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Executives

Coleman N. Lannum - Vice President of Investor Relations

Jose E. Almeida - Chairman of the Board, Chief Executive Officer and President

Charles J. Dockendorff - Chief Financial Officer and Executive Vice President

Analysts

David R. Lewis - Morgan Stanley, Research Division

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Matthew J. Dodds - Citigroup Inc, Research Division

Kristen M. Stewart - Deutsche Bank AG, Research Division

Frederick A. Wise - Stifel, Nicolaus & Co., Inc., Research Division

Richard Newitter - Leerink Swann LLC, Research Division

Jason Wittes - Brean Capital LLC, Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Glenn J. Novarro - RBC Capital Markets, LLC, Research Division

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

Matthew Taylor - Barclays Capital, Research Division

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Covidien (COV) Q2 2013 Earnings Call April 26, 2013 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the second quarter 2013 Covidien Earnings Conference Call. [Operator Instructions] During today's call, Covidien may make some forward-looking statements and it's possible that actual results could differ materially from their current expectation. Please refer to the cautionary statements contained in the Covidien's SEC filing, included in the form 10-K and 10-Q report for additional information about factors that could cause actual results to materially differ from those anticipated in such forward-looking statements. The company may also discuss some non-GAAP financial measures with respect to our performance. A reconciliation of non-GAAP to GAAP measures can be found in Covidien's press release and its related financial tables, as well as in the Investor Relations section of covidien.com.

I would now like to turn the presentation over to Mr. Cole Lannum, Vice President, Investor Relations. Please proceed, sir.

Coleman N. Lannum

Thanks, Chicana and good morning, everyone. With me today are Joe Almeida, Covidien's Chairman, President and CEO; and Chuck Dockendorff, our Chief Financial Officer. In addition, given the impending spin-off of our Pharmaceutical business in a couple of months, we also have Mark Trudeau, President of Pharmaceuticals, joining us on the call today. We'll be making some brief introductory remarks and then spend most of the time this morning answering your questions. I want to remind you that today's call we'll focus on our second quarter results. We will not be discussing guidance or our future outlook. As noted in the release, we'll provide guidance for both RemainCO Covidien and for Mallinckrodt after the close next Friday. For the second quarter, we reported GAAP diluted earnings per share of $0.93 and after adjusting for certain specified items, our non-GAAP earnings came in at $1.12 per share.

I'll now turn the call over to Joe, who'll go into more detail on the second quarter results. Joe?

Jose E. Almeida

Thanks, Cole. Let me begin by saying that we am pleased with our second quarter results. Sales are on plan, up 7% operationally and up 5% as reported. In several key categories, including stapling, Energy, neurovascular and Specialty Pharmaceuticals, we continue to grow ahead of the market and the recent investments we've made are contributing to our robust performance. In the Medical Devices segment, we had a very good quarter, with 6% operational growth and broad-based increases across the segment.

In the Pharmaceuticals business, sales were significantly higher than a year ago, led by an outstanding performance for Specialty Pharmaceuticals. And in supplies, reported sales were above a year ago, reflecting increases in Nursing Care, led by enteral feeding products.

Before I go into more detail on these results, I'd like to spend a brief moment discussing the health care products marketplace. Overall, we saw very little change in the market environment over the last several months, with no rebound in the U.S. in procedures of interest to us. In Western Europe, austerity programs and the economics slowdown continue to pressure all of med tech, with particular weakness in Spain and Italy. However, our overall European performance was better than expected, driven by the much smaller, but faster growing emerging market portion of Europe.

For our emerging markets business overall, comprising Eastern Europe, Middle East and Africa, Asia and Latin America, we had another excellent quarter, with operational sales growth in the high teens and double-digit increase in all regions and all product lines. The performance was led by continued strength in the BRIC countries. These results reflect the investments we've made in the last couple of years to expand sales and marketing and to build an on the ground presence. We still see excellent opportunities in emerging markets, and we'll be ramping up our investments throughout this year. The results we're now delivering from our prior investments give us confidence that this spending ramp-up will deliver further growth in this fast-growing regions going forward.

Let me now turn to our second quarter performance and individual product categories. As in the past, I will discuss our growth on an operational basis excluding the impact of foreign exchange. In our Endomechanical business, stapling products had another strong quarterly performance, led the innovative Tri-Staple reloads. We are experiencing strong demand for the Tri-Staple as we continue to grow above the market and gain incremental share in stapling. Our Energy business turned in another good performance, led by a double-digit gain from vessel sealing for the 30th consecutive quarter. New products, including LigaSure Small Jaw and Sonicision contributed to our good results.

Turning to Vascular. Our overall growth rate slowed a bit this quarter primarily due to the loss of a U.S. GPO contract in our compression business. We again delivered double-digit growth in neurovascular and chronic venous insufficiency products. We continue to see stroke as an attractive market, and see opportunity for the new generation of treatment devices such as Solitaire for mechanical thrombectomy. We plan to augment our investments in technology and clinical trials to further establish this important therapy.

Near term, we face difficult comps for the remainder of the year on both Solitaire and pipeline. In addition, as we noted last year, our second half results were bolstered by a competitive recall, making our peripheral vascular comps particularly difficult for the next couple of quarters. We need plans -- rather, we have plans in place to address the challenges in our business, and we still consider Vascular to be a key growth engine for the company. However, we do expect sales growth for the third quarter to be significantly below that of Q2. Longer-term, we continue to expect our Vascular franchise to grow in the mid- to high-single-digit range. In Oximetry & Monitoring products, sales were well above a year ago, aided by the Oridien acquisition and double-digit growth for pulse oximetry sensors.

