Zimmer Holdings Inc. Q2 2008 Earnings Call Transcript

 |  About: Zimmer Biomet Holdings, Inc. (ZBH)
by: SA Transcripts

Zimmer Holdings Inc. (ZMH) Q2 2008 Earnings Call July 23, 2008 8:00 AM ET

Paul Blair

Good morning, I am Paul Blair, Vice President of Investor Relations for Zimmer. I would like to welcome you to the Zimmer second quarter 2008 earnings conference call.

Joining me today to host this call are David Dvorak, President and Chief Executive Officer; Jim Crines, Executive Vice President, Finance and Chief Financial Officer; and Dr. Cheryl Blanchard, Senior Vice President, Research and Development and Chief Scientific Officer, who is joining us today to assist in responding to your questions with regard to Durom.

This morning, we’ll review our performance for the second quarter; provide you with an update on certain key issues to include those which involve our Durom product; present an update to our outlook for 2008, and conclude our discussion with a question-and-answer session.

Before we get started, I would like to point out that this presentation contains forward-looking statements within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, based on current expectations, estimates, forecasts, and projections about the orthopedic industry, management’s beliefs, and assumptions made by management.

These statements are not guarantees of future performance and involve risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from those in the forward-looking statements.

For a list and description of the risks and uncertainties, see the disclosure materials filed by Zimmer with the Securities and Exchange Commission. Zimmer disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

This presentation also contains certain non-GAAP financial measures. A reconciliation of such information to the most directly comparable GAAP financial measures, along with other financial and statistical information for the periods to be presented on this conference call, was included in the press release announcing our earnings, which may be accessed from the Zimmer website at www.zimmer.com under the section entitled Investor Relations.

A rebroadcast of this call will be available from approximately two hours following the conclusion of today’s call through the end of the day on August 6, 2008 and can also be accessed from the Investor Relations section of the Zimmer website.

At this time, I would like to introduce David Dvorak, President and Chief Executive Officer of Zimmer.

David Dvorak

Thank you, Paul, and good morning everyone. As we begin, I want to first thank you all for making the scheduling adjustment to join us this morning. I hope that you can appreciate the priority we recognized in announcing the results of our Durom Cup investigation and in initiating the steps required to communicate to surgeons.

Our first concern is patient safety and we could not delay our Durom announcement. Of course, our voluntary action with respect to the Durom Cup will have financial consequences. Therefore, accelerating the timing of our earnings release was necessary.

We wanted to make that information available to you and the investment community and answer questions as soon as we could. So that brings us together here today one day earlier than we originally planned.

This morning, as Paul stated, in addition to reviewing our overall results for the quarter, we’ll provide you with additional detail on the Durom matter; update guidance for the year, and report on the progress we’re making in furtherance of the strategic priorities we previously outlined.

Throughout these discussions, I hope you’ll recognize the pattern in the way we face difficult issues. We’ve made decisions that we believe will best prepare Zimmer to compete effectively in the expanding markets of the future.

Where we need to make improvements, we want the changes to be long-lasting and sustainable. We’re absolutely committed to positioning Zimmer to thrive for years to come.

With that as context, I’d like to review our second quarter results. Consolidated sales for the quarter of $1.080 billion were up 11.2% over the prior year’s second quarter and 5.5% in constant currency, and we generated 5% growth in adjusted earnings per share.

Our sales results, acknowledging an additional billing day in the quarter, were led by strong underlying growth in Knee unit sales with excellent balance across all of our geographic Knee segments.

Asia-Pacific led all territories with 14% constant currency growth in Knees, despite a challenging price environment, especially in Japan.

Hip sales growth was consistent with our first quarter. Some of other business franchises, however, experienced a deceleration in sales growth and we’ll talk more about that.

The weakening U.S. dollar favorably impacted our top line growth. This favorable impact on our top line is essentially neutralized on the bottom line due to our hedging program.

During the quarter, we generated operating cash flow of $281 million and we used $496 million to repurchase 6.9 million shares. Jim will discuss specific details of our financial results and stock repurchase program activity in a few minutes.

As we communicated last night, we have completed an extensive investigation into the performance of the Durom Cup here in the United States, following reports of cup loosening and revisions of the acetabular component in some patients who have undergone total hip replacement.

While many U.S. surgeons have had success with the Durom Cup since its launch in 2006, a subset have experienced elevated revision rates. This observation clearly contrasts ongoing positive clinical experience in Europe, where the product has been available since 2003.

We launched a rigorous investigation, which included a thorough review of manufacturing processes, design specifications, production documentation, and clinical experience in the U.S. and Europe. Based on the results of that investigation, we will temporarily suspend marketing and distribution of the Durom Cup in the U.S.

We’ll update labeling to provide more detailed surgical technique instructions to surgeons and prepare to implement a comprehensive surgical technique training program for the U.S.

We have reviewed our investigation and conclusions with the U.S. Food and Drug Administration and are actively communicating with surgeons now through multiple channels to explain this field action, and identify and address their related needs.

We are also communicating with customers around the world to clarify that the Durom Cup will continue to be marketed and distributed outside the United States without interruption.

Our primary objective in taking prompt action based on results of our Durom investigation is to ensure better clinical outcomes for patients. We believe that the likelihood of currently implanted patients requiring revisions is low.

But we want to make sure that we’re clear with our U.S. surgeons that they should stop implanting the Durom Cup until we issue the updated labeling that provides more detailed guidance on surgical technique and until they receive training.

We also of course want to make sure we support surgeons in every way we can as we implement these actions. With this goal in mind, we’ll provide clinical management guidelines to assist surgeons in the ongoing evaluation of patients currently implanted with the Durom Cup.

Within the next several weeks, we’ll issue a further communication to U.S. surgeons that provides them with updated labeling, including more detailed surgical technique instructions.

We also are working with experts in Europe and the United States to develop a robust surgical skills training curriculum. Following initiation of the new training program, the Durom Cup will be made available to U.S. surgeons again as they complete training.

We are confident that these measures are the prudent and responsible course of action and we are committed to conducting them in a manner that demonstrates our deep commitment to patients and our customers.

I’d now like to spend a few minutes providing an update on the investments that we are making at Zimmer that will help drive operational and earnings leverage and growth in the future. We made good progress during the quarter on our quality systems upgrades.

With respect to our Orthopedic Surgical Products operation in Dover, Ohio, our remediation plans continue as scheduled and we expect to have most, if not all, of the OSP products back in production by the end of this year, many in the next two or three months.

We also made good progress with our global IT system project during the quarter, which will allow us to apply technological efficiencies across our entire business infrastructure.

During the quarter, we continued to work on a new Zimmer facility in Shannon, Ireland, and have begun hiring and training the management team that will operate this facility in early 2009.

We also announced the planned addition of 50,000 square feet of foundry operations in Warsaw, Indiana, that is expected to increase our annual output by 1.3 million castings. Further, we announced plans to add approximately 100,000 square feet of manufacturing space to our Winterthur, Switzerland facility.

We feel it’s imperative to make these investments today in order to serve the anticipated increase in global demand for our products in the coming years.

For the past couple of quarters, we’ve explained the processes of coming to and working through the impacts of our resolution agreements with the U.S. government and how we expect those agreements and related initiatives will shape the future growth of our industry.

We’re taking the time and making the investments now to put this challenge behind us and ensure that we have a sustainable global business model for collaboration with surgeons that will not be disrupted in the future.

During the quarter, Jim, Cheryl, and I, as well as many other members of our senior management team personally met with over 100 surgeons. We explained the chronology of events of the past year or so, where we are today, and how we believe our surgeon relationships will carry forward.

While this process certainly has not been easy and we have addressed many tough and fair questions, I will tell you that it is great to be re-engaged with our surgeon community.

The surgeons we have met with are principally concerned about the quality of care for patients. They generally support our efforts to employ greater discipline around company/surgeon collaboration and are enthusiastic about the resumption of these activities.

While we have more to do, we’re making great progress towards what we believe will be much more efficient and effective relationships in the future. We at Zimmer understand and appreciate the importance of these collaborative relationships and the benefit that they have provided thousands, if not millions, of patients worldwide.

