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Zimmer Holdings Inc. (NYSE:ZMH)

Q2 2009 Earnings Call

July 23, 2009 8:00 am ET

Executives

Paul Blair - VP of IR

David Dvorak - President and CEO

Jim Crines - EVP of Finance and CFO

Analysts

David Lewis - Morgan Stanley

Bruce Nudell - UBS

Bob Hopkins - Bank of America

Mike Weinstein - JPMorgan

Matt Dodds - Citigroup

Matt Miksic - Piper Jaffray

Tao Levy - Deutsche Bank

Kristen Stewart - Credit Suisse

Raj Denhoy - Thomas Weisel Partners

Joanne Wuensch - BMO Capital Markets

Paul Blair

Good morning. I am Paul Blair, Vice President of Investor Relations for Zimmer. I'd like to welcome you to the Zimmer's second quarter 2009 Earnings Call. Joining me today to host this call are David Dvorak, President and Chief Executive Officer and Jim Crines, Executive Vice President, Finance and Chief Financial Officer.

This morning, we will review our performance for the second quarter of 2009, provide you with an update on certain key matters, present an update on 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 August 6, 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. We're glad you've joined us on the call today to discuss Zimmer's second quarter results. Our net sales for the quarter were $1.02 billion, and our adjusted earnings per share were $1. We believe these results indicate that we are stabilizing our core franchise, and we're moving forward in a disciplined fashion to restore positive momentum in our business.

As we said in our news release, we achieved sequential improvement in revenue on a day-rate basis for the quarter in six of our seven product categories, including knees and hips. We believe that we've held our global market share in knees and hips during the second quarter.

Overall, worldwide reconstructive sales decreased 2% in constant currency in the quarter. Knee sales in the second quarter declined 1% constant currency, as the result of previously disclosed share losses, negative pricing of 1%, as well as deceleration and procedure volumes as compared to the prior year.

The knee portfolio continues to benefit from our use of Trabecular Metal Technology. We're pleased the clinical data on Trabecular Metal is becoming more accessible. As an example, the July Journal of Bone and Joint Surgery featured a study that indicates the trabecular metal tibial is an effective alternative to standard cemented tibials.

Worldwide hip sales declined 4% in the quarter in constant currency, with negative price of 1% and negative volume and mix of 3%. Our hip results reflect the impact of market share losses, which again we believe have stopped in certain product gaps which we've been addressing.

Our hip portfolio continues to benefit from a very strong portfolio of stems. The Zimmer M/L Taper Hip Prosthesis family of stems is growing at nearly five times the market procedure rate. In addition, the Fitmore Hip Stem is the most frequently requested component for femoral insertion during our MIS surgical skills training events.

Extremity sales for the quarter in constant currency increased 13% over the second quarter of 2008 with strong contribution from our new shoulder systems and the launch of the TM Glenoid.

Dental sales on constant currency basis decreased 12% for the quarter. The dental market continues to experience significant pressure on a global basis due to the economy.

Trauma sales in the quarter were up over the prior year period 7% constant currency with strong performance in plates and screws and initial sales coming from the Zimmer Natural Nail.

Zimmer Spine reported 23% constant currency growth in the quarter. This growth is driven by the Abbott Spine acquisition which was completed during the fourth quarter of 2008 and contributed $20 million of incremental spine sales in the quarter. The Zimmer Legacy Spine business was negatively impacted by competitive pressures and ongoing reimbursement challenges.

Finally, Orthopedic Surgical Products and other sales increased 3% constant currency in the quarter. We're encouraged that following last year's disruptions, we now have many of the OSP products back on the market.

Looking forward, now that our development teams are reengaged in a significant way, we're really excited about the potential of our product pipeline. We've historically had substantive releases on a perpetual basis, and you should continue to see such activity from us moving forward.

During the quarter, our development partner filed for U.S. regulatory clearance to market our patient-specific knee instrumentation which allows for physician preferences and confirmation of implant placement while preserving inter-operative flexibility. Also during the quarter, we filed for regulatory clearance to market multiple new Acetabular Cups in the United States. Certain of those cups are in the process of being introduced outside the U.S. as we speak.

Among these new products is our [continuum] Acetabular Cup which offers various bearing options providing surgeons with flexibility to address each patient's needs during the primary replacement or revision procedure. Another new Acetabular offering is our MMC, or metal-on-metal large head cup system. This is an additional large diameter metal-on-metal hip replacement option, which leverages a 20-plus year history of clinical success with our medical technology.

These new cups, once approved in all jurisdictions, should provide opportunity to pull through incremental revenues of our new and innovative stems. I also want to mention a couple of notable products from our Orthobiologics group. The first is DeNovo NT which we are now rolling out in the U.S. DeNovo NT is a living tissue graft drive from donor cartilage tissue that is intended to support the surgical repair of damaged articular cartilage. There's been a great deal of interest in this technology, and it's been a real catalyst for us in terms of engaging with customers about Zimmer innovation.

During the quarter, we also entered into a 10-year agreement for the exclusive distribution rights in the United States for an innovative single-injection Hyaluronic acid product. Our product (inaudible) corporation submitted a PMA application for approval of the product in July of last year. We anticipate beginning to market the product upon approval which we would expect sometime late this year or next year, barring any of unforeseen issues. These are just two concrete examples of how Zimmer intends to participate in the treatment of arthritis patients earlier in the continuum of care than we have in the past. While we don't expect significant revenue from these new orthobiologics products in the immediate term, we do believe they will provide compelling expansion opportunities in future periods.

