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Zimmer Holdings Inc. (NYSE:ZMH)

Q4 2008 Earnings Call

January 29, 2009 8:00 am ET

Executives

Paul Blair - VP of IR

David Dvorak - President and CEO

Jim Crines - EVP of Finance and CFO

Analysts

Rick Wise - Leerink Swann

Jeff Johnson - Robert W. Baird & Co.

Bruce Nudell - UBS Equity Research

Michael Weinstein - JPMorgan Securities

David Toung - Argus Research Corporation

Bob Hopkins - Banc of America Securities

Tao Levy - Deutsche Bank Securities

Kristen Stewart - Credit Suisse

Doug Schenkel - Cowen and Company

Raj Denhoy - Thomas Weisel Partners

Ben Andrew - William Blair

David Roman - Morgan Stanley

Paul Blair

Good morning, I am Paul Blair, Vice President of Investor Relations for Zimmer. I would like to welcome you to the Zimmer Fourth Quarter 2008 Earnings Call. Joining me today to host this call are David Dvorak, President and Chief Executive Officer and Jim Crines, Executive Vice President of Finance and Chief Financial Officer.

This morning, we'll review our performance for the fourth quarter and full year of 2008, provide you with an update on certain key matters, present our outlook for 2009 and conclude our discussion with a question and answer session.

Before we get started I would like to point out, that this presentation contains forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, based on current expectations, estimates, forecasts, and projections about the orthopedics industry, management's beliefs, and assumptions made by management.

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

For a list and description of the risks and uncertainties, see the disclosure materials filed by Zimmer with the Securities and Exchange Commission. Zimmer disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

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

A rebroadcast of this call will be available from approximately two hours following the conclusion of today's call through the end of the day on February 12, 2009 and can also be accessed from the Investor Relations section of the Zimmer website.

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

David Dvorak

Thank you, Paul, and good morning everyone. It's a pleasure to be addressing you in this New Year to report on 2008 and to discuss our outlook for 2009. First I'll comment on our fourth quarter and full year 2008 results.

Consolidated sales for the fourth quarter of $1.030 billion were down 0.8% in constant currency from the prior year fourth quarter, and down 4% reported with a negative 3.2% foreign currency impact.

Adjusted diluted earnings per share for the fourth quarter were $1, a decrease of 15% compared with the prior year. Knee revenues were up slightly in the fourth quarter with a 1% constant currency increase.

Hip sales fell 3% in constant currency during the fourth quarter and our remaining business categories for the fourth quarter on a constant currency basis, Extremities was up 7% over the prior year period, Trauma was up 4%, Spine increased by 33% with the inclusion of Abbott Spine and Dental declined 10%.

Finally, our Orthopedic Surgical Products business was down 19% for the quarter, due to the continued impact of the previously announced voluntary suspension of production. The strength of the US dollar led to a negative currency translation effect of $35 million on sales in the quarter.

As we've discussed before, the top line impact of currency fluctuations is largely neutralized on the bottom line due to our hedging program. During the quarter we generated operating cash flow of $207 million.

For the full year of 2008, our net sales totaled more than $4 billion for the first time in the company's history, more than tripling our sales in 2001. Zimmer's first year as a public company.

At $4.1 billion, our 2008 net sales represented an increase of 6% over 2007, reflecting 3% constant currency growth over the prior year. Adjusted diluted earnings per share for the full year were $4.05, inclusive of one-time gains of $24 million after tax or $0.10 per share recorded during the second and third quarters.

In a year that could only be described as challenging, we recorded $924 million in adjusted net earnings and $550 million in free cash flow, evidencing the fundamental strength of our business.

We entered 2009 with confidence that we will reestablish positive momentum in our overall business and restore revenue growth as 2009 progresses. Our challenges in 2008 included the global implementation of our enhanced business model.

We made significant progress in the fourth quarter on a variety of the related issues impacting our business. The 2009 needs assessments have been completed and approved, key product development programs were solidified, and a large number of our outstanding payment obligations to consultants were brought up to date.

We have an improved royalty model in place and we're moving forward with development teams for new innovative products and technologies. We responded to our disruption in training and education events by developing a completely new model that we believe sets new standards for the industry. We resumed surgical skills training events as early as the second quarter of 2008, and are continuing to ramp up other training activities.

If you've been on our website since the consultant payments update was posted earlier this month, you'll see that we made a substantial number of surgeon and other consulting payments that had been delayed as a result of the DPA process.

In 2008, we also executed on our plan to establish third party mechanisms to oversee certain of Zimmer's educational and charitable contributions.

And we are currently developing a new process by which an internal committee of non-sales representatives will assess and act upon request for other forms of direct financial support and grants, including such things as medical education, unrestricted research and charitable activities.

We responded aggressively to the issues that we uncovered at orthopedic surgical products business and have now begun to return affected products to the market. We will be working hard to win back the OSP business that we had to forego for most of 2008.

The Durom Cup matter was clearly another challenging issue in 2008, but again, we did the right things. Our people responded appropriately, and we continued to offer this product together with a comprehensive set of training opportunities for users. We moved ahead with investments in infrastructure and instruments that we believe can be leveraged to drive improved service levels with greater efficiency.

We are now in a better position to be responsive to future demand growth in the field and provide the highest possible levels of customer service. These investments are for the most part complete.

Meanwhile, we didn't standstill in the business development area, concluding an acquisition of Abbott Spine that broadens our product line and adds greater breadth to our sales force reach.

Finally, we have added key management talent to our organization, including two seasoned healthcare executives to head our reconstructive and global businesses groups. In addition, over the past couple of years, we have installed new presidents in our trauma, spine, dental and OSP divisions.

For 2009, we are continuing to provide full year guidance rather than breaking out quarterly estimates. We think this full year approach better reflects how we run the business for long-term success, not near-term expediency.

We expect full year revenues for 2009 to increase between 1% and 3% on a constant currency basis, with revenues anticipated to be flat in the first half of the year and improving thereafter.

We are projecting full year adjusted diluted earnings per share to be in a range of $3.85 to $4, with negative growth expected in the first three quarters and positive growth projected for the fourth quarter.

Clearly, 2009 will be a pivotal year and our top priority is very clear. We must stabilize our core knee and hip franchises, which are the foundation of our overall business. New products are key to our business, and we are excited about our plans for 2009.

On the Knee side, we believe our introductions in 2007 and 2008 give us the most comprehensive portfolio in the industry. We seek to maximize our potential with what we believe are among the industry's strongest brands.

At the AAOS meeting in February, we will be introducing patient-specific instruments to complement these brands and we plan to begin marketing these systems in the second quarter of this year.

In Hips, we've clearly had some gaps, especially on the Acetabular side. We look forward to bringing new solutions to the market in the second half of the year to address these gaps and fully leverage our strong portfolio of stems.

We see opportunities in our other businesses as well, continued expansion of our Extremities portfolio, the restoration of our OSP product line to the market.

In Trauma, the new Nail System, you've heard us describe is expected to hit the market this year. And in Spine, we will continue to grow the Abbott Spine portfolio, along with our existing product line through our new, combined distribution network.

Regarding our enhanced compliance program, we expect there will be additional refinements along the way, but Zimmer's guiding principles are clear. The major disruptions are behind us and we are moving forward.

With the recent adoption of the AdvaMed code of ethics on interactions with healthcare professionals, many of our practices will now be included in the code of conduct for the medical device industry, and we consider that a recognition that we've been on the right path all along.

