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Zimmer Holdings (NYSE:ZMH)

Q4 2010 Earnings Call

January 27, 2011 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.

Richard Newitter

Steve Beuchaw - Wachovia

Michael Weinstein - JP Morgan Chase & Co

Robert Hopkins

Raj Denhoy - Jefferies & Company, Inc.

Derrick Sung - Bernstein Research

Rob Wisniewski

Adam Feinstein - Barclays Capital

Bruce Nudell - UBS Investment Bank

Joanne Wuensch - BMO Capital Markets U.S.

Operator

Mr. Blair, you may begin your call.

Paul Blair

Good morning. I'm Paul Blair, Vice President of Investor Relations for Zimmer. I'd like to welcome you to the Zimmer Fourth 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'll review our performance for the fourth quarter, provide you with an update on certain key matters, present an update on our outlook for 2011 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 the 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'd like to point out that this presentation contains forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, based on current expectations, estimates, forecasts and projections about the orthopedics industry, management's beliefs and assumptions made by management. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from those in the forward-looking statements. For a list and description of the risks and uncertainties, see the disclosure materials filed by Zimmer with the Securities and Exchange Commission. Zimmer disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. This presentation also contains certain non-GAAP financial measures. A reconciliation of such information to the most directly comparable GAAP financial measures, along with other financial and statistical information for the periods to be presented on this conference call was included in the press release announcing our earnings, which may be accessed from the Zimmer website at www.zimmer.com under the section entitled Investor Relations. 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 February 10, 2011, 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've joined us on the call today. This morning, I'll review our fourth quarter financial results and provide comments on several highlights from the quarter and the full year of 2010. Jim will then provide additional financial detail, as well as our 2011 guidance. Except as otherwise noted, I'll state all sales in constant currency terms and I'll discuss all earnings results on an adjusted basis.

In the fourth quarter, we improved top line sales and delivered a strong bottom line performance with solid earnings and cash flow. Successful execution of product launches throughout the year helped us finish out 2010 with sequential improvement in nearly all of our businesses. In fact, the only business that did not produce sequential sales growth improvement was Zimmer Surgical, which generated solid growth of 8%. Our results in the quarter and full year reflect continued progress in the execution of our strategic agenda as we drive growth in revenues, earnings and cash flow through performance improvement initiatives.

Moving into 2011, we're well positioned to further advance this agenda, strengthen our leadership position in joint reconstruction and increase share in our emerging businesses and geographic markets. Net sales for the quarter were $1.13 billion, an increase of 3.0% and our earnings per share were $1.27, an increase of 13.4% over the prior-year period. Full year 2000 (sic) [2010] sales were $4.2 billion, an increase of 2.3% and our full year 2010 earnings per share were $4.33, an increase of 9.9% over the prior year.

For the fourth quarter, we experienced balanced year-over-year sales growth in all of our geographic segments. Americas grew 3.1%, Europe, Middle East and Africa grew 2.7% and Asia Pacific, again, led our segments with sales growth of 3.2%. We delivered improved sequential performance in our Knee business, with Knee sales for the fourth quarter increasing year-over-year 0.3%, reflecting positive volume and mix of 2.3% and negative price of 2.0%. Recognizing that we have more work to do, we believe that our Knee business is positioned for further improvement based on ongoing instrumentation launches and future product development.

Patient Specific Instruments and Posterior Referencing Instruments for our Legacy systems, which remain the most widely utilized and clinically successful Knees in the world, should enhance our ability to win in the marketplace. Hip sales increased 3.6% in the fourth quarter, reflecting positive volume and mix of 5.6% and negative price of 2.0%. The encouraging performance of our Hip business was supported by strong sales in the Americas, which delivered 6.3% growth.

Of particular note was the performance of our Continuum Acetabular Cup System, which enjoyed substantial sales growth in the quarter. This innovative system enables surgeons to choose between bearing surfaces to match patients' lifestyle demands. The positive impact of product launches in many of our businesses in 2010 demonstrates how strategic innovation, combined with solid sales execution, leads to enhanced growth as evidenced by the performance of our Hip business.

Extremity products posted healthy results for the quarter with sales growth of 10.4%. Once again, the quarter's results were supported by sales of the Trabecular Metal Reverse Shoulder System and the Trabecular Metal Glenoid. The performance of these products is another example of the differentiating impact of our proprietary Trabecular Metal Technology, which we are utilizing broadly across our entire portfolio.

Our Dental business outpaced the sector once again, delivering impressive double-digit growth of 13.1% in the fourth quarter. This represents solid organic growth of 5.6%, as well as the impact of our amended RTI sourcing relationship, which will anniversary out later this year. The management team at our Dental business has done a great job in driving our performance in a market that experienced procedure pressure resulting from global economic conditions.

Trauma sales in the quarter were up 8.6% over the prior-year period, with all three of our geographic segments contributing to this growth. The performance of our Trauma business once again demonstrates the positive impact of successful product introductions.

Throughout 2010, we continued to roll out new components of our Zimmer Natural Nail family, including the Cephalomedullary Nail, as well as antegrade and retrograde femoral nails. Our Zimmer Natural Nail products experienced significant sales growth in the quarter and are proven to be real door openers for our global sales teams.

The fourth quarter also saw increased penetration of the NCB Periprosthetic Plating System, the only comprehensive solution in the market to address complex femoral fractures that can occur around the knee or a hip implant.