Turning to Pharmaceuticals. Sales grew 13% as we continued to execute our strategy of growth and expansion in Specialty Pharmaceuticals, which again registered exceptional growth, based by 2 additional dosages of Methylphenidate ER, the generic form of CONCERTA, good growth for EXALGO and the addition of Gablofen. We also benefited for some stocking orders for the Methylphenidate ER launch in the quarter. In contract -- in Contrast Products rather, as expected, sales were below last year due to significant declines in contrast media. As we noted previously, the business has become more commoditized, driven by negative market trends, lower utilization in developed markets and pricing pressure. Sales of Active Pharmaceutical Ingredients were all well above a year ago, primarily due to an increase for narcotics. In Radiopharmaceuticals, sales declined due to a lower generator [indiscernible] sales in the U.S. As we noted last quarter, one of the reactors that supplies their raw material for our generators in the Netherlands has been shut down since November. Our alternate sources of supply come at significantly higher cost to us. Our current expectations are that this reactor will restart in few more weeks. However, this restart is out of our control and presents a potential risk if it is further delayed. We remain on track for the planned spin-off of this business at the end of the fiscal third quarter. We asked Mark Trudeau to join us today to answer any questions you may have on the business.

Turning to Medical Supplies. Sales in Nursing Care were well above a year ago, reflecting strong growth for enteral feeding products as we are benefiting from a competitor withdrawal from the market. This quarter's increase also included some onetime benefits from capital purchases, which are not expected to continue in the second half of the year.

Overall, we're pleased with our results this quarter. As we've noted, we know that we face some very difficult sales comparisons for the second half, as foreign exchange continues to be a drag on our results, and we delivered a very strong performance a year ago. That said, we are committed to making incremental investments in expanding our capabilities and to capitalize on opportunities we are capturing from increased penetration of our products, particularly in emerging markets, Energy and Vascular.

I'll now pass the call over to Chuck, who will discuss the second quarter financials in more detail. Chuck?

Charles J. Dockendorff

Thanks, Joe. As Joe noted, we're pleased with our performance in the quarter as sales met our expectations. Unfavorable foreign exchange lowered the second quarter sales growth rate by about 150 basis points, and our 2012 acquisitions added about the same amount. During the quarter, we continue to increase our investments in R&D, selling and marketing to enhance our future growth. As noted in the release, we registered a 50 basis point decline in adjusted gross margin this quarter, as increased raw material costs, largely in the Pharmaceutical segment, more than offset positive mix and productivity gains. These cost increases were driven by the reactor shutdown in the Netherlands, which is currently expected to continue a few more weeks. Overall, there was no foreign exchange impact on our gross margin, as significant hedging gains offset the negative translation impact.

Reported SG&A spending was above a year ago, reflecting portfolio additions, the medical device tax and the investments we are making in emerging markets, partially countered by the productivity improvements and leverage on our back office cost and base business SG&A. The investments we've made over the last couple of years have driven organic revenue increases, and as Joe mentioned, we are committed to making significant additional incremental investments in both R&D and SG&A to accelerate our growth going forward. On an adjusted basis, our second quarter operating margin was 22.2% of sales, about even with a year ago. Net interest expense was slightly higher. The adjusted tax rate was in line with previous guidance, and we delivered adjusted EPS of $1.12.

During the quarter, we repurchased about $200 million of stock. In the last 12 months, we have returned nearly $1.7 billion in cash to shareholders, representing about 94% of our free cash flow. We plan to provide guidance for RemainCo Covidien and for standalone Mallinckrodt next Friday after the market close. We are not updating guidance today, but I do want to mention a couple of things that will impact Covidien for the remainder of 2013. We face very difficult comps next quarter as last Q3 was unusually strong, and we benefited from a couple of nonrecurring external factors, including customer order timing in emerging markets and competitor recalls in Vascular. We will continue our plan to increase reinvestments in R&D and SG&A to drive our future growth. This is consistent with the comments we made last quarter. Because of these additional investments, we will likely see pressure on both the SG&A and the R&D lines in the second half of the year. As we have said before, we are using some of the windfall benefits from Methylphenidate ER sales and profits to accelerate these growth investments. All current Covidien shareholders will benefit from this, but after the spend, these sales and profits will, of course, accrue to Mallinckrodt shareholders while the incremental spending we are doing will remain with Covidien. As we all know, foreign exchange rates have been volatile. At today's rates, FX will be negative to sales and EPS for the entire year.

Overall, the FX outlook has deteriorated since our last call in January, primarily from the significant downward move in the Japanese yen. As noted, we see a number of opportunities for investment spending to enhance our growth in 2014 and beyond, and we'll prudently fund those growth driving investments. We expect to balance these investments for future growth of the business with delivering shorter-term earnings growth. We continue to feel very good about our prospects given our robust new product pipeline, expanding product portfolio, geographic diversity and strong cash flow.

I'll now turn the call back to Cole for Q&A. Cole?

Coleman N. Lannum

Thanks, Chuck. For Q&A, we already have a number of number of people lined up. [Operator Instructions] Operator, can you please review the process for signaling a question?

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of David Lewis, representing Morgan Stanley.

David R. Lewis - Morgan Stanley, Research Division

Joe, you were really clear on the Vascular dynamics in the quarter and going forward, but I wonder if we turn to Energy for a second. There's some similar dynamics there. You have difficult comparisons this quarter, and going forward, there's been multiple competitive launches last year and into this year in Energy. And I wondered if you can comment on sort of Energy performance this quarter, which slowed maybe a little bit versus our model and how you see that franchise this quarter and how you see that franchise, going forward, given those competitive dynamics?

Jose E. Almeida

Good morning, David. Energy, let's just -- let's split a little bit what we -- how we see Energy. Our vessel sealing franchise did extraordinarily well. It -- well into the teens. What was slow for us this past quarter was hardware, and we saw an overall pressure on capital purchases from hospitals in the U.S., primarily in Europe, which reflects on our ForceTriad generator, as well as ventilators we saw in both categories. So just want to reiterate, we have been in a very competitive situation with our vessel sealing franchise, Energy franchise for a while. We have very respectable competitors. However, Covidien has created a very robust portfolio. We just launched a couple of products in the last 60 days, improvements of current line, products that are more robust, and products that also provide better clinical outcomes. So I'm extremely confident in the franchise. Like I said, our vessel sealing franchise did very well, double-digit growth. So if that was a weak spot, then I would be concerned, but I'm not at all because that franchise, which is the disposable flow of our products is very, very healthy. And capital purchases, as we all know, are very lumpy so that does not concern me at all.