We resumed U.S. hip and knee surgeon training courses during the quarter and we’ll continue to provide this critical surgeon support not only at the Zimmer Institute in Warsaw, but at various regional training centers throughout the world.

This is another example of where we’re taking the time and making the investment to create lasting and sustainable change. Our training activities will ramp out throughout the remainder of 2008, and we’ll enter 2009 with a state-of-the-art training capability and an aggressive schedule for supporting our new product introductions.

We’ve taken on the challenge of executing several important strategic initiatives concurrently and it has been a monumental endeavor. I’d like to take this opportunity to personally thank the many employees, distributors, and sales representatives who have displayed their commitment and dedication to Zimmer through their tireless efforts in this process.

I’ll now turn to our updated guidance for the full year 2008. Jim will provide more details momentarily. Due to the developments in the second quarter, including Durom, we are revising our expectations for 2008 full year sales growth to 4.5% to 5% constant currency. We are also lowering our adjusted earnings guidance for the full year to be between $4.05 and $4.10 per fully diluted share.

We naturally are disappointed to be making these adjustments. However, with regard to earnings guidance, alternative responses would have compromised momentum on strategic operational and infrastructure initiatives. We believe our response to these challenges will make it possible to deliver fully on the future promise of our business.

As we look to the future, it is with a focus on the potential of our business to drive not only our growth, but to help Zimmer achieve an enduring leadership position in healthcare.

We’re developing our business to help move our company more deeply into high potential areas where our strategic assets can make a difference in musculoskeletal health in ways that address some of the most important needs of both aging populations and challenged healthcare systems.

The market opportunity for our business is sizeable, and our 2009 strategic and operating plans will focus on leveraging our infrastructure and technology platforms across our various business franchises to grow share.

We also look forward to restoring positive earnings leverage in 2009 with the expectation of achieving at least low double digit adjusted earnings per share growth.

Jim will now provide further details on the quarter and our guidance.

James Crines

Thanks, David. I will review our performance in the quarter in more detail and then provide some additional information related to our guidance.

Sales of $1.080 billion for the quarter represent an increase of 11.2% reported and 5.5% constant currency. These results among other things reflect the benefit of one additional selling day in the quarter compared to same period in the prior year; strong underlying unit growth in Knees in all three of operating segments; and lower OSP, Durom, and dental product sales.

A weaker U.S. dollar persisted during the quarter and as compared with the prior year added 6% or $56 million in revenue in the quarter. As expected, consolidated pricing was essentially flat for the quarter.

In the Americas, as was the case in the first quarter, price contributed 0.6 point to growth. In Europe, price was 0.2 point negative versus 0.5 point negative during the first quarter, with Germany and Italy reporting low single digit reductions in average selling prices, while other markets in Europe were flat or slightly positive. Asia-Pacific results include negative price of 3.3%, driven by negative 5.2% in Japan.

Turning to our revenue growth by major product category, worldwide reconstructive sales increased 13.8% reported; 7.6% constant currency. Knee sales in the quarter improved 9.9% constant currency and were up from 6.7% in the first quarter of 2008.

With billing day differences neutralizing our first half results, Knee sales growth averaged out at 8.3% constant currency over the six-month period ended June 30. Knee pricing on a global basis was down 0.6 of a point in the quarter.

Flex Knees accounted for 51% of our Knee unit sales on a global basis in the second quarter, accounting for more than half of our Knee sales units for the first time.

We are still early into the launch of our Gender Solutions Natural-Knee Flex as well as our NexGen Mobile Bearing Knee. Unit sales of these two systems accounted for less than 10% of our Knee units on a global basis in the quarter and continue to represent an important opportunity going forward.

In addition, our new Gender Solutions Patello-Femoral Joint System is now broadly available and we are also launching a modular Trabecular Metal Tibial Tray for our NexGen Knee System. In other Knee systems, Zimmer Uni, LCCK, and RHK as well as our Prolong Highly Crosslinked Polyethylene grew in double digits.

During the quarter, our Knee portfolio showed particular strength across geographies. In the second quarter, Knee sales in constant currency increased 9.1% in the Americas, 10% in Europe, and a strong 13.7% in Asia-Pacific respectively.

Hip sales increased 4.4% in the quarter, reflecting a volume and mix increase of 5.5% offset by a decrease in average selling prices of 1.1%. In the U.S., Durom Cup sales volume was off 26% from our first quarter in response to reports of loosenings and revisions.

Durom Cup sales units outside the U.S. grew by over 10% in the second quarter compared to same period prior year. These results absent Durom related losses reflect steady growth across our primary Hip portfolio, including Porous Primary stems and our Trilogy and TM Acetabular cups.

Our TM Primary stem and M/L Taper stem with Kinectiv technology experienced steady growth, offset in part by lower sales of our VerSys Fiber Metal MidCoat, Beaded 6 inch FullCoat, and other cemented stems.

On a geographic basis and in constant currency, Hip sales increased 3.2% in the Americas, 6.7% in Europe, and 2.5% in Asia-Pacific, which includes negative pricing of 4.8%.

Extremity sales for the quarter in constant currency increased 14.3% on a challenging comp of 32.6% in the second quarter of 2007. Extremity sales increased 16.8% in the Americas; 9.2% in Europe, and 4.5% in Asia-Pacific. We experienced solid growth in both Shoulder and Elbow sales.

Dental sales increased 6.1% for the quarter on a prior year comp of 19.4%. Dental sales decreased 7.1% in the Americas. Our domestic business faced some tough challenges in the quarter, in large part as a result of temporary disruption caused by transition to our enhanced business model.

Zimmer Dental collaborates with institutions and practicing clinicians to conduct training on the use of Zimmer dental implants. As we have been working to structure Zimmer Dental’s training activities in accordance with our enhanced, enterprise-wide professional training and education platform, certain training activities have been delayed.

Our current priority with Dental is to reconcile Zimmer’s broader compliance framework with conventional marketing practices in that sector, and we are moving rapidly to resume a robust training program that is central to that division’s success.

While this disruption is temporary, this issue, together with the weak U.S. economy is expected to adversely impact Zimmer Dental sales performance in the near term.

In Europe, Dental sales increased 17.7%, including the effect of the distributor acquisition in Italy during the second quarter 2007. Dental sales increased 35% in Asia-Pacific on a small base.

Trauma sales in the quarter were up over the prior year 3.2% constant currency. Our plate and screw lines as well as bone graft substitutes led trauma growth. We continue to proceed with the development of an upgraded Nail line, which is expected to be in limited release in 2009.

On a constant currency basis, Trauma sales in the quarter increased 1.4% in the Americas, decreased 1.8% in Asia-Pacific, and increased 13.7% in Europe.

At 8.7% over prior year second quarter, Spine sales were impacted by certain delays in new product training in the U.S., similar to those experienced at Zimmer Dental.

However, sales were strong throughout the rest of the world in the quarter. Spine in the Americas was up 5.5%; Europe increased 15%, and Asia-Pacific was up 67.5% on a small base.

Finally, Orthopedic Surgical Products and Other sales declined 17.6% constant currency in the quarter, as a result of the suspension in sales of certain patient care products, partially offset by bone, cement, and accessories sales, which grew over prior year.

The OSP and Other category was down 15.6% in the Americas, declined 26.8% in Europe, and was down 17.3% in Asia-Pacific compared with the prior year period. As David indicated, our remediation plans to address the manufacturing suspension at our Dover facility continue on schedule.

Now I’ll focus on rest of the income statement. Our adjusted gross profit margin of 75.8% for the quarter is down 190 basis points from the prior year second quarter. Foreign currency hedge losses accounted for the majority of the decline in gross margin with idle plant cost and excess and obsolete inventory charges making up the balance.

R&D expense decreased 6.3% to $50 million for the quarter compared to last year, and as was the case in the first quarter, reflected lower spending on consulting services. At 4.6% of sales, R&D spending was below our historical range of 5 to 6%.

Collaborative development activities have resumed during the quarter and we expect R&D spending for the full year to be at the lower end of our previously stated 5 to 6% range.