Finally, I want to underscore emphasis on quality initiatives. In 2009, we will continue with company-wide implementation of quality system improvements. Over the past several years, we've greatly enhanced our quality programs, expanded our quality assurance staff, and are now applying these uniformly high standards across our businesses.

So in 2009, you should expect a return to positive momentum from Zimmer. We relish the opportunity to focus our full attention and energy on realizing our market opportunities, and we are encouraged by what 2009 will bring.

We want to thank the customers, who supported us in dealing with our recent challenges. We look forward to working with them to drive new solutions that address patient issues in our growing markets.

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

Jim Crines

Thanks, David. I will review our performance in the quarter and for 2008 in more detail, and then provide some additional information related to our guidance.

Sales of $1.03 billion for the quarter reflect a decrease of 0.8% constant currency and 4% reported. These results reflect greater than anticipated headwind from foreign currency as well as lower reconstructive sales relative to expectations.

The US dollar continued to strengthen during the quarter and as a consequence foreign currency translations decreased revenue by 3.2% or $35 million in the quarter. Consolidated pricing was down 0.8 percentage points for the quarter, in the Americas price was flat for the quarter, while Europe and Asia-Pacific results include negative price of minus 1% and minus 3.5% respectively.

Turning to our fourth quarter revenue growth by major product category: worldwide reconstructive sales decreased 1.4% in constant currency and 5.1% reported. Knee sales in the fourth quarter grew a modest 0.8% constant currency, reflecting slower unit growth across all geographic segments combined with lower pricing on a global basis. Knee pricing on a global basis was down 1.5 percentage points in the quarter, principally as a result of the lower reimbursement prices now in effect in Japan and Australia.

Flex Knees accounted for 52% of our Knee unit sales on a global basis in the fourth quarter, maintaining penetration levels above 50%. As we discussed during the third quarter call, we have lost market share in Knees as a result of various factors including the implementation of our enhanced global compliance program.

Looking back at the final market results for the third quarter we estimate that our Knee results reflect the loss of approximately half a point of market share in the third quarter. Our fourth quarter results continue to lag market and as such reflect additional share loss which we estimate one point in the quarter. This brings our total estimated loss in global Knee market share to 1.5 points.

As David indicated in his remarks, significant progress was made in the fourth quarter towards enhancing our competitiveness including, for example the fact that the '09 Knees assessments have been completed and key product development initiatives have progressed.

These and other initiatives we have underway are essential to stabilizing our share position in the global Knee market. Countering the effect of customer losses, our natural Knee sales increased over 15% in the quarter on a dollar basis following a recent introduction of the gender solutions femoral component for that system.

Also with the launch of our new mobile bearing knee and the new segmental knee, unit sales for these products increased 22% and 6% respectively over the third quarter. In the fourth quarter Knee sales in constant currency increased 1.2% in the Americas, 1.2% in Europe, and declined 1.9% in Asia-Pacific respectively. The Asia-Pacific results reflect the 5.8% reduction in average selling prices.

Hip sales declined 3.2% in the quarter, reflecting current product gaps and the impact of training disruption, as well as customer losses which all together contribute to the shortfall in Hip revenues relative to market.

Again, looking back, we estimate the third quarter share loss in Hips at 1.5 points and with our fourth quarter results continuing to lag the market we estimate additional share loss in the fourth quarter of approximately 0.5 point, bringing our total share loss in the global Hip market to 2 points.

As we consider the actions necessary to enhance our competitiveness in Hips, among everything's we look to the anticipated launch of Acetabular Hip products in 2009 to fully capitalize on the Hip Stem products that have been launched during the past 12 to 18 months. These Hip Stem products were primary contributors during the fourth quarter and much of 2008 and include M/L Taper with Kinectiv technology, our [Avner] for the European market and recently released Fitmore bone conserving stem.

On a geographic basis and in constant currency, fourth quarter Hip sales decreased 3.6% in the Americas, 1.9% in Europe, and 5.7% in Asia-Pacific. The latter of which includes negative pricing of 4.1%.

Extremity sales for the quarter in constant currency increased 6.8% on a challenging comp with 30% in the fourth quarter of 2007. Dental sales on a constant currency basis decreased 10.1% for the quarter on a challenging prior year comp of 24%.

Disruption in training and education, turnover in our dental sales force, competition from low priced suppliers and turmoil in the global economy continue to impact on dental revenues. I believe these disruptive factors are temporal and we are taking steps to reposition this business for future growth.

Trauma sales in the quarter were up over the prior year period 4.1% constant currency. On a constant currency basis trauma sales in the quarter decreased 0.6% in the Americas, increased 12.3% in Asia-Pacific, and increased 8.3% in Europe.

Zimmer Spine reported 32.5% constant currency growth in the quarter. This growth is driven by the Abbott Spine acquisition, which was completed during the quarter and contributed $22 million of incremental Spine sales in the quarter.

Finally, Orthopedic Surgical Products and other sales declined 19.3% constant currency in the quarter as a result of the previously announced voluntary suspension in sales of certain patient care products, partially offset by bone, cement, and accessories sales which grew over prior year.

Remediation efforts at our Dover facility continue to progress and as we said in the third quarter we look forward to stocking shelves and putting the OSP products back in the sales bag.

I'll focus now on the rest of the income statements. Our adjusted gross profit margin of 76.8% for the quarter is up 40 basis points from the prior year fourth quarter. Foreign currency hedge gains accounted for the improvement in gross margin with idle plant cost and excess and obsolete inventory charges partially offsetting the gains.

Compared to last year's fourth quarter, R&D expense as a percentage of sales decreased to 4.6%, and at $47 million for the quarter, 6.9% below prior year. The decrease is a result of reduced surgeon collaboration activities in the areas of external research, product development, medical education and clinical affairs.

As we are planning to invest in surgeon training and education, and in new development programs in 2009, our R&D expense as a percentage of revenue is expected to return to historical levels of 5% to 6%.

Selling, general and administrative expenses increased to $436 million in the fourth quarter, and are up 8.6% over prior year. At 42.3% of sales, SG&A expenses are 490 basis points above the prior year, inclusive of the significant one-time fees and expenses associated with compliance, with the resolution agreements and the implementation of our enhanced business model.

Acquisition, integration and other amounted to $43.1 million in the quarter, comprised of costs pertaining to the Abbott Spine and prior period acquisitions including an in-process research and development charge, facility consolidation costs, legal fees and retention and termination payments.

During the quarter, based on the volume of claims submitted to-date, we also revised our estimates for anticipated claims pertaining to the Durom Cup. This resulted in an increase in our provision for these claims from $47.5 million to $69 million and a charge to pre-tax earnings in the quarter of $21.5 million. This provision is classified as a non-recurring item and is, therefore, excluded from our non-GAAP earnings measure.

Adjusted operating profit in the quarter decreased 16.3% to $308.1 million. At 29.9%, adjusted operating profit sales ratio decreased by 440 basis points from prior year as a result of lower revenues and the significant step-up in SG&A costs.

Interest expense for the quarter amounted to $4.2 million, principally resulting from financing the Abbott Spine acquisition. Adjusted net earnings decreased 18.6% compared to prior year. At $224.6 million, an adjusted diluted earnings per share decreased 15.3% to $1 on 224.2 million average outstanding diluted shares.

These adjusted earnings per share are inclusive of approximately $0.06 of share-based compensation. At $0.75, reported diluted earnings per share includes certain one-time cost connected with the Abbott Spine acquisition, as well as the additional provision for Durom claims, and as such, decreased 33% from prior year fourth quarter reported EPS of $1.12.