Zimmer Spine reported a sales decrease of 3.9% in the quarter. The Spine business continues to face challenges related to reimbursement and pricing, particularly in the United States. However, this remains an attractive market with significant long-term potential globally. During the fourth quarter, our Spine business outside of the Americas generated 11.3% sales growth. We're confident that a newly established management team is well equipped to return our Spine business to positive performance, supported by a strong lineup of new products to be introduced in 2011, including our percutaneous MIS pedicle screw system, PATHFINDER NXT.

In the fourth quarter, our Zimmer Surgical and other category generated 6.7% growth. The Zimmer Surgical business continues to perform well, with growth led by our bone cement, wound debridement and tourniquet products. In December, we also announced the acquisition of the SoPlus product line of surgical power equipment. This strategic acquisition broadens Zimmer's portfolio of surgical power tools, with large and small bone systems in consumables and will strengthen the company's position in this more than $1 billion market.

Turning now from our product category results, I'd like to discuss several broad market factors. While we continue to face some pressure in the fourth quarter, pricing improved relative to the third quarter and remained stable. For the full year 2010, we experienced a pricing decrease of 1%, which is at the low end of our expectation coming into 2010. There are a number of factors affecting pricing. Of particular relevance is compression, where historic pricing differentials within certain markets such as the U.S. narrow. As we manage through this dynamic, we do not currently anticipate accelerated pricing erosion. We would rather expect the pricing trend to remain relatively stable.

Moreover, we believe our markets will continue to reward innovation with higher reimbursements and premium pricing. By way of example, Zimmer has secured premium reimbursement for the Trabecular Metal Modular Cup product in the Japanese market based on the robust long-term clinical and mechanical data supporting this technology. In addition, our Americas' Hip results for the fourth quarter reflect a significant increase in mix related to new products, which contributed to the sequential increase and sales growth of 360 basis points. In recent quarters, a number of our businesses have faced pressure from reduced procedural volumes as a result of global economic conditions. In the fourth quarter, we saw some stabilization of procedure volumes and expect further recovery as the global economy strengthens.

However, recent headwinds do not diminish the extraordinary long-term potential of our industry. It's well known that demographic trends will expand the patient base seeking the treatments we provide in developed markets. It is also important to recognize that our solutions help take costs out of these healthcare systems to reduce long-term disease management.

Consequently, we're well positioned to respond to the needs of all stakeholders, from government and private payers to surgeons and their patients, which will ultimately lead to sustained long-term growth. Additionally, a number of emerging markets will also significantly increase the potential patient base. Our fourth quarter acquisition of Beijing Montagne Medical Device Company in China establishes a broader leadership position for Zimmer in this key market.

In summary, Zimmer's performance in the quarter and in 2010 was characterized by successful commercial execution of product introductions across our portfolio. Key products introduced in 2010 reflect the overall direction of our innovation pipeline. We're developing products that address the breadth of the musculoskeletal continuum of care and that are designed to enable surgeons to customize treatments to the unique needs of their patients. Our results, including improved operating margins and strong cash flow, are a reflection of continued financial discipline. These are key features of our strategic agenda under which rigorous management of our operations and support functions provide the opportunity for investment in strategic growth drivers and leverage in the P&L. As Jim will discuss, we expect to further increase our investment in research and development in 2011, while maintaining industry-leading profit margins.

I'll now turn the call over to Jim, who will provide further details on the quarter and our guidance. Jim?

James Crines

Thanks, David. I will review our fourth quarter financial performance in more detail and then provide additional information related to our 2011 full year sales and earnings guidance. As David mentioned, our total revenues for the quarter were $1,135,000,000, a 3% constant currency increase compared to the fourth quarter of last year. Net currency impact for the quarter was slightly negative, decreasing revenues by an additional 0.5% or $5.6 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 75.8% for the quarter. The margin ratio improved 30 basis points compared to fourth quarter 2009. Manufacturing efficiencies and lower excess and obsolescence charges, offset by hedge losses in the quarter account for the improvement in gross margin compared to prior year.

R&D expense increased 10% on a reported basis when compared to the prior year and in spite of the double-digit increase in spending, R&D expense remained at the low end of our targeted range of 5% to 6%. We expect R&D expense to continue to grow in line with our strategy to direct more investment into new product development activities and clinical programs.

Selling, general and administrative expenses were $461 million in the fourth quarter and, at 40.6% of sales, were 100 basis points below prior year. Reduced spending on third-party fees and expenses and general and administrative functions enabled us to hold total SG&A expense for the fourth quarter flat to prior year, in spite of volume-related increases in selling and distribution costs.

Special items, which were formerly referred to as acquisition, integration, realignment and other, amounted to $16 million in the quarter. These expenses include integration costs from our recently completed acquisitions of Beijing Montagne and Sodem Diffusion and similar cost stemming from distributor acquisitions in our Europe, Middle East and Africa segment.

As indicated in our release, we recorded a goodwill impairment charge of $204 million in the fourth quarter related to our U.S. Spine reporting unit. The impairment is a noncash charge and is not deductible for tax purposes. So the charge amounts to $1.03 per diluted share on an after-tax basis. Goodwill is tested for impairment on an annual basis and whenever events or changes in circumstances suggest that the full carrying value of the reporting unit may not be recoverable. In accordance with accounting policies, as described in our periodic SEC filing, we performed the annual tests for impairment in the fourth quarter due to the change in the long-term outlook for the Spine market in the U.S., as well as decreased projected revenues related to the Dynesys Dynamic Stabilization System and competitive challenges, the estimated discount of future cash flows for our U.S. Spine reporting unit were negatively impacted, causing the fair value of the net assets of the reporting unit to be lower than the carrying value. We calculated the fair value of goodwill and determined that the goodwill assigned to U.S. Spine was impaired.

