Zimmer Biomet - 10-Q quarterly report FY

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-2of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2of the Exchange Act).  Yes o     No þ

As of October 29, 2007, 234,725,440 shares of the registrant’s $.01 par value common stock were outstanding.

The financial data presented herein is unaudited and should be read in conjunction with the consolidated financial statements and accompanying notes included in the 2006 Annual Report onForm 10-Kfiled 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. The December 31, 2006 condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. Results for interim periods should not be considered indicative of results for the full year. Certain amounts in the three and nine month periods ended September 30, 2006 have been reclassified to conform to the current year presentation.

Consolidated cash flows for the nine months ended September 30, 2007 include the correction of an error in presentation of $20.2 million, which had previously been reported in the three month period ended March 31, 2007, as a component of the change in receivables in operating cash flows and is now appropriately reported as proceeds from employee stock compensation in financing cash flows for the nine month period ended September 30, 2007. Management does not consider this error in presentation to be material to the Consolidated Statement of Cash Flows for the three months ended March 31, 2007.

The words “we”, “us”, “our” and similar words refer to Zimmer Holdings, Inc. and its subsidiaries. Zimmer Holdings refers to the parent company only.

We have made acquisitions that took place during the nine month period ended September 30, 2007 which are described below. These acquisitions were accounted for under the purchase method of accounting pursuant to Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” (SFAS No. 141). Accordingly, the results of operations of the acquired companies have been included in our consolidated results of operations subsequent to the transaction dates, and the respective assets and liabilities of the acquired companies have been recorded at their estimated fair values in our consolidated statement of financial position as of the transaction dates, with any excess purchase price being allocated to goodwill. Pro forma financial information has not been included as the acquisitions did not have a material impact upon our financial position or results of operations.

On April 20, 2007, we acquired Endius Incorporated (Endius), a privately held spinal products company based in Massachusetts, for an initial aggregate value of approximately $80 million in cash, before adjustments for debt repayment and other items. Endius develops and manufactures minimally invasive spine surgery products, implants and techniques to treat spine disease. The acquisition of Endius has expanded our spine product portfolio to include innovative minimally invasive instruments and implants.

On April 27, 2007, we acquired Diadent, Srl. (Diadent), a privately held distributor of our dental products in Italy, in a cash transaction. The acquisition of Diadent provides us with direct sales of dental implants in Italy.

During the second quarter of 2007, we made investments in our U.S. based distribution network, including the acquisition of certain orthopaedic implant distribution businesses. These investments and acquisitions are expected to increase future revenues by enhancing our U.S. sales and distribution infrastructure.

The reconciliation of net earnings to comprehensive income is as follows:

Other current liabilities at September 30, 2007 and December 31, 2006, consist of the following:

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). FIN 48 addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

We adopted FIN 48 on January 1, 2007. Prior to the adoption of FIN 48 we had a long term tax liability for expected settlement of various federal, state and foreign income tax liabilities that was reflected net of the corollary tax impact of these expected settlements of $102.1 million, as well as a separate accrued interest liability of $1.7 million. As a result of the adoption of FIN 48, we are required to present the different components of such liability on a gross basis versus the historical net presentation. The adoption resulted in the financial statement liability for unrecognized tax benefits decreasing by $6.4 million as of January 1, 2007. The adoption resulted in this decrease in the liability as well as a reduction to retained earnings of $4.7 million, a reduction in goodwill of $61.4 million, the establishment of a tax receivable of $58.2 million, and an increase in an interest/penalty payable of $7.9 million, all as of January 1, 2007. Therefore, after the adoption of FIN 48, the amount of unrecognized tax benefits is $95.7 million as of January 1, 2007, of which $28.6 million would impact our effective tax rate, if recognized. The amount of unrecognized tax benefits is $111.0 million as of September 30, 2007. Of this amount, $35.7 million would impact our effective tax rate, if recognized.

We recognize accrued interest and penalties related to unrecognized tax benefits in income tax expense in the Consolidated Statements of Earnings, which is consistent with the recognition of these items in prior reporting periods. As of January 1, 2007, we recorded a liability of $9.6 million for accrued interest and penalties, of which $7.5 million would impact our effective tax rate, if recognized. The amount of this liability is $12.2 million as of September 30, 2007. Of this amount, $9.1 million would impact our effective tax rate, if recognized.

We expect that the amount of tax liability for unrecognized tax benefits will change in the next twelve months; however, we do not expect these changes will have a material impact on our results of operations or financial position.