At 26.1% adjusted for the quarter, our effective tax rate reflects a favorable year-to-date adjustments to bring the effective tax rate for the year to 26.9%. This is below our first half estimates and 60 basis points below our full year 2007 ETR, due to favorable geographic mix of earnings and profits.

During the quarter, we repurchased 1.2 million shares at a total purchase price of $48.1 million, or an average price per share of $40.47. We used cash to acquire the shares under a $1.25 billion repurchase authorization, which expires at the end of 2009.

Cash outlays for the Abbott Spine business and surgeon payments reduced the amount of cash available for share repurchases during the quarter.

For the year, we repurchased 10.7 million shares for $737 million, approximately 1.13 billion remains authorized under our current repurchase program. The company had approximately 223 million shares of common stock outstanding as of December 31, 2008, down from 225 million as of September 30, 2008.

Operating cash flow for the quarter amounted to $206.9 million, down from $421.9 million in the fourth quarter of 2007. In the quarter, we resolved a large number of our outstanding payments to healthcare professionals and institutions, resulting in substantial cash outflows compared to prior-year.

We made substantial payments to third-party service providers for work completed in connection with the global rollout of our enhanced compliance program. We settled the large number of product liability claims and we invested in the build-out of inventory pipeline for certain new products we are preparing to launch in 2009.

Inventory days on hand finished the quarter at 344 days. Our trade accounts receivable days sales outstanding finished the quarter at 59 days. Depreciation and amortization expense for the quarter amounted to $79.1 million.

Capital expenditures for the quarter totaled $112 million, including $51 million for instruments and $61 million for property, plant and equipment. Cash outlays associated with investing activities during the quarter also include $363 million for the Abbott Spine acquisition and $109 million for the acquisition of intellectual property rights, in place of future royalty payments under certain of our legacy license agreement. Finally, free cash flow was $94.7 million for the quarter.

I'd like to turn now to our guidance for 2009. In our press release this morning, we announced that the company expects full year revenues to increase from 1% to 3% in constant currency, when compared to 2008, with revenues anticipated to be flat during the first half of the year and improving thereafter.

At this time, assuming currency rates remain at year-end 2008 levels, we anticipate foreign currency translation will reduce our reported 2009 revenues by an estimated 4%. Therefore, on a reported basis, our revenues are projected to be in a range of minus 3% to negative 1%, compared with 2008.

And with currency translation effect expected to be more pronounced in the first half, revenues on a reported basis are likely to be below this range during the first half of the year.

With respect to certain of the underlying assumptions we are well aware that various independent research reports projecting a moderate temporary slowdown in elective hospital procedures including Knee and Hip arthroplasty procedures. We think it's important not to overemphasize this impact our core, Knee and Hip franchises remain more insulated than most from the swings in a broader economy.

Moreover, the need for these procedures does not vanish even if the timing is affected. For planning purposes, however, we have assumed in an estimated step down in global market growth of Knee and Hip procedures 200 basis points. With this assumed step down in procedure growth, we anticipate constant currency dollar growth of 6% for the global Knee and Hip markets, compared with recent trends of 8% to 9%.

We assume pricing across the broader market will be flat. Zimmer's Knee revenues are expected to be slightly negative in constant currency for the full year, while our Hip revenues given the more significant product challenges we will face at least in the first half of the year are projected to decline to mid single-digits in constant currency for 2009.

Relative to the fourth quarter of 2008, our full year 2009 forecast for Hip and Knee revenues implies a further estimated loss in market share of up to half a point in each of these franchises. The share loss is expected to stabilize by year end 2009 as we anniversary out of the majority of the 2008 customer and product related losses and as we launch new products in sufficient quantity such that we can begin to recover some of the product related losses in 2009.

Among our other product franchises, extremities and trauma are expected to be in line with market. Dental revenues given the weak economy combined with company specific operational challenges are expected to underperform relative to market.

And finally, Spine revenues on a pro forma basis, assuming Abbott Spine as they combine with Zimmer Spine for the full year 2008 are projected to be below market as a consequence of anticipated sales to synergies associated with the ongoing integration of the two businesses.

Adjusted earnings are expected to show negative growth in the first three quarters with positive growth in the fourth quarter. 2009 full year adjusted diluted earnings per share for 2009 are projected to be in a range of $3.85 to $4.

Assuming currency rates remain at year end 2008 levels, we expect our gross margin ratio to improve as compared with 2008, principally as a consequence of the anticipated recognition of gains on hedge contracts in 2009, contrasted with the hedge losses recorded in 2008.

Although the ratio is expected to improve, year-over-year comparisons of gross profit dollars are expected to be unfavorable in the first half, and improve thereafter. Our operating expenses will be impacted by a number of factors which in the aggregate are expected to result in a modest net increase in total expense over 2008.

As we exit 2008, we expect to realize significant savings in third party fees related to compliance with the resolution agreements and the implementation of our enhanced business model. For 2009, however, we intend to offset those savings with a significant increase in spending in areas that suffered major disruption in 2008, including product development and medical education.

Our plan also reflects the dilution related to the Abbott Spine acquisition, which in part is captured in higher operating expenses. We also continue to step up our level of spending on quality systems to achieve our continuous improvement objectives in the areas of design and process control as well as ongoing product surveillance.

The interest expense and other line of our P&L is expected to be unfavorable year-over-year as we take on the cost of financing the Abbott Spine acquisition and a portion of our 2008 share repurchases, contrasted with the significant capital gains reported in 2008. This of course will be most pronounced in the third quarter.

We anticipate a tax rate of around 27.5%, above our final rate for 2008 due to a higher mix of earnings and profits from higher tax jurisdictions in 2009. We anticipate the diluted weighted average shares outstanding for 2009 to be between 216 million and 217 million shares. This assumes available free cash flow will be deployed principally to repurchase shares in 2009.

To arrive at our GAAP earnings per share you should subtract projected acquisition integration and other costs of approximately $45 million pre-tax, and inventory step up amortization of $13 million pre-tax, or approximately $0.17 per share.

Turning to cash flow, we anticipate total capital expenditures in the range of $390 million to $410 million, instrument capital in 2009 is expected to be in a range of $160 million to $170 million. Traditional PP&E is expected to be in a range of $230 million to $240 million, reflecting the cash outlays necessary to complete capital expansions initiated in 2008, as well as new product related investments and normal replacements of older machinery and equipment for 2009.

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

David Dvorak

Thanks, Jim. We believe we acted in the best interest of all key stakeholders in addressing the challenges we faced in 2008. We intend to continue to focus on providing meaningful innovation, effective products and return on our investments.

We've described for you our approach to 2009. In the short-term, we'll prioritize those activities that will restore momentum in our core business and drive growth in our global businesses. We're confident that long-term success will follow. We're bullish about our industry, one that will continue to grow, not just because of demographics, but because we help enable physicians to improve the quality of life for their patients.

Now, I'd like to open the call to your questions.

Question-and-Answer Session

Operator

We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Rick Wise of Leerink Swann.

Rick Wise - Leerink Swann

Good morning, everybody. A couple of questions, can you talk a little bit more about the Knee weakness, surprisingly if it does. First, were you surprised? Second, do you think that the new Hips will turn things around? So, one, do you expect to see that turnaround starting early in the year or is this a process that's going to take the full year?

David Dvorak

I think on the Knee side of things, obviously there has been a combination of factors that have contributed to the performance declining in the second half of 2008. The most significant of those really have been the training and education slowdown. As we said, we got some of the surgical institute events back up and running at the end of the second quarter, but that pace continues to accelerate and the full offering of medical education events is now being implemented. So we'll see improvement on that front.

