Zimmer Biomet Holdings Inc (ZBH) 2011 Q1 法說會逐字稿

Good morning.

I would like to turn the call over of to Bob Marshall, Vice President Investor Relations and Treasurer.

Mr.

Marshall, you may begin your call.

Good morning.

And welcome to Zimmer's first quarter 2011 earnings conference call.

I'm here with our President and CEO, David Dvorak, and our Executive Vice President and CFO, Jim Crines.

Before we start, I would like to remind you that statements made during this call that are not historical may be deemed forward-looking statements.

Actual results may differ materially from those indicated by forward-looking statements, due to a variety of risks and uncertainties.

Please refer to our filings with the Securities and Exchange Commission for a detailed discussion of these risks and uncertainties.

Also, the discussions during this call will include certain non-GAAP financial measures.

Reconciliations of these measures to the most directly comparable GAAP financial measures are included within the earnings release that was furnished in this morning's current report on Form 8-K.

This information is also available on our website www.zimmer.

com in the Investor Relations section under financial information reconciliations.

With that, I'll now turn the call over to David Dvorak.

David?

Thank you, Bob.

Good morning everyone and welcome to our earnings call for the first quarter of 2011.

This morning I'll review our first quarter financial results providing commentary on the year's progress to date and highlights from our performance.

Jim will then provide additional financial details.

As in previous quarters, I'll state all sales in constant currency terms, and I'll discuss all earnings results on an adjusted basis, except as otherwise noted.

Zimmer delivered solid sales results across all geographic segments and most businesses in the first quarter, resulting in improved margins and earnings.

At the same time, operational improvements enabled us to accelerate our innovation strategy with a 10% increase in research and development investments in the quarter.

Consolidated net sales for the quarter were $1.12 billion, an increase of 3.3%, and our earnings per share were $1.19, an increase of 16.7% over the prior year period.

Through the first quarter, we again experienced year-over-year sales growth in all of our geographic segments.

Americas grew 2.0%, Europe, Middle East and Africa delivered what we believe to be market-leading growth of 4.2%, and Asia Pacific again recorded impressive sales growth of 6.9%.

These results were delivered against the backdrop of an unprecedented tragedy in Japan, one of our major markets.

Zimmer is committed to supporting our colleagues and customers in Japan, who continue to demonstrate tremendous resolve in navigating the impact of the recent disasters.

Turning to the results of our product categories.

These sales for the first quarter decreased year-over-year 1.0%, reflecting positive volume and mix of 0.7%, and negative price of 1.7%.

Outside of the United States, our knee franchise delivered a stronger quarter compared with the prior-year period.

On a global basis, the Zimmer unit compartmental high flex knee and neck shin rotating hinge products generated solid unit sales growth in the quarter.

We also recently released several new products in knees to leverage proprietary Zimmer technologies, including a range of Trabecular metal augment shapes and cones which significantly strengthen our offerings in the knee revision category and the next gen LPS mobile system, that now features longevity, highly cross-linked polyethylene.

Looking forward through 2011, we expect sales of these new products, increasing utilization of PSI and PRI instrument sets to contribute to elevated growth in knees, supported by improved execution and easing comps in the second half of this year.

We again delivered above market growth in hips in the first quarter, with a sales increase of 4.7%, reflecting positive volume and mix of 6.7%, and negative price of 2.0%.

Once again, the strong performance of our hip business was supported by robust sales in the Americas, which delivered 5.0% growth and significant improvement in the Asia Pacific region, which generated sales growth of 10.2%.

We continue to benefit from improved mix in our hip business, supported by sales of recently launched innovative product lines, including the Continuum Acetabular Cup System.

The performance of the continuum system reinforces the value of products designed to provide customizable treatment solutions that enable surgeons to match their patient's lifestyle demands.

Our extremities business posted solid growth for the quarter with sales increasing by 10.7%.

The value of our proprietary technology is evident in the performance of this business, where sales of our Trabecular metal products continue to be noteworthy.

The Trabecular metal Reverse Shoulder System is now the number one selling product in the reverse shoulder category.

Zimmer's dental business continues to significantly outperform the market, with first quarter sales of 20.8%.

This impressive performance was broad-based, and represents organic growth of 13.2%, as well as the contribution of our restructured RTI distribution arrangement.

We are greatly encouraged by the continued strength of our dental business, which maintains a broad and growing portfolio.

In the first quarter, the newly released tapered screw vent implant system with [crestel] options delivered healthy sales in the United States, and we're excited to launch this product in other global markets in the second quarter.

We believe the overall dental market is showing signs of recovery after a challenging period.

Trauma achieved above market sales growth in all geographic segments in the quarter.

With sales increasing 13.5% over the prior year period.

Our performance was led by the Europe, Middle East and Africa segment with 19% growth for the quarter.

We continue to benefit from increased sales of the NTB Periprosthetic Plating System for complex fractures, as well as the Zimmer Natural Nail product family, which has now surpassed 10,000 implantations since it was introduced.

With an innovative and differentiated portfolio in trauma, and continued investments in our trauma sales force, we're confident that we'll sustain our performance in the trauma category.

