Overview

We are a global leader in the design, development, manufacture and marketing of reconstructive orthopaedic implants, including joint and dental, spinal implants, trauma products and related orthopaedic surgical products (sometimes referred to in this report as "OSP"). We also provide other healthcare related services. 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 predominantly orthopaedic surgical procedures and post-operation rehabilitation. We have operations in more than 25 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. Certain amounts in the 2007 consolidated financial statements have been reclassified to conform to the 2008 presentation.

Beginning in 2008, our Hips product category sales no longer include bone cement and accessory sales, which have been reclassified to our OSP and Other product category. Amounts in the three and nine month periods ended September 30, 2007 related to sales of bone cement and accessory products have been reclassified to conform to the 2008 presentation.

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, 2008 and our expected results for the remainder of 2008.

Demand (Volume and Mix) Trends

Increased volume and changes in the mix of product sales contributed 3 percentage points of sales growth during the three month period ended September 30, 2008, compared to 8 percentage points in the same 2007 period. The ongoing shift in demand to premium products, such as Longevity® and Durasul® Highly Crosslinked Polyethylenes, Trabecular MetalTM Technology products, high-flex knees, knee revision products, porous hip stems and the introduction of gender based devices continues to positively affect sales growth.

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 and more active lifestyles, among other factors.

Pricing Trends

Global selling prices were flat for the three month period ended September 30, 2008, which is similar to the same 2007 period. Selling prices in the Americas were flat during the three month period ended September 30, 2008, compared to a 1 percent increase in the same 2007 period. In Europe, selling prices for the three month period ended September 30, 2008 were flat, which is similar to the same 2007 period. Asia Pacific selling prices decreased 4 percent for the three month period ended September 30, 2008, compared to flat selling prices in the same 2007 period. Japan and Australia each reported a 5 percent decrease in average selling prices as a result of scheduled reductions in government controlled reimbursement prices. Japan and Australia combined currently represent approximately 10 percent of our sales. With the effect of governmental healthcare cost containment efforts and pressure from group purchasing organizations, we expect global selling prices will remain flat in 2008.

Foreign Currency Exchange Rates

For the three month period ended September 30, 2008, foreign currency exchange rates had a positive 2 percent effect on sales. 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, 2008 using average exchange rates in effect at the end of September 2008. 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 and foreign currency options 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.

Compliance-Related Matters

On September 27, 2007, we and other major U.S. orthopaedic manufacturers reached a settlement with the United States government to resolve all claims related to an investigation into financial relationships between the industry and consulting orthopaedic surgeons. We paid a $169.5 million settlement amount and entered into a Deferred Prosecution Agreement (DPA) with the United States Attorney's Office for the District of New Jersey. Under the DPA, we expect to remain subject to oversight by a federally appointed monitor through March, 2009.

We also entered into a Corporate Integrity Agreement (CIA) 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 12 to the consolidated financial statements included elsewhere in this Form 10-Q.

No tax benefit was recorded related the $169.5 million settlement expense when it was recorded in the three month period ended September 30, 2007. In the third quarter of 2008, we reached an agreement with the U.S. Internal Revenue Service confirming the deductibility of a portion of the settlement and recorded an estimated tax benefit of approximately $30.8 million, resulting in a decrease to the current period effective tax rate. For more information regarding the tax treatment of the settlement expense, see Note 7 to the consolidated financial statements included elsewhere in this Form 10-Q.

We are in the process of implementing an enhanced global compliance program which addresses areas such as product development, marketing, surgeon training and educational and charitable funding. The principles of this program meet or exceed the requirements of the DPA and CIA as they apply in most respects to all product segments and reach all worldwide operations. We currently estimate that the costs for complying with the DPA and CIA and implementing the enhanced compliance program in 2008 will be in a range of $50-$60 million, including the fees incurred for the federally appointed monitor.

Durom Acetabular Cup

In July 2008, we announced a temporary suspension of marketing and distribution of the Durom® Acetabular Component (Durom Cup) in the U.S. to permit us to update product labeling to provide more detailed surgical technique instructions and implement a surgical training program in the U.S. We resumed marketing and distribution of the Durom Cup in the U.S. in August 2008. To date, we believe that approximately one-half of the U.S. surgeons who were actively using the Durom Cup prior to the suspension have completed the requisite training program.

Following our announcement, we received claims from a number of Durom Cup patients seeking reimbursement for costs and payments for pain and suffering and we expect to receive additional similar claims. We recorded a provision for certain claims of $47.5 million in the three month period ended September 30, 2008, which represents management's estimate of liability to patients undergoing revision surgeries related to the Durom Cup. The estimate is limited to revisions associated with surgeries occurring before July 2008 and within two years of the original surgery date. Any claims received outside of these defined parameters will be managed in the normal course and reflected in our standard quarterly product liability accruals.