David R. Lewis - Morgan Stanley, Research Division

Okay. Very, clear. Maybe just a real quick one for Chuck. I think we're obviously not going to get a whole bunch of guidance information out of you before next week, but I wonder if you could just share with us plans for Covidien proper's capital deployment in terms of are we going to get a change to guidance in terms of free cash flow to shareholders, buy back dividends? Should we expect significant changes on that front next Friday afternoon?

Charles J. Dockendorff

No, David. I don't think we'll make any changes in our [indiscernible]. Like we said, we raised some debt here as part of the spin-off of Mallinckrodt, which we consider just part of the cash of Covidien, and going forward, we still remain committed to returning a minimum of 50% to our shareholders. Again, we've always stated that we certainly would like to use this to invest in acquisitions and other funding opportunities, but that is opportunistic and we will wait for those transactions to come along, but we have no interest in holding onto this cash or building the cash on our balance sheet unless we can find an investment to put it into that we think is good for Covidien. We will return it to the shareholders.

Operator

Your next question comes from the line of Mike Weinstein, representing JPMorgan.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

So let's spend a minute on the Vascular business. And Joe, if you could maybe break down for us the different pieces here because there's the compression business, which you highlighted that you lost the GPO contract there that hurts the business. There's the peripheral vascular piece. There's the neurovascular piece. There's the CVI piece, the venous insufficiency. So maybe can you give us a sense of how those 4 different pieces are doing and how you feel about this business outside of -- I know peripheral vascular is a tougher comp coming forward, but how do you feel about the growth profiles of each business?

Jose E. Almeida

Thank you, Mike. I think we're pretty clear about the compression business. Those of you not familiar with our compression business, those are pneumatic compression pumps and sleeves that go into patients' legs after or before surgery. We lost a GPO contract. Those things happen. They go up and down. We had made a lot of that loss, but that is 20% to 25% of our Vascular business. So that's an important franchise with very good margins. Clearly, we are focused on the execution so we can mitigate that going forward. So with that said, let me focus on the overall health of our business in the neurovascular peripheral vascular, CVI. The Neurovascular business is going well. As you know, we're going to be anniversary-ing the pipeline next quarter so you're going to see that impact, but we -- based on the numbers that we are collecting at this point, it like we just turned a corner in becoming #1 market shareholder in the U.S. for neurovascular. And that's really good news from a company that was probably #3 or #4 about 3 years ago. So the comps become more difficult. The competition is fierce in this area. You have not only the large competitors, but you have a lot of small companies coming out of there, out of Europe. I'll say that Covidien has amassed a very good portfolio of pre-revenue companies and acquisitions that will give us some really good confidence in going forward in terms of portfolio -- breadth of portfolio. Another thing that I want to highlight in neurovascular before moving on is the fact that our Solitare franchise, we're very excited about it, but it is a very slow process. So as we have great hopes for that, we have a significant amount of marketing dollars earmarked for that as we spend around the globe. It is a very slow process. So as we have a great product, we have a new generation product, let me put it that way, we feel confident, but it's a slow process. The peripheral vascular business, as you know, one of our competitors have a significant recall last year, as you said. We have a very good bag of products. We have total occlusion catheters now. We have our EverFlex stent, as well as atherectomy. I think we are very well-positioned to fight some of the transition from hospital to physician-owned labs. I think that is a big dynamic for us. And I think going down that path, Covidien having a full bag and the ability to be in the commercial negotiation position to do that is very important to us. It's a tough franchise. We have a significant amount of competitors, as you know, there. So it's a pretty good street fight. On the -- and to close the CVI franchise, as you know, we are the only manufacturers of RF catheters and generators for Chronic Venous Insufficiency. I feel confident that, that franchise has a lot of legs still to go, good run way. So long term, I think you're going to see, at Q3, that will be slower than usual, but I see us probably rebounding to Q4 and Q1 next year.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Joe, this week, Cook announced a global recall for the Zilver PTX drug-eluting peripheral stent. Does that ease a little bit the competitive environment the next -- maybe the next quarter or 2 for the peripheral business?

Coleman N. Lannum

Yes, yes, Mike. We're definitely familiar with that recall. The reality is, so far, Zilver had really not that big of an impact in the market. And while we certainly will take every opportunity we can to supply our products to customers that may be inconvenienced there, I wouldn't expected it to have nearly the same kind of competitive impact as the other competitive recall last year had.

Operator

And your next question comes from the line of Bob Hopkins, representing Bank of America.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

So first one for Chuck and then one for Joe. First for Chuck, on the operating margin commentary that you made, especially as it relates to the U.S., is there anyway you can quantify for us the uptick in spend that you'll be doing over the next couple of quarters? And did U.S. device operating margins declined at all this particular quarter?

