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Executives

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

David Dvorak - Chief Executive Officer, President and Director

Robert Marshall -

Analysts

Michael Matson - Mizuho Securities USA Inc.

David Roman - Goldman Sachs Group Inc.

Robert Hopkins

Michael Weinstein - JP Morgan Chase & Co

Raj Denhoy - Jefferies & Company, Inc.

Kristen Stewart - Deutsche Bank AG

Derrick Sung - Sanford C. Bernstein & Co., Inc.

Frederick Wise - Leerink Swann LLC

David Lewis - Morgan Stanley

Adam Feinstein - Barclays Capital

Zimmer Holdings (ZMH) Q1 2011 Earnings Call April 28, 2011 8:00 AM ET

Operator

Good morning. I would like to turn the call over to Bob Marshall, Vice President Investor Relations and Treasurer. Mr. Marshall, you may begin your call.

Robert Marshall

Good morning, and welcome to Zimmer's First Quarter 2011 Earnings Conference Call. I'm here with our President and CEO, David Dvorak; and our Executive Vice President and CFO, Jim Crines.

Before we start, I would like to remind you that statements made during this call that are not historical may be deemed forward-looking statements. Actual results may differ materially from those indicated by forward-looking statements due to a variety of risks and uncertainties. Please refer to our filings with the Securities and Exchange Commission for a detailed discussion of these risks and uncertainties.

Also, the discussions during this call will include certain non-GAAP financial measures. Reconciliations of these measures to the most directly comparable GAAP financial measures are included within the earnings release that was furnished in this morning's current report on Form 8-K. This information is also available on our website, www.zimmer.com, in the Investor Relations under Financial Information Reconciliation.

With that, I'll now turn the call over to David Dvorak. David?

David Dvorak

Thank you, Bob. Good morning, everyone, and welcome to our earnings call for the first quarter of 2011. This morning, I'll review our first quarter financial results, providing commentary on the year's progress-to-date and highlights from our performance. Jim will then provide additional financial details. As in previous quarters, I'll state all sales in constant-currency terms, and I'll discuss all earnings results on an adjusted basis, except as otherwise noted.

Zimmer delivered solid sales results across all geographic segments and most businesses in the first quarter, resulting in improved margins and earnings. At the same time, operational improvements enabled us to accelerate our innovation strategy with a 10% increase in research and development investments in the quarter. Consolidated net sales for the quarter were $1.12 billion, an increase of 3.3%. And our earnings per share were $1.19, an increase of 16.7% over the prior-year period.

Through the first quarter, we again experienced year-over-year sales growth in all of our geographic segments. Americas grew 2.0%; Europe, Middle East and Africa delivered what we believe to be market-leading growth of 4.2%; and Asia-Pacific again recorded impressive sales growth of 6.9%. These results were delivered against the backdrop of an unprecedented tragedy in Japan, one of our major markets. Zimmer is committed to supporting our colleagues and customers in Japan who continue to demonstrate tremendous resolve in navigating the impact of the recent disasters.

Turning to the results of our product categories. Knee sales for the first quarter decreased year-over-year 1.0%, reflecting positive volume and mix of 0.7% and negative price of 1.7%. Outside the United States, our knee franchise delivered a stronger quarter compared with the prior-year period. On a global basis, the Zimmer unit compartmental High Flex Knee and NexGen Rotating Hinge products generated solid unit sales growth in the quarter. We also recently released several new products in Knees that leverage proprietary Zimmer technologies, including a range of Trabecular Metal augment shapes and cones, which significantly strengthen our offerings in the Knee Revision category and the NexGen LPS Mobile System that now features Longevity Highly Crosslinked Polyethylene.

Looking forward through 2011, we expect sales of these new products and increasing utilization of PSI [Patient Specific Instruments] and PRI [Posterior Referencing Instruments] instrument sets to contribute to elevated growth in Knees, supported by improved execution and easing comps in the second half of this year.

We again delivered above-market growth in Hips in the first quarter, with a sales increase of 4.7%, reflecting positive volume and mix of 6.7% and negative price of 2.0%. Once again, the strong performance of our Hip business was supported by robust sales in the Americas, which delivered 5.0% growth, and significant improvement in the Asia-Pacific region, which generated sales growth of 10.2%. We continue to benefit from improved mix in our Hip business, supported by sales of recently launched innovative product lines, including the Continuum Acetabular Cup System. The performance of the Continuum System reinforces the value of products designed to provide customizable treatment solutions that enable surgeons to match their patients' lifestyle demands.

Our Extremities business posted solid growth for the quarter with sales increasing by 10.7%. The value of our proprietary technology is evident in the performance of this business, where sales of our Trabecular Metal products continue to be noteworthy. The Trabecular Metal Reverse Shoulder System is now the #1 selling product in the reverse shoulder category.

Zimmer's Dental business continues to significantly outperform the market with first quarter sales of 20.8%. This impressive performance was broad-based and represents organic growth of 13.2%, as well as the contribution of our restructured RTI distribution arrangement. We're greatly encouraged by the continued strength of our Dental business, which maintains a broad and growing portfolio. In the first quarter, the newly released Tapered Screw-Vent Implant System with crestal options delivered healthy sales in the United States, and we're excited to launch this product in other global markets in the second quarter. We believe the overall Dental market is showing signs of recovery after a challenging period.