Selling, general, and administrative expenses increased to $446 million, up 19.2% over prior year and include monitor fees as well as consulting and legal fees associated with the implementation of the enhanced compliance model, including:

A global comprehensive review of surgery collaborations and related agreements;

And assistance with implementing at a local level the enhanced standards and process to ensure collaborations will continue in accordance with our policies.

At 41.3% of sales, SG&A expenses are 270 basis points above prior year and within the quarter, include the significant increase in third-party consulting and legal fees. Such fees account for approximately 175 basis points of the increase from the same quarter of the prior year.

Acquisition, integration, and other amounted to $12.5 million in the quarter, comprised of costs pertaining to current and prior period acquisitions, including facility consolidation cost, legal fees, and retention and termination payments.

Adjusted operating profit in the quarter decreased 1.3% to $322.4 million. At 29.9%, our adjusted operating profit to sales ratio decreased by 380 basis points from prior year as a result of the lower gross margin and the significant but temporary step up in SG&A costs.

Interest and other income for the quarter amounted to $6.8 million including a one-time gain of $8.7 million from the sale of certain other assets.

Adjusted net earnings increased 1% compared to prior year at $236.9 million and adjusted diluted earnings per share rose 5.1% to $1.03 on 229.5 million average outstanding diluted shares.

These adjusted earnings per share are inclusive of approximately $0.08 of share-based compensation. At $0.99, reported diluted earnings per share increased 2.1% on prior year second quarter reported EPS of $0.97.

At 28% adjusted for the quarter, our effective tax rate is slightly below our expectations and the prior year second quarter due to favorable geographic mix of earnings and profits.

During the quarter, we repurchased 6.9 million shares at a total purchase price of $496 million, or an average price per share of $71.55. We used cash of $276 million and $220 million in borrowings to acquire the shares.

6.7 million shares were purchased under the $1 billion stock repurchase program, which was scheduled to expire on December 31, 2008. That program has now been fully executed.

During the first quarter, we announced that a separate $1.25 billion repurchase program had been authorized by the Board of Directors, expiring at the end of 2009. We utilized $19 million to acquire the balance of the 6.9 million shares during the quarter under this new program.

The company had approximately 225 million shares of common stock outstanding as of June 30, 2008, down from 231.5 million as of March 31, 2008. We continue to believe that share repurchases are an effective and efficient use of available free cash flow.

Operating cash flow for the quarter amounted to $280.6 million, a decrease of 7% compared to prior year second quarter as a result of higher estimated tax payments and higher investments in working capital.

Inventory days on hand finished the quarter at 275 days, a decrease of 9 days from prior year second quarter, reflecting higher cost of goods in the quarter. Our trade accounts receivable days sales outstanding finished the quarter at 59 days, an increase of 1 day over the prior year second quarter.

Depreciation and amortization expense for the quarter increased to $67.4 million. Capital expenditures for the quarter totaled $130.1 million, including $62 million for instruments and $68.1 million for property, plant, and equipment, with $29 million related to infrastructure initiatives.

Finally, free cash flow was $150.5 million for the quarter.

Now, I’d like to provide an update on guidance for 2008. We expect to deliver top line sales growth in 2008 of 8.5 to 9% compared to the original 10 to 11% range and adjusted earnings per share in the range of $4.05 to $4.10.

The sales guidance anticipates approximately 4 points of growth to come from foreign currency and therefore assumes a constant currency growth rate of 4.5 to 5%.

The adjustment to our sales guidance includes a projected loss of 20 to $30 million in Hip product sales pertaining principally to Durom Cup in the U.S.; weakness in U.S. Dental revenues, and slower than anticipated uptake on certain new products, partly due to delays in offering training programs in support of the new product introductions.

As I indicated in my comments regarding Zimmer Dental, this global effort we have undertaken to transition to enhance standards for collaboration has caused disruption in product training not only for Zimmer Dental, but other business units as well.

Revised adjusted earnings guidance gives effect to the reduction in sales from prior guidance as well as an increase in operating expenses associated with the global implementation of the company’s enhanced compliance program.

As part of the enterprise-wide effort to implement our enhanced program, we have engaged outside resources to, among other things, complete comprehensive reviews of all domestic and international collaborative arrangements with healthcare professionals not otherwise covered by the U.S. hip and knee resolution agreements.

Once these reviews are completed this year, we do not anticipate having a need to retain these outside resources in ongoing compliance activities.

Adjusting for these additional operating expenses in 2008 in relation to a reduced top line, we are now anticipating SG&A expense for the full year to average at or around 41% of sales.

With the anticipated completion of these and other activities over the next several months, we will have the opportunity to both reduce these fees and expenses and reinvest in the collaboration, training, and developmental efforts, which to this point of time have been delayed or otherwise disrupted.

With regard to share repurchases, we previously disclosed our intent to draw up to $500 million in our credit facility to fund share repurchases under approved repurchase programs. During the quarter, we borrowed $220 million to fund repurchases.

At the end of the first quarter, we indicated that our diluted weighted average shares for 2008 were expected to be 230 million. We now expect full year 2008 diluted weighted average shares to be between 228 and 229 million.

In addition, interest and other income is expected to be between 25 and $30 million for the full year before tax, inclusive of the interest expense on borrowings and anticipated one-time gains on the sale of other assets.

We anticipate a tax rate slightly above 28%, consistent with our year-to-date rate for 2008. To arrive at our GAAP earnings per share for the full year, you should assume subtracting acquisition, integration, and other expense of approximately of $27 million or an estimated $0.08 per share.

As always, our guidance and assumptions exclude the effect of potential future acquisitions or other unforeseen material business events or litigation matters.

Turning to cash flow, we anticipate capital expenditures in the range of 450 to $500 million, reflecting the capital components of many of our 2008 infrastructure and operating initiatives.

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

David Dvorak

Thank you, Jim. We continue to make meaningful progress in preparing Zimmer to expand its leadership position in the markets we serve. While we’ve encountered some challenges that arose during the first half of the year, our responses have been focused on long-term results and sustainable improvements.

We’re committed to building on Zimmer’s 80-year history of success, and we are excited about the ability of the 8,000 plus dedicated men and women of Zimmer to keep us moving boldly into the future.

And now, I’d like to open the call to your questions.

Question-and-Answer Session


Your first question will be from Tao Levy - Deutsche Bank.

Tao Levy - Deutsche Bank

You did mention as you move into 2009, some of the headwinds you’re facing in 2008 start to disappear. I was wondering if you could quantify the three main areas and the impact that you’re seeing this year and what percentage of that could disappear in 2009? I would love it if you could hit Durom, OSP, and the compliance monitors.

James Crines

I’ll start with OSP. As David indicated and I indicated in my comments, we’re on schedule with our remediation efforts; expect to be back in production of those patient care products between now and the end of the year, and have the opportunity to go back into the market as those products come back online.

Going into 2009, we would look to get back as much of that 70 to $80 million that we lost as we possibly can. We wouldn’t expect to get it all back, but we’ll certainly be back in the market with those products and pursuing opportunities to regain share in that segment.

Concerning the fees and expenses, we are looking now at a total in 2008 of 50 to $60 million in fees associated with the global rollout of our enhanced compliance program.

As I indicated in my comments, we will have the opportunity as we develop our plans for 2009 as we put the work that is being done this year behind us, to either reinvest that 50 to $60 million in training and development activities or deliver savings to the bottom line.

I think to some degree, we certainly understand what the target is going into the operating plan, as David referenced the fact that we are targeting at least low double digit growth in earnings in 2009.

Again, as we work through the plans for 2009, that will dictate how much of that gets reinvested as opposed to how much gets delivered to the bottom line.

David Dvorak

And finally, Tao, on Durom, certainly as we go into 2009, we are going to have our full training courses up and running, and we will have passed the point where we’d be able to allow surgeons to use that product again within the United States market.

I think that in this quarter that activity will be ramping up. We will start with reissuing the surgical technique instructions and then taking people through the training courses that are being developed currently.

