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Executives

Donald Zurbay - VP, Finance and CFO

J.C. Weigelt - Director, IR

Analysts

Brooks West - Piper Jaffray

St. Jude Medical, Inc. (STJ) Piper Jaffray Healthcare Conference Call December 3, 2013 9:30 AM ET

Brooks West - Piper Jaffray

Okay, let's start. If everybody could take a seat, we will start the next session. My name is Brooks West. I am one of the senior analysts on the healthcare team here at Piper Jaffray. We are very pleased to have Don Zurbay, the CFO of St. Jude with us today, in addition to J.C. Weigelt.

Don, we talked about this at dinner a little bit last night and it has been a recurring theme throughout the conference. Volumes in cardiology, in CRM in particular appear to be back, and it was kind of hard as we sat here last year with you guys to think about, talking about returning to growth in cardiac rhythm management, but I wanted to talk about -- what are the opportunities that that return to volume growth open up for St. Jude and how – you are in your strap plan right now, how that might kind of change your thinking about the business going forward?

Donald Zurbay

Well, I think, the way we are set up, in particular with our portfolio, we really don't need the CRM market to do more than to be flat to up slightly, and really with the latest results, the Medtronics' results, it looks like we are at that point for us to be successful. I think that, taking share is really what our program is all about, and we think we are in a good position to do that.

So for us, I think, it really fits in nicely with our goal and, where we think we need to be.

Brooks West - Piper Jaffray

Okay. So I want to talk through kind of the top line in general. I mean, you guys have been in the recent public comments, have been very bullish about the business, not only this year, going into next year. So I want to try to encapsulate that feeling. But again, on CRM, as you think about competitors coming into the market, you continue to have the advantage with the Quadpole lead here in the States. Your lead-to-port ratio has stabilized, maybe is even getting slow, it’s getting better again. We have got the Nanostim acquisition. Can you kind of talk about the growth drivers within the CRM business, and then I want to hit kind of the other revenue categories?

Donald Zurbay

At CRM, we have a leadership position with our Quadripolar Lead system. We are still the only company that has this system in the US. We are on our second generation O-US, and so when we look at the ICD portion of the market, we are really feeling like we have a great opportunity to continue to take share; and of course, that market -- that side of the market looks like it continues to improve.

The other piece of that would be our lead-to-port ratio, you mentioned, our lead share -- this was an issue. I mean, we had the Durata noise, , we lost share, but as we move forward here, we think we are in a great position to gain share, and that becomes a tail-end for us, it becomes an opportunity for us, and we are starting to see that play out of here as we got into Q3 and as we move forward.

Brooks West - Piper Jaffray

Okay. You know, we have been focused on opportunities in pacing. I think you may be haven't been given complete credit for what's going on in pacing. Obviously, it has been recently a shrinking business, but it has gone from low teens to mid-single digits to kind of low-single digits over the last quarters here. You’ve got the MRI-Safe launch in Japan, you've got some other things going on. How do we think about that business in particular impacting CRM growth?

Donald Zurbay

Yeah. Pacing for us has been a bit of an underappreciated element of the product portfolio in the second half of 2013, and that's going to help us in 2014. We have new product launches in Europe. We have the CRT-P device, which is really our Quadripole device for pacing. And then, as you mentioned, the MRI compatible device in Japan, which is candidly an area where we lost quite a bit of share, is now improved, and we are getting that share back.

And so, those two things, really have helped us. We think that that's a ramp that we are on that gets us into 2014 and helps us continue to manage that part of the portfolio, and we are excited about it, because that's an opportunity to take share, and I think when you stack Nanostim on top of that, which we think is really a revolutionary technology, a disruptive technology, and really at the beginning of what we can do with it, it right now addresses the single-chamber portion of the pacemaker market, but it's a platform that we think is relevant for the dual-chamber segment and ultimately CRT-P, and if we can get this into all those segments, we think that's a great opportunity for us.

Brooks West - Piper Jaffray

Remind people in the room again, the timeline on the Nanostim European launch, and when we are going to start the US trials; and then, the market for that, broadly speaking of the pacer market is what, $400 million or $500 million, if I am remembering that correctly.

J.C. Weigelt

For the CRT-P, single chamber.