We have some other offerings that I discussed in my script that we'll be unveiling at the academy meeting as well and then the collaborative relationships with surgeons contributed to that as well, Rick. So I think that we have ironed out many of those root causes of the instability in our Knee business and we'll see that stabilize as the year progresses.

It's also important to note that even on the Knee side, some of these disruptive factors that we faced in 2008 causes the sales force to end up in a pretty defensive mode and we're seeing the beginnings of our group of sales force folks getting reoriented towards going on the offense, and you're going to see more and more in the sequential progression of our revenue growth in 2009 on that front.

Hips, all the same factors would apply on that side as well, but here you also have some pretty significant product gaps and some field actions in the Durom area that were disruptive in 2008. We feel very strongly about the quality of our current stem offering, have some great innovations that are currently in the marketplace, but the pacing items to restore the growth rate to our hip business, we see as being the introduction of the cup side.

On the Acetabular Cup side we're going to have at least two significant offerings in the second half of 2009. So they're not going to help our performance in the first half, they will in the second half and we would expect to finish the year with some positive momentum going into 2010 in that category.

Rick Wise - Leerink Swann

Very helpful. Just two quick follow-ups. You highlighted that you expected the new products to fill in the product gaps in the product lines, both product lines. Do the new products totally get you where you need to be? And the second question, maybe just a little more on 2009 guidance, clearly higher R&D spending is going to pressure EPS. I am curious to hear your thoughts about when we start to see the positive leverage and is that more sales driven fourth quarter or do we have to wait till 2010?

David Dvorak

Sure. The first question, on the Hip side, it will address all of the needs that we have with the exception of resurfacing in the United States market. But every other need that we have on the Acetabular Cup side will be addressed with second half of the year offerings. Jim, why don't you turn to the leverage question on the P&L?

Jim Crines

Sure. Rick, the first time you would see leverage in the P&L would be in the fourth quarter of 2009, is when you would begin to see that return. If you're looking purely at EPS growth, if you look on the other hand at operating profit and this has a lot to do with the fact that we had significant capital gains reported below operating profit in the third quarter of 2008, you would begin to see some modest leverage in the third quarter the way we see things developing over the course of 2009.

Rick Wise - Leerink Swann

Thank you very much.

Jim Crines

You're welcome.

Operator

Your next question comes from the line of Jeff Johnson of Robert W. Baird & Co.

Jeff Johnson - Robert W. Baird & Co.

Thanks, guys. Jim, maybe you could just touch on, intangibles up about $130 million on the balance sheet. I'm assuming that's the buyout on the contracts. Just wondering how this is going to flow through over the next couple years? And does that go through the R&D line, or is that part of the reason SG&A is up next year as well?

Jim Crines

Well, first of all, as we said before on the buyout of the future royalty obligations under those legacy license agreements, we made a lot of progress on that obviously in the fourth quarter, paid out $109 million for the acquisition of intellectual property rights under those agreements.

That has been recorded as an asset and will get amortized over the life of those products and that just so happens to line up with the royalties that were otherwise getting recorded under those obligations.

So there's no sort of incremental operating expense, if you will, and because those royalty expenses have historically been recorded in cost of goods, the amortization of those intangible, those technology assets will be amortized in costs of goods as well.

Now, the other increase we recorded, the other thing we recognized over the course of the quarter was the preliminary purchase price allocation associated with the Abbott Spine deal. That resulted in the addition of another $75 million in intangible assets and those assets will be amortized over a period of 10 years.

Jeff Johnson - Robert W. Baird & Co.

Okay, great. Thanks. And David, maybe you could just address on the OSP side, I know you had been talking about re-launching some of those products late in Q4 and substantially all of them by the end of Q1. I didn't hear those same comments this time. How do you see those products rolling out over the next couple quarters?

David Dvorak

We were successful in reinitiating some of the products before the end of 2008. The balance of the products will be relaunched in the first and second quarter of this year. So there will be most the principal products, we will be successful at relaunching.

I think the strategically most important of those products will be relaunched before the end of this quarter with the balance coming out in the second quarter of this year. And then obviously, it's going to take some time to ramp those sales back up, but that maybe a bit different and the different subset of the product offering Jeff.

Jeff Johnson - Robert W. Baird & Co.

Fair enough. And then qualitatively I guess David, and I know it's hard to tell but, should we think about those products just slowly recapturing some share over the first few quarters, and maybe taking that process out over a three to a four quarter period?

David Dvorak

Yes, I think that is a fairway to look at it. It's going to be staggered. The first of the products that were launched in the fourth quarter of this year, I would expect that we would be in decent shape at recapturing the market share that we have built into our model by the end of the year.

So I do think that kind of a two to four quarter time period, and I don't think that it's reasonable to expect that we're going to recapture all that market share. So something better than half, but we'll keep you posted on that progress as we relaunch those products.

Jeff Johnson - Robert W. Baird & Co.

All right, great. Then last question I guess from me. I know one month does not make a trend, but a lot of questions about what's going to happen as we fall off and hit new deductibles and copays et cetera in '09. Anything you can talk about qualitatively, I guess, industry-wide that you're seeing in January relative to maybe November-December trends on Hips and Knees?

David Dvorak

Well, the best we can do is what we reflected in the guidance, as Jim said, the kind of couple of percent slowdown in the market is consistent with what we've seen over the course of the last, say, four months at this point.

Jeff Johnson - Robert W. Baird & Co.

Is that couple hundred basis points that Jim was talking about, would you assume on an annualized basis that maybe gates through at a bigger impact in the first half and lesser impact in the back. Or how are you thinking about that?

Jim Crines

Hey, Jeff this is Jim. I guess the way we are thinking about it is that step down has happened to some degree in the fourth quarter and we'll see how that plays out once everybody's reported. And that will persist through 2009. At least for planning purposes, that's how we're thinking about it.

Jeff Johnson - Robert W. Baird & Co.

All right, thanks. Very helpful, guys. Thank you.

Jim Crines

Thank you, Jeff.

Operator

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

Bruce Nudell - UBS Equity Research

Good morning. Thanks for taking the question. That was the point I was going to ask about. It looks to me like US Hip market may be like 3% in the quarter, ex-US 5% constant currency, US Knees a little under 7%, and ex-US maybe 3% which is closer to the 4% to 5% growth rate for the market. Is that in line with your thinking and do you think we're actually starting to see a small procedure dropout?

Jim Crines

The Hip grows very much in line with what we're seeing and what we're estimating for the fourth quarter, understanding that not everybody's reported yet.

Bruce Nudell - UBS Equity Research

Yeah. But we just plug what we thought was likely. And what gives you kind of confidence that we came to the same sort of conclusion that if the trend line was 5 points in units, it would be maybe 2.5 or 3 of units, which would get us down kind of to mid-single digits market. Have you done any analytics to kind of confirm the exposure to unit growth rate or is it just everybody's in the same boat and kind of making reasonable guesses?

Jim Crines

Yes. We're looking at as many sources of data as we can get our hands on, but it is a difficult thing to really pin down. Some of the data that we're looking at is relatively small samples across a number of hospitals in the US. And with that information in hand, we're making the best sort of guesses that we can, the best assumptions that we can at this point. But we do not have really access to hard data across the broader markets at this point.

Bruce Nudell - UBS Equity Research

I guess my final question is, our estimates show you the share losses that you've kind of outlined. We agree with those. What sort of analytics have you guys done internally to kind of say that 0.5% further erosion is kind of about where it will end? It certainly agrees with our survey work, but you have excellent access, of course, to the customer base. And how have you assessed the turmoil take trajectory of that loss?

Jim Crines

Well, it's done on an account-by-account basis by us, Bruce. So obviously we are rolling up all the information that we have in a very detailed fashion on those account relationships, the risk accounts, the opportunity accounts and then projecting things that we're doing to stabilize those relationships to arrive at the forecast that we're providing.

So it's obviously a major assumption, but there are a lot of details that go into that side as opposed to the first line of inquiry, which is trying to project out what's happening unit-wise across customers that we may not be working with because they're with competitors, obviously.

Bruce Nudell - UBS Equity Research

Thanks so much.

Jim Crines

You are welcome, Bruce.

Operator

Your next question comes from the line of Michael Weinstein of JPMorgan Securities.

Michael Weinstein - JPMorgan Securities

Hi, there. Can you hear me?

Jim Crines

We can, Michael. Good morning.

Michael Weinstein - JPMorgan Securities

Hey, great. Thanks for taking the questions. Let me be a little bit more direct and try and get arms around this. On the last conference call in October, you preliminarily thought that 2009 EPS would grow high single digits and now you basically have taken that down by $0.40 to $0.50. So that suggests that there has been a significant deterioration in the business over the last three months.

And your fourth quarter was obviously disappointing, as we look at the different businesses relative to market growth. But the suggestion relative to with your '09 guidance is that it's gotten a lot worse, given that significant cut you're making in the three-month period. So help us get our arms around that. Thanks.

David Dvorak

Mike, this is David. Look, we finished out the year and did fall short of what we had hoped to accomplish on the top line. We have a lot more clarity as to what's happening with those existing relationships. We also have quite a bit more clarity as to what's happening in the market in general and obviously the economy has changed fairly dramatically.

And the long and the short of it is we went through a month long process to put together the best operating plan we can to drive shareholder returns in the go-forward period and what we find is that we're going to have to spend money to put things back on track. We don't want to lose further market share and this is a plan that we think is the most constructive way to return the business to an operating pattern that it ought to be at.

So, rather than going tight on dollars that are going to be necessary to put things back on track, both in the product development side and the medical education side; we're going to show that kind of leverage as we emerge from this year, but you're going to see leveraged earnings as Jim laid out in the fourth quarter as opposed to something that would reach high single-digits across the year on a blended basis.

Michael Weinstein - JPMorgan Securities

The guidance on the top line for 2009, obviously you are suggesting that ex-currency and ex the impact of spinal concepts that your revenue growth be relatively flattish for the year, which relative to your markets obviously suggests is some meaningful share losses.

Can you help us get our arms around the surgeon base at this point in your core Hip and Knee businesses and any magnitude of surgeon loss, anything you can help us get an insight into whether it's specific territories or specific parts in the business where you are most vulnerable right now and you see yourselves losing more shares as you go into '09?

David Dvorak

This is, the issues and root causes are the same ones that we've been describing and I think that they're quite well understood in the various markets globally. So there really isn't a particular geographic segment.

Now, getting the training and education back up and running, any delayed payments is obviously awfully frustrating and disruptive to the relationships that we have with surgeons that have contributed so much in the development of the products and the assistance in training and educating other surgeons on the proper use of those products.

Now, we've made tremendous progress, over the course of even just the fourth quarter on both those fronts. So yes, on an account-by-account basis, we feel like we have good visibility into what the additional potential fallout would be.

But we're also very optimistic that as you get into the second half of the year and some of that disruption anniversaries out; in the form of the lack of training and education from 2008, in the form of the disruption to those surgeon relationships on the collaborative side, in the form of introducing products that are going to fill the gaps that we're currently up against on the Hip side in particular, and then even those field actions on OSP and Durom. We're going to get to the second half of this year and put the business back on a growth track.

Michael Weinstein - JPMorgan Securities

One of the things that you're doing is reducing the size of your product development teams. To what degree is taking your product development teams from 15 to 20 surgeons, down to three to five surgeons and the surgeons that are basically no longer on the team. Is that where you're losing your business and those surgeons in particular?

David Dvorak

I wouldn't say that it's those surgeons in particular. I think that those types of moves are all in the broader mix of factors that are contributing to the dynamics that we see right now, but those are all incorporated into the plans that we're developing to put things back on track too, Mike.

Michael Weinstein - JPMorgan Securities

Okay. Last question. And this is may be a tough question. I get this a lot from investors and obviously your business has gone through a tough '08, you're describing what's going to be arguably even in more difficult 2009. Describe the Board's patience with the strategic plan. I know a lot of people ask how long can this go on with the company, this direction, before the Board gets frustrated. So could you give us any sense of the degree to which the Board is on-board with what you're describing here?

David Dvorak

Now we're very confident in what we're going to be able to achieve this year, is the short answer to that. I don't think that 2009 is a year that anyone ought to be pessimistic about. We're telling you what we think the milestones are going to look like and we get to the second half of this year and start seeing some of these headwinds factors anniversary out, when you put the business back on track and exit this year in a very strong fashion.

Michael Weinstein - JPMorgan Securities

Okay. Thank you, David.

David Dvorak

Yes, you're welcome Mike. Thank you.

Operator

Your next question comes from the line of David Toung of Argus Research Corporation.

David Toung - Argus Research Corporation

Good morning. Thank you for taking the call.

David Dvorak

Good morning.

David Toung - Argus Research Corporation

Getting down to a little bit deeper into your relationships with the surgeons, since you're acknowledging market share losses, presumably these surgeons are temporarily using your competitor's products. What gives you the confidence that these surgeons will come back to Zimmer and what's the tone of your conversations? I know you said you made a lot of tremendous progress in your relationships, but do surgeons switch back and forth or -- just describe a little bit more on your grass roots conversations?

David Dvorak

These conversations are improving as a general matter. That's certainly the case. I mean, I'm not saying that there isn't risk of additional losses, obviously we're projecting out that there in fact will be some additional losses. But it's important to note that our assumptions going forward with growth that's built into the model in the back half for the year don't presume that we're going to be restoring all of those relationships. Many of those relationships will anniversary out.

Every day, we're developing new relationships with new customers and those are improving our performance and as some of those significant early losses anniversary out, you're going to see the top line growth would be restored as well.

So as a general matter, the root causes that have led to the disruption are being addressed and it's one of the reasons that we're so optimistic about what's going to transpire as we get deeper into 2009.

David Toung - Argus Research Corporation

Since your agreement compliance is mainly in the US, what's been the dynamic in Europe and Asia as far as the market shares and --, because I think your numbers here were across the board below market.

Jim Crines

Yes, sorry, David, this is Jim. The same programs that are governing decision making and how services are getting provided, and how the company goes about entering into relationships with our bona fide needs. There has been and is in the process of being rolled out to all of our business units and we talked about that in the past.

It has caused as we said some disruption is not only in the US but outside the US as well as we work towards getting the infrastructure in place, among other things, such that these decisions can be made in an efficient way and the services can be provided in an efficient way, responding to what we believe are bona fide needs in those markets as well.

David Toung - Argus Research Corporation

Okay. Great, thank you.

David Dvorak

Thank you.

Operator

Your next question comes from the line of Bob Hopkins of Banc of America Securities.

Bob Hopkins - Banc of America Securities

Hi, thank you. Good morning, can you hear me?

David Dvorak

Good morning.

Jim Crines

Good morning, Bob.

