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Covidien Public Limited Company (NYSE:COV)

F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

January 20, 2009 08:30 am ET

Executives

Cole Lannum – VP, IR

Rich Meelia – President and CEO

Chuck Dockendorff – EVP and CFO

Analysts

David Lewis – Morgan Stanley

Rick Wise – Leerink Swann

Taylor Harris – J.P. Morgan

David Roman – Goldman Sachs

Bob Hopkins – Banc of America

Kristen Stewart with Credit Suisse

Michael Matson – Wells Fargo Securities

Tao Levy – Deutsche Bank

Tom Gunderson – Piper Jaffray

Matthew Dodds – Citigroup

Adam Feinstein – Barclays Capital

Josh Jennings – Jefferies & Company

Tom Kouchoukos – Stifel Nicolaus

Operator

Good day ladies and gentlemen and welcome to the first quarter 2010 Covidien Plc earnings conference call. My name is Lacy, and I'll be your operator for today’s call.

At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. If you would like to participate in the question-and-answer session, please press star one on your touchtone telephone. If your question is answered and you wish to withdraw, you may press star two. Please press star one to begin.

As a reminder, this conference is being recorded for replay purposes. If you require any operator assistance, please press star followed by zero on your touchtone phone.

I would now like to turn the presentation over to your host for today’s call, Mr. Cole Lannum, Vice President, Investor Relations. Please proceed.

Cole Lannum

Thank, Lacy, and 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 first quarter results was issued earlier this morning and is available on our website and the newswires.

During today’s call, we’ll make some forward-looking statements. And it's, as always possible, that actual results could differ materially from our current expectations. I'd 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, 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, covidien.com.

We’ve also put fiscal 2008 and 2009 quarterly geographic and product line sales details on our website as of today. These tables supplement the information we provided you in the fourth quarter last year when we announced several financial reporting changes. A number of you have requested that information, and hopefully this information will be useful as you put your models together.

For the first quarter, we reported GAAP diluted earnings per share of $0.82. And after adjusting for certain one-time items, our non-GAAP earnings for the first quarter came in at $0.86 per share.

Now, I’ll turn it over to Rich, who will be going in more detail on the first quarter results. Rich?

Rich Meelia

Thanks, Cole. Overall, we had an outstanding first quarter, significantly exceeding our expectations. These results reflect the success of the company’s strategy focusing on growth and innovation. Briefly, we delivered strong growth in our large medical devices segment as all product lines contributed to an excellent quarterly sales increase.

We again reported operational growth above 20% in the mesh, biosurgery and vessel sealing product lines. The quarter featured a very strong performance for ventilators and sensors due to orders related to H1N1 and the seasonal flu. And we benefited from the Aspect and VNUS acquisitions, both of which are exceeding our expectations.

These strong results were tampered by continued restraints on capital equipment spending, including energy hardware and domestic ventilators. During the quarter, we sold our Oxygen Therapy product line, following the Sleep Diagnostics divestiture last quarter. Consequently, these divestitures put a damper on sales growth, but were positive to margins.

In the pharmaceutical segment, we reported double digit growth in radiopharmaceuticals in the quarter, as the supply situation improved compared with a year ago. However, as you know, beginning next month, the Petten reactor will be offline for an expected six to seven months.

Additionally, we learned last week that the Chalk River reactor may face an extended shutdown. This will result in more volatility and fragility in the radiopharmaceuticals over the next couple of quarters. While we are in a much stronger position this year with respect to alternative sources of moly, supply remains a major challenge.

Also, we announced a plan to divest the U.S. Radiopharmacies last month and expect the transaction to close late in the second quarter. As with the divestitures in medical devices, this will lower our sales growth, but be positive to margins.

And finally, in medical supplies, sales were on plan. On an operational basis, growth for medical surgical products was about offset by lower OEM sales, while growth in SharpSafety was restrained, as our decision to exist the business in Europe last year more than offset a small benefit we received from H1N1 related sales.

Turning to innovation, we are very excited about our new products lineup for 2010. During the year, we will be launching a number of innovative new products across our business, reflecting the increased R&D spending of the last couple of years. We also continue to make strategic investments in growth initiatives which should enable us to deliver a sustainable long-term topline growth.

In Medical Devices, we expect to launch several innovative endomechanical products, including several for use in SILS procedures and additions to our successful ENDO GIA Stapling line at SAGES in April. These products follow the very successful launches of SILS Port and Duet TRS at last year’s SAGES conference.

Also, we recently upgraded our LigaSure laparoscopic instrument line, including the LigaSure 5, and will have several new offerings in soft tissue repair and vascular coming later in the year.

In Pharmaceuticals, we expect to launch Pennsaid and the generic version of Actiq in the next few months. These products are key components of the strategy to expand our pain management franchise and should be important drivers of our pharmaceutical growth over the next few years.

We made significant progress on gross margin in the quarter, which exceeded our expectations driven by favorable mix. While Chuck will go into more detail on this, we believe that this gross margin improvement is sustainable and that is the key behind raising our operating margin guidance for 2010.

In conclusion, we were extremely pleased with our first quarter results. Sales, gross margins, operating income and EPS were all well above our expectations. We used our strong cash flow to make the investments that should allow us to deliver on our strategy to drive future sales and profit growth. We remain optimistic about our prospects for 2010 and beyond.

I’ll now pass the call over to Chuck who will discuss the first quarter in more detail and provide a guidance update.

