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Smith & Nephew PLC (NYSE:SNN)

Q3 2007 Earnings Call

November 1, 2007, 8:30 AM ET

Executives

David Illingworth - Chief Executive

Adrian Hennah - CFO

Analysts

Raj Denhoy - Bear Stearns

Michael Junging - Merrill Lynch

Yi-Dan Wang - Deutsche Bank

Martin Wales - UBS

Mark Mullikin - Piper Jaffray

Ed Ridley-Day - Lehman Brothers

Mike Matson - Wachovia

Steven Lichtman - Banc of America Securities LLC

Jason Wittes - Leerink Swann & Co

Hans Bostrom - Goldman Sachs International Ltd

Presentation

Operator

This presentation contains certain forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995. In particular, statements regarding planned growth in our business and in our operating margins discussed under outlook are forward-looking statements, as are discussions of our product pipeline. These statements, as well as the phrases aim, plan, intend, anticipate, well-placed, believe, estimate, expect, target, consider, and similar expressions are generally intended to identify forward-looking statements.

Such forward-looking statements involve known and unknown risks, uncertainties and other important factors, including, but not limited to, the outcome of litigation and regulatory approval that could cause the actual results, performance or achievements of Smith & Nephew, or industry results, to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

Please refer to the documents that Smith & Nephew has filed with the US Securities and Exchange Commission under the US Securities Exchange Act of 1934, as amended, including Smith & Nephew's most recent Annual Report on Form 20-F for a discussion of certain of these factors.

All forward-looking statements in this presentation are based on information available to Smith & Nephew as of the date hereof. All written or oral forward-looking statements attributable to Smith & Nephew or any person acting on behalf of Smith & Nephew are expressly qualified in their entirety by the foregoing. Smith & Nephew does not undertake any obligation to update or revise any forward-looking statement contained herein to reflect any change in Smith & Nephew's expectations with regard thereto or any change in events, conditions, or circumstances on which any such statement is based.

I would now like to hand the call over to Mr. David Illingworth, Chief Executive of Smith & Nephew.

David Illingworth - Chief Executive

Good morning everyone, and welcome to our Q3 results presentation. With me is Adrian Hennah, our Chief Financial Officer.

Our third quarter results show very steady progress as we continue to generate sustainable growth in revenues and profits. We had a good quarter, particularly since as you will remember we had a very strong Q3 in 2006 for all of our businesses except our Advanced Wound Management, giving us tough competitors this time around.

I am going to start with the highlights and then I am going to turn it over to Adrian to cover the financials in detail, and then I'll come back and make some final comments about the individual businesses.

So starting with the financial highlights, overall a good quarter with double-digit revenue growth. Recon continues its remarkable track record of outpacing the market which we estimate is growing at 9% globally. BHR, our Hip Resurfacing product, continues to deliver share gains for us in the US where Hip revenue growth was a full 35%. Knee revenues were as we expected; a little soft in Q3. Trauma and Clinical Therapies had revenue growth of 11%, benefiting from good volume growth in external fixation and also our number one position in the bone stimulation market. Endoscopy delivered 9% growth overall, and our focus outside the US delivered 17% growth, a very, very good result.

We're pleased with the continued strengthening of our Advanced Wound Management business. Advanced Wound Management has grown... had growth in the US of 9% and 8% globally, as this business executes on its strategy and delivered balanced growth across all geographies.

Group margins improved by 60 basis points after 100 basis points of dilution from Plus and BlueSky. Adjusted earnings per share increased by 16% as we again delivered double-digit growth in earnings.

Next, a few comments on the business highlights. We've had a very active quarter with several key events. First, our Hip Resurfacing system, BHR, had its tenth anniversary. And we now have nearly 80,000 hips implanted, further distancing itself from the competition. Outstanding clinical results supported by ten-year data, widespread clinical acceptance and a compelling track record firmly entrenched the BHR as the gold standard in Hip Resurfacing. We've also had 3D systems approved as gender specific by the FDA this quarter, attribute to the quality of our product design.

EIP, or Earnings Improvement Program, is being driven by each of our businesses. We announced two major events this quarter. First, the move of our manufacturing facility in Florida to a new factory of our own in China. And second, we also announced a new agreement for the marketing of ACTICOAT, which both improves our earnings and has allowed us to launch several new silver-based dressings.

We also settled with the DOJ this quarter, and we've started to work with the monitor, David Samson, and we expect this relationship to work well.

Now, I'm going to hand you over to Adrian who will take you through the numbers.

Adrian Hennah - Chief Financial Officer

Thank you, Dave, and good morning, ladies and gentlemen. If we can turn firstly to slide 6 and the income statement, revenue in the quarter was $845 million. This is a headline growth rate of 24% and an underlying growth rate after adjusting for changes in exchange rates and for the acquisition of Plus and BlueSky of 10% on the comparable period last year.

Trading profit in the quarter was $169 million; this represents an underlying growth of 19%. The underlying increase in the trading margin was 160 basis points. In the appendix to the presentation, you'll find an analysis of the Plus and BlueSky sales and trading profit included in these numbers.

We provided for and paid cost of $30 million in the quarter in respect to the legal settlement with the US Department of Justice. Within the $26 million restructuring and integration costs, we provided a cost of $4 million in respect to our Earnings Improvement Program and cost of $22 million in respect to the Plus integration. We spent $9 million on the EIP and cash and $3 million on the Plus integration.

The $45 million inventory revaluation item is a non-cash acquisition item required in the IFRS. It arises, as we must revalue the acquired Plus inventory from cost to essentially its selling price less some directly connected selling costs, an increase of $92 million from the $106 million valuation at cost. You can see this preliminary revaluation in note 6 of the accounts of the announcement, net of the $20 million increase and the provision for excess and obsolete inventory.

This increase must be taken to the P&L of the inventories used. We expect the charge to be about $30 million in quarter four, and about $17 million in quarter one of next year. We will continue to show it separately and exclude in the adjusted earnings number so that you can get a clear view of the company's performance.

The amortization costs of $50 million include $11 million attributable to Plus. This is based on a preliminary assessment of value of the Plus intangible of $314 million under their useful lives. We enter a final figure with our full year numbers. Net interest expense in the quarter was $13 million.