We're also making significant progress in the area of Professional Education. Medical education and surgical skills training are vital in our industry. It's through these programs that our customers become proficient in the safe and effective use of our products. Providing a quality education experience is among the most important ways we support our customers and build their trust in Zimmer as a valued partner for patient solutions.

As part of Zimmer's effort to provide first-rate medical education, we've made substantial investments to develop a highly interactive education model that we believe sets new standards for the industry. Officially launched on July 1, the new Zimmer Institute redefines industry training, providing a broad spectrum of customized courses spanning medical education, surgical skills training, and personalized surgeon-to-surgeon training. This model was developed in conjunction with adult education and subject matter experts. The key to its success is a focus on individual surgeon needs.

Surgeons move through customized programs that incorporate four levels of education. Knowledge acquisition, skill development, skill enhancement, and refinement. This customization requires that we provide training using a variety of different modalities to assure that we meet surgeon's needs. So far, the feedback we've received about this approach from participants has been excellent. They appreciate that our training is more personal, interactive, and convenient, thanks especially to regional locations. The faculty-to-participant ratio provides physicians with meaningful access to expert trainers.

We believe all these attributes distinguish the Zimmer Institute from other industry offerings. While many of the aspects of enhanced Zimmer Institute offerings may seem somewhat intuitive, the logistics involved and the resources required for investments in curriculum, course materials, and locations are substantial. Overall during 2009, we expect to train approximately 20,000 medical and dental professionals worldwide across all of our businesses.

In closing, I would like to provide our view on some of the more macro trends that relate to our business and industry. Based on reported results to date, we now believe knee and hip procedures have slowed somewhere between 3% to 4% when compared to the prior year with a more pronounced slowdown in knees. As the economy improves however, the procedures that were deferred in the interim are expected to come back. Note that this is our opinion based on our analysis of market data from a variety of sources, but given the interest in the topic, we thought it would be useful to provide our sense of the situation.

Another closely watched market dynamic is pricing. It is our view that pricing pressures have been persistent for some time and will continue. With the first half of 2009 behind us, we now anticipate worldwide pricing for Zimmer to be down about 1% for the full year.

We report [sheer] price, not price and mix. If we were to combine price and mix, the metric would be more positive. We're currently underpenetrated in higher priced segment of the hip market, for instance. Although going forward, we intend to address that with new product introductions.

One factor that some believe may indirectly influence pricing is the rates of reimbursement from Medicare. The rate proposed by CMS for most procedures in our markets show reimbursement is slightly positive for 2010, similar to increases in recent years.

Again, there is no proven correlation between those rates and overall pricing, but it doesn't add any additional pressure to pricing. We believe this reflects the U.S. government's recognition of how cost-effective these procedures are for society.

One final point I want to touch on is healthcare reform. I think we are still some time away from having a great deal of clarity on how these efforts will eventually play out. As such, we don't think it's particularly useful to speculate on how the proposals made to date might affect Zimmer or the medical device industry in general.

I can tell you, though that Zimmer is appropriately active in the healthcare reform discussion. In the beltway, we're working to disseminate our key messages that patient access to the most effective treatments must be maintained and that what constitutes medically appropriate care should be determined by healthcare professionals.

We'll continue to advance these positions and respond to healthcare reform proposals through AdvaMed, the U.S. Chamber of Commerce, and in coordination with congressional contacts through our Washington D.C. government affairs office.

Before I turn the call over to Jim, I'll summarize by saying that we are confident that our second quarter performance is indicative of stability and positive momentum in our business. We continue to believe that Zimmer is well-positioned for long-term success in an industry that has demonstrated great value and continues to have extremely bright prospects.

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

Jim Crines

Thanks, David. I will, as David said, review our performance in the quarter in more detail, and then provide some additional information related to our guidance. While the dollar strength subsided during the second quarter relative to the first quarter of 2009, compared with the prior year, foreign currency translation decreased revenue by 4.9% or $53 million in the quarter.

Consolidated pricing was down 0.7% for the quarter. In the Americas, price was negative 0.9% for the quarter, while Europe average selling prices were flat, compared to the prior year.

Asia Pacific results include negative price of 0.6%, and have improved compared to recent quarters as we have anniversaried out of the April 2008 reimbursement price cuts in Japan.

Our adjusted gross profit margin of 77.1% for the quarter is up 130 basis points over the prior year second quarter. Foreign currency hedge gains as compared against prior period hedge losses, offset by inventory charges and higher unit manufacturing costs, largely account for the improvement in gross margin in the quarter relative to prior year.

Gross profit margins are expected to be lower by approximately 200 basis points in the second half due to higher per unit manufacturing costs associated with reduced production volumes.

Moving down the income statement, R&D expense as a percentage of sales increased to 4.9% and at $49.9 million for the quarter is 3.1% above prior year. We continue to expect our R&D spend to trend higher and average just over 5% of sales for the full year.

Selling, general, and administrative expenses decreased to $432 million in the second quarter and are down 3.5% compared with the prior year. At 42.4% of sales, SG&A expenses are 90 basis points above prior year and down 30 basis points when compared to the first quarter of this year.

In this challenging economic environment, we are carefully managing our SG&A spend, reducing expenses in certain areas in order to fund growth and productivity initiatives, areas of continued investment focus include marketing and promotion. As David noted, we are also investing significantly in our global medical education programs.

