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Executives

Rich Meelia - Chairman, President and CEO

Chuck Dockendorff - EVP and CFO

Cole Lannum - VP of IR

Analysts

Tao Levy - Deutsche Bank

Taylor Harris - JPMorgan

Joanne Wuensch - BMO Capital Markets

Christopher Warren - Caris & Company

Rick Wise - Leerink Swann

Bob Hopkins - Bank of America

Matthew Dodds - Citigroup

David Lewis - Morgan Stanley

Kristen Stewart - Credit Suisse

Glenn Navarro - RBC Capital Markets

Jayson Bedford - Raymond James

Peter Bye - Jeffries and Company

Covidien Ltd. (COV) F2Q09 (Qtr End 03/27/09) Earnings Call April 30, 2009 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2009 Covidien Earnings Call. (Operator instructions).

I would like to now hand the call over to your host for today, Mr. Cole Lannum, Vice President of Investor Relations. Mr. Lannum, please proceed.

Cole Lannum

Thanks, Katie, and good morning, everyone. With me today are Rich Meelia, Covidien's President and CEO; and Chuck Dockendorff, our Chief Financial Officer. The press release with details of our fiscal second quarter results was issued earlier this morning, and is available on our website and on the Newswires.

During today's call we'll make some forward-looking statements, including an update to our 2009 financial guidance, and it's possible that actual results could differ materially from our current expectations. We ask that you please refer to the cautionary statements contained in our SEC filings for a more detailed explanation of the inherent limitations of such forward-looking statements.

For the second fiscal quarter we reported GAAP diluted earnings per share of continuing operations of $0.34. We'll also discuss some non-GAAP financial measures, with respect to our performance including in particular the term operational growth, which we define as net sales growth excluding the effect of foreign exchange.

A reconciliation of non-GAAP to GAAP measures can be found in our press release, and its related financial tables, as well as in the investor relations section of our website, covidien.com. Our discussion this morning will weigh heavily on this non-GAAP look at the business and we had a number of one time items in the current quarter that we will address.

Excluding these items, but including the impact of Oxy ER, earnings for the quarter came in at $1.07 per share. Taking these $1.07 earnings per share and adjusting for the $0.38 impact of Oxy ER in the quarter, our non-GAAP results for the second quarter came in at $0.69 per share.

We concluded the sales of Oxy ER during the second quarter. In order to give you a better insight into the base business the full details of Oxy ER's impact to our revenues, margins and earnings for the second quarter and six months of fiscal 2009 are included in the non-GAAP reconciliation section of our press release.

In addition, we published a detailed quarter-by-quarter set of supplementary financial information that's designed to allow you to more accurately understand the exact impact of Oxy ER during the brief time it was sold. The supplementary financial information is available on the investor relations section of our web site.

Finally in a few moments Chuck will be updating guidance and these numbers will be excluding Oxy from our projections, because of the significant effect of Oxy on our revenues and margins. We hope that this will provide with a better look at our expectations for the ongoing business without clouding the discussion with the one-time impact of Oxy.

For those of you who want to cross-reference these data with past quarterly information, the new guidance numbers can be combined with the new detail of Oxy ER financials to get a full reconciliation.

Now I'll turn it over to Rich, who will give a brief overview before Chuck gets to the numbers.

Rich Meelia

Thanks, Cole. Overall we had another good quarter as we delivered strong operational sales growth in our base business, made the planned investments to drive future growth and launched several new key products. We also implemented tax planning strategies, which will result in significant long-term income tax savings for the company.

At the half way point of fiscal 2009 we think Covidien is well positioned for the remainder of the year and continuing in to 2010. Second quarter sales performance was broad based as three of our four segments reported operational sales gains.

Looking geographically all of our regions registered good operational growth with particular strength in Asia Pacific and Latin America. In the United States sales was up 6% on an adjusted basis, excluding Oxy. While we again saw improved product mix aiding the gross margin in our base business, the benefit was more that offset by the negative impact of unfavorable foreign exchange and some higher product costs particularly in imaging and supplies.

We continue to make growth driving investments this quarter, and have significantly increased R&D spending to 4% of net sales excluding Oxy. We continue to leverage the recent expansion in our sales force and as such expect 2009 to include only modest increases in sales and marketing headcount. This is in contrast to the significant investment and resulting increases we have made over the last few years.

Looking at the new product front, we continue to be active as we benefit from our increasing R&D investments. In surgical, we launched the unique SILS Port for laparoscopic surgeries and Duet TRS at last week's Sages conference. SILS, which provides multiple instrument access through a single incision has a potential to help drive minimally invasive surgery to a new level, and is a long-term growth area for our surgical business.

We believe we have a good combination of break-through products and line extensions to drive our growth. Over time we plan to complement this strong new product lineup with selected technology acquisitions designed to help us fill product gaps and expand in to adjacencies.

For example in the second quarter we acquired Bacchuss Vascular broadening or vascular portfolio. Bacchuss sells the Trellis peripheral infusion system a unique catheter based drug delivery device designed to dissolve blood clots in a single fast procedure. The product is used to treat deep vein thrombosis and will complement the other DVT products in our medical devices business.

During the quarter, we also implemented tax-planning strategies that will result in a sustainable reduction in our effective tax rate, while Chuck will discuss this in more detail in a few minutes, this implementation delivers on our commitment made prior to spin to reduce our tax rate by several hundred basis points. We are confident that we will deliver additional tax rate reductions over time. While we delivered a good performance to date in 2009, we still face some challenges in our business.

In imaging there are a couple of key issues that impacted us. For us while the Petten reactor, which is one of our external suppliers of moly, is back up and fully operational at the movement, the supply chain remains fragile. Second the negative pricing trends in the US contrast media have accelerated significantly over the last six months due primarily to increased competitive activity.

While we are moving forward with our plans to improve operating margins in the imaging business, we now anticipate that our previous expectation of a mid-teens operating margin in the next year or two is no longer realistic. That said the previous guidance remains a long-term goal for the business.

