Zimmer Biomet Holdings Inc (ZBH) 2014 Q3 法說會逐字稿

Good morning.

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

Mr. Marshall, you may begin your call.

Thank you, Brittany.

And good morning, everyone.

Welcome to Zimmer's third-quarter 2014 earnings conference calm.

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

Before we start, I'd like to remind you that our discussions during this call will include 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 SEC filings 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, which is available on our website at investor.

Zimmer.com.

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

Thank you, Bob.

Good morning, everyone.

And welcome to our earnings call for the third quarter of 2014.

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

Jim will then provide additional financial details.

I'll state all sales in constant currency terms and all earnings results on an adjusted basis.

Zimmer drove solid top-line growth across several key product categories and geographies in the third quarter, notably accelerating US knee sales over a strong performance in the prior year.

Consolidated net sales for the quarter were $1.11 billion, an increase of 3.1%, and our earnings per share were $1.35, an increase of 8% over the prior year period.

In the third quarter, America's sales grew by 1% year over year, while Europe, Middle East and Africa increased by 5.7% and the Asia-Pacific region grew 6.9%.

These results reflect focused execution amid a stable global market for musculoskeletal solutions, with some modest acceleration in certain geographies.

With respect to pricing, we experienced price pressure of negative 2.2% in the third quarter.

Increased global market penetration of new products, positive long-term clinical validations of our legacy products in key international markets, and the natural cycle of contract renewals and renegotiations in the United States all contributed to a sequential improvement in negative price trends by 60 basis points.

And thanks to the ongoing success of our operational excellence initiatives in the quarter, we once again expanded operating margins and accelerated earnings growth.

We also made progress with integration planning for our pending combination with Biomet.

We continue to be excited about the compelling strategic and financial rational underlying this combination.

In addition to commercial and operational synergies, our combined entity will possess enhanced capabilities and resources for research and development, allowing us to more rapidly and efficiently bring a broad portfolio of musculoskeletal products, technologies and services to market.

We remain focused on integration planning efforts around the transaction, which we expect to close in the first quarter of 2015.

Turning now to our product categories.

Knee sales for the third quarter increased 6.3%, which we believe was an above-market performance, reflecting positive volume and mix of 9.2% and negative price of 2.9%.

Our Americas segment reported a sales increase of 5.7%, while Europe, Middle East and Africa grew by 9.8% and the Asia-Pacific region delivered 3.8% growth, compared to the prior year period.

Throughout the quarter our focused execution drove solid sales of our next-gen knee replacement system in European markets and supported the achievement of milestone sales for Persona, the personalized knee system, which has now surpassed the total of 100,000 implantations since its commercial introduction.

As we've communicated in previous quarters, the Persona system offers an unprecedented level of anatomic fidelity and next generation features, and is supported by Zimmer's intelligent instrumentation systems, including patient-specific instruments, the iASSIST personalized guidance system, and the eLIBRA dynamic knee balancing system.

We also continue to be excited about the steady growth of our joint preservation portfolio, including our single injection Gel-One Cross-Linked Hyaluronate treatment and the Zimmer knee creation, Subchondroplasty procedure.

Earlier this month, we strengthened this growing biologics portfolio of differentiated treatments for early joint disease through the acquisition of Cambridge, Massachusetts-based ETEX Holdings, Incorporated and its innovative line of solutions.

Zimmer's hip business recorded a sales increase of 2.7%, reflecting positive volume and mix of 5.2% and negative price of 2.5%.

These results include a 0.2% sales decrease in the Americas, a sales increase of 2.8% in Europe, Middle East and Africa, and an impressive 9.7% increase in the Asia-Pacific region.

We continue to position a comprehensive hip portfolio for long-term growth opportunities.

And in the quarter, we achieved above-market performances in several key overseas markets.

Global sales were led by premium solutions, such as our Continuum Acetabular System and BIOLOX delta ceramic head offerings.

We also delivered steady growth in the Americas with our M/L taper and TM primary stems, as well as the Avenir Muller hip stem in the European markets.

Our legacy hip portfolio continues to demonstrate excellent performance, as evidenced by an impressive level of clinical and scientific validation.

Zimmer continues to achieve favorable ratings by the United Kingdom's Orthopaedic Data Evaluation Panel, with 10 of our major hip brands having now attained a Class A 10-year rating.

Additionally, an ongoing extensive laboratory testing, Zimmer's Vivacit-E, vitamin E highly cross-linked polyethylene liners, have been evaluated for more than 90 million cycles of wear testing.

We believe this to be the first and only hip replacement technology to demonstrate long-term wear resistance, surpassing the number of walking steps a patient will typically take during their lifetime following total hip replacement surgery.

Turning to extremities.

Zimmer recorded a sales increase of 2.5% in the third quarter.

Competitive pressure continued to present a headwind for our shoulder business in the US, which somewhat offset our double-digit growth in the Europe, Middle East and Africa and Asia-Pacific regions.

We'll continue leveraging our differentiated shoulder portfolio, including the Trabecular metal reverse shoulder, and a patient-specific instrument shoulder system, an innovative surgical platform that further enhances our position in this rapidly growing segment of the shoulder arthoplasty market.

We'll also continue to drive sales contributions from more recently introduced products in our extremities portfolio, such as the Trabecular metal total ankle system and the Nexel Total Elbow, both of which feature advanced proprietary bearing technologies.

Zimmer dental sales decreased by 2% in the third quarter.

Our stabilizing performance in the Europe, Middle East and Africa region was offset by challenging year-over-year sales comparisons for our Asia-Pacific business and regenerative portfolio.

