more broadly on the portfolio you're already diversified competitors seem to be getting more diversified, we're seeing an announcement from Stryker today.

Any broader, higher level thoughts about the portfolio longer term?

Thanks so much.

Sure, Rick.

We like our existing portfolio and our fundamental strategy won't change due to the experience that we had in the third quarter of this year.

We're going to continue to focus on executing our plan, again, within the recon space, we think that we have great opportunities and some of this can lead to informing our views as to what external development might look like, to move up and down that continuum of care as well as emerging markets.

And so you can see that we've announced an acquisition in China that is pending at this point in time and that is consistent with our growth strategy in the recon market.

So again, up and down the continuum of care on the recon side and emerging markets and then, beyond that, we have excellent opportunities in these other product categories and I think that as early as the fourth quarter, you're going to start seeing some progress be made in one or two of those other business units.

Coming back to your spine question, I think that that's one that is -- to win there, we're going to have to do well both on internal as well as external developments to ensure that we've got the right kind of a product pipeline.

So we've got a pretty significant commitment at this point in time on internal development and just recently we launched on a limited basis an excellent MIS system, the PathFinder System.

It was well received at [NAS].

We think that we're going to make good progress in that category and have an excellent overall portfolio of MIS solutions within the spine business, but to continue to make progress on that market, it's a big market, it's one that we think we can create a lot of value in for the shareholders and provide some great solutions for patients.

The success rates are much lower at this point in time, so there is a lot of room for innovation that can make a difference for patients in that category and we want to be one of the companies providing those solutions going forward.

Appreciate that.

Thanks.

Sure, Rick.

Your next question comes from the line of Charles Chon with Stifel Nicolaus.

Thank you very much.

When adjusting for the revenue contribution from the Abbott Spine acquisition last year, the fourth quarter actually faces a tougher year-over-year growth comp on a constant currency basis, which is what we saw in the third quarter and yet you expect revenues to be flat to up 2%, so was wondering, would you be willing to speak to the confidence that you have in the fourth quarter guidance?

Is there something that you saw in the exiting trends from the 3Q that lends to the visibility for the fourth quarter here?

Actually, the anniversary now that the Abbott Spine acquisition essentially is complete by the end of the third quarter.

So there isn't anything to factor in on that front.

We're confident in the guidance that we provide.

We know that people place a lot of value and are making investment decisions and so subject to all the front-end qualifiers with Safe Harbor statements, that's our guidance, it's well informed and those are the results that we expect to achieve.

Would you be willing to talk to, then, maybe what sort of trends you saw in the third quarter as you exited the quarter, just to give us a sense of what kind of velocity we saw from the underlying business?

Yes, Charles, that question was asked and answered already and we just didn't see much of a difference at different points in time during that third quarter.

It was a pretty consistently slow procedure rate that we had a view towards throughout the third quarter.

Right.

Maybe shifting the focus away from Europe and EMEA, outside of the US, could you talk to the market dynamics in some of the emerging regions, like the brick countries, what sort of growth rates and growth dynamics are we seeing in those territories and any chance we can wrestle some granularity on price and mix from those regions as well?

Well, I'll talk to you about the growth rates.

I mean, those are -- the brick nations all provide excellent opportunities for us and right now you're seeing growth rates that are double digits in those markets and it would stand to reason that that would be the case because they're very underpenetrated at this point in time.

If you look at the opportunity to bring these solutions to patients at some large, large population bases and very low penetration rates and so there's a lot of infrastructure oftentimes to be developed.

These are markets that are -- each one of them is different.

There are different product tierings and price points and service levels and so you really can't speak in general terms beyond you look at those population bases and the penetration rates that currently exist and start to do some math around that and you see big opportunities going forward.

So those are markets where, as a global leader, we want to have a significant level of participation going forward and think that we can drive a lot of growth and improve the quality of life for patients that live in those jurisdictions.

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

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

Hey, thanks for squeezing me in.

I did have one -- to understand what's happened in knees, I guess it's a question for David.

It sounds like either because of the -- because of your transition to instruments or maybe it's because of the push into hips which is moving a little slower and pricing that it seems like the knee business is kind of caught in a little bit of a transition tier.

Is that -- is that part of it in addition to all the market pressures that you're seeing, that everyone is seeing?

I'm just trying to reconcile the sequential slowing of your business relative to the sequential slowing of some of the other players in this space.

Were there just some transitional elements between new product launches, Jim, you mentioned upgrading instrument sets, are those sort of logistical issues holding back the business or making this a tougher transition for you?

I don't think that they're logistical, but the essence of the theory, I think, is a fair one.

The way you put it, Matt.

But these are execution matters that we intend to resolve.

It is not a limitation on a great product with great clinical results, so we don't have a challenge in that respect.

It is the case that within -- in the psyche of the sales force and the marketing organizations that if there is a hot new product, there is going to be a disproportionate amount of time and attention dedicated to that, but that's always a balance that we have to strike.

We look to improve our execution and we think we have a great opportunity to do that as we launch these new instruments.

These instrument launches, and you know this industry well, Matt, they just take time, whether it's an instrument or a product launch and so we literally started that process in Q3, so you're not going to see any benefit in Q3 and you're likely to see modest benefit from that kind of an initiative in Q4, but it's all the base work and planting the seeds that are going to put us in a better position to accelerate that growth as we exit this year and get into 2011.

On that note, in moving forward out of Q4 into 2011, as you work to get through these issues, I guess, what and when are the first couple of things that we're going to see that will tell us -- because I hear the conviction that you're going to fight your way back to market growth rates and mid-single growth rates.

When and what should we expect to see that will indicate that you're getting there?

Well, I think clearly improvement in our knee performance and beyond that, continued acceleration in some of the product categories where we've emphasized new product launches and I think we have great opportunities and so we ought to be talking about that in the Q4 call as it relates to hips and we ought to be talking about that in the Q4 call as it relates to trauma as well, Matt.

Is there -- and last just quick on that point of knees, I mean, what -- is there anything in the -- is there anything about the new patient matched technology that you're rolling out that's holding you back?

Is it -- are the instruments that you're rolling out critical to making that successful or is that an area where we might see some improvement this quarter?

We continue to ramp up and execute relatively well on the patient specific instruments.

I think that an opportunity that we have is to combine those two, Matt, where we take the patient specific instruments, we're getting good clinical feedback and continuing to refine those systems and expand them, but you get into connecting that offering with the posterior referencing instruments and now you've got something that's differentiated for competitive surgeons and yet a familiar surgical philosophy to that surgeon and I think that can be pretty powerful when you layer on top of that the best performing knee systems in the world.

But if I hear that, that's not -- that doesn't sound like it will come together in Q4, that will come together as you move through 2011, is that fair?

The offering exists at this point in time, so again, it's a matter of rolling those systems out and getting the attention of surgeons and trialing and converting business.

Okay.

Well, thanks.

I'll leave it at that.

Thanks again for fitting me in here.

Okay.

Thank you, Matt.

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 conference call on January 27, at 8.00 AM.

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

Ladies and gentlemen, this concludes today's call.

You may now disconnect and have a great day.