Zimmer spine reported a sales decrease of 5.8% in the quarter.

Outside of the United States, Zimmer spine's business demonstrated sales progress.

But we continue to experience challenges in the US market, rela

ted to reimbursement and pricing.

However, we're committed to developing an increasingly competitive product portfolio in spine.

In the first quarter alone, we released two innovative offerings with a PathFinder NXT Percutaneous MIS Pedicle Screw System and TMS Trabecular medical cervical interbody fusion device.

Zimmer's surgical and other business category delivered above market sales growth of 7.3% over the prior year period.

Again, supported by strong sales of our Bone Cement, Wound Debridement and Tourniquet products.

With regard to our acquisitions of Beijing Montagne medical device Company in vie that and SoPlus surgical power equipment in Switzerland, the integration of both of these businesses is proceeding well.

In China, both Zimmer's legacy business and the Beijing Montagne franchise contributed significant growth in the first quarter.

Turning now to the broader musculoskeletal market, procedure volumes were stable relative to the fourth quarter, but remain below what we would consider to be normal growth.

As we review procedure trends in the US market, we recognize that the economic recession resulted in declining enrollment in private health plans among people under the age of 65.

As a consequence, a number of potential joint replacement patients have had to defer their treatment.

Due to the extension of COBRA benefits, it appears that these deferrals did not significantly impact trends at a macro level until the second half of 2010.

We don't believe that usage rates of total joints among the insured population have declined.

Rather, the size of the uninsured population increased as employment rates climbed.

I'm sorry, unemployment rates climbed.

Therefore, in effect, the total patient pool declined.

As we indicated in our prior call, we believe the growth rate of procedure volumes in the US will begin to recover in the second half of 2011, as we exit out of the cyclical downturn associated with increased unemployment levels.

With respect to pricing, we experienced price pressure of negative 0.9% in the first quarter, a stable trend from the previous quarter and in line with our expectations.

We maintain our pricing outlook of negative 1% to 2% for the full year, understanding we'll anniversary out of negative pricing in Japan coming out of the first quarter.

As we discussed on our last call and as the performance of several of our franchises demonstrates, the market continues to reward clinically relevant and innovative product development with premium pricing and reimbursement.

The above market growth delivered by several of Zimmer's key businesses in the first quarter demonstrates the positive impact of product innovation, supported by improved commercial execution.

Many of Zimmer's recently introduced products and instrumentation systems reflect two of the core drivers of our innovation strategy.

First, the development of customizeable implant and instrumentation systems that enable surgeons to deliver a personalized care experience to every patient, including options for all lifestyle demands.

And second, the provision of clinically relevant products that deliver long-term value to patients, hospitals, and healthcare systems.

As we drive growth in our reconstructive and emerging businesses, we also continue to explore opportunities to expand the Company's reach into early intervention products.

For example, this quarter our de novo NT natural tissue graft for cartilage repair enjoyed continued success, passing more than 2,000 cases to date.

Also in the quarter, our partner, Seikagaku Corporation, received FDA approval for gel one, a single injection, hyaluronic acid solution for pain relief that Zimmer plans to market in the United States.

By continuing to exercise disciplined financial management, the Company will generate incremental funds to advance our product development programs and other strategic priorities.

Over the last quarter, we made significant progress in our restructuring and transformation efforts with a completion of a management delayering initiative that will accelerate speed, improve operational rigor, and drive enhanced customer responsiveness.

Other ongoing initiatives include a consolidation of sourcing activities across all categories of spend and optimization efforts across our global manufacturing network.

This includes the Strategic Sourcing of manufactured components where we can achieve the highest quality, lowest cost and optimal aftertax returns.

All of these programs are designed to provide a source of funding for new innovation and clinical programs as well as to create value through enhanced operating leverage.

Beyond operational improvements, these programs also reflect our commitment to an even stronger performance-driven culture.

Pursuing the attainment of world class bench marks across the Company will accelerate growth and deliver increased value to shareholders through progressive, industry-leading operating margins and optimal deployment of capital.

I'll now ask Jim to provide further details on the first quarter and our guidance.

Jim?

Thanks, David.

I will review our first quarter performance in more detail and then provide additional information related to our 2011 guidance.

Our total revenues for the first quarter were $1.116 billion, a 3.3% constant currency increase compared with the first quarter of 2010.

Net currency impact for the quarter was positive.

Increasing revenues by an additional 1.7% or $17.4 million.

Favorable currency impact from our Japanese yen, Australian dollar, Swiss franc and Canadian dollar denominated revenues were partially offset by unfavorable currency impact from our Euro denominated revenues.

For the quarter, our adjusted gross profit margin was 75.4%.

The margin ratio improved 50 basis points compared to the first quarter of 2010.

The improvement in gross margin compared with prior year was a result of manufacturing efficiencies, which were partially offset by hedge losses and excess and obsolescence charges in the quarter.

The Company's R&D expense increased 10% on a reported basis when compared to the prior year.

Our R&D expense remains at the low end of our targeted range of 5% to 6%, despite this increase.