We expect that these headwinds in the quarter will normalize in future operating periods, and we'll continue to focus on leveraging our comprehensive dental portfolio for improved growth.

Zimmer trauma sales decreased 0.6% in the third quarter, with an impressive 9.4% sales increase in the Asia-Pacific region, offset by a 5.5% sales decrease in the Americas and a 0.7% decline in Europe, Middle East and Africa.

Although we face challenging prior-year comparisons in Europe, Middle East and Africa, we continue to achieve encouraging growth in the Asia-Pacific region on steady adoption of our core offerings, including rising sales of the Zimmer Natural Nail family.

And building on the recent launch of the Distal Radius Plating System in the United States, in the third quarter we introduced this versatile fracture system in certain European markets.

We intend to position our differentiated trauma offerings for improved growth in the future, as we continue expanding our footprint in major trauma centers around the globe.

Zimmer's spine delivered 6.4% sales growth over the prior year, which we believe is an above-market performance.

The growth of this global business continues to validate our efforts and focus on core fusion solutions, as we execute on an innovative and increasingly competitive spine portfolio.

Released in the second quarter of 2014, the Virage OCT Spinal Fixation System has already succeeded in expanding our footprint in posterior fixation surgeries, while supporting volume and mix growth for other Zimmer spine products used in the same procedures.

We've also been pleased with the ongoing commercialization of the Optio-C Anterior Cervical System, our next-generation modular surgical device which in the third quarter received an additional 510(k) clearance from the FDA for its allograft application.

Sales for Zimmer's surgical and other category decreased by 4.4% in the quarter.

We continue to face challenging sales comparisons in the US, stemming from the exceptional performance and capital sales of our differentiated Transposal Fluid Waste Management System in the prior year.

However, we drove noteworthy sales across a number of major product lines, including consumable and wound debridement products, as well as skin graft solutions.

We also continued to achieve healthy growth and capital sales of the ATS family of automated tourniquet systems, which feature advanced proprietary pressure sensing technology designed to achieve higher levels of safety, reliability and convenience.

We look forward to continuing to drive this differentiated portfolio for growth in future quarters.

With that, I'll now ask Jim to provide further details on the third quarter and our guidance.

Jim?

Thank you, David.

I will review our third quarter performance in more detail and then provide additional information related to our updated 2014 sales and earnings guidance.

Before I start, I'd like to note that our results reflect the same number of billing days in the quarter -- in the current year quarter as in the prior year.

Our total revenues for the third quarter were $1.106 billion, a 3.1% constant currency increase compared to the third quarter of 2013.

Net currency impact for the quarter decreased revenues by 0.2%, or $2 million.

The negative currency impact for the quarter related principally to our Japanese yen denominated revenues, partially offset by positive currency translation associated with our euro-based revenues.

Our adjusted gross profit margin was 73.4% for the quarter.

The margin ratio declined 10 basis points compared to the third quarter of 2013.

In the third quarter, we recognized approximately 80 basis points of charges related to the Medical Device Excise Tax.

This headwind, along with ongoing but more moderate price pressure, was effectively offset by manufacturing efficiencies, as well as modest incremental gains from our cash flow hedging program and reduced year-over-year excess and obsolescence charges.

The Company's R&D expense decreased 6.7%, or $3.3 million, to 4.2% of net sales when compared to the prior year.

The decrease in R&D expense continues to reflect focused efforts on our quality and operational excellence initiative and related dedication of resources.

Selling, general and administrative expenses were $443.5 million in the third quarter, and at 40.1% of sales were 70 basis points below the prior year.

The continuous improvement in this ratio reflects our ongoing commitment to administrative and operational efficiency.

Our global strategic sourcing initiative, as well as go-to-market and distribution optimization efforts continue to drive improved productivity and year-over-year savings in certain spend categories.

In the quarter, the Company reported pretax charges of $66.9 million in special items, $3.8 million in cost of products sold pertaining to global restructuring, quality and operational excellence initiatives and recent acquisitions, and $10.5 million of interest and upfront financing costs associated with the pending Biomet transaction.

Adjusted third-quarter 2014 figures in the earnings release exclude the impact of these charges.

Adjusted operating profit in the quarter amounted to $321.9 million, a 29.1% our adjusted operating profit to sales ratio was 100 basis points higher than the prior year third quarter.

The continued expansion of operating margin demonstrates the organization's commitment to create value through the achievement of operational efficiency goals along with the growth and capital allocation dimensions embedded within our value creation framework.

Net interest expense for the quarter amounted to $13.3 million, which was flat when compared to the prior year quarter.

Adjusted net earnings were $232.6 million for the third quarter, an increase of 7.8% compared to the prior year.

Adjusted diluted earnings per share increased 8% to $1.35 on 171.7 million average outstanding diluted shares.

These adjusted earnings per shares inclusive of approximately of $0.05 of share-based compensation, at $0.96 reported diluted earnings per share increased 6.7% from the prior year third-quarter reported EPS of $0.90.

Our adjusted effective tax rate for the quarter was 24.7%, which is 70 basis points favorable when compared to the prior year, due to a favorable change in estimate associated with certain income tax returns that were finalized in the quarter.

Our reported effective tax rate for the quarter was 27.3%, due mainly to certain nondeductible expenses connected with the pending Biomet merger.

The Company had approximately 169.3 million shares of common stock outstanding as of September 30, 2014, a decrease compared to the $170.5 million as of September 30, 2013.

