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

At October 27, 2006, there were 238,648,611 shares outstanding of the registrant’s $.01 par value Common Stock.

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-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. 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.

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

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 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.

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:

A summary of stock option activity for the nine month period ended September 30, 2006, is as follows (options in thousands):

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:

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.

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-sharetargets over the three year period.

A summary of nonvested equity share units activity for the nine month period ended September 30, 2006 is as follows (units in thousands):

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.

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.

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):

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. 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 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):

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):

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.

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, 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.

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.

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

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

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.

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.

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. and Chaiken 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. and Williams 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.

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.

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 our Minimally Invasive Solutions^tm[MIS^tm] Procedures and Technologies) and more active lifestyles, among other factors. In addition, the continued shift in demand to premium products, such asLongevity^®,Durasul^®andProlong^tmHighly Crosslinked Polyethylenes, Trabecular Metal^tmTechnology 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 Metal Technology 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 Solutions^tmHigh-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 Solutions High-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.

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

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 products, which management defines as products or stock keeping units (“SKU’s”) introduced within the prior36-monthperiod 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 Metal Modular 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^®2Bone 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 incorporating Trabecular MetalTechnology, including the Trabecular Metal Primary Hip Prosthesis, Trabecular Metal Acetabular Revision System and Trabecular Metal Spine Components;Durom^®Acetabular Cups withMetasul^®Metal-on-MetalLDH^tmLarge Diameter Heads;Epoch^® II Hip Prosthesis; Trilogy AB^®Ceramic-on-CeramicAcetabular System; Zimmer Reverse Shoulder System,Anatomical Shoulder^tmInverse/Reverse Shoulder System;Zimmer^®MIS Femoral Nailing Solutions;NCB^®Plating System;CopiOs^tmBone Void Filler³and the Gender Solutions High-Flex Knee Femoral Implant, which will become more widely available towards the end of 2006 and into 2007.

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.

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):

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.

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 NexGen LPS-Flex Knee, NexGen Trabecular MetalTibial Components, NexGen MIS Tibial Components, theNexGen CR-Flex Knee and the NexGen LCCK Revision Knee, led knee sales. In addition, the ZimmerUnicompartmental High-Flex Knee and the mobile bearing offering within theInnex^tmTotal Knee System exhibited strong growth.

Growth in porous stems, including the Trabecular MetalPrimary Hip Prosthesis, the Zimmer M/L Taper Stem, theCLS^®Spotorno^®Stem from the CLS Hip 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 distribute PALACOSBone Cement, sales of bone cement used in hip procedures improved significantly. Trabecular Metal Acetabular Cups, theAllofit^tmHip Acetabular System and Durom Acetabular Components also had strong growth.

TheBigliani/Flatow^®Shoulder Solution and the Anatomical Shoulder System led extremities sales. Orthobiologicals and prosthetic implants, including strong growth of the Tapered Screw-Vent^®Implant System, led dental sales. Zimmer Periarticular Plates, Zimmer Plates and Screws, theM/DN^®Intramedullary Fixation System, theITST^tmIntertrochanteric / Subtrochanteric Fixation System and theSirus^®Intramedullary Nail System led trauma sales. The DynesysDynamic Stabilization System, theOptima^®4ZS Spinal Fixation System and Spinal Trabecular MetalSpacers led spine sales. OSP sales were negatively affected by the loss of the distribution of theOrthoPAT^®5Autotransfusion System, which contributed approximately $7 million in sales during the three month period ended September 30, 2005. Our exclusive distribution agreement to sell the OrthoPAT Autotransfusion System ended and we stopped selling this product after February 28, 2006.

⁴  Registered Trademark of U&I Corporation.

⁵  Trademark of Haemonetics Corporation.

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

America’s sales increased 6 percent, with price contributing 2 percent. The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components,NexGen MIS Tibial Components, the NexGen LCCK Revision Knee and the NexGen CR-Flex Knee led knee sales. The Zimmer Unicompartmental High-Flex Knee also made a strong contribution.

Growth in porous stems, including growth of the ZimmerM/L Taper Stem, the Trabecular Metal Primary Hip Prosthesis and Alloclassic (Zweymüller) Hip System, led hip stem sales, but were partially offset by weaker sales of cemented primary stems and fracture stems. PALACOSBone Cement, Trabecular Metal Acetabular Cups andDurom Acetabular Components also exhibited strong growth.

The Bigliani/Flatow Shoulder Solution and theAnatomical Shoulder Inverse/Reverse System led extremities sales. The Tapered Screw-Vent Implant System led dental sales. Zimmer Periarticular Plates, ZimmerPlates and Screws and the ITSTIntertrochanteric/Subtrochanteric Fixation System led trauma sales. The Dynesys Dynamic Stabilization System, theOptima ZS Spinal Fixation System and Spinal Trabecular Metal Spacers led spine sales. OSP sales were negatively affected by the loss of the distribution of the OrthoPATAutotransfusion System.

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

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. The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components and the NexGenCR-Flex Knee, the Innex Total Knee System and theZimmer Unicompartmental High-Flex Knee led knee sales. Growth in porous and revision stems, including the CLS Spotorno Stem, led hip stem sales, but was offset by weaker sales of cemented primary stems. Longevity and DurasulHighly Crosslinked Polyethylene Liners, PALACOS Bone Cement, Durom Acetabular Components, Trabecular MetalAcetabular Cups and the Allofit Hip Acetabular System also made strong contributions to hip sales.

The Anatomical Shoulder System and the Anatomical Shoulder Inverse/Reverse System led extremities sales. TheTapered Screw-Vent Implant System and the Tapered SwissPlus^®Implant System led dental sales. The M/DN Intramedullary Fixation System and the NCB Plating System led trauma sales. TheSilhouette^tmSpinal Fixation System⁶and Trabecular Metal Spacers led spine sales. Wound management products led OSP sales.

⁶  TheSilhouette Spinal Fixation System is licensed from Spinal Innovations, LLC.

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

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. The NexGen Complete Knee Solution product line, including NexGen Trabecular MetalTibial Components, the NexGen CR-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 of DuromAcetabular Components and Trabecular Metal Acetabular Cups also exhibited strong growth.

Extremities sales declined due to weaker sales of our shoulder and elbow products. The Tapered Screw-Vent Implant System led dental sales. The ITST Intertrochanteric / Subtrochanteric Fixation System led trauma sales. TheST360º^tmSpinal Fixation System led spine sales. Powered surgical instruments led OSP sales.

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-upcosts 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.

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

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 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.

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:

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.

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.

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