Moving on to slide 7, and a bit further down the income statement, the tax charge before exceptionals and amortization in quarter three is 30%, in line with our expectations for the full year. Adjusted earnings or adjusted attributable profit for quarter three was $108 million, a 13% growth on quarter three last year. Adjusted earnings per share grew slightly faster at 16%, reflecting a reduction in shares in issue as a result of the share buyback program.

EPSA growth is less than underlying trading profit growth of 19% due to the dilutive effect in the quarter of the Plus and BlueSky acquisitions, and the small impact from the increase in the tax rate from 29% in quarter three last year. Share buyback was essentially earnings neutral.

Turning then to next slide, slide 8, an analysis of revenue by business segment; you'll here from Dave in a moment more detail behind the numbers for each business. I will therefore make only a couple of financial points in respect of this and the next two slides. On this schedule, you can see the growth rate in the quarter in each of our business segments.

And on the next slide, slide 9, you can see an analysis of revenue growth rates by segments and by geography. The underlying growth rate in our reconstruction business was 11%. This was down from the 15% rate at half one. The principal reason for the slower growth was the expected impact of Plus integration to synergies, especially in Europe as the sales forces have been combined, tougher comparatives, especially for BHR in the USA, which was launched in Q2 2006, and as expected, continued below market growth in Knees in the USA.

Growth in the USA was 15%, driven by volume and mix gains. Pricing in our reconstruction business in the US was essentially flat. Pricing outside the USA was on average slightly negative.

The Trauma and Clinical Therapies business growth rate was 11%. Fixation sales grew at 9% in quarter three worldwide, slightly behind the market growth which we estimated 10%. Clinical Therapies sales growth was 16%. We have signaled that Clinical Therapies growth in the last four quarters was boosted by the in-license of DUROLANE sales, starting in quarter three last year.

In addition to the ending of this effect, we have seen falling USA market growth in Joint Fluid Therapy and in long bone stimulation, which has impacted our sales of SUPARTZ and EXOGEN.

The Endoscopy growth rate was 9%. The Arthroscopy growth rate within that was 11%. Within this, resection sales grew in mid single-digits in the quarter, and the repair area was slightly under 20%. Visualization and DOR sales, which are lumpy, grew at 3%. Endo sales outside the USA continue to be strong with 17% growth, and now account for over one-half of endoscopy sales. Sales growth in the USA at 2% was impacted by the voluntary withdrawal of CALAXO from the market and by the lower DOR visualization growth.

Would sales grew at an underlying 8%. This is an increase on first half growth of 4% as reported. Sales excluding negative pressure wound therapy grew 9% in the USA, up from 11% at half one. Sales growth in Europe improved 7%. NPWT sales in quarter three were in line with expectations modest at $3 million. As Dave will discuss in a moment, preparations for launch in early 2003 are on track.

Turning now to slide 10, this shows the usual amount of revenue and trading profits by business segment. We have again shown separately the impact of the Plus and BlueSky acquisitions on the quarter's numbers.

As we've already noted, underlying trading margin for the group overall increased in the quarter by 160 basis points and this was diluted by 100 basis points by the Plus and BlueSky acquisitions.

Trading margin improved at all business units in the quarter, and we continue firmly on track with our earnings improvement program. It is too early to be evident in reported margin numbers, but we also continue to be on track with the cost savings from the integration of Plus.

Turning to slide 11, and a quick update on our share buyback program. As you know, we said in February that based on an assumption that we used about $2 billion on acquisitions over two years, we plan to buy back up to $1.5 billion worth of our shares over the same period. This remains our plan and we continue to keep the level of the buyback program under review as our acquisitions program proceeds.

As of the end of last week, we bought back a total of about 44 million shares for an outlay of about $537 million. This means that with something over one-third, with two years of the program elapsed, we bought back something over one-third for $1.5 billion total.

Turning then to slide 12 and the outlook for the rest of the year, our view of the company's overall outlook has not changed. In the Recon area, we see total global market growth of about 9% per annum for the third quarter in a row. We continue to expect the same sales growth benefit from our recent product launch program. Based on these launches, we continue to expect our revenue growth, including Plus sales to exceed market growth in 2007.

With regard to the Plus integration, we have signaled previously that we expected to see the impact of the anticipated sales dissynergies quite early in the integration, and that we expected the growth rate of Plus sales in the second half to be lower than the first half and quite possibly lower than market growth. This remains our expectation. We are also now expecting slightly higher sales dissynergies than previously in 2008. This will not, however, impact our net sales synergies target of about 15% of the acquired revenue or $45 million in the third year.

In Fixation, which accounts for about two-thirds of sales within the Trauma and Clinical Therapies business, we see current global market growth of about 10%. We continue to expect to remain close to market growth for 2007 as a whole.

Within Clinical Therapies, we do not expect market growth in the USA to return quickly to the levels in recent quarters. The lower market growth will continue to impact our sales growth.

In the Endo area, Arthroscopy revenue grew at 11% in quarter three. We believe this was slightly below market growth. We expect to continue slightly below the market through 2007. The visualization and DOR business within Endoscopy is much more lumpy. As already mentioned, we saw strong growth in quarter one and we are modest level in quarter two, and 2% in quarter three. We expect growth rate to continue to be volatile quarter-by-quarter. Quarter four 2006 was particularly strong for the Endo business, and we do expect this to impact the growth rate in quarter four for this year.

In the Wound area, we continue to see a curved growth rate for the market, excluding negative pressure Wound Therapy of about 6%. We grew slightly ahead of the market in quarter three. We expect to continue to grow slightly ahead of the market for the rest of this year. We continue to expect negative pressure Wound sales to have a limited impact this year, ahead of the full launch of the BlueSky product range in early 2008.

We are on track for our Earnings Improvement Program of an increase in trading margin of an average of at least 1% per annum to the end of 2010 before the impact of acquisitions. We have a year-to-date increase in trading margin this year of 130 basis points before the impact of acquisitions, and had a relatively high margin in quarter four last year. You should therefore not expect a significant quarter four on quarter four improvement this year.

We continue to expect the Plus and BlueSky acquisitions together to dilute group margins by about 1% in the full year. We expect that the reported EPSA growth rate in 2007 for the full year will be reduced by the increase in the tax charge from its low level in 2006.

Based on the expected full year tax charge of 30%, the 200 basis points increase from the 28% tax rate last year would reduce full year EPSA growth by about 4%. The EPSA growth in Q4 will be particularly impacted, as the tax rate in Q4 2006 was 25%. Based again on the expected 30% tax rate, a 500 basis points increase in the tax rate in Q4 will reduce EPSA growth by about 8%.

