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Executives

James T. Crines - Chief Financial Officer and Executive Vice President of Finance

Analysts

Matthew Taylor - Barclays Capital, Research Division

Zimmer Holdings, Inc. (ZMH) Barclays Global Healthcare Conference March 12, 2013 8:30 AM ET

Matthew Taylor - Barclays Capital, Research Division

Okay. So we have our second session starting here with Zimmer. Really pleased to have Jim Crines and Bob Marshall from Zimmer. It's a company that we like in the ortho space. They've done a good job of reducing costs, deploying capital and also growing top line in a difficult environment. So it's a company that we continue to like here.

Question-and-Answer Session

Matthew Taylor - Barclays Capital, Research Division

Maybe just to kick it off, do you want to talk a little bit about your growth over the next year? You have a number of new products that you think could boost growth, with a new knee coming out at AAOS that people are excited about and also the Gel-One product and some of your new power tools.

James T. Crines

Sure. So you mentioned the knee product, our Persona Knee System. The Personalized Knee System has been developed over a period of 3.5 years. It represents an entirely new knee platform. So this is a product line that's going to be -- it's in the process of getting introduced. Started last year in a limited release, so we had an opportunity over the course of last year to get feedback from developer, surgeons; make some tweaks to the instruments, which is what typically happens over the course of a limited release. And we're now getting into full release. Really pleased and excited with the feedback we received over the course of the limited release. We've -- there have been over 3,000 surgeries done to date, believe we have developed a truly differentiated platform in the way that this system is going to allow and enable surgeons to achieve what we think is a really personalized -- unique and personalized fit for individual patients. Just the options that are available within this system are much more comprehensive, more comprehensive than anything that's -- anything else available in the marketplace today. There's, as well, new technology that's getting introduced with this system, our SmartTools, iASSIST. And people who are -- who have the opportunity to attend the Academy meeting in Chicago next week -- certainly, our surgeons are going to have an opportunity to see that. That's going to be a big feature for us at that meeting. So we have big expectations around the launch of this new knee system. It is our largest franchise. It's a franchise that has been under pressure over the last several years from some of the newer knee systems that have been introduced into the market over the past several years. We would acknowledge that, over the last 5 years, we've lost maybe somewhere in the order of 2 to 2.5 points of market share in knees. This is a $7 billion market and, with the launch of this system, we fully expect to recover the market share that we lost over the last 5 years and would hope and expect that we can do even better than that. So that clearly is a big deal and, again, that'll be a big feature of what we have to talk to our surgeon customers about at the Academy meeting next week. We also have a long list of other new products that are getting introduced this year. I would tell you that -- and this is -- I've been with this business now for 15 years and this is, without a doubt, the most -- the largest, most robust pipeline of new product offerings that I've had the good fortune to be associated with in my career with this company. You mentioned, Matt, the Gel-One. The other thing about some of these new products, I think, that's important to note is they're products that are getting into new categories where we don't currently have a position or product sales. So they're not products that are going to be cannibalizing any existing revenue. Gel-One is a good example of that. This is a single-injection hyaluronic acid product. It'll be only the second single-injection product available in the U.S. market. That's a product that is also in the process of being fully released into the U.S. market. It's a $750 million market and, over time, we'd expect that we're going to do extremely well with that. We know, before we entered into -- or we knew before we entered into this arrangement, as a result of some survey work that we did with our surgeon customers, that most if not all of our surgeon customers use HA with their patients when they first -- often when they first present with osteoarthritic pain in the knee. And so we have obviously a captive market that we'll be going after aggressively in the first phase of this launch, that is, our surgeon customers that are already using an HA product, a competitive HA product. So that's another exciting opportunity for us and one that our sales force is really excited to get their hands on because, obviously, it's another source of commission revenue for the sales channel. Power tools. We -- I think it's probably helpful to know that, many years ago, Zimmer was in the power tools market, had a business probably about $125 million or so in size before the -- Zimmer was directed to exit that business by its then-parent company. It's a business we want to be in. We think it's a really good fit. We did -- we were able to complete an acquisition a couple of years ago, acquired a Swiss-based company that had developed what we think is a very competitive line of power tools. It's about a $1 billion market in the U.S., dominated by one of our competitors. So we're in full release mode. We'll tell you that, over time, we expect we're going to do well with the power tools but we understand that it is a longer sales cycle. It's a capital sale and there's a certain cycle around capital investments that hospitals make. So it may not ramp up as quickly as some of the other new products but, again, it's a market we've been in, in the past. We understand it. Our sales channel understands it. They've sold power tools before and we'll do well with power tools over time. We have a new ankle product that's getting us into a new category. Excited about it. We -- incorporating our Trabecular Metal technology, which is our proprietary porous metal technology that's embedded in the ankle, the design of the ankle product. As well, it's a product that uses a unique lateral surgical approach. It does require some extensive training, so the ramp-up with that product will be a little slower, as well, just given the training requirements for the surgeons.

