Zimmer Biomet Annual Report 2005

Plain-text annual report

“Pending clearance of our submitted 510(k), Zimmer will be the first orthopaedic company to offer implants designed specifically for women. The new Gender Solutions Knee Implants incorporate novel features designed to address the unique characteristics of a woman’s knee. These designs are based on Zimmer’s more than 20 years of clinical success in total knee replacement and the analyses of unique bone morphology atlases. It is built upon Zimmer’s platform of knees that accommodate high flexion for today’s active patient and can be used with Zimmer MIS Procedures.” RAY ELLIOTT, Chairman, President & CEO of Zimmer Holdings, Inc. COMMITTED TO THE CORE ZIMMER HOLDINGS, INC. 345 East Main Street P.O. Box 708 Warsaw, IN 46580, U.S.A. www.zimmer.com Z I M M E R H O L D I N GS, I N C. | 2 0 0 5 A N N U A L R E P O RT COMMITTED TO GENDER SOLUTIONS Zimmer’s innovative investments in recent history have resulted in numerous industry firsts. Our newest is the introduction of Gender SolutionsTM Knee Implants. 2006 2004 ST knee implants designed to 1 accommodate the unique anatomic features of women, Gender Solutions(1) ST Zimmer MIS TM Quad-SparingTM 1 Total Knee Arthroplasty procedure(2) ST highly crosslinked polyethylene 1 knee inserts with resistance to delamination, ProlongTM ST Zimmer MIS 2-IncisionTM Total Hip 1 Arthroplasty procedure(3) 2001 1997 ST high flexion knee in the U.S. and 1 Europe, NexGen® LPS-Flex 2000 1996 ST highly crosslinked polyethylene 1 hip liners resistant to wear and aging, Durasul® ST metal material combining high 1 porosity, structural integrity and flexibility, Trabecular Metal TM ST pedicle screw-based stabilization 1 system for the spine using flexible materials, Dynesys®(4) ST clinically proven composite 1 hip stem, Epoch® As women currently receive nearly 60 percent of all total knee arthroplasties (TKAs), a knee implant designed specifically with a woman’s unique needs in mind is a logical development. With the addition of Gender Solutions to our knee portfolio, Zimmer is planning to offer implants that are uniquely designed for women. Key characteristics common to a woman’s anatomy found in the Gender Solutions Knee Implants include: • A narrower femoral component designed to more closely match the distinctive shape of a woman’s femoral anatomy • A less prominent anterior surface of the femur • A modified femoral groove for the kneecap to move during knee flexion ON THE FRONT COVER: Zimmer’s commitment to improving the quality of life for patients includes recognizing the differ- ences between women and men in the design of our implants. A woman’s knee anatomy is quite distinguishable from a man’s. Distinctive features, to name a few, include a difference in the ratio between the width and height of the thigh bone as com- pared to men, Q-angle differences due to a wider pelvis, less pronounced bony anatomy on the anterior (front) surface of their thigh bone and greater ligament laxity. These differences have been studied and considered in the design of our new Gender Solutions Knee Implants. 2002 1998 1994 CORPORATE INFORMATION BOARD OF DIRECTORS J. Raymond Elliott Chairman, President and Chief Executive Officer Zimmer Holdings, Inc. Stuart M. Essig President and Chief Executive Officer Integra LifeSciences Holdings Corporation Larry C. Glasscock Chairman, President and Chief Executive Officer WellPoint, Inc. John L. McGoldrick Executive Vice President Bristol-Myers Squibb Company Augustus A. White, III, M.D., Ph.D. Ellen and Melvin Gordon Professor of Medical Education, Professor of Orthopaedic Surgery, Master, Oliver Wendell Holmes Society, Harvard Medical School OFFICERS AND KEY MANAGEMENT J. Raymond Elliott Chairman, President and Chief Executive Officer Cheryl R. Blanchard, Ph.D. Senior Vice President, Research and Development and Chief Scientific Officer Sheryl L. Conley Group President, Americas and Global Marketing and Chief Marketing Officer James T. Crines Senior Vice President, Finance, Operations and Corporate Controller and Chief Accounting Officer David C. Dvorak Group President, Global Businesses and Chief Legal Officer Jon E. Kramer President, U.S. Sales STOCKHOLDER INFORMATION Headquarters Zimmer Holdings, Inc. 345 East Main Street Warsaw, IN 46580, USA +1-574-267-6131 www.zimmer.com Stock Listing Zimmer is listed on the New York Stock Exchange and the SWX Swiss Exchange under the symbol ZMH. Transfer Agent Communications concerning stock transfer requirements, loss of certificates and change of address should be directed to Zimmer’s Transfer Agent: The Bank of New York P.O. Box 11258 New York, NY 10286, USA +1-888-552-8493 (Domestic) +1-610-382-7833 (International) shareowner-svcs@bankofny.com www.stockbny.com Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Officer Bruno A. Melzi Chairman, Europe, Middle East and Africa Laura C. O’Donnell Chief Compliance Officer Stephen H. L. Ooi President, Asia Pacific Investor Relations Zimmer invites stockholders, security analysts, portfolio managers and other interested parties to contact: Marc S. Ostermann Manager, Investor Relations +1-574-371-8515 marc.ostermann@zimmer.com Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Officer +1-574-372-4790 sam.leno@zimmer.com CORPORATE GOVERNANCE ISS Corporate Governance Quotient* (CGQ®) Index Ranking: 81.6 Industry Ranking: 98.2 Zimmer Holdings, Inc. outperformed 81.6 percent of the companies in the S&P 500 Index and 98.2 percent of the companies in the health care equipment and services group as of February 8, 2006. Chad F. Phipps Associate General Counsel and Secretary Renee P. Rogers, Ph.D. Vice President, Global Human Resources James P. Simpson Senior Vice President, Health Economics and Government Affairs Richard C. Stair Vice President, Global Operations and Logistics To obtain a free copy of Zimmer’s annual report including form 10-K, quarterly reports on form 10-Q, news releases, earnings releases, proxy statements, or to obtain Zimmer’s financial calendar, access SEC filings, listen to earnings calls, or to look up Zimmer stock quotes, please visit investor.zimmer.com or call +1-866-688-7656. Independent Auditors PricewaterhouseCoopers LLP Chicago, IL, USA (1) Pending 510(k) clearance (2) Tria AJ, Coon TM. Quadriceps Sparing Total Knee Arthroplasty. Sem Arthroplasty. 2005; 16:208-214 (3) Berger RA, Jacobs JJ, Meneghini RM, Della Valle C, Paprosky W, Rosenberg AG. Rapid rehabilitation and recovery with minimally invasive total hip arthroplasty. Clin Orthop. 2004; 429:239-247. (4) Cleared in the U.S. as an adjunct to fusion. * Trademark of Institutional Shareholder Services, Inc. Originally introduced in 2002, the ISS Corporate Governance Quotient (CGQ®) is a dynamic corporate governance rating tool that is designed to help investors manage investment risk and drive value while also helping corporations perform peer analysis and benchmark their corporate governance practices. TO OUR STOCKHOLDERS We believe that winning is the result of commitment. When we closed the Centerpulse acquisition in October 2003, we communicated our expectations for the combined company to generate, on an adjusted(5) basis, more than 20 percent diluted EPS growth in 2004 and 20 to 25 percent diluted EPS growth in 2005, with the potential of 25 percent or more in 2006. So far, we have delivered an average adjusted(5) diluted EPS growth of over 30 percent for 2004 and 2005 combined. Our strong 2005 performance reflects Zimmer’s scalable business model, resulting in substantially higher operating leverage compared with our competitors. We also achieved, in some cases, operating margins 50 percent higher than some of our more diversified competitors. Notably, we achieved this strong financial performance in a more chal- VALUE-ADDED EDUCATION A key to Zimmer’s historic growth has lenging market environment, especially in 2005, demonstrating that our been our leadership in professional medical education. In 2005, we focus on operational details and our disciplined financial management increased the number of surgeons trained through The Zimmer is paying off for shareholders. Let’s take a more detailed view of some of Institute, its satellites and affiliated institutions from more than 1,400 to the key achievements for 2005: almost 2,500. • Attained net sales of $3.29 billion, a 10 percent increase over 2004, reflecting strong growth in all geographies and in spine, dental, knee and extremities • Achieved diluted earnings per share of $2.93 reported and $3.10 adjusted,(5,6) up 34 percent and 29 percent, respectively • Realized record profit margins of 78 percent gross, 32 percent operating and 22 percent net, improving our profitability even with moderating price and foreign exchange impacts • Accomplished effective tax rate on adjusted basis of 29.6 percent,(5,6) a further improvement over last year • Paid off all debt related to the Centerpulse and Implex acquisitions, leaving us in a net cash position at the end of the year of $164 million(6) • Completed almost 90 percent of total planned integration milestones related to the Centerpulse acquisition • Doubled Puerto Rico manufacturing, doubled our highly automated distribution center in Warsaw, Indiana, and tripled Trabecular Metal Technology reactor capacity • Closed our Austin, Texas, manufacturing plant by the end of October, two months ahead of plan • Established new organization structure creating global businesses with enhanced focus on markets and customers Zimmer has been a leader in applying navigational technology to min- imally invasive joint replacement, launching the first electromagnetic nav- igation system for knee procedures in collaboration with Medtronic, Inc. We strengthened our leadership in Minimally Invasive SolutionsTM (MIS TM) Procedures and Technologies with the market release of the MIS Tibial Plate, the first tibial knee component that can be assembled within the patient. We expanded our offering of surgical techniques with the launch of the Zimmer MIS Anterolateral Hip Procedure. Underscoring the acceptance of our MIS Techniques, more than 3,000 Zimmer MIS 2-Incision Hip Procedures have been performed since its launch in 2001. Our commitment to MIS leadership is based on our view that the economic benefits are as compelling as the patient outcomes. We have worked with leading surgeons and institutions to develop data on the clinical benefits of our MIS Procedures and Technologies and the economic value they add. Late in 2005, one peer-reviewed article indicated that 48 out of 50 consecutive Zimmer MIS Quad-Sparing Knee Procedure patients were able to be discharged the day of surgery.(8) Another article stated that MIS Quad-Sparing Knee and MIS Mini-Incision Knee Procedures could reduce costs by almost $200 million per year in the U.S.(9) INNOVATIVE INVESTMENT To maintain and expand our leading posi- tion, Zimmer is investing more than $175 million a year in research and de- velopment to drive innovations that will make a difference in patients’ lives. In 2005, we established a record pace for new products, launching a For Zimmer and the orthopaedic industry, 2005 continued the robust growth total of 79 projects. Most recently, we are planning to introduce our Gender trends of recent years. The composition of Zimmer’s sales growth, however, has changed: While procedure volume and product mix benefits were Solutions Implants, designed specifically to accommodate the anatomical differences between men and women.(10) still strong and barely unchanged from prior periods, price and foreign Significant resources of the more than 160 projects in our pipeline exchange benefits have moderated compared to more recent history. The are focused on new growth platforms and new technologies. In 2005, aging baby boomers, more active lifestyles, increased obesity and female patients are expected to continue to drive some of our key markets.(7) To take advantage of these trends, we continue to focus on our core strategies: we generated $695 million or 21 percent of sales in new product sales, above our long-standing target range of 15 to 20 percent of total sales.(11) Particular technology areas of focus are orthobiologics, new material Value-Added Education, Innovative Investment, and Flawless Execution. technologies and intelligent or computer assisted technologies. (5) “Adjusted” refers to performance measures that exclude in process R&D write-offs, acquisition, integration and other expenses, inventory step-up, a tax benefit from decreased Swiss deferred taxes and the change in accounting principle for instruments, as applicable. (6) See enclosed reconciliations of non-GAAP financial measures, page 72. (7) Crowninshield RD, Rosenberg AG, Sporer SM. Changing demographics of patients with total joint replacement. Clin Orthop. 2006; 443:266-272 (8) Berger RA, Sanders S, Gerlinger T, Della Valle C, Jacobs J, Rosenberg A. Outpatient total knee arthroplasty with a minimally invasive technique. J Arthroplasty.2005; 20 (suppl 3):7. (9) Coon TM, Tria AJ, Lavernia C, Randall L. The economics of minimally invasive total knee surgery. Sem Arthroplasty. 2005; 16:235-238. (10) Pending 510(k) clearance (11) New products are defined as those introduced within the preceding rolling 36-month period. 1 Our ability to successfully acquire and integrate companies, as demonstrated with Centerpulse and Implex, is another important core competency that has created value for our shareholders. Complementing our in-house research re- sources are external partnerships developing technologies that are important to our future. Two particularly exciting elements of this direction are our exclusive agreement with Revivicor, Inc., signed in 2005, on xenographic porcine or- thopaedic tissue technology, and our continued collaboration with ISTO Technologies, Inc., which includes plans to begin with Phase I human clinical trials of a technology to repair cartilage in 2006. We also signed an exclusive distribution agreement with Heraeus of Germany on PALACOS® Bone Cement(12) products for the U.S. Later in the year, we expanded the agreement to distribute some of Heraeus’ products globally. We are RAY ELLIOTT Chairman, President and Chief Executive Officer positioned us favorably for both continued inter- nal growth and additional strategic acquisitions. OUTLOOK To achieve above-market growth, we implemented a new management structure in late 2005 to establish global businesses, which include Zimmer Dental, Zimmer Spine, Zimmer Trauma and Zimmer Orthopaedic Surgical Products. We were able to fill all executive posi- tions by promoting internal candidates, taking full advantage of the depth and diversity of our man- agement team. Because of the increased impor- tance of the economic outcomes of a product or technology, we have created new departments focused on global health economics as well advancing our plan to provide a full range of bearing surface options as research and consulting services, to help hospitals improve profit per for hip replacement. We received an approvable letter from the U.S. Food and Drug Administration for our Trilogy AB ® Ceramic-on-Ceramic Acetabular System in December, and we have completed submission of our filings for regulatory clearance of large head, Metasul ® Metal-on- Metal Hip Replacement products. Our commitment to investing in game- patient without compromising clinical results. Given our strong financial results and especially our record of strong cash generation, we are in an excellent position to pursue strategic acquisitions that meet our demanding criteria, specifically in biologics, dental, and spine. We believe our ability to successfully acquire and changing technologies was evident in 2005: We expanded our biologics integrate companies, as demonstrated with Centerpulse and Implex, group in Austin, Texas, and we announced plans to build a new Research is another important core competency that has created value for and Development center in Warsaw, Indiana, of approximately 100,000 our shareholders. Late in 2005, we also announced a $1 billion share square feet. repurchase program, which gives us another option to utilize cash to build shareholder value. FLAWLESS EXECUTION Even the greatest technologies will be com- We are committed to our orthopaedic businesses because the conflu- promised without outstanding follow through, and that is an area where ence of improving technologies and demographics offers attractive long- Zimmer has excelled. Our detailed focus on execution and operations term prospects. The increased importance of the baby boomer generation, is enabling us to deliver industry leading margins and strong cash flow especially women, can be a real driver for our businesses. Look for Zimmer generation. We view operations as a core competency and are looking to seek ways to disrupt traditional markets, as we did with MIS Procedures for opportunities for vertical integration, insourcing processes like castings, forgings and, potentially, spine manufacturing and high volume instrument manufacturing. These differences and investments and as we hope to do with gender-specific products, such as our Gender Solutions(13) Knee System. We’re “Committed to the Core” because we think it’s a great place to be for patients, for surgeons, for payors, for stock- in automation, robotics, our leading market shares in reconstructive holders and for us. businesses, disciplined financial management and our skilled work- force all helped us to become a low-cost manufacturer and distributor in the orthopaedic industry. The completion of almost 90 percent of the Centerpulse integration Ray Elliott milestones by the end of 2005 and the paydown of nearly $1.5 billion Chairman, President and Chief Executive Officer of debt related to both the Centerpulse and Implex acquisitions have January 31, 2006 (12) Trademark of Heraeus Kulzer GmbH (13) Pending 510(k) clearance 2 FINANCIAL HIGHLIGHTS (Dollars in millions except per share amounts) SALES BY GEOGRAPHIC SEGMENT Reported 2002 2003 2004 2005 59% 27% 14% Americas Europe Asia Pacific Consolidated $ 933 $ 1,208 $ 1,741 $ 1,942 170 269 366 327 809 431 875 469 $ 1,372 $ 1,901 $ 2,981 $ 3,286 SALES BY PRODUCT CATEGORY Reported 2002 2003 2004 2005 41% 35% 2% 5% 7% 5% 5% Reconstructive Knees Hips Extremities Dental Trauma Spine Orthopaedic Surgical Products $ 1,061 $ 1,521 $ 2,456 $ 2,721 586 441 34 — 134 — 177 801 645 45 30 150 35 195 1,194 1,079 58 125 173 134 218 1,366 1,141 66 148 180 160 225 Consolidated $ 1,372 $ 1,901 $ 2,981 $ 3,286 NET SALES(14) +10% Reported 2,590 1,901 2,168 1,372 OPERATING PROFIT 3,286 2,981 +24% Adjusted (15) +38% Reported 1,117 1,055 904 763 584 451 401 DILUTED EARNINGS PER SHARE 862 878 +29% Adjusted (15) +34% Reported 3.10 2.93 2.41 2.19 1.80 1.64 1.31 OPERATING CASH FLOW +2% Reported 495 220 02 03 04 05 02 03 04 05 02 03 04 05 02 03 04 05 (14) Net sales for 2002 and 2003 include pro forma Centerpulse sales for periods prior to the closing of the acquisition on October 3, 2003, as reflected in the Net Sales bars above. (15) “Adjusted” refers to performance measures that exclude in process R&D write-offs, acquisition, integration and other expenses, inventory step-up, a tax benefit from decreased Swiss deferred taxes and the change in accounting principle for instruments, as applicable. See enclosed reconciliations of non-GAAP financial measures, page 72. 3 COMMITTED TO THE CORE STRATEGIES VALUE-ADDED EDUCATION: CONNECTING WITH SURGEONS AND PATIENTS Since we opened The Zimmer Institute in 2003, we have trained more than 4,000 surgeons in our Minimally Invasive Solutions Procedures and Technologies at our Warsaw headquarters and at 25 satellite and contract facilities worldwide. In 2005 alone, we trained nearly 2,500 surgeons. Almost 700 people at more than 300 remote sites viewed our first live surgery of the Zimmer MIS Anterolateral Total Hip Procedure in 2005. Since then the webcasts have been rebroadcast more than 1,000 times for 1,400 registered viewers. A survey of almost 300 surgeons trained at The Zimmer Institute suggests that 63 percent of surgeons plan to utilize the Zimmer MIS Quad-Sparing Total Knee Procedure and 30 percent expect to use the Zimmer MIS 2-Incision Total Hip Procedure after completing the respective training. In addition, our new MIS Anterolateral Hip Procedure is gaining acceptance among surgeons. This technique is less demanding than the MIS 2-Incision Procedure but offers many of the same patient benefits. MIS Procedures are advancing the practice of many surgeons, making it easier for them to connect with patients. That connection is frequently established through Zimmer’s surgeon locator on Zimmer’s corporate web site, which received nearly 100,000 visitors during 2005. We are strengthening our dental brand with a commitment to training, putting confidence in the hands of dental practitioners at our soon to open Zimmer Institute in Carlsbad, California. INNOVATIVE INVESTMENT: CREATING FUTURE GROWTH POTENTIAL We have often been first to market with advances such as the NexGen MIS Tibial Plate, a knee com- ponent introduced in 2005 that can be assembled within the patient. Our product pipeline consists of more than 160 research and development projects, with signif- icant resources focused on new technologies. Leading our R&D effort is a staff of over 550 people, including 50 Ph.D.s and a 26-person biologics group. Our strategic investments in R&D helped generate $695 million in new products sales in 2005, above our target of achieving 15 to 20 percent of total sales each year with new products.(16) Currently in development through our partnerships with ISTO Technologies, Inc. and Revivicor, Inc. are biological solutions to repair and replace damaged or degenerated orthopaedic tissues. In 2005, we launched our first biologic product, the Zimmer Collagen Repair Patch to treat rotator cuff tears through a partnership with Tissue Science Laboratories plc. In the future, we ex- pect to bring to market additional orthobiological applications that, like our Trabecular Metal Technology, may offer significant clinical benefits across all our lines of business. Besides orthobiologics, we are looking at emerging applications in the areas of intelligent technologies such as sensors, computerized cutting and drilling tools, as well as new materials such as wovens, hydrogels, and other approaches such as drug/device combinations. Complementing our new products are established offerings with remarkable longevity. Zimmer has more than 10 major reconstructive brands that are still clinically active after 15 years and have excellent clinical results. We continue to improve our established products with the same passion for innovation we bring to newer offerings. This combination of emerging technologies and perennial solutions gives us a product portfolio we believe is unsurpassed in its breadth and depth. LEVERAGING THE ZIMMER INSTITUTE IN OUR DENTAL BUSINESS In June 2006 the new Zimmer Institute will host the first group of clinicians in a state of the art facility designed to enhance the knowledge, skills and confidence essential for the practice of contemporary implant dentistry. One of the hallmarks of The Zimmer Institute is the focus on extended learning through study groups, preceptorships, and alumni symposia. DEVELOPING NEW MATERIALS Zimmer is developing new materials such as biodegradable, injectable hydrogels for potential orthopaedic applications. 4 (16) New products are defined as those introduced within the preceding rolling 36-month period. THE SEARCH FOR NEXT-GENERATION SOLUTIONS The Zimmer R&D facility in Austin, Texas, is working on next-generation biologic solutions for repair and replacement of damaged tissues in bone, spine, ligament, tendon, and articular cartilage. The biologics R&D facility has extensive research lab capabilities in cell culture (pictured left), molecular biology, bio- mechanical testing, polymer synthesis, and biomateri- als testing. Its efforts are supported by our strategic partnerships with emerging technology companies. ZIMMER’S WORLDWIDE PRESENCE Our global and highly automated distribution system and our skilled co-workers allow us to promptly and efficiently serve our customers in more than 100 countries. 78% GROSS MARGINS Flawless execution has made Zimmer a low-cost manufacturer and low-cost distributor in the orthopaedics industry. As a result, Zimmer has achieved continued margin expansion, with 2005 gross margins of 78 percent even in the more challenging recent pricing environments. FLAWLESS EXECUTION: LEVERAGING OUR GLOBAL FOOTPRINT Our strategic acquisition of Centerpulse and the completion of almost 90 percent of more than 3,500 related integration milestones have created a global footprint that we think is a significant competitive advantage for Zimmer. With more than a million square feet of manufacturing capacity around the world, we operate around the clock. The combination of our “big box” strategy of running fewer but bigger plants; vertical integration; the increased use of automation and robotics; lean manufacturing efforts; the sharing of best practices across our plants; and our skilled labor force all help us to further strengthen our position as the low-cost manufacturer in the industry. Our global footprint also yields distribution advantages. Our distribution centers in North America, Europe and Asia Pacific facilitate prompt and accurate delivery of our products anywhere in the world. Computerization and automation in our Warsaw, Indiana, distribution center, for example, enable us to make up to 40,000 daily inventory “picks” with 99.996 percent accuracy. Being a low-cost manufacturer and low-cost distributor also keeps our cost of sales at record low levels. Our focus on orthopaedic implants and disciplined financial management, together with our manufacturing and distribution strategy, help us to achieve operating margins which are Price Increase % in many cases up to 50 percent better than those of companies viewed as more diversified. Our “diversity” is focused on a broad range of executional and operational skillsets, while our knowl- edge base is tightly focused on a core group of products. In fact, Zimmer has generated in most quarters between 40 and 70 cents of operating profit for every new sales dollar, demonstrating the high potential operating leverage and the scalability of our business operations. 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Adjusted Gross Margin %(17) 79 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 01 02 03 04 05 78 77 76 75 74 73 72 71 (17) See enclosed reconciliations of non-GAAP financial measures, page 72. 5 COMMITTED TO THE CORE CONSTITUENTS PATIENTS: IMPROVING QUALITY OF LIFE Our core strategies reflect our belief that we can deliver products and procedures that provide improved clinical outcomes and a better quality of life for patients worldwide. Recent data offer compelling evidence that we are achieving that result. In 2,655 clinical study cases on MIS 2-Incision Hip Procedures reported to Zimmer by surgeons since 2001, dramatic patient benefits are apparent. For example, an orthopaedic surgeon who has performed more than 200 MIS 2-Incision Procedures reported that his patients are up and moving faster, with less pain, and they return to work more quickly. Typically they are walking unassisted within two weeks. Rates of complications within the study group are well within the rates reported in scientific literature for traditional, open hip replacement using non-cemented implants. Because of the clear patient benefits of the MIS 2-Incision Hip Procedure, minimally invasive techniques are being adopted by more orthopaedic surgeons who previously preferred other approaches. Zimmer’s growing portfolio of 13 minimally invasive surgical procedures provides advanced solutions for different surgical skill levels. Most recently, we expanded our NexGen family of knees with Gender Solutions,(19) designed specifically for women and implantable using MIS Techniques. SURGEONS: ENHANCING VITAL SKILLS Many orthopaedic surgeons trained at The Zimmer Institutes practice in major metropolitan areas and perform significant numbers of reconstructive procedures every year. Zimmer is taking steps to enhance the skills at the community surgeon level and make it easier for patients to find an MIS- trained surgeon close to home. Computer-based, imageless systems are a key component of our efforts to make community surgeons more comfortable with MIS Procedures. For example, the iNAV TM (20) Portable Electro- magnetic Navigation System, offered through our exclusive partnership with Medtronic, is a high- quality, low-cost, portable computer navigation system for knees. A portable system that can be easily wheeled in and out of the operating room, the iNAV System is helping to make community surgeons more proficient at a cost that community hospitals can absorb without extensive capital investments. We currently have launched iNAV Systems in the field and have completed more than 500 surgeries. Other devices that promise to make MIS Procedures more accessible include intelligent tools that are extremely accurate and flexible to the surgeon. One such tool is the BRIGIT (19) Bone Resection Instrument Guide, a voice activated, electromechanical tele-manipulator arm that is used by the surgeon for the spatial positioning and orientation of a guide or tool. IMPROVING PATIENTS’ QUALITY OF LIFE A growing body of data suggests that patients undergoing MIS Hip Procedures are up and moving faster, with less pain, and are able to begin rehabili- tation and return to their normal lives more quickly than with traditional joint replacement surgery. In some cases, these patients are walking without any kind of support within two weeks. 96% OF PATIENTS GO HOME THE SAME DAY A study of 50 consecutive outpatient total knee arthroplasties showed that 96 percent, or 48 of 50 patients, chose to go home the day of surgery.(18) Discharged same day: Completed physical therapy same day: 48 49 Went home with cane or unaided: 10 20 30 43 40 50 6 (18) Berger, Sanders et al., op.cit. (19) Pending 510(k) clearance (20) Trademark of Medtronic, Inc. ENHANCING SURGEON SKILLS The BRIGIT (19) System (left) is a voice activated, electromechanical tele-manipulator arm used by the surgeon during joint procedures. The iNAV System (below), produced through an exclusive partnership with Medtronic, Inc. offers high-quality, low-cost portable computer navigation for knee replacements. PAYORS: REALIZING THE BENEFITS OF MIS TECHNOLOGIES Zimmer continues to work with hospitals and payors to emphasize the potential of MIS Procedures not only to enhance the quality of patients’ lives but also to shorten hospital stays and rehabilitation time. For example, as it became apparent that the MIS 2-Incision Hip Procedure improved short- term, post-operative clinical outcomes, Zimmer sought to quantify the price at which those improvements could be achieved by analyzing resource utilization at all points of patient care — from hospitals to rehabilitation providers and physicians. Early studies by Zimmer on economic efficiencies suggested a 30 percent improvement in three-month patient outcomes with a 30 percent reduction in overall cost.(21) That data has been refined and submitted for journal publication. In addition, a recent study of 50 patients undergoing total knee arthroplasty indicated that commonly performed orthopaedic knee procedures that once required a multiple-day hospital stay can now be performed on an outpatient basis using minimally invasive techniques.(18) A recent peer-reviewed journal article further suggests that the Zimmer MIS Quad-Sparing Knee Procedure provides superior economic and patient clinical benefits including average hospi- tal profitability of nearly $3,000 per patient in an environment with 60 percent Medicare patients. The authors describe potentially “staggering” savings to the healthcare system, and state that if 10 percent of standard knee replacements were converted to Zimmer minimally invasive knee re- placement procedures, the inpatient hospital cost of treating Medicare beneficiaries could decline by nearly $200 million annually.(22) Zimmer believes the patient benefits of MIS Products and Procedures will translate into benefits to the overall healthcare system by minimizing the immediate impact of surgery and returning patients more quickly to active, productive lives. $200 MILLION IN HEALTH CARE SAVINGS would result if only 10 percent of Medicare knee replacement patients received Zimmer MIS Total Knee Arthroplasties.(22) (21) Zimmer data on file. ( 22) Coon et al., op. cit. 7 COMMITTED TO THE CORE R&D INVESTMENTS OUR BROAD PORTFOLIO OF INNOVATIVE PRODUCTS AND TECHNOLOGIES Zimmer’s product portfolio encompasses orthopaedic solutions ranging from first-generation implants to newer implants designed for MIS Procedures. In the pipeline are even more advanced technologies designed to repair soft tissue, tendons and cartilage. The broad range of products and processes that comprise our platform technologies gives our R&D portfolio a breadth and depth we believe is unmatched in the industry and enables us to improve the quality of life for both younger and older patients along the continuum of care and across all of our business lines. ORTHOBIOLOGICS Our focus in orthobiologics is on solutions that could transform treatment of damaged joints by biological regeneration rather than replacement with inert materials. We believe our research and development pipeline is one of the most innovative in the industry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Genetically Modified Porcine Xenografts In 2005, Zimmer obtained exclusive worldwide distribution rights for genetically engineered tissues for regenerative therapies from Revivicor, Inc. Zimmer plans to evaluate the technologies for the repair and replacement of damaged tendon, ligament, meniscus (pictured at left), cartilage, bone and spinal nucleus tissues. . . . . . . . . . . . . . Osteochondral Allo/Xenograft The use of osteochondral grafts for resurfacing of osteochondral defects in the knee may be a useful and promising treatment for patients who are too young and too active for total knee replacement. Zimmer has ongoing development programs in the regeneration and repair of both cartilage and subchondral bone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percutaneous biologic approach to disc repair Zimmer is developing a biodegradable, injectable hydrogel device designed to alleviate pain by restoring the spinal nucleus to its original height through rehydration. Neocartilage Technology ISTO Technologies, Inc. in partnership with Zimmer is developing cartilage regen- eration and cell-based therapies (below) using cells from juvenile donor cartilage. Initial applications will target knee joints. Zimmer led a financing round of $10.8 million in 2005, which provides equity and development funds to ISTO to move its cartilage products to U.S. Phase I human clinical trials in 2006. $695 MILLION IN 2005 SALES CAME FROM NEW PRODUCTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 MINIMALLY INVASIVE SOLUTIONS PROCEDURES AND TECHNOLOGIES Zimmer MIS Anterolateral Hip Replacement Procedure incision Hip interval cross section showing how the surgeon weaves through muscles NEW MATERIAL TECHNOLOGIES Zimmer continues to be the pioneer in the development, rigorous clinical evaluation and teaching of minimally invasive orthopaedic surgery techniques. Zimmer’s growing portfolio of 13 minimally invasive technologies and approaches to surgery enables surgeons and hospitals to provide patients with superior orthopaedic medical care. Our new Zimmer MIS Anterolateral Hip Replacement Procedure also is gaining surgeon acceptance, with more than 9,000 operations performed. The word “anterolateral” describes the surgeon’s approach to the hip joint, which allows the patient to lie on his or her side during the surgical procedure. As shown in the interval cross section of a hip and surrounding soft tissue at left, the surgeon weaves through the patient’s muscles instead of cutting through them. Zimmer worked with a global surgeon team to develop and refine both the muscle- sparing surgical technique and the specialized instruments required to perform the procedure. Orthopaedic solutions have historically featured hard metal components. Zimmer is developing the next generation of solutions using materials such as hydrogels and woven metals that offer improved mechanical properties, tensile strength, flexibility and durability. Highly Crosslinked Polyethylenes and Hydrogels Zimmer signed in 2005 comprehensive agreements with Massachusetts General Hospital and the Cambridge Polymer Group to research, license and commercialize advanced orthopaedic polyethylenes, including vitamin E applications, and hydrogel materials. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ceramic-on-Ceramic Technology Expected to be available in the United States in the first half of 2006, the Trilogy AB Ceramic-on-Ceramic Hip System is part of the Trilogy® Acetabular System, the world’s largest selling family of acetabular products. The Trilogy AB Femoral Head and Cup Liner components are made of alumina ceramic and are designed to provide hard, wear-resistant articulating surfaces. Metal-on-Metal Technology Zimmer plans to extend its current Metasul Metal-on-Metal offerings in the United States with larger head sizes in the first half of 2006.(23) Wrought metal and high carbon metal alloys decrease wear and improve lubrication compared to cast metal and low carbon metal alloys. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Woven PMMA Technology Zimmer is working on a next-generation hip fixation product using woven PMMA (Polymethyl methacrylate) materials in addition to metal. An estimated 500,000 hip fractures occur every year in the United States alone, and one of four persons experiencing them dies in the subsequent year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trabecular Metal Technology The cellular structure of Trabecular Metal Material (left side of image) resembles bone (right side of image) and approximates its properties more closely than other prosthetic metals. Zimmer is leveraging the competitive advantage of our proprietary Trabecular Metal Technology by implementing it across a growing array of primary and revision hip, knee, spinal and trauma implants. INTELLIGENT TECHNOLOGIES High-speed computers, intelligent tools, 3-D visualization, and cutting-edge technology allow surgeons to provide the best patient care possible. BRIGIT Bone Resection Instrument Guide BRIGIT is a voice activated, electromechanical tele- manipulator arm that is used by the surgeon for the spatial positioning and orientation of a guide or tool.(23) iNAV Portable Electromagnetic Navigation System The iNAV System, offered through our exclusive partnership with Medtronic, Inc., is a portable computer navigation system for knees. An iNAV System for hips is under development. . . . . . . . . . . . . . . . . . . Telemeterized hip and knee implants Zimmer along with external partners is developing technology to equip implants with sensors that will measure temperature and loads. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Spine Simulation Using computerized 3-D modeling to predict how products will perform, Zimmer is using next-generation computer modeling tools to develop next-generation implants that may result in better fit, improved motion, reduced wear and better bone remodeling around implants. (23) Pending 510(k) clearance 9 COMMITTED TO THE CORE PRODUCTS KNEES Zimmer continues to expand its array of knee replacement options to reflect the changing demographics among orthopaedic patients. Not only is the population aging, it also is becoming more active and at the same time more overweight. Patients are demanding reconstructive products and procedures that fit their lifestyles, and Zimmer is responding with a broad spectrum of orthopaedic solutions designed to offer improved wear and flexibility. Zimmer MIS Minimally Invasive Solutions Procedures for Total Knee Arthroplasty In collaboration with renowned surgeons, Zimmer has developed a comprehensive portfolio of MIS Knee Procedures and training, enabling surgeons to choose the approach they feel most confident in performing. Approaches currently include the MIS Quad-Sparing, MIS Subvastus and Midvastus Procedures, and MIS Medial Parapatellar Procedure. . . . . . . . . . . . . . . . . . . . NexGen Knee Gender Solutions* Designed to accommodate the unique features of both male and female knees, Gender Solutions implants offer an improved match for the dimensions of the female knee and for anatomies having a wider pelvis, typical of the female population. This new knee design is based on more than 20 years of Zimmer’s clinical success in total knee replacement. In addition, it is built upon Zimmer’s platform of knees that accommodate high flexion for today’s active patients and it can be used with Zimmer’s MIS Procedures. * Pending 510(k) clearance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Natural-Knee® II System The Natural-Knee System consists of interchangeable implants with features including a proprietary CSTi TM Porous Coating option for stable fixation in active patients, a deepened trochlear groove to maximize range of motion, and simple to use instrumentation. The Natural-Knee II System is based on the design principles of the Natural-Knee System, which has 20 years of excellent clinical experience. . . . . . . . . . . . . . . . . . Trabecular Metal Augments and Cones These components combine the benefits of Trabecular Metal Technology with the clinically proven geometries of the NexGen Total Knee. They provide structural support in areas of significant bone loss and offer an innovative alternative to bone grafting procedures for both the femoral and tibia bone.