Additionally there remains concern in the investment community about the impact of the economic slowdown on the med tech industry. We believe however Covidien is well positioned to weather the current situation. Our broad product portfolio is used in a wide range of healthcare settings, as the results in the second quarter clearly show we have yet to see any negative impact from a reduction or slowdown in hospital procedures on the majority of our business.

In addition, while monthly trends can always be volatile, we have seen continued base business stability through the month of April. While no business is completely immune to the economic cycles, our product diversity can be a benefit despite the recent marketplace uncertainties. We continue to monitor these trends and are prepared to adjust our actions appropriately, should we see them starting to move against us.

We previously noted that less than 5% of our sales come from products that are considered capital purchases. Those capital products that we do sell include ventilators, energy power generators such as our Force Triad, contrast media power injectors, and urology tables and oximetry monitors.

We previously discussed the headwinds that we saw in these businesses starting last fall, which we believe were directly related to constrain capital spending by hospitals. In the second quarter this trend continued and we saw additional slowing in the sales and many of these categories. We are monitoring the situation closely and have taken the slowdown in to consideration in our revised guidance.

Our broad product portfolio, strong balance sheet and cash flow should ensure our ability to deliver on our strategy by making the necessary investments to drive future sales and profit growth. We remain very optimistic about our prospects.

I'll now pass the call over to Chuck who will discuss the second quarter results in more detail and update you on our guidance for fiscal 2009.

Chuck Dockendorff

Thanks, Rich, as you can see from the release, we had a number of notable items which impacted our second quarter financial results, and before I go in to detail about the quarterly performance, I would like to take a few moments to explain the larger items. First, as planned, we completed the sales of Oxy ER this quarter. As Cole mentioned the release includes a complete reconciliation of the impact Oxy has had on our P&L for the quarter year-to-date.

Also as noted we will be providing updated 2009 guidance later in the call, excluding Oxy ER, as this provides a better look at our ongoing business operations without the distortion that Oxy caused over the last three quarters. For the second quarter, Oxy sales were $258 million in line with our earlier guidance with an EPS impact of $0.38.

Second, as we have been discussing consistently since becoming a public company, we implemented tax-planning strategies this quarter to offset tax synergies that we lost as a result of the separation. The implementation will allow us to realize sustainable future tax benefits and to deliver on our long-term guidance to lower the effective tax rates over time.

We also believe the magnitude of that tax-rate reduction will be somewhat more beneficial than originally expected, closer to 300 to 400 basis points below our earlier guidance. We expect there will be additional opportunities to reduce our tax rate next year as a result of the full-year impact of the planning activities completed in the second quarter, along with other tax-planning opportunities. But we are not prepared to quantify them today. We will provide updated tax rate guidance for 2009 later in the call.

This tax-planning implementation resulted in a one-time withholding tax charge of approximately $155 million in the quarter, which appears in the income tax line of the P&L, but which we have excluded for the purposes of calculating underlying quarterly non-GAAP results.

Finally, the quarter included a $183 million charge for shareholders settlements. This represents our portion of the previously disclosed Tyco International Securities Litigation. The charge included a settlement of two cases during the quarter, two additional cases settled after the quarter ended and the establishment of a reserve for all of the remaining securities litigation. This charge coupled with earlier charges we incurred effectively puts the legacy securities litigation behind us.

Now for a closer look at the quarterly results. Overall we are generally pleased with our operational results this quarter. Sales, gross margin, and operating income were all on plan, as we delivered broad-based business growth despite the impact of unfavorable foreign exchange rates and some softness in some small capital equipment product areas as Rich mentioned.

As reported net sales increased 11% to $2.7 billion, lead by strong growth for Pharmaceutical Products due to Oxy ER. Unfavorable foreign currency lowered our overall sales growth by 6 percentage points. Excluding Oxy ER operational growth was 7% with a 6% increase in the US, and 7% growth outside of the US.

Looking at the results by segment, it was another good quarter for medical devices. On a reported basis, sales were flat at $1.7 billion, but up 7% on an operational basis, excluding foreign exchange. Performance this quarter was paced by gains in endomechanical up 3%, energy up 7%, and vascular up 9%. On an operational basis all three of these product lines plus soft tissue repair grew at a double-digit pace in the quarter.

Endomechanical growth was lead by higher sales of laparoscopic instruments, while soft tissue repair registered strong gains in hernia mesh sales in the both the US and Europe. In energy sales growth was similar to that of the first quarter, as we did see some continued slowdown in capital related hardware products.

Sales of our procedure oriented vessel sealing products were up at a very strong double-digit pace for the quarter. The gain for vascular, was led by compression and dialysis products aided by our specialized vascular access sales teams.

On an operational basis sales of oximetry and monitoring products were 6% above a year ago, primarily due to distributor order timing. While sales of airway and ventilation products were down 6%. The decline was due in part to lower sales of ventilators and sleep products with ventilation seeing a particularly large impact from a lack of capital commitment from the hospitals.

Looking next at imaging solutions, sales declined 9% to $276 million with 5 percentage points of decline due to unfavorable foreign exchange. In radiopharmaceuticals second quarter performance was negatively impacted by continued supply constraints due to the Petten reactor shutdown. While the reactor came up in late February, somewhat ahead of our earlier expectations, product availability remains well below a year ago for the majority of the quarter.

In contrast products, sales were down 9% as strong competitive activity is driving continued price pressure in the US, which more than offset positive results in Europe. We expect the US pricing to continue to negatively impact us throughout 2009, causing further downward pressure on this segment. In addition, sales of capital equipment to hospitals including urology tables and power injectors were below a year ago.

In Pharmaceutical Products, sales more than doubled in the quarter to $519 million, with Oxy ER as mentioned earlier, contributing $258 million. Excluding Oxy, pharmaceutical sales increased 9%, or 14% on an operational basis, excluding foreign exchange lead by higher sales of generic products for pain management.

We are currently benefiting from an industry wide supply issue with oxycodone related products, due in part to several competitive products being removed from the market because of recalls. As this supply constraint eases we expect growth in our pharma business to return to more normalized levels. Sales of active pharmaceutical ingredients were below a year ago entirely due to unfavorable foreign exchange.