Matthew Taylor - Barclays Capital, Research Division

Good. And it's not only top line but you've done a lot of work on cost reduction and work to offset some of the pricing pressures that your business has been seeing. And you talk about this value creation framework. You've also been returning a lot of capital. So can you talk about how the pieces all kind of work together? And how you think that adds up to your EPS growth longer term?

James T. Crines

Sure. So the Zimmer value creation framework is something we use internally to discuss with our 9,000 employees how we intend to create value for the shareholders of the company. And we put it in place after getting -- or at least taking into account all the feedback we were getting from the investment community, particularly in this environment, looking for a lot of clarity around how we intend to grow top and bottom line and then what we intend to do with the free cash flow that we generate. So there are 3 pillars to the value creation framework: a growth pillar, an operational-excellence pillar and a capital-allocation pillar. And in simple terms, it's just a tool that we use to define, again, how we're going to grow top and bottom line and then what we commit to return to shareholders. We've put this in place 2 years ago and at the time committed to return up to 2/3 of our free cash flow through our share repurchase and dividend program. We didn't have a dividend in place when we first put the value creation framework in place. We now have a dividend program. So we committed to that 2 years ago and we remain committed to return up to 2/3 of our free cash flow to shareholders on an annual basis. As far as -- the growth pillar defines what our expectations are for top line growth and how we intend to achieve that through both organic and inorganic development. And we've done some things in combination with our operational-excellence pillar to speed the pace of innovation. So there's an operational excellence dimension as well to the -- some overlap, if you will, with the growth objectives that we have. We can see the effect that the operational-excellence programs have had with our product-development programs. I can tell you, and you could see this as well, that we received more clearances from the FDA in 2012 than we had received in the last 5 years. So clearly, the number of changes that we have made to increase the pace of innovation at the company, many of them organizational, sort of structure related. We, just as an example, took the quality, engineering and regulatory resources of the company and moved them out of what used to be a central function onto the development teams so the project leaders have full ownership of those resources over the course of a project and that was an important step. And just getting the resources in the organization, across the various functions, aligned on our key product development priorities. We completed the development of the Persona, The Personalized Knee System. So as I said, it's a new platform and really the largest product development undertaking in the company's history, in my view, in 3.5 years, and that's unprecedented. The last big platform program that was completed at the company was the development of the Continuum Cup system and that took about twice the amount of time to complete. So again, these changes that we've made are really having an impact. So we have, again, the -- while we spend over $200 million a year in R&D and, under that growth pillar, each of the 7 product franchises have a defined set of new product development objectives that they're pursuing, we are also looking to supplement our growth through inorganic or external development efforts. And they're -- here, there's some sort of overlap with our capital allocation philosophy, where we define the threshold levels of return that we would expect to get from acquisitions of businesses or technologies. And if you look at what we've done over the last few years, you would see that we've done a lot of small -- smallish transactions. It just is the case that those are the transactions that typically met our return criteria and this is how we are now in a position to get into some of these new categories that I've discussed. Power tools comes to us through a business acquisition. We acquired a external-fixation device, is one of the things that has really helped us boost growth within our trauma segment, which has been growing above market for the last 2 years consistently, quarter after quarter. We'd expect that to continue going into 2013. There have been a number of other -- the licensing of the Gel-One product comes through our external development efforts. The acquisition of the Synvasive, the eLIBRA device is a technology that can be used in our biggest franchise, the knee franchise, but that also comes with revenues of power -- of blades. So there's a blades business that comes along with that, that's a nice addition to our surgical products. We acquired last year and this is somewhat serendipitous or very smart, in our case, to have acquired a company that -- and a waste disposal technology at a time when a competitor of ours has had to recall their product and clearly is the market leader in this space. So we're going to have significant opportunities with that technology just given what's going on in the marketplace today with those devices.

