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Zimmer Holdings (ZMH - Analyst Report) reported net earnings of $178.1 million or $1.02 per share in the third quarter of 2012 compared with $191.5 million or $1.01 in the year-ago quarter. However, after taking into account certain one-time items, adjusted earnings came in at $1.15, surpassing the Zacks Consensus Estimate of $1.13 and the previous year’s $1.04.

Revenues were $1.026 billion, down 0.6% on a reported basis and up 2.5% at constant exchange rates ("CER"), almost in line with the Zacks Consensus Estimate of $1.029 billion. Revenue generated in the Americas was $584 million (flat), in Europe was $246 million (up 8% at CER) and in Asia-Pacific was $196 million (up 2%).

Segments

Zimmer’s biggest segment, Reconstructive Implant, recorded a 2% increase in revenue (at CER) to $756 million, driven by growth in Europe (6% to $191 million), Asia-Pacific (1% to $145 million) while Americas dropped 1% (to $420 million). Revenues from Knees (within Reconstructive) increased 1% to $407 million while Hips and Extremities recorded a respective growth of 2% (at CER) to $309 million and 12% to $40 million.

Among the other segments at Zimmer, sales from Spine recorded a decline of 7% (at CER) to $50 million. Growth was witnessed in the other three segments – Surgical and Other (11% annually to $91 million), Dental (up 3% to $55 million) and Trauma (11% to $74 million).

Margins         

During the quarter, Zimmer’s gross margin declined 50 basis points (bps) to 75.1%. Moreover, with selling, general and administrative, and research and development expenses dropping by a respective, 3.1% to $430 million and 12% to $53.5 million, operating margin improved 130 bps to 27.9%.

We believe that better operating margin along with a 7.2% year-over-year drop in outstanding share count due to the continuous share repurchase program led to an improvement in earnings per share.

Balance Sheet and Cash Flow

Zimmer exited the third quarter of 2012 with cash and cash equivalents of $801.5 million compared with $768.3 million as of December 2011. Long-term debt increased marginally to $1,734.1 million compared with $1,576 million at the end of 2011.

Operating cash flow for the reported quarter was $345 million. The company repurchased 1.56 million shares for $97.6 million during the quarter and was left with $1.15 billion of share repurchase authorization under the current program that expires on December 31, 2014.

Outlook

Zimmer updated its outlook for 2012. The company now expects to report revenue growth of 2% at CER, lower than the previous outlook of 2.5%−3.5% growth. Currency movement is now expected to lower revenues by 2% (the previous guidance had pegged the effect at negative 2−2.5%), which in turn would lead to flat revenue growth on a reported basis.

The 2012 guidance for both adjusted EPS and on reported basis were narrowed to $5.25−$5.30 (previous guidance was $5.25−$5.35) and $4.75−$4.80 ($4.75−$4.85), respectively.

Recommendation

Zimmer offers a broad line of reconstructive implant and trauma products as well as orthopedic surgical instruments and supplies. We believe that the company has embarked on its growth trajectory with new product launches, employment of new technologies and expansion into the emerging markets.

However, Zimmer continues to witness challenges in the form of pricing pressure and lower procedure volumes resulting from economic uncertainty. Moreover, the company faces tough competition from well-capitalized players such as Smith & Nephew (SNN - Snapshot Report) and Johnson & Johnson (JNJ - Analyst Report), among others.

We have a Neutral recommendation on Zimmer. The stock holds a short-term Zacks #3 Rank (Hold).

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