Trauma achieved above market sales growth in all geographic segments in the quarter, with sales increasing 13.5% over the prior-year period. Our performance was led by the Europe, Middle East and Africa segment with 19% growth for the quarter. We continue to benefit from increased sales of the NCB Periprosthetic Plating System for complex fractures, as well as the Zimmer Natural Nail product family, which has now surpassed 10,000 implantations since it was introduced. With an innovative and differentiated portfolio in Trauma and continued investments in our Trauma sales force, we're confident that we'll sustain our performance in the Trauma category.

Zimmer Spine reported a sales decrease of 5.8% in the quarter. Outside of the United States, Zimmer's Spines business demonstrated sales progress, but we continue to experience challenges in the U.S. market related to reimbursements and pricing. However, we're committed to developing an increasingly competitive product portfolio in Spine. In the first quarter alone, we released two innovative offerings with the PATHFINDER NXT percutaneous, MIS pedicle screw system and the TM-S Trabecular Metal Cervical Interbody Fusion Device.

Zimmer’s Surgical and Other business category delivered above-market sales growth of 7.3% over the prior-year period, again supported by strong sales of our bone cement, wound debridement and tourniquet products.

With regard to our acquisitions of Beijing Montagne Medical Device Company in China and SoPlus Surgical Power equipment in Switzerland, the integration of both of these businesses is proceeding well. In China, both Zimmer's legacy business and the Beijing Montagne franchise contributed significant growth in the first quarter.

Turning now to the broader musculoskeletal market. Procedure volumes were stable relative to the fourth quarter but remained below what we would consider to be normal growth. As we review procedure trends in the U.S. market, we recognize that the economic recession resulted in declining enrollment in private health plans among people under the age of 65. As a consequence, a number of potential joint replacement patients have had to defer their treatment.

Due to the extension of COBRA benefits, it appears that these deferrals did not significantly impact trends at a macro level until the second half of 2010. We don't believe that usage rates of total joints among the insured population have declined. Rather, the size of the uninsured population increased as employment rates climbed -- I’m sorry, unemployment rates climbed. Therefore, in effect, the total patient pool declined. As we indicated in our prior call, we believe the growth rate of procedure volumes in the U.S. will begin to recover in the second half of 2011 as we exit out of the cyclical downturn associated with increased unemployment levels.

With respect to pricing. We experienced price pressure of negative 0.9% in the first quarter, a stable trend from the previous quarter and in line with our expectations. We maintain our pricing outlook of negative 1% to 2% for the full year, understanding we'll anniversary out of negative pricing in Japan coming out of the first quarter.

As we discussed on our last call and as the performance of several of our franchises demonstrates, the market continues to reward clinically relevant and innovative product development with premium pricing and reimbursement. The above-market growth delivered by several of Zimmer's key businesses in the first quarter demonstrates the positive impact of product innovation supported by improved commercial execution. Many of Zimmer's recently introduced products and instrumentation systems reflect two of the core drivers of our innovation strategy. First, the development of customizable implant and instrumentation systems enable surgeons to deliver a personalized care experience to every patient, including options for all lifestyle demands. And second, the provision of clinically relevant products that deliver long-term value to patients, hospitals and healthcare systems.

As we drive growth in our Reconstructive and Emerging businesses, we also continue to explore opportunities to expand the company's reach into early intervention products. For example, this quarter, our DeNovo NT natural tissue graft per cartilage repair enjoyed continued success, passing more than 2,000 cases to date. Also in the quarter, our partner, Seikagaku Corporation, received FDA approval for Gel-One, a single injection hyaluronic acid solution for pain relief that Zimmer plans to market in the United States.

By continuing to exercise disciplined financial management, the company will generate incremental funds to advance our product development programs and other strategic priorities. Over the last quarter, we made significant progress in our restructuring and transformation efforts with the completion of a management de-layering initiative that will accelerate speed, improve operational rigor and drive enhanced customer responsiveness. Other ongoing initiatives included consolidation of sourcing activities across all categories of spend and optimization efforts across our global manufacturing network.

This includes the strategic sourcing of manufactured components where we can achieve the highest quality, lowest cost and optimal after-tax returns. All of these programs are designed to provide a source of funding for new innovation and clinical programs, as well as to create value through enhanced operating leverage. Beyond operational improvements, these programs also reflect our commitment to an even stronger performance-driven culture. Pursuing the attainment of world-class benchmarks across the company will accelerate growth and deliver increased value to shareholders through progressive, industry-leading operating margins and optimal deployment of capital.

I'll now ask Jim to provide further details on the first quarter and our guidance. Jim?

James Crines

Thanks, David. I will review our first quarter performance in more detail and then provide additional information related to our 2011 guidance. Our total revenues for the first quarter were $1.116 billion, a 3.3% constant-currency increase compared with the first quarter of 2010. Net currency impact for the quarter was positive, increasing revenues by an additional 1.7% or $17.4 million. Favorable currency impact from our Japanese yen, Australia dollar, Swiss franc and Canadian dollar denominated revenues were partially offset by unfavorable currency impact from our euro-denominated revenues.

For the quarter, our adjusted the gross profit margin was 75.4%. The margin ratio improved 50 basis points compared to the first quarter of 2010. The improvement in gross margin compared with prior year was a result of manufacturing efficiencies, which were partially offset by hedge losses and excess in obsolescence charges in the quarter.