** ** For cemented use only in the U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NexGen LPS-Flex Knee For patients with the ability and desire to safely perform high-flexion activities, implant design should not limit postoperative range of motion. Many activities of daily living require flexion beyond 120 degrees. Consider climbing stairs (75-140 degrees), sitting in a chair and standing up again (90-130 degrees), or squatting (130-150 degrees). The NexGen LPS-Flex Fixed Knee is designed to accommodate these high-flexion daily activities. The LPS-Flex Fixed Knee extends the NexGen Complete Knee Solution to patients capable of up to 155 degrees of active flexion. . . . . . . . . . . . . . . . . . . . . . . . . . Zimmer Unicompartmental Knee System This system adds to Zimmer’s portfolio of high flexion knee replacement options. It was designed for less invasive surgeries and offers three new surgical approaches. Its design builds on the Zimmer M/G ® Unicompartmental Knee System introduced in 1987. . . . . . . . . . . . . . . . . . . . . . . . NexGen MIS Tibial Plates The NexGen MIS Tibial Component, introduced in 2005, is designed to fit into a small arthrotomy, while still allowing the surgeon the flexibility of adding a stem once the component is positioned on the tibial plateau. To be launched in 2006, the NexGen MIS Modular Stemmed Tibial Component combines the geometry of the traditional NexGen stemmed component with MIS-friendliness in a two-piece design. 10 NexGen CR-Flex Knee, Prolong Highly Crosslinked Polyethylene and the MIS Tibial Plate The NexGen CR, a “cruciate retaining” implant, is intended for patients with good bone stock and ligaments that provide adequate joint stability. Designed for people with the ability and desire to perform activities that may require up to 155 degrees of flexion, the NexGen CR-Flex Knee features an increased poste- rior contact area to help accommodate higher stresses in the polyethylene during deep flexion activities. Prolong Highly Crosslinked Polyethylene, the only articular surface product with the ability to claim “resistance to delamination,” is designed to improve polyethylene performance. 11 Durom®* Hip Resurfacing System Featuring Metasul Technology The Durom Hip Resurfacing System is particularly suited to patients who are at risk of requiring multiple hip replacements over their lifetimes. It uses Zimmer’s Metasul Metal-on-Metal Technology, a wrought metal alloy with high carbon content for improved lubrication and hardness. Because wear resistance generally improves with increased lubrication and hardness of the alloy, a wrought high-carbon alloy may result in improved wear resistance compared to cast low-carbon alloys. * Not available for commercial distribution in the U.S. 12 HIPS By collaborating with innovative hip surgeons worldwide, Zimmer strives to improve patient quality of life with Zimmer Minimally Invasive Solutions Procedures and leading-edge implant technologies that continually raise the standard of care and give surgeons confidence they’re providing the best patient solutions. Zimmer MIS Minimally Invasive Solutions Procedures for Total Hip Arthroplasty In collaboration with renowned surgeons, Zimmer has developed a comprehensive portfolio of MIS Hip Procedures and training, enabling surgeons to choose the approach they feel most confident in performing. Approaches currently available or in development include the MIS 2-Incision, Anterior, Anterolateral and Posterior Procedures, as well as the MIS Mini-Incision Anterolateral and Posterolateral Procedures. Trabecular Metal Primary Stem The Trabecular Metal Primary Hip Prosthesis is proportionally sized to meet a wide range of patient anatomies. Its design is intended to distribute more compressive forces in the proximal region of the femur to minimize stress shielding, which can occur when the femoral implant is much stiffer than the femur. The use of Trabecular Metal Material may enhance stability, help resist stem subsidence and reduce femoral hoop stress. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . CLS ® Hip System The CLS Hip is a grit-blasted, titanium, cementless stem. With a 100 percent implant survivorship at 11 years,* the CLS Stem has become a standard for proximal press-fit design. * 2004 Swedish National Registry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Zimmer M/L Taper Hip Prosthesis The M/L Taper is a titanium alloy stem that is coated with strategically placed titanium alloy plasma spray to allow the bone to grow onto the implant to help provide secure fixation once implanted. It is a popular stem choice for physicians who perform minimally invasive procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . VerSys ® Epoch® Hip Prosthesis The VerSys Epoch stem is designed to accommodate both male and female anatomies by providing a combination of stem lengths and offsets to better fit the patient’s anatomy, while providing improved joint kinematics. The composite hip technology was developed to address issues in stress shielding. The VerSys Epoch FullCoat stem incorporates this technology and is made of materials that closely match the stiffness of bone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trabecular Metal Acetabular Cup Systems Trabecular Metal Technology combines a high strength-to- weight ratio with low stiffness to mimic closely the dynamics of cancellous bone. The elliptical shape of the cups creates an interference fit with the spherically reamed acetabulum. From the pole of the dome, the interference fit increases until a 2mm differential is achieved at the face of the cup. This maximizes bone contact and enhances initial stability. Zimmer plans to introduce a unique acetabular revision system in 2006 that utilizes Trabecular Metal Components to meet surgeons’ needs to treat the growing number of complex acetabular revision cases. EXTREMITIES Zimmer’s extremity products are designed to treat arthritic conditions and fractures as well as to enhance the outcome of primary or revision surgery in shoulder, elbow, wrist and fingers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trabecular Metal Humeral Stem Evolved from the Bigliani/Flatow ® Complete Shoulder System, this stem is designed to provide a broad range of anatomic coverage and help to restore proper joint motion while offering biological fixation through the use of Trabecular Metal Technology. . . . . . . . . . . . . . . . . . . . . . . . Anatomical Shoulder TM Inverse/Reverse System The Anatomical Shoulder Inverse/Reverse System is designed to address loss of rotator cuff function. Its geometry reverses the normal relationship between scapular and humeral components, moving the center of rotation medially to increase the lever arm of the deltoid muscle, and lowers the humerus to increase tension of the deltoid. This allows the deltoid to compensate for rotator cuff deficiency, both in terms of joint stability and function. 13 Tapered Screw-Vent ® Internal Hex Implant System This implant system offers an internal hex friction-fit connection that virtually eliminates micromovement. A new Fixture Mount Transfer was designed for easier preparation and more accurate impression taking. This multi-purpose Fixture Mount is both a transfer for first-stage impressions and a prep-able temporary abutment. DENTAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Zimmer’s dental products include implants used to take the place of missing teeth, restorative components for esthetics and regenerative materials, consisting of periodontal membranes and bone grafting products used to restore hard tissue in the upper and lower jaw. Hex-Lock TM Contour Abutment Hex-Lock Contour Abutments are designed to work with Zimmer Dental’s Tapered Screw-Vent and Screw-Vent ® Implants to create a strong internal hex with friction-fit connection that virtually eliminates micromovement, for a more stable restoration. Hex-Lock Contour Abutments also feature a slender emergence profile at the base of the abutment, as well as horizontal grooves at the top for retention of an impression cap. To resist rotational forces, the abutment’s cone is non-cylindrical and features a vertical groove on the lingual aspect. . . . . . . . . . . . . . . . . . . . Puros® Family of Allograft Materials Zimmer Dental offers three unique Puros Allograft Products to use together or separately for various bone grafting needs: Puros Cancellous Particulate, Puros Cortical Particulate, and Puros Block Allografts. The natural collagen and minerals found in Puros Allografts foster strong and rapid bone growth, and facilitate full bone remodeling. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . AtlantisTM* Abutment Patient specific Atlantis Abutments use a patented process that employs 3-D optical scanning, automated design software and integrated machining to manufacture individualized components for the dental implant market. The use of Atlantis Abutments simplifies the restorative procedure and improves outcomes for patients and practitioners. * Trademark of Atlantis Components Inc. 14 SPINE Zimmer’s growth in the spine business has been driven by the Dynesys Dynamic Stabilization System, which has given us valuable access to surgeons and institu- tions. Going forward, we plan to build on our strong infrastructure, distribution and brand recognition with technology developed internally and through partnerships and acquisitions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trabecular Metal Spacers The Trabecular Metal Technology has a wide range of orthopaedic applications. Trabecular Metal shapes are indicated for Thoracolumbar Vertebral Body Replacement procedures as well as bone void fillers. . . . . . . . . . . . . . . . . . . ST360°® Spinal Fixation System The ST360° Spinal Fixation System combines the flexibility of polyaxial screws and the versatility of lateral connectors into a single system. The result is a construct that, during assembly, minimizes excessive loading to the vertebral anatomy, thus reducing potential for vertebral injury. The combination of polyaxial screws and lateral connectors reduces the potential for transferring loads, during assembly, between rods and screws that are not perfectly aligned. The system flexibility and component design reduces intraoperative time and easily allows for construct customization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Optima ®* ZS Spinal Fixation System A low-profile, in-line, polyaxial screw system, the Optima ZS System provides a three-dimensional adjustability for simple, stable construct assembly. Its modified square-thread set screw reduces the potential for cross-threading, and its micro-step circumferential locking increases mechanical stability. * Optima is a trademark of U&I Corporation Dynesys Dynamic Stabilization System The Dynesys System uses flexible materials to stabilize the affected lower spine while preserving the natural anatomy of the spine. The system is indicated as an adjunct to fusion in the U.S. 15 TRAUMA A population that is both aging and more active is driving growth in Zimmer’s trauma business. Our trauma portfolio includes products for reattaching and stabilizing damaged bone and tissue to support the body’s natural healing process. Going forward, our focus is on aligning these products with MIS Procedures and on integrating orthobiologics and other next-generation technologies into our trauma solutions. NCB ® Locking Plates The titanium NCB Locking Plates feature variable-angle locking screws to allow surgeons the choice of where to apply screws in the treatment of complex fractures. . . . . . . . . . . . Trabecular Metal Osteonecrosis Intervention Implant The Trabecular Metal Osteonecrosis Intervention Implant System has been developed to intervene in stage I or II osteonecrosis of the femoral head and may be used with bone graft. The device has the potential to limit the progression of the disease, delaying or preventing the need for a hip replacement in many patients. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ITST TM Intertrochanteric/Subtrochanteric Fixation System This intramedullary system helps surgeons provide less invasive treatment to fractures of the proximal femur, many of which are directly related to osteoporosis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Zimmer ® Periarticular Locking Plate System The Zimmer Periarticular Locking Plate System combines locking screw technology with periarticu- lar anatomically contoured plates, to create fixed- angle constructs for use in comminuted bone or where bone stock is deficient or poor bone quality is encountered. These plates can be used in osteopenic bone or other areas where traditional screw fixation may be compromised. The low profile plate facilitates fixation without impinging on soft tissues, and the plate shaft design allows for a minimally invasive technique with submuscular passage of the plate. ORTHOPAEDIC SURGICAL PRODUCTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Zimmer has developed and continues to develop technologically advanced surgical products to support its reconstructive, trauma, and spine product systems in not only the operating room but also before and after surgery, including blood and pain management products. PALACOS * R+G Bone Cement Zimmer is the exclusive U.S. distributor for the PALACOS Bone Cement line of products manufactured by Heraeus of Germany. PALACOS Bone Cement is a recognized market leader in cemented orthopaedic surgical procedures. One of the bone cements included in this agreement is PALACOS R+G Bone Cement, which is used by orthopaedic surgeons in joint replacement procedures to securely fix implants to patient bones with an antibiotic acting to reduce the risk of infection. Its handling characteristics make it well suited for minimally invasive procedures. * Trademark of Heraeus Kulzer GmbH . . . . . . . . . . . . . . . . . . . . . . . A.T.S.® Automatic Tourniquet Systems Zimmer is the market leader in surgical tourniquet systems and accessories that are used to create a bloodless surgical field. The 2005 introduction to the market is the A.T.S. 3000 Tourniquet System, which utilizes the patented “Limb Occlusion Pressure (LOP)” technology. LOP helps the physician determine the recommended pressure setting for surgery based on the patient’s specific physiology. 16 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For year ended December 31, 2005 Commission ﬁle number 001-16407 ZIMMER HOLDINGS, INC. (Exact name of registrant as speciﬁed in its charter) Delaware (State of Incorporation) 345 East Main Street, Warsaw, IN (Address of principal executive ofﬁces) 13-4151777 (IRS Employer Identiﬁcation No.) 46580 (Zip Code) Registrant’s telephone number, including area code: (574) 267-6131 Securities registered pursuant to Section 12(b) of the Act: Title of each class Common Stock, $.01 par value Name of each exchange on which registered New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as deﬁned in Rule 405 of the Securities Act. Yes ¥ No n Indicate by check mark if the registrant is not required to ﬁle reports pursuant to Section 13 or Section 15(d) of the Act. Yes n No ¥ 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 ¥ No n Indicate by check mark if disclosure of delinquent ﬁlers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in deﬁnitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¥ Indicate by checkmark 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’’ in Rule 12b-2 of the Exchange Act. Large accelerated ﬁler ¥ Non-accelerated ﬁler n Accelerated ﬁler n Indicate by checkmark whether the registrant is a shell company (as deﬁned Exchange Act Rule 12b-2). Yes n No ¥ The aggregate market value of shares held by non-afﬁliates was $18,815,529,777 (based on closing price of these shares on the New York Stock Exchange on June 30, 2005, and assuming solely for the purpose of this calculation that all directors and executive ofﬁcers of the registrant are ‘‘afﬁliates’’). As of February 13, 2006, 247,994,275 shares of the registrant’s $.01 par value common stock were outstanding. Documents Incorporated by Reference Document Portions of the Proxy Statement with respect to the 2006 Annual Meeting of Stockholders Form 10-K Part III Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K This annual report contains certain statements that are forward-looking statements within the meaning of federal securities laws. When used in this report, the words ‘‘may,’’ ‘‘will,’’ ‘‘should,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘plan,’’ ‘‘believe,’’ ‘‘predict,’’ ‘‘potential,’’ ‘‘project,’’ ‘‘target,’’ ‘‘forecast,’’ ‘‘intend’’ and similar expressions are intended to identify forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, price and product competition, rapid technological development, demographic changes, dependence on new product development, the mix of our products and services, supply and prices of raw materials and products, customer demand for our products and services, the ability to successfully integrate acquired companies including Centerpulse AG and Implex Corp., the outcome of the Department of Justice investigation announced in March 2005 and the pending informal Securities and Exchange Commission investigation of Centerpulse AG accounting, control of costs and expenses, the ability to form and implement alliances, changes in reimbursement programs by third-party payors, governmental laws and regulations affecting our U.S. and international businesses, including tax obligations and risks, product liability and intellectual property litigation losses, international growth, general industry and market conditions and growth rates and general domestic and international economic conditions including interest rate and currency exchange rate ﬂuctuations. Readers of this report are cautioned not to place undue reliance on these forward-looking statements. While we believe the assumptions on which the forward-looking statements are based are reasonable, there can be no assurance that these forward-looking statements will prove to be accurate. This cautionary statement is applicable to all forward-looking statements contained in this report and the material accompanying this report which comprise our annual report to stockholders. See Item 1A for a detailed description of Risk Factors. Table of Contents PART I Item 1. Business Item 1A. Risk Factors Item 1B. Unresolved Staff Comments Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information PART III Item 10. Directors and Executive Ofﬁcers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services PART IV Item 15. Exhibits and Financial Statement Schedules Signatures 2 Page 3 15 20 21 21 21 22 23 24 35 38 61 61 61 62 62 62 62 62 63 64 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K PART I ITEM 1. Business GENERAL 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. In this report, ‘‘Zimmer’’ ‘‘we’’, ‘‘us’’, ‘‘our’’ and similar words refer collectively to Zimmer Holdings, Inc. and its subsidiaries. Zimmer Holdings refers to the parent company only. Zimmer Holdings was incorporated in Delaware in 2001. Zimmer’s history dates to 1927, when Zimmer Manufacturing Company, a predecessor, was founded in Warsaw, Indiana. On August 6, 2001, Zimmer Holdings was spun off from its former parent and became an independent public company. In October 2003, we ﬁnalized our acquisition of Centerpulse AG (‘‘Centerpulse’’), a Switzerland-based orthopaedics company and the leader in the European reconstructive market. In addition to providing us with a leading position in the European orthopaedic reconstructive implant market, the Centerpulse acquisition furnished us with a platform in the faster growing spine and dental implant markets. In April 2004, we acquired Implex Corp. (‘‘Implex’’), now known as Zimmer Trabecular Metal Technology, Inc., a company with which we had a distribution and strategic alliance since 2000 for the commercialization of reconstructive implant and trauma products incorporating Trabecular MetalTM Technology. Throughout the past two years, a key focus of management has been the successful integration of the Centerpulse and Implex businesses. In 2005, we performed ahead of schedule under our comprehensive integration plan, having accomplished almost 90 percent of the more than 3,500 total planned integration milestones. CUSTOMERS, SALES AND MARKETING Our primary customers include musculoskeletal surgeons, neurosurgeons, oral surgeons, dentists, hospitals, distributors, healthcare dealers and, in their capacity as agents, healthcare purchasing organizations or buying groups. These customers range from large multinational enterprises to independent surgeons. We have operations in more than 24 countries and market products in more than 100 countries, with corporate headquarters in Warsaw, Indiana, and more than 100 manufacturing, distribution and warehousing and/or ofﬁce facilities worldwide. We manage our 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. Detailed ﬁnancial and other information regarding our reportable geographic segments can be found in Note 14 to the Consolidated Financial Statements, which are included in this report under Item 8. We market and sell products through three principal channels: 1) direct to health care institutions, such as hospitals, which is referred to as a direct channel account, 2) through stocking distributors and, in the Asia Paciﬁc region, healthcare dealers, and 3) directly to dental practices and dental laboratories. Through the direct channel accounts, inventory is generally consigned to sales agents or customers so that products are available when needed for surgical procedures. With the sales to stocking distributors, healthcare dealers, dental practices and dental laboratories, title to product passes generally upon shipment. Direct channel accounts represented more than 80 percent of our net sales in 2005. No individual direct channel account, stocking distributor, healthcare dealer, dental practice or dental laboratory accounted for more than 10 percent of our net sales for 2005. We stock inventory in our warehouse facilities and retain title to consigned inventory in sufﬁcient quantities so that products are available when needed for surgical procedures. Safety stock levels are determined based on a number of factors, including demand, manufacturing lead times and optimal quantities required to maintain the highest possible service levels. We also carry trade accounts receivable balances based on credit terms that are generally consistent with local market practices. We utilize a network of sales associates, sales managers and support personnel, most of whom are employed by independent distributors and sales agencies. We invest a signiﬁcant amount of time and expense in providing training in such areas as product features and beneﬁts, how to use speciﬁc products and how to best inform surgeons of such features and uses. Sales force representatives rely heavily on strong technical selling skills, medical education and the ability to provide technical support for surgeons. In response to the different healthcare systems throughout the world, our sales and marketing strategies and organizational structures differ by region. We utilize a global approach to sales force training, marketing and medical education into each locality to provide consistent, high quality service. Additionally, we keep current with key surgical developments and other issues related to musculoskeletal surgeons and the medical procedures they perform, in part through sponsorship of medical education events. In 2005, we sponsored more than 300 medical education events and meetings with and among musculoskeletal surgeons around the world. Americas. The Americas is the largest geographic segment, accounting for $1,941.8 million, or 59 percent, of 2005 net sales, with the United States accounting for $1,845.6 million of net sales in this region. The United States sales force consists of independent sales agents, together 3 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K with sales associates, sales managers and sales support personnel, the majority of which sell products exclusively for Zimmer. Sales agents in the United States receive a commission on product sales and are responsible for many operating decisions and costs. Sales commissions are accrued at the time of sale. In this region, we have also concentrated on negotiating contracts with purchasing organizations or buying groups and managed care accounts and have increased unit growth by linking the level of discounts received to volume of purchases by customer health care institutions within a speciﬁed group. At negotiated thresholds within a contract buying period, price discounts increase. Under these buying contracts, we are generally designated as one of several identiﬁed preferred purchasing sources for the members of the buying group for speciﬁed products, although usually the members are not obligated to purchase our products. A majority of hospitals in the United States belong to at least one group purchasing organization. In 2005, individual hospital orders purchased through contractual arrangements with such purchasing organizations or buying groups accounted for approximately 51 percent of our net sales in the United States. Contractual sales were highest through Novation, LLC, Premier Purchasing Partners, L.P., and Health Trust Purchasing Group, representing 29 percent, 13 percent and 7 percent, respectively, of net sales in the United States. No individual end-user, however, accounted for over 1 percent of our net sales, and the top ten end-users accounted for approximately 3.7 percent of our aggregate net sales in the United States. These buying contracts generally have a term of three years with extensions as warranted. Our current arrangements with Premier, Novation and Health Trust Purchasing Group have all been renegotiated and updated in the past 24 months. In the Americas, we maintain an extensive monitoring and incentive system ranking sales agents across a range of performance metrics. We evaluate and reward sales agents based on achieving certain sales targets and on maintaining efﬁcient levels of working capital. We set expectations for efﬁcient management of inventory and provide sales agents an incentive to aid in the collection of receivables. Europe. The European geographic segment accounted for $874.8 million, or 27 percent, of 2005 net sales, with France, Germany, Italy, Spain, Switzerland and the United Kingdom collectively accounting for more than 79 percent of net sales in the region. In addition, we also operate in other key markets such as Benelux, Nordic, Central and Eastern Europe, the Middle East and Africa. Our sales force in this region is comprised of independent distributors, commissioned agents, direct sales associates and sales support personnel. In marketing our orthopaedic implant portfolio in Europe, we have continued to emphasize the advantages of clinically proven, established designs. Asia Paciﬁc. The Asia Paciﬁc geographic segment accounted for $469.5 million, or 14 percent of 2005 net sales, with Japan being the largest market within this segment, accounting for approximately 60 percent of the sales in this 4 region. In addition, we operate in key markets such as Australia, New Zealand, Korea, China, Greater China, India, Thailand and Singapore. In Japan and most countries in the Asia Paciﬁc region, we maintain a network of dealers who act principally as order agents on behalf of hospitals in the region, together with sales associates who build and maintain strong relationships with musculoskeletal surgeons in their markets. These sales associates cover over 7,000 hospitals in the region. The knowledge and skills of our sales associates play a critical role in providing service, product information and support to surgeons who continue to enhance their knowledge and skills to improve the quality of surgical outcomes. We have strengthened, and intend to continue to support the clinical needs of surgeons in the region primarily through sponsorship of medical education and training programs relating to orthopaedic surgery. The key marketing and educational activities in the region center on minimally invasive surgical procedures and technologies, increased range of motion and improved patient outcomes. Our business is generally not seasonal in nature; however, many of our products are used in elective procedures, which typically decline during the summer months and holiday seasons. DISTRIBUTION We generally ship our orders via expedited courier. Our operations support local language labeling for shipments to the European Union member countries. We operate distribution facilities, among other places, in Warsaw, Indiana; Dover, Ohio; Statesville, North Carolina; Memphis, Tennessee; Carlsbad, California; and internationally in Australia, Belgium, Canada, France, Germany, Italy, Japan, Korea, the Netherlands, Singapore, Spain, Switzerland and the United Kingdom. Our backlog of ﬁrm orders is not considered material to an understanding of our business. PRODUCTS We design, develop, manufacture and market reconstructive orthopaedic implants, including joint and dental, spinal implants, trauma products, and related orthopaedic surgical products. 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. Our related orthopaedic surgical products include supplies and instruments designed to aid in orthopaedic surgical procedures and post-operation rehabilitation. Information about product sales can be found in Item 7 of this report. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Orthopaedic Reconstructive Implants The majority of reconstructive implant procedures restore joint function lost due to degenerative diseases such as arthritis and relieve pain in knees and hips. Minimally Invasive Solutions Procedures and Technologies In 2005, we continued to expand our efforts to apply minimally invasive surgical techniques to orthopaedic surgery, which we refer to as Minimally Invasive SolutionsTM (MISTM) Procedures and Technologies. The Zimmer Institute, with its main facility located at our global headquarters, has been used, in addition to satellite centers established in connection with 25 existing Zimmer Institute partnerships, to facilitate the training of over 4,000 surgeons on several MIS Procedures. In 2005 alone, we trained nearly 2,500 surgeons through The Zimmer Institute network. We work directly with several global medical centers to evaluate and reﬁne advanced minimally invasive knee and hip replacement procedures. We plan to continue to afﬁliate with additional North American and international institutions to provide surgeon education at The Zimmer Institute and its satellite locations. The principal goals of these MIS Technology efforts are to reduce the hardships of having a total joint replacement, such as the time a patient must spend in rehabilitation, pain reduction and lost time from work. In December 2005, we announced that we are following more than 2,500 Zimmer˛ MIS 2-IncisionTM Total Hip Replacement Procedure cases in active clinical studies. We estimate that in total more than 3,000 of these procedures have been performed worldwide since inception in 2001. At the February 2005 American Academy of Orthopaedic Surgeons meeting in Washington, D.C., we introduced the Zimmer MIS Anterolateral Hip Replacement Procedure that was developed with the speciﬁc intent to expand patient beneﬁts relative to standard hip replacement surgery. Among our achievements in MIS Procedures and Technologies in knees during 2005, we began commercializing the NexGen˛ MIS Tibial Plate, the ﬁrst modular stemmed tibial component prosthesis that can be assembled within the patient, making it more conducive to minimally invasive procedures. Throughout 2005, we continued to develop navigation systems, through the use of image-guided surgical technology, to aid surgeons in learning procedures and gaining conﬁdence in the placement of instrumentation and implants where navigation is difﬁcult due to the small incisions necessary in effectuating minimally invasive procedures. In February 2005, we announced that the ﬁrst electromagnetic CAS-enabled knee replacement procedures were successfully performed in Houston, Texas. Orthopaedic surgeons are now performing these navigation procedures in association with the Zimmer MIS Quad-SparingTM Total Knee Replacement Procedure and the Zimmer MIS Mini- Incision Total Knee Procedure. We are focused both on further commercializing existing MIS Technique approaches and investigating new ways to 2 0 0 5 F O R M 1 0 - K apply MIS Technology principles to additional procedures and products. We continue to believe that the commitment of substantial ﬁnancial and other resources in furtherance of MIS Procedures and Technologies is critical. Knee Implants Total knee replacement surgeries typically include a femoral component, a patella (knee cap), a tibial tray and an articulating surface (placed on the tibial tray). Knee replacement surgeries include ﬁrst-time joint replacement procedures and revision procedures for the replacement, repair or enhancement of an implant or component from a previous procedure. Knee implants are designed to accommodate different levels of ligament stabilization of the joint. While some knee implant designs, called cruciate retaining (CR) designs, require the retention of the posterior cruciate ligament, other designs, called posterior stabilized (PS) designs, provide joint stability without the posterior cruciate ligament. There are also procedures for partial reconstruction of the knee, which treat limited knee degeneration and involve the replacement of only one side or compartment of the knee with an unicompartmental knee prosthesis. Our portfolio of MIS Techniques includes the MIS Mini- Incision Total Knee Procedures and the MIS Quad-Sparing Total Knee Replacement Procedure, with the incorporation of CAS-enabled electromagnetic navigation capability. The MIS Mini-Incision Total Knee Instruments feature smaller instruments which accommodate a smaller incision and less disruption of the surrounding soft tissues. The MIS Quad- Sparing Total Knee Procedure features advanced instrument concepts which allow surgeons to perform the total knee arthroplasty through a 7-10 cm incision without cutting the patient’s muscles or tendons. We offer a wide range of products for specialized knee procedures, including, among others, the following brands: NexGen˛ Complete Knee Solution. The NexGen Knee product line is a comprehensive system for knee replacement surgery which has had signiﬁcant application in PS, CR and revision procedures. The NexGen Knee System offers joint stability and sizing that can be tailored to individual patient needs while providing surgeons with a uniﬁed system of interchangeable components. The NexGen Knee System provides surgeons with complete and versatile knee instrument options, including Zimmer MIS Quad- Sparing and MIS Mini-Incision Instruments, milling and multiple traditional saw blade cutting instrument systems. The breadth and versatility of the NexGen Knee System allows surgeons to change from one type of implant to another during surgery, according to the needs of the patient, and to support current surgical philosophies. The ongoing use of Trabecular Metal Monoblock Tibial Components in both CR and PS philosophies enhances our strategy to add new innovative technologies to this brand. Trabecular Metal Materials provide a higher level of porosity and surface friction than existing non-cemented alternatives and are similar in stiffness to natural bone. 5 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K The NexGen Complete Knee Solution Legacy˛ Knee-Posterior Stabilized product line provides stability in the absence of the posterior cruciate ligament. The PS capabilities were augmented through the introduction of the NexGen Legacy Posterior Stabilized Flex Knee (the ‘‘LPS- Flex Knee’’), a high-ﬂexion implant that has the potential to accommodate knee ﬂexion up to a 155-degree range of motion in some patients. The NexGen CR product line is designed to be used in conjunction with a functioning posterior cruciate ligament. The NexGen CR-Flex Fixed Bearing Knee was added to the product line in 2003 and is designed with components to provide a greater range of motion for patients who require deep bending in their daily activities. The NexGen CR-Flex Femoral Components allow the surgeon to adjust component sizing without removing additional bone. The NexGen Revision Knee product line consists of several different products that are designed to provide clinical solutions to surgeons for various revision situations. In 2004, we commercialized a new bone augmentation implant system made from Trabecular Metal Technology material. These new augments are designed to address signiﬁcant bone loss in revision surgery. We offer improved polyethylene performance in the NexGen Knee System with our conventional polyethylene and ProlongTM Highly Crosslinked Polyethylene, which represents an advance in a number of wear related areas including reduction in wear, resistance to oxidation, pitting, cracking and is the only insert FDA approved for resistance to delamination. Prolong Highly Crosslinked Polyethylene is available in both NexGen CR-Flex and LPS-Flex designs. The Natural-Knee˛ II System. The Natural-Knee II System consists of a complete range of interchangeable, anatomically designed implants which include a proprietary Cancellous-Structured TitaniumTM (CSTiTM) Porous Coating option for stable ﬁxation in active patients and Durasul˛ Highly Crosslinked Polyethylene. The original Natural-Knee System celebrated its 20th anniversary of clinical use in 2005. New Natural-Knee II MIS Instrumentation was launched in December 2004. These instruments are designed to accommodate a smaller incision during the knee procedure. The InnexTM Total Knee System. The Innex Knee System offers ﬁxed bearing and mobile bearing knee components all designed within the same system philosophy. While the Innex Knee System is best known for its mobile bearing knee offering, the availability of differing levels of articular constraint and the Innex Revision Knee components provide for a comprehensive mobile and ﬁxed bearing knee system. The Innex Knee System is currently distributed in Europe and Asia Paciﬁc, but is not available for commercial distribution in the United States. Unicompartmental Knee Systems. The M/G˛, Natural-Knee II and AllegrettoTM Unicompartmental Knee Systems apply the same ﬂexibility and quality of our other knee implant products to unicompartmental, or single 6 compartment disease. These systems offer the surgeon the ability to conserve bone by replacing only the compartment of the knee that has had degenerative changes. The Zimmer˛ Unicompartmental Knee System was commercialized in 2004 offering a high ﬂexion design to unicompartmental knee surgery. The high ﬂexion product was designed speciﬁcally for MIS Procedures and Technologies. Hip Implants Total hip replacement surgeries replace both the head of the femur and the socket portion of the pelvis (acetabulum) of the natural hip. Hip procedures include ﬁrst time, or primary, joint replacement as well as revision procedures for the replacement, repair or enhancement of an implant product or component from a previous procedure. Approximately 40 percent of the hip implant procedures involve the use of bone cement to attach or afﬁx the prosthetic components to the surrounding bone. The remaining balance of the total hip