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Covidien PLC (NYSE:COV)

F4Q09 Earnings Call

November 17, 2009 8:30 am ET

Executives

Cole Lannum - Vice President of Investor Relations

Rich Meelia - Chairman, President and CEO

Chuck Dockendorff - Chief Financial Officer

Analysts

David Roman – Goldman Sachs

Kristin Stewart – Credit Suisse

Bob Hopkins – Bank of America

Matthew Dodds – Citigroup

Rick Wise – Leerink Swann

David Lewis - Morgan Stanley

Tom Gunderson - Piper Jaffray

Glenn Novarro - RBC Capital Markets

Adam Feinstein – Barclays Capital

Joanne Wuensch - BMO Capital Markets

Taylor Harris – JP Morgan

Operator

(Operator Instructions) Welcome to the Fourth Quarter 2009 Covidien PLC Earnings Conference Call. I would now like to turn the presentation over to your host for today’s call Mr. Cole Lannum, Vice President of Investor Relations.

Cole Lannum

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 fourth quarter results was issued earlier this morning and is available on our website and the news wires.

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

We'll also discuss some non-GAAP financial measures with respect to our performance including, in particular, 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 in the investor relations section of our website www.Covidien.com. For the fourth quarter we reported GAAP diluted earnings per share from continuing operations of $0.11. After adjusting for certain one time items, our non-GAAP earnings for the fourth quarter came in at $0.72 per share.

Now, I would like to turn it over to Rich who will go into more detail on the fourth quarter results.

Rich Meelia

Overall we had another good quarter as we delivered positive operational results, continued to make investments that will drive our future growth, and launched several key new products. We finished 2009 with a solid performance, in line with our expectation and are well positioned as we move into fiscal 2010.

On a reported basis net sales were unchanged from a year ago at $2.7 billion. As you know, we have been looking at our business, excluding the impact of Oxy ER which contributed $57 million of sales in the fourth quarter a year ago. Excluding these sales and the negative impact of foreign exchange from the comparison, operational growth was 4% in the quarter.

Fourth quarter sales performance was on plan with medical devices again driving our growth. Looking geographically, all of our non-US regions registered operational gains with sales up 7% outside the US in the quarter. In the United States sales were down 1% restrained by declined in pharmaceuticals and supplies which I’ll discuss in more detail shortly.

Gross margin came in on plan driven by improved product mix, pricing, and manufacturing cost reductions which more then offset the negative impact of unfavorable foreign exchange. On an adjusted basis operating margin, income from continuing operations, and diluted earnings per share were all above a year ago.

We completed the acquisition of Aspect Medical Systems, broadening our monitoring portfolio. Aspect is a pioneer and global market leader in brain monitoring and will provide us with increased access to the OR. Aspect will also bring us enhanced clinical expertise and a strong research and development organization to supplement our technical expertise and monitoring products.

We are also very pleased to receive FDA approval for our ANDA for generic Actiq and the NDA for Pennsaid. These products are key components of the strategy to expand our pain management franchise and will be important drivers of our pharmaceutical growth over the next few years. Both products are expected to launch in the first half of calendar 2010.

Now turning to the fourth quarter sales results by segment. It was another good quarter for medical devices as we continued to launch new products and improve our market position. On a reported basis, sales were up 7% to $1.6 billion and up 9% on an operational basis excluding foreign exchange.

Operational performance this quarter was led by gains in endo-mechanical up 10%, energy up 12% and vascular up 30%. Endo-mechanical growth was paced by higher sales of stapling products while energy sales were driven by strong double digit growth in vessel sealing. We continued to see restrains on capital equipment spending across the business and this was reflected in lower energy hardware product sales in the quarter. The gain for vascular included good growth for our traditional compression products and a significant contribution from the Bacchus and Vnus acquisitions, both of which are exceeding our expectations.

In soft tissue repair, sales grew 4% operationally, somewhat below the rate we’ve reported in recent quarters. We again delivered strong double digit growth from mesh and bio-surgery products but these gains were partially offset by lower sales of sutures. In the earning category, while our growth was above competitors and ahead of the market we did see some impact from a competitive product re-launch.

On an operational basis sales of airway and ventilation products were up 3% as we again registered strong growth outside the US for ventilators due in part to orders related to the H1N1 flu epidemic. We continued to see pressure on US ventilator sales due to the capital spending restraints I mentioned a moment ago. Sales of Oximetry and monitoring products were 5% above a year ago paced by double digit increase from monitors.

During the quarter we sold our sleep diagnostics product line and plans to divest the oxygen and sleep therapy lines. These divestitures will put a damper on 2010 sales growth but will be positive to margins.

Looking next at pharmaceuticals, reported sales declined 10% to $637 million with two percentage points of the decline due to unfavorable foreign exchange. Excluding Oxy ER and foreign exchange sales were about even with a year ago. In regular pharmaceuticals operational sales increased 21%. This strong gain was primarily due to generic Mibi and our pricing initiatives on generators. The Petten Reactor, our primary third party source of supply for generators was up for the entire quarter which provided a positive sales and margin impact.

In addition, we receive a very minor benefit from the continued shut down of the Chalk River Reactor in Canada. As planned, the Petten Reactor will be offline for an expected six to seven months beginning in mid-February 2010. As always, we strive to minimize the impact of these supply chain disruptions on patient access to our diagnostic imaging products by obtaining alternative sources of supply. These alternatives, however, are typically more costly and do not always provide us with the level of supply necessary to meet demand.

That said, we have secured commitments from the Belgian Reactor to augment our modest supply during several crucial periods in 2010 when Petten is down and we are in discussions with other potential sources of supply.

In the contrast business sales were up 3% operationally despite strong competitive activity in the US. Sales of capital equipment including neurology, cables, and power injectors were below a year ago. In specialty pharmaceuticals our branded products registered a double digit decline and sales of generic products were lower primarily due to increased competition as a competitive product return to the market following a recall.

In the branded business we expect further declines as generic competition for our sleep aid Restoril recently launched and the product comes off patent in May 2010 opening the door for additional competitors. In the generics business our decision to prune the product line is also negatively impacting our results.

Sales of active pharmaceutical ingredients were slightly below last year due to lowering our products and peptide sales while sales of specialty chemicals were down 4% operationally primarily due to lower microelectronic chemical sales.

As we noted last quarter, we’ve taken some steps to improve the profitability in this segment by consolidating our sales and marketing organizations to reflect the changing marketplace, particularly in imaging. 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 the two product approvals we recently received but the launch timing will limit the benefits in fiscal 2010.

Finally, in medical supplies, sales of $433 million were 6% below a year ago. The sales decline for supplies this quarter was not unexpected as we again saw distributors working off some above normal inventories exited some low margin business and reported lower sales in our OEM business.

We are very pleased with our 2009 performance, delivering 5% operational sales growth in a difficult economic environment. We continue to make the investments that will propel our growth in the future including launching several key new products and significantly increasing R&D spending. We also made a number of portfolio moves to strengthen our business including several strategic acquisitions and licensing agreements and began to prune slower growing low margin product lines, a process that will continue in 2010.

We reorganized internally to improve our cost structure, increased speed to market, and become more operationally efficiently. Financially we implemented tax planning strategies to significantly lower our tax rate, implemented a stock buyback program and announced a 12.5% increase in our dividend. Our broad product portfolio, strong balance sheet and cash flow should enhance our ability to deliver on our strategy to drive future sales and profit growth. We remain very optimistic about our prospects as we move into 2010.

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

Chuck Dockendorff

I’ll focus the majority of my comments on the items below the sales line and then discuss our revised 2010 guidance.

Overall we are pleased with our operational results this quarter. Sales came in close to our expectations and we again improved our adjusted gross margin and as a result operating income was on plan. Our reported sales results were hindered by unfavorable foreign exchange rates and softness in the small capital equipment product areas as Rich mentioned.

Our adjusted gross margin was 53.2% up 90 basis points versus last year’s adjusted margin. We benefited from favorable volume and mix, positive pricing, manufacturing cost reduction efforts, and benefits from our restructuring program, which more then 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 later in 2010 and beyond.

Fourth quarter SG&A was up significantly versus a year ago but included a number of one time items as noted in the release. Excluding these items planned increased in selling and marketing and additional expenses from recent acquisitions were partially offset by benefits from exchange rates on our costs. SG&A came in above what most of your had modeled and this increased level should be the baseline of your future expectations. As we noted last quarter, additional spending for growth initiatives, the impact of acquisitions and a less favorable currency impact will put upward pressure on SG&A in 2010.

R&D expense climbed 7% in the quarter to 4.2% of net sales and we remain committed to further increases over time with the goal of 5% to 6% of sales over the next few years. As you saw in the release, there were a couple of other special items that affected our reported results in addition to those I’ve already mentioned; including in process R&D and restructuring charges.

Operating income was $308 million on a reported basis. Excluding the items shown in the non-GAAP reconciliation in the release, adjusted operating income was $538 million and the adjusted operating margin was 19.9%. Looking below operating income, net interest expense was $39 million, somewhat above a year ago as lower interest rates are negatively impacting our interest income.

We also reported $123 million of other income primarily representing the impact of our tax sharing agreement resulting from Tyco International settlement of certain pre-separation tax matters. This pre-separation tax settlement also had a negative impact on our fourth quarter effective tax rate as we previously communicated as individual items get settled under the tax sharing agreement it will create volatility both positive and negative on our P&L until all our legacy items have been resolved.

In addition to the tax settlement, we had a write off of a previously recognized deferred tax assets related to the specialty chemical business moving back into continuing operations during the quarter. Excluding the specified items the adjusted fourth quarter tax rate was 27% reflecting the tax planning strategies we’ve implemented during the year and consistent with our guidance.

Next let me take you through some cash flow highlights. For fiscal 2009 our operating cash flow was about $1.9 billion. We incurred about $400 million of capital spending this year, resulting in free cash flow of slightly under $1.5 billion. We made good progress this year in managing our working capital. In particular, holding down inventories and accounts receivable, despite the difficult economic environment and this contributed positively to our cash flow.

I want to emphasize that we continue to expect that our business operations will generate strong cash flow. For 2010 we continue to anticipate that free cash flow will be approximately $1.4 billion in line with the last couple of years.

Next I’d like to update you on our share buyback activities. Through the end of the fourth quarter we have bought back approximately 6 million shares for a total of $232 million. We expect to continue to purchase shares from time to time subject to market conditions.

Finally, I’d like to discuss our 2010 guidance. As we noted on Investor Day in September our long term goals including mid-single digit sales growth and double digit EPS growth achieved through combination of operational and financial leverage. Our expectations for 2010 fall right in line with these goals. We are revising our guidance to reflect the recent weakening of the dollar against most currencies since investor day, as well as the Aspect acquisition and the approvals Actiq and Pennsaid by the FDA.

Consistent with fiscal 2009 all 2010 guidance comparisons exclude the impact of Oxy ER from our 2009 base. At current exchange rates we now expect total company sales for 2010 to be up 6% to 9% versus 2009. By segment, at current rates, we expect sales in medical devices to be in the range of up 9% to 12%. For pharmaceuticals we now anticipate sales will be flat to up 3% in 2010 as we expect to benefit from the generic Actiq and Pennsaid launches later in calendar 2010. There has been no change to our guidance for medical supplies up 2% to 5% for the year.

For 2010 operating margins our expectations remain in the range of 20% to 21% while we expect continued progress on our gross margin we will maintain our ramp up in research and development spending that began several years ago. In addition, as I indicated earlier, SG&A spending will be pressured by foreign exchange, acquisition related expenses, and additional selling and marketing in pharmaceuticals related to the recent FDA approvals. While our longer term goal is to leverage SG&A we will be pressured to do so in 2010.

Our effective tax rate is expected to be in the 21% to 23% range consistent with previously guidance. This significant reduction versus our 2009 rate reflects the full year impact of the tax planning strategies we implemented in the second quarter along with some additional tax planning to be implemented in 2010.

While our tax rate has not changed versus our earlier guidance, we are feeling some upward pressure due to the additional interest related to the Tyco tax settlement we discussed earlier and the inspiration of the R&D tax credit. Both operating margin and tax rate guidance exclude the impact of any one time items.

Now I’ll turn the call over to Cole for questions and answers.

Cole Lannum

For Q&A I see a number of your have already signed in for questions. Out of fairness to everyone I’m going to ask that you please limit yourself to one question and a follow up if needed and put yourself back in the queue and we’ll get back to your in line. Can we please review the process one more time for signaling a question?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Roman – Goldman Sachs

David Roman – Goldman Sachs

One operational question then one financial question. First on the medical supplies guidance can you talk about the confidence you have in the 2% to 5% growth number following a quarter of declines? Have we seen the end of the inventory de-stocking and then on the sharp safety side is there something happening competitively versus Becton Dickinson that either will change in 2010?

Rich Meelia

The biggest difference in 2010 versus 2009 is we won’t have the effect of a business exit that we had in Europe in 2009. We basically shut down our syringe and needle business in Europe. It was north of $50 million business but it had no profitability and no return on invested capital so that was among the portfolio moves that we’ve been doing some we actually announced, others we just do. That’s a big part of it.

The other thing that happened this year is we reorganized the medical device business, created a vascular global business unit and basically blew up the old patient care and safety products and took the majority of those products which we just determined more commodities sold growth and put them into supplies. This entailed some pretty significant sales force reorganizations. They’ve been complete for a couple months. There was some disruption in the field in terms of who had responsibility for what throughout that big market. That’s behind us as well.

Inventories, we don’t make a big deal out of it because they’re adding inventory or they’re lowering inventory depending on what’s trying to get done at the big distributor level. That just will always cycle in and cycle out. In terms of Sharp Safety its becoming a smaller and smaller piece, especially the standard syringes and needles as well as the safety. I wouldn’t say there’s anything specifically different going on in the marketplace between us and our competitor its just becoming a less relevant business in terms of where values are being created at Covidien.

David Roman – Goldman Sachs

On the P&L there was almost a 15% sequential up-tick in net interest expense. For 2010 how should we think about your interest rate on cash are you getting something like less than 1% on your cash right now?

Chuck Dockendorff

The interest rates on our cash deposits have gone down significantly it just reflects the market rate of interest rates that dropped. We’re very conservative with the investments we make on this cash so they’re in relatively safe investments with very low returns. Those have declined year over year and we would expect that to continue in the foreseeable future. Of course that can change if interest rates change and things like that.

David Roman – Goldman Sachs

A number north of $160 million in interest expense next year?

Cole Lannum

Certainly north assuming no other changes. I think even though we have very, very strong cash flow, certainly north of $150 million net and it might approach the $160 million number.

David Roman – Goldman Sachs

On the sales side, any of that reorganization effect the suture business? Your closest competitor said that sutures is a good tracking number for elective procedure volume. Is there anything to read into your business from a share perspective or what’s happening in the overall market?

Rich Meelia

Its a total different sales force. Suture is in the surgical so its total separate. Our suture business, our shares are relatively small. We track procedures, the procedures that our products are used in. All these surgical procedures. The data that we see shows our colectomies, colorectal procedures, thoracic procedures, they’re all performing pretty consistently with what’s happened over the last several years. We just don’t have that many products used in elective procedures that we could point to a product line as a barometer, an indicator for what’s happening in elective procedures. Our competitor would have a much stronger presence in that and that very well could be the case.

Cole Lannum

We presented at a conference last week and actually shared some data on some of those procedures over the last several years, trying to illustrate the fact that we’ve not seen any significant move there and anyone can access that slide from our website. Also to note, we have one of the biggest launches we’ve had in our sutures business in quite some time that we introduced at ACS just recently. As we go into 2010 we’re hoping for a little bit of a better contribution from that suture business.

Operator

Your next question comes from Kristin Stewart – Credit Suisse

Kristin Stewart – Credit Suisse

I was wondering if you could walk us through the impact with the tax matters in terms of what occurred in the quarter related to the old Tyco tax outstanding matters related to the change that’ll occur on the balance sheet? As I recall there was also some implications for what runs through on the other income and expense line item.

Chuck Dockendorff

You can see those called out in the non-GAAP schedule both the increase to other income and the tax charge related to the legacy liabilities. Essentially Tyco is managing the audit for all three companies of those years that are under audit for taxes. This was a settlement that we agreed to on a specific item that we all agreed to. The liability in essence was on our legal entity. As a result of that, while overall the impact we felt was good for the whole group, we booked that increased liability on our legal entity.

Correspondingly the other income coming through would be the pieces that are owed to us, the 58% from both Tyco and Tyco Electronics and we booked that through that other income to offset that. You really have to look at those two as a net charge.

We’ve stated that we feel that we’re adequately reserved on our balance sheet for these legacy tax liabilities. There’s another component on our balance sheet which is the FIN 45 guarantee obligation. The accounting on this is a little different, its done on a fair market value and while we have some coverage in there for these type of things there’s really no adjustment made to that specific item until there’s a really significant event in the audit or resolution of some of the liabilities.

It is a little complicated, I would tell you that we can take this offline for further discussion. There also will be more discussion on this in our 10-K that comes out later this week that you can refer to.

Kristin Stewart – Credit Suisse

Will other income go up as a result of this slightly relative to where its been?

Chuck Dockendorff

It will go up slightly but it also forces a little bit higher tax expense because we recognize the interest on the tax liability as well. It is a small adjustment going forward.

Kristin Stewart – Credit Suisse

In terms of foreign currency in terms of the impact on earnings this quarter, is it fair to say that it was about a $0.08 negative impact?

Cole Lannum

About $0.09 is what we saw year over year between translation and transaction that’s correct.

Kristin Stewart – Credit Suisse

In terms of the change in FX on a go forward basis is it about another percentage point in the favorable move relative to the investor day on the top line?

Chuck Dockendorff

Are you talking about on the revenue line? Yes I think a little more then that, its weakened quite a bit here since we put those numbers together on the investor day so it will be a little higher then the 1% change.

Operator

Your next question comes from Bob Hopkins – Bank of America

Bob Hopkins – Bank of America

I wanted to talk about your SG&A comment, the current run rate is being a baseline for next year. I’m wondering what we saw in the fourth quarter here from SG&A what’s not in that number that will occur in 2010?

Chuck Dockendorff

What you’ve got is really some extra SG&A related to Aspect and some of the investments we’re making in Pennsaid and things like that. If you think about it, we talked about this SG&A ratio in context of our existing mix of business. As we bring in acquisitions, this included Vnus as well, these have very high gross margins. However, as we mentioned, they’re relatively neutral to earnings so you have a high G&A component within there which is caused by a couple of things.

One is the increased amortization, you have new accounting rules which are putting more of the purchase price allocation into intangibles so that’s coming out through amortization. That going forward along with some of the FX gains that we had, hedge gains which flow into SG&A this year in 2009 those are absent going forward. We don’t forecast a hedge gains going forward. There’s a favorable in SG&A that it won’t really increase expenses but we’re not going to recognize the favorable hedge gain as a result of the strengthening dollar through 2009.

Bob Hopkins – Bank of America

The pharma spend hasn’t started yet, it that fair?

Chuck Dockendorff

No it has not.

Bob Hopkins – Bank of America

This ratio that we see in the fourth quarter is really going to go up fairly substantially from here and maybe year over year be up a point to two points, is that a fair way to think about it?

Cole Lannum

I think we want to stay away from specifically forecasting the ratios. As noted by the comments, there is going to be some upward pressure here because of that. Some of that’s going to be offset by higher revenue numbers too. I think there’s a little bit of an offset, I don’t want people to get the impression that this is just on the pressure side, certainly the FX impact also has a positive impact on revenues and a positive impact on gross margins as well. I think the pressure overall is definitely going to be felt.

Bob Hopkins – Bank of America

On FX could you tell us at current rates in your business what you think the FX gain year over year will be for fiscal 2010 versus 2009?

Chuck Dockendorff

Right now its right around $0.14 or $0.16 a share somewhere in that range.

Bob Hopkins – Bank of America

That’s just a net EPS gain anticipated in 2010 from just currency benefit?

Chuck Dockendorff

Right.

Operator

Your next question comes from Matthew Dodds – Citigroup

Matthew Dodds – Citigroup

One question on the medical device business, it looks like US was up about 12% constant currency, I know US was up 7%. Was that a mix shift related to these acquisitions and divestitures or did surgical in particular grow faster in the US this quarter?

Rich Meelia

Surgical has been gaining for the past several quarters strong momentum in the US markets, primarily tied to the expense and the sales force and the new products we’ve launched. Just a few years ago we’ve seen lots of growth outside the US and growth in the US was below market rates. We’ve steadily increased. What you’ve seen in the US is a continuation of the trend.

Matthew Dodds – Citigroup

You still think in the US there’s modest share gains for the surgical business?

Rich Meelia

I think modest. Long term our goal is, this is what the portfolio management process is all about, its continuing to move ourselves into the higher growth markets because we do recognize you can only take share for so long especially against these very good competitors. Our goal is to continue to look and find attractive markets in which we can compete and manage the portfolio.

That was exactly what we did with the creation of the vascular business unit, high single digit growth opportunity. In total with Vnus we moved into a double digit growth business. We recognize that market share movements can be cyclical and the really long term drivers is putting ourselves in the markets.

Matthew Dodds – Citigroup

On the energy business can you give me an idea how fast vessel sealing grew constant currency, some broad number?

Cole Lannum

Once again it was well above 20% constant currency.

Operator

Your next question comes from Rick Wise – Leerink Swann

Rick Wise – Leerink Swann

Turning to gross margin, you were talking about their structuring on track and the benefits likely realized in fiscal ’10. Can you help us think through, even though I know you’re reluctant to give any specific guidance, the benefits we might see? The last couple quarters your gross margin is already in the 53% range. It seems like with volume mix and restructuring you’re talking about, thinking about 100 or 200 basis point pick up in gross margin might not be out of the question. How can you help us a little bit if you would.

Chuck Dockendorff

I think the best way to think about that is if you look at what happened in 2009. We’ve always talked about this favorable mix both within the total company through segments as well as within devices itself. It was very good in 2009 and we would expect that to continue through 2010. The biggest difference is we had a big negative in 2009 from exchange. That was over a percentage point that kind of hit us as a negative as our costs went up as we talked about in the past.

Right now, as we look to 2010 that negative is not there. That’s based on today’s rates, again we don’t want to predict what’s going to happen there but based on today’s rate that negative would go away and we actually would have some slight favorability at our back which is a big change.

The other thing, we’ll continue on with some of the savings programs, offsetting inflation in manufacturing costs and the restructuring savings is part of that. That’s flowing through but at a relatively small amount when you offset inflation and things like that on those components.

Another big thing was in the area of price. In 2009 we did get some favorable price as a result of a concerted effort around the organization to really focus on that. That’s certainly helped us this year and was one of the first times in the last four or five years that we’re able to do that. While we will continue to manage that pricing thing I think most of the low hanging fruit has been received so we’ll continue to drive that but I don’t think we’ll get the upside in ’10 as we did in ’09 from that particular component.

Those are kind of the drivers of it. We expect gross margin to continue to improve in 2010 because of it.

Rick Wise – Leerink Swann

Could you give us a little more granularity on the mesh business, soft tissue, it sounds like you lost share as your competitor came back in the market, maybe help us think about the outlook there. On the core mesh side, it sounds like that was stronger. How should we think about the outlook?

Rich Meelia

The best way to look at it is to break it down to the sub-segments of the overall hernia business. If you look at our mesh both synthetic and biologic we continue to see strong double digit growth faster then market growth so that goes well. On what we call soft tissue mechanical products, tacking systems, a competitor did re-enter re-launch product. There our overall progress we were kind of flat year over year. You definitely see the impact of the reappearance in the market of a competitor.

Overall, from a mesh standpoint, from a hernia standpoint we feel very good, the mesh is the much, much bigger component of the overall segment. The hernia and mesh business specifically is double digit grower and we foresee that to be the case in 2010 as well.

Rick Wise – Leerink Swann

The possibility of the medical device industry tax or surcharge whatever the right terms are, is that a concern to you or how are you thinking about it as you look ahead to fiscal ’10?

Rich Meelia

I’ve probably been a little more involved in this. You know the specifics of the House bill and we’re waiting a Senate version as well. Depending upon where they end up the impact is going to vary so its hard for us to put a number on it and the timing is totally different as well relative to the two bills. We look at it as more of a tens of millions of dollars kind of thing. We also see some upside from increased access not to the degree that perhaps other parts of the industry might because so much of our products are tied to surgeries which are typically done regardless of insurance because these are critical situations.

I think the reduction from $40 billion to $20 billion that occurred in some of the proposals is very helpful. There’s no question its a negative and once the final details are determined we’re just going to have to put in place a game plan that enables us to offset whatever comes out of this.

Operator

Your next question comes from David Lewis - Morgan Stanley

David Lewis - Morgan Stanley

If FX turns into material tailwind going forward, can you talk to us about your approach in reinvestment. How likely is it that you allow this FX to drop through the historical rates versus reinvesting that in your business? If you were to reinvest where should we be thinking about the most likely areas to invest?

Rich Meelia

We try to measure our business of FX upside or downside. The majority of our investments are clearly in devices as well as in pharmaceuticals, especially as we move forward on the branded pain strategy which we’re actually getting more and more excited about. If were in a position where we were getting off to a pretty good start which we anticipate, we saw opportunity for additional investment, we’d look in places like China, some of these emerging markets where we’ve done extremely well.

You go around the world; Eastern and Central Europe, Latin America, Asia and these are big businesses for us, hundred of millions of dollar businesses, high margins, all double digit growth. Even with that very impressive historical track record we believe there could be upside if there were certain things that we might do in terms of additional investments that would be reflected in upward returns, maybe not immediately in 2010 but certainly getting out into 2011.

We’re pretty committed in our investment strategy if the opportunity arose to do some additional. We’d probably look at some of these emerging markets.

David Lewis - Morgan Stanley

The timing we should assume that the majority of any FX tailwind really should drop through to the bottom line?

Chuck Dockendorff

What we’re committed to is, we’ve talked about this, is this mid-single digit sales growth rate and a double digit earnings per share growth. That’s on a consistent basis. We’ve talked about periods where we’ll have windfalls and other periods where we’ll have things that will be against us. Overall we want to drive to that consistent earnings rate. There are clearly, this plan we have out here we have a significant planned increase in research and development we’re bringing that up, how fast we accelerate that up there’s other opportunities presenting themselves in pharmaceutical to maybe accelerate some programs, we’ll take a look at that.

As we do some acquisitions some of these deals are dilutive, especially with the new accounting in the first year. Those will also be opportunities that are easier to do in this kind of environment. As Rich mentioned, the emerging markets that offers a big opportunity for growth and we were over there a couple weeks ago. Management is putting plans together to really see ways that we can accelerate into those areas and take advantage of the opportunities over there. There’s a lot of investments that we can look at and manage our way through. This is the year when those could be done and we can do them.

David Lewis - Morgan Stanley

Specifically on ventilation, are there specific contracts in place either governmental or non-governmental that you’re expecting for flu, can you quantify at this point a specific impact from flu in the forward year?

Rich Meelia

I don’t think I can quantify. I could tell you that the US ventilation business is actually down I think that’s directly correlated to the restriction in capital purchases by hospitals as a result of the tough market for everybody. Outside the US we’re seeing pick ups play a part in places like Latin America. You’re seeing the impact of the epidemic related purchases. We haven’t seen it in the US thus far but we anticipate that 2010 will be a good year in ventilation for a couple of reasons.

We think you’ve got this working in our favor and we’ve talked a lot about our investment in ventilation and we’ll begin to see some of the investments translating into actually improved product offering towards the tail end of 2010 and more aggressively into 2011. We’ve spoken quite a bit about the respiratory business and how its going to talk a little bit longer but I think you’ll start to see some of that investment payback now in this segment. We probably feel more bullish about the respiratory monitoring business now then we have anytime since we’ve spun.

David Lewis - Morgan Stanley

It sounds like you feel positive this business can improve towards the back half of the year despite certain competitive launches coming this year as well.

Rich Meelia

Yes.

Operator

Your next question comes from Tom Gunderson - Piper Jaffray

Tom Gunderson - Piper Jaffray

On the impact of recalls, you guys obviously take advantage when your competitors have recalls but then when they come back into the market, whether we’re talking hernia or we’re talking Oxycodone. Can you talk about the lasting effect of those recall opportunities, how much is sticky and how much just completely rebounds back to the original seller?

Rich Meelia

In a steady state market if you’ve got two competitors that have been competing for a fairly long period of time, the dynamics of the market are pretty steady, we understand how each other works, people understand the product offerings. I think after a recall I would say the majority of the business would begin to return to the company that comes back on the market, assuming that they come back with a product that provides good outcome for the clinician customer.

I think it gets a little more cloudy when you have a situation like we are in where you’ve got this pretty sizeable marketing force in our surgical division that heretofore had been only in the tacking piece of the overall hernia business and its probably 10% of the market, the other 90% we weren’t in and that be absorbable tacking, synthetic mesh and biologic mesh.

Here’s the situation where we now get into all aspects of the market. We do so with a partner and company we acquired and has a very impressive pipeline, great technology and development capability and then you put in these products the hands of a worldwide distribution entity like surgical who has further enhanced their sales capabilities by adding all these hernia specialists.

I think it changes that whole dynamic. I do believe that the share gains that we made we will not simply hand those back to our competitor and the fact that we’re talking about continued double digit growth in mesh, both synthetic and biologic, reflects our strong conviction that we’ll continue to grow faster then the market.

Cole Lannum

On the generic Oxy ER business the fundamentals of that marketplace are primarily price driven. While we did a lot of anticipation of how our competitors would return to that market and we set some situations up that I think have mitigated it for us, as expected when one of the primary competitors came back in, they did come in at an aggressive price. That’s what’s really been a drive to market share more then anything else. The fact that we’ve been the stay safe producer there I think helps somewhat but at the end of the day on the generic side people look for pricing.

Tom Gunderson - Piper Jaffray

On the medical device tax but more on a broad sense of hospitals this year maybe more then any year in recent history being under a lot of pressure and sharing that pressure with their vendors in the form of looking for reduced prices. Two things; one, do you think whatever tax we get, whenever it comes through, do you think any of that can be passed on to the customers? Second, on the surgical business, have you seen any changes, any increases in reusable use or are we still clicking quite nicely along on the disposable kits?

Rich Meelia

In terms of a price increase that’s a tough one to call. There are so many variables involved and competitors have some people are interested in volume increases, some are interested in margin increases and it depends how everything gets aligned. Its impossible to predict. Generally speaking I will say in all my years in this industry when your cost of doing business increases you find ways to make up for that cost, you look in your own internal organization, you look backwards to your suppliers and you look at ways to get additional value from your customers. All those things will be triggered with if there is an actual device tax.

In terms of the surgical business, I would say just by virtue of what you’re seeing in our growth that would be the biggest indicator that people continue to buy disposable products and the risk of infection and the consequences of that, especially even more so today when reimbursement will be a challenge or potentially rejected if its hospital acquired infection. I don’t think you’re going to see any huge reversal to reusable.

We do see, its not huge, but you see this steady growth of re-processors, they’re out there they won’t go away. They’ve been around for a while and I think they’ll have their niche. You’ve probably seen more of that then you are returning to reusable.

Operator

Your next question comes from Glenn Novarro - RBC Capital Markets

Glenn Novarro - RBC Capital Markets

On the increase in revenue guidance, you mentioned some of it was Aspect Medical, some of it was Actiq and Pennsaid. I’m wondering if you can quantify each item individually. In other words, how should we think about the revenue contribution from Aspect Medical in fiscal ’10 as well as Actiq and Pennsaid? As a follow up, I’m assuming that Actiq and Pennsaid will have some channel fills can you also help us with what the channel fill will be?

Cole Lannum

First of all on Aspect, its pretty straight forward, it was a publicly traded company so you can take a look at their revenue base. They were annualizing out at about $100 million a year. Now that we’ve closed we’ll have them for just over three quarters so you do the math there its probably $75 plus million in revenues just from that.

As far as Pennsaid and Actiq two different types of growth dynamics. As we’ve talked about before, on Actiq that’ll have a relatively steep growth curve. We would expect a degree of channel fill from that standpoint and we would probably be a peak sales in that product within several quarters. Maybe not in fiscal 2010 but certainly sometime early in 2011. As noted, we plan on launching that product sometime in our March quarter.

As far as Pennsaid goes, a much slower ramp as it typical from a missionary sell from a brand new branded drug where we’ll need to get out there. We’ve been talking about the fact that we’re going to need to significantly increase the amount of our sales force in anticipation of that launch and the revenue base for Pennsaid would probably be very, very small in 2010. We would not expect that same degree of channel fill that we would for Actiq so two different dynamics going on there.

Certainly when you combine the two together you’re talking about $20 million plus easily in revenues just from those two products added to our pharma base.

Glenn Novarro - RBC Capital Markets

That’s $20 million in fiscal ’10 correct?

Cole Lannum

In fiscal 2010 that’s correct.

Glenn Novarro - RBC Capital Markets

Can you provide any commentary on Exalgo in terms of what’s next in the process with the FDA and how you’re thinking now about the timing of a US launch?

Cole Lannum

As you know, we put out a press release yesterday regarding discussions we were having with the FDA there. As you may also know, our partner Neuromed is responsible for negotiations with the FDA and they happen to be currently in registration with the SEC in a merger situation. We are very, very limited as to what we can say beyond what was filed in their 8-K and what is in our press release. Certainly what I do want to stress is that this is not a death nil for the product. We are in a lot of negotiations with the FDA, it is happening real time and we are hopeful that we’ll have more information that we can share with you sooner rather then later.

Its really hard to speculate as to what this means for the launch side. We’ll have to wait. I think the first date we need to get through is the original PDUFA date that is this Sunday. Between now and then those conversations will continue and other then that I’ll just tell you that as soon as we have more information we will share it with you.

Operator

Your next question comes from Adam Feinstein – Barclays Capital

Adam Feinstein – Barclays Capital

I didn’t see a full cash flow statement here so I wanted to see if you could give us some highlights from the cash flow for the quarter. I know at your analyst day you talked about free cash flow number about $1.4 billion excluding some of the one time items. I wanted to see whether that is still the same guidance here?

Rich Meelia

We had a very good cash flow in the fourth quarter, it was over $500 million of free cash flow. Really driving to the total cash flow for the year just under $1.5 billion. I think the company did a good job, as I mentioned, managing working capital. We saw a decrease in AR days, we saw a decrease in inventory, we saw actual improvement in our AP days. All of that, you consider the kind of environment we’re working under around the world especially a lot of our sales are generated overseas, which tend to have a higher accounts receivable day related to them. A good job there managing the working capital piece going forward.

The capital equipment that we spent, a little over $400 million which was right in line with where we expected it. This kind of cash flow we generate we would expect to continue going forward. As you look at 2010 there is some different assumptions around how taxes get paid. We also had a big windfall of Oxy ER in 2009 that added to our cash flow as well. Going forward we don’t have as aggressive assumptions in the working capital in 2010 as we achieved in 2009 and that primarily is because of the low rate that will go into 2010 with.

All in all I think our capital equipment as well we’ve given guidance on that. We think its in the $425 to $475 million range which again is consistent with what we’ve done for prior years. We expect the strong cash flow to continue.

Adam Feinstein – Barclays Capital

In terms of what you’re hearing from the hospitals, we hear a lot about what’s going on in the US but just curious outside of the US what is the tone with respect to spending and has it gotten any better, worse, in recent months? Big picture outside the US what is the general feedback you’re getting from key customers.

Rich Meelia

As you know, most of the hospitals outside the US provide at least 50% of the cares is nationalized healthcare if not more. I’ve already talked about what’s happening in the emerging markets. If you just go Europe the countries like UK, Germany, have been very, very strong for us. Some of the southern European countries the economies are struggling; Spain, Greece, a little less so. Japan’s been a very good year for us. I don’t think there’s the sense of potential change in the market outside the US.

I think its more the economic downturn that just comes along from time to time and people just deal with that. We haven’t seen anything significantly different outside the US then we do when you encounter some of the cycles.

Operator

Your next question comes from Joanne Wuensch - BMO Capital Markets

Joanne Wuensch - BMO Capital Markets

I have two questions. The first one has to do with the hospital purchasing environment, particularly in regards to pricing, push back, and not response and inventory that you’re seeing at the hospital level.

Rich Meelia

Chuck might have mentioned that this was the first year in a number of years where we actually saw price improvement. We’ve been monitoring price volume forever. That was one of the characteristics of the old Tyco Healthcare simply being operationally efficient. We typically would see between 50 and 100 basis points of degradation this is the first year we actually had positive pricing. We spent a lot of time, effort, and money to improving pricing capability. The best practice is bringing in people who know more about it then we do to create certain procedures and practices in all of our businesses. It wasn’t coincidental.

In terms of general pressure, I’ve been in the business a lot time and the advent of DRGs the group’s becoming more compliant and the pressure associated with that, the Medicare modernization act back in the late 90’s. It just seems like hospitals have always been pressured and what makes a difference is if you bring them real value creating opportunity in terms of the product offering. As long as you do that, pricing seems to take care of itself because you’re giving them added value.

A lot of people who are paying attention to healthcare because of all the focus on healthcare reform I think don’t fully appreciate what the nature of this business has been for the past 20 years. Hospitals are under significant pressure, fighting with reimbursers to get more money and suppliers in the middle all the time.

Joanne Wuensch - BMO Capital Markets

My second question has to do with your SG&A spending. You noted that its going to be the base case going forward. How is that going to spend throughout the year? Should we look at it being more front end loaded or just a fairly steady rate as a percentage of revenues?

Chuck Dockendorff

I think its a steady rate. If you think about the Aspect acquisition coming in it will begin to hit at the end of the first quarter beginning into the second so we’ll see the full quarter spending in Q2. I think if you think about some of the launches we’re looking at in pharma those will build through Q2 and Q3. It should be steady ramp through the year.

Operator

Your last question comes from Taylor Harris – JP Morgan

Taylor Harris – JP Morgan

To clarify the increase in revenue guidance for next year I think its about $200 million in total. It seems like about $50 to $60 million of that is pharma, you said over $75 million from Aspect Medical, are those two numbers about right then is foreign exchange the rest?

Cole Lannum

I want to be clear on this. I don’t want to confirm your $200 million number. What we did was we moved our ranges up. We moved both the bottom end of the range and the top end of the range up. That may or may not be $200 million. We don’t quantify it that way.

Taylor Harris – JP Morgan

It seems like the math works out close to that at least. With pharma the increase in the range implies something more then what you said the $20 million or so from Actiq and Pennsaid. Is there something else going on in the pharma business. I’m curious, imaging had a really good quarter, are you assuming the imaging businesses have better years next year?

Cole Lannum

That is a small part of it. We’re feeling a little more comfortable about imaging, as Rich talked about in his opening comments, we’ve been doing a lot of work behind the scenes on addressing the availability of Mollie for 2010. while it is far from a slam dunk that everything is going to go perfectly there I think we are feeling a little bit more comfortable so the small amount there. As well, we do get some FX benefit from pharmaceuticals and that would be included as well.

Taylor Harris – JP Morgan

Obviously there are a lot of moving parts here with the top line going up but you’re saying SG&A is going to be going up a lot as well. Are you willing to comment on where street estimates are and whether you’re comfortable with them moving up modestly just given the underlying strength in revenue growth and gross margin?

Cole Lannum

I think its a fair point. You know we don’t give specific guidance ranges but I think a small movement upward is probably consistent with the different variables we’ve talked about today and I think that’s probably fair.

Operator

This concludes the question and answer portion of today’s call. I would now like to turn the call back over to Mr. Cole Lannum for closing remarks.

Cole Lannum

Thanks everyone for staying a little bit afterwards. Starting at Noon Eastern Time today a replay of the call will be available. Additionally the replay will be available on our corporate website www.Covidien.com a few hours from now. For members of the media who listened to the call and have additional questions please contact Eric Kraus our head of Corporate Communications.

For analysts having more detailed questions involving non-material information Brian and I will be available to take your calls. Thank you and have a great day.

Operator

Thank you for your participation in today’s conference. This concludes your presentation. You may now disconnect.

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Source: Covidien PLC F4Q09 (Qtr End 09/25/09) Earnings Call Transcript
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