As we get into the fourth quarter, I’d expect those courses to be fully up and running and so we’d have greater visibility as to what that revenue stream in the metal-on-metal area is going to look like as we march into 2009 probably and be able to provide you with a more meaningful update on the next quarter call.

Also, I think it is going to be important to note even though it wasn’t one of the three items that you mentioned, that our training courses are going to be up and running in full by the time we exit 2008, and that is going to help our revenue streams in some of these other business units.

We obviously made Hips and Knees the priority; got those courses back up and running on the surgical skill side during the second quarter beginning in May. We have about I think 40 courses already scheduled on the surgical skill side between now and the end of the year in that area.

But these activities are going to ramp up in the other business units, most importantly on the Dental side as well as Spine. We will see the benefits of the re-initiation of those activities too as we go into 2009.

Tao Levy - Deutsche Bank

Great, thank you very much. That was really helpful.


Your next question will be from Bruce Nudell - UBS.

Bruce Nudell - UBS

I have two questions. The first pertains to Durom itself. In your background, you mentioned 1.5% failure rate for people who knew what they were doing and around 6% for groups that really weren’t following the protocol exactly.

What is the anticipated aggregate early revision rate with the product given the disparities in training? How much reputational damage could that cause given the 13,000 implants that have taken place to date?

David Dvorak

I am going to let Cheryl respond to that question, Bruce.

Cheryl Blanchard

I think the best way to answer that question is first of all to understand that what our analysis tells us to date is that the likelihood of currently implanted patients requiring revision is going to be low.

In our detailed analysis of the clinical aspects of those investigations, you did see in the background piece that in the group that had success with the device that they had about a 1.5% revision rate while the other groups were at 5.7%.

It’s very difficult for us to project out where we think those numbers are going to go eventually. What I can tell you is that we were able to discern that there were some specific elements of surgical technique and cup placement that are the items that really make the difference in terms of those clinical outcomes.

I think it’s difficult to comment on the last part of your question, which is reputational damage. I think that that will frankly be determined by the actions that we’ve taken today and our level of being proactive as we move forward, trying to work with surgeons to help them get through this difficult situation with their patients.

We absolutely recognize that for those patients that are involved that there will be some items that we will need to help them with and we are going to be proactive about that.

David Dvorak

Let me add, Bruce, that the initial responses that we’ve received from surgeons have been understanding of the decision and appreciative of the way that we’re conducting ourselves to put them in the best position to take care of their patients.

I think that the early results are that people see this as being the prudent thing to do under the circumstances, and that always is going to be the best thing for the company’s reputation.

Bruce Nudell - UBS

My follow-up question would be pertaining to the big fear that investors have about the stock is that the new DOJ rules exacerbated by Durom, let’s say, are likely to result in a more fluid marketplace and share loss.

In the quarter, it looks as though Knees U.S., ex-U.S., and ex-U.S. Hips were in line with the market and it sounds like most of what happened in U.S. Hips was Durom.

Could you comment with regards to scale of the anticipated shortfall this year in revenues, which looks like $60 million plus or so, $30 million of which are Durom? How much of that is anticipating share loss, and do you really feel that that’s a major risk at this point in time in your key Hip and Knee business?

James Crines

I would agree with the way you characterize our performance in the quarter. We have not seen share loss, absent what we may be losing with respect to large diameter head metal-on-metal offering within the Hip segment, and we’re obviously not participating in the resurfacing in the U.S.. But outside of that, we’re not seeing share loss in our core franchise.

I will run through for you in a bit more detail the adjustment to our expectations relative to what they were coming into the year in the update that we provided on the first quarter call.

It’s an adjustment, as you pointed out, of 60 to $80 million in total, including the 25 to $30 million in Hips, related principally to Durom, but acknowledging as well the slower uptake on new products in the Hip franchise.

For us, that would include the Kinective technology, the Fitmore stem, a bone conserving stem that we’re just in the process of launching, and even the Epic stem that we’re looking to get cleared for commercial sale in the U.S. within the back half for the year.

About a $10 million adjustment to our expectations on Knees, representing really some lost opportunity for above market growth, and that is associated with again new products, in this case our Mobile Bearing knee, the Gender Solutions N-K Flex, and our Patello-femoral joint.

In Extremities, about a $5 million adjustment, and there again related to some disruption in training associated with our new TM Inverse/Reverse shoulder system.

In Dental, about a $15 million adjustment to our expectations; clearly this business and you can see it in the results reported for the quarter in the U.S., has perhaps been most affected by this transition to this enhanced compliance program and we’re working through that with the Dental organization.

In Trauma, about a 5 to $10 million adjustment in our expectations. Trauma admittedly is not so much associated with new products. There is knowledge there that we continue to see competitor pressure on our Nail system, and we’ll really not be able to effectively address that until we come out with a new Nail, which I indicated we expect to have in limited release in 2009.

Finally Spine, about a 5 to $10 million adjustment; that related to the disruption we have been talking about in surgical skills training and associated in this case with Dynesys, Atavi, and TiTLE 2 principally.

David Dvorak

Bruce, let me come back to your core theme there and I think it is a really important one for us. We have made decisions that we weren’t going to incrementalize this change with respect to the surgeon collaborative relationships.

As we previously announced, we went beyond the four corners of the DPA and the CI that we entered into last September. The point of that from the company’s strategy and with respect to our future is that we want make sure that we are able to collaborate with surgeons in all the essential ways that are most important, from the patient’s perspective especially.

That includes collaborating to develop the next generation of great products that address unmet clinical meets. It also includes having the very best training and education program out there.

Those are areas that we are very focused on. We don’t want to see disruption to these business units going forward. We are biting the bullet now to make that change and it will be a permanent change. But we believe that we are going to be operating in the market that everyone else is going to ultimately come to operate in, whether they do that voluntarily or involuntarily.

So it’s disruptive in the short term, but we firmly believe that it’s the right long-term strategy for the business. We really are confident that that’s going to prove out.

Bruce Nudell - UBS

I appreciate that. Just to clarify, are the new product issues in Hips, Knees, Extremities, Dental, and Spine, are those principally related to training, other than Durom?

James Crines

It is. Particularly when you look at what it takes in the case of some of these new products that surgeons are unfamiliar with and we look to able to get into a either cadaver-based surgical skills training program or live surgery before they would be willing to use the device.

David Dvorak

You can think of that too, Bruce, in the context of something like Kinectiv technology or our Inverse/Reverse shoulders, and even Dynesys within the spine field. Those are products that surgeons aren’t going to be comfortable adopting until they have had that training.

Frankly, we wouldn’t want them to. So that is the point that Jim has referenced in his prepared remarks about the uptake on those new products and it was also noted in our earnings release that went out last night.

Bruce Nudell - UBS

That’s very helpful, thank you.


Your next question comes from Raj Denhoy - Thomas Weisel Partners.

Raj Denhoy - Thomas Weisel Partners

I was curious if I could just clarify; did you mention it was 25 to $30 million this year in other income?

James Crines

I did.

Raj Denhoy - Thomas Weisel Partners

I think you said there was some sale of products or assets in that. Can you maybe give us a little more detail on that?

James Crines

I am not going to go into specific details on that, Raj. That’s why I gave guidance on that line item. I have pointed out that it includes both interest expense on our borrowings including the $220 million drawdown on our credit facility as well as gains, both the $8.7 million gain on sale of certain other assets, as well as additional anticipated one-time gains related to further sales of other assets we would look to accomplish in the back half of the year.

Raj Denhoy - Thomas Weisel Partners

Okay, but no detail of what those assets are?

James Crines


Raj Denhoy - Thomas Weisel Partners

Okay, if I could just ask a couple of clarification questions as well on the surgeon training program. Are you requiring that surgeons attend a hands-on training course before they can resume implantation of Durom in the U.S.?

David Dvorak

Some form of training will be required; that’s right.

Raj Denhoy - Thomas Weisel Partners

Okay, and those courses, as you mentioned, they will come online towards the end of the year. So until that time, there should be no expectation for any sales of that product at all in the U.S.?

David Dvorak

We expect to have those courses up and running over the course of the next several weeks, Raj. We would expect revenues to come back online in advance of the end of the year.