Donald Zurbay

For single chamber, right.

Brooks West - Piper Jaffray

So how do we think about that product launching, ramping, and what it might do for share or market expansion?

Donald Zurbay

Well we have launched in Q1 in Europe, and that's a portion of that $400 million or $500 million market, and then the IDE trial for that device starts in Q1, so both of those things happen in first quarter.

Brooks West - Piper Jaffray

Okay. Then, how are you thinking about that, does that cannibalize your European pacing business? Is it accretive? How should we think about that launch progressing?

Donald Zurbay

Generally it’s really, I mean, I would say cannibalizes all of the competitors’ products from the standpoint that it does everything a traditional pacemaker does, but it doesn't have a lead, you don’t need to create a pocket, it's repositionable. It’s inherently MRI compatible, and it does everything a pacemaker does, but it's really the size of, let's say AAA battery. The procedure to implant the device is much simpler. It goes right into the right ventricle, screws in, very simple. And ultimately, if we are successful with this, I think that this becomes the standard of care, it becomes a product where if you are not in this space or if you have not developed this product, you are really not going to be in the top, you are really going to need to develop, or you are going to need to try to harvest with what's left with the traditional pacemaker business, but we really view it as that kind of disruptive technology.

J.C. Weigelt

I just want to chime in and say, we got a little excited when we started off. I just want to mention the risk factors that we were talking about 2014, so I wouldn't be an IR professional if I didn't make sure we said the whole legal proceedings that there are certain risk factors, you know, we are not ready to update guidance -- give guidance, just want to get that out of the way. Everything is in our SEC filings.

Brooks West - Piper Jaffray

Thank you for laying that wet blanket over that conversation. Okay, you can actually leave now, and we will keep going. Let's talk about the CVG business. That seems to be more of a law of increasingly large numbers, 40% of the business Angio-Seal and mechanical valves have been shrinking. They have got nice growth than the rest of the portfolio. How do we think about that business in particular going forward?

Donald Zurbay

Yeah. Well this is another one of our businesses where we are seeing the mix is favorable to us, so the mix of new technologies, new products, really is favorable. It's a business where 60% of our revenues are growing double digits. The other 40% are in more of our traditional mature businesses which are declining slightly. But, if you look at the math, the 60%, that's increasing, it is increasing at a much higher rate than the 40% that's declining, so there is really natural momentum in that business to continue to grow.

The technologies in that business have a long ramp. There is a lot of opportunity left, FFR and OCT, which is really a big piece of that business, well it maybe underappreciated, because it’s the second largest portion of that sales category. It continues to be a widely accepted technology and growing double digits and very underpenetrated.

So, there is a lot of opportunity left there, and quarter after quarter as you move forward, the math that I mentioned really helps you get to a point where the growth accelerates, you can see it accelerate.

Brooks West - Piper Jaffray

Let me hit on neuro real quick, and then I want to get into gross margins, and we will kind of come back. You had a press release this morning on the Burst technology. We have already had questions, is this a sign that the warning letter lift is getting close, some comment on that, and then also, I think, as we talked about last night, the last inspection was -- from FDA was what 2012? So it sounds like you guys are just -- waiting period here, but it sounds like a lot of heavy lifting has been done, is that fair?

Donald Zurbay

I think that's fair. Hard to comment exactly on timing when we are involved with the FDA, and there is back and forth and some of the timings related to what they want to do, but I'd say that's a fair characterization.

Brooks West - Piper Jaffray

And that has been an area where you have -- it has been a painful area for you guys in terms of seeing some share. You have got products that are lined up behind that warning letter. Is that just the best way to think about that business is, you know our trends from last quarter, you lowered guidance, is that the way to think about that business until we get some news on the warning letter?

Donald Zurbay

I think that's fair, I mean, we are coming out of -- we have been sitting down to the warning letters, so there has been some competitive pressure, and on top of that, there were a few product issues that we worked through, so both things are helping us. I think the other piece to this is the investment we made in spinal modulation, which -- it's a targeted technology, it’s not a technology that's going to cannibalize from our existing pain products. This is really much more -- you are targeting a specific portion of the anatomy, and it’s gets at parts of the anatomy that the traditional pain therapy doesn't get at. And so, that for us is an opportunity. That company, where we have an investment in, we are consolidating them based on the way the accounting works. So we get credit for our sales in our P&L, even though we don't outright own the company at this point.