Acquisition, integration, realignment and other amounted to $36.5 million in the quarter and include severance expenses associated with the global workforce realignment, contract termination costs, and litigation related charges. Also reflected in our results in the quarter is a net curtailment and settlement gain of $32.1 million, resulting from the termination of a legacy retiree medical plan.

Adjusted operating profit in the quarter decreased 5.8% to $303.7 million, a 29.8% our adjusted operating profit to sales ratio is in line with the prior year second quarter.

Interest expense for the quarter amounted to $4 million, principally resulting from financing the Abbott Spine acquisition and share repurchases.

Adjusted net earnings decreased 9% compared to prior year at $215.5 million and adjusted diluted earnings per share decreased 2.9% to $1 on 215.5 million average outstanding diluted shares.

These adjusted earnings per share are inclusive of approximately $0.08 of share-based compensation. $0.98 reported diluted earnings per share which include the nonrecurring items reflected in acquisition, integration, realignment and other, a net curtailment and settlement decreased 1% from prior year second quarter reported EPS of $0.99. Our effective tax rate for the quarter was 28.1%. Our first half 2009 adjusted effective tax rate was 27.5% in line with our anticipated full-year rate.

During the quarter, we repurchased 0.8 million shares at a total purchase price of $36 million, approximately $797 million remain authorized under a $1.25 billion dollar repurchase authorization which expires at the end of 2009. The company had approximately 214 million shares of common stock outstanding as of June 30, 2009, down from 215 million as of March 31, 2009.

Operating cash flow for the quarter amounted to $195.1 million, down from $280.6 million in the second quarter of 2008. In the quarter, we continued to resolve outstanding payments to healthcare professionals and institutions resulting in substantial cash outflows compared with prior year.

Adjusted inventory days on hand finished the quarter at 375 days, up two days from the first quarter. Over the past two years, we've made investments in response to growing demand for systems that provide more versatility and better fit for patients. Our Gender Solutions Femoral Components, connective technology, Fitmore stems, contoured plates, and new Intramedullary Nails are all examples.

This trend has and will continue to put pressure on inventory days. We intend to rationalize the inventory investments over time through reductions and field-based consignments and through the use of new inventory management tools including RFID technology to speed returns and redeployments.

Offsetting reductions in field consignments will be the continued buildup of the pipeline inventory for the new Acetabular Cups and the new nail line for trauma. Our adjusted trade accounts receivable days sales outstanding finished the quarter at 63 days, an increase of two days over the first quarter.

Depreciation and amortization expense for the second quarter amounted to $81.8 million. Capital expenditures for the quarter totaled $54.4 million including $30.6 million for instruments and $23.8 million for property, plant, and equipment. This is down substantially from prior year levels as our European distribution center and China manufacturing projects are mostly complete and we adjust spending for lower production volumes.

Cash outlays associated with investing activities during the quarter also include $18 million for acquired intellectual property and another $17 million for certain international distributor acquisitions. Finally, free cash flow was $140.8 million for the quarter.

I will turn now to our guidance. We are reaffirming our sales and EPS guidance, expecting full-year revenues to increase from 1% to 3% in constant currency when compared to 2008. With the first half behind us, we see clear indications that our share position in our core reconstructive business is stabilized.

However, we also acknowledge a more pronounced temporary slowdown in the global market for knee and hip procedures than we estimated coming into this year. Based on current projections, we now believe that foreign currency translation will reduce our reported 2009 revenues by an estimated 2.5% for the full year.

Therefore, on a reported basis, our revenues are projected to be in a range of negative 1.5% to a positive 1.5% compared with 2008. As for the third and fourth quarters based on current projections, foreign currency translation is expected to reduce our third quarter 2009 revenues by an estimated 2%, and increase our fourth quarter 2009 revenues by just over 2%.

Full-year adjusted diluted earnings per share are projected to be in a range of $3.85 to $4.00. Third quarter adjusted diluted earnings per share are projected to be below prior year by approximately 12% due principally to the significant gain recognized in the third quarter of 2008 on the sale of certain investments. Fourth quarter adjusted diluted earnings per share are expected to be in line with or above the current consensus estimate of $1.07.

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

David Dvorak

Thank you, Jim. Once again, we're pleased with the progress we've made in the first half of the year and we believe that Zimmer is positioned for sustained growth in attractive markets. With that I'd like to open the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of David Lewis with Morgan Stanley.

David Lewis - Morgan Stanley

Good morning.

David Dvorak

Good morning, David.

Jim Crines

Good morning.

David Lewis - Morgan Stanley

Jim, I want to clarify some of your comments on gross margin. You've been saying throughout the year we'd expect the gross margin, kind of deceleration in the back half of the year, if you take the average back half gross margin compared to the first half is 50 or 60 basis points reduction on a reported basis, a reasonable assumption?

Jim Crines

Go back to the comment I made in the scripted comments. It's the step-down that we're anticipating in the second half of the year is more like 200 basis points.

David Lewis - Morgan Stanley

Was that on a year-over-year basis, I was speaking more sequentially?

Jim Crines

So tell me, you’re comparing that to what period?

David Lewis - Morgan Stanley

I'm just rolling off your first and second quarter and trending through the remainder of the year.

Jim Crines

Yes, so the gross margins we saw in the first half of the year averaged around 77%, and we're anticipating gross margins for the back half of the year to come in at around 75%.

David Lewis - Morgan Stanley

Okay and then maybe moving on to SG&A here for a second, you had pretty stellar SG&A here in the second quarter, so in terms of your ability to hold SG&A at current levels, given, so gross margins are probably incrementally lower than we’d expect it, you kind of talk about your visibility and expectations there?

Jim Crines

Yes, we talked about our expectations for the full year on SG&A to be in absolute dollar terms on the first quarter call to be in line with or slightly above the prior year, and that remains the case.

We would expect with the seasonal slowdown in revenues in the third quarter that the variable component of SG&A expenses will come down in the third quarter. So, you'd see sort of a modest sequential step-down in total in SG&A spend in the third quarter and then an increase in the fourth quarter with higher procedure volumes that we would expect to see in the fourth quarter.

David Lewis - Morgan Stanley

David just talking about share in the marketplace, you've been sort of hesitant to talk about the share gains. You've focused more on stabilization. Clearly, you have got two quarters here, where we seem to have some sort of relative stabilization. Are you anymore confident, given the training initiatives that should be increasing here in the back half of the year to kind of make a statement that share gains may be more possible in hips and knees and you would have expected, let's say six months ago?

David Dvorak

Well, I think that we're reaching that level of stabilization, so obviously that's step one, David, to the process of picking up share. That's going to be dependent on a lot of things. In addition to training and education, some of these new product approvals being cleared within the U.S. market in the ramp-up time. So, I think the important thing for us is that stabilization in the first instance, and then doing all the things that are necessary to get back into the share gain mode in the future, and that's really our objective for the year, as we exit 2009, and enter 2010 with everything coming together, we'd expect to be in that kind of a position.

David Lewis - Morgan Stanley

Just heading into the back half of the year price has been stable. This is what you're reporting as true price in the first half and given [you're anniversaring] in the press you were seeing in the Asia Pacific Rim. Should we expect true price to improve here in the back half for the year, or is that too much to hope for?

Jim Crines

David indicated in his comments, we would anticipate pricing to be down about a point for the full year, and that's really consistent with what we saw in the first half.

Operator

Next question comes from the line of Bruce Nudell with UBS.

Bruce Nudell - UBS

Looking at the market so far, it looks like based on what you've reported, it seems like U.S. hips and knees are around mid single-digits, but ex-U.S. hips and knees are 1% or flat. First of all, could you comment on your perception of, is anything going on ex-U.S. that is likely to persist what's the source of the downturn? Within the U.S. market, of the 5%, how much of that do you think is volume?

Jim Crines

Okay, Bruce this is Jim. Just to comment on the market, the slowdown we're seeing in markets outside the U.S., it is the case that that slowdown is really hitting in the major markets in Europe. The U.K., Germany, France, Spain and Italy perhaps much like we've seen here in the U.S. We believe that's associated with the economic climate that we're in.

We would expect the patients that are deferring these procedures in Europe in these major markets to eventually come back, so we would expect to see a rebound eventually in those major markets in Europe.

I would tell you that getting outside of the major markets in Europe that we believe there are significant opportunities still in the emerging markets. An Eastern Europe as an example, going forward, there are underpenetrated markets in places as we mentioned. If you go back to the comments I made about cash flow, that we spent some money in the quarter on distributor acquisitions. We are in the process of building out a direct presence in some of those emerging markets and believe there's some significant opportunity there going forward.

Just coming back to the question on the U.S., it is the case. We believe that the slowdown that we have seen is in procedure volumes.

Bruce Nudell - UBS

Just to push on the European major markets and this is actually a point of clarification that would help, certainly me. Our pre-existing belief was that most of these patients were insured by national health services, and hence should be less susceptible to economic pressure. What's wrong with that scenario or the governments in fact is pulling back?

David Dvorak

I think it's probably more of the [ladder] than a flawed assumption, I guess, fundamentally, but I think it's early to start to predict if that's going to be in any type of a prolonged trend at this point, Bruce. So we'll keep our eye on it, obviously, and give you as much of an update as we can in subsequent calls.

Bruce Nudell - UBS

The only other question I have is, one of the subtleties of measuring share is, you may not gain back new surgeons, but you may be able to have better mix in the volume controlled by the surgeons who are affiliated with your products. Could you just comment on that idea and whether it's valid?

David Dvorak

I think it is valid, Bruce. In my prepared remarks, I highlighted one of the principal areas where we do have that opportunity and that is on the hip side and we are underpenetrated in some of those technologies that do draw a price premium, and as you say, if you have the relationship and come out with innovative products in that area, you ought to be able to take advantage of those opportunities, and that's what we intend to do.

Bruce Nudell - UBS

Thanks so much.

David Dvorak

You are welcome.

Operator

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

Bob Hopkins - Bank of America

Thanks and good morning. Just a quick question for David, and one for Jim. First for David, just following up on Bruce's question on mix. You guys highlighted a nice stream of new product flow into the marketplace going forward. I'm just wondering, as you are launching new products, what are you seeing from the marketplace in terms of your ability to get mix out of a new product launch? Has it changed at all? Are you still able to get the [ASP] bump-up from launching a new product at a higher price?

David Dvorak

It's early for us on these launches, Bob, but our view of it at this point is the mix opportunity still exists. As we progress through the back half of this year and have more success with product launches in the U.S. markets in particular, as well as the Acetabular Cups in the large markets throughout Europe that are already launching just this week, we will be able to come back to you and confirm that our assumption is accurate here, but all the early signs are that that mix opportunity is still out there.

Bob Hopkins - Bank of America

Then specifically on the MMC, can you talk about the timing of that launch in the United States and when you expect to see an impact?

David Dvorak

Well, as we said that we are anticipating a launch of MMC in the second half of the year. We are on pace with the development of the product. We are on pace with the clearance of that product in the European markets and that clearance is pending within the U.S. right now.