Charles J. Dockendorff

I really don't want to get into -- we'll release those comments next Friday, Bob. But I think we talked on the earnings call last -- at the last earnings call, we released some pretty significant investments in R&D and SG&A. We also had done some deals here, the drug-coated balloon and others that are increasing our expenses on that line, and that was offset with some windfall we got from the Methylphenidate ER or CONCERTA and we've seen that come through. So from our standpoint, we expect to see increased spending in these areas for the devices going forward. Those profits from Methylphenidate will be with Mallinckrodt as they -- as we spin them out at the end of June. But we don't see a significant deterioration in the operating margins of the device business, and we see continued growth opportunities in emerging markets, which is coming in at a good rate, a high margin, and we see other opportunities to continue. The other thing we're doing is we are -- we don't really talk about it too much, but we've seen some leverage in our SG&A as we've been able to drive through some significant productivity on those expense line items. In fact, I think year-over-year, our adjusted SG&A is down about 60 basis points, despite the fact that we've had the medical device tax come in here and we've made those other investments. So we are driving some pretty good productivity, and we see opportunities for productivity going forward over the next couple of years to fund some of these investments that we have going forward.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Okay. We'll wait for next Friday for more details. And then for Joe, just a little bit of a bigger picture question. On the U.S. device business, since it's obviously such an important division for you, and I know there's some puts and takes this quarter, but it looks like if you exclude acquisitions, the device business this quarter really didn't grow at all. And so I'm wondering from your perspective, as we look forward for the U.S. device business, what is the outlook for the U.S. device business over the next couple of quarters? And what will turn that growth around and return you to positive growth in the U.S.?

Jose E. Almeida

The U.S. business was a very slight growth, a little better than flat. That's a reflection of the combination of utilization restriction that we see, and we've been seeing this all along, with intensification of price competition in the U.S.. So you see both them. Despite the fact that the Endomechanical, in Energy, in neuro, we're making great inroads, it's still a very, very tough market in U.S. as you could see from the other quarter earnings calls from other companies. So I don't see the dynamic changing at all. I think there's a significant amount of uncertainty about some of the further reductions a couple of years ahead of us in terms of Medicare that I think will be -- that makes people very concerned about the U.S. market in general. For Covidien, the products that we sell and the basket, our mix of products, I don't see us undertaking any significant price change for what we have now. But as I tell you, it's difficult -- it's a difficult market that has not improved.

Operator

Your next question comes from the line of Matthew Dodds, representing Citi.

Matthew J. Dodds - Citigroup Inc, Research Division

A couple of questions. Joe, just on that last comment. The prior couple of quarters, you said ASPs had trended a little better than you hoped. Is it the sense now that that's not the case primarily because of the U.S. and Europe? It's kind of in line with what you're thinking or is it a little worse?

Jose E. Almeida

It's slightly -- no, one way or the other is we don't see great variation, Matt. What we are seeing is pricing become even more the center point of any conversations that you have with our customers. And so if I had to think about more of a broad range, pricing-wise, I don't think there's going to be any relief going forward in prices improving because the basket of products that we have, we have the ability in some categories to have some price increases, but we come under a significant amount of pressure in some of the areas of our business such as our trocars, hand instruments, wound care. So some of these areas have a significant amount of pressure as we compensate in some of our new energy devices that we can still get some price increases and some new technologies. So we're balancing well the portfolio, but there's no upside to pricing going forward.

Coleman N. Lannum

Yes. One thing to keep in mind about pricing too, Matt, is our pricing is measured in basis points, not percentage points. So I think you got to be -- I mean, we've talked about this before. You got to be pretty careful about implying a trend. If one quarter, it's 38 basis points instead of 32 basis points, yes, it's a little worse, but is it really significant? I would question that point.

Matthew J. Dodds - Citigroup Inc, Research Division

Okay. And then a quick one for Chuck on the medical device tax. Can you say roughly what the dollar impact or the percentage point impact was on SG&A?

Charles J. Dockendorff

We've said 75% to 100%. It's running at that rate and that's kind of what's been hitting us in the quarter.

Coleman N. Lannum

Yes, and that's on an annualized basis.

Charles J. Dockendorff

Right, right.

Coleman N. Lannum

So divide that by 4.

Operator

Your next question comes from the line of Kristen Stewart, representing Deutsche Bank.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Chuck, I was just wondering if you could maybe just help us break out a little bit more the components of gross margin because you had mentioned that you did have some hedging there, and then obviously, the higher cost related to the radiopharmaceutical business. So how should we just kind of think about what might have been in a kind of more normalized gross margin rate in the quarter?

Charles J. Dockendorff

Yes, I think in the quarter, we were down 50 basis points year-over-year. We still see volume/mix coming in favorable as it -- the same rate as it has in the past, over 100 basis points. We see pricing pretty much where that's been, a slight negative. Nothing -- the volume mix certainly exceeding that. The FX was neutralized in the quarter because we did have the hedging gains that we hit in the quarter, offsetting some of the translation impact, and then the cost was the biggest piece. We did have probably one of the bigger negative impacts from cost. As I mentioned, that was primarily related around pharmaceuticals. That had to do with some capitalized variances with the HFR reactor shutdown, which is causing higher cost in our nuclear business. We've had some raw material increases here in I&I [ph] and in other areas. So they certainly will more than offset that from a dollar standpoint because of the CONCERTA, but from the percentage, certainly impacted us going forward. The -- and looking out, as we see it, not that we keep guidance on gross margin, but we would expect the mix and pricing to continue at the comparable rates that we see, probably a little bit negative on the FX going forward as we don't have the hedge gains anymore. And then I think from a cost standpoint, it will not be as significant as it was in the second quarter.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. And then, I guess, Joe, just real quickly, you had also commented just on -- obviously, you continue to make investments. I know you don't want to quantify that, but just to give out M&A with the spinoff of the pharmaceutical business, should we look for you guys to be a little bit more active in M&A [indiscernible]?

Jose E. Almeida

We say this all the time. Acquisitions is opportunistic. Covidien, no matter how much money we have in our balance sheet, will not undertake an acquisition, which we don't think will be a value creation to our shareholders. We don't change our models. Our models are fixed. We contemplate the opportunities in the marketplace. So pharma, not being part of Covidien's portfolio, does not open the opportunity for us to go try to replace the revenue with another acquisition that would be of similar size. That's not how we think. We made a commitment to return to our shareholders a minimum of 50% of our free cash flow. That's going to continue in a form of share buyback and dividend, and the acquisition plan that Covidien has and the strategy has not changed. We continue to look at tuck-ins. We look at an average of 10 to 20 acquisition on a monthly basis and 90-plus percent of them don't make it to the second phase, but we are always looking for opportunities.

Operator

The next question comes from the line of Rick Wise, representing Stifel.

Frederick A. Wise - Stifel, Nicolaus & Co., Inc., Research Division

Joe, just to start and then I have a related follow-up. You talked about the ramping emerging market regions and the investment there. Can you be a little bit more specific and tell us where you're particularly focused or where you're particularly investing? Discuss some of the initiatives and opportunities and how we might see the impact of some those investments.

Jose E. Almeida

Well, Rick, we are and Brian King's team is focused on looking for new investments. So let me give just a couple of examples. We are already at a point with 700 probably sales reps in China, for instance, 750. We are ramping up very quickly in Brazil, in Russia, as well in India. We're looking opportunities in Mexico, as we speak, because we see the market there starting to turn. Our R&D efforts in both India and China continue to deliver very good, promising results. We will see those results in a couple of years because registration time in Brazil, in China, primarily by the absorption of technology is being fantastic. So we will not -- we don't see any reason for not to continue to invest in, for instance, Tier 1 cities, Class 3 hospitals, which are the highest end hospitals in China. We thought we're going to tap out the opportunity at this point in time with the closure of our first wave or our first plan. We were wrong. There's more opportunity there. People are screaming for more money there. So we can have more sales reps, more feet on the street to be able to cover more accounts, to continue our penetration in hospitals there. So we see there's such a great opportunity, and I'm very optimistic that we're going to be seeing Covidien on a run rate of a about couple of billion bucks in about 2 years for that business. That is going extremely well, and the team is really focused on selecting the right investments for the company. So you'll see investments going into sales force, a bit in marketing, upstream marketing, more in R&D and also training centers. We're putting training centers in Brazil, upgrading our training centers in China, putting in India, Turkey. We're going to put another one either in Mexico or Columbia. So we're very excited about the ability to reach out to these customers and program search open to MIS, minimally invasive surgery programs. These programs are now away. We are way advanced in clinical trials, for instance, in Brazil, working with the government to show the benefits. So there's so much opportunity that we meet with those guys more often than we meet with anybody else, and they are taking the lion share of investment of Covidien other than some really early technology acquisitions that we made in Vascular and some investments in Endomechanical, lion share of our investment is going to emerging markets.

Frederick A. Wise - Stifel, Nicolaus & Co., Inc., Research Division

Yes, and if I could just follow-up on that and sort of ask you to comment on a broader perspective. I feel like with the upcoming spinoff, we're sort of and in a broad sense, at the end of the post-Tyco spin era. I mean, you've cut cost. You've built the OUS. You've built the pipeline. You've built distribution, done M&A. You're divesting non-core slower growth businesses. And I feel like the message is that more of the same from here, but can you just talk to us and it's like -- what is -- how are you thinking about the business going forward? Just building on the existing products and markets that you have, geographic and product? Or are you going to focus on new targeted higher growth areas, accelerated M&A like you talked about with Kristen? Can you give us a little broader perspective post-spin?

Jose E. Almeida

We -- as I said, lion share of investment going to emerging markets. We will -- we see significant investment is still needed in Endomechanical because Endomechanical is a global franchise, a lot of success we're having in emerging markets is because we have a phenomenal franchise in Endomechanical. Our endostapling business is on -- is close to double-digit growth. In today's world, that's unbelievable performance. So we need to continue to invest in these pockets of growth. But we have a group internally at Covidien looking at white spaces, and I say that to everyone all the time. I'm not going to talk about the spaces. Every time we talk about the spaces, the price of any acquisition, that space doubles. So we kind of became a little smart about talking about our future aspirations, but we have about 4 spaces right now that look very attractive to us. Some of them are expensive to get in, but some of them are really interesting that would balance our life cycle curves quite well, quite well. So we are relentless looking for new opportunities for the company. There's not a single day that goes by that we think that we're satisfied with the portfolio that we currently have.

Operator

Your next question comes from the line of Rich Newitter, representing Leerink Swann.

Richard Newitter - Leerink Swann LLC, Research Division

Joe, maybe just on the comments around the emerging markets and the investments. I mean, it sounds like -- and correct me if I'm wrong, the investments maybe might be a little bit more kind of internally biased versus external towards M&A, one, is that correct? And then two, can you talk a little bit -- I think you said that the emerging market's margins are -- they fall relatively in line or above the corporate average. How do we think about your pricing comments, and as you continue to expand in emerging markets, how do we think about the pricing offsetting or not some of the pressures you're seeing in the U.S.?

Jose E. Almeida

Yes, Rich, basically, we don't see. The price pressure is -- let's divide this clearly. You have emerging economies and non-emerging economies. In emerging economies, because what we sell there, we don't see the same price pressures, period. And there's opportunity in some areas to put price increase. The competition is fierce, but we're competing with different products, different technologies, meaning, you still have value in your product that is not just price-based. We're not selling in emerging markets. Any of -- almost none of this supplies business that we have in the U.S. in part in Europe because we don't think we can compete. We cannot compete with urology or basic mesh products in China. We do can compete with technology such as neurovascular, peripheral vascular, energy, endomechanical, ventilation. Those are Oximetry. Those are really great opportunities for us. And to comment on the internally driven, as I said, we don't comment on acquisitions other than understanding the strategy. We are looking at external investments in emerging markets, but we think the internal investments, because Covidien started ahead of many of companies today, they are turning their eye to the emerging markets. We have a significant amount of infrastructure already built in the region. So for us, it becomes a little easier to build on our infrastructure. And thinking about our investors and how we can return, the best return for their money is sometimes internal investments are much, much cheaper, and better ROIC than for us to go there and start buying companies in emerging markets. Not that we're never going to it. If there's an opportunity, we'll capitalize on it, but that's not the focus of the company. We have a great focus on driving productivity through our great team in emerging markets.