The company's R&D expense increased 10% on a reported basis when compared to the prior year. Our R&D expense remains at the low end of our targeted range of 5% to 6%, despite this increase. As David has discussed, product innovation is a key feature of our growth strategy, and we anticipate that R&D expense will continue to grow as we expand product development and clinical programs.

Selling, general and administrative expenses were $458 million in the first quarter, which was an increase of 2.5% on a reported basis. At 41.1% of sales, SG&A expenses were 100 basis points below prior year. For the quarter, reduced spending in general and administrative functions and lower product liability expense were offset by volume-related increases in selling and distribution costs and higher medical training and education expenses.

Special items amounted to $26 million in the quarter. These included costs and asset write-offs associated with our global restructuring and transformation initiatives. The majority of the cost incurred in the quarter related to severance, retention, acceleration of share-based compensation and other employee termination-related costs. Approximately 5% of our global workforce was impacted by our organizational change initiative, which involved a top-down de-layering of management but did not affect our direct labor or direct sales forces. The company also continues to incur integration cost from our recently completed acquisitions of Beijing Montagne Medical Device Company, SoPlus Power Equipment and third-party distributors in our Europe, Middle East and Africa segment.

Adjusted operating profit in the quarter increased to $327 million, representing a profit-to-sales ratio of 29.3%. This ratio is 130 basis points higher than the prior-year first quarter, reflecting operational improvements in manufacturing and reduced general and administrative expenses.

Net interest expense for the quarter totaled $11 million compared to $14.6 million in the first quarter of 2010. This change is primarily due to having swapped a portion of our fixed-rate debt to floating rates. Adjusted net earnings were $231 million for the first quarter, an increase of 11.4% compared to the prior year. Adjusted diluted earnings per share increased 16.7% to $1.19 on 193.8 million average outstanding diluted shares. These adjusted earnings per share are inclusive of approximately $0.05 of share-based compensation. At $1.08, reported diluted earnings per share increased 6.9% from the prior-year first quarter reported EPS of $1.01. Our adjusted effective tax rate for the quarter was 26.9%, which is in line with our full year guidance and represents an increase of 10 basis points from the first quarter of 2010.

During the quarter, we repurchased 4.2 million shares at a total purchase price of $236 million. This represents almost 50% of our intended repurchasing plan for 2011, demonstrating our commitment to returning value to our shareholders. As of March 31, 2011, approximately $970 million remained authorized under a $1.5 billion repurchase program, which expires at the end of 2013. The company had approximately 192 million shares of common stock outstanding as of March 31, 2011, down from 203 million as of March 31, 2010.

Operating cash flow for the quarter amounted to $182 million, down 30% from $260 million in the first quarter of 2010. The decrease in operating cash flow compared to the prior year was mainly due to a planned increase in accounts receivable of 6 days as we discontinued factoring in certain European markets.

Net receivables increased to $876 million from $767 million in 2010 or 14% over the prior-year period. In addition, inventories increased slightly in the first quarter of 2011. Adjusted inventory days on hand finished the quarter at 312 days, an increase of 5 days from year end 2010 and 10 days compared to the first quarter of 2010. The increase in inventory from prior-year end 2010 occurred in Hips, Dental and Surgical, all product categories that experienced above-market growth in the first quarter.

Depreciation and amortization expense for the first quarter amounted to $86 million. Free cash flow in the first quarter was $119 million, $90 million lower than the first quarter of 2010. We define free cash flow as operating cash flow less cash outflows for instruments and property plant and equipments. This change in free cash flow was principally a result of the increase in accounts receivable combined with a small increase in inventories.

Capital expenditures for the quarter totaled $63 million, including $46 million for instruments and $17 million for property plant and equipments. Cash outlays associated with investing activities during the quarter include $13 million for product distribution agreements 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 is reaffirming its full year sales and adjusted EPS guidance. We expect full year revenues to increase between 2% and 4% in constant currency when compared to 2010. We expect our Knee and Hip revenues will continue to be affected by slower market growth through the second quarter. We then look for market growth to improve in the second half against easing comps. Our guidance contemplates up to a 10% decrease in Japan's full year net sales in 2011 relative to our previous expectations due to the recent natural disasters. While it is difficult to predict the ongoing impact of these events, there may be temporary disruptions to elective hospital procedures caused by energy conservation measures.

In the year ended December 31, 2010, the Japan market represented a little less than 10% of our consolidated net sales. Therefore, we estimate the negative impact to our net sales for the full year 2011 will be approximately 1% relative to our expectations before the natural disasters.

In contrast to this, we are now anticipating somewhat stronger global revenues in our Hips, Trauma, Dental and Surgical and Other product categories relative to our previous expectations. Assuming currency rates remain at current levels, we anticipate foreign currency translation will increase our reported 2011 revenues by an estimated 3%. Therefore, on a reported basis, our revenues are projected to be between 5% and 7% above 2010 results.

We still expect our gross margin ratio for the full year to be approximately 75%. This takes into account approximately 90 basis points of anticipated losses on foreign currency hedges resulting from relative weakness in the U.S. dollar. In the second quarter, anticipated hedged losses, when compared with hedge gains from the prior-year second quarter, are expected to reduce gross margins by 160 basis points. Full year 2011 adjusted diluted earnings per share are projected to be in a range of $4.60 to $4.80. To arrive at 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. 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

Thanks, Jim. Zimmer's first quarter performance demonstrated continued progress toward our goal of consistently achieving growth at or above market rates in all of our geographies and businesses. We're committed to delivering value to our shareholders through disciplined execution of business transformation programs to generate strong cash flow for investment and strategic growth drivers and leverage in the P&L.

The musculoskeletal care market remains an exciting space that presents expansive opportunities for growth, both in established and emerging markets. We believe Zimmer is uniquely equipped to respond to the needs of all stakeholders in this market, combining the industry's most comprehensive and innovative product portfolio with robust clinical, health economic and commercial capabilities.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Adam Feinstein with Barclays Capital.

Adam Feinstein - Barclays Capital

Just I guess there are a couple of things. And everything looks very strong, and I guess now that all of the companies have reported your numbers, you definitely look very strong on a relative basis. So just as you think about just market share gains and what may be going on there, just curious to get your thoughts. And then just at the same time, just in terms of just overall market growth, as you guys think about that in the back half of the year, just with the comps being slightly easy. Just curious what your updates views are there.

David Dvorak

Sure, Adam. We feel like we had a good quarter again overall and particularly strong with respect to our Hips, Trauma, Dental, Surgical categories, all of which we believe grew above market. Good performances as well coming out of the extremities division, not a global basis, probably more in line with market and that category and close the gap importantly on Knees relative to market growth rates. So I think that the work that we're doing there is showing some progress. I think that the market saw a bit more of a step down, particularly on the U.S. side of the Knee market. But we did close the gap, and so that's encouraging to us. And then finally, more work to do on the U.S. side of our Spine business. But we feel like we're taking some of the right steps to create a more robust product portfolio there and sure up our commercial execution as well. So the trends are all very positive. Coming into the year, we and many of you expected that the first half of the year comps were going to be more difficult than the second half of the year comps, and I think that's exactly what we're seeing in the marketplace today. So we'd be optimistic that the second half of the year, with the easing comps, would show some progress in the overall market as well.

Adam Feinstein - Barclays Capital

Okay. And would you think that the Knees can grow in the second half of the year? Or is the thought process that they will be stable?

David Dvorak

The Knee market?

Adam Feinstein - Barclays Capital

Yes.

David Dvorak

Yes, we do believe that the Knee market will grow in the second half of the year. I think that what you're seeing in the U.S. side is really a consequence of what I was describing earlier, where the uninsured population base is getting access to these procedures as -- well, the uninsured population base that would like to get access to these procedures has grown because of the rising unemployment levels. And we start to anniversary out a bit of that on the market side, I think, as we enter the second half of the year. So we'd be optimistic that those comps would produce more favorable results across the market.

Operator

Your next question comes from the line of David Lewis with Morgan Stanley.

David Lewis - Morgan Stanley

Jim, quick question on guidance. Just thinking about EPS guidance and the strength in the quarter, and I appreciate the Japan issues, which you're trying to estimate in the back half of the year. But just considering the strength we're seeing in cost containment issues, product cadence that David mentioned, as well as also the comparables, is it safe to say you're now more comfortable with the upper half of EPS guidance range for the year?

James Crines

I think it's safe to say that we're very comfortable with the guidance range that we’ve provided for the full year. I think one of the things you have to keep in mind is not only the issue associated with Japan and the effect that's likely to have over the next 3 quarters, more pronounced than what we saw in the first quarter, just given the timing of those events. Is the fact that we do have -- as we pointed out on our last call and I've highlighted as well on this call, we do have some headwind that we're dealing with on the gross margin line related to the currency hedging program.

David Lewis - Morgan Stanley

Okay, very helpful. And then, David, in this call, we heard a lot about Asia-Pac clearly accelerating across multiple product lines. I wonder if you could help us sort of understand, we obviously have the Japan impact, whether that is the impact you really see in the market today, whether that's sort of the best estimate you can give in terms of what the market impact could be. And then considering what -- maybe you could tell us what Beijing Montagne is actually doing for the company. So I'm just trying to understand given the significant acceleration you're continuing to see in that business plus the acquisition and with the Japan pressure, how do you see the growth rates in Asia-Pac trending in the back half of the year, considering you're going to begin to anniversary some of the price cuts in Japan?

David Dvorak

That's true. I mean, those price cuts anniversary out as we speak here this month. And so that eliminates a headwind that we've been facing for some time. We just believe that we're doing a good job in executing. We had a good year last year in Asia-Pacific as well. So we're launching the right products in the right places and doing a nice job with those launches. And those product launches make a difference. So pardon me, our medical training education is really at full speed. That really enhances your opportunity to effectively launch of those products, and we have a stable team of experienced people leading our efforts in Asia-Pacific. And I would tell you that the same thing, I believe, is occurring in Europe, Middle East and Africa. We're seeing nice progress in those markets. Some of the disruptive factors that we faced over the last several years are now being washed out, and I think we're just regaining our momentum in the OUS markets in general.

Operator

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

Michael Weinstein - JP Morgan Chase & Co

Just a couple of clarifications. You called out the impact of your acquisition in China. Did that have any material stocking benefit to the quarter?

David Dvorak

No stocking benefit. And those revenues are not all that significant in the context of the business either, Mike. That was a business that was round numbers, a $10 million business or so at the point of acquisition.