But obviously we’ll have to see how things go on the uptake of those products as they’re reintroduced after the training, and we’ll provide you with a more full update as we enter in the third quarter call.

Raj Denhoy - Thomas Weisel Partners

Okay, and then just one broad one. I think you have mentioned several times you’re holding the company to a higher standard I think than maybe it had been previously in other companies were holding themselves to, with the voluntary recall in USB product, the voluntary withdrawal of Durom, your reworking of the surgeon relationships.

You mention that you expect this over time to be something that provides you with an advantage. Maybe I’m putting words in your mouth, but over time this will work in your favor.

I’m curious how you imagine that to play out. Is it that other companies over time will have to come up to where you are; whether it will be perceived in the marketplace that you are a company that people want to do business with, or really how does that advantage actually work to your favor over time?

David Dvorak

Obviously, trust is absolutely essential within this business. Whether it comes up in the context of these collaborative relationships; in the public’s view; in the enforcement agency’s view of how those relationships are structured and managed, that’s critical.

I think that the same theme applies in the context of making responsible decisions with respect to the products that we introduce and the benefits that those products provide to patients and how we take care of the relationships that we have with surgeons.

Our reputation and the trust that people place in us is going to be key to the future success of the company. We treat that matter very, very carefully and with a lot of protective steps in place to ensure that that trust is in no respect impaired.

I think on the collaborative relationship side, over the course of the next 5, 8, 10 years, what you’re going to see is that companies within medical devices that believe that collaborative relationships with physicians are key to their future; are going to have to implement systems that are not all that dissimilar to the quality systems that have been implemented in these medical device companies over the last many years to protect the ability to be able to collaborate with surgeons on a go-forward basis.

The enforcement agencies are going to expect those programs to be in place, and I suspect that they are going to allocate their enforcement resources in a way where obviously it’s going to be risk based analysis, and they will comment and evaluate the compliance programs and it will be very disruptive to a company that doesn’t have the right program in place.

I think that as the surgeon community becomes better informed as to those risks, they’re going to want to collaborate with the companies that have those protective systems in place. I think it’s going to rig down to our benefit in that regard as well.

Raj Denhoy - Thomas Weisel Partners

Great, thank you very much.


Your next question will be from Michael Jungling - Merrill Lynch.

Michael Jungling - Merrill Lynch

I have three questions. Firstly on the royalty payment that you delayed; are you in the breach of contract with physicians and have doctors taken legal action against you from selling products that have got their technology?

Secondly on Durom, the 20 to $30 million worth of sales, can you indicate how much that is in terms of annual sales? I think it’s pretty much the entire amount.

Thirdly on Dental, if you exclude bone augmentation products, what was the dental implant growth rate and how much competition did you see in Dental from generic competition or low cost providers? Thank you.

David Dvorak

I’ll pick up with the royalty question to begin with. Let me tell you that, we have done a lot of work and are making a lot of progress to bring those payments back on line. It is the case that we are in arrears with those payments.

We have communicated very actively with the involved third parties. We have a lot of resources committed to this, including some of those third-party resources that Jim referenced earlier in the call.

At this point in time, I do not see that our licensing rights are at significant risk. But we obviously have obligations that we need to make good on within the context of those contracts. I think that the progress that we are making will allow us to arrive at an appropriate resolution and be able to make those payments.

So those communications have really expanded over the last quarter, as have our progress steps in that regard. I think that we are doing the right things and we look to make significant progress between now and the end of the year with respect to making those payments.

James Crines

With regard to Durom, as we indicated in earlier comments, it represents about 5 to 10% of our Hip revenues in the U.S. It happens to be the case as well outside the U.S. If you look at how and we look at how that product was growing coming into the year, coming out of the first quarter before reports of loosenings and revisions, we were trending clearly to the high end of that range.

The 20 to $30 million, again, principally associated with Durom, does get you two-thirds to the full amount. But as I indicated, with regard to the Hip franchise, there is also the impact that some disruption in training is having on the new products that we have introduced in the Hip portfolio, namely the M/L Taper with Kinectiv. There is a bit more in the Epic devices that we’re focused on in the second half of the year as well.

David Dvorak

Let me pick up on your Dental question as well, Michael. I think that you rattled off several factors that could be impacting the business. At this stage prior to the other companies reporting out on their second quarter performance, it’s a little bit difficult for us to disaggregate those factors.

As we’ve already mentioned, our training efforts on the physician training and education/clinician training and education side were impaired. We obviously had to prioritize our larger business units. But we’re making good progress in that regard now.

We do think that that had a negative impact on our business. I think that there probably has been a continuation of the threat of some of the other providers, say the low-cost providers and low value providers within that marketplace. But I don’t think that that has accelerated and justifies our poor performance within the U.S. marketplace.

Anecdotally, it is true that we’ve received some reports from the field that in certain large procedures where there are multiple implants, in instances people are moving from using four implants to two implants and then connecting the gaps with bridgework or more traditional dentistry, so that could be impacting it as well.

But I think that we’ll need to carefully review the other companies’ performances and we’ll all learn more in the coming weeks on what’s happening within the U.S. marketplace.

There is no doubt that that marketplace is a bit more sensitive to the general economy because of the private pay basis for that business within the U.S. market, and so that has had an impact on the business as well.

But like I said, we’ll gain greater visibility as the other companies report and be able to disaggregate those factors and think more intelligently about our actions going forward.

Michael Jungling - Merrill Lynch

A quick follow-up question for you, Dave. I’m still confused why you suspended the sale of Durom because if you look at all the registries around the world, the actual failure rate is roughly in line with best practice or in line with competing products.

You’ll always have one- two- or three people who have higher failure rates because they haven’t followed the procedure. Why recall it when all you would need to do is perhaps train 2-3-4-5 physicians that are having issues and not make it the problem of 500 physicians who are getting very, very good results?

David Dvorak

Again, we did not recall the product. The action that we’re taking here is to step back, make sure that we can properly revise and add greater clarity to the surgical technique and the instructions for use on that product, and then make sure that everyone is trained.

We think that it’s the responsible thing to do. One could deem it to be a conservative action, but when it comes to patient safety, we’re going to make decisions on the conservative side of the continuum.

Michael Jungling - Merrill Lynch

Thank you.


Your next question comes from Michael Weinstein - JPMorgan.

Michael Weinstein - JPMorgan

Let me just pick up on a couple of the items that have been discussed thus far. On Durom, probably two questions. One, how much do you think you will spend on surgeon training with the re-launch of the product in the United States?

Is it necessarily worth the expense and the distraction on your other products to re-launch this product in the U.S.? And then how many surgeons do you think you’ll need to train in order to get the product fully back out there?

David Dvorak

The spending is not going to be anything that’s really out of the normal course for us. We incur a great deal of expense every year on surgeon training and education. It’s a very important aspect of our business.

I wouldn’t look for anything that is significant and conspicuous to come out the expenses that we incur in that regard. It will just be part of our overall effort on that side of our business.

As far as the number of surgeons, there are several hundred within the U.S. I think that our records would indicate that there have been some 900 surgeons or approaching 1,000 surgeons. We would want to train several hundred surgeons. This will be an ongoing effort, not just in the coming quarter or two, but thereafter.

We do think that the product offers great patient benefits as evidenced by the clinical success that have obtained by many U.S. surgeons and the tens of thousands of patients that have had great results with this product overseas.

We believe that the metallurgy is superior to the competitive products that are out there, so it clearly is worth the investment, but we’ve going to do this in a very responsible way, both to the surgeon customers and to the patients that receive these implants.

Cheryl Blanchard

Just as a point of clarification, the implants will be made available to the surgeons as they receive training. So there won’t be a threshold that we train a certain number and then the implants became available. They will become available to individual surgeons as they receive their training.

Michael Weinstein - JPMorgan

They have to go through the training first in order to start doing implants again?

Cheryl Blanchard

They do.

Michael Weinstein - JPMorgan

Okay. David, one of my concerns here is that I see all that has happened, particularly in the last nine months between yourselves and surgeons and the way the relationship is evolving. This is true for Zimmer, but it’s probably broadly true for the industry as well. Part of what you are talking about here is that the disruption on training and some of the other disruptions are having an impact on the uptake of the new technologies.

My question is, part of what we are seeing is that in the post-DTA world, that with changing relationships; less ability to influence surgeons; maybe less interest in surgeons on new technologies; fewer surgeons on your product development teams, why is it going forward, the uptake of new technology is going to be slower than we what we saw in the past?

David Dvorak

Mike, I don’t think that the uptake of new technologies will be slower. I will tell you that I think that what we’re going to right now is transitional in its nature and you’re seeing this with not only our company but the competitors out in the field, either to a greater or lesser extent.

But I do think that what will be the case is that because of the strains placed upon the governmental systems and third-party payors to provide healthcare with a growing population of folks that need this care that the necessity of proving out the clinical benefits to new products, if you are going to expect to get mix benefit or price benefit more generally, is going to be more rigorous.

I think that what you are seeing on the uptake right now is probably a temporary transition as people work through the compliance with these resolution agreements. But I think that the long-term dynamic is going to dictate that you do have to prove out in a more rigorous way with empirical evidence that if you want to get a premium on a product, it has to prove out to provide greater patient benefits.

You see this in the discussions that are taking place within the U.S. on the reimbursement side and notions of comparative effectiveness. In some form for sure, you’re going to see those types of principles be embedded in that decision-making.

What we want to be as an organization is a very innovative organization that addresses unmet clinical needs and have appropriate clinical data to be able to prove that out. And that’s just what we are doing in allocating our R&D efforts. We believe that we’re going to able to continue to compete very effectively and introduce innovative products going forward.

Michael Weinstein - JPMorgan

Let me close with one final question for Jim. On the other income line, you’re selling off some investments and some assets to help contribute/support 2008 earnings. Should I assume that in 2009 that other income line comes back to a more normalized level?

James Crines

Until such time as we prepare an operating plan for 2009, I’d like to stay away from providing any specific guidance on 2009, Mike. But we have in what we disclosed been careful to make it very clear that what’s running through that is one-time in nature.

Michael Weinstein - JPMorgan

Okay, perfect, thank you.


Your next question comes from Ben Andrew - William Blair.

Ben Andrew - William Blair

I just wanted to follow up with a couple of quick things. Is there any plan to accumulate clinical data related to Durom in the United States? You talked about the need for clinical evidence maybe with the registry or a broader study.

Cheryl Blanchard

What I can tell you is with respect to the ongoing experience and the experience that we will move forward with post-training that we will be continuing to very closely monitor the clinical experience with this device.

Ben Andrew - William Blair

Okay, and then just more broadly speaking back to the training issue, clearly the disruptions and delays in being able to train and work with surgeons more closely is in basically every business.

Where is the confidence coming from that you’re going to be able to see a quick restoration of the scope of relationship that you’ve had surgeons historically as you’ve been delaying that and disrupting those relationships as you get those pieces back in place; what timeframe should that be happening in?

David Dvorak

I think that we’re going to make significant progress in the coming weeks and months, and I would expect that we will have fully transitioned and be up and running at a full clip before we exit this year.

With respect to the relationships that we have with the surgeons, there is a high desire among them to get back at these activities. As I mentioned, we’ve had in-person meetings with over 100 surgeons just in the second quarter. The common theme among all of them is they want to ensure that patients’ interests are protected.

They’re very passionate about these activities; they’re very passionate about the collaborative relationships and the benefits that they think are derived for their patients through those relationships. I don’t anticipate that we’re going to have any trouble at all at getting first-rate people signed back up to help us teach these courses and participate.

Ben Andrew - William Blair

Okay, thanks.


Your next question will be from Joanne Wuensch - BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

There are two questions. The first has to do with your communication with the FDA regarding Durom, and if you think that they will take some action towards this. The second question has to do with hip resurfacing. It’s my understanding that the Durom hip cup is used as part of your resurfacing program. Does this delay introduction of that? Thank you.

Cheryl Blanchard

I’ll take both of those questions. Thanks, Joanne. First of all with respect to the communications with the FDA, we have shared our review and conclusions with the agency, and we will continue to update them. In terms of future interactions, it would be difficult for me to predict. They will be necessary and appropriate, certainly.

In terms of our ongoing U.S. IDE study on the resurfacing system, in response to the actions that we are taking today with respect to the Durom Acetabular component, which is the acetabular component in that system, we are suspending enrollment until further notice.

Joanne Wuensch - BMO Capital Markets

Thank you.


Your next question will be from Matt Miksic - Piper Jaffray.

Matt Miksic - Piper Jaffray

I just had one clarification here. I just want to make sure I understood you and then I have a couple of questions if that’s okay. The clarification was on this comment you made on SG&A. I think you talked about 175 basis points of increase due to legal and compliance expense. Is that right, Jim?

James Crines

That’s right.

Matt Miksic - Piper Jaffray

And in 175, that’s growth or is that as a percentage of sales?

James Crines

Maybe I will make it easier for you, Matt. It’s close to $20 million in expenses in the quarter.

Matt Miksic - Piper Jaffray

That’s the number I was coming up with and that sounded a little higher than I was thinking of in terms of a run rate. Is that about right?

James Crines

I think that’s fair because I talk also about 50 to $60 million for the year. So clearly, the second quarter was the high water mark.

Matt Miksic - Piper Jaffray

Okay. And then the other clarification item you talked about this first half growth and I didn’t hear whether you had attributed some percentage growth number to the selling days and the Easter effect for the quarter?

James Crines

No, I think what you ought to do is look at the growth rate for the first six months because those billing day differences get neutralized between the two quarters.

Matt Miksic - Piper Jaffray

Okay, so that 8% number or whatever you gave us was the normalized run rate first half?

James Crines

That’s right.

Matt Miksic - Piper Jaffray

Okay, there have been a lot of questions about this. But I just want to understand how we should think about it playing out over the next – granted this is going into next year, but I hope you can help us think about it.

It sounds like this rollout of the enhanced compliance program as you go into other divisions and layer in the same kind of rigor that you’re putting into orthopedics; that is slowing things down. You have more training. Do you have an implementation timeline for that? I’d love to hear when you think it will be done.

But is the right way to think about this at the end of that, assuming that you don’t lose a lot of share, that you are going to be able to reaccelerate some of the growth in those businesses as that becomes part of more normal operations, or you get people trained up or get through this implementation process?

David Dvorak

Absolutely, Matt; we are very optimistic based upon the feedback that we’ve received from surgeons that this is a transitional period. They’re enthusiastic about the fact that we’re back out and communicating with them in a very proactive way.

There are a lot of elements of this obviously and we’re prioritizing our execution plans in accordance with the import of that business unit. There are aspects that first and foremost are essential on the communication front to get the training and education programs up and running across all these business units.

With respect to U.S. Hips and Knees, obviously the payments are another area of prioritization for us and we’re making good progress on that front. I think that you can see that most of the other competitors have slowed down their payments over the course of the 9-month term of these resolution agreements as well.

But I anticipate us making very significant progress in the third quarter and working with an eye towards marching into next year and certainly by the end of first quarter of next year to have all of that stuff behind us.

I would expect just in a macro sense to have the training and education events all up and running and that process to be very smoothed out before we exit this year. And that remaining U.S. Hip and Knee payment stuff may pend over until the first quarter of next year, but largely be resolved by the first quarter of next year as well.

Matt Miksic - Piper Jaffray

Okay, and with respect to the other businesses and the global compliance, is it first or second quarter of next year that you feel like you get that behind you as well?

David Dvorak

I think no later than that, and I’m more optimistic on that front, we’ll probably have most of that behind us before this year is out.

Matt Miksic - Piper Jaffray

I see. And then the other thing about this is as you mentioned what other companies are doing, I think I understand. You talked about what you’re trying to do in terms of settling up with the surgeons that you have these royalty-based relationships with and then redrafting new agreements to go forward.