Richard Newitter - Leerink Swann LLC, Research Division

Great. Just a follow-up on the tax rate, a little bit higher than what we look for. I'm just wondering, is there anything going in there related to the spin and prep for the spin that is causing that to be higher or one-time in nature?

Charles J. Dockendorff

I think the tax rate in the quarter was actually lower than what we've had historically because of the -- in the quarter, we actually -- the R&D tax credit came through and we registered 2 quarters of that R&D tax credit in the second quarter. The portion related to 2012, we called out, and put that in the non-GAAP reconciliation table. But just on the tax rates in general, what we've said about it is that it's all determined on the mix of income. We certainly -- with Methylphenidate, that's mostly a U.S. profitable sale there. And as we do spend, the tax rates, we'll have some tax to synergies between the 2 entities so we would see a slight increase in those tax rates going forward. When you look at that them on a combined basis and then over time, we would be able to bring those back down into where they are today going forward. So we have continued tax planning opportunities. We think we continue -- can continue to drive down the tax rate over time both for Covidien, RemainCo and Mallinckrodt once it spins.

Coleman N. Lannum

Rich, just one thing to clarify. I want to make sure you understand. So that $60 million plus of Methylphenidate, that's all U.S. sales, U.S. profits and taxed at the very high U.S. tax rate. So that is one small dynamic affecting things, as Chuck said.

Operator

Your next question comes from the line of Jason Wittes, representing Brean Capital.

Jason Wittes - Brean Capital LLC, Research Division

So you mentioned there's an opportunity for Oximetry & Monitoring in emerging markets. It's actually probably the business that stands out as outperforming the most this quarter. Is that driven, A, by mostly emerging market growth; and B, should we anticipate that, that business is going to really start growing in the high single-digits rates versus previous years where it was basically pretty much the lagger?

Jose E. Almeida

Well, people, back in September, our Investor Day, asked me what was the area of the company that most of the Street was underestimating. I always thought that our Oximetry business was dead, and let's look at a couple of components. First of all, the flu season was very strong this past quarter. So we took advantage of that. So this is an environmental fact that favored the company. Second, the combination of having a great capnography product as part of Covidien's offering makes a huge difference. It's a technology that is a must-have at every hospital. There are a couple of society endorsements of the technology. It's paid for. So it's a life-saving technology. So having that in the bag of our sales reps make a huge difference. So that's a quiet business unit that is doing some really good work in terms of just blocking and tackling. I'm not going to give you guidance about what to expect about the growth going forward. I'm telling you that that's a solid business unit with good products and very, very intense competition. So I'm happy that Bob White and his team in Boulder, Colorado are doing such a great job.

Jason Wittes - Brean Capital LLC, Research Division

Okay. And then just I know there were a lot of questions about Energy. I guess my general question is I wasn't clear from your comments of how much of this is just some seasonal perturbation, et cetera, versus just increased competition out there. I mean, how would you characterize your competitive positioning and sort of your competitive outlook?

Jose E. Almeida

Competition is the same. This quarter, last quarter, the quarter before, everybody's launching products, everybody loves this space. Our growth in vessel sealing, which is part of Energy, was double digits and has been double digits for the last 30 quarters. What happened this quarter was strictly related to capital sales. So our ForceTriad sold less than we probably planned. We have a high penetration of generators anywhere on in the marketplace. The launch of Sonicision is being tremendous to Covidien. We are able to convert accounts that we never thought about converting in the past. We're getting some really good momentum and so I wouldn't read much into this Energy number other than we had a soft capital sales quarter.

Coleman N. Lannum

Yes. Let me add one thing too, Jason. You're right. It's come up a couple of times. Let's put this in perspective, okay? This Energy business is a $1.3 billion franchise, that we just printed this quarter an 8-plus-percent organic real revenue growth number. I think these days, in the world of med tech, that's a number that we're not going to really apologize for. I think we're very proud of that kind of growth rate in that franchise and we, as Joe said, we think the franchise has growth opportunities going forward.

Operator

Your next question comes from the line of David Roman, representing Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

I won't give you a hard time about 8% growth, particularly when you look at the rest of the space, but I was hoping you could spend a couple minutes just on the growth rate conceptually. And I know you don't want to give explicit guidance here. But if you look back over the past couple of years, which have been tough operating environments, you've consistently put up fairly strong operating leverage. You've been able to generate, call it, 5-ish-percent organic top-line growth and double digit, if not better, earnings growth. It sounds like we're entering a period, whereby getting a 5% growth is going to cost a whole lot more. You're going to have to work a whole lot harder to get there such that the opportunities for leverage might not be as significant as they were in the past, and just wanted to get your thoughts on that characterization.

Charles J. Dockendorff

This is Chuck, David. I think we have still some opportunities for some leverage going forward. Clearly, we have plans in place for other manufacturing opportunities, as well as back office cost. And we know that we're going to have to be more efficient in these areas with the marketplace the way it is. So we still are going through a very major program. We have to look at our opportunities in Europe, primarily Europe and the U.S., I think, where we can really do more to leverage some of our back office cost and SG&A spending. Clearly, we'll be putting the money into emerging markets and investing in there. But it's a question of we're sitting here with some good opportunities from investments both when you look at emerging markets that represents a relatively quick payback and high return on investment, but we also have some nice investments in our other franchises around Vascular, and as Joe mentioned before, around surgery business, which is really the basis of our growth in emerging market. So we continue to fund and we look at this portfolio of investments that we have, we continue to fund both the short term return as well as longer-term, and just building the base of our franchise and portfolio going long term. And it's a question of how much of that we fund versus driving the shorter-term earnings growth. So how much we fund will be determined on our top line growth, how much efficiency we can get out of our back office system, but we are committed to growing both the top line and the bottom line to the shareholders in the future.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay. And maybe just a product-specific question on the Soft Tissue Repair business, one of your competitors earlier this week talked about sort of a resurgence or a rebound in the biologic mesh segment of the market. Can you maybe just update us kind of what's the latest dynamics are in your hernia franchise and how we should think about that going forward?

