UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
Commission File Number 001-16407
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ZIMMER HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
Delaware | 13-4151777 | |
(State or other jurisdiction of incorporation or organization) | (IRS Employer Identification No.) | |
345 East Main Street, Warsaw, IN 46580
(Address of principal executive offices)
Telephone:(574) 267-6131
(Address of principal executive offices)
Telephone:(574) 267-6131
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o No þ
At October 27, 2006, there were 238,648,611 shares outstanding of the registrant’s $.01 par value Common Stock.
ZIMMER HOLDINGS, INC.
INDEX TOFORM 10-Q
September 30, 2006
2
Part I — Financial Information
Item 1. | Financial Statements |
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
(In millions, except per share amounts, unaudited)
Nine Months | ||||||||||||||||
Three Months Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Net Sales | $ | 819.8 | $ | 762.5 | $ | 2,561.8 | $ | 2,437.8 | ||||||||
Cost of products sold | 183.2 | 174.5 | 572.6 | 553.6 | ||||||||||||
Gross Profit | 636.6 | 588.0 | 1,989.2 | 1,884.2 | ||||||||||||
Research and development | 46.7 | 43.9 | 142.7 | 129.6 | ||||||||||||
Selling, general and administrative | 330.4 | 295.8 | 1,010.1 | 945.9 | ||||||||||||
Acquisition, integration and other | 5.0 | 7.7 | 9.5 | 34.7 | ||||||||||||
Operating expenses | 382.1 | 347.4 | 1,162.3 | 1,110.2 | ||||||||||||
Operating Profit | 254.5 | 240.6 | 826.9 | 774.0 | ||||||||||||
Interest income (expense) | 0.6 | (2.1 | ) | 2.3 | (13.5 | ) | ||||||||||
Earnings before income taxes and minority interest | 255.1 | 238.5 | 829.2 | 760.5 | ||||||||||||
Provision for income taxes | 71.9 | 69.7 | 239.0 | 227.0 | ||||||||||||
Minority interest | 0.1 | (0.2 | ) | (0.4 | ) | (0.6 | ) | |||||||||
Net Earnings | $ | 183.3 | $ | 168.6 | $ | 589.8 | $ | 532.9 | ||||||||
Earnings Per Common Share | ||||||||||||||||
Basic | $ | 0.76 | $ | 0.68 | $ | 2.41 | $ | 2.16 | ||||||||
Diluted | $ | 0.76 | $ | 0.67 | $ | 2.39 | $ | 2.13 | ||||||||
Weighted Average Common Shares Outstanding | ||||||||||||||||
Basic | 240.4 | 247.4 | 244.6 | 246.8 | ||||||||||||
Diluted | 242.6 | 250.2 | 246.8 | 249.7 |
The accompanying notes are an integral part of these consolidated financial statements.
3
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
(In millions, except share amounts)
September 30, | December 31, | |||||||
2006 | 2005 | |||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Current Assets: | ||||||||
Cash and equivalents | $ | 275.6 | $ | 233.2 | ||||
Restricted cash | 2.3 | 12.1 | ||||||
Accounts receivable, less allowance for doubtful accounts | 589.4 | 524.2 | ||||||
Inventories, net | 630.9 | 583.7 | ||||||
Prepaid expenses | 46.2 | 68.7 | ||||||
Deferred income taxes | 161.9 | 153.7 | ||||||
Total current assets | 1,706.3 | 1,575.6 | ||||||
Property, plant and equipment, net | 751.1 | 708.8 | ||||||
Goodwill | 2,532.6 | 2,428.8 | ||||||
Intangible assets, net | 731.1 | 756.6 | ||||||
Other assets | 187.4 | 252.1 | ||||||
Total Assets | $ | 5,908.5 | $ | 5,721.9 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Current Liabilities: | ||||||||
Accounts payable | $ | 126.4 | $ | 123.6 | ||||
Income taxes payable | 104.4 | 82.1 | ||||||
Other current liabilities | 448.0 | 401.2 | ||||||
Total current liabilities | 678.8 | 606.9 | ||||||
Other long-term liabilities | 322.2 | 348.3 | ||||||
Long-term debt | 100.9 | 81.6 | ||||||
Total Liabilities | 1,101.9 | 1,036.8 | ||||||
Commitments and Contingencies (Note 11) | ||||||||
Minority interest | 2.6 | 2.3 | ||||||
Stockholders’ Equity: | ||||||||
Common stock, $0.01 par value, one billion shares authorized, 248.5 million in 2006 (247.8 million in 2005) issued and outstanding | 2.5 | 2.5 | ||||||
Paid-in capital | 2,700.8 | 2,601.1 | ||||||
Retained earnings | 2,523.9 | 1,934.0 | ||||||
Accumulated other comprehensive income | 211.8 | 149.3 | ||||||
Treasury stock, 10.0 million shares in 2006 (59,200 in 2005) | (635.0 | ) | (4.1 | ) | ||||
Total Stockholders’ Equity | 4,804.0 | 4,682.8 | ||||||
Total Liabilities and Stockholders’ Equity | $ | 5,908.5 | $ | 5,721.9 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
4
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
(In millions, unaudited)
For the Nine Months | ||||||||
Ended September 30, | ||||||||
2006 | 2005 | |||||||
Cash flows provided by (used in) operating activities: | ||||||||
Net earnings | $ | 589.8 | $ | 532.9 | ||||
Adjustments to reconcile net earnings to cash provided by operating activities: | ||||||||
Depreciation and amortization | 144.8 | 136.0 | ||||||
Share-based payment expense | 56.0 | — | ||||||
Inventorystep-up | — | 4.6 | ||||||
Income tax benefit from stock option exercises | 5.8 | 33.8 | ||||||
Excess income tax benefit from stock option exercises | (3.7 | ) | — | |||||
Changes in operating assets and liabilities: | ||||||||
Income taxes | 67.6 | 77.7 | ||||||
Receivables | (47.9 | ) | (38.8 | ) | ||||
Inventories | (34.5 | ) | (75.6 | ) | ||||
Accounts payable and accrued expenses | 22.7 | (30.9 | ) | |||||
Other assets and liabilities | (7.0 | ) | (12.0 | ) | ||||
Net cash provided by operating activities | 793.6 | 627.7 | ||||||
Cash flows provided by (used in) investing activities: | ||||||||
Additions to instruments | (93.0 | ) | (129.6 | ) | ||||
Additions to other property, plant and equipment | (84.4 | ) | (65.5 | ) | ||||
Proceeds from sale of property, plant and equipment | 16.2 | — | ||||||
Implex acquisition, net of acquired cash | (8.5 | ) | — | |||||
Other, net | (5.0 | ) | (9.7 | ) | ||||
Net cash used in investing activities | (174.7 | ) | (204.8 | ) | ||||
Cash flows provided by (used in) financing activities: | ||||||||
Proceeds from employee stock compensation plans | 25.4 | 75.1 | ||||||
Excess income tax benefit from stock option exercises | 3.7 | — | ||||||
Repurchase of common stock | (630.9 | ) | — | |||||
Net proceeds on lines of credit | 18.8 | (5.3 | ) | |||||
Payments on term loan | — | (550.0 | ) | |||||
Debt issuance costs | — | (1.9 | ) | |||||
Net cash used in financing activities | (583.0 | ) | (482.1 | ) | ||||
Effect of exchange rates on cash and equivalents | 6.5 | (3.6 | ) | |||||
Increase (decrease) in cash and equivalents | 42.4 | (62.8 | ) | |||||
Cash and equivalents, beginning of year | 233.2 | 154.6 | ||||||
Cash and equivalents, end of period | $ | 275.6 | $ | 91.8 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
5
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
1. | Basis of Presentation |
The financial data presented herein is unaudited and should be read in conjunction with the consolidated financial statements and accompanying notes included in the 2005 Annual Report onForm 10-K filed by Zimmer Holdings, Inc. In the opinion of management, the accompanying unaudited consolidated financial statements include all adjustments necessary for a fair statement of the financial position, results of operations and cash flows for the interim periods presented. Results for interim periods should not be considered indicative of results for the full year.
The words “we”, “us”, “our” and similar words refer to Zimmer Holdings, Inc. and its subsidiaries. Zimmer Holdings refers to the parent company only.
2. | Share-Based Payment |
We adopted Statement of Financial Accounting Standard (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) effective January 1, 2006. SFAS 123(R) is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123(R) requires the recognition of the fair value of share-based payments in net earnings over the related service period. Our share-based payments primarily consist of stock options, equity share units and an employee stock purchase plan. We did not grant any equity share units until 2006. Prior to January 1, 2006, we accounted for share-based payments under APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations (“APB 25”). Under APB 25, share-based payment expense was not significant because the exercise price of the stock options generally equaled the market price of the underlying stock on the measurement date of the stock options and no equity share units had been awarded. No share-based payment expense was reflected in net income for the employee stock purchase plan under the provisions of APB 25, as the employee purchase price discount met the acceptable thresholds under Section 423 of the Internal Revenue Code.
We had three stock option plans in effect at September 30, 2006: the 2006 Stock Incentive Plan (the “2006 Plan”), the TeamShare Stock Option Plan and the Stock Plan for Non-Employee Directors. The 2006 Plan was adopted by the Board of Directors on February 17, 2006 and became effective on May 1, 2006. The 2006 Plan replaced the 2001 Stock Incentive Plan (the “2001 Plan”), which by its term expired on August 5, 2006. Following stockholder approval of the 2006 Plan, no further grants were made under the 2001 Plan. We have reserved the maximum number of shares of common stock available for award under the terms of each of these plans and have registered 42.9 million shares of common stock. The 2006 Plan provides for the grant of nonqualified stock options and incentive stock options, long-term performance awards, restricted stock awards, equity share units and stock appreciation rights. The Compensation and Management Development Committee of the Board of Directors determines the grant date for annual grants under our stock option plans. Consistent with previous annual grants under the 2001 Plan, the measurement date for annual grants under the 2006 Plan to our executive officers is expected to occur within a relatively narrow time period in the first quarter of each year. The TeamShare Stock Option Plan provides for the grant of non-qualified stock options and, in certain jurisdictions, stock appreciation rights, while the Stock Plan for Non-Employee Directors provides for awards of stock options, restricted stock and restricted stock units to non-employee directors. It has been our practice to issue shares of common stock upon exercise of stock options from previously unissued shares.