Are you concerned at all that that’s cutting these folks loose to some degree as free agents at the end of the year once that agreement is signed, whereas if I look at other manufacturers, not to sound too mercenary here, but the folks with relationships with other manufacturers clearly have a reason to maintain and concentrate on that relationship because they do have these ongoing payments.

David Dvorak

Obviously, there is no nexus in our minds between the product choice that the surgeon makes and who we’re engaging to provide services whether it’s on the training and education side or providing intellectual property and input into the design of our products.

But our initiatives in that regard, Matt, are just to make sure that these existing contracts are treated in an appropriate way and that we’re going back through and doing whatever work we need to, to make sure that the payments that go out are consistent with our current compliance program and our fair market value principles.

I don’t want to describe that as a settle-up process. Our initiative in that regard is very rigorous and comprehensive. But the objective there is to make sure that everyone that we’ve collaborated with is treated in a fair way and they are provided with full and fair value as supported by third-party valuations if necessary of those contracts. So that’s the initiative that’s underway in that context.

Matt Miksic - Piper Jaffray

Okay. I think that’s fair. The last question here was on some of the new products. The training it sounds like is part of the impact. Just to put this in perspective, we think about Natural Knee and Mobile Bearing, even when training gets going again, those are maybe a segment of your Knee business.

Is any of the sluggishness around some of these new products driven by concern over the cost of the technology or the complexity of the technology? I’m thinking of the Gender Hip with Kinectiv technology, is that something that you’re confident is going to pick back up again?

Or, to your point earlier about making a connection between new products, the premium of the product, and the clinical outcomes, is that something that you feel like you have a strong case there, or has there been pushback on the price of that product?

David Dvorak

I think that it just is in the early stages, Matt. And so we’ve seen enough disruption in the training efforts there to where we’ve lost some time to be sure but we still believe in that technology and the receptivity that we’ve received to what that technology represents and the patient benefits are still very positive. So we’re optimistic about any of these launches that we have underway right now. We just think that we lost a bit of time.

Matt Miksic - Piper Jaffray

Okay, that’s fair. Thanks again for taking the questions.


Your next question will be from David Roman - Morgan Stanley.

David Roman - Morgan Stanley

First of all, I wanted to spend a couple of seconds on the guidance. You went through all the details on the lowering of sales estimates. Given that in every case, you’re saying that that is related to training and the implementation of your own compliance standards, what surprised you during the quarter compared to Q1 that caused such a dramatic change?

David Dvorak

I don’t know that anyone anticipated the amount of work that was going to go into complying with the resolution agreements at the outset. It’s difficult to forecast out because that’s not a normal business cycle that we are going through or process that we are working through, and we probably lost some time on the front end that we didn’t fully project out or appreciate going into, even the first quarter, let alone the second quarter, and so some of it was just that dynamic.

David Roman - Morgan Stanley

So if you look at Mobile Bearing for example, and the number of physicians you’ve been able to train compared to let’s say a more rapid product launch, can you give us a sense as to how that compares six months out?

David Dvorak

I think that the difference is pretty dramatic is the way we’d characterize it as opposed to what you would normally do at the point of launching those types of products or new technology along the lines of Kinectiv would fall into that same category.

But Kinectiv and Mobile Bearing Knees, a lot of training and education is necessary prior to a physician picking up that product and feeling comfortable with it. So any disruption in that regard is going to be seen directly in the commercialization side.

David Roman - Morgan Stanley

Okay. And then on the margin front, gross margins are down, a little light relative to I think what people were looking for. Can you give us a sense as to where you think that will shake out for the full year?

James Crines

Maybe the best way to focus on that is to look at the change this quarter relative to second quarter prior year; a reduction of 190 basis points. About 160 basis points of that is related to the foreign currency hedge losses and the balance to both idle plant expense that we were experiencing at that Dover facility as well as inventory obsolescence charges.

I think if you look at where we landed for the quarter, slightly better is where we would expect to, when we consider that and the other charges had gone through there in the first quarter related to that OSP issue is where we would expect to be for the year.

David Roman - Morgan Stanley

And are you dialing anything for higher raw material cost? Are you seeing anything on that front?

James Crines

We have. That’s reflected and we had some visibility to that coming into the year and had that reflected in the guidance coming into the year. But to the extent we have seen further increases, we are now looking at what is roughly about 10 to $15 million of purchase price variances, some of which will get carried over into next year.

David Roman - Morgan Stanley

Okay, and the last question, just to follow up on SG&A, you said that the 270 basis point year-over-year increase; 175 basis points related to compliance, what’s the rest of that?

James Crines

The rest of that would be the step up we talked about coming into the year related to the operating and infrastructure initiatives. It’s opportunity for U.S. distributor organizations to earn higher compensation on Trauma product lines; pushing out more instruments into the U.S. distributor organization; the cost associated with that.

They are in a better position to deal with the demands that are being made with surgery schedules getting pushed towards the front of the week. It’s those other initiatives that are contributing to that increase.

David Roman - Morgan Stanley

And you think that those efforts will be complete in 2008?

James Crines

They are, but as we have said before, those are things that carry over as well in to future periods to some degree.

David Roman - Morgan Stanley

Got it. Okay, thank you.


Your next question will be from Doug Schenkel - Cowen & Co.

Doug Schenkel - Cowen & Co.

I believe you mentioned that Q2 R&D spend was lower than expected in part because of royalty renegotiations. And you guided us to expect R&D on the low end of the guidance range. Can you talk about how ongoing changes in your R&D practices may be affecting development timelines and how that compares to your assumptions coming into the year?

Cheryl Blanchard

First of all, just a point of clarification. There have not been any royalty renegotiations. It has really been a decrease in spend just related to straight fee-for-service consulting activity, so just a point of clarification on that note.

In terms of how it has impacted development timelines, there certainly has been an impact. I think it’s fairly well understood that during the initial phases of the monitor period that we were not holding development meetings. So there certainly will be some delays.

Overall, the projects that were in their later phases are continuing to move along and we are continuing to drive towards those timelines currently.

Doug Schenkel - Cowen & Co.

Okay, that’s helpful; maybe a follow-up to the R&D question then. Is it fair to assume that the decision to suspend, retrain, and essentially re-launch Durom in the U.S. rather than to just discontinue the product might have been different if you had a follow-on metal-on-metal product planned for launch in the U.S. either in 2009 or 2010?

David Dvorak

Again, we believe in the technology and the clinical benefits of that product. The issue is not with respect to the product but rather to the surgical technique and the specificity of that technique and the training that accompanies it. So, that is the basis for the decision.

Doug Schenkel - Cowen & Co.

Okay, so maybe a more direct follow-up, could you give us any color on when you think you might have a follow-on metal-on- metal product in the U.S.?

David Dvorak

That obviously is a very important part of our pipeline and it will continue to be a priority and has been a priority, not just metal-on-metal, but the cup side of our Hip business in general going into 2009. We would anticipate making progress and working towards launching one or more cup products within that time period.

Doug Schenkel - Cowen & Co.

Okay, and one more question. You talked about the need to see other earnings reports from some of your competitors before arriving at any firm conclusions on market dynamics. But I think at this point, it’s fair to conclude that recon volumes were decent at Biomet, DePuy, and Stryker during the quarter.

Given you said your moderation in the second half outlook goes really across your different businesses, can you help us understand why we shouldn’t conclude that some of these enhanced compliance approaches that you are implementing either aren’t going to drive you specifically to lose share if others aren’t following the same approaches or that in general, if others are taking similar approaches, that volumes in general will pull back a little bit?

David Dvorak

We understand what’s happening in the markets, Doug. In the context of Michael’s question on the dental market, I think that we do have great visibility and a clear understanding of the core recon business and what has happened in the second quarter market-wise.

That was dental specific just to start off with, but I don’t believe that this enhanced compliance model is going to negatively impact our future business. I think that it’s the right thing to do. It’s a longer term strategy.

I think that the likely impact is in the short term, but I think what you’re going to see is continued scrutiny of these relationships, and we’re making the decisions now that will allow us to continue to collaborate with surgeons in all the essential ways.

