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Zimmer Holdings (ZMH)

Q3 2007 Earnings Call

October 25, 2007 8:30 am ET

Executives

David Dvorak - President, CEO

Jim Crines - EVP, Finance, CFO

Analysts

Tao Levy - Deutsche Bank

Matt Miksic - Morgan Stanley

Bob Hopkins - Lehman Brothers

Steven Lichtman - Banc of America Securities

Mark Mullikin - Piper Jaffray

Kristen Stewart - Credit Suisse

Mike Weinstein – JP Morgan

Raj Denhoy - Piper Jaffray

Michael Matson - Wachovia Securities

Robert Faulkner - Thomas Weisel

Jason Wittes - Leerink Swann

Brian Wong - Broadpoint Capital

Jeff Johnson - Robert W. Baird

Greg Simpson - Stifel Nicolaus

Operator

Welcome everyone to the Zimmer third quarter 2007 financial results conference call. (Operator Instructions)

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 statement, 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 the 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 on the Zimmer website at www.zimmer.com under the section entitled Investor Relations.

I would now like to turn the conference over to Mr. David Dvorak, President and Chief Executive Officer of Zimmer Holdings Inc.

David Dvorak

Thank you Jennifer. Good morning, everyone. Welcome to Zimmer third quarter 2007 conference call. Joining me on the call today are Jim Crines, our Executive Vice President of Finance and Chief Financial Officer; and Sean O'Hara, who is our Associate Director of Investor Relations and Strategic Planning. We are pleased to be hosting this call to discuss a solid third quarter for Zimmer.

Consolidated sales for the quarter of $903 million, were up 10% to prior year, 8% constant currency, and we delivered leverage earnings at 18% growth. Our sales performance was less than 1% shy of our own guidance, and showed continued stability in the orthopedic market. America’s knee growth helped to drive a 9% increase in our core reconstructive category for the third straight quarter.

Earnings growth was driven by increases in sales, margin expansion, and disciplined expense control, while not sacrificing necessary investments in R&D and SG&A to drive future sales.

In the third quarter, each of our geographic segments contributed positively to our performance. Americas revenue was up 9% to $547 million, led by 10% growth in knees, and continued strength in extremities. Europe continued its steady sequential growth since the start of the year, up 8% constant currency at $226 million. Europe was led by solid growth in both hips and knees, and double-digit growth in both extremities and dental.

Finally, Asia Pacific revenues in the third quarter were $130 million, up 5% from the prior year. Tougher comps and continued price pressure in Japan slowed growth sequentially in that region.

Turning to our product categories, our worldwide reconstructive sales comprised of knees, hips, extremities and dental grew at 11% reported and 9% constant currency. Including the third quarter this marks the fourth quarter of 8% to 9% constant currency growth in this area.

Zimmer Spine grew 7%, as the addition of Endius has begun to provide a bit of a lift to our spine business, as it fills key gaps in our product portfolio. We will continue to pursue internal and external development efforts to gain critical mass in this attractive market.

Unfortunately trauma sales continue to under perform, and were flat to prior year. We are beginning now to implement changes in the trauma business to drive growth. However, we don't anticipate a meaningful recovery in trauma in the near term.

At this point, I would like to comment on a few operational highlights from the quarter. First, on September 27th, we announced that we had settled with the federal government an ongoing investigation into financial relationships with consulting orthopedic surgeons.

During the quarter, we also took steps towards enhancing our biologics offering in our dental category by signing an exclusive distribution agreement with Tutogen for regenerative products in Europe and Asia. We think regenerative products are an attractive growth segment within the dental market, and with this agreement we look to capitalize on our success with Tutogen products in the U.S. as we expand in other markets.

Finally, in August we announced the planned acquisition of ORTHOsoft, who is a market leader of computer navigation in orthopedics. While only used at this point in a small percentage of procedures, we expect computer navigation to be a meaningful component of orthopedic surgery in the future. This investment is going to bolster our smart tool strategic initiative, to bring innovative tools to the marketplace that will help create more and better reproducible outcomes for surgeons and patients. We are also looking forward to applying these technologies to our other segments, such as spine. We expect this transaction to close early next month.

At this point, Jim will provide some further details on the quarter.

Jim Crines

Thanks, David. Sales of $903.2 million for the quarter represents an increase of 10.2% reported and 7.8% constant currency. As David pointed out, these sales results are less than 1% below the company's guidance and First call consensus estimates. The shortfall is attributed to slower than anticipated growth in our hip, trauma, and OSP product segments.

The weaker U.S. dollar compared with prior year added 2.4%, or $19.4 million in revenue in the quarter, and also resulted in recognition of greater losses on foreign exchange contracts under our hedging program, which are reported in cost of products sold. As expected, price was flat for the quarter and the Americas pricing contributed a point to growth in the quarter. In Europe, Germany, France, and Italy reported negative price of 3.4%, 1.3%, and 0.5% respectively. While other market in Europe were flat or slightly positive. Asia Pacific results include negative price of 3.4% in Japan, offset by flat to positive prices in other Asia Pacific markets.

Turning to our revenue growth by major product category, worldwide reconstructive sales increased 11.2% reported, 8.7% constant currency. Knee sales fueled by the ongoing introduction and launch of our next-gen Gender Solutions Knee improved 9.3%. Pricing added 0.2%, while volume and mix contributed 9.1%. In the quarter, our supply chain was able to comfortably meet U.S. demand for the product. Flex knees now make up approximately 47% of our knee units on a global basis, up from 42% in the second quarter.

In other knee systems Zimmer Uni, Segmental, as well as our Prolong Highly Crosslinked Polyethylene grew in double digits. The Natural-Knee continued to experience modest cannibalization and competitive losses before the release of our Gender Flex design for the Natural-Knee scheduled for the fourth quarter. Geographically, our knee sales in constant currency increased 9.9% in the Americas, 5.6% in Europe, and a very strong 12.1% in Asia Pacific.