Chuck Dockendorff

Thanks, Rich. I’ll focus the majority of my comments on the items below the sales line and then discuss our revised 2010 guidance. As Rich mentioned, we’re extremely pleased with the first quarter results, which exceeded our expectations. Sales and gross margin both came in well above plan.

Looking forward, the topline benefit from foreign exchange at today’s rates will not be as positive as we reported in the first quarter. In addition, sales growth will be restrained by the divestitures of the Sleep and Oxygen lines as well as the U.S. Radiopharmacies that we announced last month. However, we believe that gross margin improvement is sustainable and as a result have taken up our guidance for operating income margin by 100 basis points for the year.

The strong improvement in adjusted gross margin was due to favorable volume and mix, manufacturing cost reduction efforts, benefits from our restructuring program and favorable foreign exchange. For the remainder of 2010, there will be some negative pressure on gross margin, as raw material prices are starting to move up, and the shut down of Petten will require us to pay more for moly, and foreign exchange becomes less positive, and we continue to lose volume in our higher margin branded pharmaceuticals like Restoril. However, we are confident that we will continue to drive favorable mix and launch innovative new products across our businesses, which we expect will largely offset these margin drains for the year.

First quarter SG&A was up significantly versus a year ago, as planned increases in selling and marketing and additional expenses from recent acquisitions combined with unfavorable exchange rates on our costs. As we noted previously, additional spending for growth initiatives, expenses related to the launch of Pennsaid, the impact of acquisitions, and a less favorable currency impact all put upward pressure on SG&A this year.

R&D was at the low end of our plan largely due to expense timing. As you know, we book expenses on a project basis, but remain committed to our goal to increase R&D to 5% to 6% of sales over the next few years. Looking below operating income, net interest expense was even with the year ago.

As planned, we continue to make progress lowering our tax rate, as our first quarter adjusted rate was nearly 600 basis points below last year's first quarter. You’ll note that the quarterly rate was at the higher end of our projected annual range as the mix of income is putting some upward pressure on it.

Next, let me take you through some cash flow highlights. We again generated strong free cash flow in the quarter and now expect for fiscal 2010 that free cash flow will exceed $1.5 billion. We also bought back 0.5 million shares in the quarter.

Finally, I’d like to discuss our 2010 guidance. Our long-term goals remain to deliver mid-single digit sales growth and double-digit EPS growth achieved through a combination of operational and financial leverage. Consistent with fiscal 2009, all 2010 guidance comparisons exclude the impact of Oxy ER from our 2009 base. At current exchange rates, we continue to expect total company sales for 2010 to be up 6% to 9% versus 2009.

By segment, at current rates, we now expect sales in medical devices to be in the range of up 10% to 13%. For Pharmaceuticals, we anticipate sales will be flat to up 3% in 2010. You’ll note that we have not changed the guidance range for Pharmaceuticals, despite the announced sale of our U.S. Radiopharmacies. There's also been no change to our guidance for medical supplies, up 2% to 5% for the year.

For 2010 operating margin, our expectations are now that we will be in the 21% to 22% range. Continued progress on our gross margin will drive this improvement, but 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. While our longer-term goal is to leverage SG&A, we do not expect to do so in 2010.

Our effective tax rate is expected to be in the 21% to 23% range, consistent with previous guidance. As I mentioned earlier, our first quarter rate was at the high end of the range. We are feeling some upward pressure due to additional interest related to the Tyco tax settlement and our mix of income. As always, both the operating margin and tax rate guidance exclude the impact of any one-time items.

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

Cole Lannum

Thanks, Chuck. As you may have noticed, we’ve cut back on our prepared remarks this quarter to allow more time for your questions. For Q&A, we’re going to strictly limit you to one question and a follow-up if needed, so we can give everyone a chance to get their questions in. If you have additional questions, either put yourself back in the queue or contact us after the call.

Lacy, can you please review the process for signaling a question once again?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question will come from the line of David Lewis with Morgan Stanley. Please proceed.

Cole Lannum

Good Morning, David.

David Lewis – Morgan Stanley

Just two quick questions here. First Rich, just given guidance in November and the very significant strength in medical devices, can you just walk us through, in your mind, the specific drivers, whether it is more product specific, more investments in sales and whether you are seeing the strength more U.S. or O-U.S.?

Rich Meelia

We've done both since our separation, added lots of people specialists, but those have been in place now pretty much for about a year. I think what you are seeing, David, is the result of the new products that we have been launching. The energy and the surgical businesses have been extremely productive from a new product launch standpoint. And having those new products in the hands of a much stronger and more focused on procedures sales force, that's what is driving the medical device sales growth. It is the new products, either developed internally or the ones we brought in over the years through acquisition in hernia, in biosurgery, some of these faster growth segments of the overall surgical market. That's what is driving it.

David Lewis – Morgan Stanley

Okay. And then Chuck, just real quickly on gross margins, if you look year-over-year, I would imagine this quarter that ventilation through H1N1 actually pressured gross margin, so you're still up 250 basis points year over year. Can you maybe walk us through whether H1N1 pressured GM in the quarter and how you think about this year-over-year expansion in terms of FX, price and mix? Thank you.

Chuck Dockendorff

Yes. Certainly, the ventilators, it wasn't that much negative pressure on our gross margin. It is below the average per se, but it is very close to it. So, from that mix standpoint, relatively neutral or maybe slightly negative, not major. But, as you look at the 250 basis point improvement year-over-year, about half of that came from volume and mix. I think even as you look in the first quarter with the substantial growth rate we had in devices, it is just becoming a bigger part of our overall mix in the product portfolio. The other half definitely came through the favorable FX cost reductions, the restructuring program we announced and things like that.

David Lewis – Morgan Stanley

Thank you very much.

Chuck Dockendorff

The point I wanted to make on it was really across all of our three segments. The gross margin was up significantly really for different purposes. When you look at devices, the majority of it was around the new product launches and mix and some FX. If you look at pharmaceutical, we had a little bit of more sales in the branded product than we anticipated. And then in supplies, they have done a great job reducing costs. We moved a big piece of the device business over to supplies, and they did a great job taking cost out of there and driving to efficiencies. So, it's just across every one of our segments is up significantly year-over-year, which is nice.

Cole Lannum

Thanks, David. Next question, please.

Operator

And our next question will come from the line of Rick Wise with Leerink Swann. Please proceed.

Rick Wise – Leerink Swann

Good morning everybody and congrats on a really great quarter. I hate to ask a big picture question, but given the election in Massachusetts, Rich, you are sort of on the -- maybe on the front and center, as the first CEO to be able to comment, your reactions on what it might mean for Medtech, healthcare and most important, Covidien?

Rich Meelia

Yes. I mean it's strictly speculation, Rick. But, I think the eventuality is now much less certain, what if anything healthcare reform is going to look like. Scott Brown has been very candid about his position, and so clearly, they don't have the votes they had. So, where we go from here, whether they try and ram this through, through some procedural process that the reconciliation or something that would be, I think highly risky, I don't know. But, we think that election is good news for us and we think it reflects the broader view that people are just concerned that the government is moving way too quickly, way too aggressively on such an important part of our economy. So, we are actually encouraged by the prospects of this election, and what it could mean to healthcare reform.

Rick Wise – Leerink Swann

Okay. Turning to EPS, given the first quarter performance, my first pass through our model suggests that EPS for the full 2010 fiscal year could be sort of in the 20% growth range, maybe in the area of $3.40 plus or minus. Does that sound rational? Is there anything in the last nine months that would derail that kind of EPS growth? Thanks.

Cole Lannum

Rick, as you know, we don't give specific EPS guidance, but certainly we would expect the numbers to come up just based on the fact that the first quarter did better than expected. I would focus though on some of the points that we made. First quarter did come in much better than our expectations. This is also relatively early in the year, and there are a lot of puts and takes that could continue to happen throughout the year.

But some of the things like the strong flu season, like the better than expected results from Restoril, like the fact we have not yet closed the Sleep Therapy transaction, those things will change throughout the year, so I think you need to keep that in mind. As well, as we noted, both the SG&A spending and the R&D spending came in a little bit less than what we would expect to progress throughout the year. So, I think it is important to take those dynamics into mind whenever you do things. Beyond that, I think we are going to stay away from commenting specifically on EPS.

Rick Wise – Leerink Swann

Thank you.

Cole Lannum

Thanks. Next question?

Operator

Our next question will come from the line of Taylor Harris with J.P. Morgan. Please proceed.

Taylor Harris – J.P. Morgan

Thanks a lot. I want to focus in on gross margin again. So, I heard, I guess to set the stage, you've had a couple of nice step functions up in gross margin over the last year, and Rich, I heard you say that you thought the gross margin gains were sustainable. Chuck, I heard you say that there were going to be some incremental pressures on gross margin through the balance of the year that would be largely offset. So, are you expecting that gross margin goes up or down from the 54.3% level for the rest of the year?

Chuck Dockendorff

Like I said, of course, it's still early in the year. But, what we are expecting in my comments that I mentioned, we expect, if you look at the FX piece of it, the currencies stay where they are, that will be neutral as we move forward. But, we are seeing pressures on raw materials on some of the components. It does take a while for that to get into our numbers.

Conversely, we are divesting some businesses that are lower margin. We're continuing on with our restructuring program. So, we think that the range it is in now and it could fluctuate a little quarter by quarter, but we don't see -- I don't sit here and see another step function within the year of what's going to drive this upwards.

I would tell you though that the first quarter as we looked at it did come in, it did surprise us with the strength of how high it came in and it goes back to I think where my earlier comments, we talked about each of the three segments all driving that gross margin up. But, I think right now, I think it's fair to assume that the rate we are at we will see throughout the year.

Taylor Harris – J.P. Morgan

Okay. That's helpful. And then just my follow up is on the pharma imagining business. You've taken a big hit, probably $100 million of revenue from divesting Radiopharmacies, and yet you kept the guidance range for 0% to 3% growth intact. So, what is going better than you thought it was in that business?

Rich Meelia

Yes. Taylor, this is Rich. From the very beginning of the year, we said the pharmaceutical business was going to be the most volatile. And when we made the decision to close the Radiopharmacies, we knew that would be a sales hit. But we just felt at this point in the year, given all the moving parts, with the Pennsaid approval, the Actiq approval we get, as you know we have got other things before the agency, that it would just be too early to change guidance in pharmaceuticals at this point in time and just we decided that we would simply maintain our guidance and see how the second quarter progresses relative to some things that could be very supportive of that sales growth rate.

Taylor Harris – J.P. Morgan

Okay. Thanks a lot.

Cole Lannum

Next question, please.

Operator

Our next question will come from the line of David Roman with Goldman Sachs. Please proceed.

David Roman – Goldman Sachs

Good morning, everybody. Thank you for taking the question. First on PulseOx, even if you take out H1N1, it looks like this was a very good quarter for that business and potentially the first one in quite a long time where it looks like you are not losing share. Can you maybe comment on what's happening there from a competitive perspective? And I have one follow up.

Rich Meelia

Sure. This is Rich. Part of that is related to the sensor volume from about six weeks of the Aspect deal, so a little bit of it is that. But, even if you take that out, it was a very strong performance for us. I know our competition spoke about a very strong quarter as well. And the folks at Nellcor will tell you that it has been a strong flu season across the board. And so I think that led to some of the gains that the market saw, not just us, but was shared by competition as well. So, I would -- at this point in time, I would lean more towards a strong market as opposed to any major changes in share.

David Roman – Goldman Sachs

Okay. Maybe just one question on cash. Can you just remind us, given your being incorporated in Ireland, what that means for your use of cash in terms of repatriation, use of cash to the United States for acquisitions? How do the tax implications compare for Covidien versus the peer group?

Chuck Dockendorff

We've always had a slight advantage on that in that our cash that we generate around the world, we have immediate access to. So, we do not have them subject to withholding taxes as we bring cash back over from different parts of the country. That didn't change when we moved from Bermuda to Ireland; that stayed the same. So there's really been no change in that component.

David Roman – Goldman Sachs

Okay. Thank you.

Operator

And our next question will come from the line of Bob Hopkins with Banc of America. Please proceed.

Bob Hopkins – Banc of America

Thanks, good morning. Can you hear me?

Cole Lannum

Absolutely, Bob, go right ahead.

Bob Hopkins – Banc of America

Good morning. A question for Chuck and then one for Rich. For Chuck first, can you give us a sense, Chuck, as to the EPS contribution in the quarter from FX changes? And also if you have it, the benefit from VNUS, Aspect and flu, just trying to get a sense for some of the one timers. And then I'll just go ahead and give the question for Rich, too. You suggested and are putting up very good free cash flow numbers and I am just curious as we think about 2010, do you think that will be a more active year from your perspective from seeking external opportunities perspective than 2009? And just how should we think about that potential going forward and your appetite for external opportunities? Thanks so much.

Chuck Dockendorff

Hey, Bob. Just on the FX component within the quarter, I think I have mentioned in the last earnings call that the full year impact at that time we thought would be in the $0.14 to $0.16 per share range. Since that time, the dollar has strengthened a bit, and so that has caused it to decline a little bit, I think around 2% to 3% to 4%. So, it's in that range and kind of spread evenly throughout the year. So I think that's the impact. I don't want to get into any specific numbers within the quarter, but certainly there was some slight favorability in the quarter related to FX. As far as VNUS and Aspect and the impact, I think the best thing to do, we really don't want to discuss those revenues specifically, so I think the best thing to do, both of those companies had a revenue run rate of about $100 million when we acquired them. And I think you can figure that that's kind of added to our revenue base as we go forward. So that's the best way to think about those.

Cole Lannum

Remember that we closed Aspect on November 6th. So, we only got a partial benefit from that in our December quarter. We closed the VNUS deal back in June, so that was a full quarter worth of impact. As far as H1N1 goes, on the revenue side of things, that probably benefited us somewhere between $25 million and $35 million in the quarter.

Rich Meelia

And then, with respect to the external opportunities, Bob, we have been pretty -- we remain pretty consistent, I think in terms of what our interests are there. We've stated that we would likely, as we plan our capital expenditures that we would allocate $500 million to $1 billion for deals. But recognizing that if a larger deal came along at the right opportunity, we wouldn't necessarily exclude it. So we don't take it off the table, but we're still focused on those deals that are more adjacent to what we do, the technology, the focus on growth and innovation. And so, we won't change our target there.

In terms of the activity increasing as a result of the increased cash flow, we are looking at opportunities. We are landscaping these different markets all the time. It's driven primarily by the different global business units, and the dynamics are such that it's driven more by what's available, who's interested and where people are and the different life cycles as a company. Because coming right out of the gate, we've had a very strong balance sheet. So our deal flow really hasn't been dictated or controlled by the availability of funds to do the deals. It's just we will do the right deals.

We've got -- I think a real strong capability within the company of identifying, negotiating and integrating acquisitions. It's one of our core competencies. And so we will continue to be as aggressive as we possibly can because the view at Covidien is that you can't take share all the time and the more we can use our portfolio, both divestitures and acquisitions to move the portfolio into stronger markets, the more we can be successful over the long term. And so that's the kind of deals you have been seeing us doing, moving into the higher growth, higher technology, higher margin segments, and that's what we will continue to do.

If you look at our activity over the last three years, we are at the top of the pack in terms of good high quality deals that have helped to contribute to this new product flow that I think has surprised everyone in terms of how quickly Covidien could go from the Tyco Healthcare, from a non-innovation to a company like Covidien which is now generating new product flow. We are pretty excited about last year's SAGES, and we are even more excited about the prospects for this year too.

Bob Hopkins – Banc of America

Great. Thanks very much.

Cole Lannum

Question please.

Operator

Our next question will come from the line of Bob -- Kristen Stewart with Credit Suisse. Please proceed.

Kristen Stewart – Credit Suisse

Hi. Thanks. Cole, just on the flu impact, I just want to make sure I had those numbers right. Did you say 25 to 30 or 25 to 35?

Cole Lannum

I said between 25 and 35 is the right number.

Kristen Stewart – Credit Suisse

Okay. And my one question would be just kind on the pricing environment, can you just -- in the past, you have said pricing was actually pretty positive net-net across your portfolios. I was just wondering if you can kind of give us an update on where that stands. And specifically maybe just looking at medical, are you still able to get positive pricing here and what to expect kind of as we move forward within some of the imaging businesses? I know contrast had been an area where there was some pricing pressure. Is that accelerating or getting a little bit better?

Rich Meelia

Yes. If you look at it in the aggregate, Kristen, for the quarter, price was pretty flat. And actually in our view, that's a victory. We are very pleased with that. We have been tracking price volume as long as I can remember and every year it was pretty consistent. This is going back to the early '90s. We would lose between 50 to 100 basis points. And then, the first time we actually had a positive, albeit a very slight one, maybe 15 basis points, was last year. And that, we believe was a direct reflection of the pricing expertise that we put into the global business units. They manage the pricing, we don't. That's where the credit goes.

So, we were very anxious to see how the first quarter looked to see if this capability would continue to be meaningful to the company from a pricing standpoint and we were glad to see that we were pretty flat in the first quarter, in a very difficult environment. So, looking at some of the individual pieces you asked about, the actual degradation of pricing in contrast wasn't quite as bad as it has been historically. So that was helpful.

And we are getting price in the generator side of the imaging business. That entire business, as you saw from the breakout, had a very good first quarter. And it was a function of supply and the pricing decisions that we have been making and continue to make right up through the quarter that we just finished.

Kristen Stewart – Credit Suisse

And then just specific to medical, is medical pricing net-net positive, medical prices that is?

Rich Meelia

I think, yes. I mean, medical device is such a big part of the business. I think what you are seeing there, again, is the concentration, the focus that the businesses are putting on price. Because when we talk price, it is not mix, it's actual pricing. So, the pricing has been pretty stable. Again, our products are bunched within a procedural reimbursement package. We are not reimbursed individually. So, we just don't seem to have the exposure or the focus that maybe higher priced, more visible products would have.

Kristen Stewart – Credit Suisse

Okay. Thanks very much.

Rich Meelia

Okay, Kristen.

Operator

And our next question will come from the line of Michael Matson with Wells Fargo Securities. Please proceed.

Michael Matson – Wells Fargo Securities

Hi, I was wondering if you could provide an update in terms of what's factored into your guidance for capital equipment sales during calendar 2010?

Rich Meelia

Yes. Our capital equipment sales are less than 5% of our total sales, just to put it in perspective. And our guidance is that capital sales are down versus the rate at which they were prior to the September 2008 economic event. So, we are not barometers of how the capital market is moving. We just don't have enough play there. But, as we made our plans based on what we are seeing, it's still tough to get money freed up at the hospital level. Although they're doing better, their investment income has improved significantly hopefully as most other people, that they are in a much better position, but I think there will be a little bit of a lag. And so we are guiding at a rate slower than the historical sales rate for our capital products.

Michael Matson – Wells Fargo Securities

Okay. Just to clarify, would that rate be up from last -- from calendar 2009 or fiscal 2009?

Rich Meelia

Very similar, Michael, actually to what it has been.

Michael Matson – Wells Fargo Securities

Okay. And then just on the radiopharmaceuticals business, can you just walk us through the impact on topline growth and margins when both Chalk River and Petten, assuming they are shut down at the same time. And then what are you assuming in your guidance for the length of that coordinated shutdown between the two?

Rich Meelia

Yes. Let me begin by saying that the folks at our imaging business have done a really super job of getting the supply of moly in a much stronger position than they were in a year ago. And just based upon alternate sources, we feel pretty comfortable that the supply of moly will be significantly stronger than it was last year even with Petten shutting down for the six or seven months. So that's what's in our guidance.

It's hard to say what the impact of Chalk River is, but Chalk River is not our primary supplier. So, we think we can manage through that, and that the troubles that we've experienced as a result of the moly shortage, we don't think based upon the assumptions we have and the plans we have in place and the way the folks have been executing on those plans, we don't think we will see a repeat of the drop we had and that we can manage this in a much more predictable way than we have seen in the past.

Michael Matson – Wells Fargo Securities

Okay. Just in the event of a shortage though, does the price typically go up in that situation?

Rich Meelia

Absolutely, yes. And it's in our guidance.

Cole Lannum

Yes. And Michael, this is Cole, one thing to keep in mind is, on a revenue standpoint, the biggest impact you are going to see in radiopharmaceuticals this year is the impact from the sale of our radiopharmacies. They will be much, much more impactful than the Petten situation. But on a cost basis, as Chuck noted in his comments, the cost of moly is going to be significantly higher in this situation for us.

Michael Matson – Wells Fargo Securities

Okay. And it's…

Cole Lannum

And we'll take the next question.

Operator

And our next question will come from the line of Tao Levy with Deutsche Bank. Please proceed.

Tao Levy – Deutsche Bank

Good morning. I was wondering maybe you could comment just generally on kind of the surgical volume trends that you have seen and if you could maybe reflect back to sort of the beginning of calendar 2009 and now exiting 2009, any changes, any improvements that you are seeing specifically on the surgical volume side?

Rich Meelia

Yes, this is Rich. Our growth has been driven by the surgical-oriented businesses, both energy and surgical. A lot of that is the result of just the continued strength in the procedures. About 15 months ago, there was a lot of talk about procedural slowdown and we weren't seeing it. We began tracking it even more closely at the surgical and energy GVU. And we are tracking obviously procedures that are relevant to our product offering. And we just saw amazing consistency going back to 2005 right through halfway through 2009, there's a little bit of lag effect.

And so, that's why we were able to generate real positive growth throughout a difficult year because most of the softness was in elective surgery and we just don't have a big product offering. The closest would be gastric bypass or the obesity surgery. And I think that's so underpenetrated relative to the qualified candidates that, that continues to be a real growth opportunity for us. And it was in 2009 and we'll see it again in 2010.

Our success is, in many respects, driven by our ability to move into higher growth segments of the surgical business such as hernia, biosurgery, come out with specialty products and suture like the V-Loc system. And then, these innovations that the folks at surgical and energy are doing with the SILS products, the tri-stapling device, the Duet, the stapling with the buttress material on it, this new LigaSure 5, which has kind of enabled them to get into more gynecological and thoracic procedures. That's what is driving the robustness that you're seeing in surgery.

Tao Levy – Deutsche Bank

Thanks. And as a follow up, Cole, on the H1N1 that you mentioned the 25 to 35, is the majority of that on the ventilator side?

Cole Lannum

The majority is in ventilation, although we did see an impact as noted in Pulse Oximetry and a much, much smaller impact in our supplies business, as well.

Tao Levy – Deutsche Bank

And does that end now or is that kind of you look forward, how long does the H1N1 benefit to O-U.S. ventilator business continue?

Cole Lannum

Yes. First, to be clear, it is H1N1 and seasonal flu, as well. This is not just H1N1 and it will probably be a little bit of a benefit going into our March quarter, but we would not expect nearly the same kind of magnitude that we saw in the December quarter. Operator, next question please.

Operator

Our next question will come from the line of Tom Gunderson with Piper Jaffray. Please proceed.

Tom Gunderson – Piper Jaffray

Hi, good morning. You have given good color on gross margin and going forward and some of the positive and negative pressures. If we move down a line to SG&A, can you give us a little bit more understanding of two things, number one, is launch and pre-launch for two new drugs, the kinds of expenses that might be involved in those things in a broad sense and the timing thereof.

And the second part, would be a minor one, but I am just looking for broad color and that would be on the legal side, I notice that you reinitiated a patent litigation recently and I am just wondering with the number of patents that you have out there and the number of patents pending, should we expect to see a little bit more expense there and a little bit more aggressiveness than maybe what you had at Tyco?

Chuck Dockendorff

Yes. I will answer some of the SG&A questions and then Rich will handle the patents. But on the SG&A, we have talked about the growth in SG&A, especially this year, and our longer term goal was to leverage this going forward. But basically, as we look at this year, between foreign exchange, some of the increased expenses from acquisitions, until we get synergies there and growth rates setting that, as well as the growth initiatives that we planned, this is clearly what's driving up the SG&A as a percentage of revenue for us in 2010. We expect that the rate we're at in this quarter will continue and slightly increase as we look over the course of the year.

As we get into the specific launches, we now have Pennsaid that is approved and we will have expenses out even beginning in this quarter as we hire a sales force of about 100 people to begin to launch that product along with some marketing programs and other things that we are doing in that area. So that will put upward pressure on those expenses in the third and fourth quarter.

We don't want to quantify specifically what those expenses are. But I think, going forward you will see an increase in the pharmaceutical side of it and we have that in our planned guidance as we talk about it.

The other areas, we're looking at other opportunities for growth in the company even in Asia, primarily China, to substantially increase our presence there and we're looking for opportunities there. And that would probably be more toward the second half of the year as we increase some expenses on that end.

Now, Rich will take about the patent.

Rich Meelia

Yes, Tom, it's Rich. And just to follow up Chuck's comment on the salespeople at the pharmaceutical business, we are in the process. We've had a couple of these affairs where you try and -- you get large groups of candidates and we are finding that there is somewhere upwards of a 1000 resumes for every position we are looking for. It's probably no surprise to you just given what’s happening probably. So we are viewing this very seriously because this is a big opportunity for our pharmaceutical folks to demonstrate their capability in entering this market, hiring good sales force, commercializing the product, launching it. So this is a big moment for us and especially for them, as well.

From an IP standpoint, we talk a lot about the patent board naming Covidien as the number one recipient of their award for two quarters in a row. And if it weren't for the fact that just two and a half years ago we were Tyco Healthcare where we had this anemic R&D spend, it probably wouldn't be, at least in our minds, such a big story. But given where we were and how far we have come so quickly to be named number one out of 122 medical device companies two quarters in a row, we think it's pretty significant.

And because of that we do have a much higher quality intellectual portfolio. We always wanted to be aggressive in terms of being an offensive defender of our patents. We just didn't have enough patents to defend. And now that we have them, we will be like anyone else. When we see somebody treading on our IP, we will aggressively pursue that and the result is, hopefully, we have a stronger position in the market, but you will see some higher legal expenses incurred along the way.

Tom Gunderson – Piper Jaffray

Thank you.

Cole Lannum

We need to go to the next question.

Operator

Our next question will come from the line of Matthew Dodds with Citigroup. Please proceed.

Matthew Dodds – Citigroup

Hi. Good morning, a couple of quick ones. First, on the soft tissue business, on the hernia side, can you say if it's coming more from biologics or synthetics, and if that is mostly share gains, or you think the market is showing some strength? That's one. And then second quickly, Cole, on the ventilators, is that U.S. or O-U.S. that the benefit from flu H1N1, or those are pretty even split?

Cole Lannum

Sure. First of all on the mesh side, it is coming from both, both synthetic and biological are doing well. And I can tell you our mesh business specifically grew in excess -- on an operational basis, grew in excess of 20% yet again. And I believe that is for now many quarters in a row, I don't have the exact number but certainly for the last six to eight quarters in a row, we have been growing that business in excess of market growth. So, it looks like we are taking some market share there.

On the ventilation side, it is coming from both U.S. and O-U.S., but it is skewed more outside the United States. I think part of the difference is, we mentioned the last couple quarters of strength due to flu outside the United States and ventilation. We had that even stronger in the December quarter that we had in either of the prior two quarters. But in the United States, we also had some flu oriented strength here and that's what drove ventilation higher as well.

Cole Lannum

Thanks.

Matthew Dodds – Citigroup

Okay. Thanks, Cole.

Operator

Our next question will come from the line of Adam Feinstein with Barclays Capital. Please proceed.

Adam Feinstein – Barclays Capital

Okay, thank you. Good morning. Just a couple of questions here, just wanted to ask about additional asset sales. You guys had called out a goal at the start of the year, made some progress. Just curious whether we should still think about that the same way. And then secondly, just in the medical supply business, definitely showed some improvement here. Last quarter, you called out some issues with the wholesalers and having above normal inventory levels, just curious whether that improved in the quarter and any other color in terms of some of the trends within medical supplies. Thank you.

Rich Meelia

Sure. Not a whole lot changed in the overall trend within medical supply, other than what Chuck talked about earlier. I mean, what they do is manage effectively and efficiently and enhance margin. I mean, that's their skill set. They're not new product innovators, they're not technology developers. And so, we saw the result of that transfer into that business and that's what we were hoping to see.

Inventory changes at the distributor level, you see them from time to time. Many of our major wholesalers are on an automated system, continuous replenishment system. So, literally as they ship, the systems trigger orders to replenish. So, it's pretty sophisticated. So we don't see the huge volatile swings typically with the Owens and Cardinal and McKessons, those kinds of people.

In terms of asset sales, I think we talked about earlier back in November that we did have certain things in mind and that specifically was the Radiopharmacies business. We don't see a whole lot going forward. But a year-and-a-half ago, we didn't the Radiopharmacies, we didn't see Sleep Diagnostics, we didn't see Sleep Therapy. We continue to emphasize to investors and analysts that the portfolio management process here is taken very seriously. We meet on it regularly, we have strategy people that are dedicated to managing portfolio, constantly. And again, it goes back to our belief that the more we do positioning Covidien in stronger markets, the more sustainable is the long term success of the company. So, just because we don't have something to talk about today doesn't mean six to 12 months from now, there won't be another opportunity because it is just a very fluid process.

Cole Lannum

Thanks, Adam. Next question, please.

Operator

Our next question will come from the line of Peter Bye with Jefferies & Company. Please proceed.

Josh Jennings – Jefferies & Company

Hi, good afternoon, gentlemen. It's actually Josh Jennings in for Peter. Just first, if you just talk again about R&D, it did come in the lower side of where you'd guided to and you mentioned product timing. Could you give us a little bit of color there? And then just also, can you describe what your priorities are in terms of pipeline development for 2010?

Rich Meelia

Sure. The R&D spend that we have targeted and that we are actually executing on, is totally project driven at the GBU level. We do not have a corporate R&D function and it's all driven by the GBUs. And so they're constantly looking at opportunities and then they develop plans. Our role at Covidien corporate is to look at overall investments from division to divisions or business unit to business unit standpoint and make costs and allocations as best we can.

And what you have been seeing is the result of some very good investments, significant investments in energy and surgery. So that's why you are seeing all the new LigaSure products, some ablation products, stapling and laparoscopic instruments, sutures, specialty sutures, hernia meshes, packing systems, that's where most of the focus has been.

And we raised our guidance for 4 to 5 up to 5 to 6 as a percent of sales over the next several years simply because we believe the quality of the projects are just -- there and we think we can support them. But you will see fluctuation from quarter to quarter; the trend line over the long-term will be pretty consistent as we move -- from the four up to the 5 to 6 range. And I think you will start to see more projects in businesses like pharmaceutical, respiratory, vascular -- as they begin to, I think develop more success and see more opportunities, now that they have established themselves in specific markets, how they can best access the higher growth and profitability opportunities in those markets.

Josh Jennings – Jefferies & Company

Okay. And then maybe just back to your commentary on cap equipment spending levels by hospitals, it's still a tough environment as you described and you're expecting sort of flattish spending levels. Can you just talk about, what you are hearing from customers and where you expect those trends to go over the course of 2010, if you basically -- if you're looking at continued improvement or what your outlook is like? Thanks a lot.

Rich Meelia

Yes. It has been a pretty consistent over the last, say, six quarters and it has been consistently down from where it was before that. Some quarters are up a little, some are down a little. But if you were to look at it on a graph going back several years, you would definitely see a drop in the overall demand. As the hospitals' financial pictures improve, I can only assume that they can -- they will eventually have to start upgrading their capital especially on some of these products like our ForceTriad which offers their surgeons so much more capability that benefits the hospital as they can move through procedures more quickly and get more volume through their fixed costs in the OR. But again, I don't feel like we can be a barometer or the bellwether company when capital comes back because it is just not that big a piece of our overall portfolio.

Cole Lannum

Operator, as a reminder, we will be ending the call promptly at the bottom of the hour. I think we have time for one or two more questions. Next question, please.

Operator

Our next question will come from the line of Jayson Bedford with Raymond James. Please proceed.

Jayson Bedford – Raymond James

Hi, Good morning. Thanks for taking the question. The 100% sales increase in the pharma sales force, is this what's holding you back from launching Pennsaid and generic Actiq? And if not, what is the gating factor in launching those drugs?

Rich Meelia

Well, part of -- I mean the whole launch needs to be done in a very specific manner. As I mentioned previously, these are kind of defining not so much the generic launch of Actiq because we have been doing that forever, but certainly our first launch of, it's brand name McCain [ph] on hiring the salespeople. We did not anticipate Pennsaid approval this quickly, that was a very pleasant surprise, and so we just want to make sure we launch this properly. This is a $200 to $300 million market, it's got good growth. We think there's differentiating factors associated with Pennsaid in some of the penetrating agent it has versus the competitors, whether gel or cream. And so we just want to do it right. And then should, [inaudible] get approved, we would be doing the same thing with that product as well.

Jayson Bedford – Raymond James

Okay. Fair enough. Just a last quick one, is it fair to assume that you exited the European SharpSafety business in the March quarter of last year? And then I guess the easier comps associated with this dynamic, is that the main driver in the assumed kind of reacceleration in med supplies in the back half of the year?

Cole Lannum

Yes. Jayson, we actually exited it over a period of time. It didn't shut down on a single day. So, we moved out of that over the March and June time period. In fact, we even had a little bit of sales into the fall timeframe. But certainly, we are seeing the tough comps now. Those do get a little better in the second half of the year.

Jayson Bedford – Raymond James

Thank you.

Operator

And our next question will come from the line of Tom Kouchoukos with Stifel Nicolaus. Please proceed.

Tom Kouchoukos – Stifel Nicolaus

Hi, good morning, thanks for taking my question. Real quick on the sutures business, I think that probably is the only thing that looked like it was flat in the medical device business. Rich, you mentioned V-Loc and seeing it at the shows and it seems like a great product that you have a lot of runway to expand into new indications with. Is this product enough to move the needle for your overall sutures business as you go forward?

Rich Meelia

I don't think so. We are in sutures and we do better outside the U.S. than inside the U.S.. Our competitor has a very strong position and protects it very aggressively. Sutures are not, general sutures line are not a huge value driver for us. We try and pick our markets carefully and it's again how you manage portfolio. We just think what it would take in cost to try and take share. It would be very prohibitive, it's not a high growth market. So, you will see emphasis on specialty products within suture, suture fulfills [ph] and complete wound closure line. You need to have it, but it is not something we spend a whole lot of time thinking about how we can grow that basic suture business.

Tom Kouchoukos – Stifel Nicolaus

Okay. That's helpful. And then to follow up on Cole's commentary on the hernia side, you mentioned mesh and biologics both grew nicely in the quarter. Can you talk about the -- maybe some of the market dynamics in the tacking side and how Covidien held up with another quarter of having a competitor on the market with a new product?

Rich Meelia

Yes. Well, we definitely saw softness in our tacking systems. Bard is a very good competitor and they've got a lot of good relationships established over the years. And so, we're seeing some trial activity and it is to no surprise. We still had growth, but the growth in the actual tacking system did slow and we think it was totally related to their reentry.

Tom Kouchoukos – Stifel Nicolaus

Okay. Thank you very much.

Cole Lannum

Thanks, Tom. Next question, please.

Operator

Our next question is a follow up question from the line of Rick Wise with Leerink Swann. Please proceed.

Rick Wise – Leerink Swann

Most of mine have been answered, but two last quick ones on the challenge side, if I could. The press release talks about an increasingly competitive environment. Just wondered what you were thinking about or if these were general comments? And second, API, the active pharmaceutical ingredients was soft in specialty chemicals. Maybe just remind us, what's happening on the specialty chemical side in your plans and is API related to some of the J&J issues, and are those likely to intensify? Thanks.

Cole Lannum

Sure. Let me take the comments on API and specialty chemicals first. On specialty chemicals, we do have an economic exposure there. A big part of that business is exposed to the electronics industry, primarily semiconductors and we've seen some weakness on the sales side for a while there. And I would expect that, it would be the same case, although we will start annualizing that. And hopefully, the good news there is that some of our business on the pharmaceutical side of things has actually started improving going forward.

On API, it's a number of different things. We are getting some pricing competition on some of our base business there. We have also walked away from some business in acetaminophen to address some pricing there and to get a little bit better margin. Would now expect a lot of strength out of our API business anytime going forward. And then Rick, I'm sorry, can you repeat real quick the first question?

Rick Wise – Leerink Swann

Yes. Cole, just the commentary in the press release talking about an increasingly competitive environment, sort of, the context that yes you did well but it is increasingly competitive environment. Just wondered if there was anything specific you all were reflecting other than generic language when you said that?

Rich Meelia

Yes. I think it was just the latter. We can't speak to any specific activity that we would say is dramatically different than what you see in this competitive mix by sector.

Rick Wise – Leerink Swann

Sounds good. Thanks so much.

Cole Lannum

I think now we're going to wrap up. Thank you very much. Starting at noon eastern time today, a replay of the call will be available. And additionally, the replay will be available on our corporate website, covidien.com a few hours from now. If members of the media who listened to the call have additional questions, please contact Eric Kraus, our Head of Corporate Communications. And for analysts having more detailed questions involving nonmaterial information, both Brian and I will be available to take your calls. Thanks and have a great day.

Operator

Thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day, everyone.

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Source: Covidien Public Limited Company F1Q10 (Qtr End 12/31/09) Earnings Call Transcript
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