Michael Weinstein - JP Morgan Chase & Co

Okay. And then, David, I just want to maybe take a step back here. If we just rewound 6 months, you had a soft third quarter, you grew about 200 basis points below the Recon market, and here we are 6 months later, the Recon market is a little bit softer but you grew about 200 basis points better than the market. And it would be your kind of your first real standout quarter relative to the market in really quite a long time. So I just want to get a little bit more perspective on the delta in the company's performance over that 6-month period of time and what you see is driving that?

David Dvorak

Yes, a number of factors, Mike, and these are all areas that we've been very focused in our efforts on for some time, and you're familiar with those efforts, I think, to a great degree. But we're launching the right products. We're launching those products effectively. We're regaining our momentum within the commercial side of our organization. And then, we just have a lot of things that are coming together and heading in the right direction. The key for us is to continue to develop momentum in these areas and to sustain that effort with new products. And we believe that we're building out the right product pipeline to achieve just that.

Michael Weinstein - JP Morgan Chase & Co

And then just I'm going to push a little bit more on the guidance question. So even with the outperformance this quarter, at least relative to Street expectations on the top and bottom line, the current guidance for the year is still the appropriate guidance range? There's no reason to narrow that range today?

James Crines

Mike, this is Jim. As we indicated on our last call, described our expectations with respect to the overall market, talked about the softness across the overall market, we anticipated to see in the first half. We also indicated that our guidance for the full year was predicated on stable employment. So just as we said on the last call, to the extent that we see the economy improvement, perhaps unemployment levels coming down, we would expect to see more robust growth in the second half and effectively to hit better results relative to the range that we provided at this point. To the extent that we see less disruption than what we have contemplated in Japan in elective procedures, that as well could lead to stronger results relative to the range that we've provided at this point. But we're one quarter into the year, and we just feel it's appropriate to maintain that guidance and the range that we've provided at this point.

Operator

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

Robert Hopkins

First one for David and then for Jim. First, on the Knee market, especially in the U.S., now that everybody but Smith [ph] and Nephews [ph] reported, we can see that the Knee market stepped down in the first quarter. Everyone's reporting negative growth just about. I was wondering, is there anything that you're seeing in the second half besides easier comps that would lead you to a conclusion that things will get better from here? Are there any leading indicators, tangible evidence that you're seeing right now that would give you confidence that we're going to see an increase? Or is it really just mostly easier comps?

David Dvorak

Well I think that -- let's talk a little bit more about the easing-of-the-comp side of it. If we go back to the root cause for what caused the drop-off in the second half of the year, we really do believe that it was the sub-65-year-old category of patients with expanding unemployment rates and those people dropping out of private insurance pools with declining enrollments that caused that decline, Bob. And so I think that COBRA probably -- the extension efforts masked some of that effect for some time, but it really found traction in the second half of last year. And so the comps are just the companies' weaker performances across the market. But I think that if you look at the population base, you're going to be growing off of, albeit a reduced base in the second half of the year. And as Jim said, if the economy gets a bit healthier, if employment expands these opportunities and enrollment, as a consequence, expands, then it could be something more than just a positive comparison off of an easier comp.

Robert Hopkins

Okay. But are you seeing anything in terms of backlogs increasing or anecdotal feedback from surgeons at this point that suggests we may see an uptick?

David Dvorak

Our comments are not so much based on leading indicators along those lines, Bob.

Robert Hopkins

Okay. Thank you. And then for Jim, two quick things. One on the SG&A front. When should we see the full benefit of the restructuring and did we see that full benefit in the first quarter? And then secondly, from the perspective of Dental, obviously, you had a very good quarter. Does that make it less likely that you'd seek external options to increase critical mass at this point?

James Crines

So with respect to the first question, we saw modest benefits from the restructuring and transformation initiatives. David indicated that one of the major initiatives, if you will, the de-layering of the management, was completed in the first quarter but largely completed towards the end of the first quarter. So again, modest benefit reflected in the numbers at this stage. We're still projecting to realize in the order of $40 million to $50 million of savings in 2011. But again, we have -- as we've indicated, we do intend to reinvest some of those savings in product development, clinical programs and as we did in this quarter, in medical education and training as well. So there's more value to come, if you will, as we get further down the road in completing the balance of those programs. And it is the case, as you pointed out with respect to the Dental business that we're very pleased with the, obviously, the performance of that business. We feel we have a very strong management team in place. We continue to provide support in terms of investments in the product development programs at our Dental business, investment in license arrangements that have enabled that business, as you know, to gain ownership of the customer relationships with respect to the biologic softening within that franchise, other license arrangements that have enabled us to expand that portfolio. And we do believe that we're well-positioned with those kind of investments to continue to create value with that business. And don't feel that it's necessary per se -- not that we wouldn't be interested in opportunities to have an even bigger position within that market, because we like that market, but don't feel that it's necessary for us to get bigger through acquisitions to be able to create value.

Operator

[Operator Instructions] Your next question comes from the line of David Roman with Goldman Sachs.

David Roman - Goldman Sachs Group Inc.

I was hoping you could come back and talk a little bit about the pricing environment. If I look across both Hips and Knees, it actually looks like things got a tad better from the fourth quarter. I think in the fourth quarter on Knees, you had quoted negative price of 2.3% and the first quarter, you said 1.7%. And then on the Hips side, I think it was 2% in the fourth quarter and 2% in the first quarter as well. Could you maybe just give us a little bit more perspective on what's happening on the pricing dynamic? I think that was sort of a key theme that came out of AOS [ph] but it looks like things there just remain very status quo.