Hip sales increased 5.2% reflecting a volume and mix increase of 5.6% offset by a decrease in average selling prices of 0.4%. These results reflect solid growth across our primary hip portfolio, including cemented stems, porous primary stems, and total cups. Our hip performance was otherwise negatively impacted by competitive hip resurfacing and new revision systems. Our TM primary, M/L Taper, and EPOCH stems all experienced double-digit growth, offset in part by lower sales of our VereSys Fiber Metal MidCoat, Beaded 6" FullCoat, and other cemented stems.

TM Modular Cups and Durom and Acetabular component sales reported strong growth, as did Metasul large-diameter heads, with the Metasul brand realizing over 50% reported growth in sales in the quarter. Bone cement and accessory sales increased 30% on a geographic basis, and in constant currency, hip sales increased 6.2% in Americas, 5.8% in Europe, 0.7% in Asia Pacific, inclusive of negative price of 2.2%.

Extremity sales for the quarter in constant currency increased 33% on a challenging comp of 16.3% in prior year third quarter. Extremity sales increased 34.7% in the Americas, 26% in Europe, and 36.4% in Asia Pacific.

Dental sales continue to grow in double digits at 16.7% for the quarter, on a prior year comp of 19%. Dental sales increased 8.5% in the Americas and 39.5% in Europe, including the impact of the distributor acquisition in Italy, which closed in the second quarter. Dental sales increased 18.1% in Asia Pacific.

Trauma sales were flat in constant currency reflecting lower sales of Intramedullary Nails, and compression hip screws compared to prior year. Trauma sales increased 1.2% in the Americas, 2.9% in Asia Pacific, and declined 4.4% in Europe. Spine sales at 7.4% over prior year saw a sequential 190 basis point improvement from the second quarter, lifted by sales of Thoracolumbar Outerbody fusion products, Interbody Spacers, and Dynesys.

Spine in the Americas was up 9.4%, Europe increased 4.9%, and Asia Pacific was down 30.4% on a small base. Asia Pacific continues to be impacted by a product registration issue in Japan that will likely remain until early 2008.

Finally, Orthopedic Surgical products and other sales grew 4.1% in the quarter, 5.4% in the Americas, 18.3% in Europe, and declined 6.7% in Asia Pacific.

Now I will turn to the rest of the income statement. Our adjusted gross profit margin of 77.9% for the quarter reflects a 20 basis point improvement over prior year, and a sequential improvement of 20 basis points as well from the second quarter. The improvement over prior year points toward favorable changes in product and geographic sales mix, and reductions in unit manufacturing costs.

R&D expense increased 14% to $53 million for the quarter, indicating higher spending for new product development across all product segments, as well as ongoing development efforts in biologics.

Selling, general, and administrative expenses totaled $353 million, and improved as a percentage of sales by 130 basis points compared with prior year. The sequential quarter increase of 40 basis points in SG&A reflects higher fixed costs as a percentage of revenue during the slower summer months. SG&A also reflects lower share-based compensation expense in the quarter, as we recalibrated expected payouts on the company's three-year performance-based incentive program. Settlement, acquisition integration, and other reflect charges included in our GAAP results, but excluded from adjusted results for better apples-to-apples comparison.

According to the Civil Settlement Agreement we entered into with the Department of Justice announced September 27th, we agreed to pay a settlement in the amount of $169.5 million. The amount was recorded and paid in the third quarter out of available cash on hand.

Acquisition, integration and other amounted to $2.9 million in the quarter, comprised principally of costs pertaining to 2007 acquisitions.

Adjusted operating profit in the quarter increased 14.9% to $298.3 million, at 33% our adjusted operating profit to sales ratio shows an improvement of 130 basis points from prior year.

Interest income for the quarter amounted to $1.8 million, adjusted net earnings increased 15.5% to $215.4 million, and adjusted diluted earnings per share rose 18.2%, to $0.91 on 236.8 million average outstanding diluted shares. These adjusted earnings per share are inclusive of approximately $0.04 of share-based compensation. At $0.19, reported diluted earnings per share including the effect of the one-time DOJ settlement charge, decreased 75% on prior year reported EPS of $0.76.

Now let's turn to the tax rate at 28.2% adjusted for the quarter, and 28.4% year-to-date, the effective tax rate is in line with expectations and the guidance provided on the second quarter call. We anticipate the effective tax rate for 2007 to be around 28.4%.

Maintaining or reducing the effective tax rate with our current structure and geographic mix of revenues and profits will depend on our taking additional steps to further diversify our manufacturing footprint, or our geographic sources of revenues and profits. As we mentioned earlier this year, for the time being we are seeing upward pressure on the tax rate, due to greater growth of products with high margins like Gender knees being sold in the U.S. We have programs in place that will allow us to begin realizing tax benefits in 2009, but in 2008 we expect to see an increase relative to where we are now. We will quantify this exactly when we deliver 2008 guidance, but would not model in anything less than our 2007 rate at this point.

As indicated, third quarter weighted average diluted shares outstanding were 236.8 million. During the quarter we repurchased 1.97 million shares at a total purchase price of $155 million, or an average price per share of $78.85. Taking into account the interest income foregone on the cash used to buy back stock and the timing of repurchases, we estimate that repurchases made in the quarter had a negligible effect on earnings per share. On a year-to-date basis, we have repurchased 5.6 million shares, at a total purchase price of $460.6 million. As of September 30, 2007, we have remaining capacity to repurchase up to $737 million of our stock under our repurchase program. For us in the absence of significant demands on our cash, stock repurchases remain an effective and efficient use of available free cash flow.

Operating cash flow for the quarter amounted to $166.8 million, down from $302.7 million in the second quarter as a result of the settlement payment of $169.5 million.

Depreciation and amortization expense for the quarter increased to $58.2 million. Capital expenditures for the quarter totaled $80.8 million, including $33.3 million for instruments, and $47.5 million for property, plant, and equipment. We anticipate full year 2007 spending for property, plant, and equipment to be in a range of 200 million to $210 million. Instrument investments for 2007 are expected to be in a range of $140 million to $150 million.

Free cash flow was $86 million for the quarter, also well below trend in the prior year as a result of the settlement payment.

Finally, inventory days on hand finished the quarter at 330 days, an increase of 20 days from prior year, reflecting greater investments in field inventory consignments in support of our new products. Our trade accounts receivable days sales outstanding finished the quarter at 60 days, slightly higher than the prior quarter and prior year.

With that, I will turn the call back over to David.

David Dvorak

Thanks, Jim. To conclude, I would like to comment on our guidance. As disclosed in our press release last night, we have updated our fourth quarter and full year 2007 guidance so I will quickly review those details with you now.

We expect fourth quarter sales to be in a range of $1.027 billion to $1.032 billion, or 10% to 11% growth over prior year, and adjusted earnings per share growth in a range of $1.03 to $1.05, or 1% to 3% over prior year. With these updates, we expect full year 2007 revenue to be in a range of $3.851 billion to $3.856 billion, an increase of 10% over prior year and adjusted earnings per share to be in a range of $3.91 to $3.93, an increase of 14% over prior year.

This updated guidance reflects a $33 million to $38 million reduction in constant currency growth, partially offset by an increase in contribution from foreign exchange of $15 million. Our constant currency sales growth has been updated to account for lower sequential growth rates in the Americas, underperforming sales trends in our Trauma and OSP categories, and the forecasted impact of hip resurfacing in the United States market.

Exiting the second quarter, we anticipate an incremental growth from our core reconstructive segments and a tailwind from the foreign currency to drive us through tougher comps in the second half. While we feel the third quarter was solid in light of the tougher comparison, we simply aren't experiencing the sales acceleration we had planned for.

As a result, our adjusted earnings guidance has been lowered by $0.11 to $0.13 in the fourth quarter comprised of the following elements. First, $0.07 to $0.08 from the $33 million to $38 million reduction in constant currency sales, and that is predominantly within our higher margin hip and knee products in the Americas. It is important to note that the incremental earnings from the $15 million of sales contributed by foreign currency are negligible, and that is all a result of our hedging program.

Next a $0.01 reduction due to foregone interest income related to the Department of Justice settlement. Also, $0.02 to 0.03 for estimated payments and reimbursements related to the appointed monitor. Finally, a $0.01 bit of dilution from the expected acquisition of ORTHOsoft as we previously disclosed.

This updated guidance is not how we had planned to wrap up an otherwise good year in sales and earnings for Zimmer. With almost six months of reviewing the state of business in this new role, it has become clear to me that several operational and product-related challenges are constraining our ability to take full advantage of the opportunities available in the marketplace, some of which are impacting our largest product categories.

First, the operational constraints we initially faced in responding to the Gender Knee demand, but fixed during the second quarter, haven't allowed us to fully exploit this opportunity to date. These constraints limited our ability to expand our market share in units and have led primarily to mix upgrades within our current customer base, which will anniversary in the fourth quarter. Competitive countermeasures and the lack of Gender in our Natural-Knee brand are contributing a slower than expected competitive uptake here. So while we still there is tremendous opportunity for Gender knees, the opportunity will likely take a bit longer to materialize. We are just now starting the limited release of the Natural-Knee Gender Flex, and will be rolling out Porous components for the next-gen brand in the first half 2008.

Second, on the product side, we do face a near-term challenge in hips with the strong uptake of hip resurfacing in the U.S. market. In the fourth quarter, Zimmer will enter limited release of the first of two Gender Solutions hip stems, the Gender Solutions M/L Taper with connective technology. We believe that the intra operative flexibility and MIS compatibility of this stem will make it a very competitive new hip product for 2008. This should help, but not entirely offset our lack of a resurfacing product in the U.S. market. Our path to resurfacing, as we have discussed in the past, remains both the IDE study and a PMA filing with foreign data.

Third, we also need to address certain product gaps and sales focus challenges with respect to some of our other businesses such as trauma, spine, and our orthopedic surgical products.

Finally, as evidenced by the estimated impact on the fourth quarter, the incremental expenses related to the federally appointed monitor are likely to be significant over the 18-month term. As a result of some of these challenges, we will wait to issue 2008 guidance as part of our fourth quarter call and full year conference call in January.

In closing, we want to be clear that these challenges do not in any way change our fundamental view of the marketplace. We still see an attractive environment with respect to both volume and mix opportunity. As a result, we are in no way wavering from our goals to expand our leadership position in hips and knees, and accelerate the growth of our other business lines through measured investment.

What we will not do right now is make dramatic changes in our core strategy, or attempt to cover these sales shortfalls and incremental expenses by omitting investments that we believe will maximize our longer-term growth potential. That would be inconsistent both with our management philosophy and our shareholders' interest.

That concludes our formal remarks on the quarter. At this time we would be happy to take any questions you have.

Question-and-Answer Session

Operator

Your first question comes from Tao Levy - Deutsche Bank.

Tao Levy - Deutsche Bank

If we could just touch on the guidance, you did a decent job of running through your current thinking. Again, the decline in some of the areas especially, for example, your hip comment on the back of a pretty strong third quarter just doesn't seem to make sense, given what we are seeing in the marketplace with some of the other hip manufacturers, not necessarily on the hip resurfacing side are seeing in their base business.

Just wondering, is there anything else going on there? Is there some impact from, for example, the DOJ settlement that you think will negatively hit your ability of your salesforce to sell products?

Jim Crines

No, Tao, the feedback that we are getting from our distributor network is that surgeons that use Zimmer products for primary hip replacements, many of them now have been trained and are using, in most cases, frankly, the Birmingham Hip Resurfacing Device on their younger patients. So we are seeing some significant cannibalization of our own business through our customers, through that sales distribution channel.

I also mentioned we are seeing some competitive challenges as well in our Revision Hip line. We saw some erosion in that business in the quarter as well.

David Dvorak

As a consequence of that, there is pull-through revenue opportunities that come with those Revision cases, as well as those resurfacing cases as they train surgeons.

Tao Levy - Deutsche Bank

So what type of strategies can be put in place to try to combat that? Also maybe an update on your U.S. hip resurfacing product, timelines, expectations? I know you touched on some of the data.

David Dvorak

We are really excited about the M/L Taper with connective technology, first and foremost. The intra operative technology of that product and the MIS capabilities with respect to the M/L Taper, we are receiving great feedback from surgeons with respect to, so we are optimistic that we are going to be able to generate nice growth in that area in 2008.

With respect to resurfacing, you’re right, we are working towards filing a PMA with foreign data, and that hopefully, is going to be a 2008 event, but that puts us out yet a couple more years from where we rest right now, and if we need to go through a full IDE/PMA process to develop U.S.-based data, that it likely a couple years further out.

Tao Levy - Deutsche Bank

In the prior conference call you talked about new products that were going to be launched in the fourth quarter that would help increase momentum going into 2008. You touched on obviously the Connective products. But there are other products which you haven't talked about, which you had highlighted in the past, De Novo technology, mobile bearing knees, for example, I was just wondering there are any delays there, or do you just now expect less contribution from those new products? Thanks.

David Dvorak

The De Novo product in the first instance, the natural tissue we have never said that it is all that significant in the way of revenue generation. We are very excited about the longer term opportunities with the De Novo brand, but that is further out. The products that will be impactful in 2008 include a gender porous component which we are expecting to launch in the first half of 2008, and then as well that Natural-Knee launch with the Gender Flex, which is under limited release right now, but it will find traction and become meaningful in 2008. With respect to the mobile bearing knee, we are awaiting FDA approval still, and have not heard anything more on that front since our last call.

Operator

Your next question comes from Matt Miksic - Morgan Stanley.

Matt Miksic - Morgan Stanley

I have to push you a little here on Q4. It seems after what looked like a pretty decent Q3, and I understand hips showed some signs of weakness, maybe in growing a little bit south of the market, it just feels almost premature here to just punt on the pressure from resurfacing.

Can you talk about, it should be what, 10% or 15% of the total market, and there is one player on the market, another launching towards through the end of the year? Can you help us understand at least what you are seeing so far in the market that is causing you to be so cautious?

Jim Crines

Matt, some of what we are seeing, as David had indicated, we had anticipated once we got to where we needed to get to, as we talked about on the second quarter call with the inventory consignment and instrument placement to the field, that we would begin to see some competitive uptake with the Gender Knee. As we look at our results for the third quarter, and as we look at what has been reported by some of our competitors we are not seeing the competitive uptake in the way we had expected to see it. As we look at that and look at the fourth – we look at that, we look at the fourth quarter, we are going to be up against much tougher comps with having launched the Gender Knee in the third quarter of last year.

On the hip side, with having launched in the second half of last year, the TM Primary Stem, our large diameter head, metal-on-metal device, and then again on the hip side, as I indicated, we are seeing some cannibalization of our primary hip business to resurfacing.

Matt Miksic - Morgan Stanley

So you are looking for some things to offset the pressure from resurfacing, and you are not seeing those come through, and that combined with the tough comps? Am I reading that right?

Jim Crines

Yes, and the new product that we are in the process of rolling out, the Natural-Knee on the knee side, that's still in limited release. It goes into a fuller release, and even as we talked about in the past with the Gender launch, these product launches take several quarters. So we won't see the M/L Taper with connective technologies, a similar issue, in terms of where we are with that launch. That is in limited release in the fourth quarter, and will go into full release in the first half of next year. So the uptake on those new products will have more of an impact in 2008 than they will in the fourth quarter.

Matt Miksic - Morgan Stanley

David, you talked about the Gender Knee from a unit share standpoint taking longer to have an impact. Can you help us understand what you mean by longer? Longer meaning how far out?

David Dvorak

We are looking to redouble our efforts on that product, and we are optimistic about the future of it, but that is probably going to be a 2008 event for us as well, and it is going to come in the form of both the next-gen offering, as well as the porous variant of that offering, Matt. As we get into a full launch of the Natural-Knee, with the Gender Flex solution as well, we are going to be able to find some traction with that one in 2008.

So I think that all of those are really going to be 2008 events, and that is part of what you are seeing impacting our fourth quarter guidance.

Matt Miksic - Morgan Stanley

So longer into 2008, but not longer into 2009?

David Dvorak

That is correct.

Matt Miksic - Morgan Stanley

Just a clarification on this, the expense, the charge around the federal monitor. Could you give us a little more color about what that is, and is that a recurring expense we should start taking out of our thinking on next year's numbers? Any color you can provide on that would be helpful.

Jim Crines

Sure. Those are estimated payments and expense reimbursements that relate to the monitor's services and obligations under the deferred prosecution agreement. So I think that at this point in time you have to consider that to be an 18-month term expense, and obviously as we gain greater clarity as to what that is likely to look like through 2008 we will bake that into our guidance that we provide to you.

Matt Miksic - Morgan Stanley

Am I reading this right? Is that like $8 million a quarter?

Jim Crines

That is correct. The range is $8 million to $10 million a quarter, Matt.

Matt Miksic - Morgan Stanley

Wow. That seems like a big number for expenses. This is what? Travel and coordination, and I don't know what else? That just seems like a big number. I think a little bit surprising, since no one else has really talked about it.

David Dvorak

Not just travel, Matt. I wouldn't describe it as that. That it's fees, professional fees.

Matt Miksic - Morgan Stanley

So fees, so the fee that they get for being the monitor, basically, is what you are saying.

David Dvorak

That is right.

Matt Miksic - Morgan Stanley

Legal fees and so on. Finally, stepping back from the changes to Q4, the changes in your expectations for some of these products hitting in '08 and taking longer, you have talked recently about the model aiming for double-digit top-line growth, acceleration to the bottom line. Has anything happened here changing that? Can you give us an idea how you look at the long-term fundamentals of this business?

David Dvorak

The objectives have not changed, Matt. We are going to execute our strategy and expand our leadership position in hips and knees, and then accelerate the growth of our spine, dental, trauma businesses. So nothing has changed in the core strategy. This is guidance with respect to the fourth quarter, based upon some of the product depth that we have here, and we expect to find more traction in 2008, but obviously we will give you a lot of clarity around what that is going to look like when we get to finishing our plans, and coming back to you in our fourth quarter call.

Operator

Your next question comes from Bob Hopkins - Lehman Brothers.

Bob Hopkins - Lehman Brothers

Somewhere in the call I think I might have missed one thing, where you did comment about '08 growth rates. It was either on the top or the bottom line where you said is it wouldn't be less than 2007. Could you just clarify what that was?

Jim Crines

The comment about less than 2007 was just in the context of the tax rate. As David indicated, we will be giving 2008 guidance in January.

Bob Hopkins - Lehman Brothers

Given the health of the overall market, would it be safe to assume that it is unlikely that you would be growing less than 7% to 8% or 9% in 2008?

Jim Crines

As we indicated, we will be providing guidance for 2008 in January as we get through our own internal planning process. It all comes together sort of towards the back end of the fourth quarter here.

Bob Hopkins - Lehman Brothers

Just in terms of operating margin going forward, given the issues you are talking about in terms of hips and knees and the challenges you face there, I guess primarily on the hip side, and then also, as you mentioned last quarter, a need to increase investment in spine and trauma, and some of the other businesses, can you drive operating leverage in your business in 2008, or might that be a year where the incremental investment and the challenges you face make it a limited year for operating margin expansion?

David Dvorak

Yes, we are going to continue to move forward with our plans to invest, as we have been talking about, in those other businesses. We feel that is essential for the long-term health of the businesses and in the best interest of the shareholders. We will clearly be challenged in that regard to the extent that these monitor costs are incremental, and that it is the right way to view those costs.

Bob Hopkins - Lehman Brothers

Can you talk just a little bit more about that? Because perhaps I don't understand exactly what is going on here, but $30 million to $40 million in expenses seems an exorbitant amount, and I was wondering if you could just break that down for us? I know you said previously it was fees, but are there consulting fees in there? Can you break that down a little bit more? Because again, it seems like a very, very high number.

David Dvorak

The fees are principally going to be professional fees, obviously and I think that the best we can do is to point you back to the deferred prosecution agreement, Bob, and the substance of those responsibilities are outlined in a fair amount of detail there. Those responsibilities and that oversight obligation that the monitor possesses are what will drive the professional fees. As I said, the DPA is the document that describes what they relate to.

Bob Hopkins - Lehman Brothers

Okay. I will go back and take a look. A 30,000 foot question around your philosophy around guidance, because obviously this is the second conference call where we are communicating live here, and I was struck by a comment at the beginning of the call where you seemed to express some degree of satisfaction that you almost achieved your goals.

I am wondering going forward as you give guidance, how should we be thinking about that guidance? Are those aspirational goals that you hope to meet, or are those things that you are 120% sure of, and hope to beat? Just trying to understand the philosophy around guidance as you will be providing it.

David Dvorak

We are looking to give you the best visibility we can as to the direction of the business. The comments on the front end of this call, we don't think there's anything to be ashamed of about the top line growth, certainly not the 18% bottom line growth for this quarter, but we are trying to give you the best visibility we can as to what we expect the fourth quarter to look like in light of these product launches and the timing of the traction for those products.

Operator

Your next question comes from Steven Lichtman - Banc of America Securities.

Steven Lichtman - Banc of America Securities

Again on Gender, I just want to get some clarity. In terms of the operational constraints, obviously I can understand why that has been impactful over the past few quarters, but I am still unclear as to why that's going to be unclear over the next few, assuming that those constraints are now behind you. Could you flesh that out a little bit more please?

David Dvorak

The constraints that we are referring to in the fourth quarter are the fact that the Gender Flex component for the Natural-Knee system is still in limited release as we work our way through the fourth quarter, which means we have a limited number of sets in inventory, consignments going out into the hands of the developers and a few other surgeons. So as we get into 2008, and we will work our way over the course of the first half of the year, putting out more significant numbers of instruments and inventory consignments, to support the full launch of that product. A similar story, Steve, on the Porous Gender Flex component for the next-gen system.

Steven Lichtman - Banc of America Securities

But on the core GSF, that was the issue previously in terms of the constraints in terms of gaining market share potentially, that is behind you, right? Is the feeling that you need the Porous coated now in order to be effective? What about the core GSF, excluding the Natural?

David Dvorak

On the core GSF, it is really a matter of taking full advantage of the sets that are deployed in the field. We are hitting a point now where we are anniversarying the mix, and so the unit growth has got to drive the performance in that area, and we just didn't see that acceleration to the extent that we were expecting in the third quarter, and that is really the primary basis for what we are projecting out for the fourth quarter.

So we need to do a better job of taking advantage with the core GSF.

Steven Lichtman - Banc of America Securities

In terms of the fourth quarter, on the EPS impact of the sales reduction, it still seems a little bit high to me relative to the sales reduction, unless the operating margins on that are very, very high. Is it just that? Is there any incremental spend that we are starting to see already as you are starting to plan for 2008?

Then maybe following on to that in response to Bob's question, you were talking about the incremental spend in trauma and spine, but as we think about next year, are there going to be incremental spends as well in the core hip and knee business that you now believe you need to make?

David Dvorak

Well on the $0.07 to $0.08, that is at the margin the impact of the sales reduction of $33 million to $38 million. So there are no incremental expenses reflected in that $0.07 to $0.08. Whatever investments we have contemplated going into the fourth quarter we have clearly taken that into account in the guidance that we provided for the quarter.

Steven Lichtman - Banc of America Securities

Next year, as we think about that increased level of investment, previously you've talked about spine, dental, and trauma. Is hips and knees and area that we are going to be seeing increased investment as well?

Jim Crines

We are going to see investment for sure. We had some significant investments, as you well know, in the first half of this year in DTP. We expect to have similar levels of investment in 2008. Not in the same program, but will be directed certainly at the opportunities that we have in hips and knees.

Steven Lichtman - Banc of America Securities

Going back to these monitor costs, is this a consistent expense per quarter, and I guess all on the SG&A side?

Jim Crines

That is the right way to think about it at this stage.

Operator

Your next question comes from Mark Mullikin - Piper Jaffray.

Mark Mullikin - Piper Jaffray

I just want to talk about the monitoring costs a little bit more. Do you know if your costs differ from your competitors? Are different companies here being held to different standards, as far as the amount of effort that is going into the compliance?

David Dvorak

We don't have any visibility, obviously, to the expenses that relate to the monitors for the other companies. The settlement agreements and resolution agreements that relate to the matter do have the same substantive provisions in them. So one has to expect that the oversight is going to be consistent, but I can't tell you what the expenses are going to translate into for the other companies.

Mark Mullikin - Piper Jaffray

Just in the spine and trauma businesses, can you give us an idea of specific steps that you are going to take to rejuvenate growth in those areas?

David Dvorak

Yes, we can speak to that. On the spine side, we saw a little bit of improvement in the performance in this quarter and would expect some more in the fourth quarter. But it is off of a small base business for us. Principally our short-term opportunities there relate to the shoring up of the Fusion line with some of the product that we picked up from the Endius transaction. We are expecting better things in the future from that division on that front, as well as Dynesys presents us with good opportunities going forward.

We need to make other internal and external developments and investments to continue to establish that as a more significant business.

On the trauma side, as we have talked about in the past, we have a very strong product line in certain areas, but a weak line in other areas. Principally our strength resides in plates and screws right now, in the area of weaknesses our nail line is one that we are looking to shore up with some internal development efforts. So that is a gap that we look to fill as we work through 2008. But it is unlikely to be impactful any time in the first half of 2008. It is probably going to be more towards the end of that year.

Beyond that we just need to do a better job on sales focus with respect to trauma and that is a global issue that we have got to resolve.

Mark Mullikin - Piper Jaffray

So at this point, your trauma salesforce is also within reconstructive is it not?

David Dvorak

That is correct.

Mark Mullikin - Piper Jaffray

Do you have plans to divisionalize that in '08?

David Dvorak

We have plans to bring greater focus to it within the existing structure.

Mark Mullikin - Piper Jaffray

How about plans for adding sales reps? Do you feel like you need to add more resources to spine or trauma?

David Dvorak

All of those divisions, as well as hips and knees for that matter, that is something that we are constantly assessing, and obviously always adding.

Operator

Your next question comes from Kristin Stewart - Credit Suisse.

Kristen Stewart - Credit Suisse

I was wondering if you could talk about the distributors that you have got relative to your sales expectations, it would seem that with the investments that you have made you should be able to generate a little bit more by way of sales. I am just curious if the guidance related to any decline in your expectations for those distributors that you brought on board? Thanks.

Jim Crines

Kristin, we are still in the process of integrating those acquisitions. They are contributing, and we do expect over the long term that they will contribute in line with the expectations that we had as we entered into those deals.

Kristen Stewart - Credit Suisse

What were the expectations for when they would start contributing? Is it a couple of quarters? A year or more? I don't know if there's any non-competes that you need to work through?

Jim Crines

That is a level of detail, Kristin, that, you know, I am not going to provide on this call.

Operator

Your next question comes from Mike Weinstein - JP Morgan.

Mike Weinstein - JP Morgan

Let me just clarify a couple of items. Jim, the math on the $33 million to $38 million sales going down to $0.07 to $0.08 EPS, using the corporate tax rate that implies a pretax operation margin of 70% to 80%? Is that right?

Jim Crines

You got that about right, Mike.

Mike Weinstein - JP Morgan

On the spine business, you guys bought Endius earlier in the year. I think you said they did about $13 million in '06, and it was obviously tracking higher. Is the Endius deal not working? What is going on there? Obviously net of Endius, it doesn't seem like that business is growing right now.

David Dvorak

That transaction, we are quite optimistic about. It is a good product fit for us, Mike. The reality of that type of a deal is, it is a small business, they have an independent distributor network, and you are going to lose some sales as you integrate that, which is something that we anticipated. The important point for us is that we get the products including the Title System, the Minute System, as well as the [inaudible] system, and by the end of integrating that in, and getting enough instruments and inventory out in the field we are already beginning to see some decent traction with that.

It is going to be a revenue synergy deal. In the short term you are going to lose some of those revenues because you are integrating those independent distributors.

Mike Weinstein - JP Morgan

Understood. It seems like with the smaller spine deals that the whole industry has done in the last few years, that every single one of them ends up being tough on the integration. Is that a fair statement?

David Dvorak

Because of the distribution channel, I there are issues there, but I will tell you that we built that into our business case. Our view as to the benefits of that transaction have not changed.

Mike Weinstein - JP Morgan

David, I want to circle back to the resurfacing discussion, because you have raised this as being an issue on the business in the short run, which makes us all wonder when are these guys going to be able to have a product in the U.S.? There is an open question there about your ability to file a PMA with foreign data in 2008. When do you think will you get visibility on that?

David Dvorak

All we can do is give you updates on a quarterly basis as to how we are tracking in that regard. We can't give you any assurance that we are going to be successful on that front with the foreign data, obviously, and if we are, it is a couple of years out, and if we aren't and we have to go through a full IDE/PMA to develop the U.S. data, it is obviously about double that time period.

Mike Weinstein - JP Morgan

The Mobile Bearing Knee, you really didn't talk about it really at all here. Someone asked a question about it. You made a comment and you haven't had a discussion with the FDA, you haven't heard from the FDA since the last earnings call, which would have been three months ago. It doesn't sound like your visibility is very good on the timing of that approval, or maybe you can give us a little bit more?

David Dvorak

We have done everything that we can do on that, and we are awaiting the FDA's response to us and so there really isn't anything more to tell you at this stage.

Operator

Your next question comes from Raj Denhoy - Bear Stearns.

Raj Denhoy - Piper Jaffray

I wanted to talk a little more on resurfacing. One of the questions that has come up with that product is whether it is going to be incremental to the market growth, or whether it's going to be cannibalizing existing sales. It sounds from your commentary that you are thinking it's going to be more the latter, and that it should be taking procedures that would have been done with traditional hips. Is that fair to say? Do you think it's somewhat of a mix here at this point?

David Dvorak

Well, I think it is both. I think that it is probably expanding the market, but also picking up some opportunities that otherwise would have gone to traditional hip procedures. We are seeing it obviously on the side where the traditional hip procedure is being lost to the resurfacing but in addition to that, I think it is also the case that when the surgeons go in and get trained on the resurfacing product, you may lose the primary total hip procedure even if they are not using the resurfacing, because they have been exposed to another company's product at that point in time.

Raj Denhoy - Piper Jaffray

So it does sound that this could be somewhat longer term, in a sense that you might actually be losing surgeons competitively here?

David Dvorak

Well, procedures.

Raj Denhoy - Piper Jaffray

But not actually the surgeon shifting their entire business over to another competitor?

