Oct 19, 2010
Executives
Stephen MacMillan – Chairman, President, and CEO Curt Hartman – VP and CFO Katherine Owen – VP of Strategy and IR
Analysts
Rich [ph] – Leerink Swann Bob Hopkins – Bank of America David Lewis – Morgan Stanley Matt Miksic – Piper Jaffray Adam Feinstein – Barclays Capital Steven Lichtman – Oppenheimer Derrick Sung – Sanford Bernstein Raj Denhoy – Jefferies Vivian Cervantes – Maxim Group Joanne Wuensch – BMO Capital Markets Bruce Nudell – UBS Doug Schenkel – Cowen and Company Mike Weinstein – JPMorgan Glenn Novaro – RBC Capital Markets Kristen Stewart – Deutsche Bank Jeff Johnson – Robert Baird Bill Plovanic – Canaccord Charles Chon – Stifel Nicolaus Matthew O’Brien – William Blair Topher Roy [ph] – Goldman Sachs
Operator
Good day, ladies and gentlemen, and welcome to the Q3 2010 Stryker earnings conference call. My name is Jeremy and I’ll be your operator for today.
At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session.
(Operator Instructions). Certain statements made in today’s conference call may constitute forward-looking statements.
They will be based upon management’s current expectations and will be subject to various risks and uncertainties that could cause the company’s actual results to differ materially from those expressed or implied in such statements. For information concerning these risks and uncertainties please see the company’s filings with the United States Securities and Exchange Commission, including the company’s annual report on Form 10-K and quarterly reports on Form 10-Q.
The company does not undertake any obligation to update or revise any of its forward-looking statements. Today’s conference call will also include a discussion of constant currency sales, performance and adjusted diluted net earnings per share.
Further information regarding these non-generally accepted accounting principles financial measures, including generally accepted accounting principles reconciliations appears in the company’s Form 8-K filed today with the SEC. The company’s SEC filings may be accessed from the “For Investors” page on the company’s website at www.stryker.com.
I would now like to turn the conference over to your host for today, Mr. Stephen MacMillan, Chairman, President and CEO.
Please proceed sir.
Stephen MacMillan
Thank you, Jeremy. Good afternoon to everyone and welcome to Stryker’s third quarter 2010 earnings report.
With me today are Curt Hartman, our Vice President and Chief Financial Officer; and Katherine Owen, Vice President of Strategy and Investor Relations. With three quarters of the year now complete, we once again recognized the benefits and strengths of our diversified revenue model.
Following the late 2009 acquisition of Ascent, we now have nine key franchises that span a broad spectrum of the medical technology market. And although at any given point, these businesses are facing different challenges and opportunities.
In totality, our unique footprint has a strong history of affording us with tremendous consistency in our financial results. And with the recent acquisition of Gaymar Industries, our medical division has further expanded its product offering and have strengthened its relevance to customers in the patient handling market.
When we look back to the start of the year, we presented investors with our sales and earnings targets recognizing that some markets would likely outperform our expectations while others would inevitably fall short. Getting here today, our MedSurg franchises continue to post results that are better than we anticipated while recon market growth in the low single digits is at the lower end of anticipated ranges.
It is no secret that the reconstructive implant market is seeing softer procedure growth in continued pricing pressure. Trends that were evident in Q2’s results for the industry and were expected to continue into the third quarter.
Although we are pleased that recon unit and price trends did not materially worsen in Q3. We hope and expect that the combination of our new hip products and the gradual recovery involvements will contribute to an improving market backdrop in the coming quarters.
We are also encouraged that certain regions and divisions that have been underperforming including Europe and spine. Reversed course in Q3 had posted a sequential albeit modest acceleration in sales growth.
All told, even in a period of challenged reconstructive growth, we are still delivering on our financial targets. In totality, our Q3 sales of modestly outperformed our forecasts and combined with continued margin improvement throughout our income statement that generated accelerated earnings growth.
Importantly, as we remain committed to delivering top tier sales growth through innovation, it’s paramount that we make the necessary investments in R&D which increased 18% year-over-year in the quarter on top of a 14% increase in the prior quarter. Year-to-date R&D spending is up to very strong 15%.
This pace of reinvestment is a strong indication of our belief that many opportunities exist across our diverse set of businesses. We also remained steadfast in our focus on enhancing our quality and compliance systems as we embark on year three of the initial three year $200 million investment.
The benefits of these investments are increasingly evident both internally and externally but much work remains to be done. The cultural change that’s taken place at our company around quality and compliance can’t be measured by the resolution of warning letters or the magnitude of dollars invested.
Rather those are data points that validate our efforts and reinforce to all our 19,000 employees around the world that we are and will remain a fundamentally different company in how we think about quality and compliance and what it means to all our customers. Against this backdrop, we are enormously proud of the fact that we haven’t wavered from the targets we offered in January despite continued economic uncertainty that has contributed the pockets of market weakness.
We now look for full year sales in earnings to be towards the high-end of our targeted range, reinforcing the collective strength of our diverse franchises and underscoring the benefits of being a broad based player in the medical technology market. With that I’ll turn the call directly over to Curt.
Curt Hartman
Thanks Steve. Jumping into the third quarter results, we are pleased to report another solid overall company performance.
Sales increased 6.9% on a reported basis and 7% excluding currency. The Ascent acquisition contributed 2.3% to our reported growth rate and for the first nine months has contributed 2.3% to our 9% reported growth.
On the earnings side, another strong gross margin result and disciplined SG&A expense management allowed us to deliver a very respectable performance. We generated adjusted diluted net earnings per share of $0.80, an increase of 15.9% over Q3 2009 results.
On a GAAP basis, diluted net earnings per share were $0.85, an increase of 49% over Q3, 2009. Our reported GAAP earnings include $24.3 million gain, $13.4 million net of tax recorded in SG&A from the sale of our Caen, France facility and a $7.4 million favorable income tax expense adjustment associated with our December 2009 repatriation of foreign earnings.
Additionally, GAAP earnings in the third quarter of 2009 included restructuring charges of $67 million, $48.4 million net of tax. Finally, the balance sheet remains healthy and we again demonstrated solid cash flow generation in the quarter.