Finally, in Medical Supplies sales of $243 million were 10% above those of a year ago, primarily due to higher sales of nursing care products. As we have said before the timing of distributor orders and supply contracts can affect us from time to time. In addition to market share gains during the quarter, we also experienced some above normal increases in distributor inventories that positively drove our medical supply sales higher. These higher inventory levels will likely reverse over time.

As mentioned last quarter, we have made the strategic decision to rationalize some very low margin business in this segment, which will also lower sales growth rates for the second half of the year. This should bring sales growth for supplies back to historical levels, consistent with our 2009 guidance.

Now turning to items below the sales line. On a GAAP basis gross margin was 56.2%. Excluding ER, the adjusted gross margin was 51.8% versus 52.4% in a year ago. The year-over-year decline was due primarily to unfavorable foreign exchange, which more than offset favorable mix. In addition, we saw some higher costs in our supplies and imaging businesses. The supplies costs were impacted by higher raw material costs while imaging experienced higher costs surrounding the disruption of our moly supply.

At current rates, we expect foreign exchange will continue to pressure our gross margin for the remainder of fiscal 2009. Second quarter SG&A was below a year ago. This reflects the timing of spending, coupled with some benefits from exchange rates on our costs.

Looking at the remainder of the year, SG&A in the second half of fiscal 2009 will likely be higher than in the first half, due primarily to additional spending for growth initiatives, higher legal spending, and less favorable currency impact, assuming today's exchange rates. R&D expense climbed 31% in the quarter to 4% of net sales excluding Oxy ER, and we remain committed to further increases over time.

As you saw in the release, we also had a couple of special items that affected our reported results in addition to those I mentioned earlier. These included $20 million for in-process research and development, and $9 million charge for restructuring. As reported, operating income was $527 million, excluding the items shown in the non-GAAP reconciliation in the release, which included Oxy ER, the legal settlements, IPR&D and restructuring. Adjusted operating income was $488 million, with an operating margin of 20%.

Looking below operating income, net interest expense was $38 million and other income was $5 million, primarily related to interest on amounts due to us under Tyco International tax sharing agreement.

Turning to income taxes, the second quarter effective tax rate was 65%. As mentioned earlier this rate reflected the shareholder settlements, and several tax matters, including about a $155 million one withholding tax incurred on repatriated earnings associated with the implementation of tax planning strategies. Excluding these items the adjusted second quarter tax rate was 23%. This rate reflects the positive impact of a catch-up in the quarter, due to the tax-planning strategies that we implemented.

Next let me take you through some of the cash-flow highlights. Year-to-date our operating cash flow was approximately $680 million. We have incurred about $180 million of capital spending this year, resulting in free cash flow of approximately $500 million. I want to emphasize that we continue to expect that our business operations will generate strong cash flow. For 2009, we now anticipate that free cash flow will be somewhat below our earlier guidance of $1.4 billion, as the positive impact of the lower tax rate will be more than offset by the one-time withholding tax payment.

Finally I would like to update our 2009 guidance reflecting our year-to-date performance and latest estimates for the remainder of the year. As you know there has been significant volatility in exchange rates over the last six months, and unfavorable exchange has damped our reported sales growth by about 5 percentage points thus far in fiscal 2009.

As noted earlier, to provide a better look at our ongoing business, we are providing guidance for the year, excluding the impact of Oxy ER. At current exchange rates, we expect total company sales for 2009 to be down 3% to flat versus 2008. Our operational growth, which excludes foreign exchange, should be up in the range of 4% to 7%.

By segment, at current rates, we continue to expect medical sales and medical devices to be in the range of down 3% to flat, consistent with our earlier guidance. We expect the endomechanical, soft issue repair, energy and vascular business will continue to deliver good growth, but this will be partially offset by slowing in hardware and capital items as noted earlier.

There has also been no change to our guidance for Medical Supplies, up 2% to 5% for the year, as indicated earlier sales growth was slow in this segment back to more normalized rates in the second half of the year. Sales of Imaging Solutions are now projected to be down 9% to down 6%. The imaging guidance takes in to account our expectation of further weakness the US contrast business and a capital slowdown partially offset by some generator pricing benefits and positive outside US performance.

For Pharmaceutical Products, we anticipate sales will be up 5% to 8% in 2009, as we expect to receive further benefits from the base oxycodone market shortage, coupled with growth for branded pharmaceutical. These gains will be partially offset by lower sales of narcotic products and peptides in the API category. As noted earlier, these new estimates exclude the one-time impact of Oxycodone ER sales both in fiscals 2008 and 2009.

In addition, the increased scrutiny in the regulatory environment is lengthening new drug approval cycles and controlled substances. So we do not expect any of our ANDAs to be approved in fiscal 2009. These products were never included in our guidance.

For 2009 operating margin, our expectations are now in a range of 19% to 20%. Foreign exchange rates will continue to pressure our gross margin and we will maintain our ramp up in R&D spending. As I mentioned SG&A dollar spending will most likely be up sequentially in the second half.

Our effective tax rate is now expected to be in the 25% to 27% range. This new rate is about 300 to 400 basis points below our previous guidance, reflecting the tax-planning initiatives we implemented this quarter. Both operating margin and tax-rate guidance exclude the impact of any one-time items.

Now I'll turn the call over to Cole for Q&A.

Cole Lannum

Thanks, Chuck. For questions and answers, I'm going to ask that you please limit yourself to one question and a follow-up if needed. We have a number of people in the queue, so after that you can put yourself back in the queue. Katie, can you please repeat once again the process for signaling for a question?

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Tao Levy from Deutsche Bank.

Tao Levy - Deutsche Bank

Just so that I am clear, and on apples-to-apples basis if I look at your operating-revenue guidance, and if I were to include Oxy, did your guidance go up by 1.6%? Is that the right math there?

Cole Lannum

The operational guidance did go up slightly, because if you look at the impact of Oxy ER, it was roughly around, a little over 3% to our revenue. So we moved our operational guidance which was with Oxy 6% to 9% to 4% to 7%.

Tao Levy - Deutsche Bank

Okay so it did go up. Okay I just wanted to be clear there. And also you had mentioned in your comments that you had seen some good stability through April in your businesses. Does that also include the surgical procedures in which Covidien is involved?

Cole Lannum

Yes, it does Tao. It has been pretty consistent, we started watching very closely as you can imagine back in the fall. You see it for sure, it is very measurable and palpable in capital, but in our surgical and energy base critical care products, you know, we have not seen any significant impact whatsoever. You have seen a little bit of distributor activity, but just the kind of ups and downs that we see typically in this business with so much of our sales going through the big wholesalers.

Tao Levy - Deutsche Bank

Did you call out the foreign currency and gross margin? That's it. Thanks.

Chuck Dockendorff

No, you're talking about the four, the specifics of impact of gross margin?

Tao Levy - Deutsche Bank

Yes, I was just wondering what it was in the quarter?

Chuck Dockendorff

We don't really mention it, but we do, it is a negative toward us. And it's a combination of the gross margin, you can see it down slightly, and it's a combination where we're getting favorable mix and that's continuing on we expect that to continue and the negative foreign exchange has some negative issues of raw materials and costs. That's to a smaller extent. The bigger impact is the FX and continues for the balance of the year.

Cole Lannum

And it's a significant impact.

Operator

(Operator Instructions). Your next question comes from the line of Taylor Harris from JPMorgan.

Taylor Harris - JPMorgan

If I look at your organic growth, excluding Oxy in the first half of year, it has been at the upper part of your range, the 6% to 7% into the range. But you mentioned a few things on the call that make me wonder if you are looking for a lower organic growth in the second half of the year, you talked about inventory issues that you're actually benefiting from pharma competitor issues. And then sounds like you are expecting the capital environment maybe you can get a little bit worse. So just can you comment on that and should we be expecting organic growth to moderate in the back half of the year?

Cole Lannum

Yes, I think when you look at the components of it, while the segments of it, we would expect medical devices to continue on typically of what they have been in that range, but on the supply segment as we talked about, we expect the second half growth to be a little lower. As we've experienced some gains from new contracts in the first half, we also have some timing and distributor order in there, so we would expect that to slow down.

So that would drive down our overall guidance a little bit or sales growth rate in the back half of the year. Including that is imaging as well, which we see, you know, some softness around the contrast products in the pricing area and competitive pressure, but those would be the major components that bring that down in the second half of the year.

Chuck Dockendorff

The only comment I would make, Taylor is I don't think we are seeing or anticipating any accelerated issues with respect to capital purchases. It has been pretty significant on like ventilators if you would break that out. You can definitely see a reduction in some of the forced [triads] to a lesser degree. But as we look going forward, you know, we don't see that deteriorating further.

Taylor Harris - JPMorgan

Okay. That's good to hear, so it sounds like not really much of a moderation in the device business at least?

Cole Lannum

Yes, correct.

Rich Meelia

Right.

Taylor Harris - JPMorgan

Okay. And as my follow-up, the SG&A performance was pretty impressive in my mind, and I'm just surprised that you held SG&A effectively to the first quarter levels, given the fact that in the first quarter, you had a hedging benefit, as I recall. So was there anything in particular that kept SG&A so well controlled.

Chuck Dockendorff

Yes, we had another hedging benefit in Q2 as well, Taylor, and that's part of the reason that it will also go up. The SG&A dollars will go up in the back half of the year, so we had benefit in Q2 as well from the hedging.

Cole Lannum

The other part about it Taylor was there were some timing issues. When you get this on a quarter-to-quarter basis, sometimes that will come through, and I think you should take away this from our intention to continue investing in the growth areas of the business, and it has not changed at all, and because of that, you'll see some higher growth and some higher spending in SG&A in the second half of the year.

Taylor Harris - JPMorgan

Chuck, are you able to quantify the hedging gain?

Chuck Dockendorff

It's roughly in the range of like $25 million.

Operator

Your next question comes from the line of Joanne Wuensch from BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

I think you are the only company that I have listened to the conference call, so far that talked about a positive impact from distributor stocking. Can you explain a little bit what that is, and if it is expected to continue?

Rich Meelia

Yes, Joanne, this is Rich. It was limited to our supplies group and really had to do with pretty significant contract that we got with one of our wholesalers where we kind of became a house brand in the wound care segment. And so there was some stocking of our product and as they destock the brand we replace. So that was kind of a first half phenomenon. They are now at the level that they need to be to service the business.

Cole Lannum

Joanne, across our other businesses. I mean, it's important to understand, we sell a lot of products, and a lot of them go through distributors, and inventories do go up or they do go down, over time, but by and large it was not material across the rest of our businesses.

Joanne Wuensch - BMO Capital Markets

Shifting to other sort of quarterly hot topics, pricing. Can you sort of give us a little bit of color or even quantify what kind of pricing environment you are seeing at the hospital levels?

Rich Meelia

Well, ironically enough, we have been measuring price volume forever around here, and this is one of the first times in several of our categories, we're actually seeing price increase, and I think it's a reflection of the added value products that we're bringing to our customers as a result of the investments in the growth initiatives we made.

I think if you think about what happened just recently at SAGES, where we launched the Bacchuss product, which is its high price with the value it brings to them in terms of safety and efficiency, its well worth it. The SILS product, the same thing.

So, the overall pressure on pricing is clearly there, we have been of the opinion that it has been there for a long, long time. Hospitals have been under pressure as a result of a lot of issues, and this might be heightened for sure, but it's not. We have not felt any significant additional pressure, the typical pressure we have been operating under for a number of years.

Joanne Wuensch - BMO Capital Markets

Okay. And then finally use of cash, how we should think about that going forward. Thank you.

Chuck Dockendorff

Yes. I think as we mentioned before, where we do have the strong cash flow, we ended with a lot of good portion of cash on the balance sheet, and what we're doing there is we paid out approximately 25% out in dividends, and we just announced a share repurchase program for $300 million as well. So we're beginning to look at this cash both use and acquisitions and further potential dividend improvements things like that, and we'll be looking at that over the next couple of months.

Operator

Your next question comes from the line of Christopher Warren from Caris & Company.

Christopher Warren - Caris & Company

Somebody who is not a drug analyst, could you maybe give some more detail on what you see as an oxycodone shortage, and how that can impact the pharmaceutical growth rates for the next couple of quarters?

Cole Lannum

Sure. Chris, there were a couple of our competitors that had issues in base sales of oxycodone, it's important to discern that's different from the oxycodone extended release contract that we were selling under this. It's a completely separate part of the business. It's more concentrated in the immediate-release section. This has been going on for a while, and we've actually talked about it very briefly on our last couple of conference calls.

It was particularly enhanced this quarter, because the FDA has been working with all the manufacturers, including ourselves to drop to try to address this shortage, because it is having a real impact on patients.

So, we have been manufacturing as quickly as we possibly could, and certainly we have been benefiting financially from the fact that these other two players have been off the market. I think the important thing to understand is as we look into second half of 2009 and certainly going in to 2010, we expect these competitors will return to the market, and as they do, some of the particularly high growth rates we're seeing in that business will return back to normalized levels.

Christopher Warren - Caris and Company

Okay. Just following up on that, so is it fair to say that maybe the pharmaceutical business can grow in your double-digits constant currency until those competitors come back on to the market?

Chuck Dockendorff

I think, I would refer back to the updated guidance that we gave excluding Oxy ER. If you take a look at what the business has done so far I mean first half of the year that implies second half growth rate that is significant below what you just now talked about.

Christopher Warren - Caris and Company

Okay and just one another quick question. Any pressure at the hospital level associated with the rack audits and the hospitals gearing up for that in the surgical area?

Rich Meelia

We haven't felt that. Just haven't seen it.

Operator

Your next question comes from the line of Rick Wise from Leerink Swann.

Rick Wise - Leerink Swann

Let me start with Med US growth for the med supply or medical device business. When I look at the six-month results, you grew 8%. The second quarter you grew 9%. It seems like you are picking up steam, your are accelerating. Do you think you are gaining share, some of it seems to be at the upper end of what we have seen from some of your competitors. To what degree our inventory stocking is there and maybe if you want to highlight the products that might be driving that share gain. Thanks.

Rich Meelia

Yes, sure, Rick. It's Rich. We believe we are taking a little bit of share from some of our competitors. The new product flow has been real, and I think the execution by the divisions has been really superb, and as a result in areas like endomechanical, where it's been a combination refurbishment of the base product line, and introduction of brand new products like SILS and TRS and the Duet.

In hernia, just doing very well with the AbsorbaTack, product recall is beginning to come around. The synthetic mesh has been great. Several different versions of that mesh have been launched over the last year. And so I think we're benefiting from these new products and the additional salespeople that we have hired in order to sell these in a very focused manner.

Christopher Warren - Caris and Company

Rich, second question, sort of a high-level one, I just would be curious to hear your latest updated thinking on both the acquisition and divestiture front. You certainly sound unhappy about understand a little about the imaging, you seemed unhappy about with respiratory recent quarters. It's uncomfortable to talk about here, like you have already seen some more radical change. On the acquisition front, you have been active, but quieter than I might have thought. Any particular reason there just again just your high level thoughts on those. Thanks

Rich Meelia

Sure. The portfolio management is probably the most important thing we do. We talk about it all the time, and we really spend a lot of time evaluating the portfolios, and we will look at investments or decisions we have made in the past, and if it looks like those decisions are not working out, we're not even a least bit proud to think that maybe we need to go in different directions.

So, as you said or you can try to share on a call like this some of our thinking, but when we launch we identified the three big areas, chemical business, and the retail diaper business. Going forward it will be a little, I think more focused and a lot less radical, but you will continue to see changes, and we will deemphasize, and that may mean divest, it may mean harvest, but we're not treating all the different pieces of the portfolio the same. On an acquisition standpoint, we're committed to using this strategy to complement what we're doing from an internal growth standpoint.

We wish we had more activity, but we're very disciplined about the kind of deals we do. We think the environment right now is probably better than it has been in the past, we did have that smaller deal that we did just a couple of months ago, the DVT clot dissolution product. So those are the kind of things we'll continue to do. The activity level is high, but deals are they are kind of things that you can't really control the flow, if you just try to push them for the sake of getting them, then you tend to get the ones that don't give you kind of paybacks that make sense long-term for real shareholder value creation.

Operator

Your next question comes from the line of Bob Hopkins from Bank of America.

Bob Hopkins - Bank of America

Good morning. Just first question obviously there is a lot of puts and takes here with the guidance and the change in methodology. So, I was wondering if you could just confirm some math for me. As we look kind of look through the new guidance, we get to, sort of a rough EPS range for fiscal 2009, including Oxy in the sort of 293 to 323 range, and then excluding Oxy in kind of the 245 to 275 range. And I was just wondering again given all of the puts and takes. If you think our math is roughly in the ballpark given all of the different assumptions and guidance points that you have laid out.

Cole Lannum

Bob, this is Cole, as you know we don't give explicit EPS guidance. The only thing I can help you with there is we did try to be very explicit and let you know what the impact of Oxy has been. For this year, it's approximately $0.50 a share. So, other than that I can only refer you back to the ranges we have given to try to come up with a bottom-line number.

Bob Hopkins - Bank of America

Okay and then two other quick things. Following up on Taylor's question about top-line growth. You guys did a little bit better than 6% constant currency in the first half. Assuming the new range that you have given that suggests roughly 5% growth in the back half as a mid-point, but the range you gave would suggest sort of 2% to 8%.

So I am just wondering how much sort of confidence you have. Is it really what you would like us to be thinking about is that midpoint, that sort of 5% or slight moderation, or did you intentionally get a pretty wide range there, because there is a bunch of unknowns. And then I will have just one quick follow-up.

Rich Meelia

Yes, this is Rich, [Taylor] we're very confident about the momentum that we have in the business and going forward, but we are also not ignoring all the uncertainties that are around us relative to the economy and impact on hospitals. I think the range we have given reflects our confidence that the business is solid, the momentum is real. Our exposure to some of these events thus far, based upon, two full quarters and what we're seeing in April. It is what it is we believe. We don't think a whole lot is going to change, but we just don't want to be unrealistic about recognizing, what is around us.