We continue to expect the BluSky acquisition to be about 1% dilutive to EPSA in the full year. And with that update on the outlook, I'll hand back to Dave to talk about the business behind the numbers. Thank you.

David Illingworth - Chief Executive

Thank you, Adrian. Let me start my review of the businesses with the Reconstruction segment. As it says on this first slide, we believe our products make us the first choice for the active informed arthritis patients. In detail for this quarter, the reconstruction continued to gain market share globally, outpacing market growth which we estimate at 9%, achieving 11% for the quarter, a very good result. Hip revenues in the US achieved continued strong growth as BHR performs well and completed its first year in the US market. The 10-year data shows industry leading 10 years of survivability and its clinical acceptance has established it as the global gold standard in Hip Resurfacing. Keen revenues performed as expected at 5% globally and 4% in the US.

Let me just take a moment to make a few comments about our Knee business. We have or will have shortly Cobalt Chrome versions of our leading products JOURNEY and LEGION. And we have now got FDA approval for three of our Knee systems to be marketed as gender specific. This will give our sales force and surgeons a much wider range of options as we work to regain momentum over the next couple of quarters.

Given our innovative product range, our expectations are for stronger momentum in our Knee sales. The integration of Plus is going well, as we reorganize our European sales force and start the selling of Plus products by the Smith and Nephew sales force and the selling of Smith and Nephew products by the previous Plus sales force we've also made good progress with Earnings Improvement Program or EIP in Recon this quarter and we've seen market increase by over 200 basis points to 25.3%. New product revenues were 20% in the quarter, a good indicator of that vitality of this business. We now have our monitor in place, as I mentioned earlier, and this is working well so far as he works with us to create a level playing field across this industry.

Now moving on to Trauma and Clinical Therapies. Our Fixation revenues grew at 9% globally in Q3, just a tad behind the market growth of 10%, growing by some 7% outside the US and 11% inside the US, as the benefits of the complete product range are being realized. In Clinical Therapies, our bone stimulation product, EXOGEN, has done very well, driving this business to 15% growth in the quarter. We get real benefit from our market leadership position in this marketplace.

The joint fluid therapy market as a whole is a little under pressure from the combination of reimbursement and pricing. Against this backdrop, Clinical Therapies has performed well with 15% revenue growth. The margin of 19.2% in this business, which is an improvement of 60 basis points over the same quarter last year, demonstrates the strong progress being made within the business and working on the earnings improvement program.

Now let's move over to Endoscopy. Our Endoscopy revenues grew by 9% in the quarter overall. Our business outside the US grew by 17% as a very strong performance was delivered by our sales force. Revenues outside the US now exceed US revenues. Our US revenues at 2% growth were impacted by voluntary withdrawal of CALAXO and low DOR and visualization revenues as that business is lumpy. We also had a tough hill to climb with the competitor, as in the same quarter last year, US revenues grew by 14% having grown by 4% or 5% in each of the other quarters in 2006.

Arthroscopy, the major proportion of our business in this business unit, performed well at 11% growth. Knee and Shoulder products are performing strongly and repair revenues are now larger than resection, as our focus on fast-growing segment is working for us. Endoscopy's margin at 19.3% for the quarter, an increase over 2% over last year, is a great performance and is showing the benefit of the completion of the reorganization of our manufacturing, which we completed earlier this year. New product revenue were 21% as new products continue to generate good revenue growth for the Endoscopy business.

Now moving on to Advanced Wound Management. The Advanced Wound Management's global revenue growth of 8% came from good performance in both the US with growth of 9% and outside the US, which grew by 8%. We estimate that the US growth was well ahead of the market growth rate of 6% for wounds, excluding negative topical pressure.

The renegotiation of our silver product licensing agreements in the quarter had two clear benefits. First, the launch of new silver products, which we expect would be a substantial addition to the product portfolio. And second, a change in the cost structure which will have long-term benefits for us.

We have also announced our reorganization plans for our Largo facility, which will see us open our own facility in China and make more use of subcontractors in the US. We expect to close the Largo manufacturing facility in 2009. However, non-manufacturing functions will continue to be based there.

Many of you are very interested to hear what we have been doing with BlueSky and our plan for the negative pressure market. I will touch on some highlights, but the more substantive detail will just have to wait for the launch in 2008. We have done a number of things so far. First, we've integrated the business in to our Largo facility. Second, we are putting a lot of effort into how we operate in this fast-growing segment and have made detailed plans. And just after the end of the quarter, we signed with United Hospital Services, UHS, as a strategic partner who will be working on our behalf in the acute care setting.

We are making good progress with BlueSky and I am sure you'll appreciate the commercial sensitivities that don't allow a lot of detail, but be assured we are very pleased with this acquisition.

Wound's margins were up 90 basis points this quarter, a very good performance. So how do we see the quarter overall? I think to sum it up, this has been a very good quarter for us, sound performance against some very tough competitors. BHR had its 10th anniversary and is delivering outstanding clinical results and continues to establish itself as the clear goal standard in Hip Resurfacing. Advanced Wound Management has started to gain momentum and is delivering balanced growth. And we've made clear measurable progress with our earnings improvement program. We are clearly focused on delivering long-term sustainable profitable growth in this group.

And at this point in time, I will go ahead and open it up for questions.

Question And Answer

Operator

Thank you sir. [Operator instructions] We have our first question from Raj Denhoy with Bear Sterns. Please go ahead.

Raj Denhoy - Bear Stearns

Hi, good morning guys.

David Illingworth - Chief Executive

Good Raj. We can hardly hear you, so speak up as much as you can.

Raj Denhoy - Bear Stearns

Sorry, is that a little bit better?

David Illingworth - Chief Executive

Yes, that's great. Thanks.

Raj Denhoy - Bear Stearns

I was curious on the Hip side, maybe our numbers are a little bit off, but it looks like BHR may have been down a little bit sequentially in the US, and I am curious if that is in fact the case?

David Illingworth - Chief Executive

Well, Raj, we are very... we don't give out actual numbers on individual product lines, which makes it a little bit difficult to answer your question. I can tell you that we are satisfied with where we are at BHR. We think we continue to take market share with that product in our Hip portfolio overall and it's growing. We had... if you think back, we had pretty healthy third quarter of '06 with the BHR product. I mean, we were in sort of full launch mode at that point in time. So, even though we can't give you exact numbers, we're very pleased and that business is still growing.