Turning to some specifics in the quarter, currency was effectively immaterial with the top line sales in this third quarter. Through the first nine months, currency has increased reported sales by approximately $67 million or 1.4%.
Looking to the fourth quarter, currency moves to a modest headwind and if rates hold near quarter end levels, we would expect the fourth quarter sales impact to be approximately flat to down 1% when compared to 2009. Using quarter end rates, the full year currency impact on top line sales would be an increase in the range of 0.5% to 1% when compared to 2009.
Next I’ll discuss the impact of price and volume mix on the top line. In the quarter, companywide selling prices declined 1.8% on a worldwide basis, down 30 basis points from Q2.
As we’ve stated previously, we are focused on the total company pricing trends which provide a better overall snapshot of how market dynamics are impacting the company. However at the detail level on hip and knee front, we continue to see relatively modest pricing pressure that was not materially different in Q3 from what we saw in either Q2 or Q1.
That same comment also applies to our spine segment recognizing the pricing pressure here is a bit greater than in our recon segment which has been the case for a number of quarters now. The number of selling days was effectively equal with 2009 in most markets.
Looking at the business segments, I’ll start with Orthopedic Implants, which represented 58% of our sales in the quarter. Orthopedic implants today is comprised of our hips, knees, trauma, spine, CMF and other implant segments.
In the quarter, total orthopedic implants recorded a 1% increase in both the reported basis and in constant currency. At the segment level on a worldwide basis, hips reported growth of 2% in dollars and 1% in constant currency.
In the US market, hip sales were up 3% while in international markets, hip sales decreased 1% on a constant currency basis. Finally, while hip sales in Europe were negative, they did improve marginally over Q2.
Our global knee segment, sales were flat on both reported and constant currency basis. US knees reported 2% growth where OUS knees were down 5% on a constant currency basis.
Amidst continued soft results European knee sales recorded their smallest declines on the year. Finally as you recall, we filed the 510(k) for OtisMed.
And while we have been targeting a 2010 approval, at this point in the year a clearance appears more likely to occur in 2011. The global trauma segment was a bit softer in the quarter, recording to 2% increase in dollars and a 4% increase in constant currency.
Our US trauma segment posted a 7% increase while our international trauma sales were up 1% on a constant currency basis. Our global spine segment continued to face challenges in the quarter but edged out a positive gain with a 1% increase on both the reported and constant currency basis.
Our US spine sales were flat versus prior year while our international spine markets delivered constant currency growth of 4% in the quarter. Next, I’ll turn to the MedSurg group which represented 42% of our sales in the quarter.
MedSurg today is comprised of our instruments, endoscopy, medical, and Ascent Healthcare businesses. MedSurg reported another solid growth quarter with sales increasing 16% both as reported and on a constant currency basis.
The Ascent acquisition added 6% to the reported increase, while the core MedSurg business segments delivered 10% reported growth in the quarter. We think that’s an encouraging result, given this is our third consecutive quarter approximately 10% for MedSurg growth.
Sales for the global instruments segment again posted strong results growing 13% in the third quarter on both the reported and constant currency basis. In the US market, the instrument segment reported a healthy 14% gain while internationally instrument sales also increased nicely recording a 11% gain in constant currency.
Our endoscopy segment reported a sales increase of 7% and advanced 8% on a constant currency basis. In the US market, endoscopy sales were steady recording 8% growth.
Internationally, endoscopy sales strengthened sequentially delivering at 6% constant currency gain. Finally, our medical segments saw global sales improve 8% in the quarter on both reported and constant currency basis.
US medical sales increased 8% while our international medical sales increased 6% in constant currency. While the reported sales growth here is below recent quarter results, overall we feel good about the momentum in this business based on order trends and the benefit from the recently completed Gaymar Industries acquisition.
Overall, we’re pleased with the results and trends from our MedSurg business segments in the quarter. I’ll now turn to the remainder of the income statement, starting with our gross margin performance.
Gross margins were again strong in the quarter at 69.4%, which represented a 200 basis point increase over third quarter 2009 levels. Frankly, the results exceeded our expectations with the improvement being paced by lower cost associated with inventory charges, solid production absorption and the favorable currency impact on cost from our Euro-based manufacturing network.
Additionally, we again benefited from the multi-currency mix of our manufacturing and distribution activities. As a remainder, timing differences across our natural hedges and multi-currency mix prevent correlating currency movement on the top line with that of gross margin and profitability across quarters.
For the year gross margins of 68.8% are slightly above our expectations and we expect the full year to remain in the 68.5% range given all the variables mentioned above. Research and development investments represented 5.6% of sales in the quarter, while increasing 18% over 2009 levels.
For the year, R&D is now at 5.3% of sales and up 15% over prior year. Our commitment to increased R&D spending will continue and we anticipate fourth quarter investments to increase at rates well above our sales growth.
Selling, general and administrative costs were flat compared with 2009 levels, while decreasing 250 basis points to 36.4% of sales versus 2009. During the quarter, we recorded a gain of $24 million associated with the sale of our orthopedic implant manufacturing facility in Caen, France.
The gain on the sale of assets is included within SG&A. Net of this gain, SG&A finished at 37.8% of sales, decreasing a 110 basis points versus prior year.
As a reminder, in the third quarter of last year, we reported $67 million of restructuring charges in operating expenses. These moves represent our ongoing commitment to evaluate our operating model to continue to drive focus and efficiency in our business.
On a 7% constant currency sales growth, operating income increased 18% on an adjusted basis and 51% as reported. The adjusted operating margin increased robust 240 basis points versus prior to 25.3% of sales.
Other income and expense reduced pretax income by $9 million in the quarter. Components of this included investment income of $12 million, offset by interest expense of $20 million and FX transactional losses of $1 million.
Lower investment yields continue to limit earnings on our invested cash even with the higher cash balances. The company’s effective income tax rate was 26.9% for the third quarter of 2010.
In the third quarter, we reported a favorable income expense adjustment of $7 million associated with repatriation of foreign earnings undertaken into fourth quarter of 2009. Additionally, the tax rate also reflects the tax charge associated with the Caen facility sale.
Absent those two items, the company’s effective income tax rate was 27.6% in line with the historical trends. In terms of the balance sheet, we ended the third quarter with $4.51 billion of cash and marketable securities of $1.56 billion from yearend of ‘09.
As a remainder we have $1 billion of debt on the balance sheet associated with our January 2010 inaugural debt offering. Asset management remains under solid control as AR days ended the quarter at 59.
This represents a decrease of two days compared to the prior year. Days in inventory finished the quarter at a disappointing 174 which was up 11 days sequentially versus the second quarter and 10 days against the prior year level.
Excluding 2009, the third quarter has always been our historical high watermark for inventory. This year is a touch outside of that range and we are clearly expecting a stronger finish before the year is out.
On cash flow, we continue to perform well with cash flow from operations of $428 million and free cash flow of $424 million. On the share repurchase program, we did not execute any additional repurchases in the quarter.
In closing, we feel good about our results and the financial stability that our diverse base of businesses create for our company. Against these results and as provided in our press release, we have increased our full year performance expectations to the upper end of the targeted ranges to include a net sales increase of 7% to 8% in constant currency versus the previous 5% to 8% range.
This will result in adjusted diluted net earnings per share now anticipated to be in the $3.27 to $3.30 range representing an increase of 11% to 12% over 2009 adjusted diluted earnings per share. This is versus the prior guidance of $3.20 to $3.30.
In summary, our Q3 results have us firmly on track to deliver the high-end of the range we established back in January. I’ll turn it now over to Steve.
Stephen MacMillan
Thanks Curt. In summary, we feel really good that despite less favorable market dynamics in some of our markets, we are again delivering at or near the top end of our commitments.
The last few quarters underscore this strength provided by the breadth of our unique sales footprint. Additionally, we will continue to look for opportunities to leverage our balance sheet in order to strengthen our core as well as broaden our presence in adjacent markets.
And our accelerated pace and investment in R&D will also drive internal innovation and help further broaden our portfolio of value-added products and services. In short, we like where we’re headed.
With that, we’ll now open it up for Q&A. Jeremy, back to you.
Operator
(Operator Instructions). Our first question comes from Rick Wise of Leerink Swann.
Please proceed.
Rich [ph] – Leerink Swann
Hi well this is Rich in for Rick. Thanks for taking the question.
Great quarter. I just had a couple of questions, just to maybe start off when you talked about your overall pricing, you said it was down 1.8%.
Is that just pure ASPs, is that your total pricing with mix or without mix?
Curt Hartman
Your assessment was correct. We said it was down 1.8%, 30 basis points down from what we reported in the second quarter and that’s total company pricing independent of any specific segment call out.
Stephen MacMillan
It is without mix to your question.
Rich – Leerink Swann
And you still feel that mix is broadly offsetting that or capable of offsetting that for the foreseeable future?
Curt Hartman
We certainly believe that mix is still a positive component here.
Operator
Our next question comes from Bob Hopkins of Bank of America. Please proceed.
Bob Hopkins – Bank of America
Thanks. Can you guys hear me okay.
Stephen MacMillan
Yes Bob, we can.
Bob Hopkins – Bank of America
Okay, great. So just two questions, one, Steve for you on pricing and then one follow-up as far as a broader question goes.
First, on pricing we’ve now seen results from you guys and BioMed and J&J and J&J talked about no real changing in pricing for hips and knees, BioMed said it got a lot worse in OUS but the same in the US. And now you guys are saying for hips and knees it’s much the – pretty much the same that has been in the last couple of quarters.
With that in mind and given what’s going on around us in terms of the all the anecdotal evidence out there about the pressures on hospitals and the like. I was wondering Steve, if you could comment on your outlook for pricing for hips and knees for the market as we look forward into 2011.
How confident are you that you think things can kind of stay in the same range versus perhaps get worse? Just would love your thoughts on the hip, knee pricing outlook for the market.
Stephen MacMillan
So Bob, I think we’ve had three quarters that are actually pretty consistent now and probably bodes somewhat well at some point here in time as we have new products get launch, get more premiums, and as people come back into the markets, I think we’re still more bullish on the markets longer term, but recognizing more of a choppy period right now and it’s hard to exactly call the end. I think to me the big message is regardless of what keeps happening in this environment we keep delivering.
And I think there has been (several) year, there has been so much focus and its back to like 2005 people looking at extreme, expecting extreme movements that frankly are not really occurring and that are again we can power through some of these changes.
Bob Hopkins – Bank of America
Okay. So basically not to put words in your mouth but as you look forward from what you see right now, you don’t see a dramatic change in the outlook for pricing as it relates to hips and knees?
Stephen MacMillan
No comments.
Bob Hopkins – Bank of America
Okay. And then the second question I just wanted to ask, there were some speculation inter quarter about certain asset that you guys might be considering buying and I don’t expect you to comment on that but I was wondering if you would just take this opportunity to kind of refresh us on little bit more detail around your philosophy around the kinds of things that you may be interested, your philosophy around M&A and dilution and just kind of an update on that front, if you would especially in light of the cash that continues to build.
Thank you.
Katherine Owen
Hi Bob, its Katherine. I’ll jump in here and really kind of reiterate what we’ve articulated on prior calls and meetings which really speaks to a three-prong cash strategy.
We continued to believe that M&A, it makes the most sense in terms of being our preferred use of cash but it’s part of that three-prong M&A, dividends, share buybacks with any mix of those taking place. We haven’t called out and we won’t be any particular area that our focus other than to say that we continue to focus on our core as Steve mentioned on the call, we have a very unique broad set businesses that allow a lot of opportunities to leverage our core.
I think Gaymar Industries is a terrific example of that. And we’re also continuing to look at opportunities that are adjacent to our core markets and we would view the Ascent acquisition last year as an example of that.
That has been the strategy we’ve been executing on. And we don’t have any plans to change that going forward.
Operator
Our next question comes from David Lewis from Morgan Stanley. Please proceed.
David Lewis – Morgan Stanley
Good afternoon. Steve, your comments in the call were pretty clear that you saw some stabilization certainly in isolated pockets of the orthopedic market, your specific orthopedic segments in the US and OUS.
Can you comment on, that stabilizations some very modest improvement, how those trends are sort of – how they trend to sort of inter quarters for August to September and perhaps into October. Are we still sort of in this stabilization mode to slight improvement, or have you seen a more sharp improvement?
Katherine Owen
Yes, so I’ll probably just jump in here. We have not probably not going to go down actually we’re not going to go down on the path of inter quarter updates on trends really just focused on the quarterly trends and going back to the comments.
We haven’t seen anything materially change from Q1 to Q2 and that’s probably the amount of granularity we want to get into.
David Lewis – Morgan Stanley
Okay, I’m sorry Katherine, Q1 to Q2 but Q2 to Q3.
Katherine Owen
Yes, I’m sorry so the comments for in Q3, we haven’t seen anything materially different going back to the prepared comments from what we saw in out of Q1 or Q2.
David Lewis – Morgan Stanley
Okay, fair enough. And then Curt, just thinking about gross margins, obviously there was some inter geographical FX things driving GM improvements.
But if we look at a go-forward basis, some of your higher margin products are underperforming right now. Is it safe to assume to an extent you can see stabilization in growth in those products going forward or we should start seeing more significant mixed impact in the P&L which would be positive for GMs heading into ‘011.
Curt Hartman
David, it’s a great question and I think it gets into where the gross margins are for those products that you’re referencing and the stability. Stability is different than growth and obviously the more volume we put through on those, the better the gross margins are going to be.
So I think it’s a little bit early to call those returning and being contributing factors at this point in time, because we would like to see more growth out of them before we’d comment on additional influence to gross margin.
Operator
Our next question comes from Matt Miksic from Piper Jaffray. Please proceed.
Matt Miksic – Piper Jaffray
Hi thanks for taking our questions. I just – if I could just clarify couple of things that you said your last question and David’s question on volume and pricing, Katherine or Steve just it sounds like you’ve seen pricing that has kind of, it’s not much different in Q3 than it was in Q1 or Q2.
Clearly volumes right, took a step down in Q2 from Q1. And so I guess then on the volume side you’re saying that from Q2 to Q3 things that didn’t get materially worse.
Is that what I heard you say Steve?
Katherine Owen
Yes, I think that’s – I’ll just jump in here, I think that’s a correct statement. Clearly volumes are seeing the impact from the economic environment, people deferring surgeries, recognizing all our checks indicate this isn’t something you can permanently defer although clearly calling the quarter when those volumes start to improve.
It’s a bit tough. It’s just something that we would anticipate happening as we go forward but no material change on that front either from – versus what we saw in Q2 as it relates to volumes.
Matt Miksic – Piper Jaffray
Great. And I had one on the P&L and one just so maybe some color on OUS trauma.
So in terms of what opportunities you have either that you’re executing on in kind of this modest growth top line environment certainly in devices. If you could talk about what kind of restructuring efforts you have underway, anything it could do to sort of quantify what they could mean for the P&L over the next quarter or next going forward.
And then just as a follow-up US – OUS trauma little on the weak side, I’d love to know how much of that was volume, was it comps, was it Japan pricing, that would be helpful. Thanks.
Curt Hartman
Matt, this is Curt. On the, I think to use your word you said the projects, we’re probably not going to get into any specifics.
I think the message we want out is that as demonstrated over the past year, as a normal part of our business routine, we’re constantly evaluating our operating models and making adjustments were appropriate. And we’re not going to pin a number out there and drive our business to that number rather we’re going to continue to evaluate the operating model and make the adjustments as necessary.
On the trauma in the OUS component or the slower growth OUS, I don’t think there is one thing we would point to here. It’s certainly not, I wouldn’t be pointing to Japan price cuts those had far less impact on trauma this year than they did in the other segments of the business.
So I don’t think we’d point to Japan as a key driver there. There is a little bit all over the board.
Just I think generally what we would say is third quarter was a little bit slower trauma season if you will.
Stephen MacMillan
And I’ll jump, Jeremy I’ll just jump in with an addition point here Matt. The back on the projects, I’d give an example, just the constant evolutionary changes we make.
Recall, last year we discontinued a series or products in our knee franchise for Europe. We’ve been paying the price on the top line growth rate for this year.
But from a bottom line profitability, we had always decided that was going to make us stronger for the company. We’re constantly doing a lot of things like that that aren’t obviously but that we do sometimes pay a price for in terms of reported sales growth and not just going for a sales growth at all costs as we get smarter.
And frankly the whole quality initiative that we’ve been through has helped China much brighter light for us on some of those opportunities and has resulted in some of those actions. That did frankly were depressing pieces of our growth rates for periods of times when we went through this but we really do think are making us fundamentally stronger as a company.
So hopefully Matt that gives a little more context to you. All right, go ahead Jeremy, next question.
Operator
Our next question comes from Adam Feinstein from Barclays Capital. Please proceed.
Adam Feinstein – Barclays Capital
Yes, thank you. Good afternoon everyone.
I guess just a follow-up with some of the other questions here, I mean clearly the growth outlook within the core ortho recon business is lower for everyone and certainly you guys have done a good job of managing through it but clearly this seems like lower than normalized growth rate. So with that backdrop, I mean what do you guys think the implications are in terms of strategy, competitive backlash and certainly your comments earlier about acquisitions being the first choice in terms of your use of cash.
Would it be safe to assume that acquisitions would be outside of ortho business similar to what you guys had been doing but is that point I guess going to be a bigger area of focus just due to the delivered growth right here. So kind of a bigger picture question there but just curious as you guys think about that what do you think the implications are?
Katherine Owen
Okay, I’m going to take part six of the question.
Adam Feinstein – Barclays Capital
Okay.
Katherine Owen
And in just terms of the M&A and really just go back to what we articulated in the beginning. We’re really not going to focus on specific areas other than reiterating what we’ve tried to express throughout the year in various meetings.
We’re focused on our core, Gaymar and we’re focused adjacent, Ascent being an example of that but as you get down really granular looking at different divisions in the like of, it just doesn’t make sense for a lot of reasons for us to comment on particular areas or segments or strategic responses to market dynamics that we may address with M&A.
Stephen MacMillan
And Adam I’ll take the rest of those the question. I think we look at it on a couple of different fronts.
If this is a cyclical downturn in the orthopedic implant marketplace, I think you want to really good about our position as a company that we can deliver these kind of results with two straight quarters of 1% orthopedic implant growth as those markets come back, you got to feel really good about what we can do. And if it’s a more secular downturn, I can also tell you we’ve got plans in place for that that we think will benefit the larger players and frankly some of the players who transcend a number of segments in orthopedics.
And we have different plans and different approaches for that way. So I think we actually don’t – I mean none of us love a market downturn, but to some degree it may allow us to differentiate.
We think we may differentiate ourselves more through this period than just a rising tide on everything.
Operator
And our next question comes from Steven Lichtman from Oppenheimer. Please proceed.
Steven Lichtman – Oppenheimer
Thank you. Hi guys, just the first question, I was wondering if you could give us any more details on the increased R&D investment we’re seeing here.
Any particular segments where that’s focused? Are these longer term bets or more of a refresher product line that we could see the benefits of in 2011?
Curt Hartman
Steve, this is Curt. I’ll take a quick stab at this and Steve or Katherine may also contribute here, but I think fundamentally every one of our operating businesses is looking at both incremental innovation because the market still drives for incremental innovation product enhancements, additional features and benefits but I also think that there is probably game changing innovation that’s going on as well.
So I wouldn’t slice our R&D investment into one specific aspect of innovation. I’d say rather each of our operating businesses have unique features and benefits that are driving in a given product line but I think they’re also looking for more what we would call true innovation.
Some of the stuff that maybe qualified as perhaps a little bit further out than what the normal business is operated on but still things that we feel add value over the long-term.
Steven Lichtman – Oppenheimer
Okay, great. And then just secondly the OtisMed slight push out there, any sense of whether this is related to the warning letter trend we saw with other manufacturers in patient specific instruments or just a little more time needed specifically with the OtisMed 510(k).
Katherine Owen
Yes, it wouldn’t be appropriate to comment on what the FDA’s processes or how they’re viewing some of the competitive products. But it’s clearly as everybody knows it becomes a more challenging market to get 510(k) clearances, PMA approval, nobody in that tech is immune to that.
We feel very good about the submission in our ability to respond to questions but trying to forecast that at an exact time is currently challenging. And we just figure at this point in the year it made more sense to start thinking about a clearance coming in 2011.
Operator
Our next question comes from Derrick Sung from Sanford Bernstein. Please proceed.
Derrick Sung – Sanford Bernstein
Hi thanks for taking the question. One of the concerns around pricing from a kind of a secular perspective has been that a lot of hospitals are moving towards kind of a capitative pricing structure where they are sitting one set cost for a certain cost of hips in saying if the vendor wants to participate at the hospital they must meet that level.
And – but I haven’t seen though any real statistics on how prevalent that is and I was just wondering if you could speak as to how much of you customer – in your customer base how much what percent of hospitals you’re seeing that might have this kind of structure in place and is this concern that investors should be focused on or is this such a small percentage that it’s not that big of a deal yet.
Katherine Owen
I think it’s like a lot of industries in med tech and certainly in our hip and knee business, you’re always going to have certain hospital accounts that try and drive very strict pricing or try and limit the number of vendors and on the other hand you have other hospitals who are really looking to ensure that they have access to the latest innovation, have carve outs in contracts. So it’s very difficult to make a blanket statement that x percent of accounts are approaching pricing from a capitated way or otherwise.
What we do see is manageable pricing pressure that hasn’t materially changed in the hip and knee market which should give you some sense of what’s happening in the larger hospital market and seeing a portion of that all set by mix which also indicates these same hospital customers are willing to pay for innovation.
Derrick Sung – Sanford Bernstein
Okay, thanks. And then on MedSurg, so on the equipment you saw a nice sort of acceleration in sequential growth rates on the bed side, you saw a step down from kind of that the blip that we saw over the last two quarters.
Maybe if you could just give us a little color as to what you see driving those and how you think about those moving out over the next few quarters?
Curt Hartman
Derrick, I think our comments on MedSurg, we overall feel good about the core MedSurg franchises, endoscopy instruments and medical. And I think if you think about endo and instruments, it shows capital sales that had evaporated in 2009 that have started to return and I referenced back to a comment that Steve has made about the shape of that curve and what it’s looking like.
And I think we’re seeing those businesses move exactly on that curve. And on the medical side it is a little bit more difficult to predict and I think our comments on medical were that while the shipment growth rate was a little bit lower, we feel pretty good about the incoming orders volume as well as the additive impact that the Gaymar Industry acquisition will have on that business.
So I think the overall high level tone on MedSurg is we feel good about the trends, feel good about the outlook here and really like these businesses when they’re operating at that 10% growth level. And don’t see anything right now that’s going to change that.
Stephen MacMillan
Okay, Derrick just to reinforce that point, after the second quarter there were a lot of people wondering, okay, great you got a one quarter pop or two quarter pop in MedSurg. To remind you that we’ve had years and years of strong performance in MedSurg and 2009 happened to be outlier, to reiterate Curt’s point, I think (inaudible).
Operator
Our next question comes from Raj Denhoy from Jefferies. Please proceed.
Raj Denhoy – Jefferies
Hi good afternoon.
Stephen MacMillan
Hi Raj.
Raj Denhoy – Jefferies
What if I could ask about Europe. It’s been a couple of quarters now you’ve been feeling the impact of the distributor change out and some of the product discontinuations you mentioned.
I’m curious if you could provide us an update on where we are in that cycle, I mean should we be anniversarying those trends fairly sooner or is this going to continue for a couple of more quarters here?
Stephen MacMillan
Sure Raj, its – we really took the charge at the end of the third quarter last year, so started the downturn in the fourth. And we’re close to the end of some of that full anniversary period.
Some of that will trickle into the fourth quarter. So I think by the end of this year certainly those distributor changes in product pieces should be behind us.