Bob Hopkins - Bank of America

Okay. Thanks for that. And then for Chuck just quickly, you just talked about SG&A a little bit in the previous question, and by our math that hedging game may have contributed one point. So ex that gain, SG&A maybe came in around 26%. So I'm wondering as we think about that going forward, is that a sort of a normalized run rate going forward. Once some of these other things, move off? In other words right now you have got some; you mentioned some extra projects, some extra legal expenses. Are those temporary in nature and then will get back to this kind of a run rate, or should we be thinking about higher numbers?

Chuck Dockendorff

I think it will be a little higher. Bob, part of this is some discretion spending, and we do have clinicals going on, new product launches going on as you know, some investment in marketing activities, and we manage that for the year and we try to give our guidance on an annual basis. So I think that's more reflective in the operating income guidance that we're giving out there. So you will see the dollars to be up in Q3 and Q4 related to what we've spent in Q2.

For that gain that we talked about on FX, but other additional spending that we are continuing on with in selling and marketing, which is around the growth investment. So our whole philosophy here is our sales growth is sustained, it has been pretty good. We're watching the market, and we want to continue to invest and stay with our strategy. It's working, and we feel very comfortable with it. So it's something that we're planning to do in this back half of the year.

Operator

Your next question comes from the line of Matthew Dodds from Citigroup.

Matthew Dodds - Citigroup

Good morning, couple of questions for you. On the hardware side Rich or Chuck can you just give us an idea in ventilation energy, how much did they decline and how much or what kind of a drag are we talking about in the hardware business versus your overall. Even though it's small, just kind of what level of decline are we seeing in those two? That's the first question.

Rich Meelia

Yes, in the ventilation side of things, Matt, it's 15% to 20%. It's pretty significant. So it's real. And then on the hardware side with energy it's quite a bit smaller, but it has been very much of a growth segment for us, and so the impact relative to our performance is important.

Chuck Dockendorff

I think that speaks a little bit to the some sort of a different current that you see around on other businesses, because in hardware and energy there was actually a little bit of a sequential improvement versus what we had in the first quarter on a year-over-year basis. The first quarter was very, very weak. Did a little bit better this quarter, but then ventilation was much worse this quarter than the first quarter.

Matthew Dodds - Citigroup

In energy did this hold you back with the generators or are there ways to get around the capital budget where you might offer a discount for volume?

Rich Meelia

Well I guess the best way to answer that, I mean, it clearly makes it more challenging, but as we look at our actual, LigaSure related sales. I mean, they are as strong as they have ever been. So the value that our surgeons, customers see in using this disposable is very strong, and so I think they are finding ways to continue to continue to increase the demand in the use despite maybe having fewer generators around. So far the data would say, that they are finding ways-to-leverage the existing base or to work with us in more creative ways to get the additional hardware units in to the hospitals.

Matthew Dodds - Citigroup

Then one follow-up question on the surgical side. In the bariatric space, Rich it sounded like it SAGES that bands have slowed down, but sleeves and gastric bypasses held in, but maybe not benefited from people shifting from bands its just been kind of a loss of bands. So maybe a little slowdown in the overall bariatric space, but not much in the areas you primarily compete in. Is that a fair assessment from what --

Rich Meelia

Yes, I think that's fair, Matt. I think what's helping us a lot in bariatrics, in addition to the fact that the products are getting better, the surgical expertise and capabilities are improving, and all the associated co-morbidities are being mitigated by all that. Still the amount of patients who actually step forward versus the amount of qualified patients, I think we're still on that 1% to 2% range.

So, as we get better in helping our customers market their capabilities, and between the surgeons and the tools, improving that expertise I think that allow us to feel good about the bariatric business, because we have not seen a slowdown in sales of bariatric related instruments at surgical.

Operator

Your next question comes from the line of David Lewis from Morgan Stanley.

David Lewis - Morgan Stanley

Chuck or Rich, just thinking about revenue for a second in terms of the guidance, obviously it's improving on a constant currency basis. It appears that most of that obviously is medical and pharma. I wonder if you could provide us on a relative basis what percent of that improvement is actually coming from better outlook in medical devices.

Chuck Dockendorff

Well we've see medical devices, we see that kind as holding steady, at the rate it has been growing in the first two quarters. So that rate will be consistent in the balance of the year. That's why we kept our guidance consistent with where it was before. So on as-reported basis, it will be down a little bit because of the FX thing, but from an operational basis we see it continuing at the same rate it has been. So, it's not a decline or a significant increase in medical device that's driving our component of our overall sales guidance.

The positive moves about medical devices is that the bigger and higher-growing segment such as endomechanical, or hernia biosurgery those are the areas where we are doing exceptionally well too. So we have said from the beginning and we think management of the portfolio and the creation of a more valuable mix is all part of the ultimate strategy here and it just continues to work. The scene is much right now, because it is some of the FX impact, but its happening.

David Lewis - Morgan Stanley

Sure I understand that, but I'm trying to get to the improvement on a constant currency basis that is implicit in your guidance that is being driven primarily from what segment? Would it be foreign products?

Cole Lannum

Yes, a big piece of it is pharma David. And we also did a little bit better in the supplies business in the quarter than we expected.

David Lewis - Morgan Stanley

And then just Rich kind of getting to your qualitative commentary on some of your core businesses, obviously soft tissue as well as energy is growing double-digits. In terms competitive launches more specifically in energy in the back half of the year and to a lesser extent hernia. Your outlook for medical devices, you are still very confident in the back half given these competitive threats?

Rich Meelia

Yes. The growth rates are very strong. They are not waning whatsoever, and just knowing what we have from new product flow, it's we do believe that the momentum is very sustainable, and that while we have taken advantages of competitive situations, I think our ability to continue to compete very, very effectively, it will be demonstrated.

David Lewis - Morgan Stanley

Rich, in terms of R&D outlook, obviously a little higher this quarter, what should we be thinking about in terms of a new long-term rate. Historically we're thinking sort of 4%, could that rate be as high as 5% for the next two years. And I guess, secondarily, are you more comfortable now than you were six months ago that any R&D increases or increased investment can be offset by your SG&A leverage programs?

