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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

Commission File Number 001-16407

ZIMMER HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

345 East Main Street, Warsaw, IN 46580
(Address of principal executive offices)
Telephone: (574) 267-6131

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  

At October 31, 2002, there were 195,037,478 shares outstanding of the Registrant’s $.01 par value Common Stock.

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ZIMMER HOLDINGS, INC.

INDEX TO FORM 10-Q

September 30, 2002

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Part I – Financial Information

Item 1. Financial Statements

ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(unaudited, in millions, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in millions, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in millions)

The accompanying notes are an integral part of these consolidated financial statements.

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ZIMMER HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

     The financial data presented herein is unaudited and should be read in conjunction with the consolidated financial statements and accompanying notes as of and for the three years ended December 31, 2001 included in the annual report on Form 10-K filed by Zimmer Holdings, Inc. (together with all its subsidiaries, the “Company”). In the opinion of management, the accompanying unaudited consolidated financial statements include all adjustments necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods presented. Results for interim periods should not be considered indicative of results for the full year. Certain amounts in the three and nine months ended September 30, 2001 have been reclassified to conform to current year presentation.

     The accompanying consolidated financial statements represent the Company’s consolidated operations as a public company commencing on August 6, 2001, combined with the operations of Zimmer as a division of Bristol-Myers Squibb Company (“Bristol-Myers Squibb”) prior to becoming a public company. For periods prior to August 6, 2001, intercompany accounts with Bristol-Myers Squibb, other than specific outstanding obligations, were combined with invested capital and reported in the consolidated financial statements as net investment in Zimmer.

2. Comprehensive Income

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

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3. Earnings Per Share

     For periods ended August 6, 2001 and prior, basic and diluted earnings per share are computed using the number of shares of Company common stock outstanding on August 6, 2001, the date all of the shares of Company common stock were distributed to the shareholders of Bristol-Myers Squibb. On the distribution date, outstanding Bristol-Myers Squibb stock options and restricted stock held by Company employees were converted into Company stock options and restricted stock. For periods subsequent to August 6, 2001, any new issuances of common stock are reflected in basic and diluted earnings per share and the dilutive effect of outstanding stock options and restricted stock has been reflected in diluted earnings per share. For the quarter ended September 30, 2002, there were approximately 0.1 million common shares that were not included in the computation of diluted earnings per share since they were anti-dilutive. The following table reconciles the diluted shares used in computing diluted earnings per share:

4. Inventories

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5. Property, Plant and Equipment

6. Financial Instruments

     The Company is exposed to market risk due to changes in currency exchange rates. As a result, the Company utilizes foreign exchange forward contracts to offset the effect of exchange rate fluctuations on certain anticipated foreign currency transactions, primarily intercompany sales expected to occur up to twenty-four months in the future. The Company does not hold financial instruments for trading or speculative purposes. For derivatives which qualify as hedges of future cash flows, the effective portion of changes in fair value is temporarily recorded in other comprehensive income, then recognized in earnings when the hedged item affects earnings. The ineffective portion of a derivative’s change in fair value, if any, is reported in earnings. The fair value of derivative instruments recorded on the balance sheet at September 30, 2002 was an unrealized net loss of $6.0 million, or $3.7 million, net of taxes, which is deferred in other comprehensive income and is expected to be reclassified to earnings over the next twenty-four months.

7. Segment Information

     The Company designs, develops, manufactures and markets orthopaedic reconstructive implants, fracture management products, and other products used for orthopaedic and general surgery. Operations are managed through three major geographic areas — the Americas, which is comprised principally of the United States and includes other North, Central and South American markets; Asia Pacific, which is comprised primarily of Japan and includes other Asian and Pacific markets; and Europe, which is comprised principally of Europe and includes the Middle East and Africa. This structure is the basis for the Company’s reportable segment information discussed below. Segment performance is evaluated based on sales and segment operating profit, exclusive of separation costs reported in 2001, and operating expenses pertaining to global operations and corporate expenses. Included in segment operating profit is a cost of capital charge which is offset in global operations. Global operations include U.S. based research,

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development engineering, brand management, corporate legal, finance, human resource functions and operations and logistics.