David Dvorak

I think that's a fair way to characterize it, David. I don't know that the variation from last quarter to this quarter really indicates any fundamental shift in some of the pressure that we've been experienced and the effect that, that's having. And the way that it shows up in negative price in the order of 1% to 2% across the various product franchises. A bit more pronounced, as you indicated, Hips and Knees. We talked on the last call about this price compression, particularly within the U.S. market. We continue to see that, as we expected to, coming into the year, and that is something that is going to carry on through the balance of 2011, at least within the U.S., and then of course, we've got an easing comp with respect to Asia-Pacific and the fact that we anniversary out of the Japan price cuts going into the second quarter.

David Roman - Goldman Sachs Group Inc.

And maybe just to follow up on Bob's last question regarding Dental. I mean in general, if you look across your portfolio, clearly, you are the #1 player in reconstructive implants and that scale is having a benefit combined with some of the new products that you've launched. If you look across some of your other businesses where you are relatively subscale from a market share perspective, while the growth rates this quarter were very strong, can you maybe talk about some of the initiatives you might undertake to increase your scale? And also maybe comment on to what extent you think scale matters in some of those segments and maybe in light of also the announced transaction yesterday.

David Dvorak

Sure. I think that we've been consistent in describing our business development strategy for some time. As far as the categories go, nothing has changed there. The musculoskeletal market is the space that we operate in. It's the place where we think we can create the most value for our shareholders and other stakeholders. So this is where we're going to live, and we think we're uniquely positioned to take advantage of the opportunities in all of these markets that we serve. You're right to point out that scale matters. I don't think that scale necessarily translates into meaning that you have to be #1 or #2 in those categories to create value for the shareholders and other stakeholders. But you certainly have to have enough critical mass to where you can justify investing in product development, for example, and feel that you have the distribution channel to be able to create value through those investments. And so those are places that we continue to emphasize the growth of the smaller businesses. Those emerging businesses are all in single-digit market shares at this point in time. But our position is that if we do the right things, we think that we can grow above market and take market share. If we find external development opportunities that allow us to accelerate progress in those categories, we would pursue those. But we wouldn't do it at the cost of an overly dilutive transaction, and we wouldn't do it if we didn't think that we weren't going to create shareholder value in a reasonable time period. So the hurdle rates are fairly rigorous, and we're always analyzing what other opportunities that we have to redeploy that cash. So it's going to be a consistent balance for us, going forward, of both internal and external development. But we're not going to be so adamant about becoming the #1 player in one of those subcategories that we would go off and do something that's adverse to the shareholders' interest.

David Roman - Goldman Sachs Group Inc.

Okay. And then Jim, just want to clarify, the second quarter gross margin, you said, was that down 160 basis points. That's on a year-over-year basis?

James Crines

That's correct.

Operator

You're next question comes from the line of Derrick Sung with Sanford Bernstein.

Derrick Sung - Sanford C. Bernstein & Co., Inc.

You've clearly sort of presented a view on reacceleration, at least in growth rate in the U.S. off of comps. I was wondering if you could provide some color in your core reconstruction market as to how you see your European growth rates playing out in the back half of the year. Are you expecting to see a similar sort of reacceleration there? And maybe just some color on how austerity and pricing is playing out there in Europe.

David Dvorak

I would describe the European market as being one that, at least in our view, seems to be stabilizing. I think that our own execution is accelerating. And I think that we would expect to perform quite well relative to the market for the balance of this year. We believe that we were leading the industry in growth from whatever numbers we can gain access to in the first quarter, and we're optimistic about that group's ability to perform. And for the balance of the year, we have strong management, great products. We're executing launches of new products quite nicely in that space, and we know what areas we have further work to do. But many of the large markets are performing at a high level at this point in time. And I would tell you that I think that we just see a stabilization in that core market with respect to those austerity measures. So whereas in the U.S., some of the pressure would manifest itself in price, some of the pressure in the past in Europe did manifest itself in procedures. But as we said all along, we view, in any of these markets, the decline in those procedure rates to be deferments as opposed to people that are going to be able to just forego the procedures. And I think that what you're starting to see in the stabilization of Europe is just that, that these patients don't go away, that even with the austerity measures that may have suppressed procedure rates in past periods, that ultimately, those health care systems have to address the needs of the patients. And so I would see a positive outlook within that market and, certainly, as it pertains to Zimmer in particular.

Derrick Sung - Sanford C. Bernstein & Co., Inc.

Great. Thank you. That's helpful. And I guess maybe a question on Spine. And I appreciate that you're kind of a small player here. But one of your competitors yesterday presented a view that they thought the Spine market, while sort of growing around 2% right now, might eventually sort of reestablish itself at kind of a mid-single growth rate. Would you share that view? And kind of what are your views of the Spine market moving forward?

David Dvorak

I think that, that's probably as good of a view as exists right now, projecting forward within that market. I think that there will continue to be some price pressure within the market. But it's a big market. It will continue to be a very interesting market, and I would say that our performance right now, as it pertains to U.S. as opposed to the OUS Spine market, is really more Zimmer-specific issues that we're well on our way towards addressing.