Operating cash flow for the quarter amounted to $255.7 million, a decrease of 12.6% from $292.7 million in the third quarter of 2013.

The decrease was driven primarily by higher tax payments relative to the same period prior year as well as increased inventory investments in support of higher field consignments and global new product launches.

Net inventories were $1.2 billion at the end of the third quarter, an increase of $30.3 million from June 30, 2014.

As I've just noted, the increase is connected with the ongoing global commercialization of new product offerings, as well as the effects of placing more inventory into distributor and hospital consignments.

Adjusted inventory days on hand finished the quarter at 348 days at compared to 284 at the prior-year quarter end.

As of the end of the third quarter, net receivables increased to $947.6 million from $898.9 million in the third quarter of 2013, or 5% above prior year.

Our adjusted trade accounts receivable day sales outstanding finished the quarter at 71 days, 2 days improved when compared with the prior year.

Depreciation and amortization expense for the third quarter amounted to $90.9 million.

Free cash flow in the third quarter was $172.5 million, $33.5 million lower than the third quarter of 2013.

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

The decrease in free cash flow was driven by decreased operating cash flows, as I've just noted, as well as increased instrument investments in support of the ongoing launch of new products.

Capital expenditures for the quarter totaled $83.2 million, including $50.9 million for instruments and $32.3 million for property, plant and equipment.

I'd like to turn now to our guidance for 2014.

In our earnings release this morning we updated the Company's expectation for 2014 revenues, and now forecast revenues to increase approximately 2.25% constant currency, when compared to 2013.

We now expect foreign currency translation to decrease our reported 2014 revenues by approximately 0.75% for the full year.

Therefore, on a reported basis our revenues are projected to be approximately 1.5% above 2013 results.

As we anniversary through the recognition of the Medical Device Excise Tax during the fourth quarter, coupled with ongoing savings from our operational excellence programs, we would expect the gross margin ratio for the year to remain between 73% and 74%.

Our guidance for R&D, SG&A and interest expense for the full year also remains unchanged.

However, as you refine your models for the fourth quarter, please consider the seasonally lower expense ratios typically experienced in the fourth quarter.

Moving down the income statement, the estimated full year tax rate is now between 25% and 25.5%.

The previously guided fully diluted share count of 172 million to 173 million shares is more likely to be toward the lower end of that range, as [exercise of] in-play stock options are lower.

In the fourth quarter, we would expect fully diluted shares to be just above 172 million shares.

Full year 2014 adjusted diluted earnings per share guidance has been updated to approximately $6.05, taking into account our updated expectations for full year revenue growth.

As indicated in our earnings release, to arrive at our anticipated reported GAAP earnings per share, you should subtract total charges for special items and certain claims of $250 million and $70 million of Biomet transaction-related expenses on a pretax basis, or approximately $1.40 per share.

Before I finish, I would like to make a few modeling comments relating to our proposed combination with Biomet.

I want to reiterate that the previously announced guidance regarding accretion and adjusted cash earnings per share applies to the first 12 months following the closing of the deal.

With that in mind, we continue to expect accretion and adjusted cash earnings per share to be between $1.15 and $1.25 on approximately 207 million fully diluted shares.

To arrive at this fully diluted share count, add the 32.7 million shares comprising the equity portion of the consideration for the deal to our projected ending diluted share count of approximately 173 million shares, as well as an additional 1.3 million shares anticipated to be issued pursuant to our employee equity programs.

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

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

Thanks, Jim.

Zimmer's third quarter was highlighted by solid sales across key products and geographies.

Our performance continues to be driven by innovative systems, such as the Persona knee, which incorporates premium technologies that we leverage across our differentiated portfolio, including Trabecular metal technology and the Vivacit-E Advanced Bearing Material.

For the balance of 2014, we'll be committing significant energy to the ongoing integration planning for our pending combination with Biomet, while continuing to deliver a compelling value proposition to patients, providers and healthcare institutions in the $45 billion musculoskeletal market.

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

Thank you, sir.

(Operator Instructions)

Our first question comes from the line of Larry Biegelsen with Wells Fargo Securities.

Please go ahead.

Hi, guys.

It's actually Craig on for Larry.

Hello, Craig.

Just, I guess I'll start with the implied growth, by my math is about 2% in Q4.

And I just wanted to know, it seems like a bit of a slowdown, especially some of the -- given some of the acceleration you saw in recon, and then some of the seasonality trends that we expect.

So I just wanted to know what headwinds or what factors make that number seem conservative to us, at least?

I think you point out the seasonality trends, and I think that's the thing to focus on.

We wouldn't expect our performance to fall off relative to market in any of these categories.

The positive trends will continue by product category and by geography.

We look to continue to improve the sales execution in the Americas, in particular.

But as you reflect back on the fourth quarter of 2013, there was a pretty significant procedural shift into that quarter, and that really is the area that one has to be careful about as we look to project Q4 market growth rates within the United States on the large joint side in particular.

Okay.

Thanks.

And if I can, as a follow-up, just ask on pricing.

Obviously, you guys -- pricing improved during the quarter, and I appreciate the color on some of the timing of contracts.

But other competitors have seen pricing pressure increase during the quarter and throughout the year.

So I just wanted to get your sense of how we should look at that going forward.

Sure, Larry.

This is Jim.

Craig.

Craig, sorry.

(Inaudible).

First of all, we're really pleased with the sequential 60 basis point improvement in negative price in the quarter.

Continue to believe our commercial teams are doing a good job of managing the pressure.

David indicated there are a number of factors contributing to the (inaudible) that we saw and the trend.