The total number of awards which may be granted in a given yearand/or over the life of the plan under each of our stock option plans is limited.
We have elected the modified prospective method for adopting SFAS 123(R). Under the modified prospective method, the provisions of SFAS 123(R) apply to all share-based payments granted or modified after the date of adoption. For share-based payments granted prior to the date of the adoption, the unrecognized expense related to the unvested portion at the date of adoption will be recognized in net earnings under the grant date fair value provisions used for our pro forma disclosures under SFAS 123. In the three and nine month periods ended
6
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
September 30, 2006, share-based payment expense was $17.0 million and $56.0 million, or $12.2 million and $40.2 million net of the related tax benefits, respectively. Share-based payment expense for the three and nine month periods ended September 30, 2005 under APB 25 was not significant. The following is the pro forma expense disclosure under SFAS 123 for the three and nine month periods ended September 30, 2005 (in millions, except per share amounts):
Three Months | Nine Months | |||||||
Ended | Ended | |||||||
September 30, | September 30, | |||||||
2005 | 2005 | |||||||
Net earnings, as reported | $ | 168.6 | $ | 532.9 | ||||
Deduct: Total share-based payment expense determined under SFAS 123 for all awards, net of tax | (9.9 | ) | (35.7 | ) | ||||
Pro forma net earnings | $ | 158.7 | $ | 497.2 | ||||
Earnings per share: | ||||||||
Basic — as reported | $ | 0.68 | $ | 2.16 | ||||
Basic — pro forma | 0.64 | 2.01 | ||||||
Diluted — as reported | 0.67 | 2.13 | ||||||
Diluted — pro forma | 0.63 | 1.99 |
Prior to adopting SFAS 123(R), we classified all tax benefits of deductions resulting from the exercise of non-qualified stock options as operating cash flows. SFAS 123(R) requires the cash flows resulting from excess tax benefits (i.e., tax deductions realized for stock options exercised in excess of the tax benefit recognized on the related share-based payment expense) to be classified as financing cash flows.
Stock options
Stock options granted to date under our plans generally vest over four years, although in no event in less than one year, and expire ten years from the date of grant. Stock options are granted with an exercise price equal to the market price of our common stock on the date of grant, except in limited circumstances where local law may dictate otherwise.
We use a Black-Scholes option-pricing model to determine the fair value of our stock options. For stock options granted during the nine month period ended September 30, 2006, expected volatility was derived from the implied volatility of our traded options that were actively traded around the grant date of the stock options with exercise prices similar to the stock options and maturities of over one year. In periods prior to January 1, 2006, we generally estimated volatility based upon historical volatility of our common stock. The change in determining the expected volatility assumption was based upon our traded options with maturities over one year being more actively traded than in the past along with the guidance provided by the Securities and Exchange Commission in Staff Accounting Bulletin No. 107. The expected term of the stock options has been derived from historical employee exercise behavior. The risk-free interest rate is determined using the implied yield currently available for zero-coupon U.S. government issues with a remaining term equal to the expected life of the options. A dividend yield of zero percent has been used as we have not paid a dividend since becoming a public company in 2001.
7
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The weighted-average fair values of the options granted in the nine month periods ended September 30, 2006 and 2005 were $22.32 and $28.19 per option, respectively, determined using the following assumptions:
Nine Months | ||||||||
Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Dividend Yield | 0.0 | % | 0.0 | % | ||||
Volatility | 25.7 | % | 30.2 | % | ||||
Risk-free interest rate | 4.5 | % | 4.1 | % | ||||
Expected life (years) | 5.1 | 5.3 |
A summary of stock option activity for the nine month period ended September 30, 2006, is as follows (options in thousands):
Stock | Weighted Average | |||||||
Options | Exercise Price | |||||||
Outstanding at January 1, 2006 | 12,562 | $ | 55.66 | |||||
Options granted | 3,407 | 69.20 | ||||||
Options exercised | (542 | ) | 25.79 | |||||
Options forfeited or expired | (503 | ) | 56.12 | |||||
Outstanding at September 30, 2006 | 14,924 | $ | 59.04 | |||||
The total intrinsic value of stock options exercised during the nine month periods ended September 30, 2006 and 2005 were $19.5 million and $107.4 million, respectively. In the three and nine month periods ended September 30, 2006, share-based payment expense related to stock options was $16.0 million and $47.6 million, or $11.5 million and $34.3 million net of the related tax benefits, respectively. The expense related to stock options represents the impact of adopting SFAS 123(R).
Summarized information about outstanding stock options as of September 30, 2006, that are already vested and those that we expect to vest, as well as stock options that are currently exercisable, is as follows:
Outstanding Stock | ||||||||
Options Already | Options | |||||||
Vested and Expected | that are | |||||||
to Vest* | Exercisable | |||||||
Number of outstanding options (in thousands) | 14,213 | 7,390 | ||||||
Weighted average remaining contractual life | 7.1 years | 5.7 years | ||||||
Weighted average exercise price per share | $ | 58.38 | $ | 46.93 | ||||
Intrinsic value (in millions) | $ | 182.4 | $ | 168.5 |
* | Includes effects of estimated forfeitures |
As of September 30, 2006, there was $105.0 million of unrecognized share-based payment expense related to nonvested stock options granted under our plans. That expense is expected to be recognized over a weighted average period of 2.6 years.
Equity Share Units
Our equity share units generally will vest at the end of the three year period ending December 31, 2008. Each equity share unit will be converted into one share of our common stock upon vesting. The number of equity share units that will be awarded, if any, varies depending on the achievement of certainearnings-per-share targets over the three year period.
8
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
A summary of nonvested equity share units activity for the nine month period ended September 30, 2006 is as follows (units in thousands):
Weighted Average | ||||||||
Equity | Grant Date | |||||||
Share Units | Fair Value | |||||||
Outstanding at January 1, 2006 | — | $ | — | |||||
Granted | 930 | 67.86 | ||||||
Forfeited | (25 | ) | 67.86 | |||||
Outstanding at September 30, 2006 | 905 | $ | 67.86 | |||||
The fair value of the equity share units was determined based upon the fair market value of our common stock on the date of grant. SFAS 123(R) requires us to estimate the number of equity share units that will vest, and recognize share-based payment expense on a straight line basis over the requisite service period. As of September 30, 2006, we estimate that approximately 446,800 equity share units will vest. If our estimate were to change in the future, the cumulative effect of the change in estimate will be recorded in that period. Based upon the number of equity share units that we expect to vest, the unrecognized share-based payment expense as of September 30, 2006 was $22.6 million, and is expected to be recognized over a period of 2.25 years. In the three and nine month periods ended September 30, 2006, pre-tax expense related to equity share units was $1.0 million and $8.4 million, respectively.
3. | Inventories |
September 30, | December 31, | |||||||
2006 | 2005 | |||||||
(In millions) | ||||||||
Finished goods | $ | 475.7 | $ | 444.0 | ||||
Work in progress | 56.0 | 40.1 | ||||||
Raw materials | 99.2 | 99.6 | ||||||
Inventories, net | $ | 630.9 | $ | 583.7 | ||||
As of September 30, 2006, we have capitalized approximately $8.9 million of share-based payment expense as part of the cost of inventory, which will be recognized as the related inventory is sold.
4. | Property, Plant and Equipment |
September 30, | December 31, | |||||||
2006 | 2005 | |||||||
(In millions) | ||||||||
Land | $ | 17.6 | $ | 20.7 | ||||
Buildings and equipment | 761.8 | 706.5 | ||||||
Instruments | 733.6 | 649.2 | ||||||
Construction in progress | 72.9 | 61.4 | ||||||
1,585.9 | 1,437.8 | |||||||
Accumulated depreciation | (834.8 | ) | (729.0 | ) | ||||
Property, plant and equipment, net | $ | 751.1 | $ | 708.8 | ||||
9
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
5. | Integration Liability |
In connection with our acquisition of Centerpulse AG (“Centerpulse”), we recorded a $75.7 million integration liability consisting of $53.1 million of employee termination and relocation costs and $22.6 million of sales agent and lease contract termination costs. Increases to the liability subsequent to the completion of the purchase price allocation period were expensed in the financial statements, and were not significant. Reductions in the liability subsequent to the completion of the allocation period were recorded as adjustments to goodwill.
Our integration plan covers all functional business areas, including sales force, research and development, manufacturing and administrative. Approximately 830 Centerpulse employees were expected to be terminated through our integration plan. As of September 30, 2006, practically all had been involuntarily terminated. The vast majority of our integration plan was complete at the end of 2005. Reconciliation of the integration liability, as of September 30, 2006, is as follows (in millions):
Employee | ||||||||||||
Termination | ||||||||||||
and Relocation | Contract | |||||||||||
Costs | Terminations | Total | ||||||||||
Balance, Closing Date | $ | 53.1 | $ | 22.6 | $ | 75.7 | ||||||
Cash Payments | (20.7 | ) | (0.2 | ) | (20.9 | ) | ||||||
Balance, December 31, 2003 | 32.4 | 22.4 | 54.8 | |||||||||
Cash Payments | (20.5 | ) | (2.3 | ) | (22.8 | ) | ||||||
Additions/(Reductions), net | 3.7 | (11.8 | ) | (8.1 | ) | |||||||
Balance, December 31, 2004 | 15.6 | 8.3 | 23.9 | |||||||||
Cash Payments | (8.8 | ) | (2.4 | ) | (11.2 | ) | ||||||
Additions/(Reductions), net | (0.3 | ) | (1.1 | ) | (1.4 | ) | ||||||
Balance, December 31, 2005 | 6.5 | 4.8 | 11.3 | |||||||||
Cash Payments | (4.5 | ) | (2.2 | ) | (6.7 | ) | ||||||
Additions/(Reductions), net | (0.5 | ) | 0.1 | (0.4 | ) | |||||||
Balance, September 30, 2006 | $ | 1.5 | $ | 2.7 | $ | 4.2 | ||||||
6. | Comprehensive Income |
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Net Earnings | $ | 183.3 | $ | 168.6 | $ | 589.8 | $ | 532.9 | ||||||||
Other Comprehensive Income (Loss): | ||||||||||||||||
Foreign currency cumulative translation adjustments | 15.2 | 2.0 | 101.7 | (150.3 | ) | |||||||||||
Unrealized foreign currency hedge gains (losses), net of tax | (6.4 | ) | (1.6 | ) | (41.1 | ) | 45.7 | |||||||||
Reclassification adjustments on foreign currency hedges, net of tax | 2.0 | 4.6 | 5.7 | 24.1 | ||||||||||||
Unrealized gains (losses) on securities, net of tax | (1.0 | ) | (0.7 | ) | (1.7 | ) | (2.1 | ) | ||||||||
Minimum pension liability, net of tax | (0.1 | ) | — | (2.1 | ) | — | ||||||||||
Total Other Comprehensive Income (Loss) | 9.7 | 4.3 | 62.5 | (82.6 | ) | |||||||||||
Comprehensive Income | $ | 193.0 | $ | 172.9 | $ | 652.3 | $ | 450.3 | ||||||||
10
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
7. | Retirement and Postretirement Benefit Plans |
We have defined benefit pension plans covering certain U.S. and Puerto Rico employees who were hired before September 2, 2002. Employees hired after September 2, 2002 are not part of the U.S. and Puerto Rico defined benefit plans, but do receive additional benefits under our defined contribution plans. Plan benefits are primarily based on years of credited service and the participant’s compensation. In addition to the U.S. and Puerto Rico defined benefit pension plans, we sponsor variousnon-U.S. pension arrangements, including retirement and termination benefit plans required by local law or coordinated with government sponsored plans.