Jose E. Almeida

Yes, David. Our biological franchise, we decided about 1.5, 2 years ago, not to put a lot of investment, not even sales time of our sales reps. So I will not comment much on that because that's not how we gauge our Soft Tissue Repair franchise. But we've seen a significant rebound in our other hernia repair products, like the all the products that were acquired about a few years ago. We see -- on the synthetic hernia mesh, we're seeing greater than 10% growth. So that business is doing extremely well. We're seeing stabilization in fixation with very modest growth in fixation, which we haven't had in a while. So between fixation being stable, synthetic hernia growing over 10% and having a very good business in sutures on a global basis, I feel very comfortable with our Soft Tissue Repair. Covidien's business is not based on biological mesh like other customers of ours. So I will not go there.

Operator

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

Joanne K. Wuensch - BMO Capital Markets U.S.

Two things at this stage. One is a couple of weeks ago, you announced another large share repurchase program on which by our math, if you did it all tomorrow, would equate to about $0.50. Could you remind us of how you think about the timing of getting in and out of the market for repurchasing shares and how that might may or may not change with the Mallinckrodt spin?

Coleman N. Lannum

Yes, Joanne, we tend to be opportunistic. As Chuck said earlier, we have a minimum amount of cash we're going to give back to shareholders every single year in dividends and share repurchases. Beyond that though, if you look historically, well, we're not going to comment what we may do going forward. If you look historically what we've done on the share repurchase side of things, I think you'll see that we've been much more active when the share price is down, less so whenever the share prices is up. And while, again, we're not going to promise what we'll do in the future, we pay attention to that. Share repurchase though is -- the nice thing about it is that it's an elective way to quickly give back to shareholders if we are generating a lot of cash, and we don't have a better use of those funds, but it needs to be a better use. As long as we feel like investing in the shares is an appropriate investment versus other alternatives, in that scenario, we give cash to shareholders back using that medium.

Joanne K. Wuensch - BMO Capital Markets U.S.

All right. Let me be a little bit more direct here, will you use it to offset some of the Mallinckrodt dilution?

Charles J. Dockendorff

We're not going to comment on that at this point in time. And again, it is cash that we have, and as we mentioned before, it's not our intention to pour the cash on the balance sheet, and if we don't have a use for it for internal funding, we have a strong enough cash flow and strong enough capacity to do any kind of acquisitions we want to do. So it's not something we're going to keep on the balance sheet.

Operator

Your next question comes from the line of Glenn Novarro, representing RBC.

Glenn J. Novarro - RBC Capital Markets, LLC, Research Division

Just one question. Joe, you called out several times, several divisions slowing of capital purchases by hospitals. Do you think this is a one-timer in the quarter? Or is this more macro related and something that's going to continue, not just for Covidien, but a general market trend, going forward, for the rest of the year?

Jose E. Almeida

Thank you, Glenn. Listen, Covidien is not a significant player in the capital market, capital equipment market. So this is a better question for some of the larger equipment manufacturers. If they already released earnings, you probably could read through their earnings. I'm telling you that we see very lumpy demand for capital and it varies, not a steady flow. This quarter was not that great. We see a little pressure there. Maybe related to that kind of class of products. As you know, our products don't sell for a lot money, you're talking about $30,000, $40,000. The only one that is really expensive, over $100,000, is the superDimension equipment. So I would say that we are not a bellwether, and I don't feel comfortable qualifying the market. We saw reduction in capital spending in our product category. If this persists for the next couple of quarters, we'll be able to give you more of a trend at this point in time. It was just an observation each quarter.

Glenn J. Novarro - RBC Capital Markets, LLC, Research Division

Okay. But the point here is for Covidien, this is more of a rounding error than something major we need to be worried about?

Jose E. Almeida

Yes, we're trying to focus on why vessel sealing was -- is likely below your expectations. The only place I can see that was below ours was a little bit on the capital side. I'm quite happy with double-digit growth in my vessel sealing. When I'm reading my competitors' press releases and earnings release and they're all in 1%, 2%, 3% growth or negative so it's all a matter of perspective. So I'm trying to respond to your question, why do we think there was little bit of slowdown in overall franchise was because of the capital.

Operator

Your next question comes from the line of Larry Keusch representing Raymond James.

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

I just want to make sure that I'm understanding just one aspect of some of the commentary on the call. It sounds like -- or I guess what I want to clarify, are you suggesting that investment spending will actually now pick up as we move forward? And if that is the case, where -- how do you fund that?

Charles J. Dockendorff

Yes, we've talked about the investment spending actually in the last call. We said that we were going to -- we have a lot of opportunities for growth. Our business units have done a great job bringing forward some good programs, and we balance these off with earnings growth. But at the end of the first quarter, we released some of these investments because where we saw the year, and we saw we had a windfall from the Methylphenidate ER, and those are coming through R&D and SG&A. In emerging markets, these are investments that we make that have a very fast pay back. It's a market that is exceeding our expectations, and it's something that we need to fund going forward. So on those areas, it's going to be on the SG&A line. But while we're doing that, we're driving through productivity. And so we're really looking to drive through more productivity in our back office cost in Europe and in the U.S. while we invest in the emerging markets. I think if you look at it, again, I mentioned earlier that our SG&A this quarter, despite the medical device tax, despite some of the deals that we've done, we've actually leveraged that 50, 60 basis points in the quarter year-over-year. But going forward, what we see, because of these opportunities for growth, that we are going to increase the investments in SG&A and R&D. They're good growth opportunities. We will fund those with as much productivity as we can drive through. And the other thing that's hitting us, and of course, the situation is with the foreign exchange impacts. That certainly will put a little pressure on the back half of the year.