As an example, as we establish higher market penetration with new products, including most importantly the Persona knee system, we tend to see more stability in prices, because these new platforms are being introduced with tighter price bands compared with our more established legacy products.

As you know, we're operating in a market environment that does not allow for the kind of variations we might have experienced in the past.

With regard to contract renewals, we have had to deal with our fair share of demand letters from our US-based hospital customers.

In our case, the total value of price concessions by quarter across all contract renewals has come down sequentially from one quarter to the next, beginning with the second quarter.

We may see an increase in demand letters in coming quarters.

We certainly expect price pressure's going to continue in this market, but still the positive trend in this quarter.

And one we believe is helped by increased market penetration of new products.

And then lastly, I would just point out that we saw improvement in all geographic segments in the quarter as compared with the second quarter.

And in this context, we believe the continued positive long-term clinical validation supporting our legacy products, which is demonstrated in registry data, is helping us in key international markets.

Great.

Thanks, guys.

You're welcome, Craig.

Thank you.

Our next question comes from the line of Bob Hopkins with Bank of America Merrill Lynch.

Please go ahead.

Thanks, and good morning.

Good morning.

So on the Biomet transaction, thanks for the details.

I just wanted to ask two things.

First sort of qualitatively, I was wondering, David, if you could comment on how the integration's going generally, or you how the early part of the integration's going generally.

Are you having good conversations with the distributors?

Just your confidence level.

And then maybe Jim more quantitatively, I appreciate your comments on the synergies and the share count, and frankly that's the kind of thing that I think a lot of people are modeling.

As I see it, the Street consensus for 2015 on a cash basis, assuming that Biomet closes in Q1 is in the high $7 area, $7.80, $7.85, somewhere in that range.

And I was just wondering if you could comment on, is that a number that you're -- or is that a range that you're relatively comfort with at this point, given what you're seeing in the business today?

I'll pick up with the first part of your question, Bob.

This is David.

We're very, very pleased with the integration planning as it relates to the combination.

I will tell you that the chemistry of the groups has been terrific.

The energy levels has been extremely high.

We've had opportunities, and part of this is enhanced by sort of the co-location benefit of the headquarters.

But I would tell you globally, leaders have set a very good tone, a very constructive tone of the integration planning work, and that's cascaded down as these teams have expanded to all levels of the organization.

I think that part of that is just a credit to the leadership, and the Biomet leaders in particular.

I want to applaud their efforts.

It's very commendable, the approach that they've taken.

I would tell you that the other element of it, that one can't fake at some level, is just the underpinnings and premises for the deal are unmistakable to folks as they get into the planning and look at the benefits of combining these portfolios, combining the R&D efforts, the strength of the combined distribution channels and on and on.

One can clearly see that this is going to be a leadership position that can make a big difference for all stakeholders involved.

And that is establishing the positive tone, in combination with the approach that the leaders are taking.

So we're right on track, if not ahead of the planning efforts relative to what we were anticipating or looking to achieve going back to the announcement date in April.

And on the distribution side in particular that you referenced, I think that's gone really well because at the sales level, they can see the benefits of the combined portfolios and they can understand the logic to the combined R&D efforts.

And what a difference that can make in the environment that we're going to be operated in, and the differentiated opportunity that we're going to have to provide better solutions to enhance patient outcomes and to do that in an increasingly cost efficient way for the customers and help shape how those solutions are delivered to the marketplace.

So all is on track, if not ahead of schedule.

And I would tell you that the tone and the attitudes are even more positive than what I had hoped for.

And Bob, this is Jim.

Understanding that we have not provided top- and bottom-line guidance for calendar year 2015, we'll do that at the closing of the deal for the combined enterprise.

Ahead of that, we would plan to continue to provide guidance on Zimmer on a standalone basis.

I will say that we understand there's a wide range of estimates that are out there for the combined enterprise, some of which may assume that the closing take place early in the first quarter, other that may assume the closing takes place later in the first quarter.

And that range will certainly tighten as we provide more specific guidance.

But I'm not at all uncomfortable.

I think by and large the analyst community has taken the $1.15 to $1.25 in accretion and cash earnings per share and built that into the assumptions that they're making at this stage.

Okay.

So there's nothing that you would point out that would be things that we would need to consider as we're kind of modeling in that sort of range?

You think we're missing any major pieces, it just comes down to the timing of the close.

And so I'm just trying to get a sense from you, are there things you think that we're not considering that we should be?

Again, the timing of the close is a pretty big assumption.

Whether or not you assume it's going to be at the beginning or the end of the first quarter.

We provided a bit more detail on average shares in my scripted comments.

That's not something we had done earlier, and are doing that in an effort to provide as much sort of detailed support as we can at this stage.

Okay.

Great.

I'll leave it at that.

Thanks very much.

You're welcome.

Thank you.

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

Please go ahead.

Thanks for taking the questions.

One, a couple, just one clarification and then one follow-up.

You talked a little about pricing in the quarter, and some of the trends that sort of affected this year so far.

And I think Craig mentioned some of the other commentary that we've heard throughout the year.

But I'd love to get your sense as to, is the stability that you're seeing with, I'm assuming Persona, some of your new products, and sort of the, I don't know, maturation of the hospital networks in the US and their cost control strategies that we've seen evolve over the last years, is that something that you expect to be converging downward from where the pricing pressure that you're seeing?

Or is this low 2% pricing pressure something you see as sustainable?

I know it's kind of a difficult thing to predict, but maybe just in terms of new activity, changes in the way hospitals are buying, is there anything that you're seeing that would indicate that this is not a sort of sustainable range over the long term?

And then I have one follow-up.

We would see the current trends as being stable, and nothing environmentally changing in a material way, Matt, that would cause us to at this point believe that the future, shorter, intermediate term will look materially different.

If you reflect back on the guidance that we came into the year in our January call, we said that we were expecting 2% to 3% negative price in the year, and Q1 was minus 2.3%, Q2 was minus 2.8%, Q3, minus 2.2%.

So very tight within that band.

And more importantly and substantially to your question, the activities that surround those dynamics are consistent with expectations.

So holding to that same band for the balance of this year, we'll give you some specific guidance and color as we get into next year and provide 2015 guidance.

But nothing that we see right now would cause us to believe that the environment is going to change dramatically.

That's great.

Thank you, David.

And a follow-up for Jim, if I could.

You mentioned a few, it sounded like a handful of sort of positives in the gross margin line.

But the margin was in fact down a touch year over year.

If you could just maybe help us understand how those factors kind of added up to a slight decline, and what we can expect kind of heading into the end of the year?

Sure.

Well, understand coming into the year we're facing into 80 basis points of headwind associated with the Medical Device Excise Tax.

So the positive things that I mentioned, the efficiencies we're getting out of our operational excellence initiatives, the slightly higher gains on hedge contracts, as well as lower excess and obsolescence charges in the quarter, third quarter this year compared to third quarter of last year, all helped to offset that 80 basis points of headwinds so that the gross margin ratio was only down 10 basis points compared to the prior year.

And then heading into the end of the year, any, say, seasonal expectations you can sketch out for us?

I would tell you, we've obviously taken -- we've increased our guidance with respect to the currency headwind for the fourth quarter.

That does typically result in a somewhat higher gross margin ratio as we realize gains on hedge contracts, on a lower top line, reported top line on our international revenues.

That, together with what we were just talking about in terms of more moderate price pressure, I would tell you sort of contribute to gross margin expectation for the fourth quarter that would put us toward the high end of the range of what we're guiding to for the full year.

Got it.

Thank you, Jim.

Thank you, David.

Welcome.

You're welcome, Matt.

Thank you.

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

Please go ahead.

Thank you.

Let me start with the 2% to -- sorry, the 2.25% revenue guidance for the year.

Maybe just give us your thoughts, and obviously you're not guiding yet, but if you think about the Company pro forma for Biomet.

Biomet grew just this last quarter organically if you adjust for their acquisition, slightly faster than that.

Can you just talk about how you think about revenue growth at this company pro forma?

And then I was hoping you could spend a little bit of time on the money you're setting aside to lock in distribution.

If you could tell us a little bit more about that, and how expensive it will be, that would be great.

Thanks.

Sure, Mike.

This is Jim.

I would just go back to the guidance we provided when we announced the deal, and expectation that in the short term the combined enterprise we would expect to grow with market.

Understanding there could very well be some disruption.

The sales channels are getting integrated, but just believe that we have significant opportunities with respect to cross-selling that can offset any revenue loss that we might experience as the sales channels are being integrated.

Now, as to what the market growth will be globally in 2015, we'll provide some color on that when we come out with 2015 guidance, somewhere in the range of low to mid single digits.

But we'll be more specific about that when we come out with that guidance in January.

And then on the money set aside, I think in the proxy, Jim or David, whoever wants to take this.

I think there was $87 million set aside for what I think it was classified as distributor and management retention.

Can you just talk about how extensive basically the pay-to-stay will be, and the agreements that you are coming to with some of the distributors?

What is the one-year agreements, two-year agreements?

If you could give us some visibility on that, that would be great.

Sure.

All that integration planning is ongoing at this point in time, Mike.

I think that the disclosure you're referencing are the plans that were put in place by Biomet.

And so that disclosure is specific, I guess, as anything that's out there publicly.

Those were programs that were designed, really pursuant to the negotiation process and the diligence process, and we were very supportive of.

But Biomet management and board's decision to put those programs in place.

I think that they continue to serve that entity well, from whatever we can see within the marketplace.

The balance of the costs of those integrations are just lumped up at this point in time, in the best estimates that we had at the time of the announcement, Mike, as to what the integration cost would be.

We just -- we've put that out there as just being a certain multiple of the anticipated net synergy benefits, but we'll be able to firm up those numbers as we lock down the plans.

And I'd be really confident that by the time the closing rolls around we're going to be able to give you really specific guidance as to what the all-in integration numbers are going to look like and the pace of retrieving the benefits of the synergies, et cetera.

Okay.

I would just say that as you guys get closer to it, if you could try and give the Street just some visibility into the types of agreements you're reaching with the distributors, and that would obviously help us gain some comfort in the synergy risk that everybody's talking about.

Yes, noted, Mike.

We'll do that consistent with the lockdown of those plans, okay?

Perfect.

Thank you, guys.

Great.

Thank you.

Thank you.

Our next question comes from the line of Matt Taylor with Barclays Capital.

Please go ahead.

Hi.

Thanks for taking the question.

I wanted to ask one just about the integration and the performance this quarter.

So I guess one of the trends in the quarter and recently, is some of those non-recon businesses that you have, have been growing more slowly.

The hip and knee businesses had a pretty good quarter this quarter.

But you referenced before you see a lot of cross-selling opportunities, and I guess can you talk about the differences that you see between combining the large recon business versus combining some of those other ones?

Do you expect more commercial synergies at those other businesses that may be sub-scale at Zimmer and Biomet?