As David has discussed, product innovation is a key feature of our growth strategy and we anticipate that R&D expense will continue to grow as we expand product development and clinical programs.

Selling, general and administrative expenses were $458 million in the first quarter, which was an increase of 2.5% on a reported basis.

At 41.1% of sales, SG&A expenses were 100 basis points below prior year.

For the quarter, reduced spending in general and administrative functions and lower product liability expense were offset by volume related increases in selling and distribution costs, and higher medical training and education expenses.

Special items amounted to $26 million in the quarter.

These included cost and asset write-offs associated with our global restructuring and transformation initiatives.

The majority of the cost incurred in the quarter related to severance, retention, acceleration of share-based compensation, and other employee termination related costs.

Approximately 5% of our global workforce was impacted by our organizational change initiative.

Which involved a top-down delayering of management but did not affect our direct labor or direct sales forces.

The Company also continues to incur integration costs from our recently completed acquisitions of Beijing Montagne medical device Company.

SoPlus power equipment and third party distributors in our Europe, Middle East and Africa segment.

Adjusted operating profit in the quarter increased to $327 million, representing a profit to sales ratio of 29.3%.

This ratio is 130 basis points higher than the prior year first quarter, reflecting operational improvements in manufacturing and reduced general and administrative expenses.

Net interest expense for the quarter totaled $11 million compared to $14.6 million in the first quarter of 2010.

This change is primarily due to having swapped a portion of our fixed rate debt to floating rate.

Adjusted net earnings were $231 million for the first quarter, an increase of 11.4% compared to the prior year.

Adjusted diluted earnings per share increased 16.7%, to $1.19 on 193.8 million average outstanding diluted shares.

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

At $1.08, reported diluted earnings per share increased 6.9% from the prior year first quarter reported EPS of $1.01.

Our adjusted effective tax rate for the quarter was 26.9%, which is in line with our full year guidance and represents an increase of 10 basis points from the first quarter of 2010.

During the quarter, we repurchased 4.2 million shares at a total purchase price of $236 million.

This represents almost 50% of our intended repurchasing plan for 2011, demonstrating our commitment to returning value to our shareholders.

As of March 31, 2011, approximately $970 million remained authorized under a $1.5 million repurchase program which expires at the end of 2013.

The Company had approximately 192 million shares of common stock outstanding as of March 31, 2011, down from 203 million as of March 31, 2010.

Operating cash flow for the quarter amounted to $182 million, down 30% from $260 million in the first quarter of 2010.

The decrease in operating cash flow compared to the prior year was mainly due to a planned increase in accounts receivable of six days, as we discontinued factoring in certain European markets.

Net receivables increased to $876 million from $767 million in 2010, or 14% over the prior year period.

In addition, inventories increased slightly in the first quarter of 2011, adjusted inventory days on hand finished the quarter at 312 days, an increase of 5 days from year end 2010, and 10 days compared to the first quarter of 2010.

The increase in inventory from prior year end 2010 occurred in hips, dental, and surgical, all product categories that experienced above market growth in the first quarter.

Depreciation and amortization expense for the first quarter amounted to $86 million.

Free cash flow in the first quarter was $119 million, $90 million lower than the first quarter of 2010.

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

This change in free cash flow is principally a result of the increase in accounts receivable combined with a small increase in inventories.

Capital expenditures for the quarter totaled $63 million, including $46 million for instruments and $17 million for property, plant and equipment.

Cash outlays associated with investing activities during the quarter include $13 million for product distribution agreements, and certain international distributor acquisitions.

I'd like to turn now to our guidance for 2011.

In our earnings release this morning we announced that the Company is reaffirming its full year sales and adjusted EPS guidance.

We expect full year revenues to increase between 2% and 4% in constant currency when compared to 2010.

We expect our knee and hip revenues will continue to be affected by slower market growth through the second quarter.

We then look for market growth to improve in the second half against easing comps.

Our guidance contemplates up to a 10% decrease in Japan's full year net sales in 2011, relative to our previous expectations due to the recent natural disasters.

While it is difficult to predict the ongoing impact of these events, there may be temporary disruptions to elective hospital procedures caused by energy conservation measures.

In the year ended December 31, 2010, the Japan market represented a little less than 10% of our consolidated net sales.

Therefore, we estimate the negative impact to our net sales for the full year 2011 will be approximately 1% relative to our expectations before the natural disasters.

In contrast to this, we are now anticipating somewhat stronger global revenues in our hips, trauma, dental, and surgical and other product categories relative to our previous expectations.

Assuming currency rates remain at current levels, we anticipate foreign currency translation will increase our reported 2011 revenues by an estimated 3%.

Therefore, on a reported basis, our revenues are projected to be between 5% and 7% above 2010 results.

We still expect our gross margin ratio for the full year to be approximately 75%.

This takes into account approximately 90 basis points of anticipated losses on foreign currency hedges resulting from relative weakness in the US dollar.

In the second quarter, anticipated hedge losses when compared with hedge gains from the prior year second quarter are expected to reduce gross margins by 160 basis points.

Full year 2011 adjusted diluted earnings per share are projected to be in a range of $4.60 to $4.80.

To arrive at GAAP earnings per share you should subtract total charges for special items of $90 million to $100 million pretax or approximately $0.33 to $0.37 per share.

Finally, please note that our guidance does not include any impact from potential acquisitions or other unforeseen events.

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

Thank you, Jim.

Zimmer's first quarter performance demonstrated continued progress toward our goal of consistently achieving growth at or above market rates in all of our geographies and businesses.

We're committed to delivering value to our shareholders through disciplined execution of business transformation programs, to generate strong cash flow for investment in strategic growth drivers and leverage in the P&L.

The musculoskeletal care market remains an exciting space that presents expansive opportunities for growth, both in established and emerging markets.

We believe Zimmer is uniquely equipped to respond to the needs of all stakeholders in this market.

Combining the industry's most comprehensive and innovative product portfolio with robust clinical, health, economic and commercial capabilities.

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

(Operator Instructions).

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

Thank you.

Good morning, everyone.

Good morning.

I guess a couple things.

Everything looks very strong.

I guess now that all of the companies have reported, your numbers definitely look very strong on a relative basis.

So just as you think about market share gains and what may be going on there, just curious to get your thoughts.

And then just at the same time, just in terms of just overall market growth as you guys think about that in the back half of the year, just with the comps being slightly easy, just curious what your updated views are there.

Thank.

Sure, Adam.

We feel like we had a good quarter again, overall, and particularly strong with respect to our hips, trauma, dental, surgical categories, all of which we believe grew above market.

Good performances as welcoming out of the extremities division on a global basis, probably more in line with market and that category and closed the gap, importantly, on knees relative to market growth rates.

So I think that the work that we're doing there is showing some progress.

I think that the market saw a bit more of a step-down, particularly in the US side of the knee market.

But we did close the gap.

And so that's encouraging to us.

And then finally, more work to do on the US side of our spine business but we feel like we're taking some of the right steps to create a more robust product portfolio there and shore up our commercial execution as well.

So the trends are all very positive.

Coming into the year, we and many of you expected that the first half of the year comps were going to be more difficult than the second half of the year comps and I think that's exactly what we're seeing in the marketplace to date.

So we would be optimistic that the second half of the year with the easing comps would show some progress in the overall market as well.

Okay.

And would you think that the knees can grow in the second half of the year or is the thought process that it will be stable?

The knee market?

Yes.

Yes, we do believe that the knee market will--.

Okay.

-- will grow in the second half of the year.

I think what you're seeing in the US side is really a consequence of what I was describing earlier, where the uninsured population base that is getting access to these procedures has -- well, the uninsured population base that would like to get access to these procedures has grown because of the rising unemployment levels, and we start to anniversary out a bit of that on the market side I think as we enter the second half of the year.

So we would be optimistic that those comps would produce more favorable results across the market.

All right.

Thank you very much.

You're welcome.

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

Good morning.

Good morning.

Jim, quick question on guidance.

Just thinking about EPS guidance and the strength in the quarter and I appreciate the Japan issues which you're trying to estimate in the back half of the year but just considering the strength we're seeing in cost containment initiatives.

Is it safe to say you're now move comfortable with the upper half of the EPS guidance range for the year?

I think it's safe to say that we're very comfortable with the guidance that we've -- range that we've provided for the full year.

One of the things you have to keep in mind, it's not only the issue associated with Japan and the effect that's likely to have over the next three quarters, more pronounced than what we saw in the first quarter, just given the timing of those events, is the fact that we do have as we pointed out on our last call and highlighted as well on this call, we do have some headwind that we're dealing with on the gross margin line related to the currency hedging program.

Okay.

Very helpful.

And then David, in this call we heard a lot about Asia Pac, clearly accelerating across multiple product lines.

I wonder if you could help us understand, we obviously have the Japan impact.

Whether that is impact you really see in the market today, whether that's sort of the best estimate you can give in terms of what the market impact could be.

And then considering what -- maybe you could tell us what Beijing Montagne is actually doing for the Company.

But I'm just trying to understand given the significant acceleration you're continuing to see in that business, plus the acquisition, and with the Japan pressure, how do you see the growth rates in Asia Pac trending in the back half of the year, considering you're going to begin to anniversary some of the price cuts in Japan?

That's true.

Those price cuts anniversary out as we speak here this month and so that eliminates a headwind that we have been facing for some time.

We just believe that we're doing a good job in executing.

We had a good year last year in Asia Pacific as well.

So we're launching the right products in the right places and doing a nice job with those launches and those product launches make a difference.

So our medical training and education is really at full speed.

That really enhances your opportunity to effectively launch those products and we have a stable team of experienced people leading our efforts in Asia Pacific and I would tell you that the same thing I believe is occurring in Europe, Middle East and Africa.

We're seeing nice progress in those markets.

Some of the disruptive factors that we faced over the last several years are now being washed out and I think we're just -- we're gaining our momentum in the O-US markets in general.

Okay.

Thank you very much.

You're welcome.

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

Thank you.

Good morning.

Just a couple clarifications.

You called out the impact of your acquisition in China.

Did that have any material stocking benefit to the quarter?

No stocking benefit.

Those revenues are not all that significant in the context of the business either, Mike.

That was a business that was round numbers a $10 million business or so at the point of the acquisition.

Okay.

And then David, just want to maybe take a step back here, if we just rewound six months.

You had a soft third quarter.

You grew about 200 basis points below the recon market and here we are six months later.

The recon market is a little bit softer but you grew about 200 basis points better than the market and it would be kind of your first real standout quarter relative to the market in really quite a long time.

So I just want to get a little bit more perspective on the delta in the Company's performance over that six-month period of time and what you see as driving that.

A number of factors, Mike, and these are all areas that we've been very focused in our efforts on for some time and you're familiar with those efforts, I think to a great degree.

But we're launching the right products.

We're launching those products effectively.

We're regaining our momentum within the commercial side of our organization.

And we just have a lot of things that are coming together and heading in the right direction.

The key for us is to continue to develop momentum in these areas and to sustain that effort with new products and we believe that we're building out the right product pipeline to achieve just that.

And then just I'm going to push a little bit more on the guidance question.

So even with the outperformance this quarter, at least relative to Street expectations on the top and bottom line, the current guidance for the year is still the appropriate guidance range?

There's no reason to narrow that range today?

Mike, this is Jim.

As we indicated on our last call, described our expectations with respect to the overall market, talked about the softness across the overall market, we anticipated to see in the first half, we also indicated that our guidance for the full year was predicated on stable employment.

So just as we said on the last call, to the extent that we see the economy improvement, perhaps unemployment levels coming down, we would expect to see more robust growth in the second half and that could lead to better results relative to the range that we provided at this point.

To the extent that we see less disruption, what we have contemplated in Japan in elective procedures, that as well could lead to stronger results relative to the range that we provided at this point.

But we're one quarter into the year and we just feel it's appropriate to maintain that guidance in the range that we provided at this point.

Perfect.

Thank you, Jim.

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

Hi.

Thanks, can you hear me okay in.

We can, Bob.

Great.

Good morning.

First one for David and then for Jim.

First, on the knee market, especially in the US, now that everybody but Smith and [Effuse] reported we can see that the knee market stepped down in the first quarter.

Everyone's reporting negative growth, just about.

I was wondering, is there anything that you're seeing in the second half besides easier comps that would lead you to a conclusion that things will get better from here?

Are there any leading indicators, tangible evidence that you're seeing right now that would give you confidence that we're going to see an increase, or is it really just mostly easier comps?

I think let's talk a little bit more about the easing of the comps side of it.

If we go back to the root cause for what caused the dropoff in the second half of the year, we really do believe that it was the sub-65-year-old category of patients with expanding unemployment rates and those people dropping out of private insurance pools with declining enrollments that caused that decline, Bob, and so I think that COBRA probably -- the extension efforts masked some of that effect for some time but it really found traction in the second half of last year and so the comps aren't just the Company's weaker performances across the market, but I think that if you look at the population base, you're going to be growing off of albeit a reduced base in the second half of the year, and as Jim said, if the economy gets a bit healthier, if employment expands these opportunities and enrollment as a consequence expands, then it could be something more than just a positive comparison off of an easier comp.

But are you seeing anything in terms of backlogs increasing or anecdotal feedback from surgeons at this point that suggests we may see an uptick.

Our comments are not so much based on leading indicaters along those lines, Bob.

Thank you.

For Jim, two quick things.

One, on the SG&A front, when should we see the full benefit of the restructuring and did we see that full benefit in the first quarter?

And then secondly, from the perspective of dental, obviously you had a very good quarter.

Does that make it less likely that you would seek external options to increase critical mass at this point?

So with respect to the first question, we saw modest benefit from the restructuring and transformation initiatives.

As David indicated, one of the major initiatives, if you will, the delayering of the management was completed in the first quarter.

But largely completed towards the end of the first quarter, so again, modest benefit reflected in the numbers at this stage.

We're still projecting to realize in the order of $40 million to $50 million of savings in 2011, but again, we have -- as we've indicated, we do intend to reinvest some of those savings in product development and clinical programs and as we did in this quarter in medical education and training as well.

So there's more value to come, if you will, from -- as we get further down the road in completing the balance of those programs.

And it is the case as you pointed out with respect to the dental business that we're very pleased with obviously the performance of that business, feel we have a very strong management team in place.

We continue to provide support in terms of investment in the product development programs at our dental business, investment in license arrangements that have enabled that business as you know to gain ownership of the customer relationships with respect to the biologics offering within that franchise.

Other license arrangements that have enabled us to expand that portfolio and we do believe that we're well positioned with those kinds of investments to continue to create value with that business and don't feel that it's necessary, per se, not that we wouldn't be interested in opportunities to have an even bigger position within that market, because we like that market, but don't feel that it's necessary for us to get bigger through acquisitions to be able to create value.

Thanks so much.

As a reminder, analysts are allowed to ask one question and one follow-up question.

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

Hey, everyone.

Sorry.

I was on mute there.

I was hoping you could come back and talk a little bit about the pricing environment.

If I look across both hips and knees, it actually looks like things got a tad better from the fourth quarter.

I think in the fourth quarter on knees you had quoted a negative price of 2.3%, and the first quarter you said 1.7%.

And then on the hip side I think it was 2% in the fourth quarter and 2% in the first quarter as well.

Maybe just give us a little bit more perspective on what's happening on the pricing dynamic.

I think that was sort of a key theme that came out of AOS.

But it looks like things have just remained very status quo.

I think that's a fair way to characterize it, David.

I don't know that the variation from last quarter to this quarter really indicates any fundamental shift in some of the pressure that we've been experiencing and the effect that that's having and the way that it shows up in negative price of -- in the order of 1% to 2% across the various product franchises.

A bit more pronounced as you indicated, hips and knees.

We talked on the last call about this price compression, particularly within the US market.

We continue to see that as we expected to coming into the year and that is something that's going to carry on through the balance of 2011, at least within the US.

And then of course we've got an easing comp with respect to Asia Pacific and the fact that we anniversary out of the Japan price cuts going into the second quarter.

And maybe just a follow-up on Bob's last question regarding dental.

I mean, in general, if you look across your portfolio, clearly you are the number one player in reconstructive implants and that scale is having a benefit combined with some of the new products that you've launched.

If you look across some of our other businesses where you are relatively subscale from a market share perspective, while the growth rates this quarter were very strong, can you maybe talk about some of the initiatives you might undertake to increase your scale and also maybe comment on to what extent you think scale matters in some of those segments and maybe in light of also the announced transaction yesterday?

Sure.

I think that we've been consistent in describing our business development strategy for some time.

As far as the categories go, nothing's changed there.

The musculoskeletal market is the space that we operate in.

It's the place where we think we can create the most value for our shareholders and other stakeholders.

So this is where we're going to live and we think we're uniquely positioned to take advantage of the opportunities in all of these markets that we serve.

You're right to point out that scale matters.

I don't think that scale necessarily translates into meaning that you have to be number one or number two in those categories to create value for the shareholders and other stakeholders.

But you certainly have to have enough critical mass to where you can justify investing in product development, for example, and feel that you have the distribution channel to be able to create value through those investments.

And so those are places that we continue to emphasize in the growth of the smaller businesses.

Those emerging businesses are all in single digit market shares at this point in time.

But our position is that if we do the right things, we think that we can grow above market and take market share.

If we find external development opportunities that allow us to accelerate progress in those categories, we would pursue those.

But we wouldn't do it at the cost of an overly dilutive transaction and we wouldn't do it if we didn't think that we weren't going to create shareholder value in a reasonable time period.

So the hurdle rates are fairly rigorous and we're always analyzing what other opportunities that we have to redeploy that cash.

So it's going to be a consistent balance for us going forward of both internal and external development.

But we're not going to be so adamant about becoming the number one player in one of those subcategories that we would go off and do something that's adverse to the shareholders' interest.

And then Jim, just want to clarify, the second quarter gross margin you said that's down 160 basis points, that's on a year-over-year basis?

That's correct.

Okay.

Thank you.

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

Good morning.

You've clearly sort of presented a view on a reacceleration at least in growth rate in the US off of comps.

I was wondering if you could provide some color in your core reconstruction market as to how you see your European growth rates playing out in the back half of the year.

Do you expect to see a similar sort of reacceleration there?

And maybe just some color on how austerity and pricing is playing out there in Europe.

I would describe the European market as being one that at least in our view seems to be stabilizing.

I think that our own execution is accelerating and I think that we would expect to perform quite well relative to the market for the balance of this year.

We believe that we were leading the industry in growth from whatever numbers we can gain access to in the first quarter, and we're optimistic about that group's ability to perform for the balance of the year.

We have strong management, great products.

We're executing launches of new products quite nicely in that space and we know what areas we have further work to do, but many of the large markets are performing at a high level l at this point in time and I would tell you that I think that we just see a stabilization in that core market with respect to those austerity measures.

So whereas in the US some of the pressure would manifest itself in price, some of the pressure in the past in Europe did manifest itself in procedures.

But as we've said all along, we view in any of these markets the decline in those procedure rates to be deferments as opposed to people that are going to be able to just forego the procedures.

And I think that what you're starting to see in the stabilization in Europe is just that, that these patients don't go away.

That even with the austerity measures that it may have suppressed procedure rates in past periods, that ultimately those healthcare systems have to address the needs of the patients and so I would see a positive outlook within that market and certainly as it pertains to Zimmer in particular.

Great.

Thank you.

That's helpful.

And I guess maybe a question on spine, and I appreciate that you're a smaller player here but one of your competitors yesterday presented a view that they thought the spine market while sort of growing around 2% right now might eventually sort of re-establish itself t at kind of a mid single digit growth rate.

Would you share that view?

Kind of your views of the spine market moving forward?

I think that that's probably as good of a view as exists right now projecting forward within that market.

I think that there will continue to be some price pressure within the market, but it's a big market.

It will continue to be a very interesting market and I would say that our performance right now as it pertains to US as opposed to the O-US spine market is really more Zimmer-specific issues that we're well on our way towards addressing.