We estimate that we will lose approximately $20-$30 million in hip product sales during 2008, in large part, as a consequence of the events involving the Durom Cup. In addition, we expect that our entry into the growing U.S. hip resurfacing market may be hindered or delayed as the Durom Cup has been integral to our plans for entry into that market.

Orthopaedic Surgical Products (OSP) Actions

In April 2008, we initiated voluntary product recalls of certain OSP patient care products manufactured at the Dover, Ohio facility that we determined did not meet internal quality standards. We do not expect these recalls to affect our core hip and knee implants business. Additionally, we voluntarily and temporarily suspended production and sales of certain OSP products manufactured at the Dover facility. We expect to have a significant portion of these products back in production by the end of 2008, with the remainder of the products coming back into production in the first quarter of 2009. We expect these actions will adversely impact 2008 OSP revenues by $70-$80 million and 2008 diluted earnings per share by $0.18-$0.20, including $0.07 related to inventory charges, idle plant costs and other non-recurring charges.

As a result of the disruptive factors discussed above, including our temporary suspension of U.S. marketing and distribution of the Durom Cup, our voluntary recall and suspension of production of certain OSP patient care products, and the implementation of our enhanced global compliance program, we believe we suffered customer losses during the three month period ended September 30, 2008. We estimate, based on information currently available to us, that these customer losses reduced our base of knee and hip revenues by approximately 3 percent. We expect our sales growth to be at a rate slower than the market in the near term due to these disruptive factors.

Third Quarter Results of Operations

Net Sales by Operating Segment

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


                          Three Months
                              Ended
                          September 30,                     Volume/                   Foreign
                        2008        2007        % Inc         Mix         Price      Exchange

        Americas       $ 563.3     $ 547.0           3 %           3 %         - %           - %
        Europe           251.0       226.0          11             4           -             7
        Asia Pacific     137.9       130.2           6             4          (4 )           6

                       $ 952.2     $ 903.2           5             3           -             2

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

Net Sales by Product Category

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


                       Three Months
                           Ended
                       September 30,                           Volume/                    Foreign
                     2008        2007        % Inc (Dec)         Mix         Price       Exchange

   Reconstructive
   Knees            $ 411.2     $ 376.9                 9 %           8 %        (1 )%           2 %
   Hips               292.3       278.9                 5             2          (1 )            4
   Extremities         27.5        23.9                15            12           1              2
   Dental              51.9        50.2                 3            (1 )         2              2

   Total              782.9       729.9                 7             5          (1 )            3

   Trauma              54.2        49.6                10             5           2              3
   Spine               50.1        45.8                 9             6           2              1
   OSP and other       65.0        77.9               (17 )         (19 )         -              2

   Total            $ 952.2     $ 903.2                 5             3           -              2

The NexGen® Complete Knee Solution product line, including Gender Solutionstm Knee Femoral Implants, the NexGen LPS-Flex Knee, the NexGen CR-Flex Knee and the NexGen LCCK Revision Knee, led knee sales. In addition, the Zimmer® Unicompartmental High-Flex Knee, the NexGen Rotating Hinge Knee and the Natural-Knee® exhibited strong growth.

The continued conversion to 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 weaker sales of cemented stems. Trabecular Metal Acetabular Cups and Longevity and Durasul Highly Crosslinked Polyethylene Liners also had strong growth. The temporary suspension of marketing and distribution of the Durom Cup in the U.S. negatively impacted hip sales growth in the quarter and we expect this trend to continue for the remainder of 2008. Additionally, with the lack of a hip resurfacing product within our U.S. hip portfolio, we expect to face a continuing challenge in hip sales growth with the adoption of hip resurfacing in the U.S. market.

The Bigliani/Flatow® Complete Shoulder Solution and the Zimmer Trabecular Metal Reverse Shoulder System led extremities sales. Orthobiologicals and prosthetic implants, including the Tapered Screw-Vent® Implant System, led dental sales. Zimmer Periarticular Locking Plates and the I.T.S.T.tm Intertrochanteric/Subtrochanteric Fixation System led trauma sales. The Dynesys® Dynamic Stabilization System and the Trinica® Select Anterior Cervical Plate System led spine sales. OSP sales were negatively affected by the patient care product recalls and related voluntary suspension of production of certain products, but these negative factors were partially offset by strong growth in PALACOS® 1 Bone Cement.