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

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

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8. Commitments and Contingencies

     The Company is subject to product liability and other claims arising in the ordinary course of business, for which the Company maintains insurance, subject to self-insured retention limits. The Company establishes 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 these cases will not have a material adverse effect on the consolidated financial position, results of operations or cash flows of the Company.

     In addition to product liability, the Company is subject to various other lawsuits and claims arising in the ordinary course of business, none of which are expected to have, upon ultimate resolution, a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

     Zimmer Holdings, Inc. is a global leader in the design, development, manufacture and marketing of orthopaedic reconstructive implants and fracture management products. Orthopaedic reconstructive implants restore joint function lost due to disease, deformity, or trauma in joints such as knees, hips, shoulders and elbows. Fracture management products are devices used primarily to reattach or stabilize damaged bone and tissue to support the body’s natural healing process. The Company also manufactures and markets other products relating to orthopaedic and general surgery. With operations in 20 countries and products marketed in approximately 70 countries, operations are managed through three geographic regions – the Americas, Asia Pacific and Europe. As used in this discussion, the “Company” means Zimmer Holdings, Inc. and its subsidiaries.

     For comparison purposes, the unaudited pro forma consolidated statements of earnings for the three and nine months ended September 30, 2001 presented herein, have been prepared giving effect to the exclusion of costs incurred by the Company to separate from its former parent and include interest expense on debt expected to be assumed or incurred at the distribution date as if such debt were outstanding from January 1, 2001, as disclosed in previous filings. The unaudited pro forma consolidated statements of earnings for the three and nine months ended September 30, 2001 have been derived from the unaudited interim consolidated statements of earnings included herein and do not purport to represent what results of operations actually would have been or to project financial performance for any future periods. The pro forma consolidated statements of earnings reflect all adjustments that, in the opinion of management, are necessary to present fairly the pro forma results of operations. This information should be read in conjunction with the historical consolidated statements of earnings and corresponding notes included elsewhere in this report and in the Company’s Form 10-K for the year ended December 31, 2001. The adjustments to the accompanying historical financial information for the three and nine months ended September 30, 2001 are described below:

	(a)		Reflect all costs incurred to date related to the separation of the Company from its former parent. The Company incurred separation costs of $28.7 million and $56.1 million in the three and nine months ended September 30, 2001, respectively, related to the separation.
	(b)		Reflect interest expense related to debt expected to be assumed or incurred under the Company’s $600 million credit facility (“Credit Facility”) for the period January 1 through July 31, 2001. Assumed average borrowings during this period were $450 million at an average interest rate of 5.4 percent and includes amortization of transaction fees.
	(c)		Reflect the tax effect of the pro forma adjustments for separation costs and interest expense using a rate of 24.6 percent and 23.8 percent for the three and nine months ended September 30, 2001, respectively, incorporating the non-deductibility of certain separation costs.

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Third Quarter Results of Operations

     The following table sets forth the consolidated results of operations for the three-months ended September 30, 2002 and the as reported and pro forma results of operations for the three-months ended September 30, 2001. The pro forma amounts exclude the effect of costs incurred to separate from the Company’s former parent and include a full quarter of interest expense:

(unaudited, in millions, except per share amounts)

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     Net Sales

     Net sales for the three-month period ended September 30, 2002 increased 18 percent to $337.5 million from $286.7 million for the comparable 2001 period. Sales growth reflected the continued strong demand for reconstructive implants and outstanding results in the Americas and Europe segments. This increase was comprised of a 12 percent increase due to incremental volume and changes in the mix of product sales, a 4 percent increase due to higher average selling prices and a 2 percent increase due to foreign exchange rate fluctuations.