Great.

Thank you very much.

You're welcome.

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

Good morning, everybody.

Thank you.

Let me turn back to the hip market.

Perhaps you could give us a little more perspective on US hips.

The metal to metal part of the market's shrinking.

I'd be curious to know where you think it is and where it's going.

I assume that that's helpful for Zimmer as you roll out the new products.

But specifically on the new products, is this helping you increase share, volume, mix, at existing accounts or is it -- in the context of the metal on metal issues, helping you get back into accounts, older accounts, opening new accounts?

Thank you.

Sure, Rick.

I think that the US hip market was fairly consistent from what we can tell sequentially from Q4 to Q1 of this year.

The overall global market we think was quite consistent from Q4 to Q1.

So our step-up in performance is really, again, driven by the new products and the enhanced execution on the commercial side.

With respect to the metal on metal market, we were never a large player in that subset of the market and I think that the views of -- kind of the collective views of the analysts are accurate, that that was probably a market that was round numbers 25% of the market as measured by units and maybe 30% or so of the market is measured by dollars.

That has declined fairly dramatically.

If you had to peg a number now, I would say that the estimates of around 10% or 10% to 15% are probably directionally correct.

And I would tell you that as it pertains to Zimmer, we're sub-5% in penetration or as it represents a percentage of our sales on the hip side.

So it isn't a risk for us going forward and it is very much an opportunity for us, not only because we don't have that headwind in the performance of our hip business, but the solutions that we've been launching are very timely, very responsive to what surgeons and patients are seeking and that's why we're seeing the great uptick of the continuum cup, of our broad portfolio of stems, and we would anticipate that we're going to continue to make progress in that market.

So it's a combination of potentially getting some business back that may have been lost historically to other companies for metal on metal users, as well as penetrating new accounts.

And I will tell you as well, we're getting some mix benefit on the hip side, and that's consistent with our view that if one innovates in the right way within this space, in the current climate you can still get mix opportunities.

So it's a combination of all those drivers.

Thank you.

I want to follow up on the gross margin question and answer.

I think we all heard you talk about the 160 basis points of hedge loss.

But in this quarter manufacturing efficiencies helped, and you also had an obsolescence charge.

I don't know to -- the right way to ask for the second quarter.

But I assume those obsolescence charges won't be there and you'll get more manufacturing efficiencies.

We shouldn't take the 75.4, minus 160 basis points, I assume, Jim, and say 73.8 for the second quarter, I assume it's not that simple.

Yes, that's right, Rick.

And I think the question was asked earlier as to how to think about that 160 basis points.

It is relative to prior year second quarter.

So it's really off of the prior year second quarter that you would need to take that into account.

And I think you do , Rick, you are sort of touching on something that may not be as evident to people, and that is that we are experiencing stronger if you will operational efficiencies than we had anticipated coming into the year.

So what puts us at a position to hold the margin guidance at 75% in spite of having an additional 2 points of currency lift on the top line, which I think as people understand always results in us having more significant hedge losses in an environment where the dollar is weak.

Those operational efficiencies are what is allowing us to offset the additional hedge losses over the course of the year and still hold to the guidance of 75% for the full

Thank you very much.

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

Good morning.

Thanks for taking the question.

I just wanted to go back again I guess you touched a little on it yesterday's announcement, with (inaudible) and J&J and just kind of your thoughts more broadly on the longer term and the need you may have to bundle across metal and obviously your hip and knee business, but not having a substantial trauma or spine, how do you think that's going to affect you, both near and long-term.

I would imagine near term maybe some disruptions.

I don't know if you would agree with that view, but any comments there would be helpful.

Sure, Kristin.

These are strong competitors and great franchises on both sides that are involved in that transaction, so they will continue to be strong competitors if that deal is consummated and notwithstanding any disruption which always exists in the integrations of companies.

I think that there is always opportunity over the course of the disruptions during those integrations, but they'll emerge as strong competitors on both sides.

The point that we're focused on is ensuring that we can compete effectively in the marketplace, and we're doing the right things to ensure that we have very competitive offerings in these categories and I think that being strong in all the subsets of the musculoskeletal care market is going to be very important to us going forward.

But it's an area that we've been focused on and vigilant about over the course of the last many years and we're starting to see some of the benefits of that focus in our commitment, our trauma performance is a good example right now of what we intend to do.

So notwithstanding that transaction, we believe that we're going to be in a share gain position within those franchises and we're making all the important moves that we need to make and investments to ensure that that is the outcome.

And do you believe that just specifically within spine and trauma that you can build those distances to some sort of critical mass in some reasonable time frame to be competitive or do you anticipate the have to go out and look for external opportunities.

I believe it's going to be a combination of the two.

I think that the opportunities that we have in those two different franchises are a bit different and what it's going to take to exploit those opportunities is a bit different.

But pull it together and it's going to be a combination of both internal and external development.

And then just a quick clarification.

On dental, in the quarter, it was also driven by 10% price increases so looks like the unit growth wasn't quite as robust as the reported number would suggest.