The U.S. federal statute of limitations remains open for the year 2003 and onward with years 2003 and 2004 currently under examination by the IRS. It is reasonably possible that a resolution with the IRS for the years 2003 through 2004 will be reached within the next twelve months, but we do not anticipate this would result in any

State income tax returns are generally subject to examination for a period of three to five years after filing of the respective return. The state impact of any federal changes remains subject to examination by various states for a period of up to one year after formal notification to the states. We have various state income tax returns in the process of examination, administrative appeals or litigation. It is reasonably possible that such matters will be resolved in the next twelve months, but we do not anticipate that the resolution of these matters would result in any material impact on our results of operations or financial position.

Foreign jurisdictions have statutes of limitations generally ranging from three to five years. Years still open to examination by foreign tax authorities in major jurisdictions include Australia (2003 onward), Canada (1998 onward), France (2004 onward), Germany (2000 onward), Italy (2003 onward), Japan (2000 onward), Puerto Rico (2005 onward), Singapore (2002 onward), Switzerland (2004 onward), and the United Kingdom (2004 onward).

Our tax returns are currently under examination in various foreign jurisdictions, including Germany, Italy and Switzerland. It is reasonably possible that such audits will be resolved in the next twelve months, but we do not anticipate that the resolution of these audits would result in any material impact on our results of operations or financial position.

On September 27, 2007, we reached a settlement with the United States government in an ongoing investigation into financial relationships between major orthopaedic manufacturers and consulting orthopaedic surgeons. Under the terms of the settlement we paid a civil settlement amount of $169.5 million and we recorded an expense in that amount in the three month period ended September 30, 2007. No tax benefit has been recorded related to the settlement expense due to the uncertainty as to the tax treatment. We intend to pursue resolution of this uncertainty with taxing authorities, but are unable to ascertain the outcome or timing for such resolution at this time. For more information regarding the settlement, see Note 14.

We have defined benefit pension plans covering certain U.S. and Puerto Rico employees who were hired before September 2, 2002. Employees hired on or 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. pensionarrangements, 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 on or 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, 2007 and 2006, for our U.S. andnon-U.S. definedbenefit retirement plans are as follows (in millions):

The components of net periodic benefit expense for the three and nine month periods ended September 30, 2007 and 2006, for our U.S. and Puerto Rico postretirement benefit plans are as follows (in millions):

We contributed $26.6 million during the nine month period ended September 30, 2007, to our U.S. and Puerto Rico defined benefit plans and do not expect to make additional contributions during the remainder of 2007. We contributed $10.8 million to our foreign-based defined benefit plans in the nine month period ended September 30, 2007, and expect to contribute an additional $2.1 million to these foreign-based plans during 2007. Contributions for the U.S. and Puerto Rico postretirement benefit plans are not expected to be significant.

Share-based compensation expense for the three and nine month periods ended September 30, 2007 was $12.4 million and $53.5 million, or $9.2 million and $37.2 million net of the related tax benefits, respectively. Share-based compensation expense for the three and nine month periods ended September 30, 2006 was $17.0 million and $56.0 million, or $12.2 million and $40.2 million net of the related tax benefits, respectively.

A summary of stock option activity for the nine month period ended September 30, 2007 is as follows (options in thousands):

The weighted-average fair value of the options granted in the nine month period ended September 30, 2007 was $24.73 per option. As of September 30, 2007, there was $131.1 million of unrecognized share-based

At September 30, 2007 there were 887,649 nonvested equity share units, with a weighted average grant date fair value of $69.91. The unrecognized share-based compensation expense as of September 30, 2007 was $6.6 million, and is expected to be recognized over a period of 1.25 years.

During the three months ended September 30, 2007, we purchased 1,970,506 shares of our common stock at an average price of $78.85 per share for a total cash outlay of $155.4 million, including commissions. During the nine months ended September 30, 2007, we purchased 5,574,762 shares of our common stock at an average price of $82.61 per share for a total cash outlay of $460.6 million, including commissions. These purchases were made under stock repurchase plans authorized by our Board of Directors in December 2005 and 2006. Purchases totaling an additional $736.8 million may be made through December 31, 2008 under the plan authorized in 2006.

The following is a reconciliation of weighted average shares for the basic and diluted shares computations (in millions):

During the three and nine month periods ended September 30, 2007, an average of 2.5 million options and 1.2 million options, respectively, to purchase shares of common stock 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, 2006, an average of 8.6 million options and 8.8 million options, respectively, were not included.

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. 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 compensation, settlement expense acquisition, integration and other expenses, inventorystep-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.