I think what we’re pleased with is, there was a clear albeit modest improvement in our European business that went from negative in the second quarter. We think we bottomed out in the second quarter.
We had modest growth in the third quarter here in Europe. So we’re not declaring victory by any stretch but we think we have bottomed out.
Raj Denhoy – Jefferies
Okay and then just one last one, you know the margin improvements continue to be quite impressive. I’m curious, are we seeing any benefit from the warning letters being lifted here, are any of those expenses coming off?
Stephen MacMillan
I would not view it as the expenses coming off, I would say we have learned a lot frankly around things like product design that have led to more efficient product designs and other things. But the gross margin, I’ll let Curt build on this, gross margin be careful not to get too far ahead yourselves on that one.
We had some currency issues – some favorable currency that dollar has now crept back up. There were – the last couple of quarters were probably unusually high.
We’re not quite ready to declare that that’s our new ongoing level but we do think we’ll continue to move it forward. Curt, do you want to build on that?
Curt Hartman
Steve I think you hit the nail right on the head. I would not read into any gross margin improvements that dial back on the quality investment.
I think Steve tried to make that really clear in his opening comments that we remain very committed here. We’re just entering the year three of the program we laid out and we’re very committed to that and the gains that we may be seeing as they related to quality are probably some of the efficiencies that enhance quality processes are enabling our manufacturing plans to be more efficient to have reductions in scrap and things of that nature that come through the broad implementation of those programs.
Stephen MacMillan
It’s painful as it was to get four warning letters and go through what we went through over the last few years. We really do believe it’s making us a better company.
Look, we still got a lot of investment to make. I think we see those opportunities paying off down the road.
Operator
Our next question comes from Vivian Cervantes from Maxim Group. Please proceed.
Vivian Cervantes – Maxim Group
Hi thank you for taking the question. I wanted to follow-up on the comment you had made on secular changes to the recon market and that having some plans on how to deal with that.
Can you sort of balance that out vis-à-vis expectations of volume trends and I know you said that its been relatively flat but volume trends that will continue to be pressured into near to mid-term. How do you sort of pull on what levers to sort of figure out secular versus prolonged cyclical pressure?
Stephen MacMillan
From a planning standpoint, we’re going to assume pricing pressure is a more secular event and that we can manage through that and volumes I think we think are probably a little more cyclical. Things like the unemployment rates being high, COBRA benefits going away all of that.
At the end of the day, joint replacement surgery is deferrable to a point. But I don’t think we see it just completely going down and people starting to live life on nonsteroidals and high (organic) acid.
There is only so long you can defer it. So I think that’s probably a little more cyclical.
Vivian Cervantes – Maxim Group
All right. And as a follow-up when you mention deferrable up to a point, are you noticing that maybe this point of deferrals has been extended, are we talking maybe six months deferral to maybe a year or has there really been no change in your thinking about how long you can defer (piece of this) surgery?
Stephen MacMillan
Vivian it’s just hard to quantify at this point, I think we’d be hitting ourselves we said we anticipated the complete slowdown that we’ve experienced in the last two quarters. And so whether it continues for another couple of quarters or another year who knows what in terms of how long people can put it off, I mean ultimately we’d probably think its quarters, years, year-ish but people are unemployed for a while.
They’re concerned about going in or don’t have the benefits that we really have to see. I think I’d just come back to the fact that we are more than a hip and knee company.
We love those businesses, but this quarter again as last quarter and as years of performance should show, we are not beholden to the growth rates (inaudible).
Operator
Our next question comes from Joanne Wuensch from BMO Capital Markets. Please proceed.
Joanne Wuensch – BMO Capital Markets
Thank you very much for taking my question. Actually there is two, one you’ve talked about the hospital purchasing recovery being sort of a Nike swoosh.
Are you still seeing that sort of pattern on where we own that design. And then the second one is in the spring you launched several new products at AAO, the ADM hip, new cervical plates, kyphoplasty products.
Could you give us a little bit of qualitative information on how those maybe doing? Thanks.
Katherine Owen
I’ll take the latter part of the question first and I think I’ll put it against the context, if you would look at the total company and what we’ve articulated at prior meetings, the academy our analyst meeting is it’s a series of singles and doubles. It’s very rarely the homerun type of product and but it’s the collective total of all those products that really allows for the top line growth.
And we would view all of those products that’s in line with that. On the hip side as many of you know and we’ve talked about it.
It’s the rollout of a new hip system particularly something like ADM that is a new design. Concept does take several quarters typically at least four quarters, certainly what we’ve seen historically and with the launch of Triathlon that’s been tremendously successful.
It takes four plus quarters to really get the message out there, surgeons trained starting to use the product, etcetera. And that’s the path that ADM and the other products that we’ve launched around.
So overall we feel very good that they are delivering what we would anticipate but recognizing none of these in isolation is going to dictate the performance in a given quarter.
Curt Hartman
And I think Joanne to your first question relative to MedSurg in where we are in that swoosh, if you will. I think we continue to trend, I think there are still segments.
I’ll use our endoscopy business as a great example. We feel very good about the capital sales results that are starting to materialize there.
With that said we’ve also said in prior quarters that the communications business which is an element of the endoscopy business still has a little bit more pressure on it because the capital ticket item there is much larger. So there are still elements of our capital franchises that are little slower but overtime we think they’ll recover as well.
Operator
Our next question comes from Bruce Nudell from UBS. Please proceed.
Bruce Nudell – UBS
Thanks for taking my questions. Just Steve qualitatively it’s our impression that hospitals when face with pressure basically try to control implant cost basis or lever they could easily pull but on the other hand they love surgery because that’s where they make their money.
Where are they in there thinking have profits internally as the hospital started to improve enough non-operating revenue etcetera so that they feel they are planning ahead now or are they just refurbishing stuff they’ve deferred or little of both. And then I guess on the second question is just structurally when you sit down and do your strat planning given the realignments that are going on.
Do you think about the major joint market across price and mix as a zero percent ASP inflation thing or do you think it’s going to be slightly positive or slightly negative. Thanks a lot.
Stephen MacMillan
Well the first one was I think we – it clearly varies a lot by hospital so it’s hard to give a blanket answer. I think there are number of larger institutions that really do grasp the total joint replacement surgery is actually a very good profit center for them.