Brooks West - Piper Jaffray

Okay. I want to make sure we get gross margins in, and we will may be come back to the revenue discussion. There was some confusion about the medical device excise tax, and how you guys treated that from an inventory standpoint that came out on the last call; and you maybe spent a lot of time on it. I don't know that the Street, you know, kind of materially adjusted gross margins looking into the second half and next year. So it's not only the medical device excise tax, but it is the Puerto Rico tax. Why don't you kind of hit what you’ve said on the last call about that, and then as we look into next year, you are talking about kind of 50 basis point to 60 basis point headwind for the full year, but that all hits in the first half if I am thinking about that correctly?

Donald Zurbay

Yeah. Beginning in 2013, obviously, we had to start paying the medical device excise tax. We were already paying the Puerto Rico excise tax. The Puerto Rico excise tax, you get a tax credit on. So really it's a net zero to St. Jude Medical, but from a P&L line item perspective, the tax itself hits our gross margin. And so, when we got into the medical device excise tax, we decided that we wanted to be consistent on our comment for excise taxes. January 1st, we began to inventory those taxes, and that was the accounting method we chose. And I think, there has been confusion in this area to some extent because companies are doing it differently. For us, we decided to inventory the cost, so beginning in the first quarter, we were inventorying both of those excise taxes in the inventory, first and second quarter, there was less of an impact because of that; and then it started to pull through cost of sales.

So as you got into Q3 and Q4, you saw a full impact of the excise taxes year-over-year, and maybe that's where the confusion came in, is that the Q3, I would say the first quarter, where we had a full impact of the excise tax pulling through.

Now, as we get into Q1 and Q2 next year, we will have a full impact of the excise taxes in our results for 2014, but those will be matched up against the 2013 quarter, where we didn't, and so, that's going to be a bit of a headwind early in the year, and as we get into Q3 and Q4, there will be a much more comparable basis quarter-over-quarter. But when you look at the year, it’s going to be a 50 to 60 basis point headwind on gross margin for the year.

Brooks West - Piper Jaffray

For the year. Okay. And so, as we think about how you typically manage your business from an operating leverage standpoint, if we think about taking into consideration of 50 BPs to 60 BPs, how do you, maybe you get to kind of flat year-over-year from a gross margin standpoint? In situations like that in the past, how have you been able to manage R&D, which is typically like -- you like to stick that spend -- or SG&A or taxes to kind of think about how a flat gross margin might flow down to the bottom line?

Donald Zurbay

Well, without being specific about 2014, I think in general though, if you are talking about gross margins that are flat, maybe down slightly, depending on the dynamics, and you think about our history of investing in R&D, which we have been committed to with all our growth programs, you look then to the SG&A line, and then the other piece is the income tax line as levers, and we did a big restructuring at the end of 2012, which helped us -- and in 2013, in terms of leverage, and there is more levers there. And then, on the tax line, with our O-US manufacturing strategy, as that continues to ramp up, there is opportunity in the tax line to improve on where we are at. So those become the levers to push us down, to growth in EPS that exceeds sales, and that has kind of been our history in what we strive to achieve.

Brooks West - Piper Jaffray

Okay. But may be just, clearly, you guys are excited about the markets, the broader markets. You are excited about the portfolio, but just may be a note of caution around the resulting leverage, as we think about how that plays out on to the bottom line? Are there any questions on any of that, before we just ask the kind of revenue categories there? Big room, so everybody is kind of shy. Okay, let's keep going.

Let's talk about AF. Endosense I think is a great acquisition for you guys. Really gets you more into a head-to-head position versus Biosense. Let me talk about the opportunities for that business as we look forward?

Donald Zurbay

Yeah. So that has been a real strong growth area for us, and really no reason to continue to not be a strong growth area for us. So a couple of reasons, one, the market continues to be robust and continues to be underpenetrated. And then I think, we are excited about our product portfolio in that area, not only our existing products, but when you look into 2014, you start talking about MediGuide, something that's very exciting.

The opportunity to reduce pleuroscopy and also improