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Covidien plc (NYSE:COV)

June 12, 2013 12:20 pm ET

Executives

Coleman N. Lannum - Vice President of Investor Relations

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

Analysts

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

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

Before I introduce the next presentation, we are required to make certain disclosures in public appearances about Goldman Sachs' relationships with companies that we discuss. The disclosure relates to investment banking relationships, compensation received through 1% or more ownership. I'm prepared to read disclosures to any -- for any issuer now or at the end of this presentation if anyone would like me to. However, these disclosures are available in our most recent reports available to you as clients on our firm portals. In addition, updates to those disclosures are available by ticker on the firm's public website at gs.com. In addition to disclosures applicable to research with respect to issuers if any mentioned herein are available through your investment representative.

So with that, I want to introduce our next presentation from Covidien. We have Cole Lannum, Chairman and Chief Executive Officer -- sorry. Joe Almeida, Chairman and Chief Executive Officer; Cole Lannum, Vice President from Investor Relations. And Cole had a nice shower and breakfast today, letting Joe do the talking, so we'll see how you do during this presentation. And obviously, I want to keep this as interactive as possible.

Coleman N. Lannum

Well, now as you've elevated me to CEO, I might do something differently.

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

Anything is possible, I'm sure.

Question-and-Answer Session

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

Maybe a good place to start is just on through the health of the end market. I know it's probably a question you get pretty commonly, it, I know, bounces around quarter-to-quarter but maybe just your perspective on what you're sort of seeing, broadly speaking, maybe and if you want to break it out, U.S., Europe, emerging markets or however you're sort of you're looking at, it might be helpful.

Jose E. Almeida

We have not seen much difference between what we have been speaking about the U.S. since our last call, at the end of the March quarter. You'll continue to see the same trends where there is a focus on medical devices and technology and also, the utilization of technology. So much more conscientious effort in looking at the use of technology associated with also pricing pressures. We still think that companies that have large offerings within a specialty, I want to make sure that I'm clear about that, that, that's not about having every product at the hospital needs. I don't think that trend will ever take off. But if you have a good and full offering within specialties of the hospital, like neurovascular, peripheral vascular, general surgery, you are better poised to compete in this environment. In Europe, it's no different. So that same dynamic applies in Europe. You see more the formation of groups of hospitals. Germany had already that going on but you've seen that in more places, and therefore, that changes how you approach that market, which was always been a tender-driven market but also, I think, the ability to have more of an offering to a certain group of hospitals is a better thing. In terms of the market, end market growth in Europe, no changes from what we reported. It's still a very difficult market in low single-digits, as well as the U.S., as we have reported back at the end of March quarter. But I would say that even in Europe, like in the U.S., if you have strong offering, you have the technology, you can still have good growth. And we've been showing growth above market in that tough market. I would say that I see no -- we see no changes in the end markets in Spain and Italy being very difficult today. Emerging market is a completely different story. Despite what everybody sees and hears about Brazil, inflation at 6.5% to 7%, there's a commitment from those markets to become better equipped to provide health care for their systems. And that is the wave that we are riding right now where there's a significant expansion of providers in places like China, India. In Brazil, it's not an expansion of providers, but it's more of people being able to get access to health care, the public systems in Brazil are doing better, so I find that dynamic very favorable to medical devices.

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

And as you think about the growth rate of the company going forward, I think emerging markets right now is in low-teens, as a percentage of total, and that becomes presumably larger over time. Is that really the swing factor that gets to sort of the sustainable 4%, 5%, 6% type top line growth or is there any reason to think that you could see an upward movement to develop market growth rate?

Jose E. Almeida

I would say that, that emerging markets growth being the biggest force behind our overall growth but also -- no, 3 areas that I would just mention being of more of a needle movers for Covidien: energy; Endomechanicals and laparoscopy surgery; and the third is neurovascular. So we think we have very good spaces that still provide for good technology to grow through market share. I would say emerging markets and developed markets, we still have a great opportunity for untapped markets like MIS market, minimally-invasive surgery market is still a great opportunity for Covidien.

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

Okay. And then, in the U.S., or maybe generally speaking, you have been, as you referenced, growing above market for quite a long period of time now. Maybe if you just help elaborate a little on what you think is allowing you to continue to grow at such a healthy rate versus your key competitors, in a lot of cases, you really only have one, maybe 2 competitors in some of these markets. And then what you think your ability to sustain that going forward is?