Net sales and segment operating profit are as follows (in millions):

Product category net sales are as follows (in millions):

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements,” (SFAS No. 157) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 157 is not expected to have a material impact on our financial position or results of operations.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115” (SFAS No. 159). SFAS No. 159 creates a “fair value option” under which an entity may elect to record certain financial assets or liabilities at fair value upon their initial recognition. Subsequent changes in fair value would be recognized in earnings as those changes occur. The election of the fair value option would be made on acontract-by-contractbasis and would need to be supported by concurrent documentation or a preexisting documented policy. SFAS No. 159 requires an entity to separately disclose the fair value of these items on the balance sheet or in the footnotes to the financial statements and to provide information that would allow the financial statement user to understand the impact on earnings from the changes in the fair value. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 is not expected to have a material impact on our financial position or results of operations.

As a result of our acquisition of Centerpulse in 2003, 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 was entered into by Centerpulse that resolved U.S. claims related to the affected products and a 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 September 30, 2007, 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, 2007 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 of U.S. Patent Nos. 6,174,934; 6,372,814; 6,664,308; and 6,818,020. On June 13, 2007, the Court granted our motion for summary judgment on the invalidity of the asserted claims of U.S. Patent Nos. 6,174,934; 6,372,814; and 6,664,308 by ruling that all of the asserted claims are invalid for indefiniteness. Our motion for summary judgment on the invalidity of certain asserted claims of U.S. Patent No. 6,818,020 remains pending before the Court. We continue to 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 (“SEC”) informed Centerpulse that it was conducting an informal investigation of Centerpulse relating to certain accounting issues that pre-date our acquisition of Centerpulse. In October 2007, the SEC filed an enforcement action in the United States District Court for the District of Columbia against three former Centerpulse officers, charging the individuals with violations of federal securities laws and seeking permanent injunctive relief, disgorgement of ill-gotten gains, if any, civil money penalties and orders barring each defendant from acting as an officer or director of any public company. One of the individuals served as our Vice President, Tax and Treasury and Tax Counsel prior to the filing of the SEC’s enforcement action and has been suspended and is not performing any service for us. We are not a party to the SEC’s enforcement action. We continue to fully cooperate with the SEC with regard to its investigation.

In March 2005, the United States Department of Justice through the United States Attorney’s Office in Newark, New Jersey commenced an investigation of us and four other orthopaedic companies pertaining to consulting contracts, professional service agreements and other agreements by which remuneration is provided to orthopaedic surgeons. On September 27, 2007, we reached a settlement with the government to resolve all claims related to this investigation. As part of the settlement, we entered into a settlement agreement with the United States of America through the United States Department of Justice and on behalf of the Office of Inspector General of the Department of Health and Human Services (the “OIG-HHS”). In addition, we entered into a Deferred Prosecution Agreement (the “DPA”) with the United States Attorney’s Office for the District of New Jersey (the “U.S. Attorney”) and a Corporate Integrity Agreement (the “CIA”) with the OIG-HHS. We did not admit any wrongdoing, plead guilty to any criminal charges or pay any criminal fines as part of the settlement.

We settled civil and administrative claims related to the federal investigation for a cash payment to the United States government of $169.5 million. We recorded a $169.5 million expense during the third quarter in connection with the settlement.

Under the terms of the DPA, the U.S. Attorney filed a criminal complaint in the United States District Court for the District of New Jersey charging us with conspiracy to commit violations of the Anti-Kickback Statute (42 U.S.C.§ 1320a-7b)during the years 2002 through 2006. The Court deferred prosecution of the criminal complaint during the18-monthterm of the DPA. The U.S. Attorney will seek dismissal of the criminal complaint after the eighteen-month period if we comply with the provisions of the DPA, including oversight by a federal monitor selected by the U.S. Attorney. Under the CIA, which has a term of five years, we agreed to continue the operation of our enhanced Corporate Compliance Program, designed to promote compliance with federal health care program requirements, in accordance with the terms set forth in that agreement. We also agreed to retain an independent review organization (“IRO”) to perform annual reviews to assist us in assessing our compliance with the obligations set forth in the CIA to ensure that arrangements we enter into do not violate the Anti-Kickback Statute. Our obligation to retain an IRO is suspended during the eighteen-month term of the DPA. A material breach of the DPA or the CIA may subject us to exclusion by OIG-HHS from participation in all federal health care programs, which would have a material adverse effect on our financial position and results of operations.

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.

Following the commencement of the Department of Justice, Antitrust Division’s investigation, we and several other major orthopaedic manufacturers were named as defendants in five putative class action lawsuits as of January 1, 2007. 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, including allegations of

On January 12, 2007, we and the other defendants in the five cases delivered a Motion for Transfer and Consolidation of Pretrial Proceedings under 28 U.S.C. § 1407 to the Judicial Panel on Multidistrict Litigation, requesting the court to transfer the cases to the United States District Court for the Southern District of Indiana for coordinated or consolidated pretrial proceedings. The motion was filed by the Panel on January 18, 2007. The plaintiffs did not oppose a stay of proceedings pending resolution of this motion. On January 15, 2007, the plaintiff in Thomas v. Biomet, Inc. et al. filed a Notice of Voluntary Dismissal Without Prejudice in the United States District Court for the Western District of Tennessee. On April 18, 2007, the Judicial Panel on Multidistrict Litigation issued a Transfer Order ordering that the three remaining actions pending outside the Southern District of Indiana be transferred to that district for coordinated or consolidated pretrial proceedings with the action already pending in that district.

On October 17, 2007, we and the other defendants in the four remaining cases entered into an agreement, which tolls or suspends the operation of applicable statutes of limitation through the earlier of (i) April 17, 2009 or (ii) 45 days after the close of the Department of Justice, Antitrust Division’s investigation. The plaintiffs filed a Notice of Voluntary Dismissal Without Prejudice on October 18, 2007 in the United States District Court for the Southern District of Indiana. The Court dismissed the four cases without prejudice on October 23, 2007.

On September 25, 2007, the Staff of the SEC informed us that it was conducting an informal investigation regarding potential violations of the Foreign Corrupt Practices Act in the sale of medical devices in a number of foreign countries by companies in the medical device industry. We understand that at least four other medical device companies received similar letters. We intend to fully cooperate with the SEC with regard to this informal investigation.

Following announcement of our entry into the DPA and CIA and commencement of the informal SEC investigation described above, two shareholder derivative actions were filed in Kosciusko Superior Court in Warsaw, Indiana as of November 1, 2007. The first action, captioned Bottner v. Dvorak et al., was filed on October 16, 2007. The second action, captioned Capizzi v. Dvorak et al., was filed on October 30, 2007. The plaintiffs seek to maintain the actions purportedly on our behalf against all of our current directors and one former director. The plaintiffs claim, among other things, breaches of fiduciary duty by the individual defendants which allegedly allowed misconduct to occur, including illegal payments to doctors, and caused us financial harm, including the cost of the settlement with the federal government described above. The plaintiffs do not seek damages from us, but instead request damages of an unspecified amount on our behalf.

In September 2007, we announced that we would acquire ORTHOsoft Inc., a leader in computer navigation for orthopaedic surgery, in a cash transaction for an estimated purchase price of $50 million. On November 5, 2007, we announced that we completed our takeover bid with the purchase 92.36% of the outstanding ORTHOsoft shares (other than shares held by us). We intend to acquire all remaining ORTHOsoft shares by way of a compulsory acquisition pursuant to the Canada Business Corporations Act. This investment will bolster our SmartTools strategic initiative designed to bring innovative tools to the marketplace that will help create better and more reproducible outcomes for surgeons and patients.

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, which account for less than one percent of sales. 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 includes supplies and instruments designed to aid in orthopaedic surgical procedures and post-operation rehabilitation. Through our consulting services subsidiary, we provide hospitals and other orthopaedic practices resource capabilities to design, implement and manage successful orthopaedic programs. 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, 2007.

Increased volume and changes in the mix of product sales contributed 8 percentage points of sales growth during the three month period ended September 30, 2007, compared to 7 percent in the same 2006 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 ourZimmer^®Minimally Invasive Solutions^TM(MIS) Procedures and Technologies), introduction of gender based devices and more active lifestyles, among other factors. In addition, the ongoing shift in demand to premium products, such asLongevity^®andDurasul^®Highly Crosslinked Polyethylenes, Trabecular Metal^TMTechnology products, high-flex knees, knee revision products and porous hip stems, continues to positively affect sales growth. For example, during the three month period ended September 30, 2007, sales of products incorporatingTrabecular Metal Technology were approximately $49 million, an increase of over 18 percent compared to the same 2006 period.

We believe innovative products will continue to affect the orthopaedics industry. In the second half of 2006, we launched the Zimmer Gender Solutions^TMHigh-Flex Knee Femoral Implant, which was the result of five years of intensive research based on an analysis of 800 femurs and patella. High Flex Knees now make up approximately 47 percent of our total femoral unit sales on a global basis, having grown from approximately 28 percent prior to the launch of the Zimmer Gender Solutions Knee.