Bob Hopkins - Banc of America Securities

Just two quick questions. First, just sort of following up on some of the issues that have been touched on previously, when you guys stated last quarter that you lost some physician relationships to competitors in Q3 and that you felt like that would continue in Q4 and obviously it looks like that did happen. But if you just look at the absolute number of physicians that you think went to competitors in Q3 and I'm making up a number, let's say it's 50, did you lose more than 50 this quarter or did you lose less than 50 this quarter? I'm just wondering in terms of absolute numbers, if things get worse this quarter than last?

Jim Crines

I would say, Bob, this is Jim, that it was less. I think some of what is in my view impacting and our view impacting on our results in the fourth quarter is what we believe is a slowdown in procedures across the broader market. I think that will prove itself out as and when all the companies have reported.

I will say that if you look at the data that we provided on the, our estimates of the market share erosion both in Knees and Hips, it was a bit more pronounced in Knees in the fourth quarter. Maybe lesser so on Hips, relative to what we experienced in the third quarter.

Bob Hopkins - Banc of America Securities

Okay. And then just a follow up on Mike's question earlier, talking about the difference between the guidance that was -- the rough guidance, preliminary guidance for '09 that was provided in the third quarter versus this, it's roughly $0.45. I am wondering if you can, can you first try to put that into buckets in terms of what's changed is there -- what are the top two or three things and how much was each one of those things contributing to that $0.40 to $0.45 difference between what you were saying three months ago versus what you are saying today? Thank you.

David Dvorak

Well, clearly, our view of the market and how the market's going to grow for 2009 is changed. We've taken down our expectations as we talked about for market growth down to 6% from where, as we said it was recently trending at 8% to 9%. Share loss being a bit more pronounced coming out of the fourth quarter relative to what our expectations were at that time.

And finally and that really makes up 85% to 90% of that adjustment on the bottom line. The rest of what makes up that adjustment on the bottom line is what we believe is needed in the way of increased spending in the areas that David touched on in order to restore growth in that core franchise and that spending is going to be focused on both product development and medical education programs.

And then finally, one other thing that I mentioned in my comments was the fact that we are going to be stepping up to a degree our spending on quality systems, as I indicated to achieve the continuous improvement objectives we have laid out in that area.

Bob Hopkins - Banc of America Securities

Okay. Thanks very much.

David Dvorak

Thank you.

Operator

Your next question comes from the line Tao Levy of Deutsche Bank Securities.

Tao Levy - Deutsche Bank Securities

Hey, good morning.

David Dvorak

Good morning, Tao.

Tao Levy - Deutsche Bank Securities

So you talked a couple times, one of the ways you guys are going to try to stop the share loss is to invest in product development. But as you walked through what you planned to launch in 2009, I think I heard maybe two products. And I didn't know if there was more there that that's coming that's in the pipeline that will come out in 2010. A few years ago there were always some big products that were coming out this year or the following year, whether it was the Gender Knee or some of the hip products.

So I'm trying to get a better sense of, is there a way, for example, in the knee business where you can the slow down some of the market share losses because it doesn't seem like you're coming out with a knee product and you have one of your competitors, which looks like it may have taken three, four market share points this past quarter.

David Dvorak

We're not going to obviously lay out everything that we have in the pipeline. The pipeline is robust, it's diversified across all the different product categories and the launch dates for those products are obviously spread out as well. So, we're trying to do is highlight the things in the short term that don't put us to the competitive disadvantage by tipping our hand but give you some visibility as to things that we think are going to make the most significant impact in the short term. And those, the principal category there is on the Hip side the Acetabular Cup offering that will be launched in the second half of this year.

Tao Levy - Deutsche Bank Securities

And on the Knee side, I think you had mentioned instruments. Is that what's going to help you guys you think in '09?

David Dvorak

Instruments and there are other plans as well.

Tao Levy - Deutsche Bank Securities

Okay. And the trauma product that you mentioned before, when do you expect to launch that in '09?

David Dvorak

That rolls out through the course of the year. Their nails for the different anatomical sites will be rolling out on a quarter-by-quarter basis to largely be completed before the year is out, if not completely out before the year.

Tao Levy - Deutsche Bank Securities

Thanks. Okay. And then when you look at and you reflect back on the issues with Durom, is there a way to quantify what type of impact that had on Zimmer's reputation and/or doctor loyalty? Because as I see the claim numbers start to go up, it seems like a high number, I assume most of the Durom patients haven't had or I assume that most of them don't have any problems with the hip.

So, I was surprised to see the number go up, unless those patients are starting to have problems and the surgeons who implanted the product are getting frustrated. So I think it kind of tie those two together.

David Dvorak

I don't think that it is the case that there is frustration that's driving that. The clinical results are what are being used to develop the criteria and make decisions around that. It's tough, I think, to quantify as you've requested the impact there. Obviously, those are situations that we do everything under our power to avoid ever having that kind of disruption for surgeons and patients.

And so we've done the thing that we think is most responsible under those circumstances and we're standing by our obligations with respect to the patient's needs in these circumstances as well. The direct financial impact is, quite quantifiable in the sense of we explained what we thought would happen revenue-wise and then provided updates on that and now the impact on the product liability side.

I think that the thing that is important to consider, though, is that it was one of several challenges that we faced in 2008, and so if nothing else, it's time consuming. It drives a lot of energy towards those issues, and as a consequence, it's disruptive from everyone's perspective.

And so, you have a sales force that is going to be less oriented towards thinking optimistically about the results they can produce with their product line until those types of issues are addressed. And that's why, we have such a great deal of optimism as we enter the second-half of the year and put some products out that we think will address the gaps that we do have on the Acetabular side.

Tao Levy - Deutsche Bank Securities

Okay. And then just my final question. I was surprised to hear, you guys mention that you're going to use most of your excess cash to buy back stock. I was wondering, are there not any sort of interesting opportunities there in your areas, just given the market conditions? Or you might make another acquisition or is sort of stock buy back now at the top of the list of just where you're going to use your cash?

Jim Crines

Tao, this is Jim. The focus clearly in 2009 will be on restoring growth in the core franchise and getting the product development programs up and running, so there is a good continuous flow of new product into those markets. Stepping up our investment and efforts in the area of medical education to be able to respond to what we believe are bona fide needs in the US and outside the US

So again, that really is the focus for the 2009 of our operating plan. And with that, we, just as we've pointed out, built in an assumption that available free cash flow will go principally towards share repurchases over the course of the year.

Tao Levy - Deutsche Bank Securities

Okay, great. Thanks a lot.

Jim Crines

Thank you.

Operator

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

Kristen Stewart - Credit Suisse

Hi, thanks for taking my questions. I just wanted to go back to the hip resurfacing I guess comment that you made earlier, where you said that you would be out without that. Are you discontinuing your current program with Durom and do you have any plans to relaunch any new ones?

David Dvorak

The study that was underway, Kristen, has been suspended and that's been the case since the middle of last year. So we will pursue a resurfacing product and we have plans on a couple of different fronts in that regard.

Kristen Stewart - Credit Suisse

Will it include Durom or it's going to be completely new?

David Dvorak

It will likely be a new cup.

Kristen Stewart - Credit Suisse

Okay. And then, just going back to the (inaudible) customer versus product related losses. Is there any way to split it out to your loss share with 50% being customer losses versus another 50% being product related issues?

David Dvorak

Well, obviously, you're trying to climb inside the minds of the decision maker there and I think it is difficult to disaggregate the two, I think if they're quite interrelated. I will tell you that a significant driver for those losses has been the disruption, as opposed to the product gaps.

I think we've been pretty specific as to the side of our business, that is the Hip side, that has been most impacted by product gaps. I don't think that the majority of the losses and the slowdown on the Knee side have been product gaps, although there have been elements of that, just far or less significant than Hips.