Operator

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

Frederick Wise - Leerink Swann LLC

Let me turn back to the Hip market, and perhaps, you could give us a little more perspective on U.S. Hips. The Metal-on-Metal, as part of the market, shrinking. I'd be curious to know where you think it is and where it's going. And I assume that, that's helpful for Zimmer as you roll out the new products. But specifically on the new products, is this helping you increase share volume mix at existing accounts? Or in the context of the Metal-on-Metal issues, helping you get back into accounts, older accounts, opening new accounts?

David Dvorak

Sure, Rick. I think that the U.S. Hip market was fairly consistent from what we can tell sequentially from Q4 to Q1 of this year. The overall global market, we think, was quite consistent from Q4 to Q1. So our step-up in performance is really again driven by the new products and the enhanced execution on the commercial side. With respect to the Metal-on-Metal market, we were never a large player in that subset of the market. And I think that the views of, kind of the collective views of the analysts are accurate, that, that was probably a market that was round numbers. 25% of the market is measured by units and maybe 30% or so of the market is measured by dollars. That has declined fairly dramatically. If you had to peg a number now, I would say that the estimates of around 10% or 10% or 15% are probably directionally correct. And I would tell you that as it pertains to Zimmer, we're sub-5% in penetration or as it represents a percentage of our sales on the Hips side. So it isn't a risk for us going forward, and it is very much an opportunity for us, not only because we don't have that headwind in the performance of our Hip business, but the solutions that we've been launching are very timely, very responsive to what surgeons and patients are seeking. And that's why we're seeing the great uptick of the Continuum Cup of our broad portfolio of stems. And we would anticipate that we're going to continue to make progress in that market. So it's a combination of potentially getting some business back that may have been lost historically to other companies for Metal-on-Metal users, as well as penetrating new accounts. And I would tell you as well, we're getting some mix benefit of the Hip side, and that's consistent with our view that if one innovates in the right way within this space, in the current climate, you can still get mix opportunities. So it's a combination of all those drivers.

Frederick Wise - Leerink Swann LLC

Right. Thank you. I want to follow up on the gross margin question and answer. I think we all heard you talk about the 160 basis points of hedge loss. But in this quarter, manufacturing efficiencies helped -- and you also had an obsolescent charge, I don't know how to -- the right way to ask you for the second quarter, but I assume those obsolescent charges won't be there and you'll get more manufacturing efficiencies? I mean, we shouldn't take the 75.4% minus 160 basis points, I assume, Jim and say 73.8% for the second quarter. I assume it's not that simple?

James Crines

Yes, that's right, Rick. And I think the question was asked earlier as to how to think about that 160 basis points. It is relative to prior-year second quarter. So that's really off of the prior-year second quarter that you would need to take that into account. And I think you do, Rick, you're sort of touching on something that may not as evident to people, and that is that we are experiencing stronger, if you will, operational efficiencies than we had anticipated coming into the year. So what puts us in the position to hold the margin guidance at 75% in spite of having an additional 2 points of currency lift on the top line, which I think as people understand, always results in us having more significant hedge losses in an environment where the dollar is weak. Those operational efficiencies are what is allowing us to offset the additional hedge losses over the course of the year and still hold to the guidance of 75% for the full year.

Operator

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

Kristen Stewart - Deutsche Bank AG

I just wanted to go back again, I guess, to -- you'd touched a little bit about it, but yesterday [indiscernible] and J&J, and just kind of your thoughts more broadly on the longer term and just kind of the need that you may have to bundle across, not only, obviously, the Knee business but not having a substantial Trauma or Spine. How do you think that's going to affect you both near and long term? I would imagine near term, maybe some disruption? I don't know if you would agree with that, but any comments there would be helpful.

David Dvorak

Sure, Kristen. These are strong competitors and great franchises on both sides that are involved in that transaction. So they will continue to be strong competitors if that deal is consummated and notwithstanding any disruption, which always exists in the integrations of companies. I think that there is always opportunity over the course of the disruptions during those integrations, but they'll emerge as strong competitors on both sides. The point that we're focused on is ensuring that we can compete effectively in the marketplace, and we're doing the right things to ensure that we have very competitive offerings in these categories. And I think that being strong in all the subsets of the musculoskeletal care market is going to be very important to us going forward. But it's an area that we've been focused on and vigilant about over the course of the last many years. And we're starting to see some of the benefits of that focus and our commitment. Our Trauma performance is a good example right now of what we intend to do. So notwithstanding that transaction, we believe that we're going to be in a share-gain position within those franchises, and we're making all the important moves that we need to make in investments to ensure that, that is the outcome.

Kristen Stewart - Deutsche Bank AG

And do you believe that just specifically within Spine and Trauma that you can build those distances to some sort of critical mass in some reasonable timeframe to be competitive or do you anticipate the need to have to go out and look for external opportunities?

James Crines

I believe it's going to be a combination of the 2. I think that the opportunities that we have in those 2 different franchises are a bit different. And what it's going to take to exploit those opportunities is a bit different. But pull it together, and it's got going to be a combination of both internal and external development.