That's a great question.

I would tell you that as you look at the portfolios, there are significant opportunities in all product categories, Matt.

I think that the complementary natures within large joints might from the outside world appear to be a bit more nuanced because both of these companies have fairly comprehensive portfolios to begin with.

But those nuances can make a big difference to the sales force as well.

And I tell you, some of the product fairs that we've had consistent with the diligence and integration planning have revealed opportunities that have the sales forces on both sides very excited within the large joint side.

It really takes on a bit of a different dimension when you get into the smaller businesses that you reference, however, because those businesses for each company have been challenged by scale historically.

And when you bring the product portfolios together, on day one you have some really significant enhancements where there are material gaps that get filled.

But then very, very importantly there are a kind of a couple other big benefits to the combination as it relates to those business that include the capability to have much more scale for R&D pipelines.

So the cadence of what's going to come out of the development effort is going to be much, much more regular for those smaller businesses.

We're going to be able to get to the point where we have scale, very competitive portfolios and then we're reinvesting in those portfolios and keeping the sales force engaged, excited, and getting out ahead rather than filling gaps, which is kind of the trap you end up stuck within if you're sub-scale.

So I think that dynamic changes in a very material way.

And then secondly, the thing I would point you to is just the capability to build out specialized sales forces at the rep level, for instance, in those different product categories which, again historically, because of the scale challenges has been difficult for either company to do fully.

But we really do see our way towards being able to build out specialized sales forces at the rep level wherever that makes sense, wherever that customer call point justifies that kind of an investment.

That's going to put us in a much stronger position, the combined product bag and the focused sales forces going forward.

Thanks.

And just a follow-up on price.

I think everybody assumes that pricing will stay down, or potentially get a little bit worse in the future.

Do you see any scenario where in large joint recon, for example, pricing could get better because of either new products and mix, or because pricing has been down for the last five years?

Well, I think that you could see some evidence of some anniversarying out of some of those trends that have created the pressure.

I just think it's premature to predict things going into positive territory.

I think that the stability message is the one that we would use, our refrain at this point in time.

The scenario that you put out there is a possibility at some point in the future.

Okay.

Thanks a lot.

You're welcome.

Thank you.

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

Please go ahead.

Good morning, and thank you for taking the question.

You had some really outsized growth rates in certain regions, if you could just comment on that.

In hips it was up almost 10% in the Asia-Pacific region, in knees, EMEA up almost 10% also.

What's going on there?

Those teams are really doing a great job, Joanne, with sales execution.

Largely the same portfolio, same competitors, the local dynamics can be a bit different.

I don't think that those should be characterized as being material.

Those sales teams are just doing an excellent job on the execution side.

That isn't the first quarter that we've seen that.

In Q2 you saw the same very strong knee performance coming out of Europe, Middle East and Africa, as well as the very strong hip performance coming out of Asia-Pacific.

So those cross-learnings are the types of things that we want to transfer back to other markets.

And I think the big positive that one should take away from that, and this is what we communicate internally to the teams, is you have the portfolio necessary to compete effectively.

But look, some of the trends that you saw within the United States market sequentially from Q2 to Q3 show some important improvement in these categories as well.

A pretty significant step-up in knees, for example, and slight improvement in hips.

So we're going to keep working forward and try to post some numbers on the board that look consistent with that high-end performance for Asia-Pacific on hips and the high-end performance for EMEA on knees.

And then in terms of a merger, could you remind us of when the deadlines are for various regulatory rulings?

And then if there's any way to give us some qualitative update on how those conversations are going, that would be appreciated.

Thank you.

Sure.

The timelines that we put out and updates publicly are what there is to say about that formally.

There's a bit more of a formalized chronology that's been put out between sort of now and the coming weeks and through the month of March even, in the case of the European filing.

The US process is ongoing, a little bit more of a rolling basis.

We're making good progress.

And the thing I would just say by way of general characterization is, that process is tracking absolutely consistently with the diligence that we did prior to announcing the deal and what we articulated at the time of the deal announcement back in April.

So everything's running on course.

And from a timing perspective, consistent with our expectations, leading us to just reiterate that we have the belief that we'll close the deal in the first quarter of 2015.

Thank you.

You're welcome.

Thank you.

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

Please go ahead.

Good morning, everybody.

Thank you for taking the questions.

I was hoping to start with the spine business because that was, if I look across the drivers of the acceleration this quarter, knees was certainly a call-out, but spine also was a very nice pick-up.

David, if I go back to your comments on the success you're having with Virage and the pull-through you're getting, could you maybe just put that in a little bit more context about where you are and sort of the full building out of your spine product portfolio?

And whether you're at a point that the product bag is competitive, and we can see this type of trajectory continue?

Sure, David.

First, let me just say we're thrilled to get a question this quarter on spine.

We're really proud of the team.

This is a team that's been together for several years.

They are the ones that developed a very intelligent strategy and approach to running that business, and importantly to what they were going to focus on by way of innovation.

Largely that team has been focused from a development effort on the core fusion market, and they've just been methodical and dogged in executing those plans, and at the same time strengthening the distribution channel.

So I believe that what you saw in Q3 is a shape of things to come by the spine division.

And we're probably in the mid-innings of building that portfolio out at this point, David.

You're seeing just the beginnings of the benefits of them executing that strategy with these products rolling out.

We have about a dozen product launches this year.

So a really robust pipeline that has been a combination of pure internal and some mix of external development through licensing and distribution arrangements.

But the primary drivers have been the internal projects that include projects like Virage.

And the benefit of those systems is obvious, right?