Adjusted operating profit in the quarter increased to $343 million. At 30.2%, our adjusted operating profit to sales ratio is 100 basis points higher than the prior-year fourth quarter and reflects the benefits of operational improvements in manufacturing and certain of our back-office functions. Net interest expense for the quarter amounted to $13.4 million compared to $8.7 million in the prior-year quarter. The change is primarily due to the $1 billion senior unsecured notes offering we completed in November of 2009.

Adjusted net earnings were $251 million for the fourth quarter, an increase of 6.1% compared to the prior year. Adjusted diluted earnings per share increased 13.4% to $1.27 on 197.4 million average outstanding diluted shares. These adjusted earnings per share are inclusive of approximately $0.06 of share-based compensation. At $0.18 reported diluted earnings per share, which include the charges reflected in the goodwill impairment and special items, decreased 76% from prior-year fourth quarter reported EPS of $0.74.

Our adjusted effective tax rate for the quarter was 23.9% and our full year 2010 adjusted tax rate was 25.8%. The lower tax rate reflects a number of factors, including: more favorable mix of earnings and profits; the effect of tax law changes enacted in the fourth quarter that extended the U.S. R&D tax credit; tax benefits from the first full year of production out of our China and Ireland facility; and the effective resolution of certain international tax contingencies.

During the quarter, we repurchased 2 million shares at a total purchase price of $101 million. As of December 31, 2010, approximately $1.2 billion remained authorized under $1.5 billion repurchase program which expires at the end of 2013. The company had approximately 196 million shares of common stock outstanding as of December 31, 2010, down from 204 million as of December 31, 2009. Operating cash flow for the quarter amounted to $341 million, down 13% from $386 million in the fourth quarter of 2009.

Net inventories were $935 million at the end of the fourth quarter, an increase of $22 million over the fourth quarter prior year. Adjusted inventory days on hand finished the quarter at 307 days, an increase of five days compared to the fourth quarter of 2009. As of year-end 2010, net receivables increased to $776 million from $751 million in 2009 or 3% over prior year. Our adjusted trade accounts receivable days sales outstanding finished the quarter at 58 days, an increase of two days over the fourth quarter of 2009. Depreciation and amortization expense for the fourth quarter amounted to $91 million.

Free cash flow in the fourth quarter was $243 million, $93 million lower than the fourth quarter of 2009. We define free cash flow as operating cash flow less cash outflows for instruments and property, plants and equipments. The change in free cash flow compared with the prior-year fourth quarter resulted from increased investments in inventory and instruments in support of ongoing new product launches.

Capital expenditures for the quarter totaled $98 million, including $59 million for instruments and $39 million for property, plants and equipments. Cash outlays associated with investing activities during the quarter include: $92 million for acquisitions and licenses, including Beijing Montagne, Sodem Diffusion and amended license and distribution agreement with RTI and certain international distributor acquisitions.

I'd like to turn now to our guidance for 2011. In our earnings release this morning, we announced that the company expects full year revenues to increase between 2% and 4% in constant currency when compared to 2010. At this time, assuming currency rates remain near recent levels, we anticipate foreign currency translation will increase our reported 2011 revenues by an estimated 1%. Therefore, on a reported basis, our revenues are projected to be between 3% and 5% above 2010 results.

Among our market assumptions for 2011, we believe that full year knee and hip procedures will grow in the low single digits. We expect market growth to be lower in the first half than the second half of 2011 due to more challenging comps. Our market growth assumption anticipates modest global economic growth and relatively stable employment. However, a significant improvement in employment levels, especially in the U.S., and a related step-up in enrollment in private health plans would lead us to take a more bullish view towards market growth.

With regard to pricing for 2011, we assume that price compression within our Reconstructive business will continue, and pricing trends for the company will remain at a level consistent with 2010 or between minus 1% and minus 2%.

Moving down the income statement. Assuming currency rates remain near recent levels, we expect our gross margin ratio to be approximately 75%. This takes into account anticipated losses on foreign currency hedges, resulting from relative weakness in the U.S. dollar, as well as some downward pressure on manufacturing volumes as we anniversary out of large pipeline inventory builds that occurred in 2010. As indicated in my earlier remarks, we target R&D expense to average between 5% and 6% of sales. And as we direct more investment toward product development and clinical programs in 2011, R&D should begin trending toward the higher end of the range.

SG&A is expected to be between 40% and 41% of sales for the year as we realize operational efficiencies from the global restructuring and transformation initiatives and further leverage revenue growth. We expect to incur lower interest expense in 2011, as we recently concluded an interest rate swap for $250 million of our 10-year fixed rate debt to variable rate. Assuming variable rates remain near recent levels, we expect interest and other expense of around $50 million in 2011.

We anticipate a 2011 full year tax rate of approximately 27%, 120 basis points above our final rate for 2010. This projected increase is primarily due to a larger proportion of our earnings and profits anticipated from higher tax jurisdictions, as well as the resolution of certain tax contingencies which we recognized in 2010 that will not repeat in 2011. We anticipate the diluted weighted average shares outstanding for 2011 to be between 192 million and 193 million shares. Therefore, 2011 full year adjusted diluted earnings per share are projected to be in a range of $4.60 to $4.80.

As indicated in our release, we expect to record pretax charges of $75 million to $80 million within the 2011 operating period related to restructuring and transformation initiative. We also expect to incur an additional $15 million to $20 million for certain acquisition and integration costs connected with the acquisition of third-party distributors and the recently completed acquisitions of Beijing Montagne Medical Device company and Sodem Diffusion S.A. Therefore to arrive at our anticipated reported GAAP earnings per share, you should subtract total charges for special items of $90 million to $100 million pretax or approximately $0.33 to $0.37 per share.

Turning to cash flow. We anticipate total capital expenditures for the year to be in a range of $250 million to $270 million. Instrument capital is expected to be in a range of $140 million to $150 million. Traditional PP&E is expected to be in a range of $110 million to $120 million, reflecting the cash outlays necessary to drive new product development activities, as well as the replacement of older machinery and equipment in the normal course of operations. Our guidance assumes that we will utilize $500 million of cash flow for share repurchases during the year. Free cash flow in excess of this $500 million is assumed to be held in cash and cash equivalents. Estimated depreciation and amortization expense for the year is in a range of $370 million to $380 million. Finally, please note that our guidance does not include any impact from potential acquisitions or other unforeseen events.

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

David Dvorak

Thank you, Jim. Zimmer's performance in 2010 was generally in line with our expectations, notwithstanding a challenging economy. Throughout the year, we made progress on a number of key initiatives that will enable us to more effectively drive sustained growth in sales, earnings and cash flow. However, we won't be satisfied until we make greater headway toward our long-term strategic goals, namely expanding Zimmer's leadership in our Reconstructive businesses, while achieving increased market share in each of the emerging businesses and geographic markets. These goals will be realized through continued financial discipline in managing the bottom line and improved performance in product development and commercial execution. Through continued focus on these fundamental strategic priorities, we expect to realize our aspirations for future growth sustained at or above market growth rates in all of our businesses.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bob Hopkins of Bank of America Merrill Lynch.

Robert Hopkins

So two questions. One for you David, then one for Jim. First, David, I just want to make sure I had the math right. On your assumptions for Hip, Knee market growth for 2011, is -- netting out all the different moving parts that you just talked about, are you suggesting, you think, the Hip and Knee market will be roughly sort of a 0% to 1% to 2% grower in 2011, is that right?

David Dvorak

In that range, Bob. I mean, we're thinking that it's lower single digits and then if the economy comes back stronger it could rise above that. But at this point in time, I think that, that's the best assumption to build in the models.

Robert Hopkins

And then also, David, is it safe to assume that you think 2011 is a year where we're going to see a pickup in M&A activity on the part of Zimmer? And then for Jim, could you break down those $0.44 of special items that are included or excluded from the -- sorry, I should say, part of the adjusted guidance. So just breakdown those $0.44 for us in terms of the moving parts.

David Dvorak

Yes, Bob, we are active obviously on the external development front, and we'll continue to be active throughout 2011. We're focused on the musculoskeletal space and so the types of deals that you saw at the end of the year are ones that you should expect in the future. And if we can find deals that make good strategic sense and can structure and price those, you could see some things that are larger than those small deals that we did at the end of the year. But those are just ongoing efforts and we'll take a disciplined approach and create value where we see the opportunities to do so.

James Crines

So Bob, on the restructuring and transformation initiatives. First of all, the $75 million to $80 million of charges we have projected related to those initiatives will include employee termination benefits, contract termination fees, facility closing costs and potential impairment charges for assets taken out of service fee. And the benefits from these programs, as we indicated in the release, are estimated at $100 million on an annualized basis, with $40 million to $50 million to be realized in 2010. I would tell you that we expect the benefits to be somewhat evenly distributed between cost of goods and selling, general and administrative expenses. The programs, so you understand, will affect all of our businesses in all of our geographic segments. Just to give you some flavor for what we're doing, among the initiatives there's a delayering of the organization which is designed to reduced management layers, bring our commercial and functional leaders a step or two closer to their customers, enhance communication throughout the organization and achieve tighter alignment on strategic priorities. With this program, we expect our operational execution to improve as managers with greater spans of control are in a better position to leverage the company's resources. Other initiatives include a consolidation of sourcing activities across all categories of spend and with the recent recruitment of new talent to the organization, with expertise in the areas of sourcing and based on some pilot work completed in 2010, we believe we can drive significant savings by centralizing our global sourcing activities. So hopefully that gives you some idea of what we have in mind.

Robert Hopkins

Is there a number of staff reductions this year that you're willing to provide?

James Crines

I would tell you this. We're farthest along with the delayering initiative, and that is something that we expect to be completed in the first quarter. So we'll be able to provide more specific information as the programs are implemented.

Operator

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

Adam Feinstein - Barclays Capital

For your outlook, can you talk about the margin outlook in a little bit more detail? So just trying to understand how you're thinking about margins for next year.

James Crines

Sure. So Adam, first of all, on gross margin, our guidance for gross margin for 2011 reflects some headwind from anticipated hedge losses, as well as some pressure on volumes as we anniversary out the large pipeline inventory builds that occurred in 2010. And we're also experiencing slower procedure growth relative to historical norms. And finally, we are engaged in ongoing efforts to drive our field-based operations toward greater efficiency in the management of our working capital. And in that respect, we do expect to suffer some temporary inefficiencies in manufacturing as we burn off excess inventory in the field. As far as getting further down into the P&L, our guidance implies a modest amount of leverage at the operating profit line in spite of some temporary headwinds on gross margin. In 2011, we are planning to invest some but not all of the savings from the restructuring and transformation initiatives into product development and clinical programs. And the increased investments in R&D are certainly going to help us strengthen our leadership position in our core Reconstructive business, increase share in emerging businesses and markets and put us in a position to, as David talked about, deliver sustained growth in revenues, earnings and cash flow. Beyond 2011, assuming we grow revenues at or above market, opportunity for leverage will be enhanced. We expect to anniversary out of the gross margin headwinds and realize the full annualized benefits from the restructuring and transformation initiatives. And then finally for 2011, keep in mind that we have also guided lower interest expense and a reduction of over 4% in a projected average share count compared with 2010.

Adam Feinstein - Barclays Capital

So just saw a pretty nice bounce back relative to the third quarter, and I know you talked about the procedure volumes. But just curious, Q3 just seemed to be pretty weak and then once again seeing the bounce back here, were you guys surprised by just the magnitude of just the improvement relative to the third quarter in terms of the revenue growth? And just curious, any more color in terms of, do you think the market growth picked up as well?

David Dvorak

I think that we were doing all the right things throughout the year, Adam. And I think the slowdown that we saw from the first half of the year into the third quarter procedure rate-wise was a difficult environment to get as much traction as we wanted to get in launching the new products. So you could see another quarter pass, then a little bit more of a stabilized market environment. We saw nice traction in the launching of those new products and a lot of productivity coming from those launches. And so that's really what drove our performance improvement at that point in time. I don't know that it was as much driven by a pick back up in procedure rates. I think more stabilization of those procedure rates and productivity of those new introductions.

Operator

Our next question comes from the line of Mike Weinstein of JP Morgan.

Michael Weinstein - JP Morgan Chase & Co

So let me just clarify, so how do you view your market growth? Let me put it this way, how do you view your 2011 guidance relative to underlying market growth in your end markets? Are you modeling it as if you're growing in line with your end markets, above, below? How should we think about that?

David Dvorak

Yes, at or a bit above, Mike, is I think the right way to think about it. We clearly anticipate that in some of these categories where we've had successful new product launches that began in 2010 in earnest, that we're going to be able to take market share. So we'd expect to take market share in categories like Hips and Trauma. We obviously have a bit more work to do to get to market in Knees, but we think we're well positioned with the new product introductions in the area of instrumentation to close that gap and perform well in that category as well as the year progresses.

Michael Weinstein - JP Morgan Chase & Co

One, on the share repurchase, the $500 million for 2011. Why is that the right amount? Why not more? You certainly could do more. You could obviously do less as well. Why is $500 million the right number for 2011 relative to how you're thinking about the year? And then second, why is it given your market commentary and what we're seeing in some of the various orthopaedic end markets, why is the best use of cash or a good use of cash to make acquisitions at this time?

James Crines

To answer the first question, Mike, we can always do more and whether or not we do more will depend in part on our ability to access that cash. We generate a lot of cash, as you know, outside the U.S. In some cases, that cash -- our intent is to reinvest that cash in the business outside the U.S. and have no intent to have that repatriated to the U.S., which is what we would have to do to deploy it towards share repurchases. So that's certainly something we take into account in arriving at we think -- at what we believe is a very appropriate and still reasonably aggressive share repurchase program at the $500 million level.

Michael Weinstein - JP Morgan Chase & Co

David, do you want to just comment on acquisitions and why do you want to buy into some of these end markets right now, given the challenges you're facing?

David Dvorak

Again, these markets, the procedure rates are clearly suppressed right now with the macroeconomic conditions, Mike. But none of that is going to change the medium- and long-term prospects for these markets. You go through the demographic analysis and we believe that the strength of the baby boomer population is still out there. There aren't alternative solutions for advanced stage osteoarthritis. So across the musculoskeletal care space, you're seeing that our ability to drive reasonably decent earnings growth numbers off of a suppressed procedure rate and that rate is only going to get better if the economy stabilizes and improves over time. So the prospects within this industry are excellent going forward, and this is the world that we live in and we like the space and think that we can provide better solutions for patients and take market share in the process and create a lot of value for our stockholders as well.

Michael Weinstein - JP Morgan Chase & Co

So if I could summarize this. You think that as we go forward and I'm talking beyond just 2011, that volumes improve in orthopaedic end markets but that pricing in our mix don't get worse, so that they don't necessarily offset that improvement work you're expecting volumes.

David Dvorak

Absolutely. We still think that there's a lot of room for innovation. We're seeing that in our Hip business right now, getting good returns in the mix category, offsetting any price pressure that exists. We don't see that price pressure growing. We think that, that's going to be manageable going forward and so long as we're innovating in the right way, we think that we're going to be performing very well in a space that is going to be accelerating as the economy improves.

Operator

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

Bruce Nudell - UBS Investment Bank

Just returning to that, so we had talked about a quarter ago and you had basically -- Dave held the view that net ASPs can be held at neutral. Just do you think -- and the market, the picture of the market today is distorted by the negative mix suffered by J&J and Biomet, especially in Hips. So if beyond that, where would project net ASPs over the next, let's say, five years might be?

David Dvorak

Bruce, I do think that you're going to see ASPs stabilize. If you talk about pure price, I think that you're going to see those prices stabilize if the company is doing the right thing to manage through this transition period. And I think that we are doing the right things in that regard. I think that the broader price definition to include mix is going to be all about innovation and innovating in a highly relevant way, which is why you see us pushing more and more resources towards our spend in the research and development area, as well as the clinical support for those developments and those innovations. And I think if we execute our plans well, we're going to be in a nice position in an environment where ultimately you're going to see procedure rates pick back up. You're going to see pricing moderate and stabilize and then the mix opportunities are going to be there, and we're going to be back to a more normalized state for this industry.

Bruce Nudell - UBS Investment Bank

But I guess to push the issue, do you think there'll be net positive ASPs or neutral ASPs? What's -- for modeling purposes, internally how do you guys think about it?

David Dvorak

I think that where we're in a position to rollout a new product, we still think that we can offset price and then some with mix.

Bruce Nudell - UBS Investment Bank

So slight positive in aggregate?

David Dvorak

That's right. So long as you’re innovating with the right cadence, that's right, Bruce.

Bruce Nudell - UBS Investment Bank

And is it still correct to think about -- could you describe the volume trends around the world like as the economy stabilizes, where do you see the developed markets in terms of volume growth? And where do you see over a five-year period and where do you see the rest of the world, the developing world in terms of volume growth?

David Dvorak

I think within the developed markets, you need to look at those procedure rates as going from low single digits to more mid-single digits as the economies stabilize globally. The procedure rate growth within the developing or emerging markets is going to be way in excess of that because the penetration rates are so much lower at this point in time. So there's significant opportunities and it's one of the reasons that you see us making investments in those markets and really emphasizing our emerging market strategic plan and executing that plan.

Bruce Nudell - UBS Investment Bank

How should we think about the ASPs in developing markets? I mean, if a hip or a knee in the United States is $6,000, where's a hip and knee in China?

David Dvorak

The Hip and Knee -- you really need to stratify those markets. In the high end of the market, there are very competitive prices. And so new technologies and cutting-edge technologies can be introduced in those markets very successfully. If you get into the middle portion of those markets, which in instances are some of the fastest-growing subsets of the markets and those price points are going to be lower and the service that's provided with the products and the technologies are going to have to be introduced in a way where you can hit that price point and maintain your margins. But we think that, that's doable. At the end of the day, the EBIT margins can be preserved so long as you have the right go-to-market strategies within that space.

Operator

[Operator Instructions] Your next question comes from the line of David Lewis of Morgan Stanley.

Steve Beuchaw - Wachovia

It's Steve Beuchaw in for David. I wanted to ask a bit of a follow up effectively to the line of questions that Bruce is going down regarding pricing. Not so much over the longer term but for 2011, I'm wondering what are the data points that you're looking at that give you this very high level of confidence in the stability of the pricing environment? What do you think are the key indicators, are these tenders? Is it something about the dynamics of healthcare systems? Can you give us a sense for what it is you're looking at?

James Crines

Sure. And understand that we measure changes at an SKU level and report that out publicly and we have done that historically, unlike some of our peers who sometimes combine discussions around price with mix. And in the U.S. market and in certain cases, this is also true outside the U.S., pricing decisions are generally made at a local level subject to guidelines and reviewed by a corporate contract management group. And when we look at contract prices for our end plants across all of our hospital accounts in the U.S. as an example, we know there is and there has historically been some variability, just given the fact that these pricing decisions again are being made at a local level. Now we're not going to answer questions as to just how much variability exists, since the metric is something that's constantly changing and it's very dynamic, particularly in this environment. But just to give you an idea, we have looked at prices for a number of our Hip and Knee devices over the last two years. And in some cases, and this is illustrative so keep that in mind, looking back to 2008, we had somewhere in the order of say 20% of our accounts at price points above a median price point and we roll those analyses forward to 2010, so generally more than half of those accounts have been migrated to a lower price point on the curve. So we know that's something that will continue through 2011, but as our price curves are narrowing to the point where this is something that we can see abating as we get beyond 2011.

Steve Beuchaw - Wachovia

One of the other drivers of your confidence in the 2011 outlook is your expectation for performance above the market just to generalize. I wonder if you might be able to get a little bit more granular on that point, specifically the impact of Metal-on-Metal Hips and the scrutiny that we've seen there now for the better part of the year. And to what extent do you see Metal-on-Metal as a driver -- the pressure on Metal-on-Metal that is, as a driver of market share shift, both in Hips and for your Orthopaedic Recon business more broadly? How much of a factor would you suggest that was in the quarter and in your outlook for 2011?

David Dvorak

Sure. Clearly, it's an opportunity for our company and one of the big reasons that it's an opportunity for our company is we didn't have a large share of that market to begin with. So we just don't face the headwind that others might face in that regard. But more importantly, we feel like we have a great portfolio to address the needs of these patients. We have one of the best-performing crosslinked polyethylene products in Longevity within that category and you couple that with the new launches of Continuum Trabecular Metal Technology and some very innovative and advanced stems including the Fitmore Stem and M/L Taper with Kinectiv Technology, and those are all the reasons that we're driving market share gain within our Hip portfolio. And we think that the circumstances within the environment with respect to Metal-on-Metal are just going to expand those opportunities for us going forward. So we like our position within the Hip space.

Steve Beuchaw - Wachovia

And just to clarify, that's unit share, correct?

David Dvorak

That's right, unit share and as we talked about, mix opportunity as well.

Operator

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

Rob Wisniewski

It's Rob filling in for Kristen. Could you guys comment on the difference in pricing in the quarter maybe across Americas, Europe and Japan and Asia?

David Dvorak

Sure. As far as just what goes into the 1% decline in pricing overall, Rob?

Rob Wisniewski

Yes.

David Dvorak

The breakout is minus 1.2% in the Americas, which is a step down from 1.6% in Q3. In Europe, plus 0.6% in price which is a step-up from flat pricing in Q3. And then in Asia Pacific, minus 3.4%, which is an increase from minus 2.9% in Q3. So again, we went from minus 1.4% globally to minus 1.0% in Q4.

Rob Wisniewski

And then regarding the pricing guidance, I know you guys commented on pricing being down 1% to 2% and being stable. Given that Japan pricing got to anniversary, that should kind of help out the year-over-year comparisons. What are you assuming for the American and the European markets? Can you comment on that?

David Dvorak

We're not going to provide that breakout just because there's a lot that goes into that. So we think that, that's the right range to build in for modeling purposes. But you're right, within Asia Pacific, anniversary-ing out of that significant price cut after Q1 is going to be helpful.

