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Zimmer Holdings (NYSE:ZMH)

Q3 2010 Earnings Call

October 28, 2010 8:00 am ET

Executives

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

Paul Blair - Vice President of Investor Relations

David Dvorak - Chief Executive Officer, President and Director

Analysts

Charles Chon - Stifel, Nicolaus & Co., Inc.

Matthew Miksic - Piper Jaffray Companies

David Roman - Goldman Sachs Group Inc.

Robert Hopkins

Michael Weinstein - JP Morgan Chase & Co

Kristen Stewart - Credit Suisse

Derrick Sung - Bernstein Research

Frederick Wise - Leerink Swann LLC

Adam Feinstein - Barclays Capital

Bruce Nudell - UBS Investment Bank

Joanne Wuensch - BMO Capital Markets U.S.

Operator

Mr. Blair, you may begin your conference.

Paul Blair

Good morning. I am Paul Blair, Vice President of Investor Relations for Zimmer. I would like to welcome you to the Zimmer Third Quarter 2010 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, provide you with an update on certain key matters, present an update on our outlook for 2010 and conclude our discussion with a question-and-answer session. We understand that this is a very busy reporting day, and we'll do our best to keep today's call close to an hour in length. Therefore, we ask that participants pose one question with one follow-up to allow as many callers as possible the opportunity to take part in today's call.

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, further 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.

In addition, we routinely post important information for investors on our website in the Investor Relations section. We intend to use this website as a means of disclosing material, non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor the Investor Relations section of our website in addition to following our press releases, SEC filings, public conference calls, presentations and webcasts.

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 11, 2010, and can also be accessed from the Investor Relations section of the Zimmer website.

At this time, I'd 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 could join us for today's call. This morning, I'll review our third quarter 2010 results and provide some commentary on general market conditions. Jim will then discuss additional financial details.

We delivered solid earnings and cash flow performance in the third quarter, notwithstanding challenging global economic conditions that negatively impacted procedure rates. Our performance reflects a focus on disciplined spending in executing our strategic plan. A core element of this plan involves a new product introductions across our businesses. These introductions will position us for an improved performance in the fourth quarter and accelerate growth beyond 2010 as the economy strengthens.

Net sales for the quarter were $965 million, a decrease of 0.5% on a constant-currency basis, and our earnings per share were $0.96 on an adjusted basis, an increase of 9.1% over the prior year period. For the quarter, our Americas and Europe, Middle East and Africa segments experienced constant currency sales declines of 0.4% and 3.8%, respectively, while the Asia Pacific region grew 4.2% constant currency.

Knee sales for the quarter decreased year-over-year 2.7% constant currency, reflecting negative volume and mix of 0.4% and negative price of 2.3%. Important advances for Zimmer Knees included a broader rollout of our Patient Specific Instruments and a limited rollout of our posterior referencing instruments.

Moving into the fourth quarter and to a greater extent throughout 2011, we expect to see accelerating growth with these knee instruments being deployed broadly. A number of additional MRI centers have been certified to process our Patient Specific Instruments, and we have had continued commercial success based on the unique and differentiating features and benefits of our system.

Meanwhile, early clinical feedback on our posterior referencing instruments have been very positive. Recent National Joint Replacement Registry data continues to demonstrate outstanding long-term clinical success of our NexGen and Natural-Knee product families, and we're confident that our enhanced instrumentation options will drive increased adoption globally.

Our Hip business performed above market in the Americas in the quarter with sales improving year-over-year, 2.7% on a constant-currency basis. Overall, our Hip sales increased 0.5% constant currency, reflecting positive volume and mix of 2.7% and negative price of 2.2%.

We're encouraged that is volume and mix growth relative to market is verification of increasing momentum we're experiencing in the commercialization of our new Hip products. In particular, the Continuum Acetabular Cup System provide surgeons with the flexibility to select from alternative bearing surfaces to meet the diverse and unique needs of their total hip replacement patients.

The Continuum System has provided an important expansion to our hip portfolio. As we've described before, momentum from a new product introduction generally builds over the course of one or more operating periods as the implement instruments and related training are deployed. We're on track with our expectations for the stage rollout of the Continuum System.

The performance of our Hip business in the quarter was also supported by continued strong sales of Revision Hip products, a category in which Zimmer has achieved overall leading market share. We also saw growth in sales of our stem products, including the M/L Taper with connective technology, which offers a modular adjustable neck system that enables surgeons to personalize fit interoperatively for each patient.

Extremities products posted sales growth of 3.6% constant currency for the quarter, which compares to a high 20.5% growth rate from the third quarter of last year. These results were again supported by sales of our Shoulder products, featuring Trabecular Metal Technology, including the TM Reverse Shoulder and TM Glenoid.

Continuing its solid performance for the year in a market heavily impacted by general economic conditions, Zimmer Dental sales increased 4.9% constant currency for the quarter. Our Dental business is generating broad-based sales momentum across implants, restorative components and regenerative products.

Trauma sales in the quarter were up over the prior year period by 0.5% constant currency. We recently announced the 1,000th U.S. implantation of our Cephalomedullary Nail, a key component of the Zimmer Natural Nail System. Continued success in the commercialization of this new product bodes well for the rest of the Zimmer Natural Nail System, which features a wide range of lengths and diameters and in innovative anatomical design. We also announced the first implantation of the NCB Periprosthetic Plating system, a first of its kind solution for addressing complex femoral fractures that can occur around the knee or hip implant.

While Zimmer Spine reported an overall sales decrease of 7.4% constant currency in the quarter, European Spine sales experienced strong growth of 21.1% constant currency. In our Spine business, we continue to drive operational changes and pursuing aggressive new product development pipeline.

In the third quarter, Zimmer Surgical, formerly known as Orthopaedic Surgical Products, experienced a solid 8.2% constant currency growth. We continue to see strong sales of our wound debridement devices and bone cement products.

I'll now touch briefly on some operational developments and other topics. Operationally, we improved our sequential gross margin and cash flow to support corporate investments, including a new product development initiatives designed to accelerate our growth. While we increased spending on product development, our margins remain strong, with operating margins improving 160 basis points in the third quarter compared to the prior year. Cash flow remains at a high level, a point on which Jim will provide more detail.

Consolidated pricing for the quarter was consistent with our expectations, decreasing slightly from the second quarter. Consolidated average selling prices in the third quarter were down 1.4% compared to the prior year period. We experienced negative pricing of 1.6% in the Americas, flat pricing in our Europe, Middle East and Africa region and negative pricing in the Asia Pacific region of 2.9%. We continue to anticipate consolidated price erosion of between 1% and 2% for the year.

In the third quarter, the market experienced a slowdown in procedure volumes due to global economic conditions, unemployment and other factors. High unemployment has resulted in expiring health insurance and COBRA subsidies in the U.S., as well as a decline in enrollment in private health plans. Demographic analysis suggests that these trends has had a particularly notable impact on the non-Medicare potential patient base for joint replacement procedures, those between 45 and 65 years of age.

The balance of the slowdown in the U.S. is attributed to seasonality effects, which include a combination of slower surgery schedules and patients delaying care until high deductibles are met. Similarly, austerity measures are contributing to the overall slowed procedure volumes in Europe.

Now long-term indicators still point towards sustained growth, and we continue to believe that the knee and hip market should grow in the mid-single digits. That outlook is based on anticipated growth in developed markets with aging populations, as well as higher penetration rates in emerging markets in which increasing numbers of patients are gaining access to healthcare.

Even with the economic pressures that we've seen over the last 18 to 24 months, healthcare providers and third-party payers recognize that these replacement procedures are cost effective. They take costs out of the system as opposed to continuing to manage the chronic conditions to which patients would otherwise be exposed. We remain committed to executing our strategic plan with the focus on disciplined financial performance.

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

James Crines

Thanks, David. I will review our third quarter performance in more detail and then provide additional information related to our 2010 guidance. As David mentioned, our total revenues for the quarter were $965 million, a 0.5% constant currency decline compared to the third quarter of last year.

Net currency impact for the quarter was slightly negative, decreasing revenues by an additional 0.5% or $5.2 million.

The unfavorable currency impact from our euro-denominated sales in the quarter was partially offset by a favorable currency impact from our Japanese yen and Australian dollar denominated revenues. Our adjusted gross profit margin was 77.3% for the quarter. The margin ratio is up 260 basis points compared to third quarter of 2009, an increase of 100 basis points compared with the second quarter 2010.

Improved management of our global inventories has resulted in lower excess in obsolescence expense compared with the third quarter of prior year. Additionally, prior year results reflect certain charges for scrap, idle plant and cleanup activities following the 2009 fire in our Warsaw manufacturing plant.

Lastly, the improvement in gross margin also reflects the manufacturing network operating at higher levels of efficiency in 2010 compared with prior year. As outlined in the second quarter call, we expect our gross margin ratio to be between 76% and 76.5% for the full year, assuming that foreign currency exchange rates remain near recent levels. This includes a lower gross margin ratio in the fourth quarter due to less favorable hedge results.

R&D expense as a percentage of sales was at 6%, and at $57.6 million for the quarter is 10% higher on a total dollar basis when compared to the prior year. This increase is in line with our strategy to focus more investment into new product development activities and clinical programs.

Selling, general and administrative expenses were $412 million in the third quarter, and at 42.7% of sales or 40 basis points above prior year. SG&A spending for the third quarter of 2010 in absolute dollar terms is slightly below the third quarter of the prior year.

Acquisition, integration, realignment and other amounted to $5 million in the quarter. These expenses include integration costs from our pending acquisition of Beijing Montagne, a onetime cost stemming from distributor acquisitions in our Europe, Middle East and Africa segment, realignment of our global IT infrastructure and other of the prior period acquisitions.

Adjusted operating profit in the quarter increased to $277 million. At 28.7%, our adjusted operating profit sales ratio is 160 basis points higher than the prior year third quarter due to improvements in gross margins that are partially offset by increased research and development expense.

Net interest expense for the quarter amounted to $14.2 million compared to $4.2 million in the prior quarter. Similar to the last two quarters, the change is primarily due to the $1 billion senior unsecured notes offering we completed in November of 2009.

Adjusted net earnings were $192 million for the third quarter, an increase of 2.2% compared to the prior year. Adjusted diluted earnings per share increased 9.1% to $0.96 on a 199.7 million average outstanding diluted shares. These adjusted earnings per share includes above approximately $0.05 of share-based compensation. At $0.96, reported diluted earnings per share, which include the items reflected in acquisition, integration, realignment and other, increased to 37% over the prior year third quarter reported EPS of $0.70.

Our adjusted effective tax rate for quarter was 26.7%. We anticipate that 2010 full year tax rate will be approximately 27%. During the quarter, we repurchased 4.2 million shares at a total purchase price of $225.6 million. As of September 30, 2010, approximately $1.3 billion remained authorized under our $1.5 billion repurchase program, which expires at the end of 2013. The company had approximately 197 million shares of common stock outstanding as of September 30, 2010, down from 204 million as of December 31, 2009.

We continually review the best utilization of the cash that we generate. Our intentions with regard to use of free cash flow remain the same as we have indicated for some time. Our first priority is external development, when and it's the right opportunity to rise. There are technology products or business that strategically align with our focus on musculoskeletal health. We balance this priority with maintaining strong liquidity and continue to believe that share repurchases are an efficient and effective way to return excess free cash flow to our shareholders.

Operating cash flow for the quarter amounted to $320 million, down 9% from $352 million in the third quarter of 2009. Net inventories were $923 million at the end of the third quarter, $44 million less than third quarter prior year. Adjusted inventory days on hand finished the quarter at 380 days, an increase of 27 days compared with the third quarter of 2009. This increase in days on hand is largely driven by the sensitivity of the calculation in year-over-year improvements and cost of goods sold. Our adjusted trade accounts receivable days sales outstanding finished the quarter at 67 days, an increase of four days over the third quarter of 2009.

Net receivables increased $14 million or 2% over prior year. Depreciation and amortization expense for the third quarter amounted to $84 million. Free cash flow in the third quarter was $256 million, $47 million lower than the third quarter of 2009. We define free cash flow as operating cash flow less cash outflows for instruments and property, plant and equipment.

Capital expenditures for the quarter totaled $64 million, including $50 million for instruments and $14 million for property, plant and equipment. Cash outlays associated with investing activities during the quarter include $2.5 million for certain international distributor acquisitions.

I'd like to turn now to our guidance for 2010. In our earnings release this morning, we provided fourth quarter revenue and adjusted EPS guidance and updated our full year guidance. Fourth quarter revenues are expected to increase between zero and 2% on a constant-currency basis as we continue to gain momentum with new products and instruments.

As a result, the company now expects 2010 full year revenues to increase approximately 2% on a constant-currency basis, which compares with prior guidance of between 3% and 5%.

Assuming foreign currency exchange rates remain near recent levels, the company estimates that foreign currency translation will decrease revenues by approximately 1% in the fourth quarter and increase revenues by 0.5% for the full year 2010. Fourth quarter adjusted diluted earnings per share are projected to be in the range of $1.17 to $1.22. As a result, adjusted diluted earnings per share are projected to be in the range of $4.24 to $4.29 for the full year 2010.

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

David Dvorak

Thank you Jim. In summary, our third quarter performance reflected solid bottom line performance in a climate of macroeconomic pressures. The outlook for the remainder of the year anticipates continued progress with recent product and instrumentation launches, supported by a full offering of medical education and training programs.

Our organization retains a broad sense of optimism about the potential for our industry. The long-term positive indicators for our sector are compelling. In the face of heightened scrutiny about healthcare costs, our increasingly diversified portfolio of early and late-stage intervention musculoskeletal products provide cost-effective solutions for the patients and global healthcare systems we serve.

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 - Bernstein Research

I wanted to start by asking you a little bit about the European dynamic in hips and knees. So it looks like Europe perhaps took another step down maybe in the market as a whole, certainly for your sales this quarter after seeing a couple of quarters of somewhat weak but stable growth. Two questions related to that. Was there anything that changed over this past quarter to result in that? And then secondly, as you think about the budgets getting reset for 2011 and the austerity measures being put in place, what it in your mind is the risk of kind of another step down in procedure volumes or another step down in sort of healthcare spending pressure that would pressure procedure volumes coming from new budgets being put in place in 2011?

David Dvorak

Derrick, we did see a slower market with respect to procedures in Europe. For us, the pricing environment didn't change much from the second quarter to the third quarter. So I think that some of the austerity measures in the macroeconomic conditions created environment where the was a more profound element of seasonality to the business. It's always a slow market in the third quarter within Europe due to the holiday schedules, but it was exacerbated by the economic conditions. I would tell you, with respect to looking forward in that market, I think that one of the limitations as to how aggressive people can push in managing these procedure rates down is a political one. At some point, the known success of these procedures among the patient base and the recognition by the payors with these national healthcare systems is that it's not a cost effective move to differ these procedures in any extended form. And frankly, it becomes politically untenable at some point. And I think that you have to that bear in mind as you look forward and anticipate what those markets would look like in the future. Now the majority of our business is in the five or six most developed markets, and those slowdowns that we saw were more profound market-wise, it seems, in hips than in knees and we obviously have a significant market share in those European markets. And so that impacted the quarter to an extent. And then finally, if you're looking at our performance within Europe sequentially, you'll note that we picked up a billing day in Q2 and lost a billing day in Q3. And so that explains a bit of the sequential performance difference from Q2 to Q3 for us.

Derrick Sung - Bernstein Research

And then just a follow up on pricing. So it looks like pricing in hips and knees decelerated further from I believe you said it was last quarter kind of in the 1.5% to 1.6% range, specifically to hips and knees, to kind of 2.2% to down 2.3% range this quarter. It sounds like most of that came from the U.S., if you're saying that Europe pricing held pretty steady. Can you provide further color on that and kind of where you see that pricing trajectory going?

David Dvorak

Yes, that pricing performance is consistent with what we expected to see coming into the year. We anticipated the 1% to 2% element of price erosion in our business, and that's exactly what we're seeing. It is true that the price erosion in the U.S. for the third quarter was a bit more significant than in the second quarter. But it's also the case with Japan because that price decline hasn't anniversaried out yet big impacted our overall step down from 0.9% to 1.4% for the quarter. And I don't think that the dynamics, Derrick, have changed much in the U.S. Those discussions are similar to what's taken place in the past quarters, and I think you could anticipate that they're going to continue to be similar with respect to pricing discussions going forward.

Operator

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

Michael Weinstein - JP Morgan Chase & Co

I wanted to touch on a couple of areas. And David, I appreciate, it's very hard to try and make sense of the market off of one difficult quarter for the company. But you expressed your confidence in what you think is a sustainable mid-single digit growth market for hips and knees. And I just wanted to maybe just get your view that within that, how do you view pricing mix play in component? In order to do a mid-single revenue growth, what you think about the growth would need to be?

David Dvorak

Again, we still think that there's an opportunity with respect to mix. And Mike, that's just going to be dependent upon where we are within each product category on new product rollouts. If you've anniversaried out of that mix benefit and you're not introducing something else within that category, you're probably going to see a bit of negative impact between price and mix at that particular point in time. On the other hand, if you're ratcheting up a launch and it's a significant launch that provides you with mixed opportunity, you could see some positive impact that's between price and mix at that point in time. So I think it's just going to be dependent upon where you are in the product rollout cycle. But if you have a healthy flow within this marketplace and you're addressing unmet clinical needs, I still do think that you can see either a wash in those categories or some modest positive impact as between price and mix going forward.

Michael Weinstein - JP Morgan Chase & Co

If we start to think about 2011, I noted in your comments earlier that price had gotten a little bit worst in the quarter. I think across the company you guys said it was down 1.7% this quarter. How should we be thinking about it for 2011?

David Dvorak

So we're not going to give 2011 guidance, but as far as the market goes, I think you have to look at price in a similar fashion to 2010 at this point in time. You're going to have a similar environment, I would believe in the United States. I think that Europe may get a little bit more aggressive. On the other hand, Asia Pacific, you're going to anniversary out after the first quarter of the Japan adjustments that took places, and those were significant for most of the competitors. And certainly, that's the case for us because of the size of that business relative to our overall Asia Pacific business.

Michael Weinstein - JP Morgan Chase & Co

So even with the kind of deterioration we saw from 2Q to 3Q in price in the Americas and it looks like a little bit in Europe, too, that you think that 2011 pricing looks similar to 2010?

David Dvorak

Yes. I mean, I think that coming into the year, we said minus 1% to 2% and that the rate where we're tracking were minus 1%. But that range I think is as good as one that I can give you at this particular point.

Operator

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

Bruce Nudell - UBS Investment Bank

David, if you kind of look from January '09 through the first quarter of '10, the combined markets constant currency were probably a little less than 5%. And based on what we saw in the United States in '09, ASPs were probably in positive territory. So it's a four-point unit market or three-point unit market in the U.S. I don't know and I don't think anybody knows. And so going forward, we're modeling 4%. You say 5% from those. But just to your comment on hips and product mix, you guys have new products. And I think you said volume mix was 2.7%, but price was minus 2.2%. Is it just a safer assumption to assume net zero ASP going forward?

David Dvorak

Net zero ASP, so a wash between price and mix?

Bruce Nudell - UBS Investment Bank

Yes.

David Dvorak

Yes, I think that that's a reasonable assumption, but I think that you're going to have point in time where there's some headwind in that category, Bruce, and then some other opportunities to show some modest positives that's between those two.

Bruce Nudell - UBS Investment Bank

But I guess just at this instance in time, you do have new hips. And hips should be -- this would be one of those times, or is there something that makes that more complicated that meets the eye?

David Dvorak

No, you're right. And again, you have to factor in where you are in the launch of those products. So we're really just beginning to hit the traction point. There's a lot of emphasis on the U.S. market, and so you saw some improvement in our performance relative to the market within the U.S. On the hip side, the penetration is continuing. Within that particular market right now, you have to remember that there's a bit of headwind on the Metal-on-Metal mix. And that's an element of that continuum set. But for that headwind, we'd be seeing a lot more mix benefit coming from Continuum. But that's the reality of the market of that we're launching the product into.

Bruce Nudell - UBS Investment Bank

And then just strategically, let's say it could be anywhere from a 4% to 5% kind of steady-state market, but there is probably a risk of deflationary pressures worsening on the net of pricing mix. What sort of things could Zimmer do strategically to kind of diversify a way from this sector, where you've got reasonable but not great volumes and some potential increase in deflationary pressure?

David Dvorak

Well, I mean, take market share in the core businesses first and foremost. But when you look at our existing portfolio as it sits today, Bruce, there are big opportunities for us in those smaller product categories. So spine, dental trauma, surgical products we have less than 10% market share. And in instances, less than 5% market share in each of those categories. And what we're experiencing there, oftentimes because of that market position, you don't have as much price pressure as you do in an instance where you have 30% or 40% market share and have had that market share historically. So we're this business and investing in these global businesses in a manner where we expect to outpace market growth, take market share and those are going to be big opportunities for us. Furthermore, the continuum of care that we've been talking both earlier interventions and late interventions put us in a position to move upstream, and the treatment of these patients intervene with biological solutions. So hyaluronic acid is an interesting one for us. We have a great set of relationships that we could to push that kind of a product to our existing distribution channels, and there are a lot of opportunities for us to broaden the business and expand our growth rates in those categories as well.

Operator

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

Robert Hopkins

So back just on the pricing front again and the sequential downtick in hips and knees, that's not all Japan sequentially I would assume. Specific as it relates to hips and knees, is that correct? It's more than just the sequential downtick in Japan.

David Dvorak

That's correct. I mean, if you're talking about the step down from the second quarter to the third quarter, that would principally be the Americas.

Robert Hopkins

And so any further color on that dynamic away from what you've said already?

James Crines

I think, Bob, when you look at what's happening with procedure volumes, our sense is that the slowdown is really happening on the private pay side. So perhaps at a hospital level, the hospitals are looking at somewhat unfavorable trend in payor mix. And we know for a fact that if you go back to 2008, 2009, Medicare enrollment was already increasing at a faster rate than enrollment in private health plans. So that's some of what has created this pressure. And I think it's fair to say that pressure has intensified somewhat. But again, we continue to manage through that pressure and believe average selling prices across our franchises globally, as David said, will be down in a range that we guided to at the beginning of the year of 1% to 2%.

Robert Hopkins

And then the one follow-up I have is on the knee franchise, you've guys have talked about Europe and the issues there. But in the U.S., it looks like on that knee franchise, you saw a deceleration. I was wondering, do you think you're losing share in knees, you're losing some surgeons? Or just talk about the knee dynamic in the United States in Q3 versus what you saw in the first half of the year.

David Dvorak

Yes, we think that we need to improve our execution front to be sure, Bob, because the performance that we saw come out of our business for in the third quarter on the U.S. side wasn't at market growth rates. And so there's some loss of business there. I think that we have the right plans in place and we're executing those plans. And most importantly, those initiatives are around these instruments to augment our already existing excellent clinical performance with the NexGen and Natural Knee Systems. And so that's a big opportunity for us because those are instrument sets that are differentiated in the case of PSI, and accommodating in the case of PRI of surgical philosophies that many competitive surgeons come to the table with. So we have one of the best-performing knee systems and now a set of instruments that's going to accommodate that particular surgeon customer, and I think that it's going to be a great growth opportunity for us. But the third quarter marked the point where we introduced those PRI instruments only on a limited basis. And again, it takes some time for those sets to get deployed for surgeons to train, to trial and to work through the sales process. And we're optimistic that as these months progress, you're going to see an improved performance driven by a that initiative as well as others.

Operator

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

Adam Feinstein - Barclays Capital

I guess just a question about new products. Maybe you could just quantify how much of your revenues came from new products in the quarter and just trying to think about just opportunity there, and just trying to think about the outlook in terms of that being a catalyst for growth so we are in a slower market environment. I guess one could argue that new product launches are more important than ever. So just trying to understand what sort of impact that may have had in the quarter, and how you're thinking about that over the next 12 months.

James Crines

Sure. We've said historically that before we spend on R&D, we look to be in a range of 15% to 20% of revenue with new product revenues, and we define that as products that have been released in the last 36 months. I would tell you with respect to the Hip franchise, we're within that target range but outside of that range when you look at the Knee franchise. And as you think about what we have going on with Knees, with the launch of these new instruments, that's where we're seeing a competitive pressure on Knees. There are competitive systems out there with new, more modern instruments. Our response to that is both the new PSI instruments as well as the posterior referencing instruments. And as David indicated, we're still early into the launch for those instrument systems. The fact those instruments will not really necessarily have an impact on that metric, so until we launch new devices within the Knee franchise, we're not likely going to see much of an increase in new product revenue within the Knee franchise. What we're really looking for to drive performance there again is the launch of the new instrument systems.

Adam Feinstein - Barclays Capital

I guess, as you guys just think about deploying your free cash flow and thinking about opportunities there and pretty conservative balance sheet, just any thoughts in terms of, I guess, the ability to take on additional leverage to buyback stock or do any acquisition opportunities? So I guess what are your most current thoughts there?

David Dvorak

Well, as I indicated in my prepared remarks

[Audio Gap]

free cash flow the way we have historically. That is the first priority we'd look for business opportunities that as I said, strategically align with our focus on musculoskeletal health. We'll otherwise continue to return excess cash to shareholders through the share repurchase program. As you know, we did issue $1 billion in long-term notes in 2009. So we have levered up to some degree, and that's helped us in some respect to be more aggressive in terms of returning cash to shareholders. As we indicated, we spent $225 million in the third quarter on share repurchases. And as we've said before, we're going to continue to target somewhere in the order returning a third to a half of our net income on an annual basis through that share repurchase program.

Operator

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

David Roman - Goldman Sachs Group Inc.

Jim, can you just talk a little bit about SG&A spending? I think on last quarter's conference call, you had guided us to a number somewhere in 43.5% of sales range. In David's openings remarks, you referenced tight cost containment measures. I assume some of that had to do with the revenue trends you saw throughout the quarter. Can you maybe just help us understand in the quarter how much of the SG&A relative to your guidance was natural leverage versus proactive measures that you took?

James Crines

Yes. So as you pointed out on our second quarter call, we indicated that SG&A was expected to be approximately 42% for the full year. At the time, we have projected approximately 43.5% for the third quarter. We clearly came in below that level. And since our third quarter SG&A expenses came in lower than we have projected and historical trends tell us that seasonality should have a favorable impact on ratio for the fourth quarter. We would now expect the full year SG&A ratio to be lower than our prior guidance of 42%. This is an area, David, that we continue to focus on. We've acknowledged that at 42%, our SG&A ratio is out of line with industry benchmarks. And I would tell as we develop our operating plans for 2011, that is something that we'll get a fair amount of attention. We have opportunity here we would acknowledge to drive more leverage through the P&L by taking that SG&A ratio down and bring it more in line with industry benchmarks.

David Roman - Goldman Sachs Group Inc.

And then on the gross margin this quarter that you called out the drivers of the year-over-year improvement, primarily being efficiencies to the plants and lower excess and obsolete inventory cost, did foreign currency gains contributed at all to the year-over-year improvement?

James Crines

They did, net hedge gains in the third quarter accounts for approximately 40 basis points of our gross margin. And I would tell you that assuming currency rates remain near-recent levels, the effect of hedge gains and losses on gross margin in the fourth quarter will be lower. So for the fourth quarter, we're projecting losses, for example, on the yen, Aussie dollar, Canadian dollar and British pound hedge contracts just given the way the dollar is traded against those currencies. And that will be partially offset by what we would predicted this time will be modest gains on euro hedge contract. So that does create a bit of a headwind going into the fourth quarter.

David Roman - Goldman Sachs Group Inc.

And then lastly for David. Obviously, you've been stepping up R&D on absolute dollars pretty consistently over the past two quarters. Maybe just help us understand where that incremental R&D spending is being focused. Is that on the core businesses, the Hip and Knee franchise? Or are dedicating an increasing percentage to those non-core businesses? And should we start to see the relative pace of new product introductions to be more significant in your peripheral businesses rather than Hips and Knees?

David Dvorak

Sure, it's broad-based across all the product categories. I think that if you look at a longer-term trend as to where we were, say, five years or so ago, David, it is broader-based. There's been greater emphasis in the global businesses than there was that five-year time period previous. And I think that you're going to start see some of the benefits of those investments in the coming quarters. Notably, we've emphasized a great deal of investment in the Trauma area and the Natural Nail line is rolling out now that we're seeing some good early clinical success with is an example of what we intent to do on those product categories. Again, those are markets that are very attractive markets. The skill sets that it takes to compete effectively in those markets are very transferable from the core recon business and in instances, the distribution channels overlapped as well. So we can create a lot of value with growth in those global businesses. And going back sometime, we started to enhance our investment to drive that opportunity.

Operator

Your next question comes from the line of Kristen Stewart with Deutsche Bank.

Kristen Stewart - Credit Suisse

I just wanted to go back to the pricing commentary about kind of Europe. And I guess you're seeing obviously more pressure from the austerity measures from a procedure basis, and I'm just wondering do you expect that some of the tenders come up to see greater pressure on price and maybe some alleviation on some of the procedure side?

David Dvorak

That is potentially the case, Kristen. I think that some of that depends on the jurisdiction and the structure and how centralized the systems are versus the more regional systems. And so there are jurisdictions where their lever is more a procedure level, and others where their lever is more of a price level. So we have a pretty significant market share in most of those developed jurisdictions across Europe. And what we reported out as being essentially flat pricing in Europe is indicative of what we're seeing right now. But it could be the case that in some of those jurisdictions, price gets pushed a bit harder as they free up the procedure rates.

Kristen Stewart - Credit Suisse

Are some of the tenders that you've gone through more recently suggesting that pricing could get worse going forward and...

David Dvorak

No, I wouldn't say that because I think that, that tender business always had that character to it. Those are typically not the highest margin opportunities but they're volume opportunities, and so they can make some economic sense on a couple on fronts. For one thing, if you're absorbing overhead, the marginal profit can still be unacceptable. On another front, it could be that you want to participate in those tenders because that's an emerging market that's going to continue to grow. And so getting in at this point in time is strategically consistent with your plans. So either way, those are elements of the business that we want to be very engaged in and have been historically.

Kristen Stewart - Credit Suisse

And then you said Americas pricing was down 1.6%. What was it last quarter again, I'm sorry, in 2Q?

James Crines

It was 1.1% in the second quarter.

Kristen Stewart - Credit Suisse

And then just as we think about that dynamic, I mean, as I have always kind of looked at things, you guys have locked up contracts with GPO, it's usually for an extended period of time. So what really is explaining such a dramatic or what seem to be a dramatic downtick sequentially? Are hospitals kind of breaking old contracts? Are the net new contracts that you're signing just suggesting that price is materially down? Can you help us just kind of understand what it's just down significant degree on a sequential basis?

David Dvorak

Kristen, I would tell you that and we've pointed this out in prior calls that we no longer would rely on broadly speaking the contracts that are in place at a given point in time. We've seen a lot of churn over the past few years, and it continued to be the case that many of our individual hospital pricing agreements are often getting renegotiated somewhere in the middle of their term or certainly prior to the end of the term. And that continues to be the case.

Kristen Stewart - Credit Suisse

So I guess then, suffice it to say, certainly as this continues then pricing is likely to get worse based upon where we're heading certainly. And if the ability of hospitals to renegotiate the middle contracts would suggest that you guys have a less of a bargaining position? Is that fair to say?

David Dvorak

Well, I would say just what we said before, we continue to manage through the pressure. It's been around for some time. And I think our contract management people working together with our independent distributors in the U.S. Our sales management teams outside the U.S. have done a pretty effective job of managing pressures. So that we are able to provide the kind of guidance that we provided coming into the year. And we're seeing results that are right in line with where we told people they would be for the year.

Operator

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

Joanne Wuensch - BMO Capital Markets U.S.

Can you give us an update on the sales force at this stage in terms of turnover, and also in terms of sentiments given that the market is going through this transition?

David Dvorak

Yes, I would say that the sales force continues to be very engaged. I don't think that there's been turnover that's been out of line with any historic averages, Joanne, either.

Joanne Wuensch - BMO Capital Markets U.S.

And then there was a new product, which you launched in the last 12 to 18 months in the Hip Continuum and the MMC. Could you please give us an update on how those products are tracking?

David Dvorak

Sure. And some of new product launches are what's driving that continued engagement within the sales force, obviously. On the Hip side, as you mentioned, the Continuum system as well as the MMC system were launches that were initiated the very end of last year. And so those launches are under way. We're starting to see the productivity of those launches, particularly on the Continuum side. I will tell you that the MMC Cup is a less significant launch in light of what's happened in that Metal-on-Metal category. I think that there's going to continue to be a market out there for the Metal-on-Metal, but it's going to be less significant. And that was not a segment that we were heavily penetrated in prior to the market turning the way that it has. So we didn't have much business in that category, and I think that those that had a lot of business in that category are seeing the mix of that business turn probably likely more towards polyethylene solutions at this point in time. But the Continuum system is a very encouraging launch for us. You can see what it's allowed us to do and even at downmarket over the course of a slow summer within the U.S. business and step up to above market growth rates. So continue to be very encouraged, and I think that there is more runway out in front of us on that launch

Operator

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

Frederick Wise - Leerink Swann LLC

Back on the procedure volumes side. Several companies this quarter have already given some sense that the third quarter seasonally weak of course, but the second half of the quarter was better than first, or they saw some signs of rebound in September and into October. Can you give us any color about the directionality? Or do you just feel like things are sort of dead flat in a broad sense? Or are we trending a little better? Any perspective will be welcome.

David Dvorak

Sure. They've been obviously a lot of questions to try to break these quarters apart. And we've anticipating the current quarter and obviously, that's a place that we can't go just as others went. I'm not familiar with people coming back and providing color along the lines of what you are articulated. But I'm sure that you have heard something from people, Rick, that give you a basis for making that statement. In our case, I would tell you that, that procedural slow down was relatively consistent through the summer months. So I can't really look at the performance on a procedural basis and disaggregate the quarter in a way that can offer you any better understanding. I think that what you see in our results was pretty consistent through the entire third quarter.

Frederick Wise - Leerink Swann LLC

And to be fair, just for you information, it was a bunch of smaller companies and some non-ortho companies just for your perspective. But just as a follow-up question. Maybe some updated portfolio strategy thoughts, and specifically as it relates to Spine and maybe more broadly. On the Spine side, continued weak. from here, and again any updated thoughts can you do it internally or are you going to look outside? And maybe more broadly on the portfolio, your already diversified compactors seem to be getting more diversified for saying at announcements starting today. Any broader, higher-level thoughts about the portfolio longer term?

David Dvorak

Sure, Rick, we like our existing portfolio. And our fundamental strategy launching due to the experience that we have in the third quarter of this year. We're going to continue to focus on executing our plan. Again, within the recon space, we think that we have great opportunities and some of this can lead to informing our views as to what external development might look like to move up and down that continuum of care as well as emerging markets. And so you can see that we've announced an acquisition in China that is pending at this point in time, and that's consistent with our growth strategy for the recon market. So again, up and down the continuum of care on the recon side in emerging markets. And then beyond that, we have excellent opportunities in these other product categories. And I think that as early in the fourth quarter, you're going to start seeing some progress to be made in one or two of those other business units. Coming back to your Spine question, I think that, that's one that is to win there, we're going to have to do well both on internal as well as external development to ensure that we've got the right kind of product pipeline. So we've got a pretty significant commitment at this point in time on internal development. And just recently, we launched on a limited basis an excellent MIS system, the Pathfinder system. It was well received. We think that we're going to make good progress in that category and have an excellent overall portfolio with MIS solutions within the Spine business. But to continue to make progress on that market, it's a big market. It's one that we think we can create a lot of value win for the shareholders and provide some good solutions for patients. The success rates are much lower at this point in time, so there is a lot of room for innovation that can make a difference for patients in that category. And we want to be one of the companies providing those solutions going forward.

Operator

Your next question comes from the line of Charles Chon with Stifel, Nicolaus.

Charles Chon - Stifel, Nicolaus & Co., Inc.

When adjusting for the revenue contribution from the Abbott Spine acquisition last year, the fourth quarter actually faces a tougher year-over-year growth comp on a constant currency basis, which is what we saw on the third quarter and you expect revenues to be flat to up 2%. So just wondering would you be willing to speak to the confidence that you have in the fourth quarter guidance? Is there something that you saw on the exiting trends from the 3Q that lands to the visibility for the fourth quarter here?

David Dvorak

Actually, the anniversary-ing out of the Abbott spine acquisition essentially is complete by the end of the third quarter. So there isn't anything to factor in on that front. We're confident in the guidance that we provide. We know that people place a lot of value and are making investment decisions. And so subject to all the front-end qualifiers, with Safe Harbor statements, that's our guidance. It's well informed. And those are the results that we expect to achieve.

Charles Chon - Stifel, Nicolaus & Co., Inc.

Would you be willing to talk to then maybe what sort of trends you saw on the third quarter as you exited the quarter, just give us a sense of what kind of velocity we saw from the underlying business?

David Dvorak

Yes, Charles, that question was asked and answered already. And we just didn't see much of a difference at different points in time. During that third quarter, it was a pretty consistently slow procedure rate that we had a view throughout the third quarter.

Charles Chon - Stifel, Nicolaus & Co., Inc.

Maybe shifting the focus away from Europe and EMEA, outside the U.S. Could you talk to the market dynamics in some of the emerging regions, like the BRIC countries? The sort of growth rates and growth rates and growth dynamics are we seeing in those territories? And any chance we can wrestle some granularity on pricing mix from those regions as well?

David Dvorak

Well, I'll talk to you about growth rates. I mean, the BRIC nations all provide excellent opportunities for us. And right now, you're seeing growth rates that are double digits in those markets and it would stand a reason that, that would be the case because they're very underpenetrated at this point in time. If you look at the opportunity to bring these solutions to patients, it's a large, large population basis and very low-penetration rates. And so there's a lot of infrastructure oftentimes to be developed. These are markets that each one of them is different, there are different product tierings and price points and service levels. And so you really can't speak in general terms beyond if you look at those population bases and the penetration rates that currently exist and start to do some math around that and you see big opportunities going forward. So those are markets where as a global leader, we want to have a significant level of participation going forward. And I think that we can drive a lot of growth and improve the quality of life per patients that live in those jurisdictions.

James Crines

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

Operator

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

Matthew Miksic - Piper Jaffray Companies

Just trying to understand what's happening or what happened in Knees. It's a question for David. It sounds like either because of your transition to instruments or maybe because of the push into Hips, which is moving a little slower and pricing that it seems like the Knee business is kind of caught in a little bit of a transition tier. Is that part of it in addition to all the market pressures that you're seeing, and everyone is seeing? I'm just trying to reconcile the sequential slowing of your business relative to the sequential slowing of some of the other players in this space. Were there just some transitional alliance between new product launches? Jim, you mentioned upgrading instruments, is there sort of logistical issues holding back the business or making this a tougher transition for you?

James Crines

I don't think they're logistical. But the essence of the theory, I think is a fair one that we put it, Matt. But these are execution matters that we intend to resolve. It is not a limitation on a great product with great clinical results, so we don't have a challenge in that respect. It is the case that within the psyche of the sales force in the marketing organizations that if there's a hot new product, there's going to be at disproportionate amount of time and attention dedicated to that. But that's always a balance that we have to strike. And I think that we look to improve our execution, and we think we have a great opportunity to do that as we launch these new estimates. Those instrument launches, and you know this industry well, Matt, they take time whether it's an instrument or a product launch. And so we literally started that process in Q3. So you're not going to see any benefit in Q3 and you're likely to see modest benefit from that kind of an initiative in Q4. But it's all the base work and planting the seeds that are going to put us in a better position to accelerate that growth as we exit this year get into 2011.

Matthew Miksic - Piper Jaffray Companies

In moving forward out of Q4 and into 2011, as you walk through to get through these issues, I guess, what and when are the first couple of things that we're going to see that will tell us that here's a conviction that you're going to fight your way back to market growth rates and mid-single growth rates. When and what should we expect to see that will indicate that you're getting there?

David Dvorak

I think, clear improvement in our Knee performance. And beyond that, continued acceleration in some of the product categories where we've emphasized new product launches and I think we have great opportunities. So we ought to be talk about that in the Q4 call as it relates to Hips, and we ought to be talking about that in the Q4 call as it relates to Trauma as well, Matt.

Matthew Miksic - Piper Jaffray Companies

And last, just quick on that point of Knee. Is there anything about the new patient match technology that you're rolling out that's holding you back? Are the instruments that you're rolling out critical to making that successful? Or is that an area where we might see some improvement this quarter?

David Dvorak

We continue to ramp up and execute relatively well on the Patient Specific Instruments side. I think that an opportunity that we have is to combine those two, Matt, where we take the Patient Specific Instruments, we're getting good clinical feedback and continuing to refine those systems and expand them. But you get into connecting that offering with the posterior referencing instruments, and now you've got something that's differentiated for competitive surgeons and yet a familiar surgical philosophy to that surgeon. And I think that can be pretty powerful when you layer on top of that the best-performing Knee system in the world.

Matthew Miksic - Piper Jaffray Companies

But if I hear that, that doesn't sound like it will come together in Q4. It will come together as you move through 2011, is that fair?

David Dvorak

The offering exists at this point in time. So again, it's a matter of rolling those systems out and getting the attention of surgeons and trialing and converting business.

David Dvorak

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 Conference Call on January 27 at 8:00 a.m. I'll now turn the call back to you, Celeste.

Operator

Ladies and gentlemen, this concludes today's call. You may now disconnect and have a great day.

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