And I think what you had certainly in the advent of passage of the Healthcare Bill this year, I think everybody coming running for the corners trying to get every cost that they could and then you have people starting to wake up and say wait a minute, there are pieces of the business that we make a lot of money in. And I always joke, if you can’t drive across the State of Michigan without seeing at least 10 billboards for hospitals advertising somehow the total joints done at their centers.
Last I checked I don’t think they’re advertising those if they’re losing money much on those. So I think there is still little more profitability that will shake out and particularly among the larger institutions.
Some of the smaller community hospitals are still certainly pressured to that end. To your second point, I think we still ultimately believe that mix will be able to more than offset pricing degradation and we’ll see some certainly volume growth in the sector.
Operator
Our next question comes from Doug Schenkel with Cowen and Company. Please proceed.
Doug Schenkel – Cowen and Company
Hi good afternoon and thanks for taking my questions. My first question is another, I guess longer term question.
Turning over to the MedSurg side of the business, while many are concern that reform efforts in the US could actually lead to direct or indirect pricing pressures many have alluded to. I think there is the belief that volumes could pick up and you actually could see some expansions in certain areas in terms of hospital building and build outs.
Have you thought about the potential for Obama care actually benefiting your MedSurg business and maybe offsetting some of the areas of potential concern on the recon side?
Curt Hartman
Doug, I think it’s certainly potential and have we thought of it. Yes, we’ve had lots of discussions about the Healthcare Reform Act and how it will either positively or negatively impact our business.
Again I think on one sense that and you can put whatever number you want to, it’s the $30 million additional insured lives, I think our opinion would be a lot of those are already getting healthcare. They are just getting it under a different form than the insurance proposal that’s out there and on the other hand if there is a better way that requires additional equipment, we’re certainly there and ready to support that expansion on the market.
I don’t think at this point in time we’re banking on anything one way or the other perhaps except the excise tax that we know very clearly is going to be an adverse event for companies in the med tech space.
Stephen MacMillan
Doug to build on that for all the pricing pressure we may feel here in now, I think the one thing we would absolutely bet on is there is going to be more money spent on healthcare going forward both in the United States and around the world.
Operator
Our next question comes from Mike Weinstein from JPMorgan. Please proceed.
Mike Weinstein – JPMorgan
Thank you for taking my questions. I wanted to focus on MedSurg, and I guess two questions.
MedSurg has been so volatile for the last two years, it was obviously at a much stronger downturn in the first, for the three quarters of 2009. And we all are expecting had this much stronger up turn and you were expecting company was expecting.
Can you have visibility on the whole question of inventories. It would seem that there could have been some inventory drawdown and so in terms of not about your inventories, I’m talking about the hospitals inventories but how they are managing them and how they are facing about particularly on the instrument side on the endoscope side.
And do you think there was drawdown in 2009, maybe we’re getting some bounce back in 2010. And then from there the second piece is how do we think about your comp – your contribution within MedSurg from volume mix and price and if you can give us any sense of what that 16% constant currency broke, how that breaks down that’d be great.
Thanks.
Curt Hartman
So Mike on the first question, I’m not sure if I would say that ‘09 was an inventory drawdown, I’ll kind of start my questions or my answer with on medical it was a flat out, we’re not buying right now. And that’s on capital equipment purchase.
On endoscopy and instruments, as you’re aware they both have disposable components of the business that component of the business is what I would call very real time. They either ordered direct from Stryker or they go through various distribution partners that have very real time inventory levels that are maintained through par level management.
It was the capital equipment in ‘09 in those businesses that slowed down and that was either the capital equipment replacement or expansion cycle that slowed down. And now we’re starting to see as a return of those investments.
It’s a deferral that can only be deferred for so long because you’re fundamentally re-channeling new dollars into repair dollars and you can only do that for so long. So I think we’re just seeing those healthy institutions needing equipment replacement cycles to occur and that’s what’s really driving those businesses right now along with our normal stream of new product introductions that go on in those businesses.
As far as the 16% I think that we called out that 6% of that came from Ascent. So my first slice would be 6% is the acquisition.
The remaining 10% I would say that that we’re not going to get into price specific commentary relative to those three segments. And it’s all wrapped into that 1.8% decline that total company felt.
So it probably gives you an indication that pricing pressure in MedSurg is no worse or no better than what it’s been on a historical basis. Again the cycles for new products innovation at MedSurg are a little bit shorter because majority of items are 510(k) so you probably getting a little bit better mix out come in those businesses as the new product pipeline coming out of the quality remediation efforts continues to ramp up and new items hit the market.
Operator
Our next question comes from Glenn Novaro from RBC Capital Markets. Please proceed.
Glenn Novaro – RBC Capital Markets
Hi, two quick questions, one on the surgical equipment side, I mean those sales came in well above our forecasts. And I was just wondering, where there any one-timers or big purchases on the quarter is question one.
And then on, okay and then on the M&A side maybe to ask the question a little bit differently, the fact that you’re not buying back stock. Does that mean like the queue of M&A is pretty full at the moment?
Thanks.
Curt Hartman
Glenn, we’re probably not going to get into many specifics here other than to go back to what I think Katherine tried to lay out pretty clearly at the beginning which was we prefer to use our cash for M&A but we do have a three-pronged approach which includes dividends and repurchase in M&A. And those are in addition to the normal working capital requirements of our business.
So really what we hope is that over time when you look at all three of those elements you see the best possible investment leading to the best possible returns for shareholders by being very judicious in how we assign dollars in each of those categories versus one specific bucket in any given quarter.
Operator
Our next question comes from Kristen Stewart from Deutsche Bank. Please proceed.
Kristen Stewart – Deutsche Bank
Hi thanks for taking my question. I was just wondering it light of the (med tech) panel which was a couple of months ago if you guys have updated your thinking on OP-1.
Stephen MacMillan
We’ve said we’ll give you an update by the end of the year and we’re on track to do that.
Kristen Stewart – Deutsche Bank
Okay. And then obviously with MedSurg the comparisons year-over-year are a little bit easier, I’m just trying to get a sense as you guys look at the business, where do you think more normalized run rate is at.