Operator

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

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

You spoke to the stabilizing of procedural patterns throughout the quarter. So it seems as if we saw a typical year-end seasonality as you conclude 2010. But as we move into the first quarter, what can we expect there? Could you give us a little guidance on how to think about what the year-over-year growth trends could look like, especially since we do run up against another healthy growth comp comparison?

David Dvorak

You're right about that. And I just don't know that we saw as much of a spike in the fourth quarter as we had in some of the prior years. That increased procedure rate that has been driven, the theory behind it is that the expanded deductibles at the personal level have increased procedures in the fourth quarter. And while we continue to hear of that in an anecdotal fashion, the numbers in the aggregate just don't really bear that out in Q4. So I think that Q4 can be looked at as a little bit more of a normal state for where we are in the economic recovery broadly. And moving into the first quarter, I would expect those procedure rates to look relatively similar. You're right in the sense of the first half of the year with tougher comps and so I think everyone expects the growth rates to pick up in the second half of the year as we work through those comps because some of the things that impacted the downturn towards the end of the first half of last year, start to anniversary out including COBRA in the United States and the effects that, that extension of the program had on the marketplace. So I do think that one should anticipate an accelerating market performance in the second half of the year versus the first half of the year.

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

There were some opportunities to take advantage of disruptions for some of your competitors. Just out of curiosity, how much of a positive impact was that for Zimmer? And our channel checks speak to how there may have been some incremental procedure mix shift towards revision surgeries. Just out of curiosity, is it possible that Zimmer's Hip performance could be attributed to that phenomenon in any way?

David Dvorak

I don't think that, that was a material driver, Charlie. I mean, I do think that those circumstances have a bunch of collateral opportunities attached them for our business going forward. But I don't think that, that was the primary driver for our performance in Hips in Q4.

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

Just moving on to R&D, especially as I move to the upper end of the historic 5% to 6% of sales for 2011. Does that in any way imply a faster product cadence here going forward? Or is this more just investing in white space opportunities to generate mix and regain share over the intermediate to longer term?

David Dvorak

It's a mix of investments, but we clearly are investing in a way where we expect a more robust pipeline to show its face as we move forward and the cadence ought to improve relative to where it's been over the last few years. Obviously, we had some really important launches in 2010 but I think what you should expect from the company going forward is just the consistent cadence of highly relevant innovations to come out of the pipeline and be difference makers within the marketplace going forward.

Operator

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

Joanne Wuensch - BMO Capital Markets U.S.

Did you quantify what the savings would be associated with some of the reorganization efforts that you will be implementing throughout 2011?

James Crines

We have. So we indicated, Joanne, in the release we're expecting to generate $100 million in savings on an annualized basis. And in 2011, just given the timing of these initiatives, expect that we'll realize $40 million to $50 million of those benefits in 2011. And that is reflected in our guidance.

Joanne Wuensch - BMO Capital Markets U.S.

And your Trauma number was much better than we are expecting in this quarter. Is there anything in particular going on? Is that new products or market share shift?

David Dvorak

It's both, Joanne. I mean, we've been working at this for quite some time and have sort of hit a point now where enough of the Zimmer Natural Nails are launched, coupled with very competitive plate and screw offerings that we've developed over the last several years and some unique technologies in the periprosthetic plate category as well, all of that combined as leading to a lot of traction in the marketplace. So these are innovative products that are making a difference in the field. And one of the things that's most heartening about the Trauma performance is it was truly a global effort. We saw nice growth come out of all three of our geographic segments. But the principle door opener there are the new products again, the Natural Nail and the NCB Periprosthetic Plate System.

Joanne Wuensch - BMO Capital Markets U.S.

My last question has to do with your personalized knee, could you just give us a little bit of color on how that launch is doing? You're one of the few manufacturers that has the right FDA labeling for that.

David Dvorak

Sure, Joanne. We're doing well with the launch. We continue to ramp up and every month we grow stronger and stronger in that category, getting good clinical results. And so this is a phase that we think is going to continue to expand and become increasingly important in the future. We're in a nice position with the technology that's launched and as you point out, properly cleared.

Operator

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

Richard Newitter

This is Rich in for Rick. Just wanted to ask a question on Asia Pacific region in your Hips and Knees. I know that you have the reimbursement for Trabecular Metal in Japan. Hoping you could just provide some color around how significant that could be in 2011 in terms of incremental sales for that region? And also if you could talk about your Beijing ortho manufacturer acquisition, what kind of contribution should we expect this year from that? And how big can that get going forward?

David Dvorak

The approval that you referenced in Japan is a really important step because it validates the clinical import of Trabecular Metal technology. So we've been awarded a significant premium price position with the launch of Trabecular Metal. In this case, it's the Trabecular Metal Modular Cup System. So it'll improve our Hip performance within that market. It's going to create opportunities for us not only to improve mix but to take market share. Now of course you know how these launches work. This is a product that is just now beginning to launch and so it will take time for us to train sales representatives, to train surgeons and as the year progresses, we expect that to support our performance. Turning to your question on Montagne. This is an acquisition that in current terms is around a $10 million business. How big can that be? In the future, it's going to be a big, big market for us. It's a market that is currently about a $1 billion market that's going to double in the next three years. By virtue of this acquisition, we now have a leadership position in large joint reconstruction within that market but that market has a long ways to go in growth. So over the course of the next five, 10 years, it's going to become a very significant part of Zimmer's business. And so we're really happy to have the Montagne employee group join the Zimmer family and looking for big things out of that market going forward.

Richard Newitter

On Spine, you talked about eventually getting that to positive growth territory. Just can you update your time frame for when you think that can happen? Could it potentially happen as we exit the year?