Selling prices remained flat during the three month period ended September 30, 2007, which is similar to the same 2006 period. The Americas experienced a 1 percent increase in selling prices during the three month period ended September 30, 2007, compared to a 2 percent increase in the same 2006 period. In Europe, selling prices for the three month period ended September 30, 2007 remained flat, compared to a 2 percent decrease in the same 2006 period. Within Europe, Germany, France and Italy reported decreases in average selling prices of 3 percent, 1 percent and 0.5 percent, respectively, in the three month period ended September 30, 2007, as a result of reductions in government implant reimbursement rates and group purchasing arrangements while most other European markets were positive to flat. Germany, France and Italy combined currently represent approximately 13 percent of our sales. Asia Pacific selling prices were flat for the three month period ended September 30, 2007,

For the three month period ended September 30, 2007, foreign currency exchange rates had a positive 2 percent effect on sales. The positive effect of foreign currency exchange rates is expected to continue through the rest of the year. We estimate that an overall weaker U.S. Dollar will have a positive effect of approximately 3 percent on sales for the year ending December 31, 2007. 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 products, which management defines as products or stock keeping units (SKU’s) introduced within the prior36-monthperiod to a particular market, accounted for 26 percent, or $234 million, of our sales during the three month period ended September 30, 2007. Adoption rates for new technologies are a key indicator of industry performance. Our sales have grown with the introduction of new products, such asTrabecular Metal Modular Acetabular Cups, certain SKU’s of theNexGen^®Complete Knee Solution including the Gender SolutionsKnee Femoral Implant for the LPS-Flex, and CR-Flex Knees, theDynesys^®1Dynamic Stabilization System, the Zimmer M/L Taper Hip Prosthesis andPALACOS^®2Bone Cement.

We believe new products in our current pipeline should continue to favorably affect our operating performance. Products we expect to contribute to new product sales in 2007 include theGender Solutions Knee Femoral Implant; products incorporating Trabecular Metal Technology, including theTrabecular Metal Primary Hip Prosthesis, Trabecular Metal Acetabular Revision System and Trabecular MetalSpine Components;Durom^®Acetabular Cups withMetasul^®LDH^® Large Diameter Heads;Versys^®Epoch^®Composite Hip Prosthesis;Zimmer^®Trabecular Metal Reverse Shoulder System; Anatomical Shoulder^TMInverse/Reverse System; Zimmer MIS Femoral Nailing Solutions;NCB^®Locking Plate System; and CopiOs^®Bone Void Filler³.

On September 27, 2007, we reached a settlement with the United States government to resolve all claims related to an ongoing investigation into financial relationships between major orthopaedic manufacturers and consulting orthopaedic surgeons. As part of the settlement, we entered into a Deferred Prosecution Agreement with the United States Attorney’s Office for the District of New Jersey. Under the provisions of the Deferred Prosecution Agreement, we are subject to oversight by a federal monitor selected by the U.S. Attorney for a period of 18 months. Beginning in the fourth quarter of 2007 through the end of the 18 month period, we are expecting to incur costs of approximately $6-9 million per quarter to comply with the Deferred Prosecution Agreement.

We settled civil and administrative claims related to the federal investigation for a cash payment to the United States government of $169.5 million. We recorded a $169.5 million expense during the third quarter in connection with the settlement.

¹ TheDynesys Dynamic 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.

We also entered into a Corporate Integrity Agreement with the Office of the Inspector General of the U.S. Department of Health and Human Services, which has a term of 5 years. For more information regarding the settlement, see Note 14 to the consolidated financial statements included elsewhere in thisForm 10-Q.

On January 1, 2007, we adopted FIN 48, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, the tax benefits from an uncertain tax position may be recognized only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

Prior to the adoption of FIN 48, we had a long term tax liability for expected settlement of various federal, state and foreign income tax liabilities that was reflected net of the corollary tax impacts of these expected settlements of $102.1 million, as well as a separate accrued interest liability of $1.7 million. As a result of the adoption of FIN 48, we are required to present the different components of such liability gross versus the historical net presentation. The adoption resulted in the tax liability for unrecognized tax benefits decreasing by $6.4 million as of January 1, 2007.

This decrease in the tax liability resulted in a reduction to retained earnings of $4.7 million, a reduction in goodwill of $61.4 million, the establishment of a tax receivable of $58.2 million, and the addition of an interest/penalty payable of $7.9 million, all as of January 1, 2007.

We acquired Endius Incorporated, a privately held spinal products company on April 20, 2007 for an initial aggregate value of approximately $80 million in cash, before adjustments for debt repayment and other items.