     The following tables set forth net sales by geographic region and product category for the three-months ended September 30, 2002 and 2001 (unaudited, in millions):

Net Sales by Geographic Region

Net Sales by Product Category

     Net sales in the Americas increased 17 percent to $230.7 million in the three-months ended September 30, 2002 compared to the same period in 2001. This increase was comprised of a 12 percent increase due to incremental volume and changes in the mix of product sales, together with a 5 percent increase due to higher average selling prices. Knee sales increased 22 percent led by growth in sales of the NexGen® Legacy® Posterior Stabilized knee, including the Flex knee, the NexGen Cruciate Retaining knee and the M/G™ Unicompartmental Knee, now featuring Minimally Invasive Solutions ™ (“MIS”) Instrumentation. Hip sales increased 16 percent, driven by continued conversion to VerSys® porous hip stems, Trabecular Metal acetabular cups and increased sales of Trilogy® Acetabular System cups incorporating Longevity® Crosslinked Polyethylene Liners. Fracture management product sales increased 13 percent in the quarter in large part due to increased sales of the Zimmer® Periarticular Plating

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System, Zimmer Plates and Screws internal fixation devices and TransFx ™** External Fixation Systems.

     Net sales in the Asia Pacific region increased 10 percent to $67.9 million in the three-month period ended September 30, 2002 compared to the same period in 2001. This increase was comprised of a 5 percent increase due to incremental volume and changes in the mix of product sales, a 2 percent increase due to higher average selling prices, and a 3 percent increase due to foreign exchange rate fluctuations. Knee sales increased 11 percent (increased 8 percent constant currency), reflecting continuing strong sales of the NexGen Legacy Posterior Stabilized Flex knee and the M/G Unicompartmental Knee, now featuring MIS Instrumentation. Hip sales increased 19 percent (increased 16 percent constant currency) driven primarily by strong sales of VerSys porous hip stems and sales of Trilogy Acetabular System cups incorporating Longevity Crosslinked Polyethylene Liners. Fracture management product sales decreased 8 percent (decreased 10 percent constant currency) reflecting a decline in M/DN® Intramedullary Fixation and compression hip screws sales, primarily in Japan.

     Net sales in Europe grew 38 percent to $38.9 million in the three-month period ended September 30, 2002 compared to the same period in 2001, driven by higher sales in Austria, Central and Eastern Europe, Finland, France, Germany, Holland, Iceland, Norway, Russia, Spain, Sweden, Switzerland, the United Kingdom and the Middle East and Africa. This increase was comprised of a 24 percent increase due to incremental volume and changes in the mix of product sales, a 2 percent increase due to higher average selling prices and a 12 percent increase due to foreign exchange rate fluctuations. Knee sales increased 39 percent (increased 26 percent constant currency) driven by strong sales of the NexGen Legacy system of knee prosthesis as well as the M/G Unicompartmental Knee with MIS Instrumentation. Hip sales increased 43 percent (increased 31 percent constant currency) supported by increased sales of Trilogy Acetabular System cups incorporating Longevity Crosslinked Polyethylene Liners, the ZMR® Hip System and VerSys porous hip stems.

     Overall, worldwide sales of reconstructive implants grew 21 percent (increased 19 percent constant currency) in the three-month period ended September 30, 2002 to $258.4 million compared to $213.6 million during the 2001 three-month period. Knee sales increased 22 percent (increased 20 percent constant currency) in the three-month period ended September 30, 2002 to $141.9 million compared to $116.0 million during the 2001 three-month period. Hip sales increased 19 percent (increased 17 percent constant currency) in the three-month period ended September 30, 2002 to $108.3 million compared to $90.8 million during the 2001 three-month period. Sales of fracture management products increased 8 percent (increased 7 percent constant currency) over the prior year to $33.9 million. Sales of orthopaedic surgical products increased 8 percent (increased 7 percent constant currency) over the prior year to $45.2 million.

     Gross Profit

     Gross profit as a percentage of net sales was 74.8 percent for the three-month period ended September 30, 2002 compared to 73.8 percent in the comparable 2001 period or 75.1 percent excluding separation costs. The decrease in gross margin is principally due to strong sales growth in Europe at lower gross profit margins and lower yen hedge gains compared to the same period in the prior year. These unfavorable effects were partially offset by the increases in

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average selling prices realized in all segments, the continued conversion from cemented implants to higher margin porous implants, increased penetration of Longevity Highly Crosslinked Polyethylene Liners, further penetration into the revision implant category and the ongoing efforts to reduce manufacturing costs through automation, in-sourcing and process improvements.