We also provide comprehensive medical and group life insurance benefits to certain U.S. and Puerto Rico retirees who elect to participate in our comprehensive medical and group life plans. The medical plan is contributory, and the life insurance plan is non-contributory. Employees hired after September 2, 2002 are not eligible for retiree medical and life insurance benefits. No similar plans exist for employees outside the U.S. and Puerto Rico.
The components of net pension expense for the three and nine month periods ended September 30, 2006 and 2005, for our defined benefit retirement plans are as follows (in millions):
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Service cost | $ | 6.0 | $ | 5.3 | $ | 17.7 | $ | 15.5 | ||||||||
Interest cost | 3.1 | 2.7 | 9.2 | 7.9 | ||||||||||||
Expected return on plan assets | (3.8 | ) | (3.4 | ) | (11.0 | ) | (9.4 | ) | ||||||||
Amortization of prior service cost | — | (0.1 | ) | — | (0.1 | ) | ||||||||||
Amortization of unrecognized actuarial loss | 1.0 | 0.9 | 2.9 | 2.1 | ||||||||||||
Net periodic benefit cost | $ | 6.3 | $ | 5.4 | $ | 18.8 | $ | 16.0 | ||||||||
The components of net periodic benefit expense for the three and nine month periods ended September 30, 2006 and 2005, for our postretirement benefit plans are as follows (in millions):
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Service cost | $ | 0.4 | $ | 0.4 | $ | 1.3 | $ | 1.2 | ||||||||
Interest cost | 0.5 | 0.5 | 1.6 | 1.5 | ||||||||||||
Amortization of prior service cost | (0.1 | ) | — | (0.2 | ) | — | ||||||||||
Amortization of unrecognized actuarial loss | 0.2 | 0.1 | 0.6 | 0.3 | ||||||||||||
Net periodic benefit cost | $ | 1.0 | $ | 1.0 | $ | 3.3 | $ | 3.0 | ||||||||
We contributed $20 million during the nine month period ended September 30, 2006, to our U.S. and Puerto Rico defined benefit plans. We contributed $8 million to our foreign based defined benefit plans in the nine month period ended September 30, 2006, and expect to contribute an additional $2 million to these foreign based plans during 2006. Contributions for the U.S. and Puerto Rico postretirement benefit plans are not expected to be significant.
11
ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
8. | Earnings Per Share |
The following is a reconciliation of weighted average shares for the basic and diluted shares computations (in millions):
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Weighted average shares outstanding for basic net earnings per share | 240.4 | 247.4 | 244.6 | 246.8 | ||||||||||||
Effect of dilutive stock options | 2.2 | 2.8 | 2.2 | 2.9 | ||||||||||||
Weighted average shares outstanding for diluted net earnings per share | 242.6 | 250.2 | 246.8 | 249.7 | ||||||||||||
During the three and nine month periods ended September 30, 2006, an average of 8.6 million and 8.8 million options to purchase shares of common stock, respectively, were not included in the computation of diluted earnings per share as the exercise prices of these options were greater than the average market price of the common stock. During the three and nine month periods ended September 30, 2005, an average of 2.2 million and 1.6 million options to purchase shares of common stock, respectively, were not included.
9. | Segment Information |
We design, develop, manufacture and market reconstructive orthopaedic implants, including joint and dental, spinal implants, trauma products and related orthopaedic surgical products which include surgical supplies and instruments designed to aid in orthopaedic surgical procedures and post-operation rehabilitation. We also provide hospital-focused consulting services to help member institutions design, implement and manage successful orthopaedic programs of distinction. We manage operations through three major geographic segments — the Americas, which is comprised principally of the United States and includes other North, Central and South American markets; Europe, which is comprised principally of Europe and includes the Middle East and Africa; and Asia Pacific, which is comprised primarily of Japan and includes other Asian and Pacific markets. This structure is the basis for our reportable segment information discussed below. Management evaluates operating segment performance based upon segment operating profit exclusive of operating expenses pertaining to global operations and corporate expenses, share-based payment expense, acquisition, integration and other expenses, inventory step-up, in-process research and development write-offs and intangible asset amortization expense. Global operations include research, development engineering, medical education, brand management, corporate legal, finance, and human resource functions, and U.S. and Puerto Rico based manufacturing operations and logistics. Intercompany transactions have been eliminated from segment operating profit.
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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Net sales and segment operating profit are as follows (in millions):
Net Sales | Operating Profit | |||||||||||||||
Three Months | Three Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Americas | $ | 502.4 | $ | 473.3 | $ | 265.1 | $ | 251.4 | ||||||||
Europe | 196.9 | 178.0 | 69.8 | 60.4 | ||||||||||||
Asia Pacific | 120.5 | 111.2 | 54.3 | 48.4 | ||||||||||||
Total | $ | 819.8 | $ | 762.5 | ||||||||||||
Share-based payment expense | (17.0 | ) | — | |||||||||||||
Inventorystep-up | — | (0.5 | ) | |||||||||||||
Acquisition, integration and other | (5.0 | ) | (7.7 | ) | ||||||||||||
Global operations and corporate functions | (112.7 | ) | (111.4 | ) | ||||||||||||
Operating profit | $ | 254.5 | $ | 240.6 | ||||||||||||
Net Sales | Operating Profit | |||||||||||||||
Nine Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Americas | $ | 1,539.3 | $ | 1,448.4 | $ | 815.3 | $ | 760.4 | ||||||||
Europe | 664.0 | 640.7 | 267.4 | 225.4 | ||||||||||||
Asia Pacific | 358.5 | 348.7 | 168.8 | 155.1 | ||||||||||||
Total | $ | 2,561.8 | $ | 2,437.8 | ||||||||||||
Share-based payment expense | (54.8 | ) | — | |||||||||||||
Inventorystep-up | — | (4.6 | ) | |||||||||||||
Acquisition, integration and other | (9.5 | ) | (34.7 | ) | ||||||||||||
Global operations and corporate functions | (360.3 | ) | (327.6 | ) | ||||||||||||
Operating profit | $ | 826.9 | $ | 774.0 | ||||||||||||
Product category net sales are as follows (in millions):
Three Months | Nine Months | |||||||||||||||
Ended | Ended | |||||||||||||||
September 30, | September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Reconstructive implants | $ | 676.0 | $ | 624.4 | $ | 2,127.3 | $ | 2,018.7 | ||||||||
Trauma | 48.4 | 44.3 | 144.2 | 134.1 | ||||||||||||
Spine | 42.2 | 38.4 | 131.3 | 117.8 | ||||||||||||
Orthopaedic surgical products & other | 53.2 | 55.4 | 159.0 | 167.2 | ||||||||||||
Total | $ | 819.8 | $ | 762.5 | $ | 2,561.8 | $ | 2,437.8 | ||||||||
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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
10. | Stock Repurchase Program |
In December 2005, the Board of Directors authorized a stock repurchase program of up to $1 billion through December 31, 2007. During the three and nine months ended September 30, 2006, respectively, we repurchased 4,793,700 shares of common stock at an average price of $65.60 for a total cash outlay of $314.5 million, and 9,892,300 shares of common stock at an average price of $63.76 for a total cash outlay of $630.7 million.
11. | Commitments and Contingencies |
As a result of the Centerpulse transaction, we acquired the entity involved in Centerpulse’s hip and knee implant litigation matter. The litigation was a result of a voluntary recall of certain hip and knee implants manufactured and sold by Centerpulse. On March 13, 2002, a U.S. Class Action Settlement Agreement (“Settlement Agreement”) was entered into by Centerpulse that resolved U.S. claims related to the affected products and a settlement trust (“Settlement Trust”) was established and funded for the most part by Centerpulse. The court approved the settlement arrangement on May 8, 2002. Under the terms of the Settlement Agreement, we will reimburse the Settlement Trust a specified amount for each revision surgery over 4,000 and revisions on reprocessed shells over 64. As of October 2, 2006, the claims administrator has received 4,133 likely valid claims for hips (cut-off date June 5, 2003) and knees (cut-off date November 17, 2003) and 200 claims for reprocessed shells (cut-off date September 8, 2004). We believe the litigation liability recorded as of September 30, 2006 is adequate to provide for any future claims regarding the hip and knee implant litigation.
On February 15, 2005, Howmedica Osteonics Corp. (“Howmedica”) filed an action against us and an unrelated party in the United States District Court for the District of New Jersey alleging infringement by the defendants of U.S. Patent Nos. 6,174,934; 6,372,814; 6,664,308; and 6,818,020. Howmedica’s complaint seeks unspecified damages and injunctive relief. On April 14, 2005, we filed our answer to the complaint denying Howmedica’s allegations. Discovery is ongoing. We believe that our defenses are valid and meritorious and we intend to defend the Howmedica lawsuit vigorously.
We are also subject to product liability and other claims and lawsuits arising in the ordinary course of business, for which we maintain insurance, subject to self-insured retention limits. We establish accruals for product liability and other claims in conjunction with outside counsel based on current information and historical settlement information for open claims, related fees and for claims incurred but not reported. While it is not possible to predict with certainty the outcome of these cases, it is the opinion of management that, upon ultimate resolution, these cases will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.
In July 2003, the Staff of the Securities and Exchange Commission informed Centerpulse that it was conducting an informal investigation of Centerpulse relating to certain accounting issues. We are continuing to fully cooperate with the Securities and Exchange Commission in this matter.
In March 2005, we received a subpoena and we have received supplemental requests since that time from the United States Department of Justice through the United States Attorney’s Office in Newark, New Jersey, requesting that we produce documents and related information for the period beginning January 1998 pertaining to consulting contracts, professional service agreements and other agreements by which we may provide remuneration to orthopaedic surgeons, including research and other grant agreements. We are cooperating fully with federal authorities with regard to this matter. We understand that similar inquiries were directed to at least four other companies in the orthopaedics industry.
In June 2006, we received a subpoena from the United States Department of Justice, Antitrust Division, requesting that we produce documents for the period beginning January 2001 through June 2006, pertaining to an investigation of possible violations of federal criminal law, including possible violations of the antitrust laws, involving the manufacture and sale of orthopaedic implant devices. We are cooperating fully with federal authorities with regard to this matter. We understand that similar inquiries were directed to at least four other companies in the orthopaedics industry.
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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Following the commencement of the Department of Justice, Antitrust Division’s investigation, we and several other major orthopaedic manufacturers have been named as defendants in six putative class action lawsuits as of October 27, 2006. These lawsuits were brought by direct and indirect purchasers of orthopaedic products alleging violations of Federal and state antitrust laws and certain state consumer protection statutes. In each of these lawsuits, the plaintiffs allege that the defendants engaged in a conspiracy to fix prices of orthopaedic implant devices. The direct purchaser cases,South Central Surgical Center, LLC v. Zimmer Holdings, Inc. et al. andChaiken DDS, P.C. v. Biomet, Inc. et al., were filed in the United States District Court for the Southern District of Indiana on July 13, 2006 and in the United States District Court for the Northern District of Indiana on July 26, 2006, respectively. The indirect purchaser cases,Morganti v. Johnson & Johnson et al.,Thomas v. Biomet, Inc. et al.,Kirschner v. Biomet, Inc. et al. andWilliams v. Biomet, Inc. et al., were filed in the United States District Court for the District of New Jersey on July 19, 2006 and in the United States District Court for the Western District of Tennessee on July 18, 2006, July 24, 2006 and July 27, 2006, respectively. In all of these cases, the plaintiffs seek damages of unspecified amounts, in some cases to be trebled under applicable law, attorneys’ fees and injunctive or other unspecified relief. We believe these lawsuits are without merit and we intend to defend them vigorously.
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Overview
We are a global leader in the design, development, manufacture and marketing of reconstructive orthopaedic implants, including joint and dental, spinal implants, trauma products and related orthopaedic surgical products (sometimes referred to in this report as “OSP”). We also provide hospital-focused consulting services to help member institutions design, implement and manage successful orthopaedic programs of distinction. Reconstructive orthopaedic implants restore joint function lost due to disease or trauma in joints such as knees, hips, shoulders and elbows. Dental reconstructive implants restore function and aesthetics in patients that have lost teeth due to trauma or disease. Spinal implants are utilized by orthopaedic surgeons and neurosurgeons in the treatment of degenerative diseases, deformities and trauma in all regions of the spine. Trauma products are devices used primarily to reattach or stabilize damaged bone and tissue to support the body’s natural healing process. OSP include supplies and instruments designed to aid in orthopaedic surgical procedures and post-operation rehabilitation. Through our consulting services, we can provide hospitals and other orthopaedic practices resource capabilities in the areas of business development, marketing, in/outpatient rehab practice, clinical pathways, care mapping and space design, community relations, customer service, delivery models, cost accounting, staff utilization and more in order to improve their profit environment. We have operations in more than 24 countries and market products in more than 100 countries. We manage operations through three reportable geographic segments — the Americas, Europe and Asia Pacific.
Certain percentages presented in Management’s Discussion and Analysis are calculated from the underlying whole-dollar amounts and therefore may not recalculate from the rounded numbers used for disclosure purposes.
We believe the following developments or trends are important in understanding our financial condition, results of operations and cash flows for the three and nine month periods ended September 30, 2006.
Demand (Volume and Mix) Trends
Increased volume and changes in the mix of product sales contributed 7 percentage points of sales growth during the three month period ended September 30, 2006, compared to 8 percentage points in the same 2005 period. We believe the market for orthopaedic procedure volume on a global basis continues to rise at mid single digit rates driven by an aging global population, obesity, proven clinical benefits, new material technologies, advances in surgical techniques (such as ourMinimally Invasive Solutionstm [MIStm] Procedures and Technologies) and more active lifestyles, among other factors. In addition, the continued shift in demand to premium products, such asLongevity®,Durasul®andProlongtm Highly Crosslinked Polyethylenes,Trabecular Metaltm Technology products, high-flex knees, knee revision products and porous hip stems, continue to positively affect sales growth. For example, during the three month period ended September 30, 2006, sales of products incorporatingTrabecular MetalTechnology were approximately $43 million, an increase of over 46 percent compared to the same 2005 period. We believe sales growth contributed from volume and mix has declined from the prior year due to lower new product mix in the quarter compared to the prior year.
We believe innovative products will continue to affect the orthopaedics industry. In May 2006, we announced the 510(k) clearance by the U.S. Food and Drug Administration of theNexGen®Gender Solutionstm High-Flex Knee Femoral Implant, which was the result of five years of intensive research based on an analysis of 800 female femurs and patella. We believe this is the first knee implant system designed specifically to address the unique anatomical needs of women. While today’s knee implants have a high rate of success, we believe this design may reduce real instances of pain and post-surgical dissatisfaction among women. We began a limited release to the design surgeons of theGender SolutionsHigh-Flex Knee Femoral Implant during the second quarter. This product will become more widely available in the United States in the fourth quarter of 2006 and throughout 2007.
Pricing Trends
Selling prices were slightly favorable during the three month period ended September 30, 2006, compared to a 1 percent increase in the same 2005 period. The Americas experienced a 2 percent increase in selling prices during the three month period ended September 30, 2006, as compared to a 1 percent increase in the same 2005 period. In
16
Europe, selling prices for the three month period ended September 30, 2006 decreased 1 percent, which is similar to the same 2005 period. Within Europe, Germany and the United Kingdom experienced 3 and 7 percent decreases in selling prices in the three month period ended September 30, 2006, as a result of reductions in government implant reimbursement rates and group purchasing arrangements. Germany and the United Kingdom combined represent approximately 9 percent of our sales. Asia Pacific selling prices had a negative 3 percent effect on segment sales for the three month period ended September 30, 2006, compared to a 1 percent increase in the same 2005 period. The primary reason for these reduced prices was the reduction in Japanese reimbursement rates that became effective April 1, 2006. Japan represents approximately 8 percent of our sales. Due to this change in reimbursement rates, we expect Japanese selling price growth to be negative throughout the remainder of the year when compared to the same periods in the prior year. We estimate this reduction will affect Japan sales negatively by approximately 4 percent for the year ending December 31, 2006. Despite continuing governmental healthcare cost containment efforts and group purchasing organizations focus, we have been able to realize positive pricing in certain markets. Consequently, we estimate global sales growth could be flat to slightly positive in the year ending December 31, 2006 due to changes in selling prices.
Foreign Currency Exchange Rates
For the three month period ended September 30, 2006, foreign currency exchange rates had a positive 1 percent effect on sales. We estimate that overall weaker foreign currency exchange rates will have a negative effect of approximately 1 percent on sales for the year ending December 31, 2006. We address currency risk through regular operating and financing activities, and under appropriate circumstances and subject to proper authorization, through the use of forward contracts solely for managing foreign currency volatility and risk. Changes to foreign currency exchange rates affect sales growth, but due to offsetting gains/losses on hedge contracts, which are recorded in cost of products sold, the effect on net earnings in the near term is expected to be minimal.
New Product Sales
New products, which management defines as products or stock keeping units (“SKU’s”) introduced within the prior36-month period to a particular market, accounted for 24 percent, or $199.0 million, of our sales during the three month period ended September 30, 2006. Adoption rates for new technologies are a key indicator of industry performance. Our sales have grown with the introduction of new products, such asTrabecular MetalModular Acetabular Cups, certain SKU’s of theNexGen®Complete Knee Solution for the LPS, LPS-Flex, and CR-Flex Knees, theDynesys®1Dynamic Stabilization System, theZimmer® M/L Taper Stem andPALACOS®2 Bone Cement.
We believe new products in our current pipeline should continue to favorably affect our operating performance. Other new products we expect to contribute to new product sales in 2006 include products incorporatingTrabecular MetalTechnology, including theTrabecular MetalPrimary Hip Prosthesis,Trabecular MetalAcetabular Revision System andTrabecular Metal Spine Components;Durom® Acetabular Cups withMetasul®Metal-on-MetalLDHtm Large Diameter Heads;Epoch® II Hip Prosthesis;Trilogy AB®Ceramic-on-Ceramic Acetabular System;ZimmerReverse Shoulder System,Anatomical Shouldertm Inverse/Reverse Shoulder System;Zimmer®MIS Femoral Nailing Solutions;NCB® Plating System;CopiOstm Bone Void Filler3 and theGender SolutionsHigh-Flex Knee Femoral Implant, which will become more widely available towards the end of 2006 and into 2007.
1 TheDynesysDynamic Stabilization Spinal System is indicated for use as an adjunct to fusion in the U.S.
2 PALACOS® is a trademark of Heraeus Kulzer GmbH. Under license from Heraeus Kulzer GmbH, Hanau, Germany.
3 Manufactured by Kensey Nash Corporation.
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New Accounting Pronouncements
On January 1, 2006, we adopted SFAS 123(R). We adopted this accounting standard using the modified prospective method and will not restate prior periods. The following is share-based payment expense recorded for the three and nine month periods ended September 30, 2006 (in millions, except per share amounts):
Three Months | Nine Months | |||||||
Ended | Ended | |||||||
September 30, 2006 | ||||||||
Share-based payment expense recognized: | ||||||||
Cost of products sold | $ | 2.7 | $ | 6.8 | ||||
Research & development | 2.1 | 6.4 | ||||||
Acquisition, integration and other | — | 1.2 | ||||||
Selling, general and administrative | 12.2 | 41.6 | ||||||
17.0 | 56.0 | |||||||
Related deferred income tax benefit | (4.8 | ) | (15.8 | ) | ||||
Decrease in net earnings | $ | 12.2 | $ | 40.2 | ||||
Decrease in basic and diluted earnings per share | $ | 0.05 | $ | 0.16 |
Our share-based payment expense is primarily derived from awards of stock options and equity share units. We did not grant any equity share units until 2006. Prior to January 1, 2006 under APB 25, share-based payment expense was not significant because the exercise price of the stock options generally equaled the market price of the underlying stock on the measurement date of the stock options and no equity share units had been awarded. We estimate share-based payment expense will reduce diluted earnings per share by $0.22 for the year ending December 31, 2006. However, this is a non-cash expense and will not have an effect on our net cash flows.