Additionally during the nine month period ended September 30, 2007, we acquired Diadent Srl., a privately held distributor of our dental products in Italy, and certain U.S. based orthopaedic implant distribution businesses. These acquisitions did not have a material impact on our results of operations, balance sheet or cash flows for the three and nine month periods ended September 30, 2007.

In September 2007, we announced that we would acquire ORTHOsoft Inc., a leader in computer navigation for orthopaedic surgery, in a cash transaction for an estimated purchase price of $50 million. On November 5, 2007, we announced that we completed our takeover bid with the purchase 92.36% of the outstanding ORTHOsoft shares (other than shares held by us). We intend to acquire all remaining ORTHOsoft shares by way of a compulsory acquisition pursuant to the Canada Business Corporations Act.

The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions):

“Foreign Exchange” as used in the tables in this report represents the effect of changes in foreign exchange rates on sales growth.

The following table presents net sales by product category and the components of the percentage changes (dollars in millions):

The NexGen Complete Knee Solution product line including the Gender Solutions Knee Femoral Implants, the NexGenLPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen CR-Flex Knee and the NexGenLCCK Revision Knee led knee sales. In addition, strong growth in the Zimmer Unicompartmental High-Flex Knee and theInnex^®Total Knee System were offset by declining sales of theNatural-Knee^®II System.

Growth in porous stems, including the Zimmer M/L Taper Hip Prosthesis, theCLS^®Spotorno^®Stem from the CLS Hip System, and theAlloclassic^®Zweymüller^®Hip Stem led hip stem sales, but were partially offset by slower growth of cemented stems and weaker sales of revision stems. Bone cement sales improved significantly, led by PALACOSBone Cement. Trabecular Metal andAllofit^TMHip Acetabular System, Durom Hip Resurfacing System products and Longevity and Durasul Highly Crosslinked Polyethylene Liners also had strong growth. We expect to face a near term challenge in hips with the adoption of hip resurfacing in the U.S. market. New products are expected to contribute in the near term but not entirely offset our lack of a hip resurfacing product within our U.S. hip portfolio.

TheBigliani/Flatow^®Complete Shoulder Solution and the Trabecular MetalReverse Shoulder System led extremities sales. Orthobiologicals and prosthetic implants, including strong growth of the Tapered Screw-Vent^®Implant System, led dental sales. Zimmer Periarticular Locking Plates and Zimmer Plates and Screws led trauma sales, but were offset by declining sales of intramedullary nails and compression hip screws. The Dynesys Dynamic Stabilization System, the TITLE 2 lumbar pedicle screw system, theTrinica^®Select cervical plate system, theOptima^TM4 ZS Spinal Fixation System and Spinal Trabecular MetalSpacers led spine sales. Wound management products led OSP sales.

⁴ Trademark of U&I Corporation.

The following table presents Americas net sales (dollars in millions):

The NexGen Complete Knee Solution product line, including the Gender Solutions Knee Femoral Implants, NexGenLPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen LCCK Revision Knee and theNexGen CR-Flex Knee led knee sales but were partially offset by declining sales of the Natural-Knee II System.

Growth in porous stems, including growth of the ZimmerM/L Taper Hip Prosthesis and Trabecular Metal Primary Hip Prosthesis led hip stem sales, but were partially offset by weaker sales of cemented stems. PALACOS Bone Cement andDurom Acetabular components also exhibited strong growth. We expect to face a near term challenge in hips with the adoption of hip resurfacing in the U.S. market. New products are expected to contribute in the near term but not entirely offset the lack of a hip resurfacing product within our U.S. hip portfolio.

The Bigliani/Flatow Shoulder Solution and theTrabecular Metal Humeral Stem led extremities sales. TheTapered Screw-Vent Implant System led dental sales.Zimmer Periarticular Plates and Zimmer Plates and Screws led trauma sales, but were offset by declining sales of intramedullary nails and compression hip screws. The DynesysDynamic Stabilization System, Trinica Select Cervical Plate System, the Optima ZS Spinal Fixation System and Spinal Trabecular Metal Spacers led spine sales. Extremity surgical products led OSP sales.

The following table presents Europe net sales (dollars in millions):

Changes in foreign exchange rates positively affected knee and hip sales both by 7 percent. Excluding these foreign exchange rate effects, the following product categories experienced positive sales growth in our Europe region: theNexGen Complete Knee Solution product line, including theNexGen LPS-Flex Knee, NexGen Trabecular MetalTibial Components, the NexGen CR-Flex Knee, and theInnex Total Knee System. Growth in porous stems, including the CLS Spotorno and Alloclassic Zweymüller Taper Stems led hip stem sales. Longevityand Durasul Highly Crosslinked Polyethylene Liners, the Durom Hip Resurfacing System, Trabecular MetalAcetabular Cups and the Allofit Hip Acetabular System also contributed to hip sales.