Jose E. Almeida

It's a combination of owning, you have to own the specialty and have the technology that differentiates either in terms of outcomes or economical outcome, either clinical or economical or both. We're finding that if you just have the biggest or the most interesting gadget that may do something really good, if you don't have a full product offering, it's difficult to penetrate in larger specialties. So having the ability to have ownership of the specialty which drives Covidien's technology development, as well as M&A, the tuck-in acquisitions that we make, are usually driven by having the capability to own a specialty. So if we have our eyes in the right technology development internally, and the right tuck-ins, we'll be probably able to get -- continue to perform slightly above market.

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

And is that -- and is the key differentiator that you're bringing the depth of product offering, is it the relative advancement of the technology, is it a little bit of both?

Jose E. Almeida

I think it's first of all is how you go-to-market is one of them. The one -- not consider the fact that having the right sales groups and the right sales strategy, instead of flooding accounts with sales reps, how do you use key account management, how you go across hospital systems, how do you provide them value beyond product, that has a big part of it, but having depth of portfolio in a certain specialty helps. What we don't see helping significantly is having a significant amount of portfolio in a certain institution. We haven't seen that turning into a positive. Meaning, if I have everything that the hospital needs, do I get to be a preferred supplier to the hospital? And we haven't seen that happening. But if you own a specialty like energy for instance, Covidien now can provide, from Sonicision, the ultrasonic, all the way to every aspect of RF, that combination, you own that specialty, you can provide value to the hospital, you can provide clinical outcome services. Same thing with peripheral vascular and other specialties.

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

And then, in that context, and I've asked this to a lot of other CEOs and CFOs here, how do you stop the conversation then from becoming about price? We see something called bundling across the line sort of we call it scale and leverage but how does a conversation not evolve into give me a deal?

Jose E. Almeida

It's about the value of the package that you're offering. You may not have, in a certain account, every single product that goes into that specialty. So the value is associated with how can I help to get that value on the table is by looking at Covidien's portfolio. At the end of the day, when you're talking to materials management, when you're talking to a GPO, when you're talking to a group, a large group of hospitals which are represented by an association, the conversation is about value. It's also about price. You can't get away from it. One thing that we're dividing up and doing well is making sure that our clinical people have different conversations with the hospital administration in terms of strokes. So let's speak about stroke. It's not about selling [indiscernible], the person who's talking to the neurovascular and the neurology group at the hospital, he's not there to sell products, to show them best practices in management of stroke. Now we do have the salespeople who will call in, and that conversation is going to be about volume and price, but we try to deepen up the conversation so we provide a bit more clarity to rolls of our people, but also to the hospital. If you become a transactional, and some hospitals want you to become a transactional supplier, then the conversation is pretty simply is what you can do for them then. There are hospitals in U.S. like that. While we see more hospitals looking for more than just a transactional. Not that they're going give away or give up their conversation about pricing.

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

Okay. And clearly, you have a pretty consistent flow of new products and Cole, maybe you want to highlight the extent to which you want to disclose it. I know it's in the analyst meeting slides but maybe if you wanted to highlight what you think some of the major new products are coming out over the next, call it year or 2, and whether that is from the acquisitions or internal, I don't know if it really matters but I know you have that timeline that you put out every year but maybe just remind people where you think the most interesting new products are coming from?

Coleman N. Lannum

Do want me to do that, Joe?

Jose E. Almeida

Up to you.

Coleman N. Lannum

So I'll say more than he will, but so go ahead. And first of all, we're not going to unveil everything. So want to keep a little bit of a surprise for the appropriate time from a competitive standpoint. And introducing with the concept to remind people of that we're not a single product-driven kind of company, our growth comes from multiple products across multiple platforms. And in some cases, iterative versus what they were. Having said that, certainly, in energy, not only do we have the continuous launch of Sonicision which is going very, very well, but new generation in our LigaSure franchise, new products that are coming out there that we recently launched and will be launching later on in the year. In the statement side of things, Tri-Staple continues to roll out new pieces on the franchise. Remember, that's a system. It's not a single product, let's say, system in the technology across all of our different SKUs of staplers, and we're not even there yet and won't be for the next couple of years. And so that's going very, very well. In the next 12 to 24 months, in the airway side of things, we will be launching our next-generation ventilator, which is something we've been working on for several years and is a completely different from the ground up redesign of that platform. That's going to be extremely important there. And then, a lot of small products. Our capnography continues to go well. And the oximetry and monitoring business. The BIS product continues to go well. The aspect businesses. And then the entire vascular franchise, again, is doing very, very well. Again, part of the thing in vascular is that we've done so spectacularly well over the last couple of years. We're not going to match that kind of growth rate over the next couple of years, but we still feel very, very comfortable with that, looking forward.