replacement procedures are press-ﬁt into bone, which means that they have a surface that bone afﬁxes to through either ongrowth or ingrowth technologies. Our portfolio of MIS Techniques includes the Zimmer MIS 2-Incision Hip Replacement Procedure, the Mini-Incision Posterior Procedure, the Mini-Incision Anterior Procedure, and the Zimmer MIS Anterolateral Techniques. The incision for a traditional open hip primary replacement may be approximately 12 inches long. Other less invasive approaches, such as a ‘‘mini’’ incision for hips, have been in existence for approximately seven years. In January 2004, the ﬁrst computer image-guided MIS 2-Incision Hip Replacement Procedure live surgery was performed utilizing new technology and instrumentation co-developed by us and our MIS Technologies computer navigation partner, Medtronic, Inc. In January 2004, the United States Patent and Trademark Ofﬁce granted us a patent speciﬁc to our MIS 2-Incision Hip Replacement Procedure. Our key hip replacement products include, among others: VerSys˛ Hip System. The VerSys Hip System is supported by a common instrumentation set and is an integrated family of hip products that offers surgeons design- speciﬁc options to meet varying surgical philosophies and patient needs. The VerSys Hip System includes the following features: a variety of stem designs and ﬁxation options for both primary and revision situations, a modular design that allows for a variety of femoral heads, optimal sizing selections, and a common instrumentation set for use with virtually all VerSys Stems. Zimmer˛ M/L Taper Prosthesis. The Zimmer M/L Taper Prosthesis was launched in early 2004. The prosthesis offers a dual wedge and proximally porous coated design that was based on long term clinically proven concepts. The M/L Taper has become widely used in MIS Procedures due to its overall design and ease of use. Speciﬁc instruments have Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K been developed to facilitate the insertion of the Zimmer M/L Taper Hip Prosthesis through the MIS Anterolateral Technique. Alloclassic˛ (Zweym ¨uller˛) Hip System. The Alloclassic (Zweym ¨uller) Hip System has become the most used, primary, cementless hip in the world. This is one of the few stems available today that is practically unchanged since its introduction in 1979. A new offset design was added in 2004 and offers the surgeon increased capability to restore the patient’s anatomical joint movement. CLS˛ Spotorno˛ Hip System. The CLS Spotorno Stem is one of our largest selling hip prostheses, especially in the European markets. Additions to the product line in 2004 provided the capability for restoration of the physiological center of rotation. The CLS Spotorno Stem has excellent clinical results, conﬁrmed by the 2004 Swedish Hip Registry with a 100 percent implant survivorship after 11 years. Trilogy˛ Acetabular System. The Trilogy Acetabular System, including titanium alloy shells, polyethylene liners, screws and instruments, is our primary acetabular cup system. The Trilogy family of products offers patients and surgeons options and versatile component designs and instrumentation. One option, the Longevity˛ Highly Crosslinked Polyethylene Liner, is designed to address the issue of wear and reduce the generation of debris in total hip arthroplasty. Polyethylene debris may cause the degeneration of bone surrounding reconstructive implants, a painful condition called osteolysis. We continue to augment our offerings of porous reconstructive hip implants through the introduction of Trabecular Metal Technology. We completed the launch of the Trabecular Metal Modular Primary Acetabular System in 2004. This particular product incorporates design features from the Trilogy family of acetabular shells augmented with the advanced ﬁxation surface of Trabecular Metal Material. In addition to the Trabecular Metal Acetabular System, we also offer a Trabecular Metal Revision Acetabular Shell for advanced ﬁxation in acetabulae with insufﬁcient bone. Alternative Bearing Technology. We have a broad portfolio of alternative bearing technologies which include Longevity and Durasul Highly Crosslinked Polyethylenes, Metasul˛ Metal-on-Metal Tribological Solution and Cerasul˛ and Trilogy AB˛ Ceramic-on-Ceramic Tribological Solutions. Alternative bearings are designed to minimize wear over time, potentially increasing the longevity of the implant. In December 2005, we announced that we received an approvable letter from the U.S. Food and Drug Administration (FDA) related to the Trilogy AB Acetabular System. The letter speciﬁed that the Premarket Approval Application (PMA) is approvable subject to an FDA inspection of our relevant facilities. We expect that the necessary inspections will be completed in 2006 and that we will begin marketing the Trilogy AB Acetabular System upon ﬁnal application approval from the FDA. Durom˛ Hip Resurfacing System. This product is particularly suited to patients who are at risk of requiring multiple hip replacements over their lifetimes since it preserves the patient’s healthy bone stock. A primary objective of this system is to allow the patient to return to an active lifestyle. The Durom System uses the highly wear resistant Metasul Metal-on-Metal Technology as the bearing surface for the implant design. Since 1988, Metasul Technology has been used successfully for total hip replacement. Today’s metal-on-metal technology is the result of over one and a half decades of development, research and clinical evaluation, which formed the foundation for the Durom Hip Resurfacing System. The option of the large diameter heads offers the advantage of a low-wear solution while providing greater joint stability and high range of motion in combination with the wide range of cemented and uncemented femoral implants. We ﬁled a 510(k) with the FDA on the Durom Acetabular Shell and associated large diameter Metasul Heads in December 2005. Extremity Implants Our extremity implants, primarily shoulder and elbow products, are designed to treat arthritic conditions and fractures, as well as to enhance the outcome of primary or revision surgery. Bigliani/Flatow˛ Complete Shoulder Solution. The Bigliani/Flatow product line gives us a signiﬁcant presence in the global shoulder implant market. This system is well recognized in all major regions of the world. Trabecular Metal Humeral Stem. Released in 2005, the Trabecular Metal Humeral Stem combined with Bigliani/Flatow Heads and Glenoids was designed to provide a broader range of anatomic coverage and to aid in the restoration of proper joint motion while offering improved orthobiological ingrowth potential through utilization of Trabecular Metal Technology. Anatomical ShoulderTM System. The Anatomical Shoulder System can be tailored to each patient’s individual anatomy. This portfolio was expanded in 2005 to include the Anatomical Shoulder Inverse/Reverse System, designed to address signiﬁcant loss of rotator cuff function. The primary shoulder implant can be converted to a reverse shoulder without removal of the initial implant. Zimmer˛ Collagen Repair Patch. Launched in 2005, this innovative biological patch is used for the repair of rotator cuff injuries in the shoulder. This product can aid in reinforcing rotator cuff tears and help provide predictable strength of repair. The underlying technology was developed by Tissue Science Laboratories plc (TSL) of the United Kingdom. We entered into a multi-year, exclusive distribution agreement with TSL in 2003. Coonrad/Morrey Total Elbow. The Coonrad/Morrey Total Elbow product line is a family of elbow replacement implant products which have helped us establish ourselves in the global elbow implant market. 7 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Dental Products Our Dental division, headquartered in Carlsbad, California, manufactures and distributes (1) dental reconstructive implants – for individuals who are totally without teeth or are missing one or more teeth; (2) dental restorative products – aimed at providing a more natural restoration to mimic the original teeth; and (3) dental regenerative products – for soft tissue and bone rehabilitation. Zimmer Dental recently opened a specialized, Zimmer Institute training center dedicated to helping clinicians further their knowledge, skills and conﬁdence essential for the practice of contemporary implant dentistry. In furtherance of our extensive educational initiatives, in 2005, we announced that Zimmer Dental formed an educational partnership with the American Dental Education Association to strengthen undergraduate and advanced dental education, including the teaching of implant dentistry. Dental Reconstructive Implants Our dental reconstructive implant products and surgical and restorative techniques include, among others: Tapered Screw-Vent˛ Implant System. Our largest selling dental product line provides the clinician a tapered geometry which mimics the natural shape of a tooth root. The Tapered Screw-Vent System, with its two-stage design, was developed to minimize valuable chair time for restorations. Featuring a patented internal hex connection, multiple lead threads for reduced insertion time and selective surface coatings, the Tapered Screw-Vent Product is a technologically advanced dental implant offering features designed to allow the clinician to meet the needs of patients even in the most demanding circumstances. AdVent˛ Implant System. Utilizing many features of the Tapered Screw-Vent System, the AdVent Product is a transgingival, one stage design that utilizes the same surgical system as the Tapered Screw-Vent System, allowing the clinician to use both design concepts without incurring the added cost of a second surgical system. Tapered SwissPlus˛ Implant System. Designed to meet the needs of clinicians who prefer a transgingival, one stage, dental implant, the Tapered SwissPlus System incorporates multiple lead threads for faster insertion time, and a tapered body to allow it to be placed in tight interdental spaces. The Tapered SwissPlus System also incorporates an internal connection. Dental Restorative Products We commercialize products for the aesthetic restorative market aimed at providing a more natural restoration. We offer a full line of prosthetic devices for each of the above 8 dental implant systems as well as a custom solution, as follows: AtlantisTM1 Abutment. We market the Atlantis Abutment System through an agreement with Atlantis Components, Inc. This product allows for a custom made restoration improving aesthetic results in dental implant procedures. The abutments use a patented process that employs 3-D optical scanning, automated design software and integrated machining to manufacture individualized components for the dental implant market. Dental Regenerative Products We market the following product lines for use in regenerative techniques in oral surgery: Puros˛ Allograft Bone Grafting Products. The Puros Material is an allograft bone grafting material which utilizes the Tutoplast˛2 Tissue Processing Technique that provides exceptional bone grafting material for use in oral surgery. Zimmer Dental offers three distinct Puros Allograft products to use together or separately for various bone grafting needs: Puros Cancellous Particulate, Puros Cortical Particulate and Puros Block Allografts. We market the Puros Allograft Bone Grafting Products through an agreement with Tutogen Medical, Inc. Spine Implants Our Spine division, located in Minneapolis, Minnesota, designs, manufactures and distributes medical devices and surgical tools that provide comprehensive spine care solutions to improve and enhance quality of life for patients with back pain, neck pain, degenerative disc conditions and injuries due to trauma. Zimmer Spine offers orthopaedic surgeons and neurosurgeons a full range of devices for posterior and anterior applications, including products in Interbody Fusion, Cervical, Thoracolumbar and Biologic applications. Our spine product offerings include, among others: Dynesys˛3 Dynamic Stabilization System. The Dynesys System is used in the treatment of lower back and leg pain in skeletally mature patients. Developed to bring the lumbar vertebrae into a more natural anatomical position while stabilizing the affected segments, the Dynesys System uses ﬂexible materials threaded through pedicle screws rather than rigid rods or bone grafts alone as an adjunct to fusion. ST360(cid:1)˛ Spinal Fixation System. The ST360(cid:1) Spinal Fixation System combines polyaxial screws and lateral connectors into a single system. The combination of polyaxial screws and lateral connectors reduces the potential for transferring loads, during assembly, between rods and screws that are not perfectly aligned. 1 Trademark of Atlantis Components, Inc. 2 Registered Trademark of Tutogen Medical, Inc. 3 The Dynesys Dynamic Stabilization Spinal System is indicated for use as an adjunct to fusion. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Optima˛4 ZS Spinal Fixation System. The Optima ZS Spinal Fixation System is a low-proﬁle, in-line, polyaxial pedicle screw design incorporating three-dimensional adjustability while allowing for simple, stable construct assembly. Trinica˛ Select Anterior Cervical Plate System. The Trinica Select Anterior Cervical Plate System and All- Through-One instrumentation is designed to simplify the surgical procedure while requiring less retraction and reducing the risk of soft-tissue damage. The Trinica Select Self-Drilling Screws are designed to provide the surgeon with the option to reduce the amount of instruments, thereby potentially reducing the amount of retraction and surgical time required to implant the Trinica Select Plate. Trabecular Metal Technology. Trabecular Metal Technology has a wide range of orthopaedic applications. In the United States, Trabecular Metal Material shapes are cleared for Vertebral Body Replacement procedures as well as bone void ﬁllers. Puros Allograft Products. We continue to sell traditional and specialty Puros Allograft Bone Products through our exclusive U.S. distribution agreement with Tutogen Medical, GmbH. Puros Products consist of traditional and specialty grafts which are donated human tissues, preserved with Tutogen’s patented Tutoplast Process of tissue preservation. The Tutoplast Process is a proprietary tissue processing system designed to signiﬁcantly reduce the amount of cells, bone marrow and lipid components from processed allograft bone and connective tissue while preserving the extra-cellular matrix (collagen and mineral components). Trauma Trauma products include devices used primarily to stabilize damaged bone and tissue to support the body’s natural healing process. The most common surgical stabilization of bone fracture involves the internal ﬁxation of bone fragments. This stabilization can involve the use of a wide assortment of plates, screws, rods, wires and pins. In addition, external ﬁxation devices may be used to stabilize fractures or correct deformities by applying them externally to the limb. We are focusing on aligning our trauma products with MIS Procedures and on integrating orthobiologics and other next-generation technologies into our trauma solutions. In 2005, we formed a new standalone Zimmer Trauma division based in Warsaw, Indiana. We offer a comprehensive line of trauma products, including, among others: M/DN˛ Intramedullary Fixation, Sirus˛ Intramedullary Nail System, and ITSTTM Intertrochanteric/ Subtrochanteric Fixation System. The M/DN, Sirus and ITST Intramedullary Nailing Systems are utilized for the internal ﬁxation of long bone fractures. The systems include 4 Registered Trademark of U&I Corporation. specialized instrumentation that allow the nails to be put in using a minimally invasive approach that can help improve patient recovery times. NCB˛ Plating System. The new titanium NCB Locking Plates deliver the ability for surgeons to target screws with polyaxial freedom and utilize both conventional and locking technology in the treatment of complex fractures. Zimmer Periarticular Locking Plates. The Zimmer Periarticular Locking Plate System locking screw technology with the advanced design of Zimmer Periarticular Plates creates constructs for use in comminuted fractures or where deﬁcient bone stock or poor bone quality is encountered. By combining locking screw holes with compression slots, the plates can be used as both locking devices and fracture compression devices. This technical innovation, combined with the transition in plate thickness – thinner in the metaphysis to thicker in the diaphyseal areas – gives surgeons the ability to lock an exact ﬁt. Zimmer Plate and Screw System. The Zimmer Plate and Screw System is a comprehensive system of stainless steel plates, screws and instruments for fracture ﬁxation. WristoreTM5 Distal Radius Fracture Fixator. In early 2003, we acquired the design of this all polymer external ﬁxator for special application to more common wrist fractures. The Wristore Fixator offers an adjustable and stable approach for fractures of the distal radius. The Wristore Fixator surgical kit provides all implants and disposable instruments in one sterile package, eliminating the need for a sterilization case and extra packaging. Trabecular Metal Osteonecrosis Intervention Implant. The Trabecular Metal Osteonecrosis Intervention Implant is an early stage intervention device for patients afﬂicted with osteonecrosis of the femoral head. The device helps delay the need for total hip replacement through a simple, minimally invasive procedure that stabilizes the hip and helps encourage bone growth and revascularization. Zimmer Cannulated Screw System. The Zimmer Cannulated Screw System makes use of enhanced material technology and innovative design which aids in precise guide wire placement to help ensure secure ﬁxation, and provide surgeons with multiple intraoperative solutions. Orthopaedic Surgical Products We develop, manufacture and market surgical products that support our reconstructive, trauma, spinal and dental product systems in the operating room environment with a focus on bone cement and accessories, blood management, surgical wound site management, pain management and 5 Trademark of Millennium Medical Technologies, Inc. 9 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K patient management products. Our orthopaedic surgical products include, among others: A.T.S.˛ Automatic Tourniquet Systems. The A.T.S. Tourniquet Systems Product Line represents a complete family of tourniquet machines and cuffs designed to safely create a bloodless surgical ﬁeld. The family of machines includes the A.T.S. 3000 Tourniquet, which utilizes patented technology to determine a patient’s proper ‘‘Limb Occlusion Pressure’’ based on the patient’s speciﬁc physiology. The range of cuffs which complement the machines provides the ﬂexibility to occlude blood ﬂow safely with convenience and accuracy for limbs of virtually every size and shape. PALACOS˛6 Bone Cement. In 2005, we ﬁnalized a multi-year agreement whereby we acquired exclusive United States distribution rights for the PALACOS line of bone cement products manufactured by Heraeus Kulzer GmbH, a world leader in the development and production of orthopaedic bone cement products and other healthcare technologies. We have non-exclusive distribution rights outside of the United States. Included in these brands are PALACOS R and PALACOS R+G Bone Cements. The PALACOS R+G product is bone cement with the antibiotic gentamiacin pre-mixed in the formulation, which is used by the orthopaedic surgeon to reduce the risk of postoperative infection. The product’s handling characteristics make it well- suited for minimally invasive procedures. cells from juvenile donor cartilage, with initial applications focused upon knee joints and spinal discs. We led an ISTO ﬁnancing round of $10.8 million in 2005, which in part provides development funds to ISTO. In 2006, we expect ISTO to move its neocartilage products to U.S. Phase 1 human clinical trials for the repair of articular cartilage. In September 2005, we announced that we acquired worldwide exclusive distribution rights for genetically engineered xenogeneic porcine tissues for orthopaedic applications from Revivicor, Inc., which has an advanced transgenic technology platform for the production of tissues and cells. We are centralizing our initial efforts on the development of technologies for orthopaedic applications, including the repair and replacement of damaged tendon, ligament, meniscus, cartilage, bone and spinal nucleus tissues. As mentioned above under the caption ‘‘Extremity Implants’’, in 2005, we launched an orthobiological patch for the repair of rotator cuff injuries in the shoulder. The underlying technology was developed by TSL and is being marketed by us as the Zimmer Collagen Repair Patch. We and our strategic partners are developing a biodegradable, injectable hydrogel device designed to alleviate pain by restoring the spinal nucleus to its original height through rehydration. RESEARCH AND DEVELOPMENT Zimmer Blood Reinfusion System. This offering in We have extensive research and development activities our portfolio of blood management products collects, ﬁlters and then reinfuses the patient’s own blood following surgery. Pulsavac˛ Plus, Pulsavac Plus AC and Pulsavac Plus LP Wound Debridement Systems. These Pulsavac Systems are used for cleaning and debridement of contaminants and foreign matter from wounds using simultaneous irrigation and suction. All three Pulsavac Systems are completely disposable to reduce the risk of cross contamination. ORTHOBIOLOGICS As part of our focused research and development efforts and desire to create new orthopaedic treatments, we have an Orthobiologics group based in Austin, Texas, with its own full-time staff and dedicated projects. We are actively involved in the ﬁeld of orthobiologics and are committed to investing extensively in orthobiologics research activities. We are working on orthobiological solutions to repair and regenerate damaged or degenerated orthopaedic tissues. These materials potentially could transform treatment of damaged joints by orthobiological repair rather than replacement with inert materials. A sampling of some of our key projects in the Orthobiologics area is set forth below. We are collaborating with ISTO Technologies, Inc. (ISTO) on a project to develop chondral and osteochondral cartilage grafts for cartilage repair. ISTO is developing cartilage regeneration and cell-based therapies using cartilage 6 Registered Trademark of Heraeus Kulzer GmbH. 10 to introduce new surgical techniques, materials, orthobiologics and product designs intended to advance the ﬁeld of orthopaedics. The product development function works closely with the strategic brand marketing function to understand and respond to our customers’ needs on a global basis, and with the research function to incorporate new technologies in our product pipeline. The rapid commercialization of innovative new materials, orthobiologics products, implant and instrument designs, and surgical techniques remains one of our core strategies and continues to be an important driver of sales growth. Among the numerous new product launches in 2005, we released the ﬁrst Trabecular Metal Hip Stem, new Durom Hip Resurfacing instruments, additional Natural-Knee II System MIS Instruments, NexGen MIS Tibial Plates, Zimmer Periarticular Locking Plates and NCB Locking Plates. Other new product, surgical technique and instrument introductions in 2005 in the orthopaedic reconstructive implants, spine implants, trauma, orthopaedic surgical products and orthobiologics product categories are more fully described above under the captions ‘‘PRODUCTS’’ and ‘‘ORTHOBIOLOGICS’’. These and other new products introduced in the last three years accounted for more than 21 percent of 2005 total sales, exceeding our new products sales goal of 15 to 20 percent of total sales on an annual basis. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K For the years ended December 31, 2005, 2004 and 2003, we spent $175.5 million, $166.7 million and $105.8 million, respectively, on research and development. The substantial increases in research and development expenditures have accelerated the output of new orthopaedic and dental reconstructive implants, spine and trauma products, including advanced new materials, product designs and surgical techniques. Our primary research and development facility is located in Warsaw, Indiana. In 2005, we announced that we are committing $24 million to an expanded research and development center in Warsaw and construction is underway. We have other research and development personnel based in, among other places, Winterthur, Switzerland; Austin, Texas; Minneapolis, Minnesota; Carlsbad, California; Dover, Ohio; and Cedar Knolls, New Jersey. As of December 31, 2005, we employed more than 550 research and development employees worldwide. We will continue to identify innovative technologies and consider acquiring complementary products or businesses, or establishing technology licensing arrangements or strategic alliances. GOVERNMENT REGULATION AND QUALITY SYSTEMS We are subject to government regulation with regard to our products and operations in the countries in which we conduct business. It is our policy to comply with all regulatory requirements governing our operations and products, and we believe that the research, development, manufacturing and quality control procedures that we employ are in material compliance with all applicable regulations. In the United States, numerous regulations govern the development, testing, manufacturing, marketing and distribution of medical devices, including, among others, the Federal Food, Drug and Cosmetic Act and regulations issued or promulgated thereunder. The FDA regulates product safety and efﬁcacy, laboratory, clinical and manufacturing practices, labeling and record keeping for medical devices and post market surveillance to identify potential problems with marketed medical devices. A few of the devices we develop and market are in a category for which the FDA has implemented stringent clinical investigation and pre-market approval requirements. The FDA has the authority to halt the distribution of certain medical devices; detain or seize adulterated or misbranded medical devices; or order the repair, replacement or refund of the costs of such devices. There are also certain requirements of state, local and foreign governments that must be complied with in the manufacture and marketing of our products. In many of the foreign countries in which we market our products, we are subject to local regulations affecting, among other things, clinical efﬁcacy, design and product standards, packaging requirements and labeling requirements. Many of the regulations applicable to our devices and products in these countries are similar to those of the FDA. The member countries of the European Union have adopted the European Medical Device Directives, which create a single set of medical device regulations for all member countries. These regulations require companies that wish to manufacture and distribute medical devices in European Union member countries to obtain CE Marks for their products. We maintain a certiﬁed status with the European and Canadian Notiﬁed Bodies, which provides for CE marking of products for these markets. We are subject to various government regulations pertaining to healthcare fraud and abuse, including anti- kickback laws and physician self-referral laws. Violations of these laws are punishable by criminal and/or civil sanctions, including, in some instances, ﬁnes, imprisonment and, within the United States, exclusion from participation in government healthcare programs, including Medicare, Medicaid, Veterans Administration (VA) health programs and Civilian Health and Medical Program Uniformed Service (CHAMPUS). The scope and enforcement of these laws and regulations are uncertain and subject to rapid change. We believe that our operations are in material compliance with these laws. We are committed to providing high quality products to our customers. To meet this commitment, we have implemented modern quality systems and concepts throughout the organization. The quality assurance department supervises our quality systems. Senior management is actively involved in setting quality policies and managing internal and external quality performance. Our regulatory affairs and compliance department is responsible for assuring compliance with all applicable regulations, standards and internal policies. We have initiated numerous quality improvement programs and all of our manufacturing operations are certiﬁed to the new ISO 13485:2003 global standard. Our facilities and operations are also subject to various government environmental and occupational health and safety requirements of the United States and foreign countries, including those relating to discharges of substances in the air, water and land, the handling, storage and disposal of wastes and the cleanup of properties by pollutants. We believe we are currently in material compliance with such requirements. COMPETITION The orthopaedics industry is highly competitive. In the global markets for reconstructive implants, trauma and orthopaedic surgical products, major competitors include: DePuy Orthopaedics, Inc. (a subsidiary of Johnson & Johnson), Stryker Corporation, Biomet, Inc., Synthes, Inc., Smith & Nephew plc and Wright Medical Group, Inc. In the Americas geographic segment, we and DePuy Orthopaedics, Inc., Stryker Corporation, Biomet, Inc., Smith & Nephew, Inc. (a subsidiary of Smith & Nephew plc), Wright Medical Group, Inc. and Synthes, Inc., account for a large majority of the total reconstructive and trauma implant sales. In the Asia Paciﬁc market for reconstructive implant and trauma products, we compete primarily with DePuy Orthopaedics, Inc., Stryker Corporation, Synthes, Inc. and Smith & Nephew plc, as well as regional companies, 11 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K including Japan Medical Materials Corporation and Japan Medical Dynamic Marketing, Inc. Factors, such as the dealer system, complex regulatory environments and the accompanying inability to compete on price, make it difﬁcult for smaller companies, particularly those that are non- regional, to compete effectively with the market leaders in the Asia Paciﬁc region. In Europe, the reconstructive implant and trauma product markets are more fragmented than the Americas or the Asia Paciﬁc segments. The variety of philosophies held by European surgeons regarding hip reconstruction, for example, has fostered the existence of many regional European companies, including Mathys AG and Plus Orthopedics Holdings AG, which compete with us in addition to the global competitors. Today most hip implants sold in Europe are products developed speciﬁcally for Europe, although global products are gaining acceptance. Therefore, we will continue to develop and produce specially tailored products to meet speciﬁc European needs. In the spinal implant category, we compete globally primarily with Medtronic Sofamor Danek, Inc. (a subsidiary of Medtronic, Inc.), DePuy Spine (a subsidiary of Johnson & Johnson), Synthes, Inc., Stryker Corporation and EBI, L.P. (a subsidiary of Biomet, Inc.). In the dental reconstructive implant category, we compete primarily with Nobel Biocare Holding AG, Straumann Holding AG, and Implant Innovations, Inc. (a subsidiary of Biomet, Inc.). Competition within the industry is primarily based on technology, innovation, quality, reputation, customer relationships and service. A key factor in our continuing success in the future will be our ability to develop new products and improve existing products and technologies. Where possible, we will continue to seek patent, trademark and other intellectual property protection concerning the surgical techniques, materials, technologies and products we design and develop. MANUFACTURING AND RAW MATERIALS We manufacture substantially all of our products at eight locations, including Warsaw, Indiana; Winterthur, Switzerland; Ponce, Puerto Rico; Dover, Ohio; Statesville, North Carolina; Carlsbad, California; Cedar Knolls, New Jersey; and Etupes, France. In 2004 and 2005, as part of the execution of the Centerpulse integration plan, we transferred some production operations among facilities in order to optimize manufacturing capacity. As previously announced as part of the Centerpulse integration plan, in 2005 we ceased all manufacturing activities in Austin, Texas and expect to liquidate the property in 2006. Over the past two years, we have expanded certain of our facilities. We believe that our manufacturing facilities set industry standards in terms of automation and have the ﬂexibility to accommodate future growth. The manufacturing operations at these facilities are designed to incorporate the cellular concept for production and to implement tenets of a manufacturing philosophy focused on continuous operational 12 improvement. In addition, at certain of our manufacturing facilities, many of the employees are cross-trained. We generally operate our manufacturing facilities at a targeted goal of approximately 90 percent of total capacity. We continually evaluate the potential to in-source products currently purchased from outside vendors to on-site production. Improving manufacturing productivity has been a major contributor to improvement in proﬁtability. Major areas of improvement have included utilization of computer-assisted robots to precision polish medical devices, automation of certain manufacturing processes, in-sourcing of core products, such as castings and forgings, high-speed machining, and negotiated reductions in third party supplier costs. We use a diverse and broad range of raw materials in the design, development and manufacturing of our products. We purchase all of our raw materials and select components used in manufacturing our products from external suppliers. In addition, we purchase some supplies from single sources for reasons of quality assurance, sole source availability, cost effectiveness or constraints resulting from regulatory requirements. We work closely with our suppliers to assure continuity of supply while maintaining high quality and reliability. Although a change in suppliers could require signiﬁcant effort or investment by us in circumstances where the items supplied are integral to the performance of our products or incorporate unique technology, we do not believe that the loss of any existing supply contract would have a material adverse effect on our ﬁnancial and operational performance. To date, we have not experienced any signiﬁcant difﬁculty in locating and obtaining the materials necessary to fulﬁll our production schedules. INTELLECTUAL PROPERTY We believe that patents and other proprietary rights are important to the continued success of our business. We also rely upon trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position. We protect our proprietary rights through a variety of methods, including conﬁdentiality agreements and proprietary information agreements with vendors, employees, consultants and others who may have access to proprietary information. We own or control through licensing arrangements more than 2,770 issued patents and more than 1,540 patent applications throughout the world that relate to aspects of the technology incorporated in many of our products. EMPLOYEES We employ more than 6,700 employees worldwide, including more than 550 employees dedicated to research and development. Approximately 4,100 employees are located within the United States and more than 2,600 employees are located outside of the United States, primarily throughout Europe and in Japan. We have over 2,300 employees dedicated to manufacturing our products worldwide. The Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Warsaw, Indiana, production facility employs more than 1,000 employees. Fewer than 200 North American employees are members of a trade union covered by a collective bargaining agreement. In May 2003, we renewed a collective bargaining agreement with the United Steelworkers of America covering employees at the Dover, Ohio, facility. This agreement will continue in effect until May 15, 2007. The agreement automatically renews thereafter on a year-to-year basis until either party gives written notice of its intent to terminate the agreement, 60 days prior to a termination date. EXECUTIVE OFFICERS The following table sets forth certain information with respect to our executive ofﬁcers as of January 31, 2006. Name J. Raymond Elliott Cheryl R. Blanchard, Ph.D. Sheryl L. Conley James T. Crines David C. Dvorak Jon E. Kramer Sam R. Leno Bruno A. Melzi Stephen H.L. Ooi Chad F. Phipps Age 56 41 45 46 42 59 60 58 52 34 Position Chairman, President and Chief Executive Ofﬁcer Senior Vice President, Research and Development and Chief Scientiﬁc Ofﬁcer Group President, Americas and Global Marketing and Chief Marketing Ofﬁcer Senior Vice President, Finance, Operations and Corporate Controller and Chief Accounting Ofﬁcer Group President, Global Businesses and Chief Legal Ofﬁcer President, U.S. Sales Executive Vice President, Finance and Corporate Services and Chief Financial Ofﬁcer Chairman, Europe, Middle East and Africa President, Asia Paciﬁc Associate General Counsel and Secretary Mr. Elliott was appointed Chairman of Zimmer Holdings on August 6, 2001 and President and Chief Executive Ofﬁcer of Zimmer Holdings on March 20, 2001. Mr. Elliott was appointed President of Zimmer, Inc., a predecessor, in November 1997. Mr. Elliott has more than 30 years of experience in orthopaedics, medical devices and consumer products. He has served as a director on more than 20 business-related boards in the U.S., Canada, Japan and Europe and has served on ﬁve occasions as Chairman. He has served as a member of the board of directors and chair of the orthopaedic sector of the Advanced Medical Technology Association (AdvaMed) and is currently a director of the State of Indiana Workplace Development Board, the Indiana Chamber of Commerce and the American Swiss Foundation. Mr. Elliott has served as the Indiana representative on the President’s State Scholars Program and as a trustee of the Orthopaedic Research and Education Foundation (OREF). Dr. Blanchard was appointed Senior Vice President, Research and Development and Chief Scientiﬁc Ofﬁcer of Zimmer Holdings in December 2005 and she is responsible for Global Research, Global Development, Global Quality, Orthobiologics, External Research and Emerging Technologies. From October 2003 to December 2005, Dr. Blanchard served as Vice President, Corporate Research and Clinical Affairs; from August 2002 to October 2003, she served as Vice President, Research and Biologics; and from October 2000 to August 2002, she served as Director, Research. Prior to joining us in October 2000, Dr. Blanchard served in Manager, Professor and Fellow roles at the Southwest Research Institute, the University of Texas Health Science Center and Oak Ridge National Laboratory, respectively. Ms. Conley was appointed Group President, Americas and Global Marketing and Chief Marketing Ofﬁcer of Zimmer Holdings in December 2005 and she is responsible for all Global Marketing and all Western Hemisphere operations, including our business in the United States, Canada and Latin America. She is our ﬁrst Chief Marketing Ofﬁcer. From October 2003 to December 2005, Ms. Conley served as President, Global Products Group. From September 2002 to October 2003, Ms. Conley served as President, Zimmer Reconstructive and from May 2000 to September 2002, she served as Vice President, Global Brand Management and Commercialization, where she was responsible for Zimmer’s worldwide branding, marketing and new product development efforts. Ms. Conley was General Manager, Zimmer Canada, from 1998 to 2000. Ms. Conley joined Zimmer, Inc. in 1983 and has held various management positions in marketing, operations and clinical research. Mr. Crines was appointed Senior Vice President, Finance, Operations and Corporate Controller and Chief Accounting Ofﬁcer of Zimmer Holdings in December 2005 and he is responsible for internal and external ﬁnancial reporting, corporate and business unit accounting, and operations and logistics. From October 2003 to December 2005, Mr. Crines served as Senior Vice President, Finance/Controller and Information Technology. From July 2001 to October 2003, Mr. Crines served as Vice President, Finance/Controller and from September 2000 to July 2001, he served as Vice President, Finance and Information Technology. Mr. Crines served Zimmer, Inc. as Director of Finance and Logistics, Japan from May 1999 until September 2000. Mr. Crines served as Associate Director, Accounting at Bristol-Myers 13 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Squibb, Zimmer’s former parent, from September 1995 until he joined Zimmer, Inc. in 1997 as Director of Finance. Mr. Crines has over 20 years of experience in corporate and operations ﬁnance and accounting, including ﬁve years as an auditor. Mr. Dvorak was appointed Group President, Global Businesses and Chief Legal Ofﬁcer of Zimmer Holdings in December 2005 and he is responsible for the existing Dental, Spine and Orthopaedic Surgical Products global divisions, as well as the development of the new global Trauma division. Additionally, Mr. Dvorak is the Chief Legal Ofﬁcer, with responsibility for the Global Legal, Intellectual Property, Litigation and Risk Groups. From October 2003 to December 2005, Mr. Dvorak served as Executive Vice President, Corporate Services, Chief Counsel and Secretary, as well as Chief Compliance Ofﬁcer. From December 2001 to October 2003, Mr. Dvorak served as Senior Vice President, Corporate Affairs and General Counsel. He served as Corporate Secretary from February 2003 to December 2005. Prior to his appointment with us, Mr. Dvorak served as Senior Vice President, General Counsel and Corporate Secretary and was a member of the Executive Committee of STERIS Corporation. Prior to joining STERIS in June 1996, Mr. Dvorak practiced corporate law at two large Cleveland, Ohio law ﬁrms, focusing on mergers and acquisitions and on securities law. Mr. Kramer was appointed President, U.S. Sales of Zimmer Holdings in December 2005 and he is responsible for our sales activities throughout the United States. From August 2004 to December 2005, Mr. Kramer served as President, Americas. From October 2003 to August 2004, Mr. Kramer served as Vice President, U.S. Sales, and from 2001 to October 2003, he was our Area Vice President for the Southeast region of the United States. Prior to joining us, Mr. Kramer served as Vice President of Sales for Implex Corp. We acquired Implex on April 23, 2004, and the company formerly known as Implex is now our wholly-owned subsidiary. Mr. Kramer has over 20 years of sales experience in the orthopaedics industry. Mr. Leno was appointed Executive Vice President, Finance and Corporate Services and Chief Financial Ofﬁcer of Zimmer Holdings in December 2005 and he has overall responsibility for Finance and Operations, as well as Global Human Resources, Business Development and Strategic Planning, and Global Information Technology. From October 2003 to December 2005, Mr. Leno served as Executive Vice President, Corporate Finance and Operations, and Chief Financial Ofﬁcer. From July 2001 to October 2003, Mr. Leno served as Senior Vice President and Chief Financial Ofﬁcer. Prior to joining us, Mr. Leno served as Senior Vice President and Chief Financial Ofﬁcer of Arrow Electronics, Inc., a global distributor of electronic components, a position he held from March 1999 until he joined Zimmer. Between 1971 and March 1999, Mr. Leno held various chief ﬁnancial ofﬁcer and other ﬁnancial positions with several U.S. based companies and he previously served as a U.S. Naval Ofﬁcer. 