Bob Hopkins - Bank of America

Ok and then for Jim, you guys had commented I think in the last quarter that your EPS guidance for the year was somewhat predicated on an assumption that the hip and knee market growth rate would be in the 6% area. Looking at that time first half results so far, it doesn't look like 6% is a conservative estimate at this point, maybe something more in the 3% to 4% range. But you're obviously maintaining your EPS guidance here. Are there extra spending cuts that are being assumed to get to that rate? Or was there just enough wiggle room in the 6% number that 3% to 4% isn't enough to really offset on the EPS side?

Jim Crines

Yes, the other thing we pointed out, Bob, when we came into the year with respect to our guidance on the top line was that we could see up to another 50 basis points of share loss in hips and knees. Looking back now at the first half of the year I would tell you we're not seeing that, not seeing any of that. So the fact, that we're not seeing any of that really offsets the fact that we now would acknowledge the markets are growing at a slower rate, maybe somewhere in the order of 4% as compared to the 6% we anticipated coming into the year. So, we're not having to save expenses to get to that bottom line.

Bob Hopkins - Bank of America

That's very helpful. Jim, lastly, can you just give us your sense as to what the market share change has been since the end of 2008 here at the half way point in 2009. Exactly, what incremental share you’ve lost or gained in hips and knees since year end '08?

Jim Crines

Yes and understand we measure it quarter-over-quarter. So, after the fourth quarter of last year we came out, we looked at fourth quarter of '08 versus fourth quarter of '07 and I had indicated that at that time we felt we had lost about 2 points of share in hips and a 1.5 points of share in knees. Then immediately we’re sort of at a point where not everybody has reported here in the second quarter. But, we are looking at our performance in the second quarter against those that have released and putting in some estimates into our own models for those that have yet to release. Our view of it is that we have not lost any incremental share in either hips or knees in the first half of this year.

Bob Hopkins - Bank of America

Great. Thanks very much, Jim.

Jim Crines

You are welcome.

Operator

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

Mike Weinstein - JPMorgan

Thank you, good morning. Good morning, guys.

David Dvorak

Good morning, Mike.

Mike Weinstein - JPMorgan

I want to start by making sure I understood your guidance. It sounds like, just based on your comments, Jim, that your guiding the street to an $0.85 number for the third quarter, is that right?

Jim Crines

That's right Mike, that's on target with obviously down 12% versus prior year.

Mike Weinstein - JPMorgan

Okay. Then the commentary for the fourth quarter was that you expected diluted earnings per share to be in line with or above the consensus of $1.07. That would imply that you'd be somewhere for the year in the $3.85 to $3.90 range. Is that basically what you're trying to imply for the year?

Jim Crines

Yes, I think that's fair. I think there maybe opportunity beyond that, particularly in the fourth quarter, but some of that would depend on where things shake out in the market and whether or not we see any rebound at all in the fourth quarter. But I otherwise, would tell you that's a fair assessment.

Mike Weinstein - JPMorgan

Okay. Did you think at all about narrowing the range? It sounds like basically that's what you're doing. Instead of saying that $3.85 to $4, you are saying $3.85 to $3.90.

Jim Crines

Well I would say that the range is the range for the full year, it's $3.85 to $4. The possibility is still there, the opportunity is still there to get to the high end of the range, but it would depend, admittedly on a couple of things. One would be some rebound in procedure growth and understand we do get into somewhat easier comps across the market in the back, particularly in the fourth quarter, and then timing of some of these new product launches if they were to hit sooner than we're anticipating, that would obviously provide us with some opportunity in the fourth quarter in particular.

Mike Weinstein - JPMorgan

The inventory issue still is a concern of mine. You did guide to lower gross margins over the back half of the year. That 75%, second half gross margin guidance. What does that assume in terms of improvement in your inventory levels?

Jim Crines

We would anticipate, if we're talking about days, first of all, that we would see an increase in days in the third quarter relative to the first and second quarter, and that has a lot to do with the seasonality that we always see in this business. So, we see somewhat of a step-down in revenues in the third quarter due to the summer holidays, and as we continue to build, produce inventory through the third quarter, we would anticipate seeing an increase in days in the third quarter, and then a pretty significant step-down in days going into the fourth quarter.

In absolute terms, our expectation is that inventory investments will remain at around current levels as we get towards the end of the year. We got some reductions in our field consignments being offset by the build-out of pipeline for the new Acetabular Cups and the new Natural Nail.

Mike Weinstein - JPMorgan

The change in the post retiree benefits got a lot of attention last month, and I was just hoping if you could give us a sense of all that trauma with your noise relative to your retirees and your employee base, how much does that save you? What I'm just trying to get a sense, are the savings worthy the noise and negative [publicity]?

Jim Crines

Well, the savings on an annual basis admittedly are not all that significant because our liability has such a long tail, the savings overtime are significant and why we have a $32 million net gain, and it reflected in the results for the quarter. That admittedly was not an easy decision for us. A difficult decision, but it was made after a careful and very thoughtful analysis of our total comp and benefit packages and how that compares with our peer group.

Operator

Your next question comes from the line of Matt Dodds with Citigroup.

Matt Dodds - Citigroup

First on ASPs, you didn't give the level of details you have given in the past. Hips have generally come down more than knees, at least the last couple quarters. For you, is that more of an industry trend, because I know you're talking about potentially you see a little more issue there, but is there maybe a growing sense that hips see more price pressure than knees based on maybe their premiums or less differentiation across classes?