1 Trademark of Heraeus Kulzer GmbH

Americas Net Sales

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


                            Three Months Ended September 30,
                              2008                     2007            % Inc (Dec)

       Reconstructive
       Knees            $          264.1         $          247.4                 7 %
       Hips                        137.8                    134.5                 2
       Extremities                  20.3                     16.9                19
       Dental                       28.3                     28.9                (2 )

       Total                       450.5                    427.7                 5

       Trauma                       30.8                     29.8                 3
       Spine                        39.2                     38.2                 2
       OSP and other                42.8                     51.3               (17 )

       Total            $          563.3         $          547.0                 3

The NexGen Complete Knee Solution product line, including the Gender Solutions Knee Femoral Implants, NexGen LPS-Flex Knee, 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 Zimmer M/L Taper Stem and the Zimmer M/L Taper Stem with Kinectiv® Technology, led hip stem sales, but were partially offset by weaker sales of cemented stems. Trabecular Metal Acetabular Cups and Longevity Highly Crosslinked Polyethylene Liners also made a strong contribution. As noted above, the temporary suspension of marketing and distribution of the Durom Cup in the U.S. negatively impacted hip sales and we also expect that the adoption of hip resurfacing in the U.S. market will continue to adversely affect our hip sales growth.

The Bigliani/Flatow Shoulder Solution and the Zimmer Trabecular Metal Reverse Shoulder System led extremities sales. Negative sales growth for our dental business reflects disruptions caused by the implementation of our enhanced compliance model and overall weakness in the U.S. economy. Zimmer Periarticular Plates and the I.T.S.T. Intertrochanteric/Subtrochanteric Fixation System led trauma sales. The Dynesys Dynamic Stabilization System and the Trinica Select Anterior Cervical Plate System led spine sales. OSP sales were negatively affected by the patient care product recalls and related voluntary suspension of production of certain products, but these negative factors were partially offset by strong growth in PALACOS Bone Cement.

Europe Net Sales

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


                            Three Months Ended September 30,
                              2008                     2007            % Inc (Dec)

       Reconstructive
       Knees            $           94.5         $           81.0                17 %
       Hips                        106.8                     98.3                 9
       Extremities                   5.7                      5.2                 9
       Dental                       15.3                     13.4                14

       Total                       222.3                    197.9                12

       Trauma                       12.2                      9.9                26
       Spine                         8.4                      6.7                27
       OSP and other                 8.1                     11.5               (30 )

       Total            $          251.0         $          226.0                11

Changes in foreign exchange rates positively affected both knee and hip sales by 8 percent. The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, the NexGen LCCK Revision Knee and the NexGen CR-Flex Knee, experienced strong sales growth in our European region.

The continued conversion to porous stems, including the CLS Spotorno Stem and the Alloclassic Zweymüller Stem, led hip sales, but was offset by weaker sales of cemented stems. Longevity and Durasul Highly Crosslinked Polyethylene Liners, Trabecular Metal Acetabular Cups and the Allofit® Hip Acetabular System also contributed to hip sales.

The Anatomical Shouldertm System and the Coonrad/Morrey Total Elbow led extremities sales. The Tapered Screw-Vent Implant System led dental sales. The Cable-Ready® Cable Grip System and the NCB® Plating System led trauma sales. The Dynesys Dynamic Stabilization System and the OptimaTM2 ZS Spinal Fixation System led spine sales. OSP sales were negatively affected by the patient care product recalls and related voluntary suspension of production of certain products, but these negative factors were partially offset by strong growth in Surgical Equipment products.

2 Trademark of U&i Corporation

Asia Pacific Net Sales

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


                            Three Months Ended September 30,
                              2008                     2007            % Inc (Dec)

       Reconstructive
       Knees            $           52.6         $           48.5                 8 %
       Hips                         47.7                     46.1                 4
       Extremities                   1.5                      1.8               (11 )
       Dental                        8.3                      7.9                 4

       Total                       110.1                    104.3                 6

       Trauma                       11.2                      9.9                13
       Spine                         2.5                      0.9               142
       OSP and other                14.1                     15.1                (6 )

       Total            $          137.9         $          130.2                 6

Changes in foreign exchange rates positively affected knee sales by 4 percent and hip sales by 7 percent. Reported decreases in average selling prices negatively affected knee sales by 6 percent and hip sales by 5 percent. The NexGen Complete Knee Solution product line, including the NexGen CR-Flex Knee and the NexGen LPS-Flex Knee, led knee sales. The Gender Solutions Knee Femoral Implant in Australia also contributed to knee sales for the period.