     Operating Expenses

     Research and development as a percentage of net sales was 6.1 percent for the three- month period ended September 30, 2002 compared to 6.4 percent for the comparable 2001 period, or 6.0 percent excluding separation costs in 2001. Research and development increased to $20.6 million from $18.3 million, or $17.2 million excluding separation costs in 2001, over the same period last year. Increases in research and development costs kept pace with sales growth, reflecting investments in active and new projects. The Company has many active projects underway focused on areas of strategic significance, including MIS, lifestyle designs, revision implants, innovative materials and biotechnology. Selling, general and administrative expense as a percentage of net sales was 39.6 percent for the three-month period ended September 30, 2002 compared to 49.7 percent for the comparable reported 2001 period or 41.4 percent excluding separation costs in 2001. Excluding separation costs, the improvement in the expense ratio reflects lower selling expenses as a result of lower costs associated with the Company’s U.S. distributor network. This was partially offset by the continued investments in various strategic initiatives including MIS, direct-to-consumer advertising, training and medical education.

     Earnings

     Operating profit for the three-month period ended September 30, 2002 increased 93 percent to $98.1 million from $50.8 million in the comparable 2001 period. Excluding separation costs of $28.7 million during the comparable period in 2001, operating profit increased 23 percent from $79.5 million, due primarily to operating expenses growing at a slower rate than sales, partially offset by lower gross profit margins, as discussed above.

     The effective tax rate on earnings before taxes decreased to 31.5 percent for the three-month period ended September 30, 2002 from 42.7 percent in the same period in 2001. Excluding separation costs and including a full quarter of interest expense, the effective tax rate was 36.1 percent for the comparable period in 2001. The Company is implementing business strategies that result in a reduction of the expected full-year effective tax rate of 34.8 percent at the end of the second quarter to 33.7 percent at the end of the current quarter. Updating the year to date effective tax rate to 33.7 percent results in a third quarter effective tax rate of 31.5 percent, with approximately $2.0 million of the third quarter benefit relating to pretax earnings through June 30, 2002.

     Net earnings increased 138 percent to $65.1 million for the three-month period ended September 30, 2002 compared to $27.4 million in the comparable 2001 period. Basic and diluted earnings per share for the three-month period ended September 30, 2002 increased 136 percent to $0.33 from $0.14 in the comparable 2001 period. Net earnings increased 36 percent from $47.9 million excluding separation costs of $21.5 million last year, net of tax, and including incremental interest expense, net of tax, of $1.0 million for the same period in 2001. Basic and

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diluted earnings per share increased 32 percent from $0.25 for the three-months ended September 30, 2001 as adjusted for separation costs and interest expense.

     Operating Profit by Segment

     The following table sets forth operating profit by segment for the three-months ended September 30, 2002 and 2001:

     Percent of net sales

     Operating profit for the Americas as a percentage of net sales increased to 46.5 percent for the three-month period ended September 30, 2002, as compared with 45.1 percent for the same period in 2001, reflecting the favorable effects of increased sales of higher margin products, higher average selling prices and lower selling expenses as a percent of sales due to lower costs associated with the U.S. distributor network. The increase was partially offset by increases in other selling, general and administrative expenses related to new product launches and investments in MIS initiatives.

     Operating profit for the Asia Pacific region as a percentage of net sales increased to 43.9 percent for the three-month period ended September 30, 2002 as compared with 40.7 percent for the same period in 2001. The increase reflects lower selling, general and administrative expenses as a percent of sales in Japan as a result of a sales force and distribution reorganization, partially offset by lower gross profit margins as a result of lower yen hedge gains compared to the same period in the prior year.

     Operating profit for Europe as a percentage of net sales increased to 16.5 percent for the three-month period ended September 30, 2002 as compared with 10.2 percent for the same period in 2001, due to improved gross profit margins and more moderate growth in selling, general and administrative expenses than sales. Improvement in operating margin was the result of leveraging sales growth in European channels developed by the Company in recent years.

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Nine Months Results of Operations

     The following table sets forth the consolidated results of operations for the nine-months ended September 30, 2002 and the as reported and pro forma results of operations for the nine-months ended September 30, 2001. The pro forma amounts exclude the effect of costs incurred to separate from the Company’s former parent and include a full nine-months of interest expense:

(unaudited, in millions, except per share amounts)