Third Quarter Results of Operations
Net Sales by Operating Segment
The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions):
Three Months | ||||||||||||||||||||||||
Ended | ||||||||||||||||||||||||
September 30, | Volume/ | Foreign | ||||||||||||||||||||||
2006 | 2005 | % Inc (Dec) | Mix | Price | Exchange | |||||||||||||||||||
Americas | $ | 502.4 | $ | 473.3 | 6 | % | 4 | % | 2 | % | — | % | ||||||||||||
Europe | 196.9 | 178.0 | 11 | 8 | (1 | ) | 4 | |||||||||||||||||
Asia Pacific | 120.5 | 111.2 | 8 | 14 | (3 | ) | (3 | ) | ||||||||||||||||
$ | 819.8 | $ | 762.5 | 8 | 7 | — | 1 | |||||||||||||||||
“Foreign Exchange” as used in the tables in this report represents the effect of changes in foreign exchange rates on sales growth.
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Net Sales by Product Category
The following table presents net sales by product category and the components of the percentage changes (dollars in millions):
Three Months | ||||||||||||||||||||||||
Ended | ||||||||||||||||||||||||
September 30, | Volume/ | Foreign | ||||||||||||||||||||||
2006 | 2005 | % Inc (Dec) | Mix | Price | Exchange | |||||||||||||||||||
Reconstructive | ||||||||||||||||||||||||
Knees | $ | 338.4 | $ | 313.9 | 8 | % | 6 | % | 1 | % | 1 | % | ||||||||||||
Hips | 277.7 | 260.3 | 7 | 7 | (1 | ) | 1 | |||||||||||||||||
Extremities | 17.7 | 15.0 | 17 | 12 | 4 | 1 | ||||||||||||||||||
Dental | 42.2 | 35.2 | 20 | 15 | 4 | 1 | ||||||||||||||||||
Total | 676.0 | 624.4 | 8 | 7 | — | 1 | ||||||||||||||||||
Trauma | 48.4 | 44.3 | 9 | 8 | 1 | — | ||||||||||||||||||
Spine | 42.2 | 38.4 | 10 | 10 | — | — | ||||||||||||||||||
OSP and other | 53.2 | 55.4 | (4 | ) | (4 | ) | — | — | ||||||||||||||||
Total | $ | 819.8 | $ | 762.5 | 8 | 7 | — | 1 | ||||||||||||||||
TheNexGenComplete Knee Solution product line, including theNexGen LPS-Flex Knee,NexGen Trabecular MetalTibial Components,NexGen MISTibial Components, theNexGenCR-Flex Knee and theNexGenLCCK Revision Knee, led knee sales. In addition, theZimmerUnicompartmental High-Flex Knee and the mobile bearing offering within theInnextm Total Knee System exhibited strong growth.
Growth in porous stems, including theTrabecular MetalPrimary Hip Prosthesis, theZimmerM/L Taper Stem, theCLS®Spotorno® Stem from theCLSHip System,and theAlloclassic®(Zweymüller®)Hip System, led hip stem sales, but were partially offset by weaker sales of cemented primary stems and fracture stems. Due to the distribution agreement we signed to distributePALACOSBone Cement, sales of bone cement used in hip procedures improved significantly.Trabecular MetalAcetabular Cups, theAllofittm Hip Acetabular System andDuromAcetabular Components also had strong growth.
TheBigliani/Flatow® Shoulder Solution and theAnatomical ShoulderSystem led extremities sales. Orthobiologicals and prosthetic implants, including strong growth of theTapered Screw-Vent® Implant System, led dental sales.ZimmerPeriarticular Plates,ZimmerPlates and Screws, theM/DN® Intramedullary Fixation System, theITSTtm Intertrochanteric / Subtrochanteric Fixation System and theSirus® Intramedullary Nail System led trauma sales. TheDynesys Dynamic Stabilization System, theOptima®4 ZS Spinal Fixation System and SpinalTrabecular MetalSpacers led spine sales. OSP sales were negatively affected by the loss of the distribution of theOrthoPAT®5 Autotransfusion System, which contributed approximately $7 million in sales during the three month period ended September 30, 2005. Our exclusive distribution agreement to sell theOrthoPATAutotransfusion System ended and we stopped selling this product after February 28, 2006.
4 Registered Trademark of U&I Corporation.
5 Trademark of Haemonetics Corporation.
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Americas Net Sales
The following table presents Americas net sales (dollars in millions):
Three Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Inc (Dec) | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 224.9 | $ | 212.4 | 6 | % | ||||||
Hips | 141.3 | 130.5 | 8 | |||||||||
Extremities | 12.6 | 11.0 | 14 | |||||||||
Dental | 26.5 | 22.2 | 19 | |||||||||
Total | 405.3 | 376.1 | 8 | |||||||||
Trauma | 29.3 | 27.6 | 6 | |||||||||
Spine | 34.9 | 32.7 | 7 | |||||||||
OSP and other | 32.9 | 36.9 | (11 | ) | ||||||||
Total | $ | 502.4 | $ | 473.3 | 6 | |||||||
America’s sales increased 6 percent, with price contributing 2 percent. TheNexGenComplete Knee Solution product line, including theNexGenLPS-Flex Knee,NexGen Trabecular MetalTibial Components,NexGen MISTibial Components, theNexGenLCCK Revision Knee and theNexGenCR-Flex Knee led knee sales. TheZimmerUnicompartmental High-Flex Knee also made a strong contribution.
Growth in porous stems, including growth of theZimmerM/L Taper Stem, theTrabecular MetalPrimary Hip Prosthesis andAlloclassic(Zweymüller) Hip System, led hip stem sales, but were partially offset by weaker sales of cemented primary stems and fracture stems.PALACOSBone Cement,Trabecular MetalAcetabular Cups andDuromAcetabular Components also exhibited strong growth.
TheBigliani/FlatowShoulder Solution and theAnatomical Shoulder Inverse/Reverse System led extremities sales. TheTapered Screw-VentImplant System led dental sales.ZimmerPeriarticular Plates,ZimmerPlates and Screws and theITSTIntertrochanteric/Subtrochanteric Fixation System led trauma sales. TheDynesysDynamic Stabilization System, theOptimaZS Spinal Fixation System and SpinalTrabecular MetalSpacers led spine sales. OSP sales were negatively affected by the loss of the distribution of theOrthoPAT Autotransfusion System.
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Europe Net Sales
The following table presents Europe net sales (dollars in millions):
Three Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Increase | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 72.0 | $ | 63.8 | 13 | % | ||||||
Hips | 90.0 | 84.8 | 6 | |||||||||
Extremities | 3.9 | 2.6 | 47 | |||||||||
Dental | 9.0 | 8.0 | 13 | |||||||||
Total | 174.9 | 159.2 | 10 | |||||||||
Trauma | 9.6 | 7.9 | 20 | |||||||||
Spine | 5.9 | 4.5 | 32 | |||||||||
OSP and other | 6.5 | 6.4 | 1 | |||||||||
Total | $ | 196.9 | $ | 178.0 | 11 | |||||||
Europe sales were strong in the quarter, increasing 11 percent. Product volume, mix and favorable foreign exchange were the principal contributors to the sales growth. This growth was offset by price of negative 1 percent, which was primarily due to Germany and United Kingdom price decreases. TheNexGen Complete Knee Solution product line, including theNexGenLPS-Flex Knee,NexGen Trabecular MetalTibial Components and theNexGenCR-Flex Knee, theInnexTotal Knee System and theZimmerUnicompartmental High-Flex Knee led knee sales. Growth in porous and revision stems, including theCLS SpotornoStem, led hip stem sales, but was offset by weaker sales of cemented primary stems.LongevityandDurasulHighly Crosslinked Polyethylene Liners,PALACOSBone Cement,DuromAcetabular Components,Trabecular MetalAcetabular Cups and theAllofitHip Acetabular System also made strong contributions to hip sales.
TheAnatomical ShoulderSystem and theAnatomical ShoulderInverse/Reverse System led extremities sales. TheTapered Screw-VentImplant System and theTapered SwissPlus® Implant System led dental sales. TheM/DN Intramedullary Fixation System and theNCBPlating System led trauma sales. TheSilhouettetm Spinal Fixation System6 andTrabecular MetalSpacers led spine sales. Wound management products led OSP sales.
6 TheSilhouetteSpinal Fixation System is licensed from Spinal Innovations, LLC.
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Asia Pacific Net Sales
The following table presents Asia Pacific net sales (dollars in millions):
Three Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Inc (Dec) | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 41.5 | $ | 37.7 | 10 | % | ||||||
Hips | 46.4 | 45.0 | 3 | |||||||||
Extremities | 1.2 | 1.4 | (14 | ) | ||||||||
Dental | 6.7 | 5.0 | 35 | |||||||||
Total | 95.8 | 89.1 | 7 | |||||||||
Trauma | 9.5 | 8.8 | 8 | |||||||||
Spine | 1.4 | 1.2 | 20 | |||||||||
OSP and other | 13.8 | 12.1 | 14 | |||||||||
Total | $ | 120.5 | $ | 111.2 | 8 | |||||||
Asia Pacific sales were strong in the quarter, increasing 8 percent. Product volume and mix were the principal contributors to the sales growth. This growth was offset by price of negative 3 percent, which was primarily due to the change in reimbursement rates in Japan, and foreign exchange of negative 3 percent. TheNexGenComplete Knee Solution product line, includingNexGen Trabecular MetalTibial Components, theNexGenCR-Flex Knee and theNexGen LPS-Flex Knee, led knee sales. The continued conversion to porous stems, including the Fiber Metal Taper Stem from theVerSys®Hip System, led hip stem sales. Sales ofDuromAcetabular Components andTrabecular Metal Acetabular Cups also exhibited strong growth.