Kristen Stewart - Deutsche Bank AG

And then just a quick clarification on Dental. In the quarter, it was also driven by 10% price increases. So it looks like the unit growth wasn't quite as robust as the reported number would suggest. Anything unusual about that 10%? Does that just reflect -- I know you said there was some distributor buy-in, I'm not sure if that's inflating that price or if you really are getting 10% price in Dental. And just kind of more broadly on the distribution kind of buy-ins. Is this something that we should continue to expect to see? It seems like it's more internationally based at this point than any decision that you guys are making in terms of rethinking the structure of the U.S. distribution network to go more direct?

David Dvorak

With respect to the first question, it is driven by -- the pricing on the Dental side is enhanced by the RTI restructuring. And so we are describing that our performance, round numbers, is about 700 basis points or so improved by virtue of that restructuring that took place going into the fourth quarter of last year. So that's what you're seeing there, Kristen. And want to pick up on the second, Jim?

James Crines

So as far as the strategy with respect to the OUS markets, that is an area where we can invest more aggressively to establish critical mass within that franchise. So we've done distributor acquisitions in the past to support that strategy, and we'll continue to look for opportunities to do that going forward.

Kristen Stewart - Deutsche Bank AG

And just regarding the U.S. more broadly just, kind of recon distribution network independent distributors. Any rethinking of that given kind of the changing market dynamics?

James Crines

Those strategies that we're currently executing too, Kristen, are OUS strategies.

Operator

Your next question comes from the line of Mike Matson with Mizuho Securities.

Michael Matson - Mizuho Securities USA Inc.

I guess just had a question on the Gel-One product. First of all, how are you going to be selling that product? Is it going to be sold through your Hip and Knees sales force? And secondly, what's the potential opportunity for that product in terms of revenue? And was any of that factored into your guidance for this year?

David Dvorak

It will not affect our performance in any material way this year just because of the timing of the launch. But to answer your question, generally, we're going to be leveraging our existing distribution channel and relationships in the sale of that product. It's a large market. We estimate that the market is, round numbers, $700 million, and there are a couple of large competitors in particular. But this Gel-One product is one of only 2 single-injection products that will be on the market. And so we feel like through the channel and the relationships that we have that this is a great fit and an opportunity that we're going to take advantage of going forward.

Michael Matson - Mizuho Securities USA Inc.

Okay. And then I just have a second question on a comment earlier in the call about strategic sourcing of manufacturing. Does that imply that you're looking at potentially setting up or sourcing manufacturing from some lower-cost regions? I know most of your competitors have facilities in Asia, particularly in China. You're probably the exception to that. So just wondering if that's a sign that you're evaluating going into some lower-cost regions.

David Dvorak

We really are focused on leveraging our existing manufacturing footprint. We have excellent people within these manufacturing operations across the globe. Obviously, the largest one is located here in Warsaw, and that will be our principal manufacturing facility for the foreseeable future. So the efforts are really to optimize our existing operations. With respect to the emerging markets, we could see production being leveraged out of the Montagne facilities and expanding, but that's likely to be production that would serve those same emerging markets as opposed to displacing any manufacturing on a domestic basis.

Michael Matson - Mizuho Securities USA Inc.

Okay. And then just given that 2 of your competitors now have these dual mobility hips, is that a product category that Zimmer would consider entering, especially given the issues with the Metal-on-Metal hips?

David Dvorak

We have very robust pipeline in development. So we're always exploring opportunities to address unmet clinical needs. And I won't respond to the direct question, but if we believe that there's a clinical benefit and a need within the marketplace, you can bet that it would be something that we would be exploring and potentially developing within our pipeline.

Operator

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

Raj Denhoy - Jefferies & Company, Inc.

I know you talked a little about the Beijing Montagne acquisition. I know it's still relatively small. But what are your thoughts around the opportunity there? I mean, where do you think that business can go for you over the course of this year and into next year?

David Dvorak

It's an important market for us going forward. But I wouldn't measure it in terms of what it can do for us in the next year or 2. I think these emerging strategies are going to be critical to the company's success in the longer term. So the growth percentages are likely to be high. And to date, we're doing a good job. We have excellent leadership in that market. And I think that the acquisition is going to be a very good fit for us. But I wouldn't focus on material numbers coming out of those markets relative to the consolidated numbers that we produced as an overall business in that timeframe, Raj.

Raj Denhoy - Jefferies & Company, Inc.

Okay. And then just lastly, on the Knee side. You and several other competitors, mostly everybody now except, I think, Stryker, have this custom knee-cutting guides. Perhaps you could give us some indication of how that's tracking or what percentage of Knees are now using those and what you think the opportunity is longer term for those as well.

David Dvorak

Yes. We think it's an important technology. But I would tell you that the penetration rate at this point in time is relatively low. It's growing at impressive rates. And I suspect that, that's the case across the market for those technologies. But I would see that as being a first-generation technology. And I think that you're going to see enhancements within the marketplace to those types of technologies that can lead to more customized solutions for patients and ensure excellent implant placements and great wear as a consequence of that for these implants going forward. So I think it's an area that you're going to see the market continue to focus on, and we intend to be a leader within that space.

Raj Denhoy - Jefferies & Company, Inc.

And are you able to get good ASP bump for those? O are they included with the knee implant? Or how do you realize some revenue from those?

David Dvorak

We have been realizing revenue from those. I'd like to thank everyone for joining the call today and for your continued interest in and support for Zimmer. We look forward to speaking you on our second quarter conference call at 8 a.m. on July 27. I'll now turn the call back to you, Brandi.

Operator

This concludes today's conference. You may now disconnect.

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