David Dvorak

We looked back over the past several quarters and I would tell you that sort of the reductions that we've seen in ASPs in hips and knees have been pretty consistent actually. It was also the case this quarter. I'll tell you more precisely that ASPs for knees on a consolidated basis were down 1.3% and for hips were down 1.3%. Then sort of those reductions in ASPs were offset by some increase in some of the other product franchises. That's how we netted out to 0.7% reduction across all franchisees on a consolidated basis.

Matt Dodds - Citigroup

One follow-up on your comments on [OUS] recon, when you are talking about building out to more direct in some of these emerging markets, where do you think Zimmer is relative to the competition in your footprint in those emerging markets? Are you ahead, behind? Is the distribution going direct? Is that a normal move for this industry?

David Dvorak

Actually it is a normal move for the industry. As those markets begin to mature and people view those opportunities more precisely, I think that it's quite natural, and I think it's consistent with what the competitors are probably doing or have already done in different markets. People are probably at different places, depending upon the company in the particular market.

Matt Dodds - Citigroup

Where do you think you are today relative to your big competitors?

David Dvorak

We're with the rest of them in the process.

Operator

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

Matt Miksic - Piper Jaffray

I had one clarification on the margins, and then I just had a couple of quick ones on sort of business trends. You talked Jim about this sort of less favorable absorption rising per unit costs from lower production volumes. Just want to make sure looking at this the right way. This is in lower production levels earlier this year that flow through the second half of this year through the P&L and into next year. Is that the right way to look at it?

Jim Crines

That's right.

Matt Miksic - Piper Jaffray

Second, on hips. Obviously still under pressure, but a bit better than we were expecting here, may be a bit better that we're expecting in the U.S. in a while, I think it's been a while since we've been able to say that. Can you talk at all about the dynamics you're seeing there, competitive landscape, maybe the change, if there is any changes in demand for advance bearing surfaces or the demographics of the patients that you're seeing?

David Dvorak

Well, I think that on that front [Matt], probably the biggest dynamic is we feel like we have some innovative offering on the stem side and as the training and education ramps back up, our ability to help train and educate the surgeons on the benefits of those stems and the safe and effective use is obviously enhanced. So I think you're starting to see us realize some of those opportunities that were pending for us through 2008, but we really weren't in a very good position to take full advantage of and we are now.

Matt Miksic - Piper Jaffray

Okay. I guess part of it is having a new product. How much of it is I think you talked earlier in the call is, we're getting back out in front of the folks getting reengaged with the surgeons?

David Dvorak

Absolutely, I think that that is a big part of it. It's something that the management team and the field organization is focused on every day as we need to be, and you are going to see continued emphasis in that regard. So, the tone of those conversations, the frequency of the context are all on positive trends at this point for us.

Matt Miksic - Piper Jaffray

Okay. I mean no change that you're seeing in the marketplace or maybe mix in the marketplace for advanced bearing surfaces? I'm just trying to dig down into maybe where the deferrals have been. Metal has ramped here pretty significantly, up to maybe 30% of the market. Is that starting to slow now for incremental penetration? Anything like that in hips that you're seeing?

David Dvorak

Well, I understand the question, and we aren't seeing that, but we don't have the best visibility to that either with our current offering. I think, that as the new Acetabular Cups get cleared, we'll be able to provide you better feedback on that, okay?

Matt Miksic - Piper Jaffray

Okay. Last thing here on spine. Still kind of bumping along, hasn't really turned the corner, what do you have to do or how long do you think it will take to sort of absorb the acquisition and start to regain momentum here?

David Dvorak

Well, it's work that will continue for some number of quarters, not years. At this point, [Matt], we are making a lot of progress. We've done a good job of cross-training the sales force. Again, training and education on the Zimmer Institute side is still ramping up in that particular sector and beyond that just the building blocks of putting the organization together on a combined basis, we are making good progress.

The management team is working very hard, they're doing good things. It will pay off for us, but it just is going to take some more time. I think that on top of those integration challenges, as we've talked about, we've had some headwinds, particularly in the area of Dynesys on the Legacy Zimmer business, because of some of the reimbursement challenges it's a product that we very much believe in.

We're going to continue to emphasize that as an important part of our portfolio, but we want to move forward with getting the broader regulatory claim and then being able to address those reimbursement challenges in that particular franchise, so those are the types of things that will make a difference in our performance going forward.

Matt Miksic - Piper Jaffray

Anything you can see to sort of integrate Pathfinder or anything you can see to sort of put a product out that would sort of show the strength of the new platform with the products you already have?

David Dvorak

Absolutely. You named one of the key areas. We have a very broad and extraordinarily competitive MIS offering within Spine at this point in time, and so that is something that we clearly will be able to take advantage of.

Operator

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

Tao Levy - Deutsche Bank

I had a quick question on the inventories again. I'm trying to make sure I understand what's going on. When I looked at your prior comments from last quarter, you are somewhat comfortable with inventory levels having gone up, so you could get more instruments out in the field for your distributors. Now, it seems like you want to rein those back in again. So I just wanted to get that dynamic stream?

David Dvorak

Well, I think, Tao, it represents an opportunity for us. It's going to require that we invest in some technology, and I referenced RFID technology in the way they are back in for used in the field to speed returns and redeployments. So we don't want to simply obviously pull the inventory out of the field and go back to putting a lot of pressure on our independent distributor network, in terms of what it takes for them to service the demand to get sets, inventory and instrument sets in hospitals day in and day out, but we do believe there is opportunity there. We have got to make the investment in the technology, in the training and education, and over time we really would like to reduce what we have invested in field consignments.