Raj Denhoy - Bear Stearns

Okay. Maybe I can ask a little bit then about your preparations then for having a competitor on that market. Are you seeing much now at this point as far as activities on the part of Stryker? Are there accounts now that have started to switch back and maybe you could you just talk about the dynamic that's going on?

David Illingworth - Chief Executive

Well, we are... this may sound a little strange to you, but we're so busy trying to continue to get this product launched in the marketplace that we're not putting a lot of thought in to what some of the other competitors are doing. I think it's clear to say that we will have competitors in the US market. This is a great technology. It deserves to be in this marketplace. It has a great track record and there is a long way to go in order to develop this market overall and I think having multiple competitors is a good thing for the industry.

What our charter is is to try and maintain the same type of global market shares that we have for the US market and if we do that it will be a great success for us and that's what we're focused on. And I think we're going a long way to establishing ourselves there. I haven't seen any of the numbers that have been reported by our competition. So, I guess when those come out we'll know a little bit more.

Raj Denhoy - Bear Stearns

Okay. And then just maybe one last on the Knee side. You outlined some of the product initiatives you have there to hopefully get business accelerate a little bit. What about on the sale side? Obviously I think in the past you have mentioned a focus from the sales force on firming and Hip may have taken a little bit away from the Knee side. Is that still the case and what are doing on that side to address the slowness there?

David Illingworth - Chief Executive

Well, I think it definitely has an impact. I think there is a couple of factors that have had an impact and we have been trying to be as transparent as we can about this over the last couple of quarters as we talk through it. I think the reality of it is that we are taking share in the Hip side and I think the competitive response is to put more pressure on the Knee side of the business. That is what I would be doing if I was losing chunks of share on the Hip side. I would be focusing my efforts somewhere else and I think that's happening and which puts a little bit of the strain on our sales force. I think that will moderate over time. And the second thing is if you think about our new product introductions in Knees over the last year, we have really brought out premium segment products. These are high performance Knees like JOURNEY and the high performance revision system like LEGION and both of those products were initially brought out in OXINIUM, which was a premium material as well. And us bringing the Cobalt Chrome versions of those products into the marketplace in the third and fourth quarter of... or the fourth quarter and the first quarter of next year into the marketplace, I think, is going to be a healthy restart for us in both of those product lines.

And I think the third factor is that there might be some things that we can do to put some additional emphasis through our variable compensation plans and measurement systems, etc. And those things are hard to change during the course of a year. You really don't want to change targets for your sales forces during the middle of the year. So, we'll be looking very hard at how do we get the right types of behavior to get balanced selling. And that's why we think that we'll start seeing the majority of the impact as we work through the first quarter of '08.

Raj Denhoy - Bear Stearns

Great. Thank you very much.

David Illingworth - Chief Executive

You are welcome Raj.

Operator

Ladies and gentlemen, our next question will come from Michael Junging with Merrill Lynch. Please go ahead.

Michael Junging - Merrill Lynch

Good day, good afternoon to everybody. I have three questions. The first question is also on BHR, slightly different. Although I haven't got all the information necessary, it seems that the actual sales, not the sales growth, but the actual sales in the third quarter were less than they were in the second quarter, perhaps even in the third quarter. I am just wondering whether you can confirm this. And then secondly, on earnings improvement plan, you have indicated in the past of expanding [ph] margin by at least one percentage point. What price cuts have you reflected for Japanese price cuts in 2008? And thirdly on Plus Orthopedics, you've highlighted in your results today that you are seeing some revenue dissynergies earlier than expected. With this development, do you still think it's reasonable to expect the 15% revenue synergies, which you indicated in your announcement on the 12th of March, 2007 when you bought Plus Orthopedics? Thank you.

David Illingworth - Chief Executive

Great, well, thanks for those questions, Michael. First, the answer to the first question on BHR is no, we're not seeing lower growth. We're seeing... we're actually seeing growth in that product line. So, I don't know where... the basis of the analysis, but we'll be more than happy to talk with you offline and try to figure out where the modeling is coming from. So, we're not seeing the same thing that you are implying. As far as EIP goes, we have factored in the different plus and minuses, the puts and takes, on the benefits and the things that are negative for us in the different marketplaces. So, we still expect to deliver the 1% on average per year margin enhancement across the business. So, we're not coming off that at all regardless of what happens in Japan. And your third question in terms of revenue dissynergies is we're not changing our model and we're not changing our guidelines and we're not changing our guidance. We have seen some earlier dissynergies in Plus due to a couple of different factors. One is just the amount of time that it's taken us to get the contractual obligations behind us in terms of some of the minority interest etc., which has accelerated some of the dissynergies that we were expecting. But as far as the... our guidelines for overall revenue synergies for that business, we expect them to be the same in the same period of time. It's just the phasing which we said the phasing might change a little bit.

Michael Junging - Merrill Lynch

And just quick follow-up. So, can I just confirm that in third quarter in the United States for BHR you sold more in absolute dollar value than you did in the second quarter of 2007?

David Illingworth - Chief Executive

Yes.

Michael Junging - Merrill Lynch

Great. And then just on Japan again, can you actually tell us what your assumptions are for price cuts in Japan for 2008?

David Illingworth - Chief Executive

You know what Michael, I don't think I have that in front of me, to be honest with you, and off the top of my head I don't want to give you a bad number. So, if you give us a ring, we can clearly give you an indication as to where we are on that.

Michael Junging - Merrill Lynch

Thank you.

Operator

We' now move to Yi-Dan Wang with Deutsche Bank. Please go ahead.

Yi-Dan Wang - Deutsche Bank

Can you hear me?

David Illingworth - Chief Executive

Yes.

Yi-Dan Wang - Deutsche Bank

Sorry, you can?

David Illingworth - Chief Executive

Yes.

Yi-Dan Wang - Deutsche Bank

Okay, great. Thank you. Sorry about that. I have several questions. First of all, can you tell us what your Hip growth rate outside the US is please? If you said it and I missed it, then I apologize. And in terms of I suppose your Hip business, you've indicated that the business grew by 2% ex-BHR in the US. So, you suggest to us that you're probably not seeing that much pull-through sales at the moment. When do you expect those pull-through sales to come through? And also could you tell us how BHR is performing outside the US where the penetration continues to increase outside the US? Regarding the reimbursement for joint fluid therapy, if you could provide us with some additional details there on the sort of changes that you are seeing that will be great. Thank you.