Rich Meelia

I would say that, from where we want to be 4% to 5% in total is over the next two to three years is what we said. And that's in the aggregate. That means $1 billion plus supply business is not going to spend much on R&D, whereas other businesses especially in devices, pharma, they will require, and we look at what our peer group spends, and that's about where we look like we'll on that 5% to 6%.

Eventually we'll be able to compensate for this investment by leveraging SG&A. I mean, our plan is to take a mid-to upper single-digit sales growth and leverage that to a double-digit earnings growth, and that remains our kind of commitment.

Chuck Dockendorff

This is Chuck. We're not sitting here trying to offset specifically on our decreases in SG&A. What we talk about this double-digit income growth, that's our goal, and there is a lot of factors that go in to that, whether it's the improvement in gross margins, mix is driving some of that, there will be some SG&A leverage, and investment in R&D, there's potential tax savings, and interest savings. So there's a whole host of things that drive to that double-digit income growth on a consistent basis. So it's a mixture of all of those, its not one-for-one offset.

David Lewis - Morgan Stanley

One last question and I'll jump back in queue, either Rich or Chuck. In terms of the imaging businesses, is there anything besides the reactor being back online that gives you more confidence and sort of that? Did that lower at the end of the guidance range?

Rich Meelia

Can you just repeat that question?

David Lewis - Morgan Stanley

Sure, just in terms of imaging guidance. You saw a reasonably comfortable last quarter, but just in terms of the lowered outlook here the comfortbility you can provide besides the reactor just being online. Is there anything else we should be aware of that's give you the confidence in that number?

Rich Meelia

The strategies that we have began executing in terms of pricing and (generics) that maybe we think they will be able to be more successful based upon the availability of generators. So, that gives us confidence that we're good relative to our guidance in imaging.

Operator

Your next question comes from the line of Kristen Stewart from Credit Suisse.

Kristen Stewart - Credit Suisse

Chuck just kind of looking at foreign exchange from an earnings impact, is it fair to say that that was probably about $0.03 to $0.04 on the earnings side day before?

Chuck Dockendorff

Yes, it was in that range. That's right, Kristen.

Kristen Stewart - Credit Suisse

Then just looking at the operating margin guidance, if we were to look at it apples-to-apples, you said you increased kind of the sales guidance, where have your operating margins changed I guess overall related to what you were expecting a quarter ago?

Cole Lannum

Kristen, it's probably a little bit better, but I think it's important that you understand that we're now taking Oxy out of the mix, and that's the main reason why the absolute numbers are lower than they were before. The actual number on an apples-to-apples basis is probably it's a tad better than it was before but not materially different.

Kristen Stewart - Credit Suisse

Okay, and then I guess just an update on the relocation over to Ireland are there any costs that you are incurring in switching over to Ireland, and just kind where does that stand in the process? And can you use some of your share repurchase flexibility to take advantage of any potential weakness, I guess to the extent S&P does remove you from the S&P index.

Rich Meelia

Yes. As far as cost there is really minimal cost. We have proxy filing and some legal things that we file, and the kind of operations that we have, [maybe] we'll have in Ireland. So it's not significant to the company and going in this year as far as any additional cost. We do have the share repurchase program authorized out there. We have been in a blackout period because of the situation here with the earnings release and reduction in tax rates, and things like that, which will open up here over the next month, and anticipated needing to approve that move is May 28th. So, certainly the S&P as Cole has talked about, that decision is up to them, but we'll be able to execute on our share repurchase any time frame in May.

Kristen Stewart - Credit Suisse

Did you guys give out the specific kind of sales performance for API and dosage in the quarter on a reported basis? What those doses were up in the case of dosage and down for API?

Rich Meelia

Hold on just one second, Kristen. I'll get that for you. The dosage business was up very, very strong. Think of that being in the 20 plus percent range, this is of course excluding Oxy ER, and that's where lot of the benefit from the competitive outage came through. On a reported basis, our API business was down high single-digit.

Operator

Your next question comes from the line of Glenn Navarro from RBC Capital Markets.

Glenn Navarro - RBC Capital Markets

First on the contrast media side over the history of Covidien you've had good years and bad years with contrast media, and this year is going to go down as a bad year. Does this business, the outlook, can it get better next year? Can pricing moderate? That's question number one. And then number two, on the tax rate moving lower is that also a good tax rate for fiscal 2010 and could the tax rate move lower in '010 and beyond? Thanks.

Rich Meelia

Sure. Glenn this is Rich I'll take the first one and Chuck can talk about the second one. The pricing on contrast this has been kind of a dynamic in the marketplace since the mid-'90s and perks and the PPL is really focused in carriers like this and its going up and down. We think that the current pressure is a result of certain competitive activity. We're not leading it.

So how it kind of projects in to the future, really depends upon how the competitors kind of decide they want to approach the market, whether it's going after share gains or just trying to deal with the pricing stability or instability. So, we're hoping that there will be a little more stability going forward, because we don't see the advantage of just driving more units at the expense of the margins. So it's a matter of watching what our competitors do. From a tax rate standpoint, Chuck you could --

Chuck Dockendorff

Yes, knowing everything that we had today I will tell you that our tax rate will be down next year from where it is, from the current guidance. Now, having said that, we don't really give guidance for 2010 until in September time frame so, but based on what we have done today and the execution of these tax-planning strategies half way through the year, we're going to realize some benefit from those. We have other tax-planning opportunities we were looking at as well. So we would fully expect that to go down.

As you know there's a lot of talk in Washington about changes to tax rates, and that doesn't reflect any of that, and we would prefer to wait in to the September range time frame to really see the potential impact on these things as well as our business to give guidance going forward. But everything else being equal from what we know today it should go down somewhat next year.

Glenn Navarro - RBC Capital Markets

Great, just one quick follow-up. You mentioned issues of tax rate in Washington, you guys are immune from that, given that you are not a US based company to begin with, correct?

Cole Lannum

Not necessarily, no I mean. There are certain parts of it that don't impact us, there are other parts that are, and so any legislation can impact income in the US that we make here.

Chuck Dockendorff

The deferred income that they are talking about today would not apply --

Cole Lannum

Would not impact us as much, right. But there is other things about deductions of US companies and things that they --

Operator

Your next question comes from the line of Jayson Bedford from Raymond James.

Jayson Bedford - Raymond James

Just on the gross margin, you mentioned the higher input cost on the supplies business and it sounds like you still have some high cost inventory there. I'm just wondering when does that reverse, and when do you start to see the impact of lower input costs?

Rich Meelia

Yes, we have really seen it. I think we talked about it. We saw it going in to the year, about $75 million increase in raw material cost. Primarily it was around our supplies business, and somewhat imaging and pharma business, and we have seen that come down consistently this year as the economy has weakened a lot and those costs have come down as well.

We're in the range now, probably if you look at year-over-year we're anticipating maybe $20 million to $30 million increase year-over-year, for those same kind of products that we are driving a $75 million increase before. So we're seeing it come down, and we expect, you know it's hard to predict where they are going to go from here, but certainly it is less than what we thought going in.

Jayson Bedford - Raymond James

Okay. That's helpful and then just secondly, can you comment on the operating margins in the imaging business. I think you highlighted some of gross margin challenges. But anything you can do structurally to improve the profitability of this segment in the face of what appears to be a little slower revenue growth.

Rich Meelia

Yes, we actually did announce in our St. Louis facility some kind of consolidation of some of the functions between imaging and pharma that will take cost out, and we're looking at other areas as well. We believe that we can continue to drive up the margins, but we think it is going to take longer and the upside is probably not what we once had hoped.

Jayson Bedford - Raymond James

Okay. Is it fair to assume the mid single-digit in the quarter?

Rich Meelia

Yes. That's a right ballpark.

Cole Lannum

Operator we are done, passed about with the hour. We can take two more question and then we will wrap up.

Operator

Your next question comes from the line of Peter Bye from Jeffries and Company.

Peter Bye - Jeffries and Company

I'll just take one, just maybe just a follow-up on your portfolio management theory. You had identified some areas when you came out of the spin. Some have been successful, some not so, when you think forward about that, how do you make the decision about hey is this tactical mythic execution structurally. Is the opportunity still there versus maybe what you alluded to on the last call about sleep or you might have underestimated the structural challenges. Maybe just the thought process that goes in to that, has that changed at all. How much time do you give a business to turnaround? Has that changed at all?

Rich Meelia

Yes, I mean, we have certain financial hurdles that all of our investments must make, and we have been pretty clear about what those are, and then we make the investments and put the resources in to, in order to get those returns. I would say that, based upon the size of the opportunity what we believe to be the degree of complexity, that affects how much time you give it before you see it begin the pay back.

We look at some of our commodity businesses and to make it (inaudible), something like sleep, which you brought up. Peter would be one that, because of the attraction of the market, and kind of the complexities in the distribution channels in trying to determine what it takes to be successful. That would take a little bit longer time.

Usually I would say within a year or two, you have a pretty good idea of your ability to succeed or not succeed, assuming you are looking at what you are bringing to the customers versus your competitors and the value propositions are equal.

So, we think one of our benefit of our space is that we're kind of the middle of the medical technology area. We're not at the high end, and it doesn't take a long, long time to develop the technology and the products to determine whether or not you can make it work or not. So I would say within a year or two most of the calls can be made with a fair amount of confidence.

Operator

Your final question comes from the line of Taylor Harris from JPMorgan.

Taylor Harris - JP Morgan

Thanks for the follow-up, couple of quick questions. Chuck can you just explain the withholding tax you are having to recognize this quarter?

Chuck Dockendorff

Yes, it had to do with, again there was some dividends that we, when we split from Tyco, we split these companies up, and that was part of the tax synergies that were left or lost as a part of that split up. So what we were able to do was to reallocate some of the cash and through that some of the dividends and capital, and that is just the tax on the repatriation of those profits from the foreign entities.

Taylor Harris - JP Morgan

Okay. I got you. Then Rich, I guess two ones for you. One you made this little deal for Bacchus in Vascular. Is vascular business, I have thought of that within Covidien as a pretty low-technology business, stockings et cetera? Is there a higher technology component that I'm not aware of, and are you going to continue to move it more in that direction. I guess that's number one. Number two, is just confirm for us, is radio pharma getting better in the balance sheet? I'm not saying that pressure is on contrast, but is the supply chain issues in radio pharma improving?

Rich Meelia

Yes. Vascular, when we talk vascular it is the compression products as well as dialysis catheters. The compression, is a very good business, high, high margin, not the technology, component that we see, but still very good business, valves, catheters, a lot of technology, coatings, antithrombosis issues, and so. We like it. The Bacchuss deal was right in the sweet spot. We are looking to invest in this area.

Taylor, we think we're a natural owner. We call on the decision-makers for these and other products, and so we like the space, and we'll start, I think talking about it more going forward. It has been buried in the patient care and safety products areas, but we think it's an example of an adjacency buildup that can make a big difference, similar to what we have done in biosurgery, hernia, ventilation, et cetera. So this is just kind of a continuation of some of the strategies we have employed in the past.

Relative to radio pharmaceuticals, it should get slightly better in the second half. We should have a steady supply of generators and the other tactics that we have been executing on relative to price and the [generics] estimate we should have a better impact in the second half.

Cole Lannum

I think the thing to keep in mind, Taylor, and everyone is that this is why we continue to talk about the fragility of the manufacturing issue there. That Petten plant will go down again sometime in calendar 2010 for at least three months, and that's something that we will be facing, we have to deal with from a planning process, as we look forward over the next 12 months or so.

Okay. Everyone I would like to thank you again. I know we went a little bit past the bottom of the hour. I appreciate it. I know we have a lot of things going on in the quarter this year. Starting at noon Eastern Time today a replay of the call will be available. Additionally the replay will be available on our corporate website, covidien.com a few hours from now.

For any member of the media who have listened to the call and have additional questions you can please contact Eric Kraus, our Head of Corporate Communications, and for any of the analysts having more detailed questions involving non-material information, Brian and I will be available to take your calls.

Thanks again, and have a great day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference call. You may now disconnect. Have a wonderful day.

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Source: Covidien Ltd. F2Q09 (Qtr End 03/27/09) Earnings Call Transcript
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