The continued conversion to porous stems, including the Fiber Metal Taper Stem from the VerSys® Hip System and the Alloclassic Zweymüller Hip System, led hip stem sales. Sales of Longevity and Durasul Highly Crosslinked Polyethylene Liners, the Trilogy® Acetabular System and Trabecular Metal Acetabular Cups also grew during the quarter.

Extremities sales were led by the Coonrad/Morrey Total Elbow. The Tapered Screw-Vent Implant System led dental sales. Trauma sales were led by the I.T.S.T. Intertrochanteric/Subtrochanteric Fixation System. The Dynesys Dynamic Stabilization System led spine sales. OSP sales were negatively affected by the patient care product recalls and related voluntary suspension of production of certain products.

Gross Profit

Gross profit as a percentage of net sales was 75.1 percent in the three month period ended September 30, 2008, compared to 77.9 percent in the same 2007 period and 75.7 percent in the three month period ended June 30, 2008. The primary contributors to the decrease in gross profit margin were the increase in period over period hedge losses, idle plant costs at our Dover facility and an increase in excess inventory and obsolescence charges due to increased inventory levels. 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, and then recognized in cost of products sold when the hedged item affects earnings.

Operating Expenses

R&D as a percentage of net sales was 4.9 percent for the three month period ended September 30, 2008, compared to 5.9 percent in the same 2007 period. R&D expense decreased to $46.7 million for the three month period ended September 30, 2008, from $53.0 million in the same 2007 period, reflecting decreased spending on certain development, clinical and external research activities due to delays connected with our operational compliance with the DPA and CIA and implementation of our enhanced compliance program. Many of the delayed development and research activities have now resumed and we expect R&D spending to return to our historical average of 5-6 percent of sales.

SG&A as a percentage of net sales was 42.5 percent for the three month period ended September 30, 2008, compared to 39.0 percent in the same 2007 period. SG&A expense increased to $404.9 million for the three month period ended September 30, 2008, from $352.6 million in the same 2007 period. Increased SG&A costs include monitor fees as well as consulting and legal fees associated with the implementation of our enhanced compliance program globally. Such costs resulted in an approximate $17 million increase over the same prior year period. Expenses related to other operating initiatives also caused an increase in SG&A as a percentage of net sales. Such operating initiatives include the planned implementation of a global IT system, improving quality systems at our Dover facility, and a new manufacturing facility in Ireland. Additionally, selling costs increased by 100 basis points in the three month period ended September 30, 2008 compared to the same 2007 period. This increase was caused by increased selling costs as a result of the ORTHOsoft acquisition, an increase in the headcount of our sales force in certain locations, increased commission incentives to sell certain key products and a change in the mix of commissions earned as a result of lower OSP sales. In a partial offset to these unfavorable items, SG&A expense related to share-based compensation was favorable by 20 basis points relative to the same prior year period due to a favorable adjustment as we recalculated estimated payouts on our three year performance-based equity incentive program taking into account recent operating performance.

Certain claims expense of $47.5 million is a provision for estimated claims of Durom Cup patients undergoing revision surgeries within specified times. Acquisition, integration and other expenses for the three month period ended September 30, 2008 were $5.6 million, compared to $2.9 million in the same 2007 period. These expenses pertain to current and prior period acquisitions, including facility consolidation costs, legal fees and retention and termination payments.

Operating Profit, Income Taxes and Net Earnings

Operating profit for the three month period ended September 30, 2008 increased 67 percent to $210.3 million, from $126.0 million in the same 2007 period. The significant increase in operating profit is due to the non-recurring settlement expense of $169.5 million that was recorded in the 2007 period. Excluding the impact of the settlement expense in the prior year, operating profit for the three month period ended September 30, 2008 would have been unfavorable compared to the same 2007 period as a result of lower gross margins, significant but temporary increases in SG&A costs attributable to the implementation of our enhanced compliance program and certain claims expense of $47.5 million.

Interest and other income for the three month period ended September 30, 2008 increased to $28.2 million, from $1.8 million in the same 2007 period. Interest and other income for the three month period ended September 30, 2008 includes a realized gain of $30.1 million related to the sale of certain marketable securities, partially offset by increased interest expense as a result of an increase in outstanding long-term debt.

The effective tax rate on earnings before income taxes and minority interest decreased to 9.8 percent for the three month period ended September 30, 2008, from 65.2 percent in the same 2007 period. The effective tax rate for the 2007 period reflects the effect of the $169.5 million settlement expense, for which no tax benefit had previously been recognized. In the third quarter of 2008, we recorded an estimated tax benefit of approximately $30.8 million, resulting in a decrease of 12.9 percent in the current period effective tax rate. The effective tax rate for the three month period ended September 30, 2008 was further reduced as a result of increased profits in lower tax jurisdictions.

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