14 Mr. Melzi was appointed Chairman, Europe, Middle East and Africa of Zimmer Holdings in October 2003 and he is responsible for overall operations in the European, Middle Eastern and African regions. Mr. Melzi also serves presently as ad interim President, Europe. From March 2000 to October 2003, Mr. Melzi served as President, Europe/MEA; from October 1997 to March 2000, he served as Vice President and Managing Director of Italy, Germany and Switzerland; and from 1990 to October 1997, he served as Managing Director, Italy. Mr. Melzi has nearly 30 years of experience in the orthopaedics and medical products industry, including serving as General Manager and member of the Board of Directors of Johnson & Johnson Italy from 1983 to 1990. Mr. Ooi was appointed President, Asia Paciﬁc of Zimmer Holdings in December 2005 and he is responsible for overall operations in the Asia Paciﬁc region, including responsibility for Japan. Following our acquisition of Centerpulse, Mr. Ooi served as President, Australasia from September 2003 to December 2005, where he was responsible for operations in Asia Paciﬁc, excluding Japan. From September 2002 to September 2003, Mr. Ooi served as President, Asia Paciﬁc region, and from January 1992 to September 2002, Mr. Ooi served as Vice President, Asia. Mr. Ooi joined us in March 1986 as Regional Manager and was promoted to General Manager, Asia in February 1987. Mr. Phipps was appointed Associate General Counsel and Secretary of Zimmer Holdings in December 2005 and, in addition to his role as Secretary to the Board of Directors, he has responsibility for Zimmer’s Global legal affairs, including general corporate and securities law matters. From September 2003 to December 2005, Mr. Phipps served as Associate Counsel and Assistant Secretary. Prior to joining us, Mr. Phipps served as Vice President and General Counsel of L&N Sales and Marketing, Inc. in Pennsylvania, and prior to joining L&N Sales and Marketing in 2002, Mr. Phipps practiced corporate law with the ﬁrm of Morgan, Lewis & Bockius in Philadelphia, Pennsylvania, focusing on corporate and securities law, mergers and acquisitions, and ﬁnancial transactions. AVAILABLE INFORMATION Our Internet website address is www.zimmer.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports ﬁled or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available or may be accessed free of charge through the Investor Relations section of our Internet website as soon as reasonably practicable after we electronically ﬁle such material with, or furnish it to, the SEC. Our Internet website and the information contained therein or connected thereto are not intended to be incorporated by reference into this Annual Report on Form 10-K. The following corporate governance and related documents, among others, are available through our website Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K or may be obtained in print form, without charge, by request to our Investor Relations Department: Corporate Governance Guidelines, Code of Business Conduct, Code of Ethics for Chief Executive Ofﬁcer and Senior Financial Ofﬁcers, Audit Committee Charter, Compensation and Management Development Committee Charter, Corporate Governance Committee Charter, and Science and Technology Committee Charter. We intend to post on our Internet website any amendment to, or waiver from, the provisions of our Code of Ethics for Chief Executive Ofﬁcer and Senior Financial Ofﬁcers. ITEM 1A. Risk Factors Risk factors which could cause actual results to differ from our expectations and which could negatively impact our ﬁnancial condition and results of operations are discussed below and elsewhere in this report. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that are currently not believed to be signiﬁcant to our business may also affect our actual results and could harm our business, ﬁnancial condition and results of operations. If any of the risks or uncertainties described below or any additional risks and uncertainties actually occur, our business, results of operations and ﬁnancial condition could be materially and adversely affected. RISKS RELATED TO OUR INDUSTRY Our success depends on our ability to effectively develop and market our products against those of our competitors. We operate in a highly competitive environment. Our present or future products could be rendered obsolete or uneconomical by technological advances by one or more of our present or future competitors or by other therapies, including orthobiological therapies. To remain competitive, we must continue to develop and acquire new products and technologies. In the global markets for reconstructive orthopaedic implants, trauma products and other orthopaedic products, a limited number of competitors, including DePuy Orthopaedics, Inc. (a subsidiary of Johnson & Johnson), Stryker Corporation, Biomet, Inc., Wright Medical Group, Inc., Synthes, Inc. and Smith & Nephew plc, compete with us for the majority of product sales. In the spinal implant category, we compete globally primarily with Medtronic Sofamor Danek, Inc. (a subsidiary of Medtronic, Inc.), DePuy Spine (a subsidiary of Johnson & Johnson), Synthes, Inc., Stryker Corporation and EBI, L.P. (a subsidiary of Biomet, Inc.). In the dental reconstructive implant category, we compete primarily with Nobel Biocare Holding AG, Straumann Holding AG, and Implant Innovations, Inc. (a subsidiary of Biomet, Inc.). Competition is primarily on the basis of: ) technology; ) innovation; ) quality; ) reputation; ) relationships with customers; and ) service. In local markets outside of the United States, other factors inﬂuence competition as well, including: ) local distribution systems; ) complex regulatory environments; and ) differing medical philosophies and product preferences. Our competitors may: ) have greater ﬁnancial, marketing and other resources than us; ) respond more quickly to new or emerging technologies; ) undertake more extensive marketing campaigns; ) adopt more aggressive pricing policies; or ) be more successful in attracting potential customers, employees and strategic partners. Any of these factors, alone or in combination, could cause us to have difﬁculty maintaining or increasing sales of our products. If third-party payors decline to reimburse our customers for our products or reduce reimbursement levels, the demand for our products may decline and our ability to sell our products proﬁtably may be harmed. We sell our products and services to hospitals, doctors, dentists and other health care providers, all of which receive reimbursement for the health care services provided to their patients from third-party payors, such as domestic and international government programs, private insurance plans and managed care programs. These third-party payors may deny reimbursement if they determine that a device used in a procedure was not in accordance with cost-effective treatment methods, as determined by the third-party payor, or was used for an unapproved indication. Third-party payors may also decline to reimburse for experimental procedures and devices. If our products are not considered cost-effective by third-party payors, our customers may not be reimbursed for our products. In addition, third-party payors are increasingly attempting to contain health care costs by limiting both coverage and the level of reimbursement for medical products and services. For example, managed care programs often prescribe only those orthopaedic recovery products that match a patient as to age, need for mobility and other parameters in an effort to provide more cost-effective care. If third-party payors reduce reimbursement levels to hospitals and other health care providers for our products, demand for our products may decline or we may experience pressure to reduce the prices of our products, which could have a material adverse effect on sales, ﬁnancial condition and results of operation. In international markets, where the movement toward health care reform and the development of managed care are generally not as advanced as in the United States, we have experienced downward pressure on product pricing and other effects of health care reform. In Japan, for example, a government-operated insurance system reimburses customers 15 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K for our products. Under this system, the Japanese government periodically reviews and reduces the reimbursement levels for products. If the Japanese government continues to reduce the reimbursement level for orthopaedic products, our sales, ﬁnancial condition and results of operation may be adversely affected. We are subject to cost-containment efforts of healthcare purchasing organizations, which may have a material adverse effect on our ﬁnancial condition and results of operations. Many existing and potential customers for our products have combined to form group purchasing organizations in an effort to contain costs. Group purchasing organizations negotiate pricing arrangements with medical supply manufacturers and distributors, and these negotiated prices are made available to a group purchasing organization’s afﬁliated hospitals and other members. If we are not one of the providers selected by a group purchasing organization, afﬁliated hospitals and other members may be less likely to purchase our products, and if the group purchasing organization has negotiated a strict compliance contract for another manufacturer’s products, we may be precluded from making sales to members of the group purchasing organization for the duration of the contractual arrangement. Our failure to respond to the cost-containment efforts of group purchasing organizations may cause us to lose market share to our competitors and could have a material adverse effect on our sales, ﬁnancial condition and results of operations. We are involved in an ongoing investigation by the United States Department of Justice of companies in the orthopaedics industry, the results of which may have a material adverse effect on our sales, ﬁnancial condition and results of operations. On March 31, 2005, we received a subpoena from the United States Department of Justice through the United States Attorney’s Ofﬁce in Newark, New Jersey, requesting documents related to consulting contracts or professional service agreements we have with orthopaedic surgeons. We understand that similar inquiries were directed to at least four other companies in the orthopaedics industry. We are cooperating fully with federal authorities with regard to this matter. If, as a result of this investigation, we are found to have violated one or more applicable laws, our business, ﬁnancial condition and results of operations could be materially adversely affected. If some of our existing business practices are challenged as unlawful, we may have to change those practices, which could have a material adverse effect on our business, ﬁnancial condition and results of operations. We and our customers are subject to various governmental regulations and we may incur signiﬁcant expenses to comply with these regulations and develop products compatible with these regulations. The medical devices we design, develop, manufacture and market are subject to rigorous regulation by the FDA and numerous other Federal, state and foreign governmental authorities. The process of obtaining regulatory approvals to market a medical device, particularly from the FDA and 16 certain foreign governmental authorities, can be costly and time consuming and approvals might not be granted for future products on a timely basis, if at all. Delays in receipt of, or failure to obtain, approvals for future products could result in delayed realization of product revenues or in substantial additional costs which could have a material adverse effect on our business or results of operations. In addition, if we fail to comply with applicable FDA medical device or other material regulatory requirements, including, for example, the Quality System Regulation, recordkeeping regulations, labeling requirements and adverse event reporting regulations, that failure could result in, among other things: ) warning letters; ) ﬁnes or civil penalties; ) injunctions; ) repairs, replacements or refunds; ) recalls or seizures of products; ) total or partial suspension of production; ) the U.S. Food and Drug Administration’s refusal to grant future premarket clearances or approvals; ) withdrawals or suspensions of current product applications; and ) criminal prosecution. Any of these actions, in combination or alone, could have a material adverse effect on our business, ﬁnancial condition and results of operations. In many of the foreign countries in which we market our products, we are subject to regulations affecting, among other things: ) clinical efﬁcacy; ) product standards; ) packaging requirements; ) labeling requirements; ) import/export restrictions; ) tariff regulations; ) duties; and ) tax requirements. Many of the regulations applicable to our devices and products in these countries, such as the European Medical Devices Directive, are similar to those of the FDA. In addition, in many countries the national health or social security organizations require our products to be qualiﬁed before they can be marketed with the beneﬁt of reimbursement eligibility. Failure to receive or delays in the receipt of, relevant foreign qualiﬁcations also could have a material adverse effect on our business, ﬁnancial condition and results of operations. As both the FDA and foreign government regulators have become increasingly stringent, we may be subject to more rigorous regulation by governmental authorities in the future. Our products and operations are also often subject to the rules of industrial standards bodies, such as the International Standards Organization. If we fail to adequately address any of these regulations, our business will be harmed. We are subject to health care fraud and abuse regulations that could require us to change our Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K business practices and restrict our operations in the future. Our industry is subject to various Federal and state laws pertaining to health care fraud and abuse, including anti- kickback laws and physician self-referral laws. Violations of these laws are punishable by criminal and/or civil sanctions, including, in some instances, ﬁnes, imprisonment and, within the United States, exclusion from participation in government healthcare programs, including Medicare, Medicaid, Veterans Administration (VA) health programs and Civilian Health and Medical Program Uniformed Service (CHAMPUS). The scope and enforcement of these laws and regulations are uncertain and subject to rapid change. Because of the far-reaching and uncertain nature of these laws, we are required to monitor our practices to remain in compliance with these laws. If we were to violate one or more of these laws, our business, ﬁnancial condition and results of operations could be materially adversely affected. If there is a change in law, regulation or administrative or judicial interpretations, some of our existing business practices could be challenged as unlawful and, as a result, we may have to change those practices, which could have a material adverse effect on our business, ﬁnancial condition and results of operations. We may incur product liability losses, and insurance coverage may be inadequate or unavailable to cover these losses. Our business is subject to potential product liability risks that are inherent in the design, development, manufacture and marketing of medical devices. Our products are often used in surgical and intensive care settings. In addition, some of the medical devices we manufacture and sell are designed to be implanted in the human body for long periods of time. In the ordinary course of business, we are the subject of product liability lawsuits alleging that component failures, manufacturing ﬂaws, design defects or inadequate disclosure of product-related risks or product-related information resulted in an unsafe condition or injury to patients. Product liability lawsuits and claims, safety alerts or product recalls, regardless of their ultimate outcome, could have a material adverse effect on our business and reputation and on our ability to attract and retain customers. As part of our risk management policy, we maintain third-party product liability insurance coverage. However, product liability claims against us may exceed the coverage limits of our insurance policies or cause us to record a self- insured loss. Even if any product liability loss is covered by an insurance policy, these policies may have substantial retentions or deductibles that provide that we will not receive insurance proceeds until the losses incurred exceed the amount of those retentions or deductibles. We will be responsible for paying any losses that are below those retentions or deductibles. A product liability claim in excess of applicable insurance could have a material adverse effect on our business, ﬁnancial position and results of operations. RISKS RELATED TO OUR BUSINESS If we fail to effectively utilize the skills and knowledge of orthopaedic surgeons, customers may not buy our products and our revenue and proﬁtability may decline. We maintain professional relationships with a number of orthopaedic surgeons who assist in product research and development and advise us on how to satisfy the full range of surgeon and patient needs. These professionals speak about our products at medical seminars, assist in the training of other professionals in the use of our products and provide us with feedback on the industry’s acceptance of our new products. The failure of our products to retain the support of orthopaedic surgeons, who frequently recommend products or are involved in product selection decisions, or the failure of our new products to secure and retain similar support from surgeons, could have a material adverse effect on our business, ﬁnancial condition and results of operations. If we fail to retain the independent agents and distributors upon whom we rely heavily to market our products, customers may not buy our products and our revenue and proﬁtability may decline. Our marketing success in the United States and abroad depends largely upon our agents’ and distributors’ sales and service expertise in the marketplace. Many of these agents have developed professional relationships with existing and potential customers because of their detailed knowledge of products and instruments. Many commonly provide operating room personnel with implant and instrument product training as well as product support in the operating room. A loss of a signiﬁcant number of these agents could have a material adverse effect on our business, ﬁnancial condition and results of operations. If some of the business practices of our independent sales agents and distributors are challenged as unlawful, they may have to change those practices, which could have a material adverse effect on our business, ﬁnancial condition and results of operations. If we do not introduce new products in a timely manner, our products may become obsolete over time, customers may not buy our products and our revenue and proﬁtability may decline. Demand for our products may change, in certain cases, in ways we may not anticipate because of: ) evolving customer needs; ) changing demographics; ) slowing industry growth rates; ) declines in the reconstructive implant market; ) the introduction of new products and technologies; ) evolving surgical philosophies; and ) evolving industry standards. Without the timely introduction of new products and enhancements, our products may become obsolete over time. If that happens, our revenue and operating results would suffer. The success of our new product offerings will depend on several factors, including our ability to: ) properly identify and anticipate customer needs; ) commercialize new products in a timely manner; 17 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ) manufacture and deliver instruments and products in ) potentially negative consequences from changes in tax sufﬁcient volumes on time; ) differentiate our offerings from competitors’ offerings; ) achieve positive clinical outcomes for new products; ) satisfy the increased demands by healthcare payors, providers and patients for shorter hospital stays, faster post-operative recovery and lower-cost procedures; ) innovate and develop new materials, product designs and surgical techniques; and ) provide adequate medical education relating to new products and attract key surgeons to advocate these new products. In addition, new materials, product designs and surgical techniques that we develop may not be accepted quickly, in some or all markets, because of, among other factors: ) entrenched patterns of clinical practice; ) the need for regulatory clearance; and ) uncertainty with respect to third-party reimbursement. Moreover, innovations generally require a substantial investment in research and development before we can determine their commercial viability and we may not have the ﬁnancial resources necessary to fund the production. In addition, even if we are able to successfully develop enhancements or new generations of our products, these enhancements or new generations of products may not produce revenue in excess of the costs of development and they may be quickly rendered obsolete by changing customer preferences or the introduction by our competitors of products embodying new technologies or features. laws; and ) political and economic instability. Any of these factors may, individually or as a group, have a material adverse effect on our business, ﬁnancial condition and results of operations. We are subject to risks arising from currency exchange rate ﬂuctuations, which can increase our costs and may cause our proﬁtability to decline. A substantial portion of our foreign generated revenues are generated in Europe and Japan. The United States dollar value of our foreign-generated revenues varies with currency exchange rate ﬂuctuations. Signiﬁcant increases in the value of the United States dollar relative to the Euro or the Japanese Yen, as well as other currencies, could have a material adverse effect on our results of operations. We address currency risk management through regular operating and ﬁnancing activities, and on a limited basis, through the use of derivative ﬁnancial instruments. The derivative ﬁnancial instruments we enter into are in the form of foreign exchange forward contracts with major ﬁnancial institutions. The forward contracts are designed to hedge anticipated foreign currency transactions, primarily intercompany sale and purchase transactions, for periods consistent with commitments. Realized and unrealized gains and losses on these contracts that qualify as cash ﬂow hedges are temporarily recorded in other comprehensive income, then recognized in earnings when the hedged item affects net earnings. We conduct a signiﬁcant amount of our sales We may fail to adequately protect our proprietary activity outside of the United States, which subjects us to additional business risks and may cause our proﬁtability to decline due to increased costs. Because we sell our products in more than 100 countries, our business is subject to risks associated with doing business internationally. In 2005, we derived approximately $1,344 million, or 41% of our total revenue, from sales of our products outside of the United States. We intend to continue to pursue growth opportunities in sales internationally, which could expose us to additional risks associated with international sales and operations. Our international operations are, and will continue to be, subject to a number of risks and potential costs, including: ) changes in foreign medical reimbursement policies and programs; ) unexpected changes in foreign regulatory requirements; ) differing local product preferences and product requirements; ) ﬂuctuations in foreign currency exchange rates; ) diminished protection of intellectual property in some countries outside of the United States; ) trade protection measures and import or export licensing requirements; ) difﬁculty in stafﬁng and managing foreign operations; ) labor force instability; ) differing labor regulations; 18 technology and other intellectual property, which would allow competitors or others to take advantage of our research and development efforts. Our long-term success largely depends on our ability to market technologically competitive products. If we fail to obtain or maintain adequate intellectual property protection, we may not be able to prevent third parties from using our proprietary technologies. Also, our currently pending or future patent applications may not result in issued patents. In the United States, patent applications are conﬁdential for 18 months following their ﬁling, and because third parties may have ﬁled patent applications for technology covered by our pending patent applications without our being aware of those applications, our patent applications may not have priority over patent applications of others. In addition, our issued patents may not contain claims sufﬁciently broad to protect us against third parties with similar technologies or products, or provide us with any competitive advantage. If a third party initiates litigation regarding our patents, our collaborators’ patents, or those patents for which we have license rights, and is successful, a court could declare our patents invalid or unenforceable or limit the scope of coverage of those patents. The United States Patent and Trademark Ofﬁce (USPTO) and the courts have not consistently treated the breadth of claims allowed or interpreted in orthopaedic reconstructive implant and biotechnology patents. If the USPTO or the courts begin to allow or interpret claims more Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K broadly, the incidence and cost of patent interference proceedings and the risk of infringement litigation will likely increase. On the other hand, if the USPTO or the courts begin to allow or interpret claims more narrowly, the value of our proprietary rights may be reduced. Any changes in, or unexpected interpretations of, the patent laws may adversely affect our ability to enforce our patent position. In addition, intellectual property rights may be unavailable or limited in some foreign countries, which could make it easier for competitors to capture market position. Competitors may also capture market share from us by designing products that mirror the capabilities of our products or technology without infringing our intellectual property rights. If we do not obtain sufﬁcient international protection for our intellectual property, our competitiveness in international markets could be impaired, which would limit our growth and future revenue. We also rely upon trade secrets, proprietary know-how, and continuing technological innovation to remain competitive. We attempt to protect this information with security measures, including the use of conﬁdentiality agreements with our employees, consultants, and corporate collaborators. These individuals may breach these agreements and any remedies available to us may be insufﬁcient to compensate our damages. Furthermore, our trade secrets, know-how and other technology may otherwise become known or be independently discovered by our competitors. We may be subject to intellectual property litigation and infringement claims, which could cause us to incur signiﬁcant expenses or prevent us from selling our products. A successful claim of patent or other intellectual property infringement against us could adversely affect our growth and proﬁtability, in some cases materially. From time to time, we receive notices from third parties of potential infringement and receive claims of potential infringement. We may be unaware of intellectual property rights of others that may cover some of our technology. If someone claims that our products infringed their intellectual property rights, any resulting litigation could be costly and time consuming and would divert the attention of management and key personnel from other business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement also might require us to enter into costly royalty or license agreements. However, we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to signiﬁcant damages or an injunction preventing us from manufacturing, selling or using some of our products in the event of a successful claim of patent or other intellectual property infringement. Any of these adverse consequences could have a material adverse effect on our business, ﬁnancial condition and results of operations. We may complete additional acquisitions, which could increase our costs or liabilities or be disruptive. We intend to continue to look for additional strategic acquisitions. We may not be able to complete additional acquisitions or to integrate successfully any acquired businesses without substantial expense, delay or other operational or ﬁnancial problems. Acquiring and integrating new businesses involves risk, including the following: ) we may need to divert more management resources to integration than we planned, which may adversely affect our ability to pursue other more proﬁtable activities; ) the difﬁculties of integration may be increased if we need to integrate geographically separated organizations, personnel with disparate business backgrounds and companies with different corporate cultures; ) we may not eliminate as many redundant costs as we anticipated in selecting our acquisition candidates; and ) one or more of our acquisition candidates also may have liabilities or adverse operating issues that we failed to discover through our diligence prior to the acquisition. If we are unable to form strategic alliances, or if our strategic alliances fail to achieve their objectives, our operating results will be negatively impacted. Several of our strategic initiatives involve alliances with other orthopaedic and biotechnology companies. These include our agreement with Revivicor, Inc. relating to orthopaedic tissue technology, our collaboration with ISTO Technologies, Inc. relating to regenerative cartilage technology and our distribution agreement with Heraeus relating to orthopaedic bone cement products. The success of these and similar arrangements is largely dependent on technology and other intellectual property contributed by our strategic partners or the resources, efforts, and skills of these partners. Disputes and difﬁculties in such relationships are common, often due to conﬂicting priorities or conﬂicts of interest. Merger and acquisition activity may exacerbate these conﬂicts. The beneﬁts of these alliances are reduced or eliminated when strategic partners: ) terminate the agreements or limit our access to the underlying intellectual property; ) fail to devote ﬁnancial or other resources to the alliances and thereby hinder or delay development, manufacturing or commercialization activities; ) fail to successfully develop, manufacture or commercialize any products; or ) fail to maintain the ﬁnancial resources necessary to continue ﬁnancing their portion of the development, manufacturing, or commercialization costs or their own operations. Furthermore, under some of our strategic alliances, we may make milestone payments well in advance of commercialization of products with no assurance that we will ever recoup these payments. We also may make equity investments in our strategic partners. These investments may decline in value and result in our incurring ﬁnancial statement charges in the future. We depend on a limited number of suppliers for some key raw materials and outsourced activities. We use a number of suppliers for raw materials we need to manufacture our products and to outsource some key manufacturing activities. These suppliers must provide the materials and perform the activities to our standards for us to 19 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K meet our quality and regulatory requirements. Some key raw materials and outsourced activities can only be obtained from a single source or a limited number of sources. A prolonged disruption or other inability to obtain these materials or activities could materially and adversely affect our ability to satisfy demand for our products, which could have a material adverse effect on our business, ﬁnancial condition and results of operations. Our future proﬁtability may be affected by changes to our product category and region sales mix. Reconstructive implants produce the highest operating proﬁt margins among our product categories. These products accounted for approximately 83 percent of 2005 net sales. Sales in our Americas region accounted for approximately 59 percent of 2005 net sales. Sales in the Americas region produce the highest operating proﬁt margins in the geographic markets in which we operate. While we expect net sales of reconstructive implants and net sales in the Americas region to remain strong, changes to our product category mix or our region sales mix could adversely affect our future proﬁtability. ITEM 1B. Unresolved Staff Comments Not Applicable. 20 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ITEM 2. Properties We have the following properties: Location Warsaw, Indiana Warsaw, Indiana Warsaw, Indiana Carlsbad, California Minneapolis, Minnesota Statesville, North Carolina Dover, Ohio Allendale, New Jersey Cedar Knolls, New Jersey Parsippany, New Jersey Memphis, Tennessee Austin, Texas Austin, Texas Sydney, Australia M ¨odling, Austria Wemmel, Belgium Mississauga, Canada Shanghai, China Etupes, France Freiburg, Germany Kiel, Germany Milan, Italy Gotemba, Japan Tokyo, Japan Seoul, Korea Utrecht, Netherlands Ponce, Puerto Rico Singapore Barcelona, Spain Baar, Switzerland Winterthur, Switzerland M ¨unsingen, Switzerland Swindon, United Kingdom Use Owned/Leased Square Feet Research & Development, Manufacturing, Warehousing, Marketing & Administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Corporate Headquarters and The Zimmer Institute . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces, Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Leased Ofﬁces, Research & Development & Manufacturing . . . . . . . . . . . . . . . . . . . . . Ofﬁces & Research & Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Research & Development, Manufacturing & Warehousing . . . . . . . . . . . . . . . . Owned Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Research & Development, Manufacturing & Warehousing . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Research & Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces, Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces, Service Center & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces, Manufacturing & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces, Research & Development & Manufacturing . . . . . . . . . . . . . . . . . . . . . Leased Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Owned Ofﬁces & Warehousing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leased 853,000 115,000 102,000 118,000 42,000 156,000 140,000 23,000 23,000 115,000 30,000 210,000 14,000 36,000 14,000 15,000 52,000 18,000 90,000 51,000 21,000 47,000 87,000 24,000 22,000 16,000 213,000 10,000 16,000 40,000 265,000 76,000 70,000 We ceased production at our Austin, Texas facility in October 2005 and expect to liquidate the property in 2006. We are in the process of expanding the research and development facilities at our Warsaw location. The expansion should be completed in 2006 and add approximately 100,000 square feet to our existing research and development facilities. We believe the current facilities, including manufacturing, warehousing, research and development and ofﬁce space, together with the planned expansions provide sufﬁcient capacity to meet ongoing demands. Once a facility reaches 85 percent utilization, we examine alternatives for either expanding that facility or acquiring new facilities to meet our ongoing demands. In addition to the above, we maintain more than 100 other ofﬁces and warehouse facilities in more than 24 countries around the world, including the United States, Japan, Australia, France, Russia, India, Germany, Italy, Switzerland and China. We believe that all of the facilities and equipment are in good condition, well maintained and able to operate at present levels. ITEM 3. Legal Proceedings Information pertaining to legal proceedings can be found in Note 16 to the Consolidated Financial Statements, which are included in this report under Item 8. ITEM 4. Submission of Matters to a Vote of Security Holders Not Applicable. 21 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Part II ITEM 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock is traded on the New York Stock Exchange and the SWX Swiss Exchange under the symbol ‘‘ZMH.’’ The high and low sales prices for our common stock on the New York Stock Exchange for the calendar quarters of ﬁscal years 2005 and 2004 are set forth as follows: Quarterly High-Low Share Prices Year Ended December 31, 2005: First Quarter Second Quarter Third Quarter Fourth Quarter Year Ended December 31, 2004: First Quarter Second Quarter Third Quarter Fourth Quarter High Low $89.10 $83.70 $85.10 $71.60 $81.68 $88.95 $89.44 $84.99 $74.25 $72.71 $67.62 $60.19 $68.24 $73.66 $64.40 $67.00 We have not declared or paid dividends on our common stock since becoming a public company on August 6, 2001. Currently, we do not anticipate paying any cash dividends on the common stock in the foreseeable future. Our credit facility also restricts the payment of dividends under certain circumstances. The number of beneﬁcial owners of our common stock on February 13, 2006 was approximately 537,700. On February 13, 2006, the closing price of the common stock, as reported on the New York Stock Exchange, was $68.63 per share. The information required by this Item concerning equity compensation plans is incorporated by reference to Item 12 of this report. The following table summarizes treasury shares purchased during 2005: December 2005 Total Total Number of Shares Purchased Average Price Paid per Share 59,200 59,200 $68.73 $68.73 Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs(1) Approximate Dollar Value of Shares that May Yet Be Purchased Under Plans or Programs 59,200 59,200 $995,931,185 $995,931,185 (1) In December 2005, our Board of Directors authorized the repurchase of up to $1 billion of common stock through December 31, 2007. Prior to December 2005 we did not have a share repurchase program. 22 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S ITEM 6. Selected Financial Data 2 0 0 5 F O R M 1 0 - K The ﬁnancial information for each of the past ﬁve years ended December 31, is set forth below (in millions, except per share amounts): Summary of Operations Net sales Net earnings Pro forma net earnings assuming change in accounting principle for instruments is applied retroactively(2) Earnings per common share Basic Diluted Pro forma earnings per common share assuming change in accounting principle for instruments is applied retroactively(2) Basic Diluted Average common shares outstanding Basic Diluted Balance Sheet Data Total assets Short-term debt Long-term debt Other long-term obligations Stockholders’ equity 2005 2004 $3,286.1 732.5 $2,980.9 541.8 2003(1) $1,901.0 346.3 2002 2001 $1,372.4 257.8 $1,178.6 149.8 732.5 541.8 291.2 260.8 156.2 $ $ 2.96 2.93 2.96 2.93 247.1 249.8 $5,721.9 – 81.6 348.3 4,682.8 $ $ 2.22 2.19 2.22 2.19 244.4 247.8 $5,695.5 27.5 624.0 420.9 3,942.5 $ $ 1.67 1.64 1.40 1.38 207.7 211.2 $5,156.0 101.3 1,007.8 352.6 3,143.3 $ $ 1.33 1.31 1.34 1.33 194.5 196.8 $ 858.9 156.7 – 91.8 366.3 $ $ 0.77 0.77 0.81 0.80 193.7 194.3 $ 745.0 150.0 213.9 79.3 78.7 (1) Includes the results of Centerpulse subsequent to October 2, 2003 and Centerpulse balance sheet data as of December 31, 2003. See Note 3 to the audited ﬁnancial statements for more information on the Centerpulse acquisition. (2) Pro forma net earnings for the year ended December 31, 2003 are before the cumulative effect of an accounting change of $55.1 million. The years ended December 31, 2002 and 2001 reﬂect the retroactive application of a new accounting method for instruments. Effective January 1, 2003, we changed the method of accounting for instruments which we own and are used by orthopaedic surgeons during total joint replacement and other surgical procedures. Instruments are recognized as long-lived assets and are included in property, plant and equipment and are depreciated using the straight-line method based on estimated useful lives, determined principally in reference to associated product life cycles, primarily ﬁve years. In prior periods, undeployed instruments were carried as a prepaid cost and recognized in selling, general and administrative expense in the year in which the instruments were placed into service. 23 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the consolidated ﬁnancial statements and the corresponding notes included elsewhere in this Form 10-K. This discussion and analysis contains forward- looking statements. 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’’). 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. 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. We believe the following developments or trends are important in understanding our ﬁnancial condition, results of operations and cash ﬂows for the year ended December 31, 2005. Demand (Volume and Mix) Trends Increased volume and changes in the mix of product sales contributed 9 percentage points of sales growth, which is the same as 2004 sales growth when compared to 2003 on a pro forma7 basis. We believe the market for orthopaedic procedure volume on a global basis continues to rise at mid to high single digit rates driven by an aging global population, obesity, proven clinical beneﬁts, new material technologies, advances in surgical techniques (such as our MIS Procedures and Technologies) and more active lifestyles, among other factors. In addition, the continued shift in demand to premium products, such as Longevity, Durasul and Prolong Highly Crosslinked Polyethylenes, Trabecular Metal Technology products, high-ﬂex knees, knee revision products and porous hip stems, continue to positively affect sales 7 The unaudited pro forma net sales information for 2003, including comparisons to 2004 net sales, contained in this Form 10-K and presented in accordance with U.S. generally accepted accounting principles has been derived from the audited ﬁnancial statements of Zimmer Holdings for the year ended December 31, 2003 and the ﬁnancial statements of Centerpulse for the nine months ended September 30, 2003 to give effect to the Centerpulse acquisition as if it had occurred on January 1, 2003. 24 growth. For example, during the year ended December 31, 2005, sales of products incorporating Trabecular Metal Technology were over $100 million, an increase of nearly 40 percent over 2004. We believe innovative surgical approaches will continue to signiﬁcantly affect the orthopaedics industry. We have made signiﬁcant progress in the development and introduction of MIS Implants, Procedures and Technologies. During the year ended December 31, 2005, The Zimmer Institute and its satellite locations trained nearly 2,500 surgeons on advanced techniques, including over 2,200 surgeons on MIS Procedures, which is approximately 70 percent greater than the number of surgeons trained last year. Pricing Trends Selling price increases contributed 1 percentage point of sales growth during the year ended December 31, 2005 compared to 2 percentage points in 2004 when compared to 2003 on a pro forma basis. The reduced beneﬁt from selling price increases in 2005 compared to 2004 is primarily attributed to the Americas operating segment. The Americas experienced a 1 percent increase in selling prices during the year ended December 31, 2005, compared to a 4 percent increase in 2004 on a pro forma basis. We believe the slower growth in selling price increases was primarily due to hospital cost containment efforts. In Europe, selling prices for the year ended December 31, 2005 decreased 1 percent, compared to a negligible effect in 2004 on a pro forma basis. Within Europe, Germany, which constitutes approximately 6 percent of our sales, experienced a 5 percent decrease in selling prices in the year ended December 31, 2005, as a result of reductions in government implant reimbursement rates. The decline in Germany was partially offset by increased selling prices in other European markets. Asia Paciﬁc selling prices had a negligible effect on sales for the year ended December 31, 2005, compared to a 2 percent decrease in 2004 on a pro forma basis. Effective April 1, 2004, the Japanese government reduced reimbursement rates, which contributed to a reduction of our selling prices in Japan by approximately 4 percent during the year ended December 31, 2004, on a pro forma basis. The negative effect of this decrease in Japan occurred only in the ﬁrst quarter of 2005, as the anniversary of the price reductions was April 1, 2005. Japan represents approximately 9 percent of our sales. The next Japanese reimbursement change is expected to be April 1, 2006, and therefore, we expect Japanese selling prices to remain the same through the ﬁrst quarter of 2006 compared to the same period in the prior year. We expect the Japanese government to reduce reimbursement rates again at that time. We estimate this reduction will affect Japan sales negatively by approximately 5 percent for the year ending December 31, 2006, based upon Zimmer Japan’s portfolio of reconstructive and trauma products. With pressure from governmental healthcare cost containment efforts and group purchasing organizations, we estimate Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K global sales could decline by approximately 1 percent in 2006 due to selling price decreases. Foreign Currency Exchange Rates For the year ended December 31, 2005, foreign currency exchange rates had a negligible effect on global sales growth. However, a stronger U.S. Dollar compared to most foreign currencies in the three month period ended December 31, 2005, compared to the same 2004 period, decreased sales by 3 percentage points. If foreign currency exchange rates remain consistent with the year end rates, we estimate that weaker foreign currency exchange rates will have a negative effect of approximately 1 percent on sales for the year ended December 31, 2006. We address currency risk through regular operating and ﬁnancing activities, and under appropriate circumstances and subject to proper authorization, through the use of forward contracts solely for managing foreign currency volatility and risk. Changes to foreign currency exchange rates affect sales growth, but due to offsetting gains /losses on hedge contracts, which are recorded in cost of products sold, the effect on net earnings in the near term is expected to be minimal. New Product Sales New products, which management deﬁnes as products or stock keeping units (‘‘SKU’s’’) introduced within the prior 36-month period to a particular market, accounted for 21 percent, or $695 million, of our sales during the year ended December 31, 2005. Adoption rates for new technologies are a key indicator of industry performance. Our sales have grown with the introduction of new products, such as Trabecular Metal Modular Acetabular Cups, certain SKU’s of the NexGen Complete Knee Solution for the LPS, LPS-Flex, and CR-Flex Knees, and the Dynesys Dynamic Stabilization System. 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 2006 include products incorporating Trabecular Metal Technology, including a hip stem and humeral shoulder, the VerSys Epoch˛ Composite Full Coat Hip Prosthesis, the NexGen MIS Tibial Plate, various trauma products including new Zimmer Periarticular Locking Plates and the Sirus Intramedullary Nail System released to the U.S. market, and alternative bearing surfaces including ceramic-on-ceramic and metal-on-metal. Acquisition of Centerpulse We are near completion of our integration plan for Centerpulse. In the fourth quarter of 2005, we ceased manufacturing operations at our Austin, Texas facility. Remaining integration milestones relate to IT systems conversions, primarily in Europe and Asia Paciﬁc, the residual costs of decommissioning the Austin facility and disposing of this asset, continued in-sourcing and a few miscellaneous items. We expect to complete the integration plan for Centerpulse by the end of 2006. Net synergies associated with the acquisition and integration of Centerpulse were approximately $63 million in 2005. We deﬁne net synergies as expense synergies less operating proﬁt reductions resulting from integration related sales losses and increases in operating expenses directly resulting from the acquisition. With the majority of our manufacturing integration plan completed, additional expense synergies should be realized in 2006 and 2007 as the inventory produced after the completion of the integration plan is sold. Operating expense synergies, principally in selling, general and administrative expenses, have exceeded our original expectations, reﬂecting more rapid than expected execution and achievement of operational efﬁciencies. We estimate our integration related sales losses and increased operating expenses were approximately $28 million in 2005. Expense synergies for 2006 are expected to be in excess of $100 million. We expect these synergies will be slightly offset by sales losses and increased operating expenses. We incurred $56.6 million of acquisition and integration expenses during the year ended December 31, 2005, and expect to incur $12 – $15 million of acquisition and integration expenses in 2006. Acquisition of Implex We completed the acquisition of Implex on April 23, 2004. We had a strategic alliance with Implex since 2000 for the development and distribution of reconstructive implant and trauma products incorporating Trabecular Metal Technology. Pursuant to the strategic alliance, we sold products incorporating Trabecular Metal Technology, which represented over 90 percent of Implex sales. New Accounting Pronouncements On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123(R), ‘‘Share-Based Payment’’. We adopted this accounting standard using the prospective method and will not restate prior periods. We estimate the adoption of this accounting standard will reduce diluted earnings per share by $0.23 – $0.25 during the year ended December 31, 2006. However, this is a non-cash expense and will not have an effect on our net cash ﬂows. 25 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K RESULTS OF OPERATIONS Year Ended December 31, 2005 Compared to Year Ended December 31, 2004 Net Sales by Operating Segment The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions): Americas Europe Asia Paciﬁc Year Ended December 31, 2005 2004 % Inc $1,941.8 874.8 469.5 $1,741.3 808.3 431.3 $3,286.1 $2,980.9 12% 8 9 10 Volume/ Mix 10% 9 8 9 Price 1% (1) – 1 Foreign Exchange 1% – 1 – ‘‘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): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2005 2004 % Inc Volume/ Mix Price Foreign Exchange $1,366.2 1,140.6 148.1 66.1 $1,194.5 1,079.0 124.7 58.1 2,721.0 2,456.3 179.8 160.4 224.9 172.9 134.2 217.5 $3,286.1 $2,980.9 14% 6 19 14 11 4 20 3 10 13% 5 16 10 10 2 19 2 9 1% – 2 4 – 2 1 1 1 –% 1 1 – 1 – – – – The NexGen Complete Knee Solution product line including the NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen CR-Flex Knee, the NexGen Rotating 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 Fiber Metal Taper Stem from the VerSys Hip System, Zimmer M/L Taper Stem, the CLS Spotorno Stem from the CLS Hip System, and the Alloclassic (Zweymueller) Hip System led hip sales. Trabecular Metal Acetabular Cups, Durom Hip Resurfacing System products internationally, and Longevity and Durasul Highly Crosslinked Polyethylene Liners also had strong growth. Orthobiologicals and prosthetic implants, including strong growth of the Tapered Screw-Vent Implant System, led dental sales. The Bigliani/Flatow Shoulder Solution led extremities sales. Zimmer Periarticular Plates, Zimmer Plates and Screws and ITST Intertrochanteric/Subtrochanteric Fixation System led trauma sales. The Dynesys Dynamic Stabilization System, the ST360(cid:1) Spinal Fixation System and Spinal Trabecular Metal Spacers led spine sales. The growth of the OrthoPAT˛8Autotransfusion System and wound management products led OSP sales. On August 30, 2005, Haemonetics Corporation announced they were ending an exclusive distribution agreement with us. We expect to sell the OrthoPAT Autotransfusion System through February 2006. 8 Trademark of Haemonetics Corporation. 26 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K The following table presents estimated* 2005 global market size and market share information (dollars in billions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine*** Global Market Size $ 4.8 4.2 1.6 0.4 $11.0 $ 2.7 $ 4.7 Global Market % Growth** Zimmer Market Share Zimmer Market Position 14% 28% 7 18 14 12 13 20 27 9 18 25 7 3 1 1 4 2 1 5 6 * Estimates based on company annual ﬁlings, Wall Street equity research and Zimmer management ** Excludes the effect of changes in foreign exchange rates on sales growth *** Spine includes related orthobiologics Americas Net Sales The following table presents Americas net sales (dollars Year Ended December 31, 2005 2004 % Inc (Dec) Europe Net Sales The following table presents Europe net sales (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2005 2004 % Inc $ 327.0 410.3 40.1 13.7 $ 292.0 398.4 34.8 11.6 791.1 736.8 33.1 22.4 28.2 29.5 19.8 22.2 $ 874.8 $ 808.3 12% 3 15 20 7 12 13 27 8 Strong knee sales drove growth in Europe. The NexGen Complete Knee Solution product line and the Innex Total Knee System led knee sales. Hip sales growth was negatively affected by reduced selling prices in Germany, Italy, Spain, Portugal and the UK. The CLS Spotorno Stem, Longevity and Durasul Highly Crosslinked Polyethylene Liners, Durom Hip Resurfacing System and Trabecular Metal Acetabular Cups led hip sales. $ 880.5 538.1 88.8 46.2 $ 762.0 499.6 75.3 41.1 1,553.6 1,378.0 107.5 132.7 148.0 105.7 111.0 146.6 Dental, extremities, trauma, spine and OSP experienced 16% double digit percentage growth compared to the prior year. 8 Dental sales were led by the Tapered Screw-Vent Implant 18 System. The Bigliani/Flatow Shoulder Solution led 12 extremities sales. Cable-Ready˛ Cable Products and Zimmer Periarticular Plates led trauma sales. The SilhouetteTM Spinal Fixation System9 and Trabecular Metal Spacers led spine sales. Wound management products led OSP sales. 2 20 1 13 $1,941.8 $1,741.3 12 Asia Paciﬁc Net Sales in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Strong knee sales drove growth in the Americas. The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, NexGen Trabecular Metal 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. We also beneﬁted from strong hip sales in a relatively softer market compared to the prior year. Growth in porous stems, including growth of the Zimmer M/L Taper Stem and Alloclassic (Zweymueller) Hip System led hip sales, but were partially offset by weaker sales of cemented stems. Trabecular Metal Acetabular Cups and Longevity and Durasul Highly Crosslinked Polyethylene Liners also exhibited strong growth. Dental, extremities and spine experienced double digit percentage growth compared to the prior year. The Tapered Screw-Vent Implant System led dental sales. The Bigliani/ Flatow Shoulder Solution led extremities sales. The Dynesys Dynamic Stabilization System and the ST360(cid:1) Spinal Fixation System led spine sales. The following table presents Asia Paciﬁc net sales (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2005 2004 % Inc $ 158.7 192.2 19.2 6.2 $ 140.5 181.0 14.6 5.4 376.3 341.5 39.2 5.3 48.7 37.7 3.4 48.7 $ 469.5 $ 431.3 13% 6 31 15 10 4 57 – 9 Strong knee and hip sales drove growth in Asia Paciﬁc. NexGen Trabecular Metal Tibial Components, the NexGen CR-Flex Knee and the NexGen LPS-Flex Knee led knee sales. The continued conversion to porous stems, including the VerSys Hip System, the Alloclassic (Zweymueller) Hip System and the CLS Spotorno Stem led hip sales, partially offset by weaker sales of revision stems. Sales of Longevity 9 The Silhouette Spinal Fixation System is licensed from Spinal Innovations, LLC. 27 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K and Durasul Highly Crosslinked Polyethylene Liners and Trabecular Metal Acetabular Cups also exhibited strong growth. Dental, extremities and spine experienced double digit percentage growth compared to the prior year. The Tapered Screw-Vent Implant System and the Spline˛ Implant System led dental sales. The Bigliani/Flatow Shoulder Solution led extremities sales. The ST360(cid:1) Spinal Fixation System led spine sales. Gross Proﬁt Gross proﬁt as a percentage of net sales was 77.5 percent in the year ended December 31, 2005, compared to 73.8 percent in 2004. The following table reconciles the gross margin for the year ended December 31, 2005 and 2004: Year ended December 31, 2004 gross margin Inventory step-up charge Improved inventory management Increased selling prices Resolution of certain legal and other matters Other Year ended December 31, 2005 gross margin 73.8% 1.8 0.8 0.2 0.2 0.7 77.5% Inventory step-up costs in the year ended December 31, 2005 decreased to $5.0 million, or 0.2 percent of sales, compared to $59.4 million, or 2.0 percent of sales, in 2004. We deﬁne ‘‘inventory step-up’’ as the difference between the cost basis and the fair value of acquired Centerpulse and Implex inventories. Other primary contributors to the improvement in gross proﬁt margin were reduced inventory charges due to improved inventory management, increased selling prices, favorable resolution of certain legal and other matters and reduced royalties. Royalty expenses as a percentage of sales declined due to a favorable mix of non- royalty bearing sales. Operating Expenses R&D as a percentage of net sales was 5.3 percent for the year ended December 31, 2005, compared to 5.6 percent in 2004. R&D increased to $175.5 million for the year ended December 31, 2005 from $166.7 million in 2004, reﬂecting increased spending on projects focused on areas of strategic signiﬁcance, including orthobiologics. In 2005, we doubled the number of internal people and project-related orthobiological investments. Currently, our product pipeline consists of more than 160 active projects. We are also investing in MIS Procedures and Technologies, material technologies, including woven materials and drug/device combinations and intelligence technologies, including sensor technology. We delivered more than 79 projects to the market in 2005. We target R&D spending to the high end of what management believes to be an average of 4-6 percent for the industry. SG&A as a percentage of net sales was 38.3 percent for the year ended December 31, 2005, compared to 39.9 percent in 2004. The decrease was primarily due to sales growth and realized expense synergies. In addition, lower product liability claims and well controlled general and administrative spending reduced SG&A as a percentage of sales. Acquisition, integration and other expenses for the year ended December 31, 2005 were $56.6 million compared to $81.1 million in 2004, and included $13.3 million of employee severance and retention expenses, $12.7 million of sales agent contract termination expenses, $6.9 million of costs related to integrating our information technology systems, $6.2 million of facility relocation expenses, $5.6 million of integration consulting expenses, $3.2 million related to the impairment loss on the Austin facility, $3.1 million of personnel expenses and travel for full-time integration team members and $5.6 million of other expenses. Operating Proﬁt, Income Taxes and Net Earnings Operating proﬁt for the year ended December 31, 2005 increased 38 percent to $1,055.0 million, from $763.2 million in 2004. Increased sales, improved gross proﬁt margins, realized operating expense synergies, controlled operating expenses and decreased acquisition and integration expenses drove operating proﬁt. The effective tax rate on earnings before income taxes, minority interest and cumulative effect of change in accounting principle increased to 29.5 percent for the year ended December 31, 2005, from 25.9 percent in 2004. The provision for income taxes in 2004 included a $34.5 million beneﬁt (4.7 percent) as a result of revaluing deferred taxes of acquired Centerpulse operations due to a reduction in the ongoing Swiss tax rate. Exclusive of this one time beneﬁt in the provision for income taxes, we were able to realize a lower effective tax rate. The reasons for the lower effective tax rate were the implementation of several European restructuring initiatives, the successful negotiation of a lower ongoing Swiss tax rate (from approximately 24 percent to 12.5 percent) and the continued expansion of operations in lower tax jurisdictions, including Puerto Rico. In 2004, the successful negotiation of the lower Swiss tax rate was effective for the last ﬁve months of the year, whereas in 2005 the beneﬁt was recognized for the entire year. Net earnings increased 35 percent to $732.5 million for the year ended December 31, 2005, compared to $541.8 million in 2004. The increase was primarily due to higher operating proﬁt and decreased interest expense due to a lower average outstanding debt balance, offset by a higher effective tax rate. Basic and diluted earnings per share increased 33 and 34 percent to $2.96 and $2.93, respectively, from $2.22 and $2.19 in 2004. 28 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Year Ended December 31, 2004 Compared to Year Ended December 31, 2003 Net Sales by Operating Segment The following table presents net sales by operating segment and the components of the percentage changes (dollars in millions): Americas Europe Asia Paciﬁc Year Ended December 31, 2004 2003 % Inc Zimmer Standalone Volume/ Mix Price Foreign Exchange Impact of Centerpulse Acquisition $1,741.3 808.3 431.3 $1,208.3 366.0 326.7 $2,980.9 $1,901.0 44% 121 32 57 16% 9 10 14 5% 2 (3) 3 –% 23% 10 8 3 100 17 37 ‘‘Impact of Centerpulse Acquisition’’ as used in the tables in this report represents the effect of the Centerpulse acquisition on sales growth. The following table presents 2004 net sales by operating segment and 2003 unaudited pro forma net sales by operating segment and the components of the percentage changes (dollars in millions): Americas Europe Asia Paciﬁc Net Sales by Product Category Year Ended December 31, Reported 2004 $1,741.3 808.3 431.3 Pro forma 2003 $1,499.1 707.1 383.4 $2,980.9 $2,589.6 % Inc Volume/ Mix Price Foreign Exchange 16% 14 13 15 12% 5 7 9 4% – (2) 2 –% 9 8 4 The following table presents net sales by product category and the components of the percentage changes (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2004 2003 % Inc Zimmer Standalone Volume/ Mix Price Foreign Exchange Impact of Centerpulse Acquisition $1,194.5 1,079.0 124.7 58.1 $ 800.6 645.5 29.8 45.1 2,456.3 1,521.0 172.9 134.2 217.5 150.1 35.1 194.8 $2,980.9 $1,901.0 49% 67 319 28 62 15 281 12 57 18% 16 – 9 17 2 – 5 14 3% 2 – 5 3 3 – 2 3 3% 3 – 3 3 3 – 2 3 25% 46 319 11 39 7 281 3 37 The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components and the NexGen CR-Flex Knee, led knee sales. In addition, the NexGen Rotating Hinge Knee and the Innex Total Knee System exhibited strong growth. Growth in porous stems, including signiﬁcant growth of the VerSys Fiber Metal and Zimmer M/L Taper Stems, Trabecular Metal Acetabular Cups, Trilogy Acetabular Cups, Durom Hip Resurfacing System products internationally, and Longevity and Durasul Highly Crosslinked Polyethylene Liners led hip sales. The Alloclassic (Zweymueller) Hip System and AlloﬁtTM Acetabular Shell also had strong growth. Sales of orthobiologicals, surgical products and prosthetic implants, including strong growth of the SwissPlus Implant System and Tapered Screw-Vent Implant System led dental sales. The Bigliani/Flatow Shoulder Solution led extremities sales. Zimmer Periarticular Plates, Cable-Ready Cable Products, Zimmer Plates and Screws System, ITST and Sirus Intramedullary Nails, TransFxTM External Fixation System and the Trabecular Metal ON Rod led trauma sales. The Dynesys Dynamic Stabilization System and Trinica Select Anterior Cervical Plate System led spine sales. The continued growth of the OrthoPAT Autotransfusion System and wound management and drainage products drove OSP sales. 29 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K The following table presents 2004 net sales by product category and 2003 unaudited pro forma net sales by product category and the components of the percentage changes (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, Reported 2004 Pro forma 2003 % Inc Volume/ Mix Price Foreign Exchange $1,194.5 1,079.0 124.7 58.1 $1,007.8 937.6 99.9 52.2 2,456.3 2,097.5 172.9 134.2 217.5 161.4 130.9 199.8 $2,980.9 $2,589.6 19% 15 25 11 17 7 3 9 15 12% 9 19 3 11 1 (3) 5 9 3% 1 3 5 2 3 4 1 2 4% 5 3 3 4 3 2 3 4 Americas Net Sales Europe Net Sales The following table presents Americas net sales (dollars The following table presents Europe net sales (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total in millions): Year Ended December 31, 2004 2003 % Inc Impact of Centerpulse Acquisition $ 762.0 499.6 75.3 41.1 1,378.0 105.7 111.0 146.6 $ 523.6 365.6 18.2 34.0 941.4 100.3 29.5 137.1 $1,741.3 $1,208.3 46% 37 314 21 46 5 276 7 44 18% 16 314 5 21 – 249 – 23 Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2004 2003 % Inc Impact of Centerpulse Acquisition $ 292.0 398.4 34.8 11.6 $ 162.8 151.7 8.2 7.1 736.8 329.8 29.5 19.8 22.2 16.3 4.6 15.3 $ 808.3 $ 366.0 79% 61% 163 323 62 124 81 330 45 121 137 323 44 103 59 330 29 100 Strong knee and hip sales drove growth in the Americas. The NexGen Complete Knee Solution product line, including the NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components, the NexGen LCCK Revision Knee, the NexGen CR-Flex Knee and Prolong Highly Crosslinked Polyethylene led knee sales. The Natural-Knee System also made a strong contribution. Growth in porous stems, including signiﬁcant growth of the VerSys Fiber Metal and Zimmer M/L Taper Stems, beaded stems, Trabecular Metal Acetabular Cups and Longevity and Durasul Highly Crosslinked Polyethylene Liners led hip sales. The following table presents 2004 Americas net sales and 2003 Americas unaudited pro forma net sales (dollars in millions): Strong knee and hip sales drove growth in Europe. Strong sales of the NexGen Complete Knee Solution product line, including the NexGen CR Knee, NexGen Trabecular Metal Tibial Components and the NexGen Rotating Hinge Knee led knee sales. Strong sales of Longevity and Durasul Highly Crosslinked Polyethylene Liners, VerSys Porous Stems and Trabecular Metal Acetabular Cups led hip sales. The Alloclassic (Zweymueller) Hip System and Alloﬁt Acetabular Shell also had strong growth. The following table presents 2004 Europe net sales and 2003 Europe unaudited pro forma net sales (dollars in millions): Year Ended December 31, Reported 2004 Pro forma 2003 % Inc (Dec) $ 762.0 499.6 75.3 41.1 $ 625.9 425.1 61.0 37.3 1,378.0 1,149.3 105.7 111.0 146.6 100.9 112.0 136.9 $1,741.3 $1,499.1 22% 18 23 10 20 5 (1) 7 16 Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total 30 Year Ended December 31, Reported 2004 Pro forma 2003 % Inc $ 292.0 398.4 34.8 11.6 $ 254.4 351.5 27.9 10.3 736.8 644.1 29.5 19.8 22.2 26.0 16.7 20.3 $ 808.3 $ 707.1 15% 13 25 11 14 14 19 9 14 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Asia Paciﬁc Net Sales The following table presents Asia Paciﬁc net sales (dollars in millions): Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Year Ended December 31, 2004 2003 % Inc Impact of Centerpulse Acquisition $ 140.5 181.0 14.6 5.4 $ 114.2 128.3 3.4 4.0 341.5 249.9 37.7 3.4 48.7 33.4 1.0 42.4 $ 431.3 $ 326.7 23% 41 333 34 37 13 213 15 32 9% 25 333 8 22 2 213 – 17 Strong knee and hip sales drove growth in Asia Paciﬁc. The NexGen LPS-Flex Knee, NexGen Trabecular Metal Tibial Components and the NexGen CR Knee led knee sales. The Natural-Knee System also made a strong contribution. The continued conversion to porous stems, including VerSys Porous Stems, and sales of Longevity Highly Crosslinked Polyethylene Liners led hip sales. The following table presents 2004 Asia Paciﬁc net sales and 2003 Asia Paciﬁc unaudited pro forma net sales (dollars in millions): Year Ended December 31, Reported 2004 Pro forma 2003 $ 140.5 181.0 14.6 5.4 $ 127.5 161.0 11.0 4.6 341.5 304.1 37.7 3.4 48.7 34.5 2.2 42.6 $ 431.3 $ 383.4 % Inc 10% 12 33 17 12 9 51 15 13 Reconstructive Knees Hips Dental Extremities Total Trauma Spine OSP Total Gross Proﬁt Gross proﬁt as a percentage of net sales was 73.8 percent in 2004, compared to 72.8 percent in 2003 and 68.1 percent for the three month period ended December 31, 2003 (the ﬁrst quarter of combined operations reﬂecting Centerpulse). The following table reconciles the gross margin for the year ended December 31, 2004 and for the three month period ended December 31, 2003. Three month period ended December 31, 2003 gross margin Inventory step-up charge Increased selling prices Operating segment and product category mix Other Year ended December 31, 2004 gross margin 68.1% 4.1 1.8 0.2 (0.4) 73.8% Decreased Centerpulse and Implex inventory step-up charges as a percentage of net sales during 2004 ($59.4 million, or 2.0 percent of net sales) compared to the three month period ended December 31, 2003 ($42.7 million, or 6.1 percent of net sales) and increases in selling prices were the primary contributors to improved gross margins. In addition, operating segment mix and product category mix both had a positive effect on gross margins due to higher sales growth in the more proﬁtable Americas segment compared to Europe and Asia Paciﬁc, higher sales growth of reconstructive implants and the continued shift to premium products. Offsetting these favorable effects were a variety of other items, including increased royalty expenses and higher losses on foreign exchange contracts included in cost of products sold, partially offset by reduced manufacturing costs due to automation, vertical integration and process improvements. Operating Expenses R&D as a percentage of net sales was 5.6 percent for the years ended December 31, 2004 and 2003. R&D increased to $166.7 million from $105.8 million, reﬂecting a full year of Centerpulse research and development expenses and increased spending on active projects focused on areas of strategic signiﬁcance. During 2004, we delivered more than 40 major development projects to market. SG&A as a percentage of net sales was 39.9 percent for the year ended December 31, 2004 compared to 38.8 percent for the same 2003 period. Amortization expense increased to $39.1 million, or 1.3 percent of sales, during the year ended December 31, 2004 compared to $10.9 million, or less than 1 percent of sales, during the year ended December 31, 2003. The increase was primarily due to amortization expense related to Centerpulse and Implex ﬁnite lived intangible assets. In addition, during 2004 we continued to introduce or expand strategic programs and activities. In 2004, The Zimmer Institute and its satellite locations were well utilized with over 1,400 surgeons trained, compared to 500 surgeons trained in 2003. These surgeon training costs are recognized in SG&A. We also recognized approximately $5 million of Sarbanes-Oxley compliance expenses, including consultant fees and increased audit fees. These increases were partially offset by expense synergies realized from the Centerpulse acquisition and controlled spending. Acquisition and integration expenses related to the acquisitions of Centerpulse and Implex were $81.1 million compared to $79.6 million for the same 2003 period and included $24.4 million of sales agent and lease contract termination expenses, $24.2 million of integration consulting expenses, $9.4 million of employee severance and retention expenses, $7.8 million of professional fees, $5.2 million of personnel expenses and travel for full-time integration team members, $4.3 million of costs related to integrating our information technology systems, $2.9 million of costs related to relocation of facilities, and $2.9 million of other miscellaneous acquisition and integration expenses. Operating Proﬁt, Income Taxes and Net Earnings Operating proﬁt for the year ended December 31, 2004 increased 69 percent to $763.2 million from $450.7 million in the comparable 2003 period. Operating proﬁt growth was driven by Zimmer standalone sales growth, operating proﬁt 31 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K contributed by Centerpulse, effectively controlled operating expenses and the absence of in-process research and development expense in 2004 compared to $11.2 million in 2003. These favorable items were partially offset by Centerpulse and Implex inventory step-up of $59.4 million in 2004 compared to $42.7 million in 2003 and intangible asset amortization of $39.1 million in 2004 versus $10.9 million in 2003. The effective tax rate on earnings before income taxes, minority interest and cumulative effect of change in accounting principle decreased to 25.9 percent for the year ended December 31, 2004 from 33.6 percent for the same period in 2003. A major component of the decrease (4.7 percent, or $34.5 million) was the result of revaluing deferred taxes of acquired Centerpulse operations due to a reduction in the ongoing Swiss tax rate. The major reasons for the remaining decrease in the effective tax rate were the ongoing European restructuring initiatives, the successful negotiation of a lower ongoing Swiss tax rate (from approximately 24 percent to 12.5 percent) and continued expansion of operations in lower tax jurisdictions. Net earnings increased 57 percent to $541.8 million for the year ended December 31, 2004 compared to $346.3 million in the same 2003 period. The increase was due to higher operating proﬁt offset partially by increased interest expense, $31.7 million in 2004 compared to $13.2 million in 2003. Net earnings for 2003 also included a one-time, $55.1 million (net of tax), non-cash cumulative effect of a change in accounting principle for instruments. Net earnings in 2004 also beneﬁted from the decreased effective income tax rate. Basic and diluted earnings per share increased 33 percent and 34 percent to $2.22 and $2.19, respectively, from $1.67 and $1.64 in 2003. OPERATING PROFIT BY SEGMENT Management evaluates operating segment performance based upon segment operating proﬁt exclusive of operating expenses pertaining to global operations and corporate expenses, 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. For more information regarding our segments, see Note 14 to the consolidated ﬁnancial statements included in Item 8 of this Form 10-K. The following table sets forth the operating proﬁt as a percentage of sales by segment for the years ended December 31, 2005, 2004 and 2003: Percent of net sales Year Ended December 31, Americas Europe Asia Paciﬁc 32 2005 52.6% 36.3 45.2 2004 51.3% 35.1 42.3 2003 51.2% 26.3 45.3 Year Ended December 31, 2005 Compared to Year Ended December 31, 2004 In the Americas, operating proﬁt as a percentage of sales increased due to product category mix and the effective control of operating expenses, including realized expense synergies and controlled general and administrative spending. European operating proﬁt as a percentage of net sales improved due to the realization of expense synergies related to the elimination of redundant functions and controlled selling, general and administrative spending. Asia Paciﬁc operating proﬁt as a percentage of net sales increased primarily due to product category mix, lower royalty expenses as a percentage of sales and improved inventory management. Year Ended December 31, 2004 Compared to Year Ended December 31, 2003 In the Americas, operating proﬁt as a percentage of sales improved slightly due to improved selling prices, lower royalty expenses as a percentage of net sales, product category mix and controlled operating expenses. Increased selling expenses as a percentage of net sales due to the restructuring of certain distributor contracts partially offset these improvements. In Europe, operating proﬁt as a percentage of net sales improved due to improved selling prices, product category mix, country sales mix, controlled operating expenses and the favorable effect of the Centerpulse acquisition. Country sales mix made favorable contributions as the more proﬁtable German market represented a greater percentage of total Europe sales. Asia Paciﬁc operating proﬁt as a percentage of net sales declined primarily due to decreased selling prices, principally the result of the decrease in government reimbursement rates in Japan, and increased selling expenses as a percentage of net sales due to the restructuring of certain dealer contracts in Japan. LIQUIDITY AND CAPITAL RESOURCES Cash ﬂows provided by operating activities were $878.2 million in 2005 compared to $862.2 million in 2004. The principal source of cash was net earnings of $732.5 million. We experienced $119.3 million of positive cash ﬂow related to income taxes during the year ended December 31, 2005 primarily due to the utilization of acquired Centerpulse tax attributes, the utilization of foreign tax credits, the realization of certain state/local tax incentives and exercises of employee stock options. Operating cash ﬂows from working capital decreased compared to the 2004 period as a result of sales growth, payment of acquisition and integration related expenses and resolution of certain legal and product liability matters. Working capital management continues to be a key focus. At December 31, 2005, we had 56 days of sales outstanding in accounts receivable, favorable to December 31, 2004 by 3 days. The improvement was achieved through improvement in all reporting segments. At December 31, 2005, we had Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K 283 days of inventory on hand, unfavorable to December 31, 2004 by 28 days. Our inventory levels have increased due to new products, higher purchases of raw materials in advance of expected increases of raw material prices and inventory build up to accommodate the Austin facility shut-down. Cash ﬂows used in investing activities were $311.1 million in the year ended December 31, 2005, compared to $388.3 million in 2004. In 2005, we paid $44.1 million pursuant to the terms of the Implex acquisition agreement for contingent earn-out payments. Additions to instruments during the year ended December 31, 2005 were $150.0 million compared to $139.6 million in 2004. Increases in instrument purchases were primarily to support new product launches and sales growth. In 2006, we expect purchases of instruments to approximate $110 – $115 million as we continue to invest in instruments to support new products, sales growth and MIS Procedures. The anticipated decrease in instrument purchases compared to 2005 is the result of high rates of penetration already achieved with MIS instruments across our broad base of customers. Additionally, we have been able to successfully in-source instruments at a lower cost. Additions to other property, plant and equipment during the year ended December 31, 2005 were $105.3 million compared to $100.8 million in 2004. Increases were related to facility expansions in Warsaw, Indiana; Ponce, Puerto Rico; and Parsippany, New Jersey. Facility expansions were due to increased demand, the transfer of production to our other manufacturing sites as a result of the closure of the Austin, Texas facility and the tripling of Trabecular Metal Technology production capacity. During 2006, we expect purchases of other property, plant and equipment to approximate $140 – $150 million, as a result of ongoing facility expansions in Warsaw, Indiana, new information technology systems and further productivity related investments. Cash ﬂows used in ﬁnancing activities were $484.6 million for the year ended December 31, 2005, compared to $402.0 million in 2004. We repaid $555.3 million of debt, net, in the year ended December 31, 2005, utilizing cash on hand, cash generated from operating activities and $76.7 million in cash proceeds received from employee stock compensation plans. Additionally, in December our Board of Directors approved a stock repurchase program which resulted in the repurchase of $4.1 million of common stock in 2005. We have a ﬁve year $1,350 million revolving, multi-currency, senior unsecured credit facility maturing March 31, 2010 (the ‘‘Senior Credit Facility’’). We had $81.6 million outstanding under the Senior Credit Facility at December 31, 2005, and therefore, our available borrowings were $1,268.4 million. The $81.6 million is in Japan and carries a low interest rate, which is why we have not repaid the debt. The Senior Credit Facility contains a provision whereby borrowings may be increased to $1,750 million. We and certain of our wholly owned foreign and domestic subsidiaries are the borrowers and our wholly owned domestic subsidiaries are the guarantors of the Senior Credit Facility. Borrowings under the Senior Credit Facility are used for general corporate purposes and bear interest at a LIBOR-based rate plus an applicable margin determined by reference to our senior unsecured long-term credit rating and the amounts drawn under the Senior Credit Facility, at an alternate base rate, or at a ﬁxed rate determined through a competitive bid process. The Senior Credit Facility contains customary afﬁrmative and negative covenants and events of default for an unsecured ﬁnancing arrangement, including, among other things, limitations on consolidations, mergers and sales of assets. Financial covenants include a maximum leverage ratio of 3.0 to 1.0 and a minimum interest coverage ratio of 3.5 to 1.0. If we fall below an investment grade credit rating, additional restrictions would result, including restrictions on investments, payment of dividends and stock repurchases. We were in compliance with all covenants under the Senior Credit Facility as of December 31, 2005. Commitments under the Senior Credit Facility are subject to certain fees, including a facility and a utilization fee. The Senior Credit Facility is rated BBB+ by Standard & Poor’s Ratings Services and is not rated by Moody’s Investors’ Service, Inc. We also have available uncommitted credit facilities totaling $65 million. The terms of the Implex acquisition include additional cash earn-out payments that are contingent on the year-over- year growth of Implex product sales through 2006. We have paid $96.0 million of earn-out payments through December 31, 2005. We estimate remaining payments, which will occur in 2006, to be in a range from $30 million to $40 million. In December, our Board of Directors authorized a stock repurchase program of up to $1 billion through December 31, 2007. As of December 31, 2005, $4.1 million of common stock had been repurchased. We may use excess cash to repurchase additional common stock under this program. Management believes that cash ﬂows from operations, together with available borrowings under the Senior Credit Facility, will be sufﬁcient to meet our working capital, capital expenditure and debt service needs. Should investment opportunities arise, we believe that our earnings, balance sheet and cash ﬂows will allow us to obtain additional capital, if necessary. 