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

And when you sort of think about new product launches, are these market share drivers? Do you still get positive mix for value-added products? And how do you sort of flesh into the numbers?

Jose E. Almeida

If you look at the highest market growth rates that Covidien has today, neurovascular is one, the other one is probably energy. And to some extent, Endomechanical, because there's a huge growth rate coming out of emerging markets. So in those -- in products that you'll have the specialty ownership, either they are adjacencies to capture more, or they are iterations of what you have with 1 caveat, they've got to be made much less expensive than what is today in the market. So Covidien has commercial leverage. Second is they need to attend to clinical and performance needs at or better than what's in the market today. So if you look at neurovascular, Covidien is not #1 in coils. It's going to be very difficult for Covidien to launch a product lining coils that will become -- make the company become #1. But what Covidien is doing is investing in technologies that eventually will eat away the coil market. So for us, it's all new revenue. It is a market share loss for whoever has that. So we have that way. In energy, it's all about conversion of procedures, the one we use today, energy, 2 procedures that use energy. But without the technology and the breadth, you can't get there. So our products have a variety of objectives to surprise. I would tell you, for a company that spends 5% in research and development, and is considered one of the most innovative companies in med tech, I'm very proud of our R&D group that can deliver that kind of performance, because a lot of millions go with ask and not give them the money.

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

I want to open up to any questions in the audience, if there are any. Okay. While we're sort of in the topic of R&D efficiency or spending, if you look at your revenue or earnings profile, you've been able to keep the top line growth rate at a very strong level relative to the peer group, pretty consistent in that 4%, 5%, 6% range, in some quarters, a little bit better. Operating margins have been pretty flattish over the past couple of years. Is that sort of the new reality is sort of spend money to make money? And there might be some room for property margin expansion but more of the leverage is going to come from share repurchases or do you think there's a point in which we're going to start to see more meaningful EBIT margin expansion?

Jose E. Almeida

In Covidien, we use both the financial and the operational leverage. So the financial leverage, you all know, Covidien is pretty explicit about how we use our cash, 50% or more of our free cash flow will be returned to the shareholders. In some years, we do more. We usually don't horde cash. And if we have an acquisition that will require more cash that we could return to the shareholders, we will look into either reduce that, we specifically borrow the money. But you've seen our track record has been pretty consistent about how we've financially leveraged the company as being, in my point of view, a success story. The operational leverage is one that there's a confluency of facts right now associated with the spinoff of the Mallinckrodt business and different ways of going to market. And the continued need for investment in emerging markets. They will bring Covidien to a very aggressive manufacturing and G&A productivity programs, and we'll speak more clearly about that during our Investor Day, but that's in forefront of my mind. I'll tell you something, R&D is something that Covidien has spent, being very efficient about it, it is an area that I have no intentions of reducing. We're going to probably grow R&D slightly higher than we grow sales, but not much higher. Covidien's never going be an 8%, 9% company, we're going to be between 5% or 6%. We think we can be very effective in launching product from technology 5% to 6%. So that is not changing. We need to create more leverage in our expenses but stay tuned, we're going to talk to you in September.

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

And on the guidance call that you had posted the issuance of the separate Mallinckrodt and Covidien guidance. Chuck talked about continued objective of mid single-digit top line growth, leveraging to double-digit bottom line. Any -- I have 2 questions. One, any percentage you can provide with respective time period? And then secondly, maybe a question for Cole. Where do you sort of think consensus has come out on RemainCo earnings growth over the next couple of years?

Jose E. Almeida

I'll tackle the first piece pretty straightforward. We will talk to you in September. You're going to have more clarity about our going forward programs. I don't find the productivity programs, when it comes to corporate effectiveness, this is very different than an R&D program, we'll show you in that factory. So we're going to continue to have manufacturing programs very aggressively but you're going to see a bit more of Covidien tackling the G&A, and you should see that in the next couple of years.