Extremities sales declined due to weaker sales of our shoulder and elbow products. TheTapered Screw-VentImplant System led dental sales. TheITST Intertrochanteric / Subtrochanteric Fixation System led trauma sales. TheST360ºtm Spinal Fixation System led spine sales. Powered surgical instruments led OSP sales.
Gross Profit
Gross profit as a percentage of net sales was 77.7 percent in the three month period ended September 30, 2006, compared to 77.1 percent in the same 2005 period. There were no inventorystep-up costs in the three month period ended September 30, 2006, compared to $0.5 million in the same 2005 period. Cost of products sold increased by $2.7 million, or 0.3 percent of sales, for share-based payment expense. A primary contributor to the improvement in gross margin was the effect of changes in foreign exchange rates combined with our hedging program. Under our hedging program, for derivatives which qualify as hedges of future cash flows, the effective portion of changes in fair value is temporarily recorded in other comprehensive income, then recognized in cost of products sold when the hedged item affects earnings.
Operating Expenses
R&D as a percentage of net sales was 5.7 percent for the three month period ended September 30, 2006, compared to 5.8 percent in the same 2005 period. R&D increased to $46.7 million for the three month period ended September 30, 2006, from $43.9 million in the same 2005 period, reflecting increased spending on projects focused on areas of strategic significance, including orthobiologics, and $2.1 million of share-based payment expense. We estimate that nearly two-thirds of our R&D spending relates to innovative products and platforms to improve patient quality of life.
SG&A as a percentage of net sales was 40.3 percent for the three month period ended September 30, 2006, compared to 38.8 percent in the same 2005 period. SG&A increased to $330.4 million for the three month period ended September 30, 2006, from $295.8 million in the same 2005 period. SG&A expenses have increased by
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$12.2 million, or 1.5 percent of sales, for share-based payment expense. Without the share-based payment expense, SG&A expenses as a percentage of sales were consistent with the same period in 2005.
Acquisition, integration and other expenses for the three month period ended September 30, 2006 were $5.0 million compared to $7.7 million in the same 2005 period. The expenses included integration consulting fees, costs for integrating information technology systems and facility relocation.
Operating Profit, Income Taxes and Net Earnings
Operating profit for the three month period ended September 30, 2006 increased 6 percent to $254.5 million, from $240.6 million in the same 2005 period. Increased sales, realized operating expense synergies, controlled operating expenses and decreased acquisition, integration and other expenses drove operating profit. These were partially offset by $17.0 million of share-based payment expense.
The effective tax rate on earnings before income taxes and minority interest decreased to 28.2 percent for the three month period ended September 30, 2006, from 29.2 percent in the same 2005 period. The decrease in the effective tax rate is primarily due to increased profitability in lower tax jurisdictions as well as the effect of anticipated settlement of certain tax contingencies, offset by the negative impact associated with the expiration of the R&D tax credit. In May 2006, the Tax Increase Prevention and Reconciliation Act (TIPRA) was passed. TIPRA impacts us beginning as of January 1, 2006 and we are currently evaluating the tax impacts of the new legislation.
Net earnings increased 9 percent to $183.3 million for the three month period ended September 30, 2006, compared to $168.6 million in the same 2005 period. The increase was primarily due to higher operating profit, net interest income, and a lower effective tax rate. Basic and diluted earnings per share increased 12 percent and 13 percent, respectively, to $0.76, from $0.68 and $0.67, respectively, in the same 2005 period.
Operating Profit by Segment
Management evaluates operating segment performance based upon segment operating profit exclusive of operating expenses pertaining to global operations and corporate expenses, share-based payment expense, acquisition, integration and other expenses, inventory step-up, in-process research and development write-offs and intangible asset amortization expense. Global operations include research, development engineering, medical education, brand management, corporate legal, finance, and human resource functions, and U.S. and Puerto Rico based operations and logistics. Intercompany transactions have been eliminated from segment operating profit. For more information regarding our segments, see Note 9 to the interim consolidated financial statements included elsewhere in thisForm 10-Q.
The following table sets forth operating profit as a percentage of sales by segment for the three month periods ended September 30, 2006 and 2005:
Percent of net sales
Three Months | ||||||||
Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Americas | 52.8 | % | 53.1 | % | ||||
Europe | 35.5 | 33.9 | ||||||
Asia Pacific | 45.1 | 43.5 |
In the Americas, operating profit as a percentage of sales decreased due to increased royalties and inventory obsolescence, which was partially offset by a better mix of products sold and controlled selling, general and administrative spending.
European operating profit as a percentage of net sales increased due to controlled selling, general and administrative spending.
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Asia Pacific operating profit as a percentage of net sales increased due to improved gross margins, offset partially by higher selling, general and administrative spending.
Nine Months Results of Operations
Net Sales by Operating Segment
The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions):
Nine Months | ||||||||||||||||||||||||
Ended | ||||||||||||||||||||||||
September 30, | Volume/ | Foreign | ||||||||||||||||||||||
2006 | 2005 | % Inc (Dec) | Mix | Price | Exchange | |||||||||||||||||||
Americas | $ | 1,539.3 | $ | 1,448.4 | 6 | % | 4 | % | 2 | % | — | % | ||||||||||||
Europe | 664.0 | 640.7 | 4 | 8 | (2 | ) | (2 | ) | ||||||||||||||||
Asia Pacific | 358.5 | 348.7 | 3 | 10 | (2 | ) | (5 | ) | ||||||||||||||||
$ | 2,561.8 | $ | 2,437.8 | 5 | 6 | — | (1 | ) | ||||||||||||||||
Net Sales by Product Category
The following table presents net sales by product category and the components of the percentage changes (dollars in millions):
Nine Months | ||||||||||||||||||||||||
Ended | ||||||||||||||||||||||||
September 30, | Volume/ | Foreign | ||||||||||||||||||||||
2006 | 2005 | % Inc (Dec) | Mix | Price | Exchange | |||||||||||||||||||
Reconstructive | ||||||||||||||||||||||||
Knees | $ | 1,072.8 | $ | 1,015.0 | 6 | % | 7 | % | — | % | (1 | )% | ||||||||||||
Hips | 870.2 | 846.8 | 3 | 5 | — | (2 | ) | |||||||||||||||||
Extremities | 55.6 | 48.6 | 14 | 11 | 4 | (1 | ) | |||||||||||||||||
Dental | 128.7 | 108.3 | 19 | 15 | 4 | — | ||||||||||||||||||
Total | 2,127.3 | 2,018.7 | 5 | 7 | — | (2 | ) | |||||||||||||||||
Trauma | 144.2 | 134.1 | 8 | 7 | 2 | (1 | ) | |||||||||||||||||
Spine | 131.3 | 117.8 | 12 | 12 | — | — | ||||||||||||||||||
OSP and other | 159.0 | 167.2 | (5 | ) | (5 | ) | — | — | ||||||||||||||||
Total | $ | 2,561.8 | $ | 2,437.8 | 5 | 6 | — | (1 | ) | |||||||||||||||
TheNexGenComplete Knee Solution product line, including theNexGen LPS-Flex Knee,NexGen Trabecular MetalTibial Components, theNexGenCR-Flex Knee and theNexGenLCCK Revision Knee, led knee sales. In addition, theZimmerUnicompartmental High-Flex Knee and the mobile bearing system within theInnexTotal Knee System exhibited strong growth.
Growth in porous stems, including theTrabecular MetalPrimary Hip Prosthesis, theZimmerM/L Taper Stem, theCLS SpotornoStem from theCLSHip System,and theAlloclassic (Zweymüller)Hip System, led hip stem sales, but were offset by weaker sales of cemented primary stems. Due to the distribution agreement we signed to distributePALACOSBone Cement, sales of bone cement used in hip procedures improved significantly.Trabecular MetalAcetabular Cups, theAllofitHip Acetabular System andDuromAcetabular Components also had strong growth.
TheBigliani/FlatowShoulder Solution and theAnatomical ShoulderSystem led extremities sales. Orthobiologicals and prosthetic implants, including strong growth of theTapered Screw-VentImplant System, led dental sales.ZimmerPeriarticular Plates,ZimmerPlates and Screws, theM/DNIntramedullary Fixation System, theITST
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Intertrochanteric / Subtrochanteric Fixation System and theSirusIntramedullary Nail System led trauma sales. TheDynesysDynamic Stabilization System, theOptimaZS Spinal Fixation System and SpinalTrabecular MetalSpacers led spine sales. OSP sales were negatively affected by the loss of the distribution of theOrthoPATAutotransfusion System, which contributed approximately $22 million in sales during the nine month period ended September 30, 2005.
Americas Net Sales
The following table presents Americas net sales (dollars in millions):
Nine Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Inc (Dec) | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 700.2 | $ | 660.3 | 6 | % | ||||||
Hips | 429.6 | 400.4 | 7 | |||||||||
Extremities | 39.0 | 34.3 | 13 | |||||||||
Dental | 77.2 | 64.4 | 20 | |||||||||
Total | 1,246.0 | 1,159.4 | 8 | |||||||||
Trauma | 87.0 | 79.9 | 9 | |||||||||
Spine | 109.1 | 97.3 | 12 | |||||||||
OSP and other | 97.2 | 111.8 | (13 | ) | ||||||||
Total | $ | 1,539.3 | $ | 1,448.4 | 6 | |||||||
TheNexGenComplete Knee Solution product line, including theNexGen LPS-Flex Knee,NexGen Trabecular MetalTibial Components, theNexGenLCCK Revision Knee and theNexGenCR-Flex Knee, led knee sales. TheZimmer Unicompartmental High-Flex Knee also made a strong contribution.
Growth in porous stems, including growth of theZimmerM/L Taper Stem, theTrabecular MetalPrimary Hip Prosthesis andAlloclassic(Zweymüller) Hip System, led hip stem sales, but were partially offset by weaker sales of cemented primary stems.PALACOSBone Cement,Trabecular MetalAcetabular Cups andDuromAcetabular Components also exhibited strong growth.
TheBigliani/FlatowShoulder Solution led extremities sales. TheTapered Screw-VentImplant System led dental sales.ZimmerPeriarticular Plates,ZimmerPlates and Screws and theITSTIntertrochanteric/Subtrochanteric Fixation System led trauma sales. TheDynesysDynamic Stabilization System, theOptimaZS Spinal Fixation System and SpinalTrabecular MetalSpacers led spine sales. OSP sales were negatively affected by the loss of the distribution of theOrthoPATAutotransfusion System.
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Europe Net Sales
The following table presents Europe net sales (dollars in millions):
Nine Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Inc (Dec) | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 250.9 | $ | 236.9 | 6 | % | ||||||
Hips | 299.3 | 302.9 | (1 | ) | ||||||||
Extremities | 12.7 | 9.7 | 31 | |||||||||
Dental | 32.7 | 29.9 | 9 | |||||||||
Total | 595.6 | 579.4 | 3 | |||||||||
Trauma | 28.0 | 25.0 | 12 | |||||||||
Spine | 17.5 | 16.6 | 6 | |||||||||
OSP and other | 22.9 | 19.7 | 16 | |||||||||
Total | $ | 664.0 | $ | 640.7 | 4 | |||||||
Europe sales were negatively affected by the German and United Kingdom price decreases and some rotating German hospital strikes. Changes in foreign exchange rates negatively affected knee and hip sales by 3 percent and 2 percent, respectively. TheNexGenComplete Knee Solution product line, including theNexGenLPS-Flex Knee,NexGen Trabecular MetalTibial Components and theNexGenCR-Flex Knee, theInnexTotal Knee System and theZimmer Unicompartmental High-Flex Knee led knee sales. Growth in porous stems, including theCLS SpotornoStem, led hip stem sales, but was offset by weaker sales of revision and cemented primary stems.LongevityandDurasulHighly Crosslinked Polyethylene Liners,PALACOSBone Cement,DuromAcetabular Components,Trabecular MetalAcetabular Cups and theAllofitHip Acetabular System also made strong contributions to hip sales.
TheAnatomical ShoulderSystem and the Coonrad/Morrey Total Elbow led extremities sales. TheTapered Screw-VentImplant System and theTapered SwissPlusImplant System led dental sales. TheM/DNIntramedullary Fixation System and theNCBPlating System led trauma sales. TheSilhouetteSpinal Fixation System andTrabecular MetalSpacers led spine sales. Wound management products led OSP sales.
Asia Pacific Net Sales
The following table presents Asia Pacific net sales (dollars in millions):
Nine Months | ||||||||||||
Ended | ||||||||||||
September 30, | ||||||||||||
2006 | 2005 | % Inc (Dec) | ||||||||||
Reconstructive | ||||||||||||
Knees | $ | 121.7 | $ | 117.8 | 3 | % | ||||||
Hips | 141.3 | 143.5 | (1 | ) | ||||||||
Extremities | 3.9 | 4.6 | (15 | ) | ||||||||
Dental | 18.8 | 14.0 | 35 | |||||||||
Total | 285.7 | 279.9 | 2 | |||||||||
Trauma | 29.2 | 29.2 | — | |||||||||
Spine | 4.7 | 3.9 | 18 | |||||||||
OSP and other | 38.9 | 35.7 | 9 | |||||||||
Total | $ | 358.5 | $ | 348.7 | 3 | |||||||
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Changes in foreign exchange rates negatively affected knee and hip sales by 5 percent. In addition, knee and hip sales were negatively affected by the change in reimbursement rates in Japan. On a volume/mix basis, these significant product categories in our Asia Pacific region were able to experience positive sales growth. TheNexGenComplete Knee Solution product line, includingNexGen Trabecular MetalTibial Components, theNexGenCR-Flex Knee and theNexGenLPS-Flex Knee, led knee sales. The continued conversion to porous stems, including the Fiber Metal Taper Stem from theVerSysHip System, led hip stem sales. Sales ofDuromAcetabular Components andTrabecular Metal Acetabular Cups also exhibited strong growth.
Extremities sales declined due to weaker sales of our shoulder and elbow products. TheTapered Screw-VentImplant System led dental sales. TheITST Intertrochanteric / Subtrochanteric Fixation System led trauma sales. TheST360º Spinal Fixation System led spine sales. Powered surgical instruments led OSP sales.
Gross Profit
Gross profit as a percentage of net sales was 77.6 percent in the nine month period ended September 30, 2006, compared to 77.3 percent in the same 2005 period. There were no inventorystep-up costs in the nine month period ended September 30, 2006, compared to $4.6 million, or 0.2 percent of sales in the same 2005 period. Cost of products sold increased by $6.8 million, or 0.3 percent of sales, for share-based payment expense. In the nine month period ended September 30, 2005, approximately $6.5 million, or 0.3 percent, of pre-tax income was reflected in costs of products sold related to the favorable resolution of certain legal and other matters. The other primary contributor to the improvement in gross profit margin was the effects of changes in foreign exchange rates combined with our hedging program. Under our hedging program, for derivatives which qualify as hedges of future cash flows, the effective portion of changes in fair value is temporarily recorded in other comprehensive income, then recognized in cost of products sold when the hedged item affects earnings. This was partially offset by increased excess and obsolete expenses related to certain products.
Operating Expenses
R&D as a percentage of net sales was 5.6 percent for the nine month period ended September 30, 2006, compared to 5.3 percent in the same 2005 period. R&D increased to $142.7 million for the nine month period ended September 30, 2006, from $129.6 million in the same 2005 period, reflecting increased spending on projects focused on areas of strategic significance, including orthobiologics, and $6.4 million for share-based payment expense. We estimate that nearly two-thirds of our R&D spending relates to innovative products and platforms to improve patient quality of life. We target R&D spending to the high end of what management believes to be an average of 4-6 percent for our industry.
SG&A as a percentage of net sales was 39.4 percent for the nine month period ended September 30, 2006, compared to 38.8 percent in the same 2005 period. SG&A increased to $1,010.1 million for the nine month period ended September 30, 2006, from $945.9 million in the same 2005 period. SG&A expenses have increased by $41.6 million, or 1.7 percent of sales, for share-based payment expense. Without the share-based payment expense, SG&A expenses as a percentage of sales have been favorable due to Centerpulse integration related synergies, cost effective resolution of product liability claims and controlled headcount.
Acquisition, integration and other expenses for the nine month period ended September 30, 2006 were $9.5 million compared to $34.7 million in the same 2005 period. The expenses included integration consulting fees, costs for integrating information technology systems and employee termination benefits. These costs were partially offset by a gain on the sale of our Austin, Texas facility and land and a favorable adjustment to acquired Centerpulse reserves related to product liabilities.
Operating Profit, Income Taxes and Net Earnings
Operating profit for the nine month period ended September 30, 2006 increased 7 percent to $826.9 million, from $774.0 million in the same 2005 period. Increased sales, improved gross profit margins, realized operating expense synergies, controlled operating expenses and decreased acquisition, integration and other expenses drove operating profit. These were partially offset by $56.0 million of expense related to share-based payment expense.
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The effective tax rate on earnings before income taxes and minority interest decreased to 28.8 percent for the nine month period ended September 30, 2006, from 29.9 percent in the same 2005 period. The decrease in the effective tax rate is primarily due to increased profitability in lower tax jurisdictions as well as the effect of anticipated settlement of certain tax contingencies, offset by expiration of the R&D tax credit. In May 2006, TIPRA was passed. TIPRA impacts us beginning as of January 1, 2006 and we are currently evaluating the tax impacts of the new legislation.
Net earnings increased 11 percent to $589.8 million for the nine month period ended September 30, 2006, compared to $532.9 million in the same 2005 period. The increase was primarily due to higher operating profit, net interest income, and a lower effective tax rate. Basic and diluted earnings per share increased 12 percent to $2.41 and $2.39, respectively, from $2.16 and $2.13, respectively, in the same 2005 period.
Operating Profit by Segment
The following table sets forth operating profit as a percentage of sales by segment for the nine month periods ended September 30, 2006 and 2005:
Percent of net sales
Nine Months | ||||||||
Ended | ||||||||
September 30, | ||||||||
2006 | 2005 | |||||||
Americas | 53.0 | % | 52.5 | % | ||||
Europe | 40.3 | 35.2 | ||||||
Asia Pacific | 47.1 | 44.5 |
In the Americas, operating profit as a percentage of sales increased due to controlled selling, general and administrative spending and partially offset by higher royalties.
European operating profit as a percentage of net sales increased due to controlled selling, general and administrative spending and improved gross margins.
Asia Pacific operating profit as a percentage of net sales increased due to controlled selling, general and administrative spending and improved gross margins.
Liquidity and Capital Resources
Cash flows provided by operating activities were $793.6 million during the nine month period ended September 30, 2006, compared to $627.7 million in the same 2005 period. The principal source of cash was net earnings of $589.8 million. In 2006, we had positive cash flows of $67.6 million from income taxes, primarily related to the utilization of acquired Centerpulse tax attributes. Income tax benefit from stock option exercises by our employees decreased in 2006 to $2.1 million compared to $33.8 million of operating cash flows in 2005. Due to the adoption of SFAS 123(R), the excess tax benefit realized from exercises of non-qualified stock options are recognized as a financing cash flow activity. Operating cash flows from working capital changes for the nine month period ended September 30, 2006 have improved over 2005.
We continue to focus on working capital management. At September 30, 2006, we had 59 days of sales outstanding in trade accounts receivable, which is unfavorable to September 30, 2005, by 1 day and consistent with June 30, 2006. At September 30, 2006, we had 310 days of inventory on hand, unfavorable to September 30, 2005 by 7 days and unfavorable to June 30, 2006 by 37 days. We have increased inventory days compared to the prior year due to a relatively high number of new product launches in the second half of 2006. The third quarter increase over second quarter reflects the pattern of seasonality in our reconstructive business and the sensitivity of our days inventory on hand method of calculation based on quarterly results.
Cash flows used in investing activities were $174.7 million in the nine month period ended September 30, 2006, compared to $204.8 million used in investing in the same 2005 period. Additions to instruments during the nine month period ended September 30, 2006 were $93.0 million, compared to $129.6 million in the same 2005
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period. The decrease in instrument purchases compared to 2005 is the result of high rates of penetration already achieved withMIS instruments across our base of customers. Additionally, we have been able to successfully in-source instruments at lower costs. In 2006, we expect purchases of instruments to approximate $125 million as we continue to invest in instruments to support new products, sales growth andMISProcedures. Additions to other property, plant and equipment during the nine month period ended September 30, 2006 were $84.4 million, compared to $65.5 million in the same 2005 period. The increase was primarily related to facility expansions and systems in Warsaw, Indiana. During 2006, we expect purchases of other property, plant and equipment to approximate $130 million, as a result of ongoing facility expansions in Warsaw, Indiana, and further productivity related investments. We realized proceeds of $16.2 million in the nine month period ended September 30, 2006, from the sale of our Austin, Texas facility and land.
Cash flows used in financing activities were $583.0 million for the nine month period ended September 30, 2006, compared to $482.1 million used in financing activities in the same 2005 period. We repaid $550.0 million of debt in the nine month period ended September 30, 2005, and elected not to repay any of our remaining debt balance in the nine months ended September 30, 2006. With our excess cash, we repurchased $630.9 million of our common stock in the nine month period ended September 30, 2006. Proceeds from our stock compensation plans have decreased in the nine month period ended September 30, 2006, compared to the same 2005 period due to fewer employee stock option exercises.
We have a five year $1,350 million revolving, multi-currency, senior unsecured credit facility maturing March 31, 2010 (the “Senior Credit Facility”). We had $100.9 million outstanding under the Senior Credit Facility at September 30, 2006, and therefore, our available borrowings were $1,249.1 million. The $100.9 million is owed by our Japan subsidiary and carries a low interest rate, which is why we have not repaid the debt. The Senior Credit Facility contains a provision whereby borrowings may be increased to $1,750 million. We were in compliance with all covenants under the Senior Credit Facility as of September 30, 2006.
We also have available uncommitted credit facilities totaling $61 million.
In 2004, we acquired Implex Corp. (“Implex”). The terms of the Implex acquisition include additional cash earn-out payments that are contingent on theyear-over-year growth of Implex product sales through 2006. We have paid $104.5 million of earn-out payments through September 30, 2006, including $8.5 million paid in 2006. We estimate remaining payments, which will occur in 2006, to be in a range from $20 million to $30 million. The Company has no further earn-out obligations for the Implex acquisition beyond 2006.
In December 2005, our Board of Directors authorized a stock repurchase program of up to $1 billion through December 31, 2007. As of September 30, 2006, we had repurchased 10.0 million shares of common stock with an aggregate purchase price of $634.8 million. We may use some of our excess cash to repurchase additional common stock under this program.
Management believes that cash flows from operations, together with available borrowings under the Senior Credit Facility, is sufficient to meet our working capital, capital expenditure and debt service needs. Should investment opportunities arise, we believe that our earnings, balance sheet and cash flows will allow us to obtain additional capital, if necessary.
Recent Accounting Pronouncements
In June 2006, The Financial Accounting Standards Board issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109,Accounting for Income Taxes(FIN 48), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosures and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We will adopt FIN 48 as of January 1, 2007, as required. The cumulative effect of adopting FIN 48 will be recorded in retained earnings [and other accounts as applicable]. We have not determined the effect, if any, the adoption of FIN 48 will have on our financial position and results of operations.
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In September 2006, the Financial Accounting Standards Board issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”, which requires that the full funding status of defined benefit pension and other postretirement plans be recognized on the balance sheet as an asset (for overfunded plans) or as a liability (for underfunded plans). In addition, SFAS 158 requires recognition in other comprehensive income the gains or losses and prior service costs or credits that are not yet included as components of periodic benefit expense. Finally, SFAS 158 requires that the measurement of defined benefit plan assets and obligations be as of the balance sheet date. We will adopt SFAS 158 as of December 31, 2006 and we have not determined the effect the adoption will have on our financial position.
On September 13, 2006, the SEC issued Staff Accounting Bulletin (SAB) 108,“Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides a single quantification framework that requires public companies to use both the “roll-over” and “iron curtain” methods in quantifying prior year misstatements, referred to as the “dual approach.” SAB 108 allows for prior year corrections that are not material to prior year (i.e., a restatement is not necessary) and material to the current year to be recorded through retained earnings with prior year financial statements corrected in future filings. SAB 99,“Materiality”, has not been changed and continues to be the guidance for assessing materiality through both quantitative and qualitative factors. We will adopt SAB 108 as of December 31, 2006 and we do not expect the adoption to have a material effect on our financial position or results of operations
Critical Accounting Estimates
Our financial results are affected by the selection and application of accounting policies and methods. Due to the adoption of SFAS 123(R), we have new critical accounting estimates. We account for share-based payment expense in accordance with the fair value recognition provisions of SFAS 123(R). Under the fair value recognition provisions of SFAS 123(R), share-based payment expense is measured at the grant date based on the fair value of the award and is recognized over the requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating the expected life of stock options and the expected volatility of our stock. Additionally, we must estimate the amount of share-based awards that are expected to be forfeited. We estimate expected volatility based upon the implied volatility of our actively traded options. The expected life of stock options and estimated forfeitures are based upon our employees’ historical exercise and forfeiture behaviors. The assumptions used in determining the grant date fair value and the expected forfeitures represent management’s best estimates.
There were no other changes in the three and nine month periods ended September 30, 2006 to the application of critical accounting estimates as described in our Annual Report onForm 10-K for the year ended December 31, 2005.
Forward Looking Statements
This quarterly report contains certain statements that are forward-looking statements within the meaning of federal securities laws. When used in this report, the words “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “plan,” “believe,” “predict,” “potential,” “project,” “target,” “forecast,” “intend” and similar expressions are intended to identify forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to:
• | competition; | |
• | pricing pressures; | |
• | dependence on new product development, technological advances and innovation; | |
• | reductions in reimbursement levels by third-party payors and cost containment efforts of health care purchasing organizations; | |
• | the outcome of the pending U.S. Department of Justice investigations announced in March 2005 and June 2006; |
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• | challenges relating to changes in and compliance with Federal, state and foreign governmental laws and regulations affecting our U.S. and international businesses, including tax obligations and risks; | |
• | retention of our independent agents and distributors; | |
• | changes in customer demand for our products and services caused by demographic changes or other factors; | |
• | changes in general domestic and international economic conditions, including interest rate and currency exchange rate fluctuations; | |
• | our ability to protect proprietary technology and other intellectual property and claims for infringement of the intellectual property rights of third parties; | |
• | product liability claims; | |
• | the possible disruptive effect of additional strategic acquisitions and our ability to successfully integrate acquired companies; | |
• | our ability to form strategic alliances with other orthopaedic and biotechnology companies; | |
• | changes in prices of raw materials and products and our ability to control costs and expenses; | |
• | changes in general industry and market conditions, including domestic and international growth rates; | |
• | our dependence on a limited number of suppliers for key raw materials and outsourced activities; and | |
• | shifts in our product category sales mix or our regional sales mix away from products or geographic regions that generate higher operating margins. |
We discuss these and other important risks and uncertainties that may affect our future operations in Part I, Item 1A — Risk Factors in our most recent Annual Report onForm 10-K and may update that discussion in Part II, Item 1A — Risk Factors in this or another Quarterly Report onForm 10-Q we file hereafter. Readers of this report are cautioned not to place undue reliance on these forward-looking statements. While we believe the assumptions on which the forward-looking statements are based are reasonable, there can be no assurance that these forward-looking statements will prove to be accurate. This cautionary statement is applicable to all forward-looking statements contained in this report.
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
There have been no material changes from the information provided in our Annual Report onForm 10-K for the year ended December 31, 2005.
Item 4. | Controls and Procedures |
We have established disclosure controls and procedures and internal controls over financial reporting to provide reasonable assurance that material information relating to us, including our consolidated subsidiaries, is made known on a timely basis to management and the Board of Directors. However, no control system, no matter how well designed and operated, can provide absolute assurance that the objectives of the control system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined inRule 13a-15(e) of the Securities Exchange Act of 1934) as of September 30, 2006. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures, as of the end of the period covered by this report, are effective.
There was no change in our internal control over financial reporting (as defined inRule 13a-15(f) of the Securities Exchange Act of 1934) that occurred during the quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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Part II — Other Information
Item 1. | Legal Proceedings |
Information pertaining to legal proceedings can be found in Note 10 to the interim consolidated financial statements included in Part I of this report.
Item 1A. | Risk Factors |
Except as reported in any previously filed Quarterly Report ofForm 10-Q, there have been no material changes from the risk factors disclosed in Part I, Item 1A — Risk Factors in our Annual Report onForm 10-K for the year ended December 31, 2005.
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
The following table summarizes repurchases of common stock settled during the three month period ended September 30, 2006:
Total Number of | Approximate | |||||||||||||||
Shares Purchased | Dollar Value of | |||||||||||||||
as Part of | Shares that May | |||||||||||||||
Total Number | Publicly | Yet Be Purchased | ||||||||||||||
of Shares | Average Price | Announced Plans | Under Plans | |||||||||||||
Purchased | Paid per Share | or Programs* | or Programs | |||||||||||||
July 2006 | 425,000 | 57.56 | 425,000 | $ | 655,211,846 | |||||||||||
August 2006 | 4,368,700 | $ | 66.38 | 4,368,700 | 365,212,607 | |||||||||||
September 2006 | — | — | — | 365,212,607 | ||||||||||||
Total | 4,793,700 | $ | 65.60 | 4,793,700 | $ | 365,212,607 | ||||||||||
* | In December 2005, our Board of Directors authorized the repurchase of up to $1 billion of common stock through December 31, 2007. |
Item 5. | Other Information |
During the period covered by this report, the Audit Committee of our Board of Directors approved the engagement of PricewaterhouseCoopers LLP, our independent registered public accounting firm, to perform certain tax related services which represent non-audit services. This disclosure is made pursuant to Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002.
Item 6. | Exhibits |
The following documents are filed as exhibits to this report:
3 | Restated By-Laws of Zimmer Holdings, Inc., together with Amendment No. 1 and Amendment No. 2 to the Restated By-Laws of Zimmer Holdings, Inc. | |||
31 | .1 | Certification pursuant toRule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 of the Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ||
31 | .2 | Certification pursuant toRule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 of the Chief Financial Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | ||
32 | Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
ZIMMER HOLDINGS, INC.
(Registrant)
(Registrant)
By: | /s/ Sam R. Leno |
Sam R. Leno
Executive Vice President, Finance and
Corporate Services and Chief Financial Officer
Date: November 8, 2006
By: | /s/ James T. Crines |
James T. Crines
Senior Vice President, Finance, Operations and
Corporate Controller and Chief Accounting Officer
Date: November 8, 2006
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