Kristen Stewart - Credit Suisse

And are you surprised in this tightened environment with the DOJ and different investigations that you've seen as many customer losses given the environment?

David Dvorak

Well, overall, obviously this is a pretty dynamic period of time. I don't know that anyone could have predicted with absolute certainty going into things a year and half ago, but I think that we have great clarity now as to where things are headed and what kind of a job we can do to drive the restoration of our performance in the sequential quarters in 2009 and where we'll end up as we March into 2010.

So, I think what's important to us at this point is that understanding and our confidence level to do the right things to put the business back on track as this year progresses.

Kristen Stewart - Credit Suisse

Just to make sure I understood you. I think you had commented that there was a slowdown across the broader market and as other companies report this will become increasingly evident. We heard from two of the same size kind of competitors talk about them not seeing a slowdown. Is there anything different about your mix of business that would make you more apt to be seeing a slowdown versus others?

David Dvorak

I think that anyone's visibility and this is the question that Bruce was posing too, you have views into pockets and there are pockets that have slowed down. There are other pockets that don't seem to be affected by the general economic downturn, but it is the case that when you do the math on the numbers of the companies that have already reported, it's fairly irrefutable that there has been an overall market slowdown, and then you start drawing analysis into and assumptions about how much of that is a unit slowdown.

And the tough thing I think about coming to a definitive and all-knowing physician on that front is, as I said, all you have is anecdotal information and geographic pockets or accounts that have slowed down, rather than anything that is all that broad based. And you know, look it could be happening at different paces across different geographic locations as well with the economy having gone through what it's gone through and continuing to go through what we're seeing right now.

Kristen Stewart - Credit Suisse

In the fourth quarter, you felt there was a slowdown in your core business due to the economy?

David Dvorak

Yeah, I think that's clear that the market did drop off.

Kristen Stewart - Credit Suisse

Okay. My last question, then and I know there were many. You had commented also that there was some dilution associated with the Abbott Spine deal within operations. How do you breakout the difference between what you're including in operations versus what you're going to include in this acquisition and integration charges which is I think about $0.13 in earnings that is excluded from the adjusted range?

David Dvorak

Yes. What's included in our adjusted results related to Abbott Spine are the sales and operating earnings or losses of that business. What is excluded as you pointed out is the inventory step-up amortization and any significant one-time integration costs as we work towards putting the two businesses and the two organizations together.

Kristen Stewart - Credit Suisse

And so the $0.13 for the full year is just one-time related to distributors or what's specifically is $0.13?

David Dvorak

A big piece of it is related to the integration of the sales networks around the world.

Kristen Stewart - Credit Suisse

Okay. I'll drop off. Thanks so much.

David Dvorak

Thank you.

Operator

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

Doug Schenkel - Cowen and Company

Hi, good morning.

David Dvorak

Good morning.

Jim Crines

Good morning.

Doug Schenkel - Cowen and Company

Do you feel you are where you need to be in providing visibility to your consultants on the structure of royalty and consultant agreements? And generally speaking do you believe you can make a good case to surgeons that they are not make any less working with you rather than your competitors. And I guess how important has progress in this effort been in attempting to stabilize share?

David Dvorak

Yes. I'm absolutely confident of our ability to be able to recruit and engage the very best design talent in the world on our projects. We went through a quite elaborate process with outside help to develop a royalty model that we think is appropriate going forward and competitive within the marketplace.

That model has been signed off on by the oversight that we're currently receiving with our monitor and others. And I will tell you that we already have been successful at engaging world class teams to move forward projects. So the answer is yes and we've proven it out.

Doug Schenkel - Cowen and Company

Okay. Thanks for that. It sounds like your long-term strategy to -- try to simplify this a little bit -- in Hips and Knees is based largely on trying to stabilize share loss in 2009 and then getting back to market levels of growth while maybe doing what you've done in the past, which is getting relatively higher mix benefit.

Assuming this is correct, recognizing that hospital administrators are always trying to control pricing and do their best to limit surgeon discretion. Is there anything you're seeing recently that's different, given the current environment? I'm just trying to get at how you're thinking about the potential for mix benefits longer term?

David Dvorak

Our plan is to not only stabilize our Hip and Knee business but as we progress through 2009 and enter 2010 to go back to taking market share, obviously. And that means new accounts, not just mix. I think that mix has already become a bit more challenging and I think it will continue to be so.

I think that there is going to be greater scrutiny placed on the introduction of new products and one is going to have to prove out in a clinical empirically driven manner that we are creating better patient outcomes taking costs out of the system to be able to get that mix benefit. And our development programs are designed with that aim in mind.

So yes, I think that mix has already gotten to be more challenging over the last operating period or two and will continue to be the case. So, one is going to have to do a better job in their development efforts to prove out the benefits.

Doug Schenkel - Cowen and Company

Okay. And last question, you talked about Knee share of loss being relatively more pronounced than Hip share loss in the quarter. Is it right to assume that this is somewhat a function of the fact you that had earlier challenges in the year on the Hip side, both because of the lack of resurfacing and also because of [there are] mid-year. I'm just trying to get at whether the Knees being a little bit worse than Hips, is not necessarily suggesting that Hips are holding up better?

David Dvorak

I think that the pacing could be a bit different. Those moves have been a little bit lumpy, obviously beginning in the third quarter and continuing in the fourth quarter. I think that we now have a good understanding as to what we think will occur going forward and what we can do to optimize our performance relating into those risks.

Doug Schenkel - Cowen and Company

Okay. Thanks for taking the questions.

David Dvorak

You're welcome, Doug. Thank you.

Operator

Your next question comes from the line of Raj Denhoy of Thomas Weisel Partners.

Raj Denhoy - Thomas Weisel Partners

Good morning. I just have a couple of questions. It's pretty clear you guys are going to be aggressive in spending and trying to stem the share losses you're seeing. But is price a lever you're willing to start to play in order to sort of get business back or even in order to stabilize business at this point?

David Dvorak

I don't think our pricing strategy has changed or will change going forward at all, Raj. I mean, the areas that we're going to be concentrating on is getting, innovative products out the door and ramping up our training and education, so that surgeons understand how to use those products in a safe and effective way.

I'll tell you that, on the training and education front, as those programs ramp up and we get new technologies out, we are seeing successes in the adoption rates of those products. Jim pointed out, a couple of those pockets and so, those are the basics for the business going forward as opposed to price.

Raj Denhoy - Thomas Weisel Partners

Okay. Along those same lines, we're sort of nearing the end of the monitoring period here. The Department of Justice settlement and you guys have unfortunately endured probably a tougher path than your competitors through this time.

Do you feel the playing field has been leveled here? Is the compliance standard costing across industry at this point or do you feel that you are, that the other orthopedic companies need to maybe come up to where you guys are or will have to overtime?

David Dvorak

Well, I think that different competitors are going to go about this at different speeds and in different locations within their geographic segments. I don't know if there's ever going to be a magical day that rolls around, where it's a perfectly level playing field across all geographic segments.

I will tell you that I think the trends, are all very much in that direction, whether it comes in the form of enforcement or updated codes of ethics, either AdvaMed or [Eucomed] practices that we see are beginning to conform much more consistently with these higher standards. Hospital administrators are driving this. State legislators are driving it, as well as a legislation that's pending at the federal level. So all the trends are very consistent with the decisions that we made.

And again, what we were doing strategically was ensuring that for our organization we weren't going to incrementalize this process and I think it's really important to note that cultural changes are necessary in these times, and the approach that we took drove a cultural change through the organization.