33 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K liabilities and reserves. We believe adequate provisions exist for income taxes for all periods and jurisdictions subject to review or audit. Commitments and Contingencies – Accruals for product liability and other claims are established with internal and external legal counsel based on current information and historical settlement information for claims, related fees and for claims incurred but not reported. We use an actuarial model to assist management in determining an appropriate level of accruals for product liability claims. Historical patterns of claim loss development over time are statistically analyzed to arrive at factors which are then applied to loss estimates in the actuarial model. The amounts established represent management’s best estimate of the ultimate costs that it will incur under the various contingencies. Goodwill and Intangible Assets – We evaluate the carrying value of goodwill and indeﬁnite life intangible assets annually, or whenever events or circumstances indicate the carrying value may not be recoverable. We evaluate the carrying value of ﬁnite life intangible assets whenever events or circumstances indicate the carrying value may not be recoverable. Signiﬁcant assumptions are required to estimate the fair value of goodwill and intangible assets, most notably estimated future cash ﬂows generated by these assets. Changes to these assumptions could require us to record impairment charges on these assets. RECENT ACCOUNTING PRONOUNCEMENTS Information about recent accounting pronouncements is included in Note 2 to the Consolidated Financial Statements, which are included in this report under Item 8. CONTRACTUAL OBLIGATIONS We have entered into contracts with various third parties in the normal course of business which will require future payments. The following table illustrates our contractual obligations (in millions): Contractual Obligations Total 2006 2007 and 2008 2009 and 2010 2011 and Thereafter Long-term debt $ 81.6 $ – $ – $ 81.6 $ – Operating leases Purchase Obligations 112.3 22.5 26.8 22.1 39.1 0.4 21.0 – 25.4 – Other long-term liabilities Total contractual obligations 348.3 – 83.9 32.6 231.8 $564.7 $48.9 $123.4 $135.2 $257.2 CRITICAL ACCOUNTING ESTIMATES Our ﬁnancial results are affected by the selection and application of accounting policies and methods. Signiﬁcant accounting policies which require management’s judgment are discussed below. Excess Inventory and Instruments – We must determine as of each balance sheet date how much, if any, of our inventory may ultimately prove to be unsaleable or unsaleable at our carrying cost. Similarly, we must also determine if instruments on hand will be put to productive use or remain undeployed as a result of excess supply. Reserves are established to effectively adjust inventory and instruments to net realizable value. To determine the appropriate level of reserves, we evaluate current stock levels in relation to historical and expected patterns of demand for all of our products and instrument systems and components. The basis for the determination is generally the same for all inventory and instrument items and categories except for work-in-progress inventory, which is recorded at cost. Obsolete or discontinued items are generally destroyed and completely written off. Management evaluates the need for changes to valuation reserves based on market conditions, competitive offerings and other factors on a regular basis. Income Taxes – We estimate income tax expense and income tax liabilities and assets by taxable jurisdiction. Realization of deferred tax assets in each taxable jurisdiction is dependent on our ability to generate future taxable income sufﬁcient to realize the beneﬁts. We evaluate deferred tax assets on an ongoing basis and provide valuation allowances if it is determined to be ‘‘more likely than not’’ that the deferred tax beneﬁt will not be realized. Federal income taxes are provided on the portion of the income of foreign subsidiaries that is expected to be remitted to the U.S. We operate within numerous taxing jurisdictions. We are subject to regulatory review or audit in virtually all of those jurisdictions and those reviews and audits may require extended periods of time to resolve. We make use of all available information and make reasoned judgments regarding matters requiring interpretation in establishing tax expense, 34 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk MARKET RISK We are exposed to certain market risks as part of our ongoing business operations, including risks from changes in foreign currency exchange rates, interest rates and commodity prices that could affect our ﬁnancial condition, results of operations and cash ﬂows. We manage our exposure to these and other market risks through regular operating and ﬁnancing activities, and through the use of derivative ﬁnancial instruments. We use derivative ﬁnancial instruments solely as risk management tools and not for speculative investment purposes. FOREIGN CURRENCY EXCHANGE RISK We operate on a global basis and are exposed to the risk that our ﬁnancial condition, results of operations and cash ﬂows could be adversely affected by changes in foreign currency exchange rates. We are primarily exposed to foreign currency exchange rate risk with respect to transactions and net assets denominated in Euros, Swiss Francs, Japanese Yen, British Pounds, Canadian Dollars and Australian Dollars. We manage the foreign currency exposure centrally, on a combined basis, which allows us to net exposures and to take advantage of any natural offsets. To reduce the uncertainty of foreign exchange rate movements on transactions denominated in foreign currencies, we enter into derivative ﬁnancial instruments in the form of foreign exchange forward contracts with major ﬁnancial institutions. These forward contracts are designed to hedge anticipated foreign currency transactions, primarily intercompany sale and purchase transactions, for periods consistent with commitments. Realized and unrealized gains and losses on these contracts that qualify as cash ﬂow hedges are temporarily recorded in other comprehensive income, then recognized in cost of products sold when the hedged item affects net earnings. For contracts outstanding at December 31, 2005, we had obligations to purchase U.S. Dollars and sell Euros, Japanese Yen, British Pounds, Canadian Dollars and Australian Dollars or purchase Swiss Francs and sell U.S. Dollars at set maturity dates ranging from January 2006 through May 2008. The notional amounts of outstanding forward contracts entered into with third parties to purchase U.S. Dollars at December 31, 2005 and 2004, were $1,142 million and $861 million, respectively. The notional amounts of outstanding forward contracts entered into with third parties to purchase Swiss Francs at December 31, 2005 and 2004, were $195 million and $191 million, respectively. The weighted average contract rates outstanding are Euro: USD 1.26, USD: Swiss Franc 1.20, USD: Japanese Yen 102, British Pound: USD 1.79, USD: Canadian Dollar 1.22 and Australian Dollar: USD 0.73. We maintain written policies and procedures governing our risk management activities. Our policy requires that critical terms of hedging instruments are the same as hedged forecasted transactions. On this basis, with respect to cash ﬂow hedges, changes in cash ﬂows attributable to hedged transactions are generally expected to be completely offset by changes in the fair value of hedge instruments. As part of our risk management program, we also perform sensitivity analyses to assess potential changes in revenue, operating results, cash ﬂows and ﬁnancial position relating to hypothetical movements in currency exchange rates. A sensitivity analysis of changes in the fair value of foreign exchange forward contracts outstanding at December 31, 2005, indicated that, if the U.S. Dollar uniformly changed in value by 10 percent relative to the Euro, Swiss Franc, Japanese Yen, British Pound, Canadian Dollar and Australian Dollar, with no change in the interest differentials, the fair value of those contracts would increase or decrease earnings before income taxes in periods through 2009, depending on the direction of the change, by an average approximate amount of $67.4 million, $21.2 million, $20.0 million, $11.2 million, $6.9 million and $5.9 million for the Euro, Swiss Franc, Japanese Yen, British Pound, Canadian Dollar and Australian Dollar contracts, respectively. Any change in the fair value of foreign exchange forward contracts as a result of a ﬂuctuation in a currency exchange rate is expected to be largely offset by a change in the value of the hedged transaction. Consequently, foreign exchange contracts would not subject us to material risk due to exchange rate movements because gains and losses on these contracts offset gains and losses on the assets, liabilities, and transactions being hedged. We had net investment exposures to net foreign currency denominated assets and liabilities of approximately $1,775 million at December 31, 2005, primarily in Swiss Francs, Japanese Yen and Euros. Approximately $1,003 million of the net asset exposure at December 31, 2005 relates to goodwill recorded in the Europe and Asia Paciﬁc geographic segments. We enter into foreign currency forward exchange contracts with terms of one month to manage currency exposures for assets and liabilities denominated in a currency other than an entity’s functional currency. As a result, foreign currency translation gains /losses recognized in earnings under SFAS No. 52, ‘‘Foreign Currency Translation’’ are generally offset with gain/losses on the foreign currency forward exchange contracts in the same reporting period. COMMODITY PRICE RISK We purchase raw material commodities such as cobalt chrome, titanium, tantalum, polymer and sterile packaging. We enter into 12 to 24 month supply contracts, where available, on these commodities to alleviate the effect of market ﬂuctuation in prices. As part of our risk management program, we perform sensitivity analyses related to potential commodity price changes. A 10 percent price change across all these commodities would not have a material effect on our consolidated ﬁnancial position, results of operations or cash ﬂows. 35 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K our trade receivables are concentrated in the public and private hospital and healthcare industry in the U.S. and internationally or with distributors or dealers who operate in international markets and, accordingly, are exposed to their respective business, economic and country speciﬁc variables. Repayment is dependent upon the ﬁnancial stability of these industry sectors and the respective countries’ national economic and health care systems. Exposure to credit risk is controlled through credit approvals, credit limits and monitoring procedures and we believe that reserves for losses are adequate. There is no signiﬁcant net exposure due to any individual customer or other major concentration of credit risk. INTEREST RATE RISK In the normal course of business, we are exposed to market risk from changes in interest rates that could affect our results of operations and ﬁnancial condition. We manage our exposure to interest rate risks through our regular operations and ﬁnancing activities. Presently, we invest our cash and equivalents in money market and investment-grade short-term debt instruments. The primary investment objective is to ensure capital preservation of our invested principal funds by limiting default and market risk. Currently, we do not use derivative ﬁnancial instruments in our investment portfolio. Our principal exposure to interest rate risk arises from the variable rates associated with our credit facilities. We are subject to interest rate risk through movements in interest rates on the committed Senior Credit Facility and our uncommitted credit facilities. Presently, all of our debt outstanding bears interest at short-term rates. We currently do not hedge our interest rate exposure, but may do so in the future. Based upon our overall interest rate exposure as of December 31, 2005, a change of 10 percent in interest rates, assuming the amount outstanding remains constant, would not have a material effect on interest expense. However, due to the uncertainty of the actions that would be taken and their possible effects, this analysis assumes no such action, nor management actions to mitigate interest rate changes. Further, this analysis does not consider the effect of the change in the level of overall economic activity that could exist in such an environment. CREDIT RISK Financial instruments, which potentially subject us to concentrations of credit risk, are primarily cash, cash equivalents, counterparty transactions, and accounts receivable. We place our investments in highly rated ﬁnancial institutions and money market instruments, and limit the amount of credit exposure to any one entity. We believe we do not have any signiﬁcant credit risk on our cash and equivalents and investments. We are exposed to credit loss if the ﬁnancial institutions with which we conduct business fail to perform. However, this loss is limited to the amounts, if any, by which the obligations of the counterparty to the ﬁnancial instrument contract exceed our obligation. We also minimize exposure to credit risk by dealing with a diversiﬁed group of major ﬁnancial institutions. Credit risk is managed through the monitoring of counterparty ﬁnancial condition and by the use of standard credit guidelines. We do not anticipate any nonperformance by any of the counterparties. Concentration of credit risk with respect to trade accounts receivable is limited due to the large number of customers and their dispersion across a number of geographic areas and by frequent monitoring of the creditworthiness of the customers to whom credit is granted in the normal course of business. However, essentially all of 36 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Management’s Report on Internal Control Over Financial Reporting The management of Zimmer Holdings, Inc. (the ‘‘Company’’) is responsible for establishing and maintaining adequate internal control over ﬁnancial reporting. Internal control over ﬁnancial reporting is deﬁned in Rules 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company’s principal executive and principal ﬁnancial ofﬁcers and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that: ) Pertain to the maintenance of records that in reasonable detail accurately and fairly reﬂect the transactions and dispositions of the assets of the Company; ) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁnancial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and ) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the ﬁnancial statements. Because of its inherent limitations, the Company’s internal control over ﬁnancial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. The Company’s management assessed the effectiveness of the Company’s internal control over ﬁnancial reporting as of December 31, 2005. In making this assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on that assessment, management has concluded that, as of December 31, 2005, the Company’s internal control over ﬁnancial reporting is effective based on those criteria. The Company’s independent registered public accounting ﬁrm has audited management’s assessment of the effectiveness of the Company’s internal control over ﬁnancial reporting as of December 31, 2005, as stated in their report which appears in Item 8 of this Annual Report on Form 10-K. 37 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ITEM 8. Financial Statements and Supplementary Data Zimmer Holdings, Inc. Index to Consolidated Financial Statements FINANCIAL STATEMENTS: Report of Independent Registered Public Accounting Firm Consolidated Statements of Earnings for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Balance Sheets as of December 31, 2005 and 2004 Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2005, 2004 and 2003 Notes to Consolidated Financial Statements Page 39 41 42 43 44 45 46 38 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of Zimmer Holdings, Inc.: We have completed integrated audits of Zimmer Holdings, Inc.’s 2005 and 2004 consolidated ﬁnancial statements and of its internal control over ﬁnancial reporting as of December 31, 2005, and an audit of its 2003 consolidated ﬁnancial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below. Consolidated ﬁnancial statements and ﬁnancial statement schedule In our opinion, the consolidated ﬁnancial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the ﬁnancial position of Zimmer Holdings, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash ﬂows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the ﬁnancial statement schedule listed in the index appearing under Item 15(a) (2), presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated ﬁnancial statements. These ﬁnancial statements and ﬁnancial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements and ﬁnancial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit of ﬁnancial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements, assessing the accounting principles used and signiﬁcant estimates made by management, and evaluating the overall ﬁnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 4, the Company changed its method of accounting for instruments effective January 1, 2003. Internal control over ﬁnancial reporting Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing at the conclusion of Item 7A, that the Company maintained effective internal control over ﬁnancial reporting as of December 31, 2005 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over ﬁnancial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over ﬁnancial reporting and for its assessment of the effectiveness of internal control over ﬁnancial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over ﬁnancial reporting based on our audit. We conducted our audit of internal control over ﬁnancial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁnancial reporting was maintained in all material respects. An audit of internal control over ﬁnancial reporting includes obtaining an understanding of internal control over ﬁnancial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over ﬁnancial reporting is a process designed to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁnancial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁnancial statements. 39 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Report of Independent Registered Public Accounting Firm (Continued) Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. PricewaterhouseCoopers LLP Chicago, Illinois February 27, 2006 40 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Consolidated Statements of Earnings For the Years Ended December 31, Net Sales Cost of products sold Gross Proﬁt Research and development Selling, general and administrative In-process research and development Acquisition, integration and other Operating expenses Operating Proﬁt Interest expense, net Earnings before income taxes, minority interest and cumulative effect of change in accounting principle Provision for income taxes Minority interest Earnings before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net of tax Net Earnings Earnings Per Common Share – Basic Earnings before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net of tax Earnings Per Common Share – Basic Earnings Per Common Share – Diluted Earnings before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net of tax Earnings Per Common Share – Diluted Weighted Average Common Shares Outstanding Basic Diluted The accompanying notes are an integral part of these consolidated ﬁnancial statements. 2 0 0 5 F O R M 1 0 - K (in millions, except per share amounts) 2005 2004 2003 $3,286.1 739.4 $2,980.9 779.9 $1,901.0 516.2 2,546.7 2,201.0 1,384.8 175.5 1,259.6 – 56.6 166.7 1,190.0 – 81.1 1,491.7 1,437.8 1,055.0 14.3 763.2 31.7 1,040.7 307.3 (0.9) 731.5 189.6 (0.1) 732.5 – 541.8 – 105.8 737.5 11.2 79.6 934.1 450.7 13.2 437.5 146.8 0.5 291.2 55.1 $ 732.5 $ 541.8 $ 346.3 $ 2.96 $ 2.22 $ – – 1.40 0.27 $ 2.96 $ 2.22 $ 1.67 $ $ 2.93 – 2.93 $ $ 2.19 – 2.19 $ $ 1.38 0.26 1.64 247.1 249.8 244.4 247.8 207.7 211.2 41 2 0 0 5 F O R M 1 0 - K (in millions, except share amounts) 2005 2004 $ 233.2 12.1 524.2 583.7 68.7 153.7 1,575.6 708.8 2,428.8 756.6 252.1 $ 154.6 18.9 524.8 536.0 54.0 272.6 1,560.9 628.5 2,528.9 794.8 182.4 $5,721.9 $5,695.5 $ 123.6 82.1 401.2 – 606.9 348.3 81.6 $ 131.6 34.2 507.7 27.5 701.0 420.9 624.0 1,036.8 1,745.9 2.3 7.1 2.5 2,601.1 1,934.0 149.3 (4.1) 2.5 2,485.2 1,201.5 253.3 – 4,682.8 3,942.5 $5,721.9 $5,695.5 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Consolidated Balance Sheets December 31, ASSETS Current Assets: Cash and equivalents Restricted cash Accounts receivable, less allowance for doubtful accounts Inventories, net Prepaid expenses Deferred income taxes Total Current Assets Property, plant and equipment, net Goodwill Intangible assets, net Other assets Total Assets LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts payable Income taxes payable Other current liabilities Short-term debt Total Current Liabilities Other long-term liabilities Long-term debt Total Liabilities Commitments and Contingencies (Note 16) Minority Interest Stockholders’ Equity: Common stock, $0.01 par value, one billion shares authorized, 247.8 million (245.5 million in 2004) issued and outstanding Paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock, 59,200 shares in 2005 Total Stockholders’ Equity Total Liabilities and Stockholders’ Equity The accompanying notes are an integral part of these consolidated ﬁnancial statements. 42 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Consolidated Statements of Stockholders’ Equity Common Shares Number Amount Paid-in Capital Retained Earnings Accumulated Other Comprehensive Treasury Shares Income Number Amount Balance January 1, 2003 Net earnings Other comprehensive income Centerpulse and InCentive exchange offers net of $(11.9) million equity issuance costs Stock compensation plans, including tax beneﬁts Other Balance December 31, 2003 Net earnings Other comprehensive income Centerpulse and InCentive compulsory acquisition Stock compensation plans, including tax beneﬁts Other Balance December 31, 2004 Net earnings Other comprehensive loss Stock compensation plans, including tax beneﬁts Share repurchases Other 195.2 – – 44.5 2.7 – 242.4 – – 0.6 2.5 – 245.5 – – 2.3 – – $2.0 – – $ 36.9 – – $ 313.4 346.3 – 0.4 – – 2.4 – – – 0.1 – 2.5 – – – – – 2,211.6 93.0 1.0 2,342.5 – – 28.1 107.5 7.1 2,485.2 – – 111.0 – 4.9 – – – 659.7 541.8 – – – – 1,201.5 732.5 – – – – $ 14.0 – 124.7 – – – 138.7 – 114.6 – – – – – – – – – – – – – – – $ – – – – – – – – – – – – 253.3 – (104.0) – – – – – – – (0.1) – – – – – (4.1) – (in millions) Total Stockholders’ Equity $ 366.3 346.3 124.7 2,212.0 93.0 1.0 3,143.3 541.8 114.6 28.1 107.6 7.1 3,942.5 732.5 (104.0) 111.0 (4.1) 4.9 Balance December 31, 2005 247.8 $2.5 $2,601.1 $1,934.0 $149.3 (0.1) $(4.1) $4,682.8 The accompanying notes are an integral part of these consolidated ﬁnancial statements. 43 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Consolidated Statements of Cash Flows For the Years Ended December 31, Cash ﬂows provided by (used in) operating activities: Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization Inventory step-up Income tax beneﬁt from stock option exercises Write off of in-process research and development Cumulative effect of change in accounting principle Changes in operating assets and liabilities, net of acquired assets and liabilities Income taxes Receivables Inventories Accounts payable and accrued liabilities Other assets and liabilities (in millions) 2005 2004 2003 $ 732.5 $ 541.8 $ 346.3 185.7 5.0 34.3 – – 85.0 (35.3) (79.2) (40.1) (9.7) 181.3 59.4 42.5 – – 96.7 (10.6) (44.7) (3.1) (1.1) 103.3 42.7 22.5 11.2 (89.1) 95.3 (39.0) (53.0) 75.9 (21.3) Net cash provided by operating activities 878.2 862.2 494.8 Cash ﬂows provided by (used in) investing activities: Additions to instruments Additions to other property, plant and equipment Centerpulse and InCentive acquisitions, net of acquired cash Implex acquisition, net of acquired cash Proceeds from note receivable Investments in other assets Net cash used in investing activities Cash ﬂows provided by (used in) ﬁnancing activities: Net proceeds (payments) on lines of credit Proceeds from term loans Payments on term loans Proceeds from employee stock compensation plans Debt issuance costs Repurchase of common stock Equity issuance costs Net cash provided by (used in) ﬁnancing activities Effect of exchange rates on cash and equivalents Increase in cash and equivalents Cash and equivalents, beginning of year Cash and equivalents, end of year The accompanying notes are an integral part of these consolidated ﬁnancial statements. (150.0) (105.3) – (44.1) – (11.7) (139.6) (100.8) (18.2) (153.1) 25.0 (1.6) (113.6) (44.9) (927.7) – – (16.5) (311.1) (388.3) (1,102.7) (5.3) – (550.0) 76.7 (1.9) (4.1) – (561.4) 100.0 – 65.0 (0.6) – (5.0) 170.6 550.0 (100.0) 70.5 (19.4) – (6.9) (484.6) (402.0) 664.8 (3.9) 78.6 154.6 5.2 77.1 77.5 4.9 61.8 15.7 $ 233.2 $ 154.6 $ 77.5 44 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Consolidated Statements of Comprehensive Income For the Years Ended December 31, Net Earnings Other Comprehensive Income (Loss): Foreign currency cumulative translation adjustments Unrealized foreign currency hedge gains /(losses), net of tax effects of $(17.8) in 2005, $10.0 in 2004 and $21.6 in 2003 Reclassiﬁcation adjustments on foreign currency hedges, net of tax effects of $(12.7) in 2005, $(9.6) in 2004 and $(2.1) in 2003 Unrealized gains /(losses) on securities, net of tax effects of $0.9 in 2005 and $(1.5) in 2004 Minimum pension liability, net of tax effects of $0.2 in 2004 Other comprehensive income (loss) Comprehensive Income The accompanying notes are an integral part of these consolidated ﬁnancial statements. (in millions) 2005 2004 2003 $ 732.5 $541.8 $346.3 (201.3) 145.5 156.6 71.2 (48.7) (35.3) 27.6 (1.5) – 15.7 2.4 (0.3) 3.4 – – (104.0) 114.6 124.7 $ 628.5 $656.4 $471.0 45 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements 1. BUSINESS We design, develop, manufacture and market reconstructive orthopaedic implants, including joint and dental, spinal implants, trauma products and related orthopaedic surgical products. Joint reconstructive implants restore 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. Our related orthopaedic surgical products include surgical supplies and instruments designed to aid in orthopaedic surgical procedures and post-operation rehabilitation. We have operations in more than 24 countries and market our products in more than 100 countries. We operate in a single industry but have three reportable geographic segments, the Americas, Europe and Asia Paciﬁc. The words ‘‘we’’, ‘‘us’’, ‘‘our’’ and similar words refer to Zimmer Holdings, Inc. and its subsidiaries. Zimmer Holdings refers to the parent company only. 2. SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation – The consolidated ﬁnancial statements include the accounts of Zimmer Holdings and its subsidiaries in which it holds a controlling equity position. Investments in companies in which we exercise signiﬁcant inﬂuence over the operating and ﬁnancial affairs, but do not control, are accounted for under the equity method. Under the equity method, we record the investment at cost and adjust the carrying amount of the investment by our proportionate share of the investee’s net earnings or losses. All signiﬁcant intercompany accounts and transactions are eliminated. Certain amounts in the 2004 and 2003 consolidated ﬁnancial statements have been reclassiﬁed to conform to the 2005 presentation. Use of Estimates – The consolidated ﬁnancial statements are prepared in conformity with accounting principles generally accepted in the United States and include amounts that are based on management’s best estimates and judgments. Actual results could differ from those estimates. Foreign Currency Translation – The ﬁnancial statements of our foreign subsidiaries are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates for operating results. Unrealized translation gains and losses are included in accumulated other comprehensive income in stockholders’ 46 equity. When a transaction is denominated in a currency other than the subsidiary’s functional currency, we recognize a transaction gain or loss when the transaction is settled. Foreign currency transaction gains and losses included in net earnings for the years ended December 31, 2005, 2004 and 2003 were not signiﬁcant. Revenue Recognition – We sell product through three principal channels: 1) direct to health care institutions, referred to as direct channel accounts, 2) through stocking distributors and healthcare dealers and 3) directly to dental practices and dental laboratories. The direct channel accounts represent more than 80 percent of our net sales. Through this channel, inventory is generally consigned to sales agents or customers so that products are available when needed for surgical procedures. No revenue is recognized upon the placement of inventory into consignment as we retain title and maintain the inventory on our balance sheet. Upon implantation, we issue an invoice and revenue is recognized. Pricing for products is generally predetermined by contracts with customers, agents acting on behalf of customer groups or by government regulatory bodies, depending on the market. Price discounts under group purchasing contracts are generally linked to volume of implant purchases by customer health care institutions within a speciﬁed group. At negotiated thresholds within a contract buying period, price discounts may increase. Revenue is recognized on sales to stocking distributors, healthcare dealers, dental practices and dental laboratories, which account for less than 20 percent of our net sales, when title to product passes to them, generally upon shipment. Product is generally sold to distributors on secured credit terms at ﬁxed prices for speciﬁed periods. A distributor may return product in the event that we terminate the relationship. Under those circumstances, we record an estimated sales return in the period in which constructive notice of termination is given to a distributor. The reserves for doubtful accounts were $23.3 million and $28.4 million as of December 31, 2005 and 2004, respectively. Shipping and Handling – Amounts billed to customers for shipping and handling of products are reﬂected in net sales, and are not signiﬁcant. Expenses incurred related to shipping and handling of products are reﬂected in selling, general and administrative and were $91.6 million, $86.3 million and $50.7 million for the years ended December 31, 2005, 2004 and 2003, respectively. Acquisition, Integration and Other – We recognize incremental expenses resulting directly from the acquisitions of Centerpulse and Implex as ‘‘Acquisition, integration and other’’ expenses. Acquisition, integration and other expenses Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) for the years ended December 31, 2005, 2004 and 2003, included (in millions): For the Years Ended December 31, 2005 2004 2003 Employee severance and retention Sales agent and lease contract terminations Information technology integration Facility and employee relocation Integration consulting Impairment loss on Austin facility Integration personnel Professional fees Other $13.3 12.7 6.9 6.2 5.6 3.2 3.1 – 5.6 $ 9.4 24.4 4.3 3.4 24.2 – 5.2 7.8 2.4 $10.2 36.1 – 1.1 15.4 – 2.0 6.4 8.4 $56.6 $81.1 $79.6 Cash and Equivalents – We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. The carrying amounts reported in the balance sheet for cash and equivalents are valued at cost, which approximates their fair value. Restricted cash is primarily composed of cash held in escrow related to certain insurance coverage. Inventories – Inventories, net of allowances for obsolete and slow-moving goods, are stated at the lower of cost or market, with cost determined on a ﬁrst-in ﬁrst-out basis. Property, Plant and Equipment – Property, plant and equipment is carried at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on estimated useful lives of ten to forty years for buildings and improvements, three to eight years for machinery and equipment and generally ﬁve years for instruments. Maintenance and repairs are expensed as incurred. In accordance with Statement of Financial Accounting Standards (‘‘SFAS’’) No. 144, ‘‘Accounting for the Impairment or Disposal of Long-Lived Assets,’’ we review property, plant and equipment for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. An impairment loss would be recognized when estimated future undiscounted cash ﬂows relating to the asset are less than its carrying amount. An impairment loss is measured as the amount by which the carrying amount of an asset exceeds its fair value. Instruments – Instruments are hand held devices used by orthopaedic surgeons during total joint replacement and other surgical procedures. Instruments are recognized as long-lived assets and are included in property, plant and equipment. Undeployed instruments are carried at cost, net of allowances for excess and obsolete instruments. Instruments in the ﬁeld are carried at cost less accumulated depreciation. Depreciation is computed using the straight-line method based on average estimated useful lives, determined principally in reference to associated product life cycles, primarily ﬁve years. We review instruments for impairment in accordance with SFAS No. 144. Depreciation of instruments is recognized as selling, general and administrative expense. Goodwill – We account for goodwill in accordance with SFAS No. 142, ‘‘Goodwill and Other Intangible Assets’’. Goodwill is not amortized but is subject to annual impairment tests. Goodwill has been assigned to reporting units, which are consistent with our operating segments. We perform annual impairment tests by comparing each reporting unit’s fair value to its carrying amount to determine if there is potential impairment. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the implied fair value of the reporting unit goodwill is less than the carrying value of the reporting unit goodwill. The fair value of the reporting unit and the implied fair value of goodwill are determined based upon discounted cash ﬂows, market multiples or appraised values as appropriate. Intangible Assets – We account for intangible assets in accordance with SFAS No. 142. Intangible assets with an indeﬁnite life, including certain trademarks and trade names, are not amortized. The useful lives of indeﬁnite life intangible assets are assessed annually to determine whether events and circumstances continue to support an indeﬁnite life. Intangible assets with a ﬁnite life, including core and developed technology, certain trademarks and trade names, customer related intangibles and patents and licenses are amortized on a straight-line basis over their estimated useful life, ranging from seven to thirty years. Intangible assets with an indeﬁnite life are tested for impairment annually, or whenever events or circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognized if the carrying amount exceeds the estimated fair value of the asset. The amount of the impairment loss to be recorded would be determined based upon the excess of the asset’s carrying value over its fair value. Intangible assets with a ﬁnite life are tested for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. The useful lives of intangible assets range from 3 to 40 years. In determining the useful lives of intangible assets, we consider the expected use of the assets and the effects of obsolescence, demand, competition, anticipated technological advances, changes in surgical techniques, market inﬂuences and other economic factors. For technology based intangible assets, we consider the expected product life cycles of products, absent unforeseen technological advances, which incorporate the corresponding technology. Trademarks and trade names that do not have a wasting characteristic (i.e. there are no legal, regulatory, contractual, competitive, economic or other factors which limit the useful life) are assigned an indeﬁnite life. Trademarks and trade names that are related to products expected to be phased out are assigned lives consistent with the period in which the products bearing each brand are expected to be sold. For customer relationship intangible assets, we assign useful lives based upon historical levels of customer attrition. Research and Development – We expense all research and development costs as incurred. Research and development costs include salaries, prototypes, depreciation 47 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) of equipment used in research and development, consultant fees and amounts paid to collaborative partners. Income Taxes – We account for income taxes in accordance with SFAS No. 109, ‘‘Accounting for Income Taxes.’’ Deferred tax assets and liabilities are determined based on differences between ﬁnancial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates in effect for the years in which the differences are expected to reverse. Federal income taxes are provided on the portion of the income of foreign subsidiaries that is expected to be remitted to the U.S. Derivative Financial Instruments – We account for all derivative ﬁnancial instruments in accordance with SFAS No. 133, ‘‘Accounting for Derivative Instruments and Hedging Activities,’’ as amended by SFAS No. 138, ‘‘Accounting for Certain Derivative Instruments and Certain Hedging Activities (an amendment of FASB Statement No. 133)’’ and SFAS No. 149, ‘‘Amendment of Statement 133 on Derivative Instruments and Hedging Activities’’. SFAS No. 133 requires that all derivative instruments be reported as assets or liabilities on the balance sheet and measured at fair value. We maintain written policies and procedures that permit, under appropriate circumstances and subject to proper authorization, the use of derivative ﬁnancial instruments solely for hedging purposes. The use of derivative ﬁnancial instruments for trading or speculative purposes is prohibited. We are exposed to market risk due to changes in currency exchange rates. As a result, we utilize foreign exchange forward contracts to offset the effect of exchange rate ﬂuctuations on anticipated foreign currency transactions, generally intercompany sales and purchases expected to occur within the next twelve to thirty months. Derivative instruments that qualify as cash ﬂow hedges are designated as such from inception. We maintain formal documentation regarding our objectives, the nature of the risk being hedged, identiﬁcation of the instrument, the hedged transaction, the hedging relationship and how effectiveness of the hedging instrument will be assessed. Our policy requires that critical terms of a hedging instrument are essentially the same as a hedged forecasted transaction. On this basis, with respect to a cash ﬂow hedge, changes in cash ﬂows attributable to the hedged transaction are generally expected to be completely offset by the cash ﬂows attributable to hedge instruments. We, therefore, perform quarterly assessments of hedge effectiveness by verifying and documenting those critical terms of the hedge instrument and that forecasted transactions have not changed. We also assess on a quarterly basis whether there have been adverse developments regarding the risk of a counterparty default. 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 net earnings. The ineffective portion of a derivative’s change in fair value, if any, is reported in cost of products sold 48 immediately. The net amount recognized in earnings during the years ended December 31, 2005, 2004 and 2003, due to ineffectiveness and amounts excluded from the assessment of hedge effectiveness, was not signiﬁcant. For contracts outstanding at December 31, 2005, we have an obligation to purchase U.S. Dollars and sell Euros, Japanese Yen, British Pounds, Canadian Dollars and Australian Dollars or purchase Swiss Francs and sell U.S. Dollars at set maturity dates ranging from January 2006 through May 2008. The notional amounts of outstanding forward contracts entered into with third parties to purchase U.S. Dollars at December 31, 2005 were $1,142.2 million. The notional amounts of outstanding forward contracts entered into with third parties to purchase Swiss Francs at December 31, 2005 were $195.0 million. The fair value of outstanding derivative instruments recorded on the balance sheet at December 31, 2005, together with settled derivatives where the hedged item has not yet affected earnings, was a net unrealized gain of $31.1 million, or $25.4 million net of taxes, which is deferred in other comprehensive income, of which, $10.2 million, or $9.2 million, net of taxes, is expected to be reclassiﬁed to earnings over the next twelve months. We also enter into foreign currency forward exchange contracts with terms of one month to manage currency exposures for assets and liabilities denominated in a currency other than an entity’s functional currency. As a result, any foreign currency translation gains /losses recognized in earnings under SFAS No. 52, ‘‘Foreign Currency Translation’’ are generally offset with gains /losses on the foreign currency forward exchange contracts in the same reporting period. Stock Compensation – At December 31, 2005, we had three stock option plans, which are described more fully in Note 13 and an employee stock purchase plan. Additionally, restricted stock has been granted under one of the stock option plans. We account for those plans under the recognition and measurement principles of APB Opinion No. 25, ‘‘Accounting for Stock Issued to Employees,’’ and related Interpretations. For stock options that vest based upon service, no share-based compensation cost is reﬂected in net earnings, as the options granted under the plans had exercise prices equal to the market value of the underlying common stock on the date of grant. We granted performance- conditioned stock options in 2005 that require us to recognize an expense to the extent the market value of the stock exceeds the exercise price on the measurement date. No compensation cost was recognized in the year ended December 31, 2005, as the exercise price exceeded the market value of the stock. No compensation cost is reﬂected in net income for the employee stock purchase plan under the provisions of APB 25, which allows a discounted purchase price under Section 423 of the Internal Revenue Code. Compensation cost related to restricted stock is recognized in earnings over the vesting period of the stock, which is generally ﬁve years. Compensation cost related to restricted stock was not signiﬁcant for the years ended December 31, 2005, 2004 and 2003. The following table illustrates the effect Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) on net earnings and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, ‘‘Accounting for Stock Based Compensation,’’ to the above plans. For the Years Ended December 31, Net earnings, as reported Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax Pro forma net earnings Earnings per share: (in millions, except per share amounts) 2005 2004 2003 $732.5 $541.8 $346.3 (46.1) (26.0) (14.3) $686.4 $515.8 $332.0 Basic – as reported Basic – pro forma Diluted – as reported Diluted – pro forma $ 1.67 1.60 1.64 1.57 The fair value of each option granted is estimated on the $ 2.22 2.11 2.19 2.08 $ 2.96 2.78 2.93 2.75 date of grant using the Black-Scholes option-pricing model with the following assumptions: Dividend Yield Volatility Risk-free interest rate Expected life (years) The weighted average fair value for options granted during 2005, 2004 and 2003 was $28.11, $21.85 and $12.85, respectively. Other Comprehensive Income – Other comprehensive income refers to revenues, expenses, gains and losses that under generally accepted accounting principles are included in comprehensive income but are excluded from net earnings as these amounts are recorded directly as an adjustment to stockholders’ equity. Other comprehensive income is comprised of foreign currency translation adjustments, unrealized foreign currency hedge gains and losses, unrealized gains and losses on available-for-sale securities, and minimum pension liability adjustments. The components of accumulated other comprehensive income are as follows (in millions): Balance at January 1, 2005 Other Comprehensive Income (Loss) Balance at December 31, 2005 $325.2 $(201.3) $123.9 (73.4) 2.4 (0.9) 98.8 (1.5) — 25.4 0.9 (0.9) Foreign currency translation Foreign currency hedges Unrealized gains on securities Minimum pension liability Accumulated other comprehensive income reduction of shareholders equity. We may reissue common stock held in treasury only for limited purposes. Accounting Pronouncements – In December 2004, the Financial Accounting Standards Board (‘‘FASB’’) issued FASB Staff Position (‘‘FSP’’) 109-2, ‘‘Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (the ‘‘Act’’)’’. As a result of the Act, we could have repatriated earnings of foreign subsidiaries at reduced U.S. tax rates in 2005. However, we determined it was not beneﬁcial to repatriate earnings under the Act based upon our facts and circumstances and therefore this did not have an effect on our ﬁnancial position, results of operations or cash ﬂows. In December 2004, the FASB issued SFAS No. 123(R), ‘‘Share-Based Payment’’, which is a revision to SFAS No. 123. SFAS 123(R) requires all share-based payments to employees, including stock options, to be expensed based on their fair values. We have disclosed the effect on net earnings and earnings per share if we had applied the fair value recognition provisions of SFAS 123. We will adopt –% SFAS 123(R) on January 1, 2006 using the prospective 2005 2004 –% –% 2003 30.2% 28.0% 27.1% method and will not restate prior periods. SFAS 123(R) will 4.1% 3.4% 3.1% apply to new awards and to awards that are outstanding as of 5.3 5.0 5.0 January 1, 2006. Compensation expense for outstanding awards for which the requisite service has not been rendered as of January 1, 2006, will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under SFAS 123. We estimate the adoption of this accounting standard will reduce diluted earnings per share by $0.23 – $0.25 during the year ended December 31, 2006. In November 2004, the FASB issued SFAS No. 151, ‘‘Inventory Costs’’ to clarify the accounting for abnormal amounts of idle facility expense. SFAS No. 151 requires that ﬁxed overhead production costs be applied to inventory at ‘‘normal capacity’’ and any excess ﬁxed overhead production costs be charged to expense in the period in which they were incurred. SFAS No. 151 is effective for ﬁscal years beginning after June 15, 2005. We do not expect SFAS No. 151 to have a material effect on our ﬁnancial position, results of operations, or cash ﬂows. In May 2005, the FASB issued SFAS No. 154, ‘‘Accounting Changes and Error Corrections’’, which is effective for ﬁscal years beginning after December 15, 2005. This standard is a replacement of APB Opinion No. 20, ‘‘Accounting Changes’’. SFAS No. 154 changes the requirements for accounting for and reporting of a change in accounting principle. We do not expect SFAS No. 154 to have a material effect on our ﬁnancial position, results of operations, or cash ﬂows. $253.3 $(104.0) $149.3 3. ACQUISITIONS Treasury Stock – We account for repurchases of common stock under the cost method and present treasury stock as a Centerpulse AG and InCentive Capital AG On October 2, 2003 (the ‘‘Closing Date’’), we closed our exchange offer for Centerpulse, a global orthopaedic medical 49 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) device company headquartered in Switzerland that services the reconstructive joint, spine and dental implant markets. We also closed our exchange offer for InCentive, a company that, at the Closing Date, owned only cash and beneﬁcially owned 18.3 percent of the issued Centerpulse shares. The primary reason for making the Centerpulse and InCentive exchange offers was to create a global leader in the design, development, manufacture and marketing of orthopaedic reconstructive implants, including joint and dental, spine implants, and trauma products. The combined strategic compatibilities of products and technologies is expected to provide signiﬁcant earnings power and a strong platform from which we can actively pursue growth opportunities in the industry. Centerpulse provided a unique platform for growth and diversiﬁcation in Europe as well as in the spine and dental areas of the medical device industry. The aggregate consideration paid in the exchange offers was $3,495.7 million, consisting of Zimmer Holdings common stock valued at $2,252.0 million (45,101,640 shares exchanged), $1,201.3 million of cash and $42.4 million of direct acquisition costs. Accordingly, Centerpulse and InCentive results of operations have been included in our consolidated results of operations subsequent to the Closing Date, and their respective assets and liabilities were recorded at their estimated fair values in our consolidated statement of ﬁnancial position as of the Closing Date, with the excess purchase price being allocated to goodwill. As of the Closing Date, 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. In accordance with Emerging Issues Task Force (‘‘EITF’’) 95-3 ‘‘Recognition of Liabilities Assumed in a Purchase Business Combination’’, these liabilities were included in the allocation of the purchase price. Increases to the liability subsequent to the completion of the allocation period are expensed in the ﬁnancial statements, and were not signiﬁcant. Reductions in the liability subsequent to the completion of the allocation period are 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 have been or will be involuntarily terminated through our integration plan. As of December 31, 2005, approximately 810 Centerpulse employees had been involuntarily terminated. We completed the production phase- out of our Austin, Texas manufacturing facility in the fourth quarter of 2005. The phase-out resulted in the involuntary termination of approximately 550 employees, including 390 employees involved in manufacturing. Products previously manufactured at the Austin facility are being sourced from our other manufacturing facilities. We have hired additional manufacturing employees at our other manufacturing facilities to handle increased production schedules. A majority of our integration plan has been 50 completed as of December 31, 2005. Remaining portions of the integration plan include IT systems conversions, primarily in Europe and Asia Paciﬁc, decommissioning the Austin facility and disposing of this asset, continued in-sourcing and a few other items. Reconciliation of the integration liability, as of December 31, 2005, is as follow (in millions): Employee Termination and Relocation Costs $ 53.1 (20.7) 32.4 (20.5) 3.7 15.6 (8.8) (0.3) Contract Terminations Total $ 22.6 (0.2) $ 75.7 (20.9) 22.4 (2.3) (11.8) 8.3 (2.4) (1.1) 54.8 (22.8) (8.1) 23.9 (11.2) (1.4) Balance, Closing Date Cash Payments Balance, December 31, 2003 Cash Payments Additions /(Reductions), net Balance, December 31, 2004 Cash Payments Additions /(Reductions), net Balance, December 31, 2005 $ 6.5 $ 4.8 $ 11.3 Implex Corp. On April 23, 2004, we acquired Implex, a privately held orthopaedics company based in New Jersey, pursuant to an Amended and Restated Merger Agreement. We acquired 100 percent of the shares of Implex for an initial cash consideration of approximately $108.0 million, before adjustments for debt repayment, certain payments previously made by us to Implex pursuant to a pre-existing strategic alliance and other items. The aggregate cash consideration paid by us through December 31, 2005 was $197.2 million, consisting of a $98.6 million payment at closing, $2.6 million of direct acquisition costs and $96.0 million of earn-out payments made pursuant to the merger agreement. The acquisition resulted from the strategic alliance agreement we had with Implex since 2000 for the development and distribution of reconstructive implant and trauma products incorporating Trabecular Metal Technology. The merger agreement contains provisions for additional annual cash earn-out payments that are based on year-over- year sales growth through 2006 of certain products that incorporate Trabecular Metal Technology. We estimate an additional $30 – $40 million of earn-out payments will be made in 2006. These earn-out payments represent contingent consideration and, in accordance with SFAS No. 141 and EITF 95-8 ‘‘Accounting for Contingent Consideration Paid to the Shareholders of an Acquired Enterprise in a Purchase Business Combination’’, are recorded as an additional cost of the transaction upon resolution of the contingency and therefore increase goodwill. We completed the purchase price allocation in 2005 in accordance with U.S. generally accepted accounting principles. The only signiﬁcant adjustment to the preliminary purchase price allocation made in 2005 related to a $44.1 million earn-out payment. See Note 7 for additional information on goodwill. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) 4. CHANGE IN ACCOUNTING PRINCIPLE Effective January 1, 2003, we changed our method of accounting for instruments. Prior to January 1, 2003, undeployed instruments were carried as a prepaid expense at cost, net of allowances for excess and obsolete instruments, and recognized in selling, general and administrative expense in the year in which the instruments were placed into service. The new method of accounting for instruments was adopted to recognize the cost of these important assets within the consolidated balance sheet and allocate the cost of these assets over the periods beneﬁted, typically ﬁve years. The effect of the change during the year ended December 31, 2003 was to increase earnings before cumulative effect of change in accounting principle by $26.8 million ($17.8 million net of tax), or $0.08 per diluted share. The cumulative effect adjustment of $55.1 million (net of income taxes of $34.0 million) to retroactively apply the new capitalization method as if applied in years prior to 2003 is included in earnings during the year ended December 31, 2003. 5. INVENTORIES Inventories at December 31, 2005 and 2004, consist of the following (in millions): Finished goods Work in progress Raw materials Inventory step-up (primarily ﬁnished goods) Inventories, net 2005 $444.0 40.1 99.6 – $583.7 2004 $420.5 42.0 70.2 3.3 $536.0 Reserves for excess and obsolete inventory were $121.0 million and $124.1 million at December 31, 2005 and 2004, respectively. 6. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment at December 31, 2005 and 2004, was as follows (in millions): Land Building and equipment Instruments Construction in progress Accumulated depreciation $ 2005 20.7 706.5 649.2 61.4 $ 2004 20.0 677.1 557.8 57.9 1,437.8 (729.0) 1,312.8 (684.3) Property, plant and equipment, net $ 708.8 $ 628.5 Depreciation expense was $144.0 million, $142.2 million and $92.4 million for the years ended December 31, 2005, 2004 and 2003, respectively. 7. GOODWILL AND OTHER INTANGIBLE ASSETS The following table summarizes the changes in the carrying amount of goodwill for the years ended December 31, 2005 and 2004 (in millions): Balance at January 1, 2004 $1,275.5 $ 906.0 $110.3 $2,291.8 Americas Europe Asia Paciﬁc Total Completion of Centerpulse and InCentive compulsory acquisition process Acquisition of Implex Change in preliminary fair value estimates of Centerpulse related to: Intangible assets Income taxes Property, plant and equipment Inventories Integration liability Other assets Preacquisition contingencies Other Currency translation Balance at December 31, 24.3 61.0 16.0 – 10.7 (33.7) 26.5 6.6 (5.3) 6.5 4.9 10.3 37.9 (3.0) – (3.1) 1.8 (12.8) – – (0.8) 83.0 2.0 – – 0.3 – – (0.2) – – (0.1) 4.3 42.3 61.0 37.2 (26.8) (8.4) 8.3 (8.1) 10.3 37.9 (3.9) 87.3 2004 1,389.1 1,023.2 116.6 2,528.9 Change in preliminary fair value estimates of Centerpulse related to: Income taxes Integration liability Change in preliminary fair value estimates of Implex related to: Earn-out payment liability Income taxes Integration liability Inventories Other Purchase of Allo Systems Srl minority interest Currency translation Balance at December 31, (7.8) (0.2) 0.5 (1.4) 44.1 0.6 (0.1) 0.7 (0.2) – – – – – – – – – – – – (7.3) (1.6) 44.1 0.6 (0.1) 0.7 (0.2) – – 2.0 (127.4) – (10.9) 2.0 (138.3) 2005 $1,426.2 $ 896.9 $105.7 $2,428.8 51 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) The components of identiﬁable intangible assets are as follows (in millions): Core Technology Developed Technology Trademarks and Trade Names Customer Relationships Other Total As of December 31, 2005: Intangible assets subject to amortization: Gross carrying amount Accumulated amortization Intangible assets not subject to amortization: Gross carrying amount Total identiﬁable intangible assets As of December 31, 2004: Intangible assets subject to amortization: Gross carrying amount Accumulated amortization Intangible assets not subject to amortization: Gross carrying amount Total identiﬁable intangible assets Total amortization expense for ﬁnite-lived intangible assets was $41.7 million, $39.1 million and $10.9 million for the years ended December 31, 2005, 2004 and 2003, respectively, and was recorded as part of selling, general and administrative. Estimated annual amortization expense for the years ending December 31, 2006 through 2010 is $41.6 million, $41.5 million, $41.4 million, $41.4 million and $39.3 million, respectively. 8. OTHER CURRENT AND LONG-TERM LIABILITIES Other current and long-term liabilities at December 31, 2005 and 2004, consist of the following (in millions): Other current liabilities: Service arrangements Fair value of derivatives Salaries, wages and beneﬁts Litigation liability Accrued liabilities 2005 2004 $ 112.3 8.7 54.9 17.9 207.4 $ 114.3 72.8 54.7 38.3 227.6 Total other current liabilities $ 401.2 $ 507.7 Other long-term liabilities: Long-term income tax payable Other long-term liabilities Total other long-term liabilities 9. DEBT $ 150.1 198.2 $ 156.7 264.2 $ 348.3 $ 420.9 On March 31, 2005, we amended and restated our revolving credit and term loan agreement dated as of May 24, 2004 (the ‘‘Prior Facility’’) into a ﬁve year $1,350 million amended and restated credit agreement (the ‘‘Amended and Restated Facility’’). The Amended and Restated Facility is a revolving, multi-currency, senior unsecured credit facility maturing March 31, 2010. Available borrowings under the Amended and Restated Facility at December 31, 2005, were $1,268.4 million. The Amended and Restated Facility contains a provision whereby borrowings may be increased to $1,750 million. We and certain of our wholly owned foreign and domestic subsidiaries are the borrowers and our wholly 52 $118.9 (14.2) $417.3 (60.0) – – $104.7 $357.3 $117.9 (8.0) $417.3 (31.9) – – $109.9 $385.4 $ 31.7 (6.8) 215.0 $239.9 $ 31.7 (3.8) 218.1 $246.0 $34.4 (2.4) $ 39.7 (17.0) $ 642.0 (100.4) – – 215.0 $32.0 $ 22.7 $ 756.6 $34.4 (1.3) $ 34.1 (13.7) $ 635.4 (58.7) – – 218.1 $33.1 $ 20.4 $ 794.8 owned domestic subsidiaries are the guarantors of the Amended and Restated Facility. Borrowings under the Amended and Restated Facility bear interest at a LIBOR- based rate plus an applicable margin determined by reference to our senior unsecured long-term credit rating and the amounts drawn under the Amended and Restated Facility, at an alternate base rate, or at a ﬁxed rate determined through a competitive bid process. The Amended and Restated Facility contains customary afﬁrmative and negative covenants and events of default for an unsecured ﬁnancing arrangement, including, among other things, limitations on consolidations, mergers and sales of assets. Financial covenants include a maximum leverage ratio of 3.0 to 1.0 and a minimum interest coverage ratio of 3.5 to 1.0. If we fall below an investment grade credit rating, additional restrictions would result, including restrictions on investments, payment of dividends and stock repurchases. We were in compliance with all covenants under the Amended and Restated Facility as of December 31, 2005. Commitments under the Amended and Restated Facility are subject to certain fees, including a facility and a utilization fee. Outstanding debt as of December 31, 2005 and 2004 consists of the following (in millions): Prior Facility Three-year revolving credit facility Five-year term loan Amended and Restated Facility Uncommitted credit facilities Other Total debt Less: Current Portion Total Long-Term Debt 2005 2004 $ – – 81.6 – – 81.6 – $ 97.8 550.0 – 1.1 2.6 651.5 27.5 $81.6 $624.0 We also have available uncommitted credit facilities totaling $65 million. The weighted average interest rate for borrowings under the Amended and Restated Facility is 0.41 percent at December 31, 2005. Borrowings under the Amended and Restated Facility at December 31, 2005 are Japanese Yen based borrowings. We paid $15.3 million, $27.9 million and Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) $6.3 million in interest during 2005, 2004 and 2003, respectively. Debt issuance costs of $20.5 million were incurred to obtain the Prior Facility arrangement and an additional $1.9 million were incurred for the Amended and Restated Facility. These costs were capitalized and are amortized to interest expense over the lives of the related facilities. At December 31, 2005, unamortized debt issuance costs were $7.7 million. 10. RETIREMENT AND POSTRETIREMENT BENEFIT PLANS We have deﬁned beneﬁt pension plans covering certain U.S. and Puerto Rico employees who were hired before September 2, 2002. Employees hired after September 2, 2002 are not part of the U.S. and Puerto Rico deﬁned beneﬁt plans, but do receive additional beneﬁts under our deﬁned contribution plans. Plan beneﬁts are primarily based on years of credited service and the participant’s average eligible compensation. In addition to the U.S. and Puerto Rico deﬁned beneﬁt pension plans, we sponsor various non-U.S. pension arrangements, including retirement and termination beneﬁt plans required by local law or coordinated with government sponsored plans. We also provide comprehensive medical and group life insurance beneﬁts to certain U.S. and Puerto Rico eligible 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. No similar plans exist for employees outside the U.S. and Puerto Rico. Employees hired after September 2, 2002, are not eligible for retiree medical and life insurance beneﬁts. We use a December 31 measurement date for our beneﬁt plans. The components of net pension expense for the years ended December 31, 2005, 2004 and 2003 for our deﬁned beneﬁt retirement plans are as follows (in millions): Service cost Interest cost Expected return on plan assets Amortization of prior service cost Amortization of unrecognized actuarial loss Net periodic beneﬁt cost U.S. and Puerto Rico 2005 $11.4 5.6 (6.4) (0.1) 2.1 $12.6 2004 $ 9.7 4.2 (4.8) (0.1) 0.9 $ 9.9 2003 $ 8.6 3.1 (2.8) (0.2) 0.5 $ 9.2 2005 $ 8.7 4.9 (6.0) – 0.6 $ 8.2 Non-U.S. 2004 $ 9.6 4.8 (5.8) 0.4 0.6 $ 9.6 2003 $ 4.9 2.0 (2.2) 1.9 0.4 $ 7.0 The weighted average actuarial assumptions used to determine net pension expense for our deﬁned beneﬁt retirement plans were as follows: Discount rate Rate of compensation increase Expected long-term return on plan assets U.S. and Puerto Rico 2005 6.25% 3.82% 8.50% 2004 6.75% 3.60% 8.75% 2003 7.00% 3.62% 9.00% 2005 3.78% 2.28% 4.77% Non-U.S. 2004 3.81% 1.57% 4.83% 2003 4.08% 2.27% 4.77% The expected long-term rates of return on plan assets is based on the period expected beneﬁts will be paid and the historical rates of return on the different asset classes held in the plans. The expected long-term rate of return is the weighted average of the target asset allocation of each individual asset class. We believe that historical asset results approximate expected market returns applicable to the funding of a long-term beneﬁt obligation. Discount rates were determined for each of our deﬁned beneﬁt retirement plans at their measurement date to reﬂect the yield of a portfolio of high quality bonds matched against the timing and amounts of projected future beneﬁt payments. 53 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) Changes in projected beneﬁt obligations and plan assets, for the years ended December 31, 2005 and 2004 for our deﬁned beneﬁt retirement plans, were (in millions): Projected beneﬁt obligation – beginning of year Plan amendments Service cost Interest cost Employee contributions Beneﬁts paid Actuarial loss Translation (gain) loss Projected beneﬁt obligation – end of year Plan assets at fair market value – beginning of year Actual return on plan assets Company contributions Employee contributions Beneﬁts paid Expenses Translation gain (loss) Plan assets at fair market value – end of year Funded status Unrecognized prior service cost Unrecognized actuarial loss Net amount recognized Amounts recognized in consolidated balance sheet: Prepaid pension Accrued beneﬁt liability Accumulated other comprehensive income Net amount recognized U.S. and Puerto Rico Non-U.S. 2005 2004 2005 2004 $ 89.2 0.2 11.4 5.6 – (0.8) 24.8 – $130.4 $ 66.1 3.4 17.4 – (0.8) (0.5) – $ 85.6 $(44.8) (0.3) 52.6 $ 63.8 (0.1) 9.7 4.2 – (0.7) 12.3 – $ 89.2 $ 45.5 5.4 16.5 – (0.7) (0.6) – $ 66.1 $(23.1) (0.6) 26.4 $143.0 (0.3) 8.7 4.9 9.8 (14.2) 13.6 (19.0) $130.2 – 9.6 4.8 7.8 (20.9) 0.6 10.9 $146.5 $143.0 $137.2 11.4 9.8 9.8 (14.2) – (18.3) $135.7 $(10.8) – 9.3 $128.0 2.3 9.1 7.8 (20.9) – 10.9 $137.2 $ (5.8) 1.2 0.8 $ 7.5 $ 2.7 $ (1.5) $ (3.8) $ 12.2 (6.2) 1.5 $ 7.5 $ 5.8 (4.6) 1.5 $ 2.7 $ 4.6 (6.1) – $ 6.1 (9.9) – $ (1.5) $ (3.8) The weighted average actuarial assumptions used to determine the projected beneﬁt obligation for our deﬁned beneﬁt retirement plans were as follows: Discount rate Rate of compensation increase U.S. and Puerto Rico 2005 5.84% 3.82% 2004 6.25% 3.84% 2003 6.75% 3.62% 2005 3.15% 2.27% Non-U.S. 2004 3.75% 2.22% 2003 4.03% 2.27% Plans with projected beneﬁt obligations in excess of plan assets as of December 31, 2005 and 2004 were as follows (in millions): Beneﬁt obligation Plan assets at fair market value U.S. and Puerto Rico Non-U.S. 2005 $122.6 77.3 2004 $82.9 58.1 2005 $131.6 118.1 2004 $38.9 30.2 Plans with accumulated beneﬁt obligations in excess of plan assets as of December 31, 2005 and 2004 were as follows (in millions): Accumulated beneﬁt obligation Plan assets at fair market value 54 U.S. and Puerto Rico Non-U.S. 2005 $7.1 – 2004 $4.0 – 2005 $16.9 13.2 2004 $16.2 12.5 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) The accumulated beneﬁt obligation for U.S. and Puerto Rico deﬁned beneﬁt retirement pension plans was $80.3 million and $53.0 million as of December 31, 2005 and 2004, respectively. The accumulated beneﬁt obligation for non-U.S. deﬁned beneﬁt retirement plans was $131.8 million and $126.6 million as of December 31, 2005 and 2004, respectively. We expect that we will have no minimum funding requirements by law in 2006 for the U.S. and Puerto Rico deﬁned beneﬁt retirement plans. However, we expect to voluntarily contribute between $13 million to $18 million to these plans during 2006. Contributions to non-U.S. deﬁned beneﬁt plans are estimated to be approximately $9 million in 2006. The beneﬁts expected to be paid out in each of the next We also sponsor deﬁned contribution plans for ﬁve years and for the ﬁve years combined thereafter are as follows (in millions): For the Years Ending December 31, 2006 2007 2008 2009 2010 2011 – 2015 U.S. and Puerto Rico $ 1.8 2.0 2.6 3.4 4.2 41.5 Non-U.S. $ 6.4 9.4 8.4 11.3 10.7 74.4 substantially all of the U.S. and Puerto Rico employees and certain employees in other countries. The beneﬁts of these plans relate to local customs and practices in the countries concerned. We expensed $11.3 million, $6.4 million and $4.8 million related to these plans for the years ended December 31, 2005, 2004 and 2003, respectively. The components of net periodic expense for the year ended December 31, 2005, 2004 and 2003 for our unfunded postretirement beneﬁt plans are as follows (in millions): Our weighted-average asset allocations at December 31, December 31, 2005 and 2004, by asset category are as follows: U.S. and Puerto Rico Non-U.S. Service cost Interest cost Amortization of unrecognized actuarial loss Asset Category Equity Securities Debt Securities Real Estate Cash Funds Other Total 2005 2004 2005 2004 Net periodic beneﬁt cost 65% 35 – – – 65% 35 – – – 35% 38 14 5 8 37% 35 15 5 8 The weighted average actuarial assumptions used in accounting for our postretirement beneﬁt plans were as follows: 100% 100% 100% 100% December 31, 2005 2004 2003 $ 1.6 2.0 0.3 $ 3.9 $ 1.4 1.7 0.2 $ 3.3 $ 1.3 1.5 0.1 $ 2.9 The U.S. and Puerto Rico deﬁned beneﬁt retirement plans’ overall investment strategy is to maximize total returns by emphasizing long-term growth of capital while avoiding risk. We have established target ranges of assets held by the plans of 50 to 75 percent for equity securities and 25 to 50 percent for debt securities. The plans strive to have sufﬁciently diversiﬁed assets so that adverse or unexpected results from one asset class will not have an unduly detrimental impact on the entire portfolio. The investments in the plans are rebalanced quarterly based upon the target asset allocation of the plans. The investment strategies of non-U.S. based plans vary according to the plan provisions and local laws. The majority of the assets in non-U.S. based plans are located in Switzerland based plans. These assets are held in trusts and are commingled with the assets of other Swiss companies, with representatives of all the companies making the investment decisions. The overall strategy is to maximize total returns while avoiding risk. The trustees of the assets have established target ranges of assets held by the plans of 30 to 50 percent in debt securities, 20 to 37 percent in equity securities, 15 to 24 percent in real estate, 3 to 15 percent in cash funds and 0 to 12 percent in other funds. As of December 31, 2005 and 2004, our deﬁned beneﬁt pension plans’ assets did not hold any direct investment in Zimmer Holdings common stock. Discount rate – Beneﬁt obligation Discount rate – Net periodic beneﬁt cost Initial health care cost trend rate Ultimate health care cost trend rate First year of ultimate trend rate 2005 2004 2003 5.84% 6.25% 9.00% 5.00% 2014 6.25% 6.75% 9.50% 5.00% 2014 6.75% 7.00% 9.00% 5.00% 2012 Changes in beneﬁt obligations for our postretirement beneﬁt plans were (in millions): December 31, Beneﬁt obligation – beginning of year Service cost Interest cost Beneﬁts paid Actuarial loss Beneﬁt obligation – end of year Funded status Unrecognized prior service cost Unrecognized actuarial loss Net amount recognized Accrued beneﬁt liability recognized 2005 2004 $ 31.2 1.6 2.0 (0.5) 5.5 $ 25.0 1.4 1.7 (0.4) 3.5 $ 39.8 $ 31.2 $(39.8) (0.1) 12.2 $(31.2) (0.1) 7.0 $(27.7) $(24.3) $(27.7) $(24.3) A one percentage point change in the assumed health care cost trend rates would have no signiﬁcant effect on the service and interest cost components of net postretirement beneﬁt expense and the accumulated postretirement beneﬁt obligation. The effect of a change in the healthcare cost trend rate is tempered by an annual cap that limits medical costs we pay. 55 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) The beneﬁts expected to be paid out in each of the next The components of deferred income taxes consisted of ﬁve years and for the ﬁve years combined thereafter are as follows (in millions): the following (in millions): For the Years Ending December 31, 2006 2007 2008 2009 2010 2011 – 2015 11. INCOME TAXES $ 0.7 1.2 1.6 2.0 2.5 17.7 Inventory Fixed assets Net operating loss carryover Capital loss carryover Tax credit carryover Accrued liabilities Intangible assets Valuation allowances Other 2005 2004 $ 102.9 (22.9) 214.8 11.2 87.2 111.0 (174.5) (57.5) 27.6 $ 102.4 (31.8) 297.9 11.5 76.5 158.4 (201.4) (67.6) 22.4 $ 299.8 $ 368.3 The components of earnings before taxes consist of the following (in millions): United States operations Foreign operations Total 2005 2004 2003 $ 706.5 334.2 $385.7 345.8 $307.6 129.9 $1,040.7 $731.5 $437.5 The provision for income taxes consists of (in millions): Current: Federal State Foreign Deferred: Federal State Foreign $ 150.5 22.7 80.3 $122.7 17.1 114.9 $(14.3) 3.8 60.6 253.5 254.7 50.1 63.0 – (9.2) 53.8 (20.2) (9.6) (35.3) (65.1) 116.0 6.1 (25.4) 96.7 $ 307.3 $189.6 $146.8 Income taxes paid during 2005, 2004 and 2003 were $189.2 million, $143.3 million and $116.1 million, respectively. A reconciliation of the U.S. statutory income tax rate to our effective tax rate is as follows: 2005 2004 2003 U.S. statutory income tax rate State taxes, net of federal deduction Foreign income taxes at rates different from the U.S. statutory rate, net of foreign tax credits Tax beneﬁt from decreased deferred taxes of acquired Centerpulse operations; due to Swiss tax rate reduction Tax beneﬁt relating to operations in Puerto Rico Tax beneﬁt relating to U.S. export sales R&D credit Non-deductible expenses In-process research & development Other 35.0% 35.0% 35.0% 0.7 0.9 1.5 (3.9) (2.3) – (4.7) (1.3) (0.8) (0.5) 0.1 – – (1.7) (1.3) (0.7) 0.6 – 0.3 – – (2.7) (0.3) (0.4) 0.1 0.9 (0.5) Effective income tax rate 29.5% 25.9% 33.6% Deferred income taxes reﬂect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for ﬁnancial reporting purposes and the amounts used for income tax purposes. 56 At December 31, 2005, the vast majority of the net operating loss is available to reduce future federal and state taxable earnings of the U.S. companies. These losses generally expire within a period of 1 to 19 years. $21.0 million of state losses are subject to valuation allowances and certain restrictions. The tax credits are entirely available to offset future federal and state tax liabilities of the U.S. companies. These credits generally expire within a 1 to 14 year period. $11.3 million of the tax credits are subject to valuation allowances and certain restrictions. The capital loss carryover is also available to reduce future federal taxable earnings of the U.S. companies; however, the entire carryover is subject to a valuation allowance and expires within a period of 1 to 4 years. Our former parent received a ruling from the Internal Revenue Service (‘‘IRS’’), that the 2001 spin-off of Zimmer would qualify as a tax-free transaction. Such a ruling, while generally binding upon the IRS, is subject to certain factual representations and assumptions. We have agreed to certain restrictions on our future actions to provide further assurances that the spin-off will qualify as tax-free. If we fail to abide by such restrictions and, as a result, the spin-off fails to qualify as a tax-free transaction, we will be obligated to indemnify our former parent for any resulting tax liability. During 2004, our tax provision included a deferred tax beneﬁt of $34.5 million as a result of revaluing deferred taxes of acquired Centerpulse operations due to a reduction in the ongoing Swiss tax rate (from approximately 24 percent to 12.5 percent). We have a long-term tax liability of $150.1 million at December 31, 2005 for expected settlement of various U.S. and foreign income tax liabilities. At December 31, 2005, we had an aggregate of approximately $279 million of unremitted earnings of foreign subsidiaries that have been, or are intended to be, permanently reinvested for continued use in foreign operations. If the total undistributed earnings of foreign subsidiaries were remitted, a signiﬁcant amount of the additional tax would be offset by the allowable foreign tax credits. It is impractical for us to determine the additional tax of remitting these earnings. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) 12. CAPITAL STOCK AND EARNINGS PER SHARE We have 2 million shares of Series A Participating Cumulative Preferred Stock (‘‘Series A Preferred Stock’’) authorized for issuance, none of which were outstanding as of December 31, 2005. The numerator for both basic and diluted earnings per share is net earnings available to common stockholders. The denominator for basic earnings per share is the weighted average number of common shares outstanding during the period. The denominator for diluted earnings per share is weighted average shares outstanding adjusted for the effect of dilutive stock options. The following is a reconciliation of weighted average shares for the basic and diluted share computations for the years ending December 31 (in millions): Weighted average shares outstanding for basic net earnings per share Effect of dilutive stock options Weighted average shares outstanding for 2005 2004 2003 247.1 2.7 244.4 3.4 207.7 3.5 diluted net earnings per share 249.8 247.8 211.2 For the year ended December 31, 2005, an average of 2.9 million options 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. There were no anti-dilutive options excluded from the computation of diluted earnings per share for the years ended December 31, 2004 and 2003. In December 2005, our Board of Directors authorized a stock repurchase program of up to $1 billion through December 31, 2007. As of December 31, 2005 we had acquired approximately 59,200 shares at a cost of $4.1 million. 13. STOCK OPTION AND COMPENSATION PLANS We had three stock option plans in effect at December 31, 2005: the 2001 Stock Incentive Plan, the TeamShare Stock Option Plan and the Stock Plan for Non- Employee Directors. 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. Options may be granted under these plans at a price of not less than the fair market value of a share of common stock on the date of grant. The 2001 Stock Incentive Plan provides for the grant of nonqualiﬁed stock options and incentive stock options, long-term performance awards, restricted stock awards and deferred stock units. Options granted under the 2001 Stock Incentive Plan may include stock appreciation rights. 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. Options granted under these plans generally vest over four years, although in no event in less than one year, and expire ten years from the date of grant. In the past, certain options have had price thresholds, which affect exercisability. All such price thresholds have been satisﬁed. The total number of awards which may be granted in a given year and/or over the life of the plan under each of our stock option plans is limited to prevent dilution. In addition, under the terms of the 2001 Stock Incentive Plan, no participant may receive options or awards which in the aggregate exceed 2 million shares of stock over the life of the plan. A summary of the status of all options granted to employees and non-employee directors for the years ended December 31, 2005, 2004 and 2003 is presented below (options in thousands): Outstanding at January 1, 2003 Options granted Options exercised Options cancelled Outstanding at December 31, 2003 Options granted Options exercised Options cancelled Outstanding at December 31, 2004 Options granted Options exercised Options cancelled Outstanding at December 31, 2005 Weighted Average Exercise Price $26.51 43.06 23.80 34.76 30.77 70.41 25.90 50.81 43.60 79.76 31.46 68.01 $55.66 Options 11,035 2,395 (2,688) (272) 10,470 3,407 (2,450) (136) 11,291 3,648 (2,130) (247) 12,562 The following table summarizes information about stock options outstanding at December 31, 2005 (options in thousands): Range of Exercise Prices $10.50 – $17.00 $19.50 – $27.50 $27.51 – $37.50 $39.50 – $51.00 $63.00 – $87.50 Outstanding Weighted Average Remaining Contractual Life 0.84 3.86 5.27 7.22 8.75 7.25 Options 93 1,060 2,944 1,771 6,694 12,562 Weighted Average Exercise Price $14.38 24.79 30.73 43.04 75.43 55.66 Exercisable Options 93 1,060 2,560 779 778 5,270 Weighted Average Exercise Price $14.38 24.79 30.80 42.75 70.49 36.93 57 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) Options exercisable at December 31, 2004 and 2003 were 4.8 million and 4.9 million, respectively, with average exercise prices of $29.30 and $25.97, respectively. See Note 2 for the effect on net earnings and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation. 14. SEGMENT DATA 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 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, 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. Management reviews accounts receivable, inventory, property, plant and equipment, goodwill and intangible assets by reportable segment exclusive of U.S. and Puerto Rico based manufacturing operations and logistics and corporate assets. Net sales, segment operating proﬁt and year-end assets are as follows (in millions): Net Sales Operating Proﬁt Year-End Assets 2005 2004 2003 2005 2004 2003 2005 2004 $1,941.8 874.8 469.5 $1,741.3 808.3 431.3 $1,208.3 366.0 326.7 $1,020.8 317.9 212.4 $ 893.1 283.9 182.3 $ 619.2 96.4 148.1 $2,408.6 1,695.4 290.5 $2,430.9 1,824.4 310.6 $3,286.1 $2,980.9 $1,901.0 Americas Europe Asia Paciﬁc Net sales Inventory step-up Acquisition and integration In-process research and development Global operations and corporate functions Operating proﬁt Total assets U.S. sales were $1,845.6 million, $1,664.5 million and $1,152.0 million for the years ended December 31, 2005, 2004 and 2003, respectively. Sales to any individual country outside of the U.S. were not signiﬁcant. Sales are attributable to a country based upon the customer’s country of domicile. Net sales by product category are as follows (in millions): 2005 2004 2003 Reconstructive implants Knees Hips Dental Extremeties Total Trauma Spine Orthopaedic surgical products $1,366.2 1,140.6 148.1 66.1 $1,194.5 1,079.0 124.7 58.1 $ 800.6 645.5 29.8 45.1 2,721.0 2,456.3 1,521.0 179.8 160.4 224.9 172.9 134.2 217.5 150.1 35.1 194.8 Total $3,286.1 $2,980.9 $1,901.0 58 (5.0) (59.4) (42.7) (56.6) – (434.5) (81.1) – (455.6) (79.6) (11.2) (279.5) $1,055.0 $ 763.2 $ 450.7 1,327.4 1,129.6 $5,721.9 $5,695.5 Long-lived tangible assets as of December 31, 2005 and 2004 are as follows: Americas Europe Asia Paciﬁc 2005 2004 $501.3 172.9 34.6 $416.8 170.9 40.8 $708.8 $628.5 The Americas long-lived tangible assets are located primarily in the U.S. Approximately $143.9 million of Europe long-lived tangible assets are located in Switzerland. Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) Capital expenditures by operating segment for the years ended December 31, 2005, 2004 and 2003 were as follows (in millions): Americas Additions to instruments Additions to other property, plant and equipment Europe Additions to instruments Additions to other property, plant and equipment Asia Paciﬁc Additions to instruments Additions to other property, plant and equipment Global operations and corporate functions Additions to instruments Additions to other property, plant 2005 2004 2003 $ – $ – $ 1.5 0.7 8.3 0.3 14.0 20.0 24.4 2.4 1.0 1.4 3.2 0.8 4.0 5.4 1.0 3.5 139.3 124.2 107.1 and equipment For segment reporting purposes, deployed instruments 72.9 83.6 35.2 are included in the measurement of operating segment assets while undeployed instruments at U.S. and Puerto Rico based manufacturing operations and logistics are included in global operations and corporate functions. The majority of instruments are purchased by U.S. and Puerto Rico based manufacturing operations and logistics and are deployed to the operating segments as needed for the business. Depreciation and amortization used in determining operating segment proﬁt for the years ended December 31, 2005, 2004 and 2003 was as follows (in millions): Americas Europe Asia Paciﬁc Global operations and corporate functions 2005 2004 2003 $ 51.0 40.8 14.8 $ 45.9 45.5 12.3 $ 36.8 23.4 16.8 79.1 77.6 26.3 $185.7 $181.3 $103.3 The increase in deprecation and amortization in 2004 from 2003 was primarily caused by a full year of depreciation and amortization on Centerpulse acquired assets in 2004 versus one quarter of depreciation and amortization in 2003. 15. LEASES Future minimum rental commitments under non- cancelable operating leases in effect as of December 31, 2005 were $26.8 million for 2006, $20.9 million for 2007, $18.2 million for 2008, $11.1 million for 2009, $9.9 million for 2010 and $25.4 million thereafter. Total rent expense for the years ended December 31, 2005, 2004 and 2003 aggregated $27.9 million, $24.2 million and $15.7 million, respectively. 16. COMMITMENTS AND CONTINGENCIES As a result of the Centerpulse transaction, we acquired the entity involved in Centerpulse’s hip and knee implant litigation matter. The litigation was a result of a voluntary recall of certain hip and knee implants manufactured and sold by Centerpulse. On March 13, 2002, a U.S. Class Action Settlement Agreement (‘‘Settlement Agreement’’) was entered into by Centerpulse that resolved U.S. claims related to the affected products and a settlement trust (‘‘Settlement Trust’’) was established and funded for the most part by Centerpulse. The court approved the settlement arrangement on May 8, 2002. Under the terms of the Settlement Agreement, we will reimburse the Settlement Trust a speciﬁed amount for each revision surgery over 4,000 and revisions on reprocessed shells over 64. As of February 14, 2006, the claims administrator has received 4,135 likely valid claims for hips (cut-off date June 5, 2003) and knees (cut-off date November 17, 2003) and 201 claims for reprocessed shells (cut-off date September 8, 2004). We believe the litigation liability recorded as of December 31, 2005 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. On July 25, 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. On March 31, 2005, we received a subpoena from the United States Department of Justice through the United States Attorney’s Ofﬁce in Newark, New Jersey, requesting that we produce documents for the period beginning January 2002 through March 2005 pertaining to consulting contracts, professional service agreements and other agreements by which we may provide remuneration to orthopaedic surgeons. We have produced documents in response to the subpoena. We are cooperating fully with federal authorities with regard to this matter. We understand that similar inquiries were 59 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Notes to Consolidated Financial Statements (Continued) directed to at least four other companies in the orthopaedics industry. 17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (in millions, except per share data) Net sales Gross proﬁt Net earnings Net earnings per common share Basic Diluted 2005 Quarter Ended 2004 Quarter Ended Mar Jun Sep Dec Mar Jun Sep Dec $828.5 638.2 173.6 $846.8 658.0 190.7 $762.5 588.0 168.6 $848.3 662.5 199.6 $742.2 522.7 97.6 $737.4 535.5 116.3 $700.2 531.1 127.9 $801.1 611.7 200.0 0.71 0.70 0.77 0.76 0.68 0.67 0.81 0.80 0.40 0.40 0.48 0.47 0.52 0.52 0.82 0.81 60 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None ITEM 9A. Controls and Procedures We have established disclosure controls and procedures Based on their evaluation, our principal executive ofﬁcer and internal controls over ﬁnancial reporting to provide reasonable assurance that material information relating to us, including our consolidated subsidiaries, is made known on a timely basis to management and the Board of Directors. However, any control system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the control system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. and principal ﬁnancial ofﬁcer have concluded that our disclosure controls and procedures as of the end of the period covered by this report are effective. Management’s report on internal control over ﬁnancial reporting appears in this report at the conclusion of Item 7A. There was no change in our internal control over ﬁnancial reporting (as deﬁned in Rule 13a-15(f)) that occurred during the fourth quarter of 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over ﬁnancial reporting. ITEM 9B. Other Information During the fourth quarter of 2005, the Audit Committee of the Board of Directors did not approve the engagement of PricewaterhouseCoopers LLP, our independent registered public accounting ﬁrm, to perform any non-audit services. This disclosure is made pursuant to Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002. The Zimmer Holdings, Inc. Employee Stock Purchase Plan was amended effective January 1, 2006. A copy of the plan as amended is being ﬁled with the Securities and Exchange Commission as Exhibit 99.2 to this report. 61 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K PART III ITEM 10. Directors and Executive Ofﬁcers of the Registrant The information required by this Item concerning our directors and executive ofﬁcers is incorporated herein by reference from our deﬁnitive Proxy Statement for our 2006 Annual Meeting of Stockholders which will be ﬁled with the Commission pursuant to Regulation 14A within 120 days after the end of our most recent ﬁscal year and the information included under the caption ‘‘Executive Ofﬁcers’’ in Part I of this report. ITEM 11. Executive Compensation The information required by this Item concerning remuneration of our ofﬁcers and directors and information concerning material transactions involving such ofﬁcers and directors is incorporated herein by reference from our deﬁnitive Proxy Statement for our 2006 Annual Meeting of Stockholders which will be ﬁled with the Commission pursuant to Regulation 14A within 120 days after the end of our most recent ﬁscal year. ITEM 12. Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters The information required by this Item concerning the stock ownership of management and ﬁve percent beneﬁcial owners and related stockholder matters, including equity compensation plan information, is incorporated herein by reference from our deﬁnitive Proxy Statement for our 2006 Annual Meeting of Stockholders which will be ﬁled with the Commission pursuant to Regulation 14A within 120 days after the end of our most recent ﬁscal year. ITEM 13. Certain Relationships and Related Transactions The information required by this Item concerning certain relationships and related transactions is incorporated herein by reference from our deﬁnitive Proxy Statement for our 2006 Annual Meeting of Stockholders which will be ﬁled with the Commission pursuant to Regulation 14A within 120 days after the end of our most recent ﬁscal year. ITEM 14. Principal Accounting Fees and Services The information required by this Item concerning principal accounting fees and services is incorporated herein by reference from our deﬁnitive Proxy Statement for our 2006 Annual Meeting of Stockholders which will be ﬁled with the Commission pursuant to Regulation 14A within 120 days after the end of our most recent ﬁscal year. 62 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K PART IV ITEM 15. Exhibits and Financial Statement Schedules (a) 1. Financial Statements The following consolidated ﬁnancial statements of Zimmer Holdings, Inc. and its subsidiaries are set forth in Part II, Item 8. Report of Independent Registered Public Accounting Firm Consolidated Statements of Earnings for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Balance Sheets as of December 31, 2005 and 2004 Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003 Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2005, 2004 and 2003 Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule II. Valuation and Qualifying Accounts Other ﬁnancial statement schedules are omitted because they are not applicable or the required information is shown in the ﬁnancial statements or the notes thereto. 3. Exhibits A list of exhibits required to be ﬁled as part of this report is set forth in the Index to Exhibits, which immediately precedes such exhibits, and is incorporated herein by reference. 63 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ZIMMER HOLDINGS, INC. By: /s/ J. RAYMOND ELLIOTT J. Raymond Elliott Chairman of the Board President and Chief Executive Ofﬁcer Dated: March 1, 2006 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ J. RAYMOND ELLIOTT J. Raymond Elliott Chairman of the Board, President, Chief Executive Ofﬁcer and Director (Principal Executive Ofﬁcer) March 1, 2006 /s/ SAM R. LENO Sam R. Leno /s/ JAMES T. CRINES James T. Crines Executive Vice President, Finance and Corporate Services and Chief Financial Ofﬁcer (Principal Financial Ofﬁcer) Senior Vice President, Finance, Operations and Corporate Controller and Chief Accounting Ofﬁcer (Principal Accounting Ofﬁcer) March 1, 2006 March 1, 2006 /s/ STUART M. ESSIG Director March 1, 2006 Stuart M. Essig /s/ LARRY C. GLASSCOCK Director March 1, 2006 Larry C. Glasscock /s/ JOHN L. MCGOLDRICK Director March 1, 2006 John L. McGoldrick /s/ AUGUSTUS A. WHITE, III Director March 1, 2006 Augustus A. White, III 64 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Index to Exhibits Exhibit No Description 3.1 3.2 3.3 4.1 10.1* 10.2* 10.3* 10.4* 10.5* 10.6* 10.7* 10.8* 10.9* 10.10* 10.11* 10.12* 10.13* 10.14* 10.15* 10.16* 10.17* 10.18* 10.19* Restated Certiﬁcate of Incorporation of Zimmer Holdings, Inc. (incorporated herein by reference to Exhibit 3.1 to Current Report on Form 8-K dated November 13, 2001) Certiﬁcate of Designations of Series A Participating Cumulative Preferred Stock of Zimmer Holdings, Inc., dated as of August 6, 2001 (incorporated herein by reference to Exhibit 3.2 to Current Report on Form 8-K dated November 13, 2001) Restated By-Laws of Zimmer Holdings, Inc., together with Amendment No. 1 to the Restated By-Laws of Zimmer Holdings, Inc. (incorporated herein by reference to Exhibit 3 to Quarterly Report on Form 10-Q dated November 14, 2003) Specimen Common Stock certiﬁcate (incorporated herein by reference to Exhibit 4.3 to Registration Statement on Form S-8 ﬁled January 20, 2006) Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated herein by reference to Appendix B to the Registrant’s deﬁnitive Proxy Statement on Schedule 14A dated March 24, 2003) First Amendment to the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K ﬁled December 15, 2005) Zimmer Holdings, Inc. Executive Performance Incentive Plan, effective August 6, 2001 (incorporated herein by reference to Appendix C to the Registrant’s deﬁnitive Proxy Statement on Schedule 14A dated March 24, 2003) Zimmer Holdings, Inc. Supplemental Performance Incentive Plan (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q dated August 5, 2004) Zimmer Holdings, Inc. Stock Plan for Non-Employee Directors, effective August 6, 2001 (incorporated by reference to Exhibit 10.6 to Current Report on Form 8-K dated August 6, 2001) First Amendment to the Zimmer Holdings, Inc. Stock Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.3 to Current Report on Form 8-K ﬁled December 15, 2005) Restated Zimmer Holdings, Inc. Deferred Compensation Plan for Non-Employee Directors, effective January 1, 2005 (incorporated herein by reference to Exhibit 10.2 to Current Report on Form 8-K ﬁled December 15, 2005) Zimmer Holdings, Inc. Long-Term Disability Income Plan for Highly Compensated Employees (incorporated herein by reference to Exhibit 10.15 to Current Report on Form 8-K dated November 13, 2001) Change in Control Severance Agreement with J. Raymond Elliott (incorporated herein by reference to Exhibit 10.2 to Quarterly Report on Form 10-Q dated May 8, 2002) Change in Control Severance Agreement with Sam R. Leno, Bruno A. Melzi and David C. Dvorak (incorporated herein by reference to Exhibit 10.3 to Quarterly Report on Form 10-Q dated May 8, 2002) Change in Control Severance Agreement with James T. Crines (incorporated herein by reference to Exhibit 10.4 to Quarterly Report on Form 10-Q dated May 8, 2002) Change in Control Severance Agreement with Sheryl L. Conley (incorporated herein by reference to Exhibit 10.2 to Quarterly Report on Form 10-Q dated August 8, 2003) Change in Control Severance Agreement with Jon E. Kramer (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q dated November 8, 2004) Change in Control Severance Agreement with Richard Fritschi (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q dated November 8, 2004) Employment Contract with Richard Fritschi (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q dated November 8, 2004) Conﬁdentiality, Non-Competition and Non-Solicitation Employment Agreement with Richard Fritschi (incorporated by reference to Exhibit 10.4 to the Registrant’s Quarterly Report on Form 10-Q dated November 8, 2004) Change in Control Severance Agreement with Cheryl R. Blanchard (incorporated by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q dated August 9, 2005) Change in Control Severance Agreement with Stephen Hong Liang Ooi (incorporated by reference to Exhibit 10.21 to the Registrant’s Annual Report on Form 10-K ﬁled March 12, 2003) Beneﬁt Equalization Plan of Zimmer Holdings, Inc. and Its Subsidiary or Afﬁliated Corporations Participating in the Zimmer Holdings, Inc. Savings and Investment Program (incorporated by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q dated August 9, 2005) 65 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Index to Exhibits (Continued) Exhibit No Description 2 0 0 5 F O R M 1 0 - K 10.20* 10.21* 10.22* 10.23* 10.24* 10.25* 10.26* 10.27* 10.28* Beneﬁt Equalization Plan of Zimmer Holdings, Inc. and Its Subsidiary or Afﬁliated Corporations Participating in the Zimmer Holdings, Inc. Retirement Income Plan or the Zimmer Puerto Rico Retirement Income Plan (incorporated by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q dated August 9, 2005) First Amendment of Beneﬁt Equalization Plan of Zimmer Holdings, Inc. and Its Subsidiary or Afﬁliate Corporations Participating in the Zimmer Holdings, Inc. Retirement Income Plan or the Zimmer Puerto Rico Retirement Income Plan (incorporated by reference to Exhibit 10.4 to the Registrant’s Quarterly Report on Form 10-Q dated August 9, 2005) Form of Nonqualiﬁed Stock Option Award Letter under the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to Current Report on Form 8-K dated January 11, 2006) Form of Restricted Stock Award Letter under the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K dated January 12, 2005) Form of Nonqualiﬁed Performance-Conditioned Stock Option Grant Award Letter under the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K ﬁled January 21, 2005) Form of Performance Share Award Letter under the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K dated January 11, 2006) Form of Performance Share Award Letter under the Zimmer Holdings, Inc. 2001 Stock Incentive Plan (for Non-U.S. employees) (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K dated January 11, 2006) Form of Nonqualiﬁed Stock Option Award Letter under the Zimmer Holdings, Inc. Stock Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K ﬁled April 5, 2005) Form of Restricted Stock Unit Award Letter under the Zimmer Holdings, Inc. Stock Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K ﬁled February 21, 2006) 10.29* Summary Compensation Sheet 10.30 10.31 21 23 31.1 31.2 32 99.1 99.2 $1,350,000,000 Amended and Restated Credit Agreement dated as of March 31, 2005 among Zimmer Holdings, Inc., Zimmer, Inc., Zimmer K.K., Zimmer Ltd., Zimmer Switzerland Holdings Ltd., Zimmer Investment Luxembourg S.C.A., Zimmer GmbH, the borrowing subsidiaries, the subsidiary guarantors, the lenders named therein, JPMorgan Chase Bank, N.A., as general administrative agent, JPMorgan Chase Bank, N.A., Tokyo Branch, as Japanese Administrative Agent, and J.P. Morgan Europe Limited, as European Administrative Agent (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K ﬁled April 5, 2005) Amendment No. 1 dated as of April 15, 2005 to the Amended and Restated Credit Agreement dated as of March 31, 2005 among Zimmer Holdings, Inc., Zimmer, Inc., Zimmer K.K., Zimmer Ltd., Zimmer Switzerland Holdings Ltd., Zimmer Investment Luxembourg S.C.A., Zimmer GmbH, the borrowing subsidiaries, the subsidiary guarantors, the lenders named therein, JPMorgan Chase Bank, N.A., as general administrative agent, JPMorgan Chase Bank, N.A., Tokyo Branch, as Japanese Administrative Agent, and J.P. Morgan Europe Limited, as European Administrative Agent List of Subsidiaries of Zimmer Holdings, Inc. Consent of PricewaterhouseCoopers LLP Certiﬁcation pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 of the Chief Executive Ofﬁcer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certiﬁcation pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934 of the Chief Financial Ofﬁcer, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certiﬁcation pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Annual CEO Certiﬁcation ﬁled with the New York Stock Exchange on May 13, 2005 Zimmer Holdings, Inc. Employee Stock Purchase Plan (as amended effective January 1, 2006) * indicates management contracts or compensatory plans or arrangements 66 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Valuation and Qualifying Accounts Description Doubtful Accounts: Year Ended December 31, 2003 Year Ended December 31, 2004 Year Ended December 31, 2005 Excess and Obsolete Inventory: Year Ended December 31, 2003 Year Ended December 31, 2004 Year Ended December 31, 2005 Excess and Obsolete Instruments: Year Ended December 31, 2003 Year Ended December 31, 2004 Year Ended December 31, 2005 2 0 0 5 F O R M 1 0 - K Schedule II (in millions) Balance at Beginning of Period $ 7.2 29.5 28.4 $ 45.5 129.1 124.1 $ 7.4 35.7 36.4 Additions Charged (Credited) to Expense Deductions to Reserve Effects of Foreign Currency Acquired Centerpulse Allowances Balance Sheet Reclass* Balance at End of Period $ 2.6 4.9 (2.2) $ (1.5) (7.4) (1.5) $11.6 30.8 21.6 $18.7 1.9 10.0 $(11.7) (14.1) (18.5) $ (1.1) (1.6) (7.8) $1.7 1.4 (1.4) $2.0 2.9 (6.2) $0.5 0.4 (0.9) $ $19.5 – – – – – $ 29.5 28.4 23.3 $81.7 – – $ – (24.6) – $129.1 124.1 121.0 $ $10.2 – – – – – $ 35.7 36.4 37.7 * In 2004, a balance sheet reclassiﬁcation between gross inventory and the reserve for excess and obsolete inventory was recorded which had no effect on the net inventory balance. 67 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Certiﬁcation 2 0 0 5 F O R M 1 0 - K Exhibit 31.1 Certiﬁcation pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, J. Raymond Elliott, certify that: 1. I have reviewed this Annual Report on Form 10-K of Zimmer Holdings, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the ﬁnancial statements, and other ﬁnancial information included in this report, fairly present in all material respects the ﬁnancial condition, results of operations and cash ﬂows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying ofﬁcer and I are responsible for establishing and maintaining disclosure controls and procedures (as deﬁned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over ﬁnancial reporting (as deﬁned in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over ﬁnancial reporting, or caused such internal control over ﬁnancial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over ﬁnancial reporting that occurred during the registrant’s most recent ﬁscal quarter (the registrant’s fourth ﬁscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over ﬁnancial reporting; and 5. The registrant’s other certifying ofﬁcer and I have disclosed, based on our most recent evaluation of internal control over ﬁnancial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors: a. All signiﬁcant deﬁciencies and material weaknesses in the design or operation of internal control over ﬁnancial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report ﬁnancial information; and b. Any fraud, whether or not material, that involves management or other employees who have a signiﬁcant role in the registrant’s internal control over ﬁnancial reporting. Date: March 1, 2006 J. Raymond Elliott Chairman, President and Chief Executive Ofﬁcer 68 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Certiﬁcation 2 0 0 5 F O R M 1 0 - K Exhibit 31.2 Certiﬁcation pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Sam R. Leno, certify that: 1. I have reviewed this Annual Report on Form 10-K of Zimmer Holdings, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the ﬁnancial statements, and other ﬁnancial information included in this report, fairly present in all material respects the ﬁnancial condition, results of operations and cash ﬂows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying ofﬁcer and I are responsible for establishing and maintaining disclosure controls and procedures (as deﬁned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over ﬁnancial reporting (as deﬁned in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b. Designed such internal control over ﬁnancial reporting, or caused such internal control over ﬁnancial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles; c. Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d. Disclosed in this report any change in the registrant’s internal control over ﬁnancial reporting that occurred during the registrant’s most recent ﬁscal quarter (the registrant’s fourth ﬁscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over ﬁnancial reporting; and 5. The registrant’s other certifying ofﬁcer and I have disclosed, based on our most recent evaluation of internal control over ﬁnancial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors: a. All signiﬁcant deﬁciencies and material weaknesses in the design or operation of internal control over ﬁnancial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report ﬁnancial information; and b. Any fraud, whether or not material, that involves management or other employees who have a signiﬁcant role in the registrant’s internal control over ﬁnancial reporting. Date: March 1, 2006 Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Ofﬁcer 69 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Certiﬁcation Certiﬁcation pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 2 0 0 5 F O R M 1 0 - K Exhibit 32 In connection with the Annual Report of Zimmer Holdings, Inc. (the ‘‘Company’’) on Form 10-K for the period ending December 31, 2005 as ﬁled with the Securities and Exchange Commission on the date hereof (the ‘‘Report’’), each of the undersigned certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the ﬁnancial condition and results of operations of the Company. J. Raymond Elliott Chairman, President and Chief Executive Ofﬁcer March 1, 2006 Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Ofﬁcer March 1, 2006 70 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S Certiﬁcation Annual CEO Certiﬁcation (Section 303A.12(a)) 2 0 0 5 F O R M 1 0 - K Exhibit 99.1 As the Chief Executive Ofﬁcer of Zimmer Holdings, Inc. (‘‘Company’’), and as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual, I hereby certify that as of the date hereof I am not aware of any violation by the Company of NYSE’s Corporate Governance listing standards, other than has been notiﬁed to the Exchange pursuant to Section 303A.12(b) and disclosed as Exhibit H to the Company’s Section 303A Annual Written Afﬁrmation. By: /s/ J. RAYMOND ELLIOTT Print Name: J. Raymond Elliott Title: Chairman, President and Chief Executive Ofﬁcer Date: May 13, 2005 71 Z I M M E R H O L D I N G S , I N C . A N D S U B S I D I A R I E S 2 0 0 5 F O R M 1 0 - K Reconciliations of Non-GAAP Financial Measures Reconciliation of Operating Proﬁt to Adjusted Operating Proﬁt for the Years Ended December 31, 2005, 2004 and 2003 Reconciliation of Cash and Net Cash as of December 31, 2005 Operating Proﬁt Acquisition, integration and other Inventory step-up In-process research and development (in millions, unaudited) For the Years Ended December 31, 2005 2004 2003 $1,055.0 56.6 5.0 — $763.2 81.1 59.4 — $450.7 79.6 42.7 11.2 (in millions, unaudited) Cash and equivalents Restricted cash Total cash Long-term debt Adjusted Operating Proﬁt $1,116.6 $903.7 $584.2 Net cash Reconciliation of Diluted EPS to Adjusted Diluted EPS for the Years Ended December 31, 2005, 2004 and 2003 (unaudited) For the Years Ended December 31, Diluted EPS Acquisition, integration and other Inventory step-up In-process research and development Tax beneﬁt of acquisition, integration and other, inventory step-up and in-process research and development Tax beneﬁt from decreased deferred taxes of acquired Centerpulse operations; due to Swiss tax rate reduction Cumulative effect of change in accounting principle, net of tax Adjusted Diluted EPS 2005 $ 2.93 0.23 0.02 — (0.08) — — $ 3.10 2004 $ 2.19 0.32 0.24 — (0.20) (0.14) — $ 2.41 December 31, 2005 $233.2 12.1 245.3 81.6 $163.7 2003 $ 1.64 0.38 0.20 0.05 (0.21) — (0.26) $ 1.80 Reconciliation of Gross Margin to Adjusted Gross Margin for the Quarters Ending Between December 31, 2003 through September 30, 2005* Gross Margin % Inventory step-up % Adjusted Gross Margin % 2003 Q4 68.1 6.0 74.1 (unaudited) 2004 Q1 70.4 4.2 74.6 Q2 72.6 2.5 75.1 Q3 75.8 1.0 76.8 Q4 76.4 0.4 76.8 Q1 77.0 0.3 77.3 2005 Q2 77.7 0.3 78.0 Q3 77.1 0.1 77.2 * For quarters prior to December 31, 2003 and after September 30, 2005, no reconciliation has been provided, as reported and adjusted gross margins are equal. Reconciliation of Effective Tax Rate to Adjusted Effective Tax Rate for the Years Ended December 31, 2005 and 2004 Effective tax rate Impact of acquisition, integration and other Impact of inventory step-up Impact of decreased deferred taxes of acquired Centerpulse operations; due to Swiss tax rate reduction Adjusted effective tax rate (in millions, unaudited) For the Years Ended December 31, 2005 29.5% 0.1 — — 29.6% 2004 25.9% 0.6 0.3 4.7 31.5% 72 COMMITTED TO GENDER SOLUTIONS Zimmer’s innovative investments in recent history have resulted in numerous industry firsts. Our newest is the introduction of Gender SolutionsTM Knee Implants. 2006 2004 ST knee implants designed to 1 accommodate the unique anatomic features of women, Gender Solutions(1) ST Zimmer MIS TM Quad-SparingTM 1 Total Knee Arthroplasty procedure(2) ST highly crosslinked polyethylene 1 knee inserts with resistance to delamination, ProlongTM ST Zimmer MIS 2-IncisionTM Total Hip 1 Arthroplasty procedure(3) 2001 1997 ST high flexion knee in the U.S. and 1 Europe, NexGen® LPS-Flex 2000 1996 ST highly crosslinked polyethylene 1 hip liners resistant to wear and aging, Durasul® ST metal material combining high 1 porosity, structural integrity and flexibility, Trabecular Metal TM ST pedicle screw-based stabilization 1 system for the spine using flexible materials, Dynesys®(4) ST clinically proven composite 1 hip stem, Epoch® As women currently receive nearly 60 percent of all total knee arthroplasties (TKAs), a knee implant designed specifically with a woman’s unique needs in mind is a logical development. With the addition of Gender Solutions to our knee portfolio, Zimmer is planning to offer implants that are uniquely designed for women. Key characteristics common to a woman’s anatomy found in the Gender Solutions Knee Implants include: • A narrower femoral component designed to more closely match the distinctive shape of a woman’s femoral anatomy • A less prominent anterior surface of the femur • A modified femoral groove for the kneecap to move during knee flexion ON THE FRONT COVER: Zimmer’s commitment to improving the quality of life for patients includes recognizing the differ- ences between women and men in the design of our implants. A woman’s knee anatomy is quite distinguishable from a man’s. Distinctive features, to name a few, include a difference in the ratio between the width and height of the thigh bone as com- pared to men, Q-angle differences due to a wider pelvis, less pronounced bony anatomy on the anterior (front) surface of their thigh bone and greater ligament laxity. These differences have been studied and considered in the design of our new Gender Solutions Knee Implants. 2002 1998 1994 CORPORATE INFORMATION BOARD OF DIRECTORS J. Raymond Elliott Chairman, President and Chief Executive Officer Zimmer Holdings, Inc. Stuart M. Essig President and Chief Executive Officer Integra LifeSciences Holdings Corporation Larry C. Glasscock Chairman, President and Chief Executive Officer WellPoint, Inc. John L. McGoldrick Executive Vice President Bristol-Myers Squibb Company Augustus A. White, III, M.D., Ph.D. Ellen and Melvin Gordon Professor of Medical Education, Professor of Orthopaedic Surgery, Master, Oliver Wendell Holmes Society, Harvard Medical School OFFICERS AND KEY MANAGEMENT J. Raymond Elliott Chairman, President and Chief Executive Officer Cheryl R. Blanchard, Ph.D. Senior Vice President, Research and Development and Chief Scientific Officer Sheryl L. Conley Group President, Americas and Global Marketing and Chief Marketing Officer James T. Crines Senior Vice President, Finance, Operations and Corporate Controller and Chief Accounting Officer David C. Dvorak Group President, Global Businesses and Chief Legal Officer Jon E. Kramer President, U.S. Sales STOCKHOLDER INFORMATION Headquarters Zimmer Holdings, Inc. 345 East Main Street Warsaw, IN 46580, USA +1-574-267-6131 www.zimmer.com Stock Listing Zimmer is listed on the New York Stock Exchange and the SWX Swiss Exchange under the symbol ZMH. Transfer Agent Communications concerning stock transfer requirements, loss of certificates and change of address should be directed to Zimmer’s Transfer Agent: The Bank of New York P.O. Box 11258 New York, NY 10286, USA +1-888-552-8493 (Domestic) +1-610-382-7833 (International) shareowner-svcs@bankofny.com www.stockbny.com Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Officer Bruno A. Melzi Chairman, Europe, Middle East and Africa Laura C. O’Donnell Chief Compliance Officer Stephen H. L. Ooi President, Asia Pacific Investor Relations Zimmer invites stockholders, security analysts, portfolio managers and other interested parties to contact: Marc S. Ostermann Manager, Investor Relations +1-574-371-8515 marc.ostermann@zimmer.com Sam R. Leno Executive Vice President, Finance and Corporate Services and Chief Financial Officer +1-574-372-4790 sam.leno@zimmer.com CORPORATE GOVERNANCE ISS Corporate Governance Quotient* (CGQ®) Index Ranking: 81.6 Industry Ranking: 98.2 Zimmer Holdings, Inc. outperformed 81.6 percent of the companies in the S&P 500 Index and 98.2 percent of the companies in the health care equipment and services group as of February 8, 2006. Chad F. Phipps Associate General Counsel and Secretary Renee P. Rogers, Ph.D. Vice President, Global Human Resources James P. Simpson Senior Vice President, Health Economics and Government Affairs Richard C. Stair Vice President, Global Operations and Logistics To obtain a free copy of Zimmer’s annual report including form 10-K, quarterly reports on form 10-Q, news releases, earnings releases, proxy statements, or to obtain Zimmer’s financial calendar, access SEC filings, listen to earnings calls, or to look up Zimmer stock quotes, please visit investor.zimmer.com or call +1-866-688-7656. Independent Auditors PricewaterhouseCoopers LLP Chicago, IL, USA (1) Pending 510(k) clearance (2) Tria AJ, Coon TM. Quadriceps Sparing Total Knee Arthroplasty. Sem Arthroplasty. 2005; 16:208-214 (3) Berger RA, Jacobs JJ, Meneghini RM, Della Valle C, Paprosky W, Rosenberg AG. Rapid rehabilitation and recovery with minimally invasive total hip arthroplasty. Clin Orthop. 2004; 429:239-247. (4) Cleared in the U.S. as an adjunct to fusion. * Trademark of Institutional Shareholder Services, Inc. Originally introduced in 2002, the ISS Corporate Governance Quotient (CGQ®) is a dynamic corporate governance rating tool that is designed to help investors manage investment risk and drive value while also helping corporations perform peer analysis and benchmark their corporate governance practices. “Pending clearance of our submitted 510(k), Zimmer will be the first orthopaedic company to offer implants designed specifically for women. The new Gender Solutions Knee Implants incorporate novel features designed to address the unique characteristics of a woman’s knee. These designs are based on Zimmer’s more than 20 years of clinical success in total knee replacement and the analyses of unique bone morphology atlases. It is built upon Zimmer’s platform of knees that accommodate high flexion for today’s active patient and can be used with Zimmer MIS Procedures.” RAY ELLIOTT, Chairman, President & CEO of Zimmer Holdings, Inc. COMMITTED TO THE CORE ZIMMER HOLDINGS, INC. 345 East Main Street P.O. Box 708 Warsaw, IN 46580, U.S.A. www.zimmer.com Z I M M E R H O L D I N GS, I N C. | 2 0 0 5 A N N U A L R E P O RT

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