Anything unusual about that 10%?

Does that just reflect -- I know you said there was some distributor buy-in, I'm not sure if that's inflating that price or if you really are getting 10% price in dental.

And just kind of more broadly on the distribution kind of buy-ins, is this something that we should continue to expect to see?

It seems like it's more internationally based at this point but any decision that you guys are making in terms of rethinking the structure of the US distribution network to go more direct?

With respect to the first question, it is driven by the -- the pricing on the dental side is enhanced by the RTI restructuring, and so we were describing that our performance, round numbers, is about 700 basis points or so improved by virtue of that restructuring that took place going into the fourth quarter of last year.

So that's what you're seeing there, Kristin.

And want to pick up on the second, Jim?

As far as the strategy with respect to the O-US markets, that is an area where we can invest more aggressively to establish critical mass within that franchise.

So we've done distributor acquisitions in the past to support that strategy and we'll continue to look for opportunities to do that going forward.

And just regarding the US more broadly, just kind of recon distribution network, independent distributors, any rethinking of that given kind of the changing market dynamics and--?

Those strategies we're currently executing to, Kristin, are O-US strategies.

Okay.

Thank you.

Your next question comes from the line of Mike Matson with Mizuho Securities.

Thanks for taking my question.

I guess just had a question on the gel one product.

First of all, how are you going to be selling that product?

Is it going to be sold through your hip and knee sales force?

And secondly, what's the potential opportunity for that product in terms of revenue and was any of that factored into your guidance for this year?

It will not affect our performance in any material way this year, just because of the timing of the launch.

But to answer your question generally we're going to be leveraging our existing distribution channel and relationships in the sale of that product.

It's a large market.

We estimate that the market is round numbers $700 million, and there are a couple of large competitors in particular, but this gel one product is one of only two single injection products that will be on the market and so we feel like through the channel and the relationships that we have, that this is a great fit and an opportunity that we're going to take advantage of going forward.

Okay.

And then just have a second question on a comment earlier in the call about strategic sourcing of manufacturing.

Does that imply that you're looking at potentially setting up or sourcing manufacturing from some lower cost regions?

I know most of your competitors have facilities in Asia, particularly in China.

You're probably the exception to that.

So just wondering if that's a sign that you're evaluating going into some lower cost regions.

We really are focused on leveraging our existing manufacturing footprint.

We have excellent people within these manufacturing operations, across the globe.

Obviously the largest one is located here in Warsaw and that will be our principal manufacturing facility for the foreseeable future.

So the efforts are really to optimize our existing operations.

With respect to the emerging markets, we could see production being leveraged out of the Montagne facilities and expanding, but that's likely to be production that would serve those same emerging markets as opposed to displacing any manufacturing on a domestic basis.

Okay.

And then just given that two of your competitors now have these dual mobility hips, is that a product category that Zimmer would consider entering, especially given the issues with the metal on metal hips?

We have a robust product pipeline in development, so we're always exploring opportunities to address unmet clinical needs and I won't respond to the direct question, but if we believe that there's a clinical benefit and a need within the marketplace, you can bet that it would be something that we would be exploring and potentially developing within our pipeline.

All right.

That's all I have.

Thank you.

You're welcome.

We have time for one more call.

Your final question comes from the line of Raj Denhoy with Jefferies.

Great.

Thanks.

Good morning, guys.

Good morning.

I know you talked a little bit about the Beijing Montagne acquisition.

I know it's still relatively small.

What are your thoughts around the opportunity there?

Where do you think that business can go for you over the course of this year and into next year?

It's an important market for us going forward.

But I wouldn't measure it in terms of what it can do for us in the next year or two.

I think these emerging markets strategies are going to be critical to the Company's success in the longer term.

So the growth percentages are likely to be high and to date we're doing a good job.

We have excellent leadership in that market and I think that the acquisition is going to be a very good fit for us.

But I wouldn't focus on material numbers coming out of those markets relative to the consolidated numbers that we produce as an overall business in that time frame, Raj.

Okay.

And then just lastly on the knee side, you and several other competitors, mostly everybody now except I think Stryker have these custom knee cutting guides.

Perhaps you could give us some indication of how that's tracking or what percentage of knees are now using those, what do you think the opportunity is longer term for those as well.

We think it's important technology, but I would tell you that the penetration rate at this point in time is relatively low.

It's growing at impressive rates and I suspect that that's the case across the market for those technologies.

But I would see that as being a first generation technology and I think that you're going to see enhancements within the marketplace to those types of technologies that can lead to more customized solutions for patients and ensure excellent implant placement and great wear as a consequence of that for these implants going forward.

So I think it's an area that you're going to see the market continue to focus on and we intend to be a leader within that space.

And are you able to get good ASP bump for those or are they just included with the knee implant or how do you realize some revenue from those?

We have been realizing revenue from those.

Okay.

Great.

Thank you.

Thanks, Raj.

Well, I'd like to thank everyone for joining the call today and for your continued interest and support for Zimmer.

We look forward to speaking to you on our second quarter conference call at 8.00 AM on July 27.

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

This concludes today's conference.

You may now disconnect.