The Anatomical Shoulder System, the Anatomical Shoulder Inverse/Reverse System and the Coonrad/Morrey Total Elbow led extremities sales. The addition of a direct sales force in Italy as a result of the Diadent acquisition contributed to growth in dental sales and the Tapered Screw-Vent Implant System led dental sales. TheCable-Ready^®Cable Grip System, Zimmer Periarticular Plates and theNCB Plating System led trauma sales, which were offset by weaker sales of our intramedullary fixation systems. TheDynesys Dynamic Stabilization System, the OptimaZS Spinal Fixation System and Trabecular MetalSpacers led spine sales. Wound management products led OSP sales.

The following table presents Asia Pacific net sales (dollars in millions):

Changes in foreign exchange rates positively affected knee and hip sales by 5 percent and 3 percent, respectively. Reported decreases in average selling prices negatively affected hip sales by 2 percent. The NexGen Complete Knee Solution product line, including NexGen Trabecular MetalTibial Components, the NexGenCR-FlexKnee and the NexGen LPS-Flex Knee led knee sales. Launch of the Gender Solutions Knee Femoral Implant in Australia also contributed to strong knee sales for the period. The continued conversion to porous stems, including the Fiber Metal Taper Stem from the VerSys Hip System, and theAlloclassic Zweymüller Hip System led hip stem sales. Sales of Longevity Highly Crosslinked Polyethylene Liners,Trilogy^®Acetabular Sytem and Trabecular Metal Acetabular Cups also exhibited growth.

Extremities sales increased due to stronger sales of our shoulder products. TheSpline^®Twist^TMImplant System led dental sales. Trauma sales were affected by a reported 4 percent decrease in average selling prices during the three months ended September 30, 2007. A registration issue with theST360°^®Spinal Fixation System in Japan resulted in a decrease in sales of this device, contributing to the negative growth in Spine sales for the period. Powered surgical instruments led OSP sales.

Gross profit as a percentage of net sales was 77.9 percent in the three month period ended September 30, 2007, compared to 77.7 percent in the same 2006 period. The improvement in gross profit margin over the same 2006

R&D as a percentage of net sales was 5.9 percent for the three month period ended September 30, 2007, compared to 5.7 percent for the same 2006 period. R&D increased to $53.0 million for the three month period ended September 30, 2007, from $46.7 million in the same 2006 period, reflecting increased spending on projects focused on areas of strategic significance, including orthobiologics. 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 39.0 percent for the three month period ended September 30, 2007, compared to 40.3 percent in the same 2006 period. SG&A increased to $352.6 million for the three month period ended September 30, 2007, from $330.4 million in the same 2006 period. The improvement in SG&A as a percent of net sales from the prior year is due to controlled spending and lower share based compensation expense. SG&A for the three month period ended September 30, 2007 reflects a reduction in share-based compensation expense of approximately $6.7 million as we recalculated estimated payouts on our three year performance based incentive program taking into account the effect of the lost interest income on the $169.5 million settlement payment, estimated monitor fees and expenses and recent operating performance.

Settlement expense of $169.5 million for the three month period ended September 30, 2007 relates to the settlement of the federal investigation into financial relationships between major orthopaedic manufacturers and consulting orthopaedic surgeons. Acquisition, integration and other expenses for the three month period ended September 30, 2007 were $2.9 million compared to $5.0 million in the same 2006 period. These expenses principally reflect costs related to the integration of acquired U.S. distributors, integration consulting fees and costs for integrating information technology systems.

Operating profit for the three month period ended September 30, 2007 decreased 50 percent to $126.0 million, from $254.5 million in the same 2006 period. The decrease was driven principally by the $169.5 million settlement expense. The effect of the settlement expense on operating profit was partially offset by increased sales, improved gross profit margins and controlled operating expenses compared to the same 2006 period.

The effective tax rate on earnings before income taxes and minority interest increased to 65.2 percent for the three month period ended September 30, 2007, from 28.2 percent in the same 2006 period. The significant increase in the effective tax rate is due primarily to the effect of the $169.5 million settlement expense for which no tax benefit has been recognized.