David Illingworth - Chief Executive

Great. Well, I'll tell you what, I'm going to split this up because I couldn't write fast enough to get all those questions down, Yi-Dan. Our Hip growth outside the US was 2%.

Adrian Hennah - Chief Financial Officer

No, it's 6%. No, sorry 2%.

David Illingworth - Chief Executive

2% outside the US. And the second question, well, I think the answer the pull-through sales is no different than what we've been communicating over the last couple of quarters. We think it's going to take longer than we originally expected and we still believe that penetrating competitive accounts that we traditionally have not been in is going to be a good thing for us long term, especially with a product like BHR, which is truly a gold standard and Hip Resurfacing. So, it's a little bit tougher given the fact that our competition really tries hard to defend their turf, especially when we come in and take business on the Hip Resurfacing side. And I think it takes time to build the relationships and I think those relationships will get built and we will see pull through, but it's not something that we're counting in large numbers at this point in time.

In terms of joint fluid therapy, I think we are seeing some pricing pressures in general from the competition. There's been some reduction in pricing in the marketplace by some of the competition. My guess is it's in response to some of the market share gains that we've made over the last year or so. And that clearly is having an impact on the business and I think also there is at least a question that there is going to be some pressure in the areas of reimbursement and we continue to monitor that. We don't have a real good visibility as to what that is, but we thought we would see it up for the group here that that we think it is something... well, it's definitely some that's our radar.

Yi-Dan Wang - Deutsche Bank

Okay. In terms of just following up on your answers, what sort of price cuts are your competition is making? And in terms of sales for Hips outside of US, why is the growth there a little more moderate than what we expect group... sorry, market growth rates to be and how you are doing for... in BHR? How you are doing with BHR in those markets? Is it still rating at a 25% plus level outside the US?

David Illingworth - Chief Executive

Yeah, Yi-Dan, I don't really know exactly the absolute numbers that our competition is... what they're doing with their pricing, but I can tell you that we are feeling price pressure in the marketplace and it is our belief it is coming from reduced average selling prices from the competition. And if we can get a better handle on that over the next couple of quarters, we have no issue in sharing that.

In terms of the growth of the Hips outside the US, hang on a second, let me look for some... hang on one second, bear with me. The market growth was... yes, we do have some dissynergies to deal with in terms of the integration with Plus. In the European market, as you know, we are taking a roughly two equal size businesses and putting them together, and we'll talk a little about some of the accelerated sales dissynergies there and quarterly on the Hip side, it's probably more pronounced because Plus was known more as a Hip business than they were anything else.

Yi-Dan Wang - Deutsche Bank

And sorry, BHR outside the US?

David Illingworth - Chief Executive

What was the question?

Yi-Dan Wang - Deutsche Bank

How is BHR doing outside the US?

David Illingworth - Chief Executive

Yes, I think it's doing well. Do you have the exact numbers? Yes, I think it's fairly flat Yi-Dan, would be the best way to describe it. There is some competition outside the US in the European markets that do exert some pricing pressure in some of the larger markets and we deal with that on a continuous basis, but I have to say that it's fairly flat.

Yi-Dan Wang - Deutsche Bank

Great, thank you.

David Illingworth - Chief Executive

You are welcome.

Operator

Our next question will come from Martin Wales with UBS. Please go ahead.

Martin Wales - UBS

Good afternoon. Two quick questions. Firstly, coming back to the US Knees business given that it sounds like even with these new products launches we will see limited impact for 2008. How much longer do you give this business before you think about doing something more radical in terms of returning to growth? Second question on the Arthroscopy side, obviously it's contributed very little to earnings improvement program, although it contributed very little. Have you revisited the Arthroscopy business on the cost side and is there anything more that could be done perhaps with or on top of the Earnings Improvement Program to improve margins in that business?

David Illingworth - Chief Executive

Well, we are far from panicking on the Knee side. We think we got a pretty... we think we have an incredibly strong portfolio of products and that the risk of repeating myself on the factors that we are dealing with, I think they are manageable. But I think they are real. We... I'll take our overall growth historically in our reconstructive business against any of the competitors over almost any quarter over the last five years. And there is always some balance and some decisions to be made about where do you put your focus. And right now I think we are doing the right thing. We are very, very proud of the efforts that's being put in by the not only the marketing and the launch teams, but also the field sales forces.

So I think there is not a lot of radical movement that needs to take place in our Knee business to strengthen it up. I think that if we... we have a good plan, I think we will see some good growth and a return to momentum in that business, and we are very... we are quite happy with the plans that we have in front of us and we are very happy with the overall growth in this reconstructive business. We have been consistently outgrowing the market overall in the reconstructive business and that is the number that we are shooting for. And obviously you would like to have every single piece of your business firing on every cylinder and that's obviously the goal and we will continue to work and strive in that direction.

Yes, on the Arthroscopy, do you want to guide on it?

Adrian Hennah - Chief Financial Officer

Yes, I think on the Arthroscopy question, you are absolutely right. We signaled when we launched EIP that you saw less scope in Arthroscopy in either divisions. It really is a function of history and the way that business had been managed historically. But it isn't to say no potential, in deed you can see the 20 basis point year-to-date that was driven from manufacturing improvements that they have been making. But going forward, we do see less, and I think it really is a function of history and the way it has been run. In the DOR and Visualization costs of Endoscopy, we have consistently informed you, signaled, those are much less profitable than the Arthroscopy side. And there is potential there although frankly it's not one we have yet quantified or clarified specifically. So, yes, in summary, there is less opportunity, we said there was, it's a function of history.

Martin Wales - UBS

But do you see you can do more than you've currently factored in EIP now you have a chance to look at it in more detail?

Adrian Hennah - Chief Financial Officer

We haven't crystallized any other specific things, although there are areas that we are working on, Martin.

Martin Wales - UBS

Okay, thank you very much guys.

Operator

We have Mark Mullikin with Piper Jaffray next. Please go ahead sir.

Mark Mullikin - Piper Jaffray

Thanks for taking my question. I just want to talk more about the US Hip business. Is BHR cannibalizing the total Hip business at this point and what are your expectations for that going forward?