I think we are making the hard decisions out in front. For anyone who decides that they are going to be dragged through this transition process by an outside entity as opposed to internally driving a cultural change and a rigorous program in this context, what they are likely to see is future disruption to their ability to collaborate with surgeons. So that’s what we are going to avoid with the process that we’re going through now.

Doug Schenkel - Cowen & Co.

Great, thanks for taking my questions.


Your next question will be from Kristen Stewart - Credit Suisse.

Kristen Stewart - Credit Suisse

I have a couple. In the quarter, it looks like from your cash flows, obviously you talked about selling a business and you also bought something. Can you give us any color since those are obviously closed deals on what those were?

James Crines

I am not going to give on the sale of the other assets specific detail. I think there is the fair amount of information out in the public domain that people are able to get a fair idea of what contributed to that gain in the quarter. Then with respect to the very small acquisition that we did in the quarter, that was an acquisition of our independent recon distributor based in Finland.

Kristen Stewart - Credit Suisse

Okay, and I know this has been asked several times, but your other income including the gain on the sale of the assets, I am curious on your philosophy with adjusted net earnings since it looks like you are excluding all of the costs associated with acquisitions but now including gains for divestitures.

Should we really be looking at it as $1.03 less what looks like $0.03 in the quarter as more of an ongoing run rate basis?

James Crines

Kristen, our philosophy with respect to how we report our financial results is to be very clear and transparent, and I think we’ve accomplished that. That gain, you can see it is in the interest in other income line. It’s below operating profit, as it should be. And we’ve been very clear about how much and any impact that it is having on earnings.

Kristen Stewart - Credit Suisse

What did you say the guidance was for the full year on that line?

James Crines

25 to $30 million.

Kristen Stewart - Credit Suisse

And that’s all gains?

James Crines

No, that’s a net number, so that includes both interest expense on our borrowings as well as anticipated one-time gains.

Kristen Stewart - Credit Suisse

Then just going back to your going into the field and looking at the experience with Durom. I know that this product has been used off-label in hip resurfacing. Are you seeing any higher incidents of revisions when it’s used in that condition versus any use in a more traditional hip arthroplasty procedure, and what may be the implications for resurfacing?

I know you said you’re suspending enrollment, but how do you look at the going forward? I think the last update you gave would be at best 2011. How do you feel positioned to compete against your competitors that will likely have a system, especially in light of some of your commentary last fall on how concerned you were with hip resurfacing?

Cheryl Blanchard

Let me take first of all your question on its potential use in off-label applications. I will tell you that in our very in-depth investigation where we reviewed individually 1,300 cases that we did not see one example of where the Durom Cup was used in any other instance other than a large diameter head application in a total hip arthroplasty.

I find myself not in a position to comment on its use in off-label application because I’m not seeing it. I’m not saying that it’s not out there. Certainly surgeons had the opportunity to direct their own use for the best care of their patients. But I will tell you that we have not seen it.

In terms of your question related to the IDE study, because that cup is the acetabular component in that resurfacing study and because we’ve taken the action that we have, we find it only appropriate to suspend enrollment on that study until further notice.

Then in terms of our ability to compete in that product line going forward, I’m going to turn that one over to Jim.

James Crines

You hit it, Kristen, for rightly pointing out that hip work clearly is going to be the focused on competing in the 90% to 92%, depending on where hip resurfacing levels out in the U.S. market, whether it’s the 10%.

With everything else that we have in our portfolio including Trabecular Metal, which is unique and proprietary; the new products, the M/L Taper with Kinectiv technology; David referenced some work that we have underway in development to bring out what will be a new acetabular component system, there with the suspension, I would suspect, although this is something that still obviously has to be evaluated, there will be some delay beyond that 2011 period that we earlier referenced.

Kristen Stewart - Credit Suisse

Okay, and Cheryl, just going back to your comments on reviewing, I think you said 1,300 patients?

Cheryl Blanchard

In the United States, yes.

Kristen Stewart - Credit Suisse

Is that just 10% of all U.S. procedures and are you very comfortable that that’s a good sample to project on what the total experience that they...

Cheryl Blanchard

Yes, that does represent about 10% of the cases that are currently available in the United States. The tack that we took was to go to among the highest volume sites in United States because there was a certain sense of urgency related to our ability to come to conclusion on the issues that were raised by our knowledge of loosenings and revisions that were occurring.

Do we think that it’s a statistically significant representative sample that allows us to draw the conclusions that we did and take the actions that we did? The answer is absolutely yes.

Paul Blair

Operator, in the interest of everyone’s time, let’s take two more questions.


Your next question will be from Robert Hopkins - Banc of America.

Robert Hopkins - Banc of America

I have got just two questions. The first question is on the stability of the sales organization. Can you comment on the stability of the sales organization? And specifically, have you lost any distributors?

Then when it comes down to individual reps, what is a normal rate of turnover that you might see in a quarter and what’s the current rate of turnover that you saw in this quarter? Thank you.

David Dvorak

We won’t go into turnover but we’ve had extraordinary stability among the U.S. distributor sales force. Furthermore, I think that our distributor group has really answered the call and addressed the challenges that we’ve gone through in an admirable way.

They are clearly very on board with what we are doing as an organization. We think that we have the best distribution channel on the industry. Their reaction and how they conducted themselves through this period evidences that. So I have absolute confidence in our ability to execute with that group and we’re proud to be affiliated with them.

Robert Hopkins - Banc of America

So you haven’t lost any?

David Dvorak

We have lost no distributors.

Robert Hopkins - Banc of America

And you’re basically comfortable saying that you’ve got no abnormal level of turnover with the sales organization?

David Dvorak

That’s right. The single exception to that has been we’ve had some turnover on the Dental side within the U.S. But I have seen nothing abnormal at all outside of that.

Robert Hopkins - Banc of America

Okay, and then the second question is, would you rule out M&A as an option to bolster your metal-on-metal offerings and by extension hip resurfacing?

David Dvorak

We would never rule out any external opportunities. Obviously we are constantly evaluating external opportunities and those are getting evaluated in the context of our internal development plans at all time.

So if there was technology that we thought was unique or that could accelerate, addressing any aspect of our offering that we thought was going to provide significant clinical benefits to patients, we would be interested in that.

Robert Hopkins - Banc of America

Are those deals less likely now in giving the incremental expenses that you’re incurring in 2008 and early part of 2009 or not necessarily?

David Dvorak

No, they are less likely.

Robert Hopkins - Banc of America

Thank you for your time.


Your last question will be from Jeff Johnson - Robert W. Baird.

Jeff Johnson - Robert W. Baird

Just a few clarifications here at the end. One, do you need any regulatory sign-off on the labeling changes for Durom? And if so, could that be the rate limiting step here as opposed to the training courses?

Number two, just a clarification on the P&L treatment of the royalty agreements that are in arrears at this point. Have you been running these presumed payments at all through the P&L or have they been left out of the P&L the last two quarters?

Then the third question/clarification, Jim, obviously some sensitivity around talking about the asset sales. But is it fair to assume the stock sales in the quarter that did add to the non-recurring gain would be the same sales going forward, and there would be no other type of non-strategic asset sales, they would just be similar ones we saw here in this quarter?

Cheryl Blanchard

I’m happy to take your first question regarding regulatory sign-offs. There will certainly be appropriate communication with the FDA on that aspect of the sealed action. We will submit to them the labeling change, which is the regulatory action that’s occurring as the result of this.

I do not believe that that will be a rate limiting step. I think that will happen in the normal course of our business. That will not be anything that would be causing us to slow down anything on the training and education side at all.

James Crines

The response to the question about royalty expense, we have continued to reflect that in the income statement, and we’ve talked as well about the fact that it has contributed as well, to the extent that we are not making those payments, so it’s getting reported in terms of free cash flow. And it’s in the order of 20 to $25 million on a quarterly basis.

And then finally on the asset sales, I’m not going to answer that directly other than to say with whatever asset sales we undertake in the balance of the year, we’ll do that in an organized and orderly fashion to ensure that we get good value for any assets that we sell.

Jeff Johnson - Robert W. Baird

Fair enough. Thanks.


This concludes today’s conference call. Thank you for your participation, you may now disconnect.

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