Net earnings decreased 76 percent to $44.5 million for the three month period ended September 30, 2007, compared to $183.3 million in the same 2006 period. The decrease was due to the $169.5 million settlement expense and the higher effective tax rate that also resulted from the settlement expense. Basic and diluted earnings per share both decreased 75 percent to $0.19, respectively, from $0.76, respectively, in the same 2006 period. The effect of the settlement expense on net earnings and basic and diluted earnings per share was partially offset by increased sales, improved gross profit margins and controlled operating expenses compared to the same 2006 period.

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, settlement expense, acquisition, integration and other expenses, inventorystep-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

The following table sets forth operating profit as a percentage of sales by segment for the three month periods ended September 30, 2007 and 2006:

In the Americas, operating profit as a percentage of net sales decreased due primarily to increased sales force related expenses due to the expansion of our U.S. distributor network. These increases were partially offset by improved gross margins.

European operating profit as a percentage of net sales increased due to improved gross margins compared to the same 2006 period. Gross margins increased throughout most European markets, including Germany, despite decreases in average selling prices in Germany as a result of reductions in government controlled reimbursement prices. The improvement in gross margins in Europe is due to favorable product sales mix and lower unit manufacturing costs.

Asia Pacific operating profit as a percentage of net sales increased primarily due to increases in gross margins as compared to the prior year. Gross margins increased throughout many Asia Pacific markets, including Japan, despite decreases in average selling prices in Japan as a result of reductions in government controlled reimbursement prices. The improvement in gross margins in Asia Pacific is due to favorable product sales mix and lower unit manufacturing costs.

The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions):

The following table presents net sales by product category and the components of the percentage changes (dollars in millions):

The NexGen Complete Knee Solution product line including the Gender Solutions Knee Femoral Implants, the NexGenLPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen CR-Flex Knee, the NexGenRotating Hinge Knee and the NexGen LCCK Revision Knee led knee sales. In addition, the Zimmer Unicompartmental High-Flex Knee and the Innex Total Knee System exhibited strong growth.

Growth in porous stems, including the Zimmer M/L Taper Stem, the CLS Spotorno Stem from the CLS Hip System, and the Alloclassic Zweymüller Hip Stem led hip stem sales, but were partially offset by slower growth of cemented stems and weaker sales of revision stems. Sales of bone cement improved significantly, led by PALACOSBone Cement. Trabecular Metal Acetabular Cups,Trabecular Metal Primary Hip Prosthesis, Durom Hip Resurfacing System products, and Longevity and DurasulHighly Crosslinked Polyethylene Liners also had strong growth. We expect to face a near term challenge in hips with the adoption of hip resurfacing in the U.S. market. New products are expected to contribute in the near term but not entirely offset the lack of a hip resurfacing product within our U.S. hip portfolio.

The Bigliani/Flatow Complete Shoulder Solution and theTrabecular Metal Humeral Stem led extremities sales. Orthobiologicals and prosthetic implants, including strong growth of the Tapered Screw-Vent Implant System, led dental sales. Zimmer Periarticular Locking Plates andZimmer Plates and Screws led trauma sales. The DynesysDynamic Stabilization System, the TITLE 2 lumbar pedicle screw system, the Trinica Select, the OptimaZS Spinal Fixation System and Spinal Trabecular MetalSpacers led spine sales. Extremity Surgical Products led OSP sales.

The following table presents Americas net sales (dollars in millions):

The NexGen Complete Knee Solution product line, including the Gender Solutions Knee Femoral Implants, NexGenLPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen LCCK Revision Knee and theNexGen CR-Flex Knee led knee sales. The ZimmerUnicompartmental High-Flex Knee also made a strong contribution.

Growth in porous stems, including growth of the ZimmerM/L Taper Stem and Trabecular Metal Primary Hip Prosthesis led hip stem sales, but were partially offset by weaker sales of cemented stems. PALACOS Bone Cement,Trabecular Metal Acetabular Cups and Durom Hip Resurfacing System products also exhibited strong growth. We expect to face a near term challenge in hips with the adoption of hip resurfacing in the U.S. market. New products are expected to contribute in the near term but not entirely offset the lack of a hip resurfacing product within our U.S. hip portfolio.

The Bigliani/Flatow Shoulder Solution and theTrabecular Metal Humeral Stem led extremities sales. TheTapered Screw-Vent Implant System led dental sales.Zimmer Periarticular Plates and Zimmer Plates and Screws led trauma sales, but were offset by declining sales of intramedullary nails and compression hip screws. The DynesysDynamic Stabilization System, the Optima ZS Spinal Fixation System and Spinal Trabecular Metal Spacers led spine sales. Extremity surgical products led OSP sales.

The following table presents Europe net sales (dollars in millions):