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Executives

Paul Blair – VP, IR

David Dvorak – President and CEO

Jim Crines – EVP, Finance and CFO

Analysts

Derrick Sung – Sanford Bernstein

David Roman – Goldman Sachs

Bob Hopkins – Bank of America

Adam Feinstein – Barclays Capital

Mike Weinstein – J.P. Morgan

Eric Snyder – UBS

Kristen Stewart – Credit Suisse

Rick Wise – Leerink Swann

Matt Miksic – Piper Jaffray

Tao Levy – Deutsche Bank

Zimmer Holdings, Inc. (ZMH) Q3 2009 Earnings Call Transcript October 22, 2009 8:00 AM ET

Paul Blair

Good morning. I am Paul Blair, Vice President of Investor Relations for Zimmer. I'd like to welcome you to the Zimmer third quarter 2009 earnings conference 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 third quarter 2009, provide you with an update on certain key matters, present an update on our outlook for 2009 and conclude our discussion with the 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 review 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 Web site at www.zimmer.com under the section titled “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 November 5th, 2009 and can also be accessed from the Investor Relations section of the Zimmer Web site.

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 to-date to discuss Zimmer's third quarter results. We're pleased to report that our net sales for the quarter were $976 million and that earnings per share were $0.88 adjusted, slightly above quarterly consensus expectations and in line with our annual guidance.

Let me start by reporting on the progress we're making in restoring growth to our core reconstructive franchises. We see positive momentum continuing to build in the knee and hip franchises globally. As an example, this quarter's results and certain geographic markets including the U.S., various European countries and Japan, demonstrate the powerful clinical legacy behind NexGen, the world's largest selling knee brand.

These results also demonstrate the broad acceptance of patient specific solutions which are represented within our knee and hip portfolios by products like our gender solutions femoral components and our ML taper stems with connective technology.

Knee revenues in Asia-Pacific led all geographies, up 7.1% in constant currency with strong sales across the NexGen platform and increased penetration of our Unicompartmental Knee.

Overall, during the quarter we recorded worldwide year-over-year constant currency sales growth of 3.6%, reflecting growth in all three of our major geographic segments.

Our momentum is further evidenced by the 4.2% increase in our constant currency sequential growth rate. Reconstructive sales increased 2.3% in constant currency in the quarter.

Knee sales in the third quarter increased 2.8% constant currency with volume and mix growth of 3.9% offset by negative price of 1.1%. Hip sales were flat in the quarter in constant currency reflecting positive volume and mix of 1.2% less negative price of 1.2%.

In the quarter, we saw positive uptick with our new stems; including the ML taper with connective technology and the bone conserving fit more family of stems as well as solid results with our Trabecular Metal Modular Cups. We are in the initial phases of launching our new Acetabular Cup Systems outside the U.S. And early surgeon feedback on the new cup systems has been very positive. Extremity products posted outstanding results for the quarter with sales growth reported at 21% constant currency.

Once again, our proprietary Trabecular Metal technology is playing a critical role in addressing previously unmet clinical needs in the expanding and extremities mark.

Dental sales on a constant currency basis decreased 5.9% for the quarter. A weak global economy continues to adversely affect market demand for dental implants. While revenues in the Americas and Asia-Pacific reflected this weakness, dental sales in Europe for the quarter increased 11%.

Trauma sales in the quarter were up over the prior period 6% constant currency with solid results in locking plates and continued uptick of the antegrade femoral and tibial nails within the new Zimmer natural nail line.

Zimmer spine reported 26% constant currency growth in the quarter including $21 million of acquired revenue from the Abbott Spine acquisition. Solid sales of the acquired fusion devices as well as legacy interbody devices and bone graft substitutes partly offset a decline in Dynesys revenue in the quarter.

Because the Abbott Spine transaction closed approximately one year ago future results will more clearly reflect the performance of the combined business, including sales to synergies realized as part of the integration. Orthopedic surgical products and other sales increased 6.8% in constant currency led by the reintroduced wound debridement product line.

The realignment actions taken in the second quarter have enabled us to move ahead with a number of important strategic initiatives. In the third quarter, we bolstered our investments in product development, quality systems, talent recruitment and marketing. We intend to continue to intensify our efforts in these areas in order to maintain or return positive momentum and achieve sustained growth across all of our product franchises.

We'll manage our spend accordingly. For example, as we saw business picking up in the third quarter, we cleared the way to accelerate certain key initiatives. We remain bullish on the opportunities for sustainable long-term growth and demand for our products.

A recently issued research report highlights some significant data points regarding often quoted demographic and usage trends. I believe they're worth emphasizing. According to U.S. Census Bureau reports, the segment of the U.S. population between the ages of 65 and 74 is expanding at a rapid pace from a growth rate of under 1% in 2003 to a growth rate of over 5% by 2012. Similar dynamics are in play in markets outside the United States as well.

Just as relevant are the usage statistics which indicate that the rate of joint replacement in the United States increased two and one half fold from 10 and 10,000 in 1990 to 26 in 10,000 by 2006. We believe this expansion of the market, which is likely driven by a number of factors including high long-term success rates, advances in implant designs and materials, and increasing patient awareness should continue as new innovations are introduced and patient demand and expectations grow.

Beyond these trends, we have great optimism for current or near-term product launches. We're pleased to be collaborating with some of the most talented surgeon developers in our industry to build out our product pipeline across all of our businesses.

In addition, to our new acetabular products, we're pleased with the continued build-out of our ortho biologics business. Further, we have more opportunities to leverage platform technology like Trabecular Metal, which can provide excellent initial fixation and stability.

Recent 10-year clinical outcome studies demonstrate exceptional biologic in growth and increased bone density around Trabecular Metal implants. No other porous metal material so closely resembles the structure, function, and physiology of cancellous bone. This is why we continue to find applications for the technology across our various product franchises.

Now I'd like to provide a few thoughts on some of the dynamics at work in our markets. In the third quarter, price pressure remained a factor in our results with consolidated average selling prices down 0.7% compared to the prior year period. This moderate change in price is consistent with the trends that have emerged over the course of the year. While we believe pricing pressure will continue, we don't expect to see any dramatic changes for the balance of the year.

Turning to procedure volumes, we believe there are early signs of some improvement. The third quarter competitive results reported to-date and our internal reports suggest a bit of an easing in the procedure deferrals we've seen over the past year. This improvement appears to be more pronounced in knees globally and in hips outside of the United States. Although there continues to be some uncertainty about the rate at which procedure volumes will return, we believe this quarter's results suggest the early indications of stabilization and potential trends towards more normalized growth rates.

Finally, I want to briefly mention healthcare reform. On our last call, I said there really wasn't enough clarity to engage in useful forecasting about the impact of healthcare reform and I think that's still true. We will continue to voice our opposition to the proposed $40 billion industry tax, which is part of the Senate Finance Committee Healthcare Reform Bill.

We also continue to communicate our strong concerns on this matter to our elected representatives in Washington, including members of the Indiana Congressional delegation. We have been and will remain quite active through AdvaMed, the U.S. chamber and with our congressional representatives to assure Zimmer's concerns are understood and represented as the healthcare reform debate continues to play out. We remain supportive of constructive healthcare reform and we believe patients should have access to the most effective treatments as determined by healthcare professionals.

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

Jim Crines

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

Our total revenues for the quarter, as David mentioned, were $976 million, a 3.6% constant currency improvement compared to the third quarter of last year. Dollar weakness in the quarter resulted in lower than anticipated headwind from foreign currency translation, which decreased revenues by 1.2% or $11 million in the quarter.

As David also indicated, consolidated pricing was down 0.7% for the quarter, pricing in the Americas and Europe was negative 1.1% and negative 0.5% respectively, while Asia-Pacific results include slightly positive average selling prices compared to the prior year third quarter.

Our adjusted gross profit margin of 74.7% for the quarter is down 50 basis points from the prior year third quarter and in line with the comments made on the second quarter call.

Foreign currency hedge gains as compared against prior period hedge losses were more than offset by higher unit manufacturing costs, inventory charges and idle plant costs.

Moving down to income statement, R&D expense as a percentage of sales increased to 5.3% and at $52.1 million for the quarter is 8.8% above prior year. We expect our total dollar R&D spend to trend higher in the fourth quarter and average just over 5% of sales for the full year.

Selling, general and administrative expenses increased to $413 million in the third quarter and are up 2.3% compared with the prior year. A 42.3% of sales, SG&A expenses are 10 basis points below prior year. We expect SG&A expenses as a percent of sales to moderate going forward.

During the third quarter, the Company recorded a provision of $35 million for known and anticipated claims related to the Durom Cup. This brings the total provision for Durom related claims to $104 million. As previously disclosed our estimate for these claims is limited to revisions associated with surgeries that predate the 2008 temporary U.S. suspension and which also occurred within two years of the original surgery date.

This provision is classified as a non-recurring item and is therefore excluded from our non-GAAP earnings measure. Any claims received outside of the defined parameters are managed in the normal course and reflected in our standard quarterly product liability accruals.

Acquisition, integration, realignment and other amounted to $22.2 million in the quarter and are comprised of costs pertaining to prior period acquisitions including facility consolidation costs, litigation related charges and termination payments.

Adjusted operating profit in the quarter was flat at $264.1 million and at 27.1% our adjusted operating profit to sales ratio is 70 basis points lower than the prior year third quarter.

Net interest expense for the quarter amounted to $4.2 million on $600 million of outstanding net debt. As a reminder our third quarter 2008 net interest and other income of $28 million included a pretax gain of $30 million from the sale of certain assets.

Adjusted net earnings decreased 13.9% compared to prior year at $188.3 million, and adjusted diluted earnings per share decreased 9.3% to $0.88 on 214.5 million average outstanding diluted shares. These adjusted earnings per share inclusive of approximately $0.06 of share-based compensation at $0.70 reported diluted earnings per share, which include the nonrecurring items reflected in certain claims and acquisition, integration, realignment and other decreased 26.3% from prior year third quarter reported EPS of $0.95. Our effective tax rate for the quarter was 27.6% and our anticipated full year tax rate remains around 27.5%.

During the quarter, we repurchased 1.5 million shares at a total purchase price of $67 million. Approximately, $730 million remain authorized under a $1.25 billion repurchase authorization, which was set to expire at the end of 2009. Also in the third quarter the board of directors approved an extension of this authorization through December 31, 2010. The Company had approximately 213 million shares of common stock outstanding as of September 30, 2009, down from 214 million as of June 30, 2009.

Operating cash flow for the quarter amounted to 352.3 million, up 14% from $307.9 million in the third quarter of 2008. An increased focus on working capital management contributed to the improvement. Our most significant improvement in the quarter among all the critical financial metrics we track was in free cash flow, defined as operating cash flow less cash outflows for instruments and property, plant and equipment.

At $303.4 million in the third quarter, free cash flow is more than two times higher than the trailing six quarter average. This demonstrates meaningful progress and represents an important source of leverage going forward. At a more detailed level, adjusted inventory days on hand finished the quarter at 353 days, down 22 days from the second quarter. This is well ahead of our expectations coming into the quarter. We made more rapid progress on inventory reductions in part through stronger top-line performance.

Our adjusted trade accounts receivable day sales outstanding finished the quarter at 63 days consistent with historically strong performance on the collection and application of cash.

Depreciation and amortization expense for the third quarter amounted to $88.2 million. Capital expenditures for the quarter totaled $48.9 million, including $26.8 million for instruments and $22.1 million for property, plant and equipment.

As indicated in our second quarter call, this is down substantially from prior year level as our European distribution center and Shannon, Ireland manufacturing projects are mostly complete and we adjust spending for lower production volumes.

Cash outlays associated with investing activities during the quarter also include $7 million for acquired intellectual property and another $17.7 million for certain international distributor acquisitions.

I'd like to turn now to our guidance. We are reaffirming sales guidance expecting full year revenues to increase from 1% to 3% in constant currency when compared to 2008. This is consistent with our expectations throughout the year. Based on current projections we now believe that foreign currency translation will reduce our reported 2009 revenues by an estimated 1.6% for the full year. Therefore, on a reported basis, our revenues are projected to be in a range of negative 0.6% to a positive 1.4% compared with 2008.

For the fourth quarter 2009, foreign currency translation is expected to increase our revenues by an estimated 4.4%. In our earnings release this morning, we reaffirmed our full year adjusted diluted guidance to be in a range of $3.85 to $4.

Fourth quarter adjusted diluted earnings per share are expected to be in line with the current consensus estimate of $1.07.

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

David Dvorak

Thanks, Jim. Through three quarters, our 2009 performance has unfolded largely as we had expected and we're fully focused on moving forward. We understand that improved top line performance is the key to progress. We're pleased to have stabilized our business and established new momentum. More over, we expect to restore adjusted earnings per share growth in the fourth quarter and regain leverage in 2010.

Our optimism for Zimmer's long-term success is based on the solid foundation we're creating and on the hard work and dedication of our employees and representatives.

Our strategic plan is in place. We'll continue to make growth-oriented investments to support our innovation and commercialization priorities. We believe our long-term outlook and opportunities are compelling.

Demographics and clinical success in our established markets should drive growth and expansions into new product categories and emerging markets provide even greater potential. Zimmer is well positioned to focus on realizing these opportunities.

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

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Derrick Sung with Sanford Bernstein.

Derrick Sung – Sanford Bernstein

Thanks for taking my question. If I could start on the hip and knee broad markets, it looks like the knee markets did pick up this quarter versus last quarter. I think our numbers have at least in the US growing at perhaps 6% versus 4%. And I was wondering if you could comment on whether what you are seeing is less deferral of procedures there or if you think we're actually starting to see moving of pent-up demand working through the system already.

David Dvorak

I think that when you reference the improvement, it looks to us to be of a point as opposed to two points within that U.S. market, Derrick. But I do think that you're just seeing stabilization. The economy broadly on variety of fronts begins to stabilize, people feel like they have more predictability in their futures and start to make decisions to move ahead, so, whether it's deferrals or a quicker turnaround of that individual it's come to the point where they need to have a replacement in either the knee or the hip category. They're moving forward with those procedures more rapidly I think. But again, this is a step. We have said all along that there was going to be no permanent solution. These were deferments. We weren't going to miss these procedures ultimately and so this is a step towards more normalized growth rate. You're really looking at kind of a point recovery of the three points to four points decline in procedure rates that we saw earlier in the year.

Derrick Sung – Sanford Bernstein

Okay. And if you could give us a status on the update of the regulatory filings for the new Acetabular Hip Cups that you have currently filed. Are you seeing any signs of any potential delays there or are those on track from your perspective?

David Dvorak

Well, those are 510K filings in the United States and so the filings have been made. As is usual we respond to questions as those filings progress through. And so that's the current status of it. I don't know that there's anything that looks all that unusual about those filings at this point in time, but of course, because of the 515 request that went out earlier in the year there's some potential that those filings could take on a different form or the requests that come from the FDA could take on a different form as well. So, there's no absolute assurances to timing on those clearances.

Derrick Sung – Sanford Bernstein

And then lastly just a question on your guidance. You sort of reaffirming the same Q4 guidance at I guess $1.07, I think this is where consensus is that you had sort of reaffirmed or guided us to last quarter despite kind of the $0.02 beat in the third quarter. Is that the right way to be looking at this? And if so why not raise your expectations for Q4?

David Dvorak

I think that is the right way to look at it at this point in time. And as I stated in my prepared remarks, we want to make sure we do is fund all the strategic initiatives that are going to be important to positioning the company for long-term and sustained growth. So we've got some initiatives underway that we think are the right ones, it's a well developed plan; there's a lot of clarity as to where we think there are opportunities going forward. So to the extent we were to see any additional pick-up, we're going to be accelerating the investments in those strategic initiatives.

Derrick Sung – Sanford Bernstein

Great, thank you very much.

David Dvorak

Thanks, Derrick.

Operator

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

David Roman – Goldman Sachs

Good morning and thank you for taking the question. Could you highlight for us on the gross margin line, Jim, you talked a little bit about improvements in inventory levels in your discussion about cash flow. Can you give us some ways to think about the gross margin going forward; maybe some gating on as volume increases certain percent we can start to see stabilization in the gross margin?

Jim Crines

I think that is. We talked obviously on the last quarter call about the step down that we anticipated coming into this quarter. And you're seeing that obviously reflected in our results at 74.7%. To your point, I would acknowledge that there is some headwind going into 2010 as we begin to sell off that higher cost inventory that sitting on the shelf. And that is the principal contributor to the step down in margin relative to what we saw in the first half of this year. I think that is fully reflected I would tell you in this quarter's results and provide some indication of what you would expect to see going forward from here.

David Roman – Goldman Sachs

And then as we look to next year to some of the moving parts on gross margin, currency is a negative as the dollar weakens, if I'm correct, in that at some point you work through the under absorption, but certainly FX is an issue to think about for the first half of next year.

Jim Crines

It is. One of the things I would point out about currency. And we provide a fair amount of detail on the impact that it's having in the year-over-year comparisons in the margin ratio, which been pretty significant this year. But in absolute terms, the hedge gains that are running through cost of goods this year are not as significant. So we take into account all the things going to impact margin going into 2010, that's certainly one of them. But there will be some other things that will potentially be going in the other direction.

David Roman – Goldman Sachs

Okay. And then lastly, by my math, this is the first quarter in seven or eight or so, where SG&A has grown at a slower rate than sales, albeit sort of modestly. Can you maybe talk to us about what was going on there and how to think about that on a go-forward basis?

Jim Crines

Yes, I would say that as we talked about this before as we restore growth to the top line and made this comment in my prepared remarks. We would expect to see some moderation in SG&A spending as a percent of revenue.

David Roman – Goldman Sachs

Okay. And then maybe just one more on volume. You talked about just looking at reported numbers and seeing a stabilization this quarter, but could you give us maybe some of the other factors you're looking at as you talk to your surgeon, customers and sales reps whether its waiting lists or referral trends, operating room schedules, et cetera?

David Dvorak

It's all of those things at this point, David. Those are meaningful data points; they're anecdotal really in their nature. And so we are seeing some stabilization on those various more subjective factors. Overall though, I think what we're looking at is kind of a point improvement in the quarter-over-quarter numbers and I think that's a fair estimation as to what one might see for the balance of the year. I just don't think that you're going to see anything turning negative from that improvement. And then you get into debates about how quickly you're going to see the market restored to normalized rates and some theories about whether it's going to come in the form of a bolus or not. We personally don't believe that it's going to come in the form of a bolus. But we think that over time you are just going to see a continued progression towards a more normalized procedure rate.

David Roman – Goldman Sachs

Okay, thank you very much.

David Dvorak

Thank you.

Operator

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

Bob Hopkins – Bank of America

Thanks. Can you hear me okay?

Jim Crines

Yes, Bob.

David Dvorak

Good morning.

Bob Hopkins – Bank of America

Great, good morning. Jim, first for you, I think David mentioned that 2010 was a year where you felt you could return to some more significant operating leverage. I was wondering if you could just remind us of the various moving parts there in terms of some of the spending that's going on in 2009 that won't materialize and in 20 0 or is that comment just strictly function of improving top line?

Jim Crines

It's principally a function of improved performance on the top line and as I just pointed out a minute ago, we are going to be managing the SG&A spend as a percent of revenue. You can expect to see SG&A spending grow at a slower rate than the top line and that's principal source of operating leverage. And then of course there's the leverage as we get down below the line that we can also deliver by use of putting our free cash flow to use through our share repurchase program.

Bob Hopkins – Bank of America

But then are there any of the quality initiatives that have trued up some spending in 2009 that you have quantified, kind of ending in 2010? Are those any specific numbers that you can talk to there?

Jim Crines

Well, one of the things that I will tell you helps us or puts us in a position where we can leverage that SG&A spend is, as an example, the investment that we've made in a centralized distribution hub in central Europe. In Germany, we've invested in highly automated facility and we've worked through the process of closing down a number of forward stocking points and that part of Europe and have eliminated redundant positions and spending on head count and have also been able to reduce the cost of moving inventory in and out of hospitals in that part of Europe. So that's just one of the investments that we've been able to make over the past 18 months that we're going to be able to leverage going forward. And there are others as well.

Bob Hopkins – Bank of America

Okay. Great. Just curious really quick follow-ups. One, do you guys have any visibility on the potential Japanese pricing changes in April? And secondly, for David, could you just give us some comments on the state of business in Europe? It seems like growth there is a little bit lower than other geographies still. What are you seeing in Europe? Are there signs of real stabilization there as well? Just any comments there would be helpful. Thanks.

Jim Crines

Bob, this is Jim. First of all, on the Japan adjustments and reimbursement prices, we would expect there to be some adjustment in reimbursement prices in April of next year. We do not have visibility to what those adjustments are going to look like at this point. And then if I can just take a stab at the question on Europe, I would tell you, as we look at this quarter's results, and what we believe, based on the data that we have is going on in the five major markets of Europe, we define as the UK, Germany, France, Italy, and Spain, we see market growth, basically flat in the third quarter, and that's consistent with what we saw as well in the second quarter. We would expect and that's funding for single payer systems for elective procedures is maybe less available in this economic environment than it was prior to this economic downturn. Now I would tell you these are life changing procedures as we talked about and as waiting much grow in those markets, I think political pressure build to provide ultimately put some funding back into the healthcare system there to address those patient needs. So we would expect over time to see those markets recover back to mid single-digit growth and demand. Now, those five markets, as we look at it, represent about two-thirds of the total market as we define Europe. There are another 15 markets or 16 markets in Europe as we look at then that in the aggregate are growing at around mid-single digit, then continue to grow at mid single digit. Total, having the five big markets flat and then the other 15 or so markets growing in mid single digit we're seeing low, very low single-digit growth in those markets in the aggregate.

Bob Hopkins – Bank of America

Great, thanks for the color, Jim. I appreciate it.

Jim Crines

Sure.

Operator

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

Adam Feinstein – Barclays Capital

Hey, great, thank you, good mornings everyone.

David Dvorak

Good morning, Adam.

Jim Crines

Good morning.

Adam Feinstein – Barclays Capital

Maybe just one quick housekeeping question and then just a couple follow-ups. You gave some detailed pricing data. Just want to make sure I got that. You went through kind of fast. Just want to make sure that I had the pricing data for the U.S. for hips and knees.

Jim Crines

Adam, we did give pricing data for hips and knees in the aggregate. Knees were down 1.1% in the quarter. Hips were down 1.2%. It's very consistent with what we saw in the first half of the year.

Adam Feinstein – Barclays Capital

Sure. Okay. Great. And then as we look at your Recon business here, comps get very easy starting in the fourth quarter, I'm referring to constant currency basis, so distributing out the impact from FX. So, just as we think about that, do you think we can see a more normalized type of growth number coming off of these easier comps or are there other things we have to keep in mind as you guys think about the overall industry environment and pricing and what's going on there? So just curious to get your thoughts how we should interpret the growth rate for next quarter just with the comps from the price levels. Thank you.

Jim Crines

Sure. I think we would expect that, David's talked about before to see continuing sort of improvement in our performance in our core hip and knee franchises. I will tell you one of the things you have to obviously keep in mind with respect to the fourth quarter is the fact that we anniversary the lift we've been getting from the Abbott Spine acquisition, which was adding about two points of growth per quarter to our top line in the first three quarters of the year. And then with respect to the pace at which we see that momentum picking up in the core hip and knee franchise is some of that is going to be dependent on where we are with these new product launches. So as we said is in our prepared remarks, we're in the early stages of launching the new Acetabular Cups outside the U.S., regulatory clearances are still pending for the new cup systems here in the U.S., and the regulatory clearances are still pending with respect to our patient specific instruments on the knee side as well, which once we get there, would be, we believe will be a catalyst for improved performance going forward.

Adam Feinstein – Barclays Capital

Okay, great. One more question. Just maybe you mentioned the Spine business. Can you give us an update there, how things are going, where we are in the process? I'm just curious as you think about the growth rate of your legacy Zimmer Spine business relative to the Abbott Spine business, just wanted to get a better sense in terms of the trends in the quarter? Thank you.

Jim Crines

Sure. Glad to give you an update on that. I think that we continue to make good progress. I will tell you that over the course of last quarter in particular a lot of progress o-U.S. on the integration efforts, and so that's going to serve us well as we progress into 2010. Sales training, the surgeon training programs as well continue to get spun up and I think we're making good progress on that front. You end up with a lot of headwind in that type of a deal and revenue dyssynergies. And so that's principally what we're facing on the Abbott Spine side. On the Zimmer Spine side, the majority of the headwind comes in the form of Dynesys performance. And as you're probably are aware we're heading for a panel review of the Dynesys product with the broader indications coming up next month. So that's going to be telling to the future of that product line, but we are big believers in the clinical success of that product and believe that it's really a product that can make a big difference for patients. So we're quite optimistic about the future of Dynesys. So this is the proper work-in-process, I think you can look for the next couple of quarters to be continued work-in-progress and then we're going to have a lot more clarity as we work towards the middle of next year in the Spine business.

Adam Feinstein – Barclays Capital

All right. Thank you very much.

David Dvorak

You're welcome, Adam.

Operator

Your next question comes from the line of Mike Weinstein with J.P. Morgan.

Mike Weinstein – J.P. Morgan

Thank you, good morning.

Jim Crines

Good morning, Mike.

Mike Weinstein – J.P. Morgan

First, Jim, let me just clarify; your inventory math always throws us off a bit. The map we had was less profound than I think your inventories have come down by 8 million, 9 million in the quarter. You said that your inventory days came down by 23 days. Can you just walk me through real quick your math?

Jim Crines

Inventory on a cash basis came down closer to 30 million in the quarter. So what's sort of netting out the decrease in inventories on a cash basis is the effect of currency translation on the inventory balances that are reported, particularly our Yen-based inventories, given the size of our business in Japan. So that's really the most significant thing you would not have obviously visibility to and how we get to the 22-day increase on a day basis.

Mike Weinstein – J.P. Morgan

Okay. I want to make sure I was understanding some of the comments you're making earlier just about operating leverage. In 2010, given the pushes and pulls, what you've said about how you run the facilities and the expectations that inventories will come down and then the rollover of the FX hedges on the gross margin, do you think you generate operating leverage in 2010?

Jim Crines

I would tell that you that we're going to have head winds in 2010, but I think those headwinds are getting fully reflected in our gross margin this quarter and what we guided to for the second half of this year.

Mike Weinstein – J.P. Morgan

I'm making sure I understand what you're saying. You're saying that you think you have worked through your inventory issues in the back half of this year or the degree of degradation that we're seeing in the back half of the year is consistent with what you're assuming for 2010?

Jim Crines

I think the gross margin at this level is reflective of the headwinds and the principal headwind being higher unit cost inventory that we're selling through and we'll continue to sell through as we go into 2010.

Mike Weinstein – J.P. Morgan

Okay. But the net picture of where you're coming at so you think you don't necessarily generate operating leverage, but you generate earnings leverage based on your usage of your cash?

Jim Crines

Well, that and I did talk about generating some operating leverage through the SG&A line.

Mike Weinstein – J.P. Morgan

Yes, I'm netting out SG&A and gross margin.

Jim Crines

Okay.

Mike Weinstein – J.P. Morgan

And then, David, just I want to get your thought process. If healthcare reform goes forward and there is an excise tax on medical device companies or U.S. class II, III medical device sales, how will you manage the business differently for 2010? Have you thought that through yet?

David Dvorak

Sure. We have scenarios that we're building out, Mike, and there are questions about the amount, the existence of the tax first and foremost, which is you can guess we're not supportive of. We think that this is bad policy. We do think that on a broad basis, it's going to hurt innovation and you are going to find that patients get access to life changing technologies much later than they otherwise would as a consequence of that. So that's the first place to start the discussion. And we think that this is bad policy.

If something goes through the magnitude of such an excise tax as well as the timing are going to be the first factors that are going to have to be developed out and built into plans, if it ended up impacting 2010, then obviously you'd have to overlay that on to a developed operating plan and figure out are you going to take out and what you are going to reposition. So you're going to look at every line of the P&L if that thing comes through and it's going to affect jobs, it's going to affect the pace of innovation within our R&D portfolio as well as the ramp up of some of the other opportunities that we have, but obviously it would affect the industry, broadly, so it wouldn't be anything unique to our particular company.

Mike Weinstein – J.P. Morgan

Okay. I'll let others jump in. Thanks, guys.

David Dvorak

Thanks, Mike.

Operator

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

Eric Snyder – UBS

Hi, good morning, it's Eric Snyder for Bruce. Just a couple questions. As you noted on knees and hips, the pricing pressure that you are seeing there, was that pure price or was that ASP, so price net of mix benefits and pure price?

Jim Crines

That for us is pure price.

Eric Snyder – UBS

And are you still this year able to offset that with mix?

Jim Crines

There is certainly mix benefit reflect and what we report out as volume mix.

Eric Snyder – UBS

But net ASPs up or down?

Jim Crines

We are generally able to much like others have reported, generally able to offset, may not be an exact offset, but generally able to offset the erosion in ASPs with positive mix benefit. As we see increased penetration, particularly with the Trabecular Metal-based implant devices

Eric Snyder – UBS

Okay, and then, Dave, as you noted the potential consequences of the max tax potentially going through in D.C., you didn't note an ability to pass any of those costs on to customers. Do you think that there is an option for that? Do you think it's just too rough a pricing environment to do that?

David Dvorak

That is certainly an option that would be fully explored. I think right now, with the number of moving pieces in the overall make-up of such a proposal it just is difficult to speculate further, Eric.

Eric Snyder – UBS

And then given the clear poser demographics in terms of ageing and obesity, are you still at the sort of mid single 5% to 6% expected mid to long-term unit growth for major joints?

David Dvorak

I think that serves the right way to characterize the broader market demand in this area, Eric, that's right.

Eric Snyder – UBS

Okay, great, thank you very much.

David Dvorak

You're welcome.

Operator

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

Kristen Stewart – Credit Suisse

Hi, thanks for taking my question. I was wondering if you could just dive a little deeper on the pricing side. I think you guys had anniversaried some of the price cuts in Australia in July, so can you break out just the hip and knee pricing in Americas and Europe? In the Americas, looks like the past two quarters there's a little bit of a decline in pricing. I guess it falls in Europe. If you just help us fill in the pieces there?

Jim Crines

Sure. Kristen, in the Americas, knee pricing was down 1 5 points in the quarter. Hip pricing was down 1.7%,and I think you'll find that's very consistent with what we saw in the first half of the year. Asia-Pacific, where we saw some improvement in price trends in the quarter, given that we anniversary that of both the April, Japan price adjustments and the July, Australia price adjustments, we had positive price on hips about half a point and still negative price on knees of about half a point. And then in Europe, knee pricing was down just 2/10th of a point and hip pricing was down 1.4%.

Kristen Stewart – Credit Suisse

Thanks. And then I guess just in terms of how we should think about kind of a pricing, I know you guys generally do in some instances multi-year contract, so can you help to kind of, it seems that the incremental new contracts, particularly in the Americas maybe down, obviously much larger than your balance of your book of business. So what does that really tell us about kind of trends going forward? How confident are you that we won't see further pressure in kind of the Americas?

Jim Crines

Yes, what I would tell you, what we've seen in the Americas over the past three quarters has been very consistent with hip and knee pricing down about a 1.5 or a little more than a 1.5. I guess one of the things you have to understand, when we talk about increased pressure on pricing is that the price adjustments do not always coincide with contract renewal dates. So we've seen broadly and have had to deal broadly with request for proposals from many of our hospital systems and that is really what's getting reflected in the trends that we've seen over the past three-quarters. So we think it is very representative of what's going on more broadly across the entire U.S. market.

Kristen Stewart – Credit Suisse

And then just kind of looking at, I guess the hip business, particular within the Americas, can you just remind us again what the impact last quarter was with the Durom suspension in terms of how we should think about kind of apples to apples growth rate within the business?

Jim Crines

Kristen, I have to say I don't have that right here in front of me. And off the top of my head, I'm not going to be able to answer that question.

Kristen Stewart – Credit Suisse

Okay, no problem, I'll take that offline and then I guess last question would be, you obviously had very strong cash flows in the quarter, only repurchased 6 million to 7 million in terms of shares, how are you thinking about the use of cash kind of moving into 2010 and what will the role of acquisitions play? Do you still feel comfortable getting to a double-digit earnings growth rate absent any acquisitions?

Jim Crines

Yes, I would tell you as we said before that our first priority for use of free cash flow would be focused on any strategic opportunities that we would identify where, particularly where we would have the opportunity to continue to build out the other musculoskeletal franchises outside of our core hip and knee franchises, where we have smaller market share position. Talked about the interest that we have in Spine, the Abbott Spine deal is representative of the kind of deal that would look very attractive to us. Certainly, continue to have an interest in building out our ortho biologics portfolio and do that through a combination of potential acquisitions or licensing, like the licensing arrangement we've entered into with Sacagacu [ph]. So that will remain sort of our first priority with respect to the use of free cash flow and then to the extent that there are no immediate opportunities in front of us, we would otherwise put it to use through our share repurchase program. We have over 700 million remaining over the share repurchase authorization that as I pointed out in my remarks has now been extended out through December 2010.

Kristen Stewart – Credit Suisse

And then just the confidence in 10% kind of growth absent acquisition earnings growth?

Jim Crines

We'll talk very specifically about what our expectations are for 2010 on our fourth quarter call.

Kristen Stewart – Credit Suisse

Thank you very much.

Jim Crines

Thank you.

Operator

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

Rick Wise – Leerink Swann

Good morning, everybody. Turning back to trauma, we've seen stable growth year-over-year in the first three quarters. One of your competitors reported yesterday, one of the bigger players, very strong results. I'm trying to gauge just your thoughts about how, when and where Zimmer might start to gain share in trauma. You highlighted your new nail line. When do we start to see the impact of that and other new products?

Jim Crines

We expect to show the impact of that in some of the investments that we've made strategically as we progress into 20 10, Rick.

Rick Wise – Leerink Swann

So is it too much to think we might see accelerating growth rate as we get into 2010 helped by the new products hopefully?

Jim Crines

Yes, that's exactly what we expect to be able to produce in the way of results.

Rick Wise – Leerink Swann

And I know you're not going to give us 2010 guidance, but just thinking conceptually about gross margin, looking at the year ahead, I'm sort of wondering whether 2010 gross margin flow might be the reverse of what we've seen in 2009 with a weaker first half as you've suggested, a rebound in the second half as the higher cost inventory works through, volumes continue to grow. But just in general, ending up with gross margin much like the sort of 76% kind of range we're talking about for this year, is that the right kind of thought process?

Jim Crines

Well, that is getting into 2010 guidance, Rick. I think at this stage, I would just repeat what I've said earlier and that is that kind of the headwinds in terms of the higher unit manufacturing costs that we're currently dealing with and going to continue to deal with going into 2010 are fully reflected in our results this quarter. We have still a year's worth of inventory on hand. So it will take some time before we're able to benefit from the increased leverage that we will eventually get as we see more volume running through our facility.

Rick Wise – Leerink Swann

Okay, dental still is weak as you've suggested. Maybe any additional color you can give us there, any signs of stabilizing or anything that might change the outlook for that business in coming quarters?

David Dvorak

Well, I think that you're just looking at the macroeconomic factors. The unemployment rates, the consumer confidence levels, the financial community getting back in order and providing capability for these people to secure the resources that they need for the broader procedures, especially in the private pay markets. So those are all the broad factors. But I would tell you that's a market we don't have double-digit market share and I'm not sure that we're the ones to provide with you much more color on that at this point, Rick.

Rick Wise – Leerink Swann

Okay. And two last questions. Maybe just a little more color on your comments about going back to the Recon market, the growing and building sales momentum. Is this more in existing accounts are you at the point now where you feel like you're winning competitive accounts as you move past issues in the last couple of years?

Jim Crines

I would describe it as stabilization of the customer base, Rick.

Rick Wise – Leerink Swann

Driving things more. And on the shorter term basis, just thinking about SG&A as we move from the third quarter, fourth quarter, clearly you're getting the positive SG&A leverage. I'm guessing currency helps a little bit. But to get to the consensus numbers, we'd have to see a pretty strong step up, something approaching 40 million sequential increase plus or minus, depending on other numbers. And appreciating the seasonal nature of SG&A is it possible that there might be a little more leverage as we look ahead to the fourth quarter than those numbers might suggest?

Jim Crines

I think it's fair to say that just given the seasonality in the business it's fair to expect that we're going to see some significant improvement going from the third quarter to the fourth quarter.

Rick Wise – Leerink Swann

Okay. Thank you very much.

Operator

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

Matt Miksic – Piper Jaffray

Hi, thanks for taking my question. So first question on inventories. I just a few follow-ups here on some things that I think folks have touched on, on the call, and then I had a sort of broader question for you, Jim, and one for David. So the follow-ups here, inventories as you talked about were down. I wish I could get a sense of where you are in terms of capacity utilization as you think about your current production levels versus a year ago. And maybe if you could just talk about when you think you're going to get back to sort of a normalized rate, just because that seems to be sort of the predictive element of when gross margins will start to (inaudible) from current levels.

Jim Crines

Well, of course, a lot of that. Matt it's going to be dependent on the momentum on the top-line as well as whether or not we see some recovery and when we will see a recovery and the five major markets in Europe. We talked about earlier. Some of that will depend certainly on getting the 510Ks that we have in cleared. But we would expect the utilization from current levels will improve in a linear fashion from here. And then it's just a question of how steep that improvement is going to be. And as I said, all that is going to depend on, couple things I mentioned, when we would see a recovery in those major markets in Europe and when specifically we would be able to get clearances, particularly for the new Acetabular Cups here in the U.S.

Matt Miksic – Piper Jaffray

Just on that, I mean you do have new products filed. I'm assuming that you don't wait for approval before you start ramping production. We have seen slight improvement here in terms of deferrals in the third quarter. So have you started to get to a point where you've eased back into some production level higher than, you took it down pretty significantly in the first half, is that correct?

Jim Crines

We did. And it does increase from here for the sort of very reasons that you stated. And some of these new products as we pointed out were in the early stages of launching those products outside the U.S. So the production volumes, there's the opportunity, obviously for those production volumes to increase once those products are cleared and out in the marketplace and you're not just building the pipeline, but the facilities are responding to demand for replenishment once those products have been commercialized.

Matt Miksic – Piper Jaffray

Okay, that's helpful. Another follow-up here on, I think there were some questions on the European market. It looked like they have kind of improved little earlier than w were expecting on a constant currency basis. Is there anything there that's changed? And also is there any difference that you see there in terms of hips and knee performance? You mentioned the bunch of markets that are still growing, and the major markets are maybe stabilizing, but anything in terms of competition or your product that would sort of drive the recovery in knees before hips?

Jim Crines

Well, I would tell you where we saw the significant improvement in performance on the knee side was not so much in Europe as it was more for us in our case at least there was more Asia-Pacific and specifically Japan. What we saw in Europe in the quarter was we think fairly consistent with what we saw in the second quarter.

Matt Miksic – Piper Jaffray

Okay. And then lastly, the follow-up here and then I do have a couple of questions, but on Spine, you talked about Dynesys, David, and annualizing some of the dyssynergies here heading into the fourth quarter. There's a lot of moving parts there. Dynesys seems to be currently challenged, but then you have this new indication, new data that could drive further adoption. What's the strategy there for returning the core business to grow post the comps? Is it penetration of Pathfinder? Do you need the new indications for Dynesys to grow that business?

David Dvorak

The strategy for growth there is we really have a broad foundation of fusion offerings at this point in time, post integration of the Abbott Spine deal. So you have everything that you need on the outer body and the inner body side within the fusion market, as well we have a strong MIS offering between Pathfinder and the technologies and products we picked up through the NDS acquisition. So that's comes together very nicely. It is the case that as you suggest that the broader indication on Dynesys is going to be very important to restoring the right trajectory on that franchise and the path there really is the broader claims allow us to go back and address the non-coverage decisions. I don't think anyone either among the surgeon users or within our business has question about the clinical efficacy of that product and the solution that it provides for patients. So we need to get the broader indication so that we can address those non-coverage decisions over time and get that important franchise that truly is a differentiator for us back on track and then continue to emphasize the MIS offerings.

Matt Miksic – Piper Jaffray

Jim, on the P&L, it's just a broad question as you look forward and I'm not trying to pin you down here for 2010 growth or anything like that, but I think if I understand, the goal is to sort of restore some level of sales growth and then to achieve some kind of acceleration to the bottom-line, in very sort of long terms. But what level of top line growth is enough to give you some meaningful leverage to the bottom line, putting aside year-over-year comps that you're facing now? On a go-forward basis is low to mid single-digit enough? Do you feel like you need to break the mid single-digit level, given your margin structure to show acceleration?

Jim Crines

That is a tough question to answer at this point, Matt. We'll be able to respond to that very specifically when we comment with guidance for 2010. Certainly, the opportunity is there longer-term, at least in terms of how we think about it with the market longer-term on a unit basis growing in mid single-digit, and opportunity beyond that with some positive mix benefit, net mix benefit coming from the introduction of new innovative devices.

Matt Miksic – Piper Jaffray

And last one here, for David, on healthcare reform, just a broad question, David, about this element of comparative effectiveness. You've talked about the great success, life restoring benefits of joint replacement, which I think a lot of folks would agree with. But is there any strategy to sort of put data on the board that would help position you in the sort of a new world of clinical evaluation that we may be facing from payers?

David Dvorak

It's going to become more and more important. Not only the clinical efficacy, but the economics of these solutions and we have such a great story to tell within our space in particular. You look at these procedures and over half the people that have a hip or knee replacement are returned to work, that were out of work previously. If you look at it from the individual's perspective, the cost of managing these chronic conditions, this replacement will lead to savings of anywhere estimated from $68,000 to $180,000 per individual. So, whether you're looking at the broad system cost or the individual cost, these procedures with 90-plus percent success rate, 10 years, 20 years into the replacement, I have a great story to tell.

And the economic development to that story and communication of it we need to do a better job on that front. And I think that that's true for the broader industry too, when you start talking about healthcare reform. I mean no one argues with the desirability of getting more access to patients. It's a matter of how you do it and how you build greater efficiencies into the system without inhibiting the innovation that leads to these better outcomes for individuals and greater efficiencies and economies in a broad sense. So those are the points that we make in these discussions, I think that accrued and material excise tax that's currently being proposed cuts very much against the core substance of what is trying to be repaired with healthcare reform so comparative effectiveness makes sense, a $40 billion tax does not.

Matt Miksic – Piper Jaffray

That's helpful, thanks.

David Dvorak

Sure.

Paul Blair

Celeste, in the interest of everyone's time, let's take one more question.

Operator

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

Tao Levy – Deutsche Bank

Great, thanks a lot for filling me in. I have two quick questions. One, I was wondering given that some of the regulatory of the new products that you're expecting to improve haven't come through how much sort of the inventory improvement that we saw in the quarter was somewhat related to not having to build for those new products and how much was sort of real work down of products?

David Dvorak

I don't think, Tao, the improvement in the quarter was at all material. To some extent, you end up with these pending approvals and then you're going ahead with build plans in anticipation of the approvals. So I don't think that you would see anything other than a modest impact on the deferral of those clearances.

Tao Levy – Deutsche Bank

I was actually going after the sort of the inventory levels that you have. I don't know if you're starting to build up already for them or in the last quarter you kind of alluded to inventories potentially either staying flat with the second quarter because of these new products that you're going to be manufacturing.

David Dvorak

I think that what we talked about in the past is just that there's a little bit of a wash out effect. We're doing a better job of managing our inventory more efficiently and more effectively and at the same time we're starting to ramp up the production for these new product launches in anticipation of those clearances and finding some traction with the commercialization of the new products. And so there's a washing out as between the two, but net we still saw improvement in the quarter, obviously.

Tao Levy – Deutsche Bank

Perfect. And on the hip side, when I look at the numbers from the companies that reported, looks like maybe you lost a little bit of share sequentially. Is that more in related to these new products that you're expecting?

David Dvorak

Yes, I think that we don't believe that we're losing customers at this point in time. We may be losing some cases because of those gaps that we talked about extensively in the past and these product launches that are underway right now. O-US fill those gaps and then some. We have some very differentiated technology built into the Acetabular Cups, for instance, and so we're really optimistic about the future there and then of course to get after those same opportunities within the U.S. market is going to require these clearances coming through.

Tao Levy – Deutsche Bank

Great, thanks a lot.

David Dvorak

Okay, thank you, Tao. And thanks again everyone for joining us today and for your continued interest in Zimmer. We look forward to speaking to you on our fourth quarter and year-end conference call at 8:00 A.M. on January 28, 2010. So I'll 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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