David Dvorak

We haven't seen a lot of that but we probably have seen some procedure loss, and in instances, some of the primary business.

Raj Denhoy - Piper Jaffray

You continue to buy back stock here at a pretty good rate. Obviously there has been a lot of commentary about reinvesting your business and looking for opportunities to accelerate some of the product lines in the spine, trauma, and other areas. Perhaps could you just talk a little bit about the opportunities for investment in the business? Are there programs that are now starting to come up? Are you looking for more things to invest in? Are you looking more aggressively outside? I guess the level of investment, and also the urgency at which you are going to be tackling these things, and really trying to reaccelerate the business here?

Jim Crines

We certainly are focused on opportunities outside and inside. As we think about inside, obviously, we have talked specifically about the kinds of investments we are already making in dental, talked about trauma and the issues around sales focus, and our intention to invest there.

As we look on the outside we will as we always have, apply some fairly rigid criteria to those opportunities. We are looking for things that have good strategic fit, that keep us within musculoskeletal health, any deals that we would look at, pay a lot of attention to as we model out the opportunities -- accretion, dilution, diligent IP, as we have said, the focus we have on spine, dental, biologics, particularly in the spine area, that gets to be an issue.

Appropriate valuations gets to be an issue, and we focus, as you can well imagine in this environment on compliant business practices. So we are active, and will remain active in exploring opportunities on the outside, subject to the discipline that I described.

Operator

Your next question comes from Michael Matson - Wachovia Securities.

Michael Matson - Wachovia Securities

With regard to the changes in compliance practices and the federal monitor, obviously you talked about the charges that the federal monitor is going to result in. But are there going to be any hits to productivity from your other employees in terms of having to spend more time tracking their work with consultants, and spending on entertainment, things like that? Is there any possibility that those sorts of things could put some pressure on your margins as well?

Jim Crines

Well, I think that as far as the expenses that relate to compliance with the deferred prosecution agreement, what we outlined in the way of incremental expense is going to be the most significant, and that is the monitoring costs.

We have a fairly significant investment and are constantly expanding that to ensure that we are meeting the needs, so I can't tell you with any precision at this point in time what that will look like for 2008, but any of those incremental expenses that will relate to the fourth quarter are baked into our guidance.

Michael Matson - Wachovia Securities

Just with regard to the guidance, you said January. Does that mean you are going to give it on your fourth quarter call? Is that what you are saying?

Jim Crines

That is correct.

Michael Matson - Wachovia Securities

How big of a deal is it, in your view, probably early next year you are going to have the oldest knee platform on the market with the launch of DePuy's new Sigma Knee? Obviously you have Gender, but let's be frank, it seems like that has been pretty disappointing. It is really more of a line extension than a completely new knee system. Are there plans to launch a new knee, and is that going to cause further pain next year?

David Dvorak

We continue to have the number one knee system on the market, and we are excited about many of the introductions that are coming out. We have outlined those with specificity. We think that we are going to be able to get good traction out of Gender. We think that the Natural-Knee Gender Flex offering is going to be meaningful in 2008, so we have a good lineup, including the mobile bearing opportunity, provided we get the FDA clearance on that.

Michael Matson - Wachovia Securities

With regard to the reinvestment that you talk about in the spine and trauma businesses, is that going to be primarily in R&D, SG&A, or sort of spread across both areas?

David Dvorak

It is going to be spread across different areas, depending upon which of those divisions. There are instances where we have a pretty full product line in some of those divisions; others where we have some gaps that we are looking to fill. Obviously those gaps in the trauma area we have talked about some internal development efforts there.

On the spine side, it is going to be a combination of internal and external developments. We are looking to develop critical mass in all those business divisions. More feet on the street is going to be necessary to accomplish that objective as well.

Michael Matson - Wachovia Securities

In your hip product category, I guess about a year ago you were rolling out your large diameter metal-on-metal hip. I was just wondering if you could give us any kind of an sense of where things stand with the penetration of that product, because I guess we had thought that would be sort of a mix driver, because some of the other companies, that percentage, it is gotten to be 30% or more.

David Dvorak

We continue to see, as I indicated in my comments, significant growth with that large diameter head metal-on-metal product line, I think I had indicated in my scripted comments that we saw an increase within the Metasul brand of over 50% in the quarter. So we are still ramping that up level of penetration, and I would tell you it is not at the levels that you, not yet at the levels that you quoted with respect to competition.

Operator

Your next question comes from Robert Faulkner - Thomas Weisel.

Robert Faulkner - Thomas Weisel Partners

I want to dig in a little bit on the guidance, and just ask what in your mind changed from last quarter at this time to now? Resurfacing was out there. Some of your constraints were visible. Maybe they became more profound, and the comparisons were also known. So is this a function of becoming more familiar with the operations in forecasting dynamics, or did something really jump out this quarter, learning that resurfacing was worse, et cetera?

David Dvorak

The point that you raised is a contributor, I will tell you. I think that we are learning more specifically as to how effective we are doing in some of these different product areas on the execution side, and where we are challenged on the product offering side.

The short statement to that is really the expected acceleration on the Americas side, hips and knees both, wasn't there at the levels that we anticipated it. Now we think there are good opportunities going forward, and we think that we understand what we need to do with a fair amount of specificity at this point to fully exploit the opportunities that we have in the marketplace with our current offering.

But it is a degree of familiarity, and not finding the traction. We talked specifically as well about the selling on the next-gen Gender side, and as we move into this fourth quarter, and start to overlap on the mix benefit that we enjoyed a year ago, obviously if we are not taking the competitive business at the levels that we originally had forecasted, that growth starts to fall off on the year-over-year comparisons.

Robert Faulkner - Thomas Weisel Partners

In terms of the acceleration, was that more of a forecasting dynamic? I think you maybe mentioned earlier one particular product that wasn't doing what you expected, or is there a real product inside the hip business that isn't accelerating the way you thought it would be?

David Dvorak

I think it is across the various lines that we described earlier in the call.

Robert Faulkner - Thomas Weisel Partners

As a follow-up, maybe could you comment on use of cash, or at least let us know how you are thinking about the two alternatives you mentioned. One is acquisitions, the other is share repurchase. How do you think about allocating cash to one versus the other? Do you have a preference?