David Dvorak

That's a 2011 goal of ours. There isn't any reason we shouldn't put that business on a track to get back in a positive space and market growth levels within this fiscal year. So that's reasonable, Rich.

Operator

Your next question comes from the line of Derrick Sung of Sanford Bernstein.

Derrick Sung - Bernstein Research

Just want to first clarify your view on sort of how you performed relative to the market this quarter. So with DePuy and Biomet posting weak sales and you and Stryker posting very strong sales, am I correct in that what you're saying is that, essentially the market from a revenue basis was stable this quarter versus Q3 and your outperformance was essentially revenue share gains versus the market? Is that a fair characterization?

David Dvorak

Yes, I think that the right way to think of that in a big picture context is, if the market improved in 10s of basis points, and our performance improvement as you can see was in the range of a few hundred basis points. And in the large category, you can look at 10-, 30-basis point improvement in market numbers dependent upon how you want to adjust the competitors that have already reported out results for billing days, et cetera. And we had a 300 basis point or so improvement in some of those big categories.

Derrick Sung - Bernstein Research

And how much of that revenue share gain is actually through procedure share versus the Metal-on-Metal guys seeing a mix shift down and you seeing a mix shift up from your Continuum Cup and new product launch?

David Dvorak

Yes, it's a mix of both. I mean, we're getting healthy mix out of the new product launches but I think we're also seeing procedure growth.

Derrick Sung - Bernstein Research

On your Knee business, this is a business that -- it looks almost over the last three years, you've sort of been consistently struggling growing below the market. When we look at the business on the surface, it doesn't look like there's any big product gaps that you're missing versus your competitors. You're out there with your Patient Specific knees, et cetera. Can you just give us some more color as to what's really the challenges that you're facing here? Is it a product gap issue that you can point to that you've just been missing a couple key products for the last couple years? Or is it an execution issue? Help us understand what's been going on there and you've mentioned that new products turn it around, but is that really the issue that you're facing?

David Dvorak

You had some competitors over the last three to five years have introduced new Knee systems and with those systems they provided updated instrumentation sets as well. And so to the extent that there was any gap that was the gap and that was a gap that we addressed last year and those posterior referencing instruments are rolling out now. They have been for the last half of the year or so. So we're starting to see some traction with those and beyond that it is an execution game for us. But we're in a good position. We have a very comprehensive product portfolio. We have the best Knee system in the world, the NexGen, as evidenced by the registry data and revision rates. So we're in a good position to get back to market growth, and we're going to bring the right level of focus on the commercial side to ensure that, that happens in 2011.

Derrick Sung - Bernstein Research

And just quickly on that, why is it that you would have an execution problem on the Knee side versus the Hip side where it's essentially the same sales force, et cetera?

David Dvorak

Well, you bring focus and priorities within those forces and those are both big categories. We have brought a lot of focus to getting the Knee business that was off market growth for a number of years, and it looks like it resolved that issue and so you should expect the same thing to come from us on the execution improvement side in Knees going forward, Derrick.

Operator

Your final question comes from the line of Raj Denhoy of Jefferies & Company.

Raj Denhoy - Jefferies & Company, Inc.

I wondered if I could ask a little bit about the Spine business again. You guys wrote off a lot of the Abbott Spine deal if not all of it. Dynesys continues to struggle there. You announced a restructuring I guess of the management side of that. I'm curious now as you look out over the next couple of years what your broad strategies are there. Do you think you need to get larger in Spine to be relevant? Do you need some differentiated products in that? Just generally, how you think about that business over the next couple of years.

David Dvorak

Let me just first address correcting out that the write-off was not the Abbott Spine acquisition. That business continues to grow well for us. Combination of things led to us taking that impairment charge. But more importantly, going forward, we do think that we have the right leadership team in place. We've got a product cadence and pipeline that we're excited about for 2011 that we think is going to improve our position. This is a business that we're growing successfully OUS [outside the U.S. ] So we know we have the capability with the existing product portfolio. Some of the more unique technologies that we have within that portfolio benefit us outside the U.S. because of the regulatory barriers within the United States currently and the most profound example of that is the Dynesys System with what's happened in the last couple of years on the regulatory process within the United States. So we think we have the right pieces coming into place, a core product offering that's very competitive, a pipeline that is going to improve our position in that regard, a leadership team that's coming together and going to be a strong group I think that will drive future improvement to our performance. Beyond that, we do want to expand our critical mass in this space. So as we get those pieces together performing in an acceptable way, we'll be looking at opportunities to expand our footprint on Spine and pickup more technologies and expand our distribution footprints as well on a global basis.

Raj Denhoy - Jefferies & Company, Inc.

On the pricing commentary, I know you focused primarily on this notion of compression between the upper end of your pricing band and then the lower end. That upper band moving down. I'm curious about your confidence so that, that lower band doesn't deteriorate, that as hospitals and payers get more aggressive on that front that they start pushing on that end. What gives you that, again, that confidence that, that lower band is stable at this point?

David Dvorak

Well, fundamentally, that's not something that we're seeing and we think that the innovations are a big part of the answer to that. We're going to continue to improve the solutions that we provide and comprehensive solution is just beyond features and benefits of the products, and our strategy is to position us to where we don't see any downward pressure on that side of the pricing curve and we're confident that we're going to be able to execute our plans in a way where that doesn't come to fruition. So thanks, again, everyone for joining us today and for your continued interest in Zimmer. We look forward to speaking to you on our first quarter conference call at 8 a. m. on April 28, 2011. I'll now turn the call back to you, Christie.

Operator

Thank you again for participating in today's conference call. You may now disconnect.

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