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

Okay. That's helpful. And just keying off of the FX comment, can you just -- it seems that the euro -- the euro is less of an issue. The yen, obviously, is what's been more volatile and potentially continues to weaken here. Can you just help us understand your exposure to that currency and are you synthetically hedged over there? And any thoughts that might just help us sort of work through the exposure that you have to an increasing, or I should say, decreasing yen?

Charles J. Dockendorff

We have a very good business in Japan, and we do hedge a portion of it, but it is not at as large as much as we hedge in the euro. The yen, since we began the year, our planning year actually, has devalued about 24%. Since the last time we gave guidance, it's devalued about 16%. So it's a pretty big drop. We expect that to continue, but the market for us over there is very, very good. Our surgery products are growing at a very good clip over there. They've actually reimbursed at higher rates on minimally invasive surgery, which has grown our surgery business over there at a good rate. And while we're going it, we are facing that devaluation of the currency, which will annualize, it looks like now, and it will take a year to annualize this entire thing out. So that's something we have to deal with over there, but it's a very profitable and a very good business for Covidien in Japan.

Operator

Your next question comes from the line of Matt Taylor, representing Barclays.

Matthew Taylor - Barclays Capital, Research Division

So I just wanted to ask a bigger picture question about the spending. Obviously, we will expect emerging markets to slow down here in the near future. So should we expect the spending cycle to be a multiyear cycle? Or is it something that you're thinking is going to be a couple quarters and then we could see more leverage?

Jose E. Almeida

Matt, it will take more than a couple of quarters. We are at this for the last 2.5, 3 years, okay? And you're starting to see the results. Growth in China, over 25%, growth in Brazil now in the high teens. So you've seen some really exciting growth rates, and it is almost irresponsible from our side if we did not capitalize on this. It would not be -- it will be a very shareholder unfriendly move. So expect us to continue to invest for the -- no, for the mid to the near to the mid-term future, not talking about a couple of quarters, I'm talking about a couple of years.

Matthew Taylor - Barclays Capital, Research Division

Okay, great. And then a lot of your competitors have talked about weakness in utilization in the U.S., which I appreciate you made a small comment on the call on and also selling days. Can you talk about -- any help you can give us in terms of quantifying the impact of utilization and/or for selling days and how you think about those 2 factors for your results?

Jose E. Almeida

Matt, I believe your question is a serious question because otherwise, we don't -- we have 91 days per quarter at Covidien. You're always going to have a day short here. You always have Easter fall in one quarter versus the other. You guys have been with us for 6 years, almost 6 years, as a public traded company. There are 2 things that Covidien has not used as a justification for sales softness is number of days. We never did, and if we see it, like we saw in 2011 for about a week, then we had a difference in a week, we told you. We're always going to have days falling here and there by our salespeople, our general managers, understand that they need to sell 91 days per quarter, and that's been the conversation. And the second thing about distributors, distributors will always destock and restock in very random patterns. This is how they do business. They have to manage their cash flow. It is always -- does that impact on us? Absolutely. Do we have an impact this quarter because somebody decided to destock some of our products? Sure, we did. Not enough to talk to our investors about. This something we need to do internally and our sales growth, it is where our sales growth are.

Operator

Your next question comes from the line of Matthew O'Brien, representing William Blair.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Just one quick clarification question. The commentary that you're making about tougher comps in the second half of the year in the device business, is that really more focused on the peripheral stent recall that you had to deal with or that you benefited from as well as pipeline? Or is it more of a broad statement?

Charles J. Dockendorff

I think it's a couple of things. One is I think in Q3, specifically, we talked about Vascular with some of the recall information that was on the stents and the year-over-year compares with that, the annualization of pipeline. But I think, going forward, what we try to talk about is the foreign exchange headwind will mostly hit Covidien RemainCo going forward. And the spending that we do, again, is mostly with Covidien and emerging markets and some of the R&D programs that we have teed up. So it's a combination of both of those things going forward.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Okay. And then within your peripheral business, you mentioned the transition from hospitals over to ASCs. I would assume that's likely the source of the pricing pressures that we've been hearing about in the industry. Can you give us a sense for how long you think that will happen or will it persist? And then whether the hospitals, as this is going on, are getting more aggressive in terms of asking for price? And then how you're dealing with that internally? How you're dealing with that dynamic internally?

Jose E. Almeida

We deal with that by looking at how we go-to-market in several different markets and adapting quickly. We tend not to go with major, major wholesale changes in how we approach the buying patterns of hospitals, but more how we segment the account and how we get to the utilization of our SG&A. Bottom line is with the market changes in the U.S. and Europe, sales expenses are very expensive. So you've got to make sure you have the right type of salespeople and you have the right approach to your accounts. Key account management is becoming much more prevalent. This is where probably we're going to be investing more and more money, understanding how to satisfy a need for reduction in the overall health care cost is key so how we design our products. But we need to be very conscientious about our sale -- our selling spending to make sure that is directed to right places. That's, hence, how we are thinking about the investments in emerging markets versus how we invest in sales and marketing in the U.S. and Europe.

Operator

At this time, this concludes the Q&A session. I would now like to turn the call back over to Mr. Cole Lannum for closing remarks.

Coleman N. Lannum

Thanks very much, operator. Starting at noon Eastern time today, a replay of this call will be available. This replay will also be available on our corporate website, covidien.com. For members of the media who listened to the call and have additional questions, please contact Bruce Farmer in our Corporate Communications Department. For analysts having more detailed questions involving nonmaterial information, both Todd and I will be available to take your calls.

One last thing before we believe, I will remind everyone, next Friday, a week from today, after the close of the market, we will be releasing the information on Mallinckrodt guidance, Newco Covidien guidance and historical Newco Covidien information quarterly through the first quarter of this year and annually for the last several years. We're releasing it on a Friday after the close to give you plenty of time to look through the information. Obviously, we'll be available to take you through any questions you may have. Have a great weekend. Have a great day, and we'll talk to you soon. Bye-bye.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and have a great day.

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