Tao Levy - Deutsche Bank

Ok, all right. On the operating margin side in the back half of the year, you gave some good visibility and so, where you thought the gross margins were going to go, down a couple of 100 basis points, and then you mentioned SG&A and R&D were going to stay at a healthy [clip]. Should we just assume between 100, 200 basis points of operating margin of declines during the back half?

David Dvorak

Well, you see more of that clearly if you sort of go through the guidance we provided on the third quarter on the bottom-line, probably a more significant step-down in that third quarter and fourth quarter more in line with what we are reporting here in the second quarter.

Tao Levy - Deutsche Bank

3% to 4% that you're now indicating you think the orthopedic market may have slowed down versus the 2% in your prior comment. I didn't catch it. Is that main change? Is that U.S., Europe, worldwide? Is there something that maybe different in this quarter?

Jim Crines

That's consolidated, Tao. But as we pointed out, in the discussion with Bruce earlier in the call, it looks like in the second quarter the step-down was more significant OUS.

Operator

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

Kristen Stewart - Credit Suisse

You were talking about ASPs, and I believe that you were giving them on a global basis. Would you be willing to share, like you have in past quarters what the U.S. ASPs were because it seems that we have or I guess we're starting to anniversary some of the price cuts in Asia Pacific that maybe looks like that might help upward [biased cycle with globalised ASPs]?

Jim Crines

Kristen, I will provide you at least for the core franchise. For the second quarter our ASPs on knees in the U.S. were down 1.4%, and on hips were down 1.8%. In Asia Pacific, our ASPs on knees were down 2% and that continues to reflect the adjustments we saw that took place in Australia in July, beginning from July of last year. Hips on the other hand in Asia Pacific were flat. In Europe, knee pricing was down seven tense of a percent and hip pricing was down 1.2%.

Kristen Stewart - Credit Suisse

It seems that there's a pretty dramatic change between, at least, from what I recall with the U.S. business, this quarter relative to last, is this something that we should continue to see more of a deceleration trend with pricing here? Is it possible that for the U.S. we could start to see down 2% as some of your GPO contract start rolling off and new contracts are entered into?

Jim Crines

It is the case that we're seeing some increased pressure in the U.S. and as you pointed out, kind of reflected in those numbers that I just quoted for the U.S. on hips and knees. On a global basis, it's being offset to a degree by lower headwinds as we anniversary out of the Japan price cuts that took place in April 2008.

Kristen Stewart - Credit Suisse

Does your 1% price assume further degradation in price in the U.S. for the second half?

Jim Crines

It assumes that pricing dynamics globally are going to be in line with and consistent with what we saw this quarter.

Kristen Stewart - Credit Suisse

Okay. So it sounds like U.S. might get worse, because I think Japan rolls off coming up to that should be more of a positive.

Jim Crines

As you pointed out, Kristen that is obviously reflected in the pricing dynamics for the U.S. this quarter relative to the first quarter of this year.

Kristen Stewart - Credit Suisse

With respect to just some of the reconciliations to GAAP, it looks like now your GAAP net guidance has remained the same, but you're now including a $0.15 benefit from this net curtailment and settlement. So, it looks like you're anticipating higher than what you had last quarter acquisition, integration and realignment costs. What’s prompting that change and are some of those costs being taken out to help kind of get to the adjusted numbers for the back half, given the lower gross margin assumptions? Is that some of those additional restructuring maybe helping the SG&A lines be a little bit lower than what you would have anticipated in the first quarter?

Jim Crines

Well, the way I would characterize it, Kristen, that we did incur higher than anticipated costs on that line of the P&L relative to what our expectations were coming into the year, and almost all of that is associated with workforce realignment that took place in the second quarter and the severance and related costs associated with that.

It is the case that within the quarter that cost is being offset by the curtailment and settlement gain. I would tell you with respect to the savings that come following that, the changes we made, the adjustments we made in the second quarter, that those savings are being sort of reinvested.

The savings are going to allow us to go forward and execute on our plans to invest in the areas that I mentioned in marketing and promotion and also to move forward with the investments that we're making in the medical education program, all of which are going to help us restore growth and reestablish momentum across all of our product franchises.

Kristen Stewart - Credit Suisse

I guess I'm just still struggling with the kind of change in gross margin guidance, but yet your constant currency growth rate still remains kind of the same. So, what's really different in helping you to still get to the numbers that you're expecting for the full year?

Jim Crines

Well, if you go back, I think will you’ll find that the gross margin guidance for the full year really hasn't changed. So, the gross margin came in a little stronger than we anticipated in the first half of the year and it's coming in a little weaker than we anticipated in the back half, but on balance, it's in line with our expectations for the full year.

Operator

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

Raj Denhoy - Thomas Weisel Partners

I wonder if I could ask a little bit about the complexion of the share losses we experienced last year. Could you remind us when those started occurring and when they sort of hit in earnest, and it sounds like you haven't seen anything this year. Is that correct?

David Dvorak

Well, I think that as we described in the prior calls, those share losses on a customer loss side were primarily in the third and the fourth quarter of last year. That's not to say that there wasn't some activity at the beginning of this year, but I think that that activity was offset by some of the offensive efforts that were put in place.

Raj Denhoy - Thomas Weisel Partners

So, when we are trying to sort of look out into next year and building models, there is really no reason your growth should be below the market rate, whatever that is next year, at some point in the first quarter?