Matthew Taylor - Barclays Capital, Research Division

I want to pause and just ask the audience a question about capital deployment because you talk a lot about your strategy. So let's just see what the audience thinks you should be doing with some of the excess cash. So if you're new to the room here: We're doing some audience participation today with some quality music and going to ask some questions. You push the number of the answer that you think is most relevant. So I'll give the first question. It's: What do you believe Zimmer should be doing with excess cash? We have bolt-on M&A, larger M&A, buybacks, dividends, internal investment and debt paydown.

[Voting]

Matthew Taylor - Barclays Capital, Research Division

Okay, so a little bit of a mix but seeing M&A and buybacks as being some of the key areas that people are looking for. And maybe you just want to kind of reiterate your balanced strategy here. You're looking at a number of these areas that you've highlighted but does that surprise you at all in terms of what people are looking for?

James T. Crines

I might be just a little surprised by the large M&A. The -- although, I would tell you that, particularly as we make progress on the operational-excellence initiative, that really does lay the foundation for us to get bigger and even -- that would include getting bigger in our core franchises. But in the short term -- short to medium term, we're going to continue with the bolt-on M&A activities. We're seeing good value. I can see that we're going to get really nice returns on the deals, the small deals, that we have done and the ones that we talked about. We're clearly going to continue with the share buyback program. We have a program, it's $1.5 billion in size that runs through the end of 2014 that has us buying -- spending about $500 million a year on share repurchases. That's going to continue. We just announced an increase in our annual dividend. And as we get to the end of 2014 and look beyond that, I have no doubt that there will be some discussions with the Board around whether or not we want to change the mix between the share buyback and the dividend program, potentially pay a higher dividend and be spending a little less than $500 million a year on share repurchases.

Matthew Taylor - Barclays Capital, Research Division

Let's talk about some of the dynamics that impact your business and what you're seeing in some of those trends. So the pricing always comes up as an issue and you've done some good work to offset that with some cost reductions. What do you see on the pricing front now? Is there anything that stands out by geography? And has your business been impacted by any recent weakness in Europe? It's kind of been a trend that a lot of companies have talked about. I don't know if it's...

James T. Crines

Yes, the bad news on price is that it is negative and there is pressure. There's going to continue to be pressure on price. The good news is that it's been relatively stable. We've been able to forecast with -- I would tell you, with a high degree of accuracy, what that -- how that's going to impact on our type line -- on our top line and, consequently, we're able to plan around that and still deliver on our bottom line commitments. So we, as an example, went into last year expecting that prices would be down across all of our geographies and all of our product franchises about 2% and, sure enough, that's where we landed at the end of the year. Last year, we were dealing with the biannual price reductions that happen in Japan. They were a bit more significant last year than we had expected when we went into the year but we were able to offset that with some other markets and other geographies and even get some positive price, in some cases, across -- within certain franchises and certain geographies. We go into 2013 with a similar expectation, knowing that we're going to anniversary out of the Japanese price cuts at the end of March. So that pressure's off, if you will, in Japan at least, coming out of the first quarter. But we do expect some incremental pressure in Europe as a consequence of the austerity programs that are well underway within the major European markets.

Matthew Taylor - Barclays Capital, Research Division

And what about emerging markets? It seems like that is one that you've talked about less than some of your competitors but you're actually early into China with a deal there in the ortho side. And it seems to be something that you've been focused on but maybe under the radar for some people. Can you talk about your efforts there and how that can contribute to top line growth?