Coleman N. Lannum

As far as consensus goes, we're in a no man's land right now. Prior to when we is your trading, we have some folks out on the street that have adjusted their models for Newco Covidien. We have some people that are out there that still have the old Covidien inclusive of Mallinckrodt. In their numbers, a lot of apples and oranges. I expect that will get much more clarified, certainly within the next week, when issue trading starts and I think some people will adjust models then. And then certainly then, even more so after July 1, whenever Mallinckrodt starts trading on its own. I think, the one thing though, I want to make sure people understand because we didn't talk about the long-term goals on revenue and bottom line numbers and we said that for 2013, were it not for the med tech tax and negative foreign currency, we'd be at that double-digit EPS growth this year. But clearly, we won't be on a reported basis, primarily because of those 2 negative factors. And the reason why I bring that up is it's very important people understand those things are going to be pressuring us in 2014 as well, because of our September fiscal year, the med tech tax will hit us yet again for the first quarter of 2014. So that's going to be a drag. And foreign exchange is going to, even though it's improved a little bit here, still going to be a negative through the first half of 2014. So that's something that we're going to have to deal with and manage through.

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

And the other is sort of nearer-term fact you've talked about is probably some step up in the SG&A levels and internal spending priorities, as well as some comp issues in vascular. Anything else that you think people need to be aware of adding into maybe next week as we start to get more clarity and where numbers shakeout?

Coleman N. Lannum

No, I think those are big -- I mean, we've talked about that pressure on SG&A and R&D, by the way. We've been talking about that very explicitly since November of last year. I think it was a little frustrating that the people thought that there was some kind of new piece of information but it's clearly consistent with what we've been saying for a long period of time. And the comp issue is primarily a third quarter issue, it's primary vascular. Again, I think we'd beat the dead horse on that. So I would be very shocked and disappointed if people were surprised by that but that is going to be a reality we're going to have in our fiscal third quarter.

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

Okay. Maybe switching to capital deployment. You talked a little bit about acquisitions already. You are in a fortuitous given your IRS status to use cash pretty freely. But maybe just sort of talk about M&A. I mean, it's been -- I think, you announced ev3 in the summer of 2010. Since then, you have done a number deals that aggravate up to decent number but nothing really of size. So what's your appetite for larger deals? What's the M&A landscape look like? And how are you conceptually thinking about deals right now?

Jose E. Almeida

We're, first of all, open to deals about the size of ev3. We're being very diligent internally looking at new space that they'll provide that kind of platform. If you noticed, we bought ev3 in 2010, and we have about 7, 8 different deals that we put together technology-wise. Some are R&D deals, some are a little bit ahead of the product in the market. They're surrounded, both franchise, peripheral vascular and neurovascular, with products that will really will make that business continue to deliver good returns to continue in the next 5, 6 years. So once you do that, you say, okay, what's next? Over the last 2 years, we've been in an internal program called Darwin. And we created a group of -- bring a group of executives together and they looked at all kinds of white spaces. We looked at probably about 12 so far, 2 we acted upon on, one was lung with superD, and we're going to talk about the lung space during our Investor Day, how we're going to go about it, not only doing the detection, but also the therapy. And also, hypertension was another one. But we killed 10 of them. And we killed 10 of them because, like yourselves, if you're investors in Covidien, I get paid when you get paid. And I'm very driven with total shareholder return, be able to deliver an ROIC that makes sense to the business, balance in long-term and short-term. And none of those deals, despite the fact these spaces are very attractive, they're very, very expensive. And those would be the strength for Covidien and there's nothing worse to a company, when you trying to get a deal done, because you think that's going to be a good thing for a top line, but at that the end of the day, it's straining value to our shareholders. So I want you folks to have a clear assurance that we are scouting the earth, going every place possible to find deals for Covidien. However, we will not, in any shape or form, compromise the commitment that I have and Covidien has with our shareholders about going into places and not destroying value for you, for our company.

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

And what, as you look back, sort of over, if you had an M&A scorecard of what you've done so far and what would that look like? I mean, how are deals tracking now versus when you acquired them in terms of growth, ROIC metrics, internal models?

Jose E. Almeida

Exactly. We look at -- if I take a 5-year look, we do this all the time for ourselves and for the Board, we probably have a 75% of hit rate. Meaning, if you add all the MPVs that we do in our models, and I'm not going to go into how we do our models, but I can guarantee our models are pretty solid and they are not changeable by deal type, they are there and we do what we need to do, we are at 70% to 75%, which is a pretty high hit rate for acquisitions. So I have, like every company, we have regrettable acquisitions. And those are small sizes but you learn from that, you move on. In the aggregate, Covidien has done, in my opinion, a very, very solid job in getting acquisitions, integrate and delivering to our shareholders.

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

And is there any -- I know you've sort of talked about generic metrics. Any sort of more specific financial metric that you can share or sort examples that you want to give about parameters around some of the deals that you have done or are looking at?

Jose E. Almeida

We look at accretion and dilution. We look at MPV, ROIC, 1, 3 and 5 and 10. And we are very conservative in how we allow cost of capital to be plugged in. Cost of capital is fully loaded cost of equity, cost of debt put together for the company, as well as we're very conservative when it comes to terminal value. I lived long enough that I know that if you look at projection in sales and profit, they really escalate at the end of the curve. The curve we tend to terminal value that at a very low percentage so we don't capture that kind of inflection. And one thing that we do, this is how we match with those deals, and it's how much appetite for accretion that the company has for dilution. We'll do -- some deals would be dilutive like we did but they are dilutive for 1 year, 1.5 years and then we'd pick up momentum. We tend not to be -- if we have dilution that's over that period, we will compensate by financial leverage, if we need to. But I want to make sure that people understand that when we look at deals, I always ask for an external contrarian view of the deal. I want somebody to convince Covidien that we should not do that deal. I'm not talking about a $50 million deal, I'm talking about a $200 million, $300 million, $400 million, $500 million in the box. So you're rest assured that when we look at something that is of any given size, not only the financials makes sense but also we go out and we seek people who will come in and tell us and convince us why we should not do a deal. So we're very critical upon ourselves. We have a lot of passionate people working for Covidien. We have great people working for us. But we're all passionate about spaces that we want to buy companies and that's one thing that we have developed over time is that discipline.

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

The other thing we should talk about, a little bit of records this morning on capital allocations, dividends versus buybacks. Clearly, you guys are doing both. You just announced another big authorization, I think, back in March, worth $3 billion. Your dividend yield is a little bit lower, how do you define the peer group, I guess. But how do you sort of think about the tradeoff between the 2 or the mix of the 2?

Jose E. Almeida

I think that we can debate the merits of each one of them for the whole day. You can bring people here who'll swear by 1 versus the other. And our point of view is we want to be able to bring value back to the shareholder in 2 vehicles. Covidien have strong confidence in our cash flows. We are a marriage domicile company. So Covidien can distribute the cash that it has to our shareholders in a less punitive manner. I would say that, just to comment on the [indiscernible], once Covidien made a commitment not to take down the dividend. Mallinckrodt is not going to pay dividend. Covidien is going to pick up that whole thing. So the payout ratio will be different. We don't control stock price, you do. So the yields is under your control, not mine. But we will be -- we're committed to increase dividend higher than earnings going forward. We made that clear. And we also made clear we're not going to hold cash in our balance sheet. Now the ratio, we can always have a balance. I think, we're going to -- if we increase the payout, the percentage of dividends at a higher rate, the payout at a higher rate that our earnings growth is currently projected, we eventually get to a place that's a pretty balanced mix of the both.

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

Okay. And then maybe lastly, it's a 2-part question. What's the biggest concern you have or is there anything that keeps you up at night? And then secondly, is there anything you've taken in the story right now that people are missing or an area that you did too many questions on or you think is overplayed or too few questions on, it's underappreciated?

Jose E. Almeida

Last first. I think, we have a wonderful company, a real success story, but I don't control the stock price, the shareholders do. So I think our story is pretty clear, pretty straightforward. We have proven a theory how we invest in R&D and M&A and how things come out of the top line and how we leverage the company. So I think it's been a pretty transparent story. When it comes to what keeps me up at night, it's not any specific issues. I think a company the size of Covidien has a really good grip of what's happening across the globe in our businesses. The question is, are our executives looking around the corner and preempting some of those trends that's going to hit us. So looking around the corner, for me, is one thing that I -- may keep me up at night, are our people really looking around the corner and preempting? Because some of these changes, they look far into the future or they are not. It's like surfing, either you surf the wave or get crushed by the wave. So that's what I talk to our executives all the time, look around corner and act fast.

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

Okay. With that, we are almost out of time. I want to be sensitive to people's schedules. Joe and Cole, I want to thank you again for participating in the conference and I look forward to hosting again next year.

Jose E. Almeida

Thank you.

Coleman N. Lannum

Thank you, David.

Jose E. Almeida

It's a pleasure.

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Source: Covidien plc Presents at Goldman Sachs 34th Annual Global Healthcare Conference, Jun-12-2013 09:20 AM
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