Jim Crines

I would tell you, we believe with any of the opportunities we would be looking at in terms of acquisitions, we have with our balance sheet the opportunity to do whatever we need to do, whether it is to fund those out of available free cash flow, or if we were to need to, draw down on our credit facility, we could do that but otherwise put available free cash flow to work through our share repurchase program. Frankly don't see a need to build cash on the balance sheet.

Robert Faulkner - Thomas Weisel Partners

Finally, the $0.07 to $0.08 that you attributed to operating deleverage in the fourth quarter in your guidance, that is a lot of deleverage. It rounds to about I think 50%, unless I am doing the math incorrectly. How do you think about kind of the impact? Are we back to the old marginal flowthrough argument with that forecast?

Jim Crines

What we said on that is $0.08 is specifically attributed to the $33 million to $38 million reduction in constant currency sales, which we have said is predominantly talking about our high-margin hip and knee product sales in our Americas business.

Robert Faulkner - Thomas Weisel Partners

The foreign exchange is hedged, so it affects the whole $38 million?

Jim Crines

That is right.

Operator

Your next question comes from Jason Wittes - Leerink Swann.

Jason Wittes - Leerink Swann

Another question about the monitor expense, is that all external expense, or is there some internal expense as well? In other words, is all that money going to the monitor, or also some changes being done internally that are part of it?

Jim Crines

That is all external.

Jason Wittes - Leerink Swann

In terms of your Gender-Specific Knee outlook, you are lowering it, and I am wondering, is that just because the amount of time it is going to take to launch, or is that also because some of the response has been muted, in part due to the fact that at least a couple of your competitors have responded with what you would call their own versions of Gender-Specific?

Jim Crines

The latter is the fair way to characterize it. As we have said, we have not seen the competitive uptake that we had anticipated we would see at this stage. We still believe it is a very unique device, and we have to do a better job of executing to get after that competitive opportunity.

We will have further opportunities as we get into the launch of the Gender Flex component for the Natural-Knee, and we get the porous component out for the next-gen line, but to your point, and at least in the first nine months of this year, we have been challenged, and in some cases would acknowledge that competitors have put effective countermeasures in place.

Operator

Your next question comes from Brian Wong - Broadpoint Capital.

Brian Wong - Broadpoint Capital

I have just a quick question regarding your distribution agreement with Regeneration Technologies. Just wondering if you could comment on where you are with that? Are you still on track for the fourth quarter launch of that product?

Jim Crines

Yes. We are working through those logistical details of getting those products launched, and it is pretty much in line with the expectations we had outlined in earlier calls.

Brian Wong - Broadpoint Capital

Can we just get the 30,000-foot view, what do you see as the growth rate of the overall market. Is it accelerating? Is it staying the same? Just your thoughts on the overall market in general, please?

Jim Crines

The overall market, we don't see changes relative to our view in the past. I mean, we are still of the belief that on the unit side you are looking at mid-single digit growth, with mix opportunity of 1% to 3%. I think that for any of the companies within this industry that have new systems out, they are probably on the high end of that mix, if they are successfully launching those products, maybe even above that. We think that the market continues to be a very attractive market.

Operator

Your next question comes from Jeff Johnson - Robert W. Baird.

Jeff Johnson - Robert W. Baird

Understanding you are not going to '08 guidance at this point, but as we look at the $0.07 to $0.08 cut to Q4 from an operational standpoint, is it fair to say, given that we are moving some of these product launches out a little bit, that we should kind of gauge our '08 number in a similar manner, as far as the first couple of quarters could see similar operational impact from these lack of new products, and the loss of Americas hip and knee business?

Jim Crines

We will be specific about that as we provide the 2008 guidance, but clearly the trends that we are forecasting now for the fourth quarter are going to provide a different base to jump off of into 2008, so it is going to have an impact in that regard.

Jeff Johnson - Robert W. Baird

Fair enough. Again, the first half of the year we should think of this as maybe Q4, if that is a trough number, so slowly recovering throughout 2008?

Jim Crines

I would appreciate it if you would just bear with us and let us come back to you with the 2008 guidance, and we will give you as much clarity as possible once we solidify our plans. We are going to be in a much better position to do that intelligently in January.

Jeff Johnson - Robert W. Baird

Fair enough. On the monitoring expenses, sorry to beat that issue. We have read through the DPA, if it is an 18-month agreement, assuming everybody complies with everything they are supposed to and what have you, is it fair to think we can kind of punt on '08, as far as the expenses, but as we look into '09 those expenses should go away? Again, assuming full compliance on everybody's end?

Jim Crines

Yes, after the first quarter of 2009.

Operator

Your final question comes from Greg Simpson - Stifel Nicolaus.

Greg Simpson - Stifel Nicolaus

If could I follow up on Rob Faulkner's question on Gender, David, on your question about competitive share, should we take it to assume that you think you have gained competitive share, but just not at the rate that you thought you would, or you don't think you have gained share it at all?

David Dvorak

No, we have gained competitive share, but you are right to say not at the rate that we thought we would. As we are examining those trends, we look out to the fourth quarter, and as I said, you start to overlap with that mix benefit that we enjoyed last year, and obviously what we are counting on for acceleration in the year-over-year comparisons is more competitive.

Greg Simpson - Stifel Nicolaus

Not trying to back-door '08 guidance or anything along those lines, but with respect to Gender again, if you look at interest level and training of competitive surgeons, does it give you a sense of hope, in terms of gaining additional competitive share as we go forward, but again just not at the pace you thought? Is that process accelerating?

David Dvorak

No, we are still enthusiastic about the opportunity with Gender. I think we need to do a better job of executing on that opportunity.

Operator

There are no further questions at this time. Are there any closing remarks?

David Dvorak

Thanks, Jennifer. I just wanted to say thanks to everyone for joining us today, and for your continued interest in Zimmer. We are looking forward to speaking to you again on our fourth quarter and full year 2007 conference call, which will take place on Tuesday, January 29 at 8:00 a.m. Have a good day.

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Source: Zimmer Holdings Q3 2007 Earnings Call Transcript
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