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Covidien PLC (NYSE:COV)

F3Q09 Earnings Call

July 30, 2009 8:30 am ET

Executives

Richard J. Meelia - Chairman, Chief Executive Officer, and President

Charles J. Dockendorff - Chief Financial Officer

Coleman N. Lannum - Vice President of Investor Relations

Analysts

Thomas Gunderson - Piper Jaffray

Frederick Wise - Leerink Swann

Robert Hopkins - BAS-ML

Taylor Harris - J.P. Morgan

Matthew Dodds - Citigroup

Tao Levy - Deutsche Bank Securities

Joanne Wuensch - BMO Capital Markets

David Lewis - Morgan Stanley

Kristen Stewart - Credit Suisse

Glenn Novarro - RBC Capital Markets

Christopher Warren - Caris & Co.

Thomas Kouchoukos - Stifel Nicolaus & Co.

Operator

Good day ladies and gentlemen and welcome to the third quarter 2009 Covidien PLC earnings conference call. (Operator instructions). I would now like to turn the presentation over to your host for today’s call, Mr. Cole Lannum, Vice President of Investor Relations.

Coleman N. Lannum

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

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

We'll also discuss some non-GAAP financial measures with respect to our performance including in particular the operational growth which is net sales growth excluding the effect of foreign exchange. A reconciliation of non-GAAP to GAAP measures can be found in our press release and its related financial tables as well as the investor relations section of our website, covidien.com.

For fiscal third quarter we reported GAAP diluted earnings per share from continuing operations of $0.54, but after adjusting for certain one-time items, our non-GAAP earnings for the third quarter came in at $0.74 per share.

I’d like to turn it over to Rich who will go into more detail on the third quarter results.

Richard J. Meelia

Overall, we had another good quarter as we delivered positive operational sales growth, continued to make the investments that would drive our future growth of several key new products. With the majority of fiscal 2009 behind us, we think Covidien is well positioned for the rest of the year and continuing to 2010. As reported, net sales decreased 3% to $2.5 billion. Excluding the impact of unfavorable foreign currency which lowered our overall sales growth rate by 5 percentage points, operational growth was 2%.

Third quarter sales performance was slightly below our plan with medical devices the only one of the four segments to deliver operational growth. Looking geographically, all of our regions registered operational gains with particular strength in Asia Pacific and Latin America. In the United States sales were up 1%, restrained by a decline in pharmaceutical products which I’ll discuss in more detail shortly. Gross margin came in above our expectations as improved product mix and manufacturing cost reductions more than offset the negative impact of unfavorable foreign exchange. On an adjusted basis, both income from continuing operations and diluted earnings per share were above a year ago.

We completed the acquisition of VNUS Medical Technologies. VNUS is a developer of medical devices for minimally invasive treatment of venous reflux disease, the underlying cause of varicose veins. We also announced two strategic licensing agreements in our pharmaceutical business which should provide us with new branded offerings; and just yesterday, we announced an agreement to acquire Power Medical Interventions, a provider of computer-assisted power actuated surgical stapling and cutting products that will supplement our manual stapling product line.

Now, turning to the third quarter sales results by segment; it was another good quarter for medical devices as we continue to launch new products and improve our market positions. On a reported basis, sales were down 3% to $1.7 billion but up 4% on an operational basis excluding foreign exchange. Operational performance this quarter was led by gains in Endomechanical up 6%, Energy up 11%, and Vascular up 15%. Endomechanical growth was paced by higher sales of laparoscopic instruments while Energy sales were driven by another quarter of strong double-digit growth for vessel sealing.

We did see some continued slow-down in capital related Energy hardware products. The gain for Vascular was led by compression in dialysis products and included a contribution from Bacchus and VNUS acquisitions.

In Soft Tissue Repair, sales grew 7% operationally as strong growth for mesh and biosurgery was partially offset by lower sales of sutures. On an operational basis, sales of oximetry monitoring products were 2% above a year ago primarily due to the higher sensor volume while sales of airway and ventilation products were down 1%. This decline was due in part to lower sales of sleep products and ventilators in the US as the domestic ventilator market was contracting due to constrained capital spending by hospitals. Outside the US, we saw increased ventilator sales as we benefited from higher orders in Asia related to the H1N1 flu epidemic.

Imaging reported sales decline of 6% to $299 million with 5 percentage points of the decline due to unfavorable foreign exchange. In radiopharmaceuticals, operational sales increased 4%. The Petten reactor, our primary third party source of supply for generators was up for the entire quarter which provided a positive margin impact. In addition, we received a very minor benefit from the unexpected shut-down of the Chalk River reactor in Canada. As planned, the Petten reactor is now down for routine maintenance, a process that is expected to last about a month and will go flying again for an expected 6 to 7 months beginning in the first quarter of 2010.

As always, we strived to minimize the impact of these supply chain disruptions on patient access to our diagnostic imaging products by obtaining alternative sources of supply, but these alternatives are typically more costly and do not always provide us with the level of supply necessary to meet demand.

In the Contrast business, sales were down 4% operationally as strong competitive activity is driving lower volume and price pressures in the US. In addition, sales of capital equipment to hospitals including urology tables and power injectors were below a year ago. We’ve recently taken some steps to improve the profitability in this segment by consolidating our sales and marketing organization to reflect the commoditization in contrast media.

In Pharmaceutical products, reported sales were down 5% to $245 million with 3 percentage points of the decline due to unfavorable exchange. The decline was primarily due to lower sales of active pharmaceutical ingredients as an increase for acetaminophen was more than offset by lower narcotics and peptide sales. In specialty pharmaceuticals, our branded products registered the double-digit decline though we reported strong growth in oxycodone immediate release as we benefited from the industry-wide supply issue due to several competitive products being removed from the market because of recalls.

In the Branded business, we expect further declines as additional generic competition for our sleep aid Restoril is possible and highly likely once the product comes off patent in May 2010. For oxycodone, we expect several of the competitors to return to the market over the coming months. As we have noted, we face difficult comparisons in pharmaceutical products next year due to several one-time benefits we received in 2009 coupled with the continued decline of branded sales. We do expect positive developments from several future new products, but the magnitude and timing are dependent on receipt of regulatory approvals.

Finally, in medical supplies, sales of $238 million were even with a year ago as higher sales of nursing care products were just about offset by lower OEM sales. The slower growth for supplies this quarter was expected as distributors reduced some of the inventory build we noted last quarter as well as our exit from some low margin business.

During the quarter, we became more aggressive in selectively pruning some of our lower margin products in several segments. While this aided our gross margin improvement, it did slightly restrain our sales growth in the quarter. We have identified additional opportunities to eliminate lower margin offerings and will be implementing them over the next couple of quarters which should partially offset some of the currency pressure on gross margin given current rates.

Finally, I’d like to briefly comment on the impact of the economic slow-down on Covidien. While it is difficult to obtain timely accurate market data, we are seeing some accelerated pressure on selective elective procedures. This has been somewhat offset by market share gains we have achieved which can often mask an overall market slow-down. As we’ve noted previously, only a small portion of our total sales come from products that are considered capital purchases including ventilators, energy power generators such as the Force Triad, contrast media power injectors, urology tables and oximetry monitors. While these are only about 5% of our total business, we did see further slowing in all of these categories during the quarter in our monitoring this situation closely.

While no business is completely immune to the economic cycles, our product diversity can be a benefit in the recent marketplace uncertainties. We continue to monitor the trends and are prepared to adjust our actions appropriately should that be necessary. Our broad product portfolio, strong balance sheet, and cash flow should enhance our ability to deliver on our strategy by making the necessary investors drive future sales and profit growth. We remain optimistic about our prospects as we complete fiscal 2009 and look forward to 2010.

I’ll now pass the call over to Chuck who will discuss the third quarter financial results in more detail.

Charles J. Dockendorff

I’ll focus the majority of my comments on the items below the sales line and discuss the segment reporting changes we announced this morning.

Overall, we’re generally pleased with our operational results this quarter. Sales came in about as planned. We again improved our gross margin, and as a result, operating income was better than planned. Our reported sales results were hinted by unfavorable foreign exchange rates and softness in the small capital equipment product areas as Rich mentioned.

Gross margin came in ahead of our expectations at 54.4%, up 70 basis points versus a year ago. We benefited from favorable mix, manufacturing cost reduction efforts, and benefits from our restructuring program which more than offset unfavorable foreign exchange. Our restructuring program is on track and we expect that the majority of charges will occur over the next couple of quarters with benefits realized late in 2010 and beyond.

Third quarter SG&A was below a year ago as planned increases in selling and marketing were more than offset by benefits from exchange rates on our cost. As we noted last quarter, additional spending for growth initiatives, NOS favorable currency impact should put upward pressure on SG&A.

R&D expense climbed 53% in the quarter to 5% of net sales including the $30 million of licensing fees for two recent pharmaceutical licensing agreements. Excluding the impact of these agreements, R&D was 4% of sales and we remain committed to further increases over time. As you saw in the release, in addition to the $30 million expense in R&D, we also had a couple of other special items that affected our reported results. These included $59 million for in-process R&D related to the VNUS acquisition and a $5 million charge for restructuring.

As reported, operating income was $441 million excluding the items shown in the non-GAAP reconciliation in the release, licensing fees, in-process research and development, and restructuring. Adjusted operating income was $535 million and the adjusted operating margin was 21.3%.

Looking below operating income, net interest expense was $35 million and other income was $7 million related to income arising from the Tyco International tax sharing agreement.

Turning to income taxes, the third quarter effective tax rate was 34%. As mentioned earlier, this rate reflected the impact of several specified items including the in-process research and development for which no tax benefit was realized as well as the licensing fees and several tax matters. Excluding these items, the adjusted third quarter tax rate was 26% reflecting the tax planning strategies we implemented last quarter in consistent with our guidance for the full year.

Regarding guidance, we will not be updating 2009 guidance today. We are confident we will end the year at a high end of our overall financial expectations. We will provide full year 2010 guidance ranges at our investor meeting in early September.

Next, I’d like to update you on our share buy-back program. Through the end of the third quarter we have bought back about 2 million shares for a total of $71 million. We expect to continue to purchase shares from time to time subject to market conditions.

As noted in the release, we announced several segment reporting changes today to more closely align external segment reporting with the recent changes in our internal reporting structure. These changes have no impact on any of our total company results and are merely a re-classification of several businesses between segments.

First, we are combining the pharmaceutical products and the imaging solutions segments into a single operating segment. This is intended to streamline our internal structure, generate cost savings by eliminating duplicate functions and allow us to more quickly respond to new market opportunities. We will continue to report quarterly sales for the four product lines currently in the pharmaceutical and imaging segments.

Second, we are moving the sharpsafety and clinical care product lines from the medical device segment to the medical supply segment. Subsequent to the acquisition of VNUS, we determined that the marketing strategies associated with these products are better aligned with the businesses within the medical supplies segment.

Third, a couple of minor changes as we move sales of several hernia repair products from endomechanical product line to the soft tissue repair product line, and one product from contrast product line in imaging to the vascular product line in medical devices.

We will provide you with restated historical segment and product line financials in advance of our September 10th investor meeting.

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

Coleman N. Lannum

For questions and answers, I am going to ask you to please limit yourself to one question and a followup if needed and put yourself back in the queue. I already see we have a number of people in the queue already.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Thomas Gunderson - Piper Jaffray.

Thomas Gunderson - Piper Jaffray

I’ll ask my one general question, may be you could give us, Rich, a little bit more color or granularity on the hospital situation in United States to the economy; we talked about capital equipment and we have that fairly well knocked down, but Tennant reported this week and said their outpatient surgeries were up slightly, Columbia ACA said yesterday their outpatient was down slightly, so let’s call it too close to call and flat, but you guys have access to a lot of data on hospital procedures, can you give us a sense of how it’s feeling to you right now relative to earlier in the year and late in 2008, are things starting to feel better?

Richard J. Meelia

It’s been inconsistent, Tom, as it has affected us. First quarter capital, we talked about capital quite differently than we sound and then second quarter kind of rebounded a little bit, and this quarter we sound again worse than it was in the first quarter; so, I guess I characterize it by saying generally inconsistent. We started seeing, I think, for the first time a little softness in the elective procedures that affected us, our bariatrics were down a little bit, still good growth, but the surgical segment was seeing a little softening there. Overall, procedures are okay for us. We continue to see good procedural demand with the exception of what we talked about capital and the bariatric procedures; no major changes that we saw in this quarter versus what’s been preceding it.

Charles J. Dockendorff

Tom, one more thing to keep in mind, when you take a look at the hospital procedures, particularly as they report, for one thing, geography in hospitals can make very wide variations where you could have some parts of the country doing much better than others for a variety of different reasons including the economy, but the second point is, remember a big part of the US hospital system is not for profits and companies don’t report to the general investment community, and so, sometimes the trends may be skewed from what you hear from the publicly owned hospitals.

Thomas Gunderson - Piper Jaffray

Thanks for that, and that’s why I was hoping to get some color from you guys because you can see it better than we can. The followup would be, within the same category, Bard reported a little bit better or easier comp on hernia as they start to come back into the market, how was hernia for you guys in the quarter?

Richard J. Meelia

Hernias and soft tissue repair and that includes biosurgery hernia and suture, and I think we’re reporting about 7% growth in the total category, but if you would break out just hernia, you would see now a strong double-digit growth as well as in biosurgery; the suture business which is much more of a commodity business, much lower margin as well drive that business down, although sequentially even suture was good, just a tough comparison.

Charles J. Dockendorff

Tom, I think we’re comfortable saying that our overall hernia business in the quarter was up in excess of 20%.

Operator

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

Frederick Wise - Leerink Swann

Let me start with gross margins; Chuck, I think you highlighted that mix and cost reductions and low-margin products helped, where can we go from here; I think at new record levels at 54.4% in the quarter, is that sustained into the fourth quarter and beyond, and if you want to quantify, how much more cost cutting or restructuring might help us as we think over the next 13 months or so?

Charles J. Dockendorff

We were very pleased with the gross margin improvement we saw in the quarter and I think just a couple of comments on that; when we did start off on the separation, we really focused on improving gross margins and had that throughout our organization knowing that we were going to increase our requirement in SG&A and R&D, and it’s really a broad category things that are beginning to come together, but if you think about it, we’ve again invested in those higher margin, higher growth areas, and that’s driving the favorable mix, and we would see that continuing going forward. That’s been a real nice improvement and better than what we had expected in the components of it, but along with that, we’ve started a restructuring program and we’re beginning to see some of those savings that are coming through; we’ve always had the aggressive cost reduction programs and those are certainly up this year in Q3; we’ve initiated some pricing strategies and where we’ve typically had price declines in our business overall, we’re beginning to see that flatten out, and so, although we do have small price declines, they’re much smaller than they have been in the past, and we’ve launched new products which are also adding to that gross margin line coming out in a higher profitability. The other thing we’re doing, and we mentioned a little bit about it, we’re getting much more aggressive with our low margin type businesses and we’re looking at bigger areas in that area as well, but these are components within our class of trades and some of these specific products will have low margins and we’re getting more aggressive on the pricing around some of those or potentially exiting them if they are less profitable. So, all of these things are coming together to drive that gross margin, and we would expect over the long term continued improvements in gross margin; however, I would tell you that quarter to quarter mix can change, and so, if you look at our historical gross margin by quarter, we were slightly lower in Q2 than Q1 and up in Q3, so I wouldn’t straight-line this by the quarter, but I think long-term I think you’ll see continued improvements in gross margin in the business as a result of all of these factors.

Frederick Wise - Leerink Swann

Thanks for that, and maybe for Rich, can you help us with a little bigger picture to think through the pharma; clearly there are some challenges, it seems like you’re a little bit of out of gas on the growth front without any new products, you’ve done some deals, may be just help us understand and are we looking basically at low single-digit growth there all things equal for the next year or so until these new products stories come to pass, and that’s may be two years away; I just don’t know how to frame it for myself.

Richard J. Meelia

I would say that absent product approvals, we’re going to be struggling to find any significant growth in pharma; we do have a couple of ANDAs; it’s impossible to forget regulatory outcomes, but we’re confident and hopeful that we’ll something within the next fiscal year, and if we get that, they could be very positive events for us, but absent that, the deals that we’ve announced are more 2011-2012 types of opportunities, and the pharma team there, they’re building to create a business with growth opportunities like focusing on areas of pain where we feel like we have capabilities to distinguish ourselves, but those are going to take some time. So, based upon how we do relative to a couple of those key ANDAs, we’ll have a lot to do whether we’re seeing decent growth or very limited growth.

Operator

Your next question comes from the line of Robert Hopkins - BAS-ML.

Robert Hopkins - BAS-ML

I have two questions; first, could you just let us know what the foreign currency hit was to earnings per share this quarter?

Richard J. Meelia

It was ballpark about $0.10 a share, certainly much stronger hit than we’ve seen in the first half of the year like we had expected; currency ended up doing a little bit better, going in our favor throughout the quarter, so, it came in a little better but very important to say that it still hurt us pretty dramatically in the third quarter and we would expect a pretty dramatic negative in the fourth quarter as well.

Robert Hopkins - BAS-ML

And then, Chuck, on gross margins, the gross margin you put up this quarter was materially ahead of what we were looking for, and frankly, I had in model 54% until 2012 and now I think what I just heard you say in response to maybe Rick’s question was that you think you see further improvements ahead; so, I just want to make sure that I heard that correctly and also wanted to understand what the effects with the negative impact was on gross margins this particular quarter?

Charles J. Dockendorff

You did hear correctly; I think the one point I want to make was I wouldn’t consider this a floor as to every quarter will be above this, but I think over the long term you’ll continue to see the trends in gross margin continue to improve based on all those factors that we talked about. Certainly, FX was a big component this year and we’re assuming that that stays where it is going forward. This year, we don’t quantify specifically the FX component within gross margin and the hit of it, but I would tell you that it was quite large year-over-year that impacted us on the gross margin piece of it.

Richard J. Meelia

The only thing I would add is, we’ve talked from day 1 of Covidien’s existence of the importance of managing the broad and diverse portfolio. Early on, there was some pretty bold moves that people saw like in the retail and attempting to move Baker, but since then, we continue to look at the portfolio; we look at returns right down to the product line level, and we have our businesses focused on managing that portfolio so that we are enriching the value of this every quarter, and every product isn’t created equal, and every contract isn’t the same, and so, we have the businesses really focused on managing their individual portfolios, they may not rise to the level of a retail divestiture for example, but over time, as we keep everybody focused on all of these different components of their portfolio, we think we can continue to create a more profitable business in totality.

Robert Hopkins - BAS-ML

And Rich, I think in terms of your commentary on the medical device division, you obviously spoke about capital equipment side, but in terms of electro-procedures, is Europe the only area that you really saw a slow-down was in bariatric or was there an impact outside of that, and how does that affect the way you think about the growth outlook for medical devices overall going forward, do you still consider that a mid single-digit grower?

Richard J. Meelia

Yes, we do, Bob. Bariatric procedures grew, just not at the same rate they had grown, and I think we saw some of the effect of the economy, but the things that we’ve been doing relative to new product launches, some of the acquisitions most recently power, all these are designed to really strengthen the capability to differentiate and distinguish ourselves in the medical device business, and we think we’ve developed some really nice technologies; our M&A strategy is just doing exactly what we would like it to do, and I just remind everybody, R&D spend is still only 4% of sales despite that we had excellent new product launches, but our goal is to get that up to a level that’s more consistent with our peer group, and so I think once we do that we’ll see I think even better new product flow, and when we launch these new products, these were all planned to have higher growth, higher margin, and higher return on invested capital; so, again, it’s designed to make the portfolio more valuable.

Operator

Your next question comes from the line of Taylor Harris - J.P. Morgan.

Taylor Harris - J.P. Morgan

Just a couple questions; first of all on some of your big devices in the endomechanical, soft tissue, and energy, have you hit some really tough comparables in those businesses this quarter; looking forward, do you think the growth rates you had this quarter are probably likely to continue for a couple of quarters or; I know you launched a fair number of new products earlier this year; is there a ramp stage for those products, that should mean did some of these categories pick up steam?

Charles J. Dockendorff

You were a little bit faint there; which categories were you talking about?

Taylor Harris - J.P. Morgan

Particularly endomechanical, soft tissue, and energy.

Charles J. Dockendorff

The growth in all three of those businesses as we project outlooks is really strong. We did have a tough comparison within the quarter, but a lot of the new products, as you indicated Taylor, have been in that area that do that; we’ve got some exciting things still to come. Energy is continuing to offer new applications to the end procedures that didn’t exist prior to some of the development that they’ve done. Hernia, as Cole mentioned before, 20% plus type of growth. So, those really are big drivers within medical devices. We feel pretty confident, we see these big worldwide markets that we service very well, and the new product flow is getting stronger, the deal activity is complimenting what we’re doing internally. So, all the ingredients for a nice good mid to upper single-digit growth remain there.

Taylor Harris - J.P. Morgan

Any way you guys can quantify for us, not necessarily this quarter, but maybe over the next year about how much in dollars sales are going to be pruning and where exactly in your reported revenue breakdown do those activities occur?

Richard J. Meelia

Right now we’re looking across the range of our products and their SKUs within specific areas in various categories. We’re taking a more aggressive approach on some of these as we look towards them and I think we’ll cover more of these in our guidance that we give out in 2010 at the Investor Day and talk about the reasons behind those and what we’re doing.

Charles J. Dockendorff

I would just add Taylor that the recently announced creation of the Vascular GVU and the moving of some of the former patient care safety products to supplies, it is just further evidence of what we’re doing at the separation and creation of Covidien, we looked at some of these products and thought that there was a good opportunity to grow and increase profitability, and over time we’ve made the decision that there are other products of our portfolio that warrants the investment, the resource capital and allocation, and that’s where it’s going and so we move these products that have a different profile into our supplies group and we have a very capable management team that can manage these types of products and maximize their contribution to Covidien. These are I think really concrete examples of what we’re talking about theoretically.

Operator

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

Matthew Dodds - Citigroup

Rich, when you look at the surgical business, the main parts; the endomechanical, soft tissue, energy, I think more of that is actually OUS than US and you commented earlier about what you’re seeing in the US; can you frame that also for the international side both in procedures and then in the capital side?

Richard J. Meelia

Capital has been as affected; in fact, in some parts of the world like Asia and Latin America, for example, we have really high double-digit ventilator growth because of H1N1. In Europe, Matt, there was some softness in some of those countries, especially southern European countries. I think it’s got to do with some of the economic pressures they’re experiencing involving nationalized healthcare over there as you know, and so when their economy struggled there is less money available. That clearly reflected some of the non-US economic growth.

Matthew Dodds - Citigroup

On the procedure side for Surgery; you are seeing any of that softness pop out in the US, whether it’s bariatrics or anything?

Richard J. Meelia

That was pretty much the only real palpable thing we could feel, and again, it wasn’t a decline, just a slower growth. We’ve always been comforted by the very low penetration of eligible patients that actually have the procedure. So we think that works to our favor because we’re continuing to do what we can in working with our bariatrics surgeon helping to create interest and people understand what the implications of the whole procedure are. So, we’re trying to create demand with them. So there is still a lot of runway there, but right now in that specific area we’re seeing a slowdown.

Matthew Dodds - Citigroup

Chuck, same line of questioning; when you look at the capital component, is part of the jump in the gross margin this quarter related in some way to the big drop in the capital; meaning is that a lower margin for you and because capital seemed to be down across the board, it may have had a bit more of an impact this quarter?

Charles J. Dockendorff

The margin on our capital, just on an average, tends to be a little lower than our overall average in the company, but the favorable mix is more coming from, when you really get into the faster growing areas within endomechanical and the energy based products and those kind of products, and the new products that we’re launching, that far outpaces anything we see from say a decline in the capital piece of the mix.

Operator

Your next question comes from the line of Tao Levy - Deutsche Bank Securities.

Tao Levy - Deutsche Bank Securities

On the Endomechanical business versus what we’re looking for seemed a little bit softer, I know you mentioned tough comps, but I was wondering if you’re seeing any increase of competitive pressure on maybe some of the lower-end trocar business, and you’re starting to gain some traction with the SILS family of products.

Charles J. Dockendorff

We are beginning to see more and more activity with SILS. We’re seeing articles about different surgeons utilizing SILS all over the world actually. So, we’re definitely seeing that. The overall Endomechanical business continues to do very well. It really is in that area a big comparison issue because if you look at our sequential sales in these areas, second quarter was stronger than the first and the third was stronger than the second. We’re not worried about any softness in those areas at all and as Cole mentioned in the hernia repair, it continues to be very very solid for us.

Richard J. Meelia

In fact Tao, when you look at the sequential, a pretty significant acceleration in our Endomechanical business on a constant currency basis; third quarter versus second quarter when compared to second quarter versus first. So, it’s doing really well, but we certainly did have really tough comps last year as we talked about before.

Tao Levy - Deutsche Bank Securities

On the Oximetry business, last quarter you mentioned that you had a little bit of a stocking benefit, but it still seems like you did decently well this quarter there; any improving trends in the US and internationally that you’re seeing; do you feel like that business for Covidien is starting to stabilize?

Richard J. Meelia

I think it has been stable the last several quarters. We talked about how a couple of years ago our growth was actually flat and we were losing pretty significant share in a 7% to 8% growing market, and over the last year or so, our growth has been more, 3% or 4%. We stabilized, but outside the US is much better than inside the US; our infrastructure and presence has a big advantage there. Until we get some of these new parameters that we’re working on as well as some of the efforts come to fruition relative to utilizing algorithms that we don’t have to pay royalty on. I think this is what we’ll see in Oxymetry. It’s a very profitable business, we like it, we want to get better in it. As we’ve said repeatedly, it’s going to take more time.

Operator

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

Joanne Wuensch - BMO Capital Markets

Can you comment on what’s happening at the hospital level in terms of inventory management and pricing pressures?

Richard J. Meelia

We see inventory fluctuations in all of our businesses every quarter. I haven’t seen anything relative to any materiality worth mentioning either in these Q&A’s that I would comment upon. Pricing; it’s interesting Joanne, we put in some very significant pricing resources throughout Covidien. We felt like that was one area where we had underperformed, underinvested, and we have historically and continued to watch our price volume on a quarterly basis; so we know exactly what’s happening and our situation has never looked better in a time when people talk about the increased price pressure due to economic downturn. So, we haven’t seen it yet.

Joanne Wuensch - BMO Capital Markets

As a followup, can you give us an update over the moly supply chain and is this just something that every quarter is going to be a downward pressure on not just you but the whole industry as we look forward?

Coleman N. Lannum

First of all I think it is important though we have said for a while that this manufacturing chain is extremely fragile and unfortunately we continue to get concrete evidence of that all the time. I think your assessment is correct. I think it is going to be volatile. Our number one goal is making sure that we address the issues with patience. I think it’s important that we all realize here that while this has financial implications and of course we pay attention to that, this is a very very serious health issue around the world. There is just not enough of this stuff to go around, and so our number one priority is making sure that we can make as much as we possibly can given the very limited supply and get it out to patients as quickly and as efficiently as we can. Unfortunately, just in the last three months we have seen the situation where the Petten plant came up more quickly than expected, then Chalk River in Canada unexpectedly went down, then Chalk River extended the length extended the length of a deem down until they said now no earlier than the end of this year, and then Petten came out and said that their period going down next year has gone from “at least three months to now somewhere between 22 and 26 week.” So, I think that just illustrates the fact that you’re absolutely right. It is quickly changing. We do our best to try to forecast things and to implement the changes we need to make as quickly as possible, but I don’t think that we have the ability to see things that far in the future just given the number of things that are going on there.

Operator

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

David Lewis - Morgan Stanley

I am wondering if you can give us a sense, I know you’re not updating guidance here and are hesitant to give the fourth quarter guidance, but given the changes in currency, could you help us at all with constant currency guidance here for the year or the impact of currency on your numbers versus where your totals historically versus now.

Charles J. Dockendorff

Yes, I think we started out the beginning of the year with close to $0.40 on the earnings impact year over year. Later on during the year that dropped and it was about a $0.30 impact year over year, and then most recently as we look at it, again the dollar has weakened somewhat through the last couple of months. It’s roughly in the $0.20 to $0.25 range for the year; we’re seeing improvements on that piece of it. Again, we’ve talked about the impact to gross margin and that is to total earnings of course but the gross margin, we are seeing that negative come through; that will continue in the fourth quarter, and then correspondingly the year-over-year comps should level out in 2010 as we move forward.

David Lewis - Morgan Stanley

Do we also have to assume on the revenue line that constant currency revenue is a little lower than you would have expected or should we assume that there is some type of sequential improvement in pharmaceutical?

Charles J. Dockendorff

The operational growth in the quarter did come a little below where we expected it to be and that was offset with some favorable currency.

Coleman N. Lannum

To the point that you made at the beginning of your question, we’re not going to comment on what it might be doing in the fourth quarter.

David Lewis - Morgan Stanley

Rich, interesting commentary about the restructuring and the focused businesses versus an unfocused business; am I hearing you correctly that you were willing going forward in areas like supplies and perhaps imaging to sacrifice top line growth for greater profitability?

Richard J. Meelia

We’re not prepared to quantify what that level is, but I would say that we have done that. We’re literally looking at profitability by SKU, by contract, and when you go at it with that degree of intensity and detail, you would be surprised what you find, and we’re finding that there is just too much business. There was an European needle and syringe business that was $30 million to $40 million that there was no profitability associated with, there was no way to profitability, and over the past six months we just essentially wound that down to nothing. So, we are doing that.

Charles J. Dockendorff

David, I think the way to think about it and the way we analyze it is really kind of in terms of return on invested capital. We may be making small margins, low margins on these businesses, but when we look at the return on invested capital and then the continued investment required to continue selling these products, it just is not worth it and not a business we want to be in, and we don’t want to allocate capital to those specific items. So, we get aggressive with the pricing, that we’ll do it at a certain price, and if not, we don’t want to continue this business and we’ll put our resources elsewhere. We have a lot of other opportunities. So, you’re pushing the framing of losing revenue growth or profitability; that certainly could be the outcome, but it’s framed around the return on invested capital analysis.

Richard J. Meelia

Also, I think what gives us the luxury of being able to do that is the richness of the overall portfolio and we have limited resources and a lot more opportunities. So, we can make choices I suppose now than to live with something.

David Lewis - Morgan Stanley

Not your most important product line, but within sutures, just a clarification; is this demand weakness because given the position of your larger competitor I am wondering if this is a pricing strategy or a portfolio management strategy for Covidien?

Richard J. Meelia

I don’t think the demand has changed, it’s pretty consistent. Sutures is a very strong area for our major competitor and I would say that they probably did take the dynamics in that part of the overall market more than us, and this as Chuck just described, is now one of those parts of our portfolio that is highly contributory to the overall value.

Operator

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

Kristen Stewart - Credit Suisse

Just on the imaging again; what was the timing for the Petten reactor shutdown, is that early next year or do you have any definitive dates on that?

Charles J. Dockendorff

Kristen, they actually have not given a specific date. The consortium in Europe makes that ultimate decision. They’ve only said “early next year.” I think realistically it’s appropriate to assume that all eyes are on Canada and the ultimate impact of when that plant might come back online could have an effect on when Petten decides to shut down to repair itself, but that’s again just speculations. The only thing they’ve said is “early in 2010” and “between 22 and 26 weeks of total shutdown time.”

Kristen Stewart - Credit Suisse

On the contrast agent business; is that something where we’re just going to continue to see that under pressure, is there anything at all that you could do to maybe offset some of the pricing?

Richard J. Meelia

We have done something internally Kristen that can address what we described as the further commoditization of that business. You just have several manufacturers and right now there is one that’s being very aggressive trying to get volume and I don’t see anything changing what’s happening. It has been happening for a long time. So, what we recently have done was look at all the expense that we had associated with supporting that product line and we made some rightsizing decisions relative to how we manage that part of our business, and then in terms of the pharma imaging in total, we had had essentially two businesses supported by two sets of infrastructure and we collapsed that to where we think we can very effectively manage that as one business with different product segments, and it’s allowing us I think to be able to model up some more profitability in the future as a result of that expense tightening.

Charles J. Dockendorff

Kristen, I think it’s important to understand too that the contrast business is still okay profitability and generates some nice cash. It’s not a horrible business. It just doesn’t have the growth characteristics and it has been that way really since the middle 90s and nothing is going to change any time soon.

Kristen Stewart - Credit Suisse

Chuck, could you just give us some statistics on cash flows in the quarter, DSOs, or anything on inventory level that you guys are seeing?

Charles J. Dockendorff

Cash flow in the quarter was pretty good, it was over $400 million, and pretty much in line, better than what we expected. So, we’re pleased with that and we would expect the cash flow to remain strong in the company. We didn’t really see any major changes in our working capital components. We had internally a slight increase in inventory, but DSOs and things like that are staying pretty consistent.

Kristen Stewart - Credit Suisse

You’re not seeing anything with your AR outside the US or even inside the US as some hospitals struggle?

Charles J. Dockendorff

No, we are certainly in certain countries, in Greece and Italy, seeing some slowdown in payment; we’ve been able to make that up in other areas, but there are pockets of the world where the slowdown of payments has increased a bit. We’re keeping a close watchful eye on that and working with the governments and the respective authorities to handle that situation.

Kristen Stewart - Credit Suisse

Have you guys quantified how much of your business goes through distributors versus direct sales?

Charles J. Dockendorff

In the US it’s the majority.

Coleman N. Lannum

It’s well above 75% in the US. OUS, we’re much more largely direct.

Operator

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

Glenn Novarro - RBC Capital Markets

I just had a followup question on the guidance. Chuck, in your prepared remarks, you said we’re not going to provide an update, but we expect to be at the high end of previous guidance, and then I go back to what you said on the fiscal 2Q call three months ago, and you said revenue guidance back then would be for the year down 3 to flat. So should we now assume flat revenue growth? You said operating margin 19% to 20%, should we be assuming now 20%? Any additional color, and as I go back to my notes, you also gave a lot of guidance per revenue line for medical devices to medical supplies; again, are you saying we should be at the higher end of the ranges that you gave per line item on the revenue line?

Charles J. Dockendorff

I think to clarify my statements in the prepared remarked, when I was referring to the guidance, more below the sales lines, with the increase in the gross margin it is flowing down into the operating margin as you can see what happened in this quarter. So, we expect that piece of the guidance ranges that we gave to be at that upper end. Sales, we saw that it came in a little lighter than we expected, and I don’t want to update specific sales guidance for the year, but I was more referring to those items below sales guidance.

Coleman N. Lannum

The one thing I would add Glenn is that, it would make people feel comfortable, I think in general from a profitability standpoint, we talked about this, gross margins and overall profitability came in better than we expected, I think better than most observers out there have expected; we want to make all of you feel comfortable that despite that we still look pretty good going into the end of the year.

Operator

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

Christopher Warren - Caris & Co.

I heard some great anecdotes about SILS Port uptake with physicians and how that was encouraging them to sign up for courses; wondering if you might share with us a couple of the top procedure courses that these doctors are signing up with, maybe we could look for some growth in the next 12 to 18 months month from now.

Coleman N. Lannum

It is interesting, as we launched it, we thought there would be a pretty measured uptake and primarily in some of the more basic, laparoscopic procedures, things like laparoscopic cholecystectomies, maybe on the appendix thing or some hysterectomies; what we’ve seen is that once we got the tool in the doctors’ hands, that the use has broadened pretty dramatically, and they’re really using it for everything; this is a portal both literally and figuratively that the doctors can use to do things, and of course, part of the concept behind it is getting it into their hands and then letting them decide what is useful for them and what’s not, and then we take that information back from the customers to try to improve on things going forward; but, really, I can tell you right now, every single laparoscopic procedure that’s being done out there, everything from the simple things like laparoscopic cholecystectomies all the way up to much more complex operations like lap-hernias, lap-gastric bypass, even live nephrectomies are being done right now.

Operator

Your next question comes from the line of Thomas Kouchoukos - Stifel Nicolaus & Co.

Thomas Kouchoukos - Stifel Nicolaus & Co.

Just curious on the VNUS business, you guys bought that company when it was really at the top of its game and I know there’s integration in the quarter and all that, can you just comment on how that business performed as you worked it into the Covidien umbrella?

Richard J. Meelia

We only had it for a couple of weeks, it just kind of kicked off, and in the early stages there are no surprises, it’s going just as we had expected, in fact a little bit better.

Thomas Kouchoukos - Stifel Nicolaus & Co.

And then, just with respect to the Power Medical bill you did yesterday, it might be early to ask this question, but I know that you had an agreement with Intuitive Surgical, a developmental deal, I’m just curious, did that stay put or could you comment on may be what that looks like going forward?

Richard J. Meelia

It’s a very valid question that we’ll be prepared to talk a little more on after closing, but to make it clear here, Power did have a number of agreements with Intuitive, our plan is to honor those agreements, we look forward to working with Intuitive, we were very aware of exactly what those agreements entail that we look at doing with diligence; obviously Intuitive is very familiar with us as a company and vice versa, we will absolutely honor those.

Operator

We have no further questions. I would now like to turn the call back to Mr. Cole Lannum for closing remarks.

Coleman N. Lannum

Before we wrap-up, I just want to take a moment to talk about our September 10th investor day. We’ll have more information going out in the next couple of weeks on specifics with the agenda of exactly what we’re going to be doing, but it will be September 10th at The Plaza in New York City, it will be the afternoon and a small part of the late morning of that day, but importantly, the design around the investor day this year is going to be science oriented and oriented around a lot of the evidence-base medicine that we’re working on not only to drive procedures but also that we’re using to implement new product development. In addition, what we’re also going to do is we’re going to set aside a significant amount of time to make sure that you have a lot of one-on-one time with executive management because we’ve heard over and over again that that’s something you really value. So, be on the lookout for that September 10th in New York City. We’ll have more details out in the next couple of weeks. Starting at noon Eastern Time today, a replay of the call will be available; additionally, the replay will be available on our corporate website covidien.com a few hours from now. For members of the media, you’ve listened to the call and if you have additional questions, please contact Eric Kraus, our Head of Corporate Communications. For analysts and anyone else in the investor community having more detailed questions involving non-material information, Brian and I will be available to take your calls throughout the day.

Thanks again, and have a great day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day.

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Source: Covidien PLC F3Q09 (Qtr End 06/26/09) Earnings Call Transcript
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