James T. Crines

Sure. I would tell you that we were very fortunate to have done a deal in China when we did. The -- just looking at the -- what it now would take to get a deal done in China where you -- where often the strategy behind getting a deal done there is get a position within the sort of lower-tiered -- middle -- what we would call the middle-tier markets. Because we're -- in the premium segments, we have a share position that's very similar to what we have in developed markets and we're competing against the same, very familiar names who have similar share positions to what we all enjoy in our more developed markets. It's that next tier, where there's a lot of competition and a lot of investment being made to establish a position with the channel in that next tier. We were able to accomplish that with the acquisition of the Beijing Montagne Company. It's a company that had developed principally a hip product line. They have a knee product line we haven't -- that hasn't done as well. Knees are, frankly, a lot more challenging for any small, development-stage company to get into. But they've done extremely well with the hip portfolio. They have a completely built-out channel that covers those second-tier cities. So through the acquisition of that company, we have now a manufacturing capability, a development capability and we have a fully built-out channel that is calling on those hospitals in those second-tier cities. And we were able to do that with -- at a price tag of 50 million as opposed to the 1 billion-or-so price tags that you're seeing others have to spend to establish a similar position. So I -- we're very, very pleased with the position we have. We're going to be able to invest behind that acquisition to expand the capacity of that operation and with a focus on development capabilities and manufacturing capabilities and ultimately leverage some of the manufacturing capabilities there as a source of lower-cost instruments, principally, both for that region, other markets within that region and then, over the long term, for developed markets in Europe and in the U.S., even. And that's just China. There are clearly a number of other emerging markets we have on our radar screen. We've been making investments -- similar kinds of investments, although not -- more typically, I would say, in some of the other emerging markets, more focused on sales channel. So where we've sold, for example, historically, through an independent third-party distributor, we'll acquire that independent distributor and take control of the sales channels in those markets. We've done that in a number of other emerging markets. So we're -- behind those investments, feel that we're pretty well positioned. If you look at our performance in what we call our Europe-Middle East operating segment in 2012, you can see the benefit of the investments and the return that we're getting on the investments we've made on those sales channel. And it's a good example because people talk about the challenges in Europe and, certainly, there are challenges in the 6 major markets: France, Spain, Italy, the U.K., Germany, Switzerland. But if you look at our business and those big -- the 6 big markets represent more than 75% of our revenues in Europe. But then there are another -- which people tend to not talk a lot about but there are another 10 to 15 markets within that operating segment for us. That includes Poland, Hungary, Turkey, Russia, the Czech Republic. In our case, it also includes South Africa and the Middle East. And we're seeing high-single-digit growth in some of those markets. We're experiencing even higher growth that that, in our case, behind some of the investments that we've made. And that's what's enabled us to offset the weakness or the pressure in the 6 big markets in Europe and still deliver growth within that operating segment.

Matthew Taylor - Barclays Capital, Research Division

And we touched on this a little bit in your value-creation framework discussion but you set out some targets for reducing operating costs and you've seen some better performance on the operating margin side in the most recent quarter. Can you talk about your expectations for operating margins over the next couple of years and how we could see that progress in terms of cost reduction or any improvement from mix around the gross margin side?

James T. Crines

Sure. We are -- through the operational-excellence initiatives, we are going to be taking $400 million of costs out of the business. About 60% of that comes -- our expectation is that about 60% of that will come out of costs, manufacturing costs; the other 40% out of SG&A. We've made good progress on those initiatives. Came out of 2012 at a run rate of about $135 million in annualized operating cost savings. We expect to get an incremental $80 million out of programs that will be completed this year, $30 million to $40 million of which will be realized and reflected in our results, bottom line results, this year. It's what's going to help us be able to offset the medical device excise tax in the U.S. So those savings are building up evenly, that $400 million target we said we would achieve by 2016 and are confident that we're going to get there based on the progress that we've been making to date. We've -- the initiatives are very well defined. There's a central sourcing initiative. There's a go-to-market logistics initiative looking at the way that we distribute products, the number of warehouse facilities that we have supporting the kitting that takes place, the service, surgeries. We've looked at that and feel that all of that can be done much more efficiently. We've hired-in subject matter experts that are helping us through these initiatives. We've provided them with the resources that they need. And if you look at our guidance on reported earnings per share, you can see that we're spending $125 million a year on these programs. So the project leaders are getting all the resources that they need to make these changes. These are significant changes. They don't come without some significant amount of effort, some risk of disruption but, again, that's why we're spending what we are to make sure that we get them done, get them done without disrupting the business. And another really critical initiative is our advanced manufacturing initiative. We're leaning out. And there's significant -- more than -- beyond the cost savings, there are other very significant benefits that come out of the advanced manufacturing initiative, probably the most significant of which is the way that, that initiative is going to enable us to significantly increase our capacity without making additional capital investments. So the way it's going to do that is it's going to reduce cycle times and allow us to get more throughput out of our existing footprint. And that opportunity is a significant one. And as I said, it obviously comes with other benefits beyond the cost savings.

Matthew Taylor - Barclays Capital, Research Division

Great. Well, I think we ran a little over so maybe we should wrap up there. But Jim, thanks a lot for your time.

James T. Crines

Thank you.

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