You strengthen the outer body and it shores up your capability to get the inner body device within those procedures.

And increasingly that team is positioning itself to become much, much more competitive in sort of the teaching institutions and academic centers because we're shoring up our deformity and complex and trauma offerings.

That will continue, and I would say that over the course of the next 12 to 24 months those programs will continue to produce very important launches that will completely round out that core fusion line.

So I think we're in a really good position to start posting consistently positive above-market growth numbers.

And I think it's just going to get stronger the next 12 to 24 months.

That's helpful.

And then maybe just a follow-up on sort of the broader macro.

At least the analysis that we've looked at on your core business would suggest that the volume growth that the industry and you have posted over the past couple years is probably below what you would think the normal demographic trends would support.

And I understand that there's some hesitancy to call out a broader turn in utilization, but as we look at the data points that have surfaced this quarter, whether it's your numbers, your key competitors, some of the hospitals, et cetera, the environment does look to be getting better.

So I was just hoping to get your perspective on what it would take to get you more constructive on a sustainable turn whereby we can start to see volume growth reflect more of the demographic nature of the categories you serve.

I think that you could certainly see that in what we articulated happened, and we were able to drive within the market on the knee side, for instance, David, within the quarter.

I think some of the hesitancy on that is, understandably from everyone's perspective, just the seasonality shift that may be going on primarily within the United States market, but even OUS where there are national healthcare systems that are either dialing up or down procedure rates because of austerity measures or disciplines in that regard, you get a little bit of lumpiness.

So that said, we've had really consistent and good performance in the OUS markets.

So I think that the underlying procedural demand for these solutions is just unmistakable.

And maybe a topic that hasn't come up in this call, but you can certainly see that in the emerging markets.

We continue to perform very, very well in the emerging markets, and those penetration rates are low.

Growing classes of folks that are going to be future patients within those markets, expanding infrastructure to deliver those solutions.

And so we're going to be a big part of providing those solutions to customers going forward in the important emerging markets.

I think that the dynamics are all positive.

And I just think it's a matter of stringing some quarters together from a market growth rate that allows people to become increasingly comfortable that the aging population, the fact that for late-stage osteoarthritic patients this is the only solution out there, and it works really well, and it's cost effective for the systems, All of that lines up well for the continued health within these markets that we serve.

Okay.

I appreciate all the perspective.

Thank you very much.

You're welcome.

Thank you.

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

Please go ahead.

Hi.

Thanks for taking the question.

Hi.

I was wondering if you guys could update us on just -- I guess it's a two part question, the FDA outstanding warning letters, where do we stand with that?

And then kind of as a parallel to that, the special items that you guys are reporting.

If I look back to the last couple years, it's steadily increased from $75 million to now you're expecting $250 million.

How much of those, I guess, special items are really going towards resolving some of the FDA warning letter issues?

And maybe just some more clarity on how should we think about that number going forward, since the trend is seemingly increased over the last couple years.

So I'll pick up on the first part of the question, Kristin.

This is David.

The reference to warning letters, pleural, is incorrect.

We have a pending warning letter out of the Ponce, Puerto Rico facility.

We're putting a lot of effort into addressing those concerns.

Any of the follow-up inspections that take place that result in Form 483 insepectional observations are the top priority for the Company as it relates to our quality and operational excellence efforts.

And we have a lot of focus and good work that's been done there.

We're communicating that progress to the FDA on a very regular basis.

And I'm quite optimistic that we're on a very positive track towards resolving any of those outstanding issues going forward.

I think importantly, beyond the reference to the warning letter, is just this is a core value for the Company.

It is the top priority to ensure that we have the right quality systems at the foundation of our business, and we've made tremendous progress in the last couple years in particular on that front.

And that really is going to be the enabler going forward for continued, not only quality, but operational excellence improvement that's going to support the financial returns, ultimately.

But it is germane to every aspect of our business.

And I think that we have the right level of focus and the right effort under way to not only resolve that, but set the Company up with the right kind of foundation for the future.

Kristen, this is Jim.

With respect to the actual spending that you pointed out, we coming into the year indicated that we anticipated spending around $250 million on quality and operational excellence initiatives, as well as some ongoing spend associated with certain of our innovate and improve initiatives.

Slightly more than half of that spend is connected with the quality and operational excellence efforts across all of our manufacturing sites.

So although, as David pointed out, the warning letter connected with the single facility, we're taking the approach to upgrade our quality systems, and across all dimensions of our quality systems, production and process controls, design controls, controls around design transfer, across all of our facilities.

So it's a very significant effort, a large project.

We've got a very capability leader who's a member of our operating committee who is overseeing the entire effort.

And expect that that spend will begin to taper off towards the end of 2015.

So it will carry over into 2015, but begin to taper off towards the end of 2015.

By taper off, does that -- I assume it doesn't go away.

So we should expect some continued costs, I guess, looking you out for the next couple years?

Is that fair or --

I think it's fair to say that it will be reduced significantly by the end of 2015, going into 2016.

Okay.

Thanks very much.

You're welcome.

Thank you.

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

Please go ahead.

Hi, thanks for taking my questions.

I think we're all trying to get kind of a sense of the industry landscape and what that will all look like post consolidation.

One of the perspectives that we haven't heard too much from is, what's the hospital customers are thinking and telling you about the impending consolidation.

And so I was just wondering if you could maybe share some color on your conversations with the hospitals and the hospital administrators, and what they would say about the impending merger that you're going to be undergoing?

I think that the conversations we've had in that regard have been positive at this point, Derrick.

We probably have had more conversations at the surgeon level, or I have been involved in more conversations at the surgeon level than necessarily the administrative level.

But here's the thing that the administration, and increasingly as time progresses the surgeons care a lot about, providing better solutions for the patients but finding a way to do that in an increasingly cost effective way.

And I'll tell you the message that resonates with the administration side deeply is, how can we develop deeper and deeper partnerships than we've had historically to bring those solutions about in increasingly cost effective way?

The broad musculoskeletal portfolio innovation within systems, but as well comprehensive solutions and integrated services is of high interest to the administrative leaders within those institutions.

And that's an area where I think we're going to be able to put a lot more effort and a lot more resources behind and look to collaboratively construct solution and service offerings that can achieve objectives on both those fronts: provide better patient solutions and do that in an increasingly cost effective.

It just makes sense when you think about some of the reforms that are taking place.

Pick a market around the world that -- here in the United States, the reforms that are being driven by the ACA with the delivery model changes, whether it's ACO or bundling, give these administrators much more of a reason to become in tune in advance of re-admission charges and complications coming back to impact their P&Ls.

I think that this is a good thing.

I think it's going to be a good thing for patients, because it's going to allow us to come forward in these more comprehensive partnerships to provide these solutions and to work towards a common goal of getting it right for that patient in the short, intermediate and long term.

Great.

Thanks.

That's helpful.

And as a follow-up, just wanted to put your views of the global market trajectory in the context of the accretion from the Biomet deal that you're guiding to.

So I guess Jim, how sensitive is that accretion guidance that you're providing to whether the global markets end up growing in the low single digits versus the mid single digits?

And maybe just any additional color you can provide to us on your global view of the markets would be helpful.

Thanks.

Sure.

We've said with the announcement, I pointed out earlier our expectation is the combined enterprise will be able to grow in line with markets in the short term.

And again, we'll give sort of more specific color on what we think that is in our fourth quarter call towards the end of January.

This is a market, although we'd acknowledge that this is a market that has grown as we've said in a range of low to mid single digits.

As you well know, this is a high-margin business.

There's certainly opportunity, as you're growing at the higher end of that range, for the accretion to be at the higher end of the range that we guided to.

But I would tell you that within that range we're very comfortable with the $1.15 to $1.25 accretion in adjusted cash earnings per share.

Because at the end of the day it's really a function of the acquired operating earnings offset by the interest cost on the financing and the dilution associated with the additional shares that are getting issued in connection with the transaction.

So as long as Biomet continues to perform the way that they have into the close, and the acquired operating earnings are somewhere in line with what we sort of expect them to be, as we put that model together and we have no reason to believe at this point that they won't be.

I think Derrick, I would tell you we continue to have a high degree of confidence around the guidance that we provided on accretion.

Okay.

Thanks, Jim.

That's helpful.

Brittany, we have time for one additional question.

Thank you, sir.

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

Please go ahead.

Good morning.

Maybe just two quick questions.

First, Jim, just a question on margins.

If you look at this quarter, there's been five consecutive quarters of EBIT margin improvement.

So I just wonder, what's the sustainability of that trend, and sort of your ability to complete your cost program as you head into Biomet?

And related to that margin question, I have a follow-up for Dave as well.

The gross margin has not been a source of upside here.

But given the pricing environment, is flat GM sort of the best we could hope for?

So those two questions on margins, and then a follow-up for David.

Sure.

We're going to continue to drive hard on the operational excellence initiatives.

There's still a lot of work to do, I would tell you David, a lot of opportunity in front of us.

And if nothing else, those programs, specifically those associated with manufacturing, have to offset the impact of any price erosion that we continue to experience on the top line.

And we have confidence that they will.

But believe that the opportunity could very well go beyond that to the point where, particularly as we see more stability in pricing trends, we could potentially see some expansion of the gross margin.

With respect to operating costs, some of what we're doing, some of what we had planned in the way of innovate and improve initiatives to drive towards the $400 million of savings by 2016 as a standalone enterprise, we will get incorporated into and added onto the synergy targets that the teams are driving across for the combined enterprise.

So we have, as we pointed out I think at the time of the announcement, I think good visibility to exactly where we'll be going into the close.

And good visibility into where those additional opportunities are and what we need to do to drive towards more efficiency in the administrative functions, as well as in the operating functions.

Okay.

And then David, just a quick question on FTC.

Over the last several years, the FTC and EU have become increasingly coordinated, but they obviously are independent entities.

You've been clear in this first quarter 2015 close, no change in timeline.

I think a lot of investors are sort of focused on what we're going to hear this year.

What's the likelihood we hear something from the FTC before we hear from the EU in the first quarter on any possible remediation?

Thank you.

I think that we're just -- the process, the way that it has worked from the point of initiation, just naturally sets up a circumstance where the US process is ahead of the EU process.

And so it's more likely that we'll progress to the point of clarification in the US than the European side of things, as far as the forecast between now and the balance of the year.

But obviously we'll keep people posted as we make progress.

Again, things are tracking very consistently with our original analyses, and nothing's changed in the many months that we either were evaluating this area of the deal or executing our plans to seek those clearances.

So we're very optimistic that we're going to land where we need to land, and get the deal closed in the first quarter of 2015.

Great.

Thank you very much.

You're welcome.

And with that, 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 fourth quarter conference call, which is scheduled for 8 AM on January 29, 2015.

I'll turn the call back to you, Brittany.

Thank you, sir.

And thank you again for participating in today's conference call.

You may now disconnect.