Do you feel confident that it can be mid-single digits as we look ahead obviously we’re going to be anniversarying some tough trends but where do you think MedSurg overall can grow up?
Stephen MacMillan
We absolutely think it can be in mid-single digits. No problem.
Operator
Our next question comes from Jeff Johnson from Robert Baird. Please proceed.
Jeff Johnson – Robert Baird
Thank you, good afternoon. Steve, let me just follow-up I guess on your last answer there, no problem on the mid-single digit MedSurg meaning you could foresee it being higher than that as well fairly easily?
Katherine Owen
I would go back to when we gave the revised guidance for the full year up to the upper end of the range I don’t think anybody is assuming some dramatic reacceleration in the recon market. Our comments spoke to the fact expected to improve over time than we’ve got one quarter left.
So kind of gives you some sense about what’s going to be driving the components to get to that revised guidance.
Jeff Johnson – Robert Baird
Yes, understood Katherine on that, I guess Steve, sounded pretty confident there though just wondering maybe qualitatively longer term its mid-single digit kind of the base of what your expectations would be, Steve?
Stephen MacMillan
We’re not getting into longer term guidance at this point Jeff, we’ll give just 2011 guidance in January but I just pointed out, we’ve got a long, long history of building very good MedSurg businesses and we continue to believe in those businesses.
Operator
Our next question comes from Bill Plovanic from Canaccord. Please proceed.
Bill Plovanic – Canaccord
Very thanks. Just a couple of questions here, one you talked about the discontinue of some products in Europe and I know you addressed the distribution changes.
Is it fair to say as we go through 2011, we’ll be clean in on the comps and see more normalized growth rate and then two, just kind of on the hospital you did talked a little about pricing the way they’re thinking. Has there been any change in the way that they look at carve outs and think about that and maybe either include or exclude that as you go to negotiations with them in the future?
Thanks that’s all.
Katherine Owen
So I’ll take the second question first, no there has been real change in terms of how hospitals think about carve outs and wanting to be able to have access to innovation as a lot of business positions preference item as you look at the hip and knee market. And in terms of the first part of your question.
Stephen MacMillan
Bill the first part of the question really distributor and product obsolescence that does specifically relate to Europe and we are sun setting those events and really would not expect to see any of that on an adverse side as we head into 2011. That said as I mentioned earlier, we continue to evaluate our business and will take opportunities to make adjustments where appropriate but we have with this quarter now sunsetted the changes in Europe.
Operator
Our next question comes from Charles Chon from Stifel Nicolaus. Please proceed.
Charles Chon – Stifel Nicolaus
Great, thanks for taking the question. Hits in the US awesome, nice sequential acceleration which is a different sequential trajectory for what we’ve been seeing from other companies.
Can you speak a little more about what drove that sequential improvement? Was it volumes and, or maybe you guys launched some products earlier this year, it could be mix?
Stephen MacMillan
We’re getting to get some traction with our new product.
Charles Chon – Stifel Nicolaus
Okay and the follow-up questions is actually similar one for US spine again transforming out there. Is that also volume driven or is that new product mix driven?
Katherine Owen
I would just caution the sequential improvement in spine although it’s better than a sequential decline. It’s still very modest, that business was flat domestically.
So we’ll look for that to gradually get better but I think way too early to ring any bells that new products are having a meaningful impact.
Stephen MacMillan
Even hips was only – it was a little bit better. We’re not declaring victory on that one.
Operator
Our next question comes from Matthew O’Brien from William Blair. Please proceed.
Matthew O’Brien – William Blair
Good afternoon and thanks for taking the question. Just a follow-up on that last question a little bit, when do you think, we’ll start to really see the firm traction from those new hip products.
Is it a kind of Q1, Q2 event in ‘011 or a bit further out?
Katherine Owen
As we talked about earlier in the call, is we think about reconstructive market in a long history of having product rollouts here. It typically takes four plus quarters before new products starts to get meaningful traction and we’ve rolled these products out during the first quarter.
So we would really look to start to see more of an impact in 2011.
Matthew O’Brien – William Blair
Okay and then just one, just one last one, everybody is focused on the pricing dynamic right now and the offset on the mix but what leverage do you have to offset further pricing declines, be it service or elsewhere from these levels say if it was to go from kind of a negative 2% where it’s been in this quarter to negative 4% or something along those lines just going forward.
Stephen MacMillan
Look at this way, we went from a positive several percent a couple of years ago, down to zero to minus 2% and we’ve continued to grow pretty healthy through that. We continue to look both at the gross margin line, in terms of the cost of goods side as well as frankly at the middle of the P&L.
And I think we continue to feel that we can deliver in whatever environment is coming at us.
Operator
And our next question is from David Roman from Goldman Sachs. Please proceed.
Topher Roy [ph] – Goldman Sachs
It is actually Topher Roy in for David Roman. I had a quick question about CapEx spending in Europe, kind of where you guys saw it over the past quarter, where you guys see that going for the next six months and kind of how it relates to how domestic spending.
Thanks.
Stephen MacMillan
Our instruments business had a pretty quarter in Europe. A little bit of capital, little bit of disposables.
I think frankly we’re still not that exposed to the capital market in Europe. We don’t really have much of a medical business there.
Our endo and instruments businesses are heavily disposable in some capital. So even if it comes down a little bit, I think again I think what it remained everybody of is with our diverse footprint, one of these things knocks us out one way or the other and people freak about whether its hip pricing or knee pricing in the United States or Japan, capital spending in Europe and all these things.
And I think again we just somehow quarter-after-quarter feel pretty good about our ability to muddle through these. I think with that Jeremy that was the final question as well I believe, right?
Operator
That’s correct sir. There are no more questions.
Stephen MacMillan
Great. I think that probably wraps it up reasonably well.
And again I think we continue to deliver. And we will be back with you to report our fourth quarter with mostly our full year operating results on January 25th of 2011.
Thank you everyone.
Operator
Ladies and gentlemen, that concludes today’s conference. Thank you for your participation.
You may now disconnect. Have a great day.
Operator