There is absolute buy into what we're doing. We're going to get our business back on track and have a healthy environment for this new world that we're going to be operating in and I think it's going to be one of the reasons that we're going to be so successful.

Raj Denhoy - Thomas Weisel Partners

And then just one last one on the Abbott Spine business, I think you mentioned if I understand that correctly, you did about $22 million in the quarter (inaudible) $88 million or so on an annualized basis. If I'm not mistaken, that business is doing north of $100 million or $110 million when you acquired it. I guess that implies that you've seen some disruption in the distribution. What should we think about is kind of a normalized run rate for the Abbott Spine business now that you guys own it?

David Dvorak

Yes, I indicated in my comments, we think about that business on a combined basis and as I said, on a combined basis compared to 2008, we do expect that Spine revenues are going to lag market growth. As a consequence of the synergies that we had built into our model and we fully expected as we put those two sales networks together and, they are major market here in the US and in other markets outside the US.

Raj Denhoy - Thomas Weisel Partners

But has that disruption in the sales infrastructure in the distributor base, has that been more when you thought it was going to be? Have you lost more salespeople?

David Dvorak

I would tell you that $22 million that we saw in the fourth quarter is in line with what we had in our model.

Raj Denhoy - Thomas Weisel Partners

Okay. And then just one last one, broadly on the sales force for the company, in general the sales infrastructure. Is this rough time, have you seen a greater disruption in your sales force? Have you lost people because of what's going on out in the marketplace?

David Dvorak

We have not seen any turnover beyond what we have experienced in more normalized times, so the answer is no.

Raj Denhoy - Thomas Weisel Partners

Great. Thank you very much.

David Dvorak

Thanks, Raj.

Operator

Your next question comes from the line of Ben Andrew of William Blair.

Ben Andrew - William Blair

Actually, all my questions have been asked. Thanks.

David Dvorak

Thank you, Ben.

Operator

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

David Roman - Morgan Stanley

Good morning, everyone. Thank you for taking the question. Just a couple of things on the guidance. Jim, did you bake in anything on the earnings line for a contribution from share repurchases?

Jim Crines

Yes. And if you go back to the transcript, I think you'll see that we actually gave guidance on what our expectations are for the average share count for 2009 at 216 million to 217 million. So that clearly does take into account the effect that the share repurchase program will have that and what we have assumed in the way of interest cost or lower interest income for 2009.

David Roman - Morgan Stanley

And can you give us some sense for '09, I know you gave an expectation for free cash flow, but what the outflows will be from surgeon payments for the full year?

Jim Crines

Well, as David indicated, we've made very significant progress in the fourth quarter. There are still some payments that remain outstanding and we have in our plans to bring all of those payments up-to-date through the course of 2009.

Having said that, there are some of these arrangements where the settling out of those payments may be a bit complicated and it's difficult to predict how and when exactly some of them may ultimately settle out. But that is all sort of reflected in the expectations that we laid out regarding cash flow.

David Roman - Morgan Stanley

Are you closer to 30% of the way there or 80% of the way there?

Jim Crines

I'd say we're closer to 80% of the way there.

David Roman - Morgan Stanley

Okay. And then David, on several occasions now at conferences you've talked about the need to increase investment spending either through research and development or external investments to generate premium price products. Can you maybe talk about, and maybe give us a little more detail behind that thinking and then what Zimmer is doing to address that?

David Dvorak

Well, I think that it's clear that we're entering an environment where one is going to have to prove out in an empirical way that products that are being introduced where you're expecting premiums in the way of pricing, that is mix, you're going to have to provide better patient solutions.

So our R&D efforts and the allocation of our resources are very consistent with that. Obviously, on the extreme end, our biological solutions that would introduce earlier interventions to the disease state for that patient, but there are other material advancements short of biological solution that can be made and we're working on those actively within our current efforts.

David Roman - Morgan Stanley

Okay. And do you think that 5% to 6% of sales for R&D is sustainable to support those efforts over a longer period of time?

David Dvorak

I do. I think that the mix of the R&D spend will change, but I think that that level or roughly that level is probably going to be adequate.

David Roman - Morgan Stanley

Okay. Thank you very much.

David Dvorak

Thank you, David.

Paul Blair

Carey in the interest of our caller's time, let's take one more question, please.

Operator

Your final question will come from the line of Joanne Wuensch of BMO Capital Markets.

Unidentified Analyst

Hi, this is Matt for Joanne. Can you hear me?

David Dvorak

Yes.

Unidentified Analyst

This was touched on, but could I just delve into the sales force a little bit more. You talked about the synergies at Abbott, some turnover in dental. In the past you've talked about some disruption in the focus of your Hip and Knee guys.

Could you just expand on those ideas a little bit more and tell us a little bit more about the turnover in dental and what the synergies are? And how you're getting the Hip and Knee guys back on track and what their current sort of feeling is about the business?

David Dvorak

Sure. Let me start with dental because it's a bit more discrete, obviously. I think that we explained probably in prior conference calls when asked the question about sales force stability, that we weren't seeing any changes other than in dental and some quarters back we did see excessive turnover in dental. That has now stabilized.

I don't think that currently we're seeing anything beyond what would be a normal turnover level, so I think that that situation has been remedied and the sales force is stabilized there.

The Abbott Spine side of things, I don't know that we have a lot more color to add there, Matt. Obviously, one of the key strategic assets that we were picking up through that acquisition was in enhanced channel, and so we went through a very deliberate process over the course of the fourth quarter to determine which distributors we were going to continue on with and which geographic segments and ended up integrating the best of each into our go-forward distribution channel which we feel is a very strong one.

Obviously, in sheer size, there's a lot more critical mass in those distributorships as you layer on top the Abbott Spine revenues, and so it's one of the strategic areas that we were after in that deal. I think that that promise is going to be realized and has already been solidified in the go-forward distribution group that's been put together there. And so it is a combination of legacy Zimmer and legacy Abbott Spine folks that have been assembled.

On the Hip and Knee side of things, look, we went through a year where there was pretty significant disruption due to the implementation of our enhanced compliance program. We slowed down for periods of time, training and education and then went through a lot of content development and process development as well, to be able to get that ramp back up.

Those activities have progressed to a large extent and I would say now in certain geographic segments, we're ironing out the final wrinkles that will be necessary to go full bore and I would expect in all geographic segment to have things up and running completely by the end of the first half of this year, but some geographic segment are ahead of others.

You layer on top of that disruption though, the justifiable frustration among some of the surgeons that we had collaborated with in the past. We are doing a better job in providing clarity in our communications with how their issues will be resolved.

As Jim said, we are better than three-quarters of the way there. I think by any measurements, whether it's on the royalty side or the general consulting side, so that helps in those relationships as well.

And then as we move forward and get past OSP, Durom and then some of the other product gaps that we have already talked a lot about on this call, I think that all of those things allow a sales force to get reoriented on going to the offensive side and that's just what we're planning to do in 2009.

So, again one of the reasons that we are very optimistic about the progress that we are going to make with this business over the course of this year.

Unidentified Analyst

Thank you very much.

David Dvorak

You're welcome, Matt. Thank you. And let me say thanks again to everyone for joining us today and for your continued interest in Zimmer. We look forward to speaking to you on our first quarter conference call on Thursday, April 23rd at 8:00 o'clock.

With that, I'll now turn the call back to you, Carey.

Operator

Thank you for your participation in today's conference. You may now disconnect.

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Source: Zimmer Holdings Inc. Q4 2008 Earnings Call Transcript
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