David Dvorak

Not due to those customer losses, that's fair.

Raj Denhoy - Thomas Weisel Partners

Ok, is there anything else we should think about there? I mean, I guess, you've talked about new products and getting a bit more offensive, but it sounds like, again, we should be through this period and next year we might see more market type growth rates for the balance of the year?

David Dvorak

Yes, everything that we are doing is positioning the company to restore our growth and reestablish that momentum. So the customer focus that we have been talking about, our relationships with the customers, the time we are spending in the field, the emphasis on surgeon training and education through the Zimmer Institute as well you referenced the new product launches on Acetabular Cups, the knees with patient-specific instruments, natural nail within trauma, those are all keys to the future.

Raj Denhoy - Thomas Weisel Partners

Then on the deferral side, have you given a lot of thoughts to when we might see these patients come back, I mean is there a period at which you feel patients can delay, but then they must return or have to return, or is this really something that could roll for a year plus, we might not see a bolus of patients at one point come back?

David Dvorak

The reference that you make, you say a half year to a year. I think that that's a range of what's reasonable to expect, but the other big dynamic is just the stabilization of the economy, and obviously that's a more difficult one for anyone to predict, and I think that it's going to happen at different rates across the globe and with the geographic diversity of our business, we'll see pickups in certain places and probably some geographic segments lagging that pickup. I will tell you again that we're very confident that it is a deferral as apposed to a permanent loss of those procedures. They'll come back and we'll be well-positioned to help those patients get the right solution.

Raj Denhoy - Thomas Weisel Partners

So, when you look out to 2010, do you anticipate sort of an above trend year in recon volumes?

David Dvorak

I would think that you have to look at what's happening now is a baseline, and as the second half of the year rolls out, you are going to have a greater capability to read what 2010 is going to look like.

Raj Denhoy - Thomas Weisel Partners

Then just on the margin side, we have the last year plus talked about incremental spending on your part for a lot of initiatives, and then there was at one point of promise is some of that flowing through. So that we might see kind of better leverage at some point, it sounds like a lot of that has kind of been reinvested in. Again when we look out into 2010, are we anticipating really sort of more natural leverage coming from your model, or is it a case where we might see kind of additional incremental leverage because of some of the initiatives that you've been spending on for the last two plus years or two years or so?

David Dvorak

Well, I think the way you characterized, it is fair, that we would see more natural leverage in 2010, particularly given the fact that we are and have been able to push ahead this year with getting the spend back into the P&L, for example, on the training and education and some other areas.

We're on the other hand I suppose that that spending is sort of ramping up over the course of the year. We haven't done a plan for 2010 that may sort of present a bit of a headwind in the first couple of quarters of the year, but we are going to be as we develop our operating plans for 2010 where we are certainly going to be looking to restore that kind of natural leverage. The other thing, frankly that it is going to help to restore that is getting the growth back on the top-line.

Raj Denhoy - Thomas Weisel Partners

Sure, but your comment about how some of this incremental spending might [bleed] now again into 2010, I mean should we then not think about real leverage until the second half 2010 at this point?

David Dvorak

We'll have more to say about 2010 on our fourth quarter call.

Operator

Your final question comes from the line of Joanne Wuensch with BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

Can we switch to the legacy spine problems that you were talking about? I'm a little unclear what's going on there. Then if we can assume that that weighed down the quarter what would have the spine growth been without the Abbott acquisition?

David Dvorak

I will address that with you, Joanne. I think that the biggest couple of areas that focus on are first of all in the integration of those sales forces. In each of those geographic segments we were choosing those distributors and the sales force channel that we thought was strongest and most consistent with our ability to build that business going forward. So in some instances, the legacy Abbott Spine people were chosen and so they were going to be revenue dissynergies on the Legacy Zimmer side, and so those were, in fact, incurred.

I think the second major factor is the one that I already pointed out, Dynesys which has been a significant growth driver for our business and there have been some non-coverage decisions that have mounted against their product. That product is marketed as an adjunct to fusion as it's been cleared within the United States.

We have a PMA that is pending at this point in time, and we believe that after we receive the approval, we'd be able to go back and start working through those non-coverage decisions. We really feel strongly about the clinical benefits of the product, so that's created some pretty significant headwind in the year-over-year comparisons.

Joanne Wuensch - BMO Capital Markets

Can we assume that without Abbott, we would be seeing negative growth?

David Dvorak

Yes.

Joanne Wuensch - BMO Capital Markets

Okay, and one of the more interesting products I saw showcased at your AAOS booth was in the patient-specific products, it was both hips and knees. What kind of market opportunity do you think that holds?

David Dvorak

We think that there's a significant market opportunity for the patient-specific instruments. As we said, the regulatory filing has been made there and we're awaiting clearance at this point in time. It is a patient-specific instrument technology that applies to knees, not hips as well at this stage, but there has been some pretty significant interest shared by community hospitals as well as larger volume surgeons, and so we think it's going to be more broad-based than one might have initially anticipated.

Joanne Wuensch - BMO Capital Markets

Very helpful. Thank you.

David Dvorak

Thank you, Joanne. With that last question having been addressed, I just want to thank everyone again for joining us today and for your continued interest in Zimmer. We look forward to speaking to you on our third quarter conference call at 8:00 am, on October 22nd. I will now turn the call back to you, [Celeste].

Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.

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Source: Zimmer Holdings Inc. Q2 2009 Earnings Call Transcript
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