David Illingworth - Chief Executive

Well, I don't think it's a different answer than I gave to this question last quarter. It's hard for us to quantify exactly what's happening because we don't have the granularity of the data in order to quite figure it out yet, but we do know enough about what's going on in the marketplace to know that there are some... what your describing as cannibalization is somebody who might get a traditional Hip Stem implanted versus expanding the market to the younger, more active patient. I think there clearly is some of that going on. What exact percentage of that is substitution of BHR for a traditional Hip Stem in a 65-year-old patient, let's say, we just don't know exactly what that number is, but clearly there is a percentage of that in the marketplace without a doubt. And it could be fairly substantial. We just.. we don't have a clear view of it as of yet. We do know that we are expanding the market. I think you can take a look at the market growth rates over the last five or six quarters and make that same conclusion for yourself that the BHR introduction is expanding the growth rate in the US for Hips and that's an area that we are clearly focused on. We want to continue to be involved in segments that expand this marketplace for ourselves.

Mark Mullikin - Piper Jaffray

Do you have enough sales reps in the US at this time or is it just an issue of how they allocate their time?

David Illingworth - Chief Executive

The number of sales reps that we have currently is not an issue for us. There is always instances where you wish you had one more here and one less there, but... and balancing it out, but right now that is not an open issue for us, the number of sales reps. So we are happy with where we are. And then that continues to grow.

Mark Mullikin - Piper Jaffray

Great and then just over on the Advance Wound Management side, will there be any stocking of BlueSky comps associated with the UHS deal?

David Illingworth - Chief Executive

We are not going to give out any details on that business model until we launch it. And I know it sounds like a broken record on this, but it's important for us to have a launch that is done in a very disappointed way in order for us to take full advantage of this marketplace.

Mark Mullikin - Piper Jaffray

Okay. I guess what I am just trying to get at is whether or not we would expect any lumpiness in the AWM line in '08 as a result of that.

Adrian Hennah - Chief Financial Officer

Well, I think the answer is in... when we got for launch.

Mark Mullikin - Piper Jaffray

Okay, well, thank you.

Adrian Hennah - Chief Financial Officer

Obviously we can't talk about what lumpiness you might expect because that will be business models implicit in that. So clearly I don't think we can say anything more at the moment [ph], Mark.

Mark Mullikin - Piper Jaffray

Okay, thanks.

Adrian Hennah - Chief Financial Officer

Yes.

Operator

We now move to Ed Ridley-Day with Lehman Brothers. Please go ahead.

Ed Ridley-Day - Lehman Brothers

Hi, thank you. Firstly on the Endoscopy and the visualization business, obviously you just had a number of launches there, particularly with the HD Camera. Can you talk a little bit around what benefit those had and how you see visualization sales maybe moving both into the fourth quarter and into the next year. And put your back [ph]... just back to dissynergies in Europe with Plus, can you give us a little bit more granularity about the timeline that you expect that business, the European Recon business to move back to, should we say, more normalized growth rate?

Adrian Hennah - Chief Financial Officer

Okay. I think in terms of the HD Camera, Ed, the launch is proceeding to plan. The two [ph] broader question, how do we see the future of the visualization business. I think we've signaled to you on several occasions over the recent quarters that this area is less profitable, significantly less profitable than the bulk of the Arthroscopy business. So that's inevitably makes us think about it. We don't have any significant crystallized plans that are different, but we are looking at for opportunities, as you would expect to see. I am not sure that anything more we can say beyond that at this stage.

In terms of timelines for Plus, I don't think there is any major change from what we have said before. We are going through this period of sale dissynergies. They are slightly higher we are experiencing now than we had originally anticipated. But do not see as any fundamental issue. That's really just a question as you get down to the absolute granularity, combining sales forces and as Dave mentioned, dealing with issues like minorities who can somewhat unpredictably slow you off on occasions or Works Council issues in Europe and so on. You just get down to some really granular stuff, which is a little different from what we expected. But there is nothing that we have come across, nothing at all we have come across that tells us that in the round this thing is different from the guidance we gave, in any way, shape or form. Exact quarter by quarter though 2008, it's too hard for us to predict that, to be honest. We will just take that as it goes, but fundamentally this acquisition is going absolutely fine and we are very, very pleased with it.

Ed Ridley-Day - Lehman Brothers

Okay, thank you. And just a quick follow-up. One of your competitors, obviously fall under DOJ investigations talking about rather large fees that they were going to be paying for around consultancy around dealing with the settlement and I take it that you aren't seeing that kind of cost around the settlement?

Adrian Hennah - Chief Financial Officer

Yes, I mean, we are in discussions with our monitor now about exactly how much time you see these firms [ph] are going to spend on things. It will be unwise of us to prejudge the outcome of those discussions and obviously on top of that there are some internal costs for ourselves, not really so much in changing our practices which are very close indeed to the ones that we certainly require. There is a number of process change that obviously are imposed upon us. So we... it will be silly for us to prejudge working that through in the monitor, which we're doing in a very positive way. I think however can say that we will be very surprised if we ended up with numbers of the size that Zimmer apparently indicated on their call.

Ed Ridley-Day - Lehman Brothers

Okay, thanks.

Operator

The next question will come from Michael Matson with Wachovia, please go ahead.

Mike Matson - Wachovia

Hi. I guess first of fall I think you had mentioned that you had $2 million in BlueSky revenue, is that correct? And I assume that's from NPWT sales domestically or internationally or --?

Adrian Hennah - Chief Financial Officer

Yes, we have $2 million, yes, it is overwhelming in the USA.

Mike Matson - Wachovia

Okay. And then in your Clinical Therapies business, your EXOGEN product, it sounds like that really outperformed the other product there, the growth of that being I assume was well above 15%. Is that a fair... the overall growth of that category, is that a fair assessment?

Adrian Hennah - Chief Financial Officer

Not sure if I am answering your question exactly, but certainly we took significant share in long bone stimulation in the US with EXOGEN no question about that.

Mike Matson - Wachovia

Okay. And then are there any plans to ever try to enter the spinal fusion market with your EXOGEN technology?

David Illingworth - Chief Executive

Well, I am not sure we're ready or willing or even able to comment on that question at this point in time. Let me take it from a different level because this is something that's been asked of us pretty consistently and that is our interest in the spine business in general. I think that we are always looking for high growth segments, especially ones that have strong adjacencies to the ones that we are in, in order to compete in. And this is one of reasons why we went into topical negative pressure, for instance, because we felt like we had a right to win in that marketplace given our access to the large wound treatment market. And I think the same thing goes in spine.

Spine would be a great market to be involved in. I think I said that pretty consistently quarter after quarter. The key for us is how do we do it and then what technologies do we bring to the table and what kind of... how do we distinguish and differentiate ourselves in that marketplace. And it's an ongoing investigation for us. We are quite interested in the spine market in general. It's a high growth segment. It's an area that would be very natural for us to be a part of and as far as actually entering into the spinal stimulation market, I think that's a little bit of a stretch at this point in time. We think more in terms of how do we get in to the market in general.

Mike Matson - Wachovia

Okay. That makes sense. And then can you give some clarification on the reimbursement pressures that you were talking about? Do you see that as more of a outside US, the European issue, or do you see kind of coming pressure in the US as well?

David Illingworth - Chief Executive

In what segment are you referring to?

Mike Matson - Wachovia

More in the, I guess, in the Recon side.

David Illingworth - Chief Executive

I don't think there has been a substantive change in the pricing environment. I think this is something that we have been debating and it's better played out in the analysts' reports, amongst yourselves as to how do you evaluate what's going on in this marketplace. I think it's the same debate we've been having for the last year and a half. There are healthier systems around the world that have price... that have pressure on them. I think it's incumbent on us to develop a clinical products that not only give great clinical results, but have an economic benefit as well. And I think that if you look at products like BHR, yes, it's a premium-priced product. But if you can get a 40-year-old productive person back to their job, it's actually a very, very cost-effective to deliver healthcare in a system if it can be captured properly. And that's what we're trying to do. We always look at our products in terms of the economic value and the economic benefit. And we will continue do that. Will there be pricing pressure? Sure, absolutely there will be. And I think the majority of the pricing pressure is going to come in those commoditized... commoditized type products, the traditional Hip Stem, the traditional Knee products or whatever. And that's one of the reasons why we work so hard at innovation and so hard at expanding our marketplace to the high value areas that are outside some of those traditional areas. Products like JOURNEY DEUCE, the bi-compartmental knee system, the High Performance Knee, the BHR, and the list goes on and on. I mean, these are products that we talk about all the time. We don't talk about our standard products that do have the majority of the pricing pressure associated with us. It's a model and a business plan and a strategy that has been working well for us and we are going to continue with it.

Mike Matson - Wachovia

Okay. And then just one last question on your Knee business, you mentioned that your are launching Cobalt Chrome version of the JOURNEY and LEGION.

David Illingworth - Chief Executive

Yes.

Mike Matson - Wachovia

So I assume that you haven't had this out before, and is there any risk that there could be... I assume that those will be cheaper than in the OXINIUM version. So is there any risk that there could be some negative mix shift there?

David Illingworth - Chief Executive

Well, I think that we are not worried about it I guess is the simple answer. We need to have a more price-competitive version of those leading products. I mean, we have products that have wonderful performance characteristics associated with them. They are being well accepted, but they are pricey. Not only are they high performance products, but they also are made in a material that is very expensive to produce. And the plan was always to get the brand introduced at those premium levels and then bring in the other products as well. This is not something that we've reacted to, it's something that was planned all along. So and I do think it is going to reinvigorate our business on the Knee side. I think not everybody is going to... believes that a super-premium product is the appropriate product in 100% of the cases. And in those cases where you are looking for a more cost-effective option, we are at a disadvantage. So we won't be at a disadvantage anymore.

Mike Matson - Wachovia

All right, that's all I've got, thanks a lot.

David Illingworth - Chief Executive

Okay, thank you

Operator

The next question will come from Steven Lichtman with Banc of America. Please go ahead.

Steven Lichtman - Banc of America Securities LLC

Thank you, good morning guys. Few questions, first of all, on Hip Resurfacing, now a little over a year into US launch, any change in views on the market opportunity here? Do you still see it as a 10% plus of the market over time... do you think, or more than that now? Do you think that you took some initial pent-up demand and now it's more incremental? At least your qualitative comments would be great.

David Illingworth - Chief Executive

Steven, I really don't think there is anything that leads us to start predicting that it will be more than 10% to 15% of the marketplace. I think that it would be a pleasant development if it happened. But we're too early in the penetration of this product in this marketplace in the US to really predict anything more than penetration rates based on some historical data that we've seen in some of the other developed countries. So I think we are sticking with that number. I think it's a good number to stick with at this point in time.

Steven Lichtman - Banc of America Securities LLC

And in terms of the early experience, do you get the sense that there was a big pent-up demand that you worked through or working through or it may be a little bit more incremental from here?

David Illingworth - Chief Executive

On BHR, yes.

Adrian Hennah - Chief Financial Officer

Yes, just actually on this question, I think Michael asked a very specific question earlier about sales levels. And I think we may have slightly confused you in the answer because there is question that quarter three sales in BHR was substantially above quarter one, but they were in fact in absolute terms in the USA slightly underneath quarter two because we got the holiday effect of having particularly August and then parts of July in that. So it's just an absolutely a factual question go back to Michael. But in terms of bonus [ph], no, they are absolutely right.

Steven Lichtman - Banc of America Securities LLC

Okay. And then you were commenting earlier about whether this is a market substituting or expansion. Is it fair to say early on this has certainly been more substitution for you guys because you mentioned that your ex-BHR sales were up about 2%, is that fair early on here?

Adrian Hennah - Chief Financial Officer

Yes.

David Illingworth - Chief Executive

Yes, that is correct.

Steven Lichtman - Banc of America Securities LLC

Okay. And then on the Knee side, as you rollout the Cobalt Chrome here, any concern about mix messages, OXINIUM versus the Cobalt Chrome and how are you going to sort of pitch this, so to speak, to your customers in terms of why they should... why they should purchase the OXINIUM?

David Illingworth - Chief Executive

I think it will be dead simple. We have in our early product lines like GENESIS II etc., we have both OXINIUM and Cobalt Chrome versions and our sales force is quite used to selling the whole value range. There are different benefits. One is the benefit in terms of wear characteristics and other is a benefit in the Knee design in general. The benefit of that it's an anatomical knee. It's a high performance knee, it's a natural feeling knee. So it's a choice by the surgeon. I mean, if he has an older patient who he feels like the wear characteristics of OXINIUM don't warrant, yes, then they have an option to put in the Cobalt Chrome. And I think our sales force is very, very adept at doing this.

Steven Lichtman - Banc of America Securities LLC

Okay. And then also on the Knee side, any anticipation of doing a PTC [ph] campaign for the new gender indications or is this going to be more for something for your surgeons to have in hand as they discuss with patients?

David Illingworth - Chief Executive

The latter at this point.

Steven Lichtman - Banc of America Securities LLC

Yes. And then one more on the Hip side and then one on the Endo. On the Hip side, is it fair to say that you don't believe you have gained market share, primary market share as a result of BHR? In other words bringing over doctors and having them now become Smith & Nephew doctors in total beyond just the Hip Resurfacing procedures, do you think you have not done that yet?

David Illingworth - Chief Executive

Well, I don't know what the new definition of primary market share is. We are gaining market share and you know what, wherever it comes from we are happy to get it. It's nice to come in our direction. I think to slice and dice it that way for us isn't helpful. It's a total market out there, we are going to try to address it, and that's what we are doing. Yes, there is some substitution, this and that, puts and takes, but when it's all said and done, the market grows X percent and we are taking share, and that's what we are all about.

Steven Lichtman - Banc of America Securities LLC

Okay, all right, fair enough. And then lastly on the Endo side, Adrian, just a commentary about the fourth quarter, just if you can revisit what you mentioned, you were saying something about the comps, just that the fourth quarter comps are far tougher to you, is that what you were referring to?

Adrian Hennah - Chief Financial Officer

Yes, it was quite simply that.

Steven Lichtman - Banc of America Securities LLC

Okay. And are they any tougher than they were in the third? I thought they were about the same, or is it a little tougher? Maybe I am incorrect.

Adrian Hennah - Chief Financial Officer

Certainly weaker and a little tougher. [indiscernible]

David Illingworth - Chief Executive

Yes, they were much tougher in Q3.

Steven Lichtman - Banc of America Securities LLC

Okay. I can follow up. Thanks a lot. Thanks guys.

David Illingworth - Chief Executive

You are welcome.

Operator

Moving now to Jason Wittes with Leerink Swann. Please go ahead.

Jason Wittes - Leerink Swann & Co

Hi, thank you very much. First off, in terms of the DOJ charges relating to the monitor, I understand that you are still negotiating, but should we assume that this has any impact on the your EIP program or is that already sort of priced in whatever impact might be, especially given the ranges that you are at least discussing right now?

Adrian Hennah - Chief Financial Officer

I don't think this number should be major focus for you guys in putting your spreadsheets together. I mean, it's clearly going to be a number.

David Illingworth - Chief Executive

At this point in time, we do not believe it's going to impact what we've committed on earnings improvement. And if it changes, we will clearly indicate that, but we do not believe... I mean, we have some estimates in our models and we... we were expecting to absorb them. But given some of the press that we read as well, if something changes, which we don't expect it to, then we will communicate it as quickly as we can.

Jason Wittes - Leerink Swann & Co

Okay.

David Illingworth - Chief Executive

We are going to have to probably take one more question because of time here on this end, we are all catching airplane. So we will take one more please.

Operator

Certainly sir. The last question will come from Hans Bostrom with Goldman Sachs, please go ahead sir.

Hans Bostrom - Goldman Sachs International Ltd

Good afternoon gentlemen. Had a couple of questions from me, first relating to Adrian's comment on the visualization and Digital OR business. Am I hearing that you are considering disentangling this business from the company or was that a complete misunderstanding on my part? And if so, what type of evaluation horizon you have for that? And secondly, if you could repeat what comments you made regarding the fourth quarter EBITDA margin, was it the case that that wouldn't improve on the last year's fourth quarter? And I just have a check on that. And lastly, if you could comment on how you think pricing in the United States develop for BHR in the course of 2007 that would also be very helpful. Thank you.

Adrian Hennah - Chief Financial Officer

Yes. This is Adrian. Yes, in terms of the Visualization and DOR, we were simply referring to the... questions in response to where do you see margin opportunities in Endoscopy. And we are pointing out that there is... when we launched EIP, we said that the Arthroscopy margin we had we felt were quite good ones. That's the way the business has been managed historically. So, we saw limited opportunity there other than the manufacturing program they will then embark upon. But within our DOR and Visualization business, the margins were much lower and therefore it was an area we were obviously giving attention to. And that's... there is really no more to it than that. I mean, we are giving attention to... there are a number of options, nothing is crystallized yet. No more comments than that, Hans.

Hans Bostrom - Goldman Sachs International Ltd

Are there any cross-selling benefits between the two? That was I though, it was really part of the strength of the digital operating concept --

Adrian Hennah - Chief Financial Officer

Yes, absolutely that's a part of the complexity of it. And when looks at the margins, one has to take those sort of things into account. I think you shouldn't read anymore into the comment than that, Hans, really.

In terms of your second question on what did we say about Q4 EBITDA margins, really just, yes. I mean, we are I think reaffirming our... the sort of longer term guidance of around 1%... or at least 1% per annum on average... per annum, pointing out that we are ahead of that year-to-date, and pointing out that we have a strong quarter four margin comparative. And therefore exactly what it will in Q4, I can't predict, but you need to be more... it needs to be significantly lower than the gains year-to-date, exactly what it is, Hans, I don't know. I'm not going to stick to within fractions of a decimal points.

And then I think you were asking about price evolution on BHR in the USA as your third question. And yes, I mean, I think it's as you would expect. We started off with some pretty robust pricing, we singled then that we wouldn't expect that to stay at that high level for ever. And the exact way that's evolving over time and how it will evolve with new competitors in the market, we will have to see exactly frankly, but it's not... we have been quite clear it isn't going to go up.

Hans Bostrom - Goldman Sachs International Ltd

But are we talking about the double digit percentage change downwards on pricing from first quarter to third quarter or is it less than that?

Adrian Hennah - Chief Financial Officer

We are not talking about it in very precise terms, Hans. The reason, I am sure you can understand, but you can imagine in the mix there price that's not moving favorably, let's say. And that... we expect that to continue to be the case going forward, and that should really comment as no surprise.

Jason Wittes - Leerink Swann & Co

Okay. Thank you.

David Illingworth - Chief Executive

Great. Well, I would like to thank everyone for joining us today. We are going to sign off at this point in time. Thanks for all your attention and have great day.

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Source: Smith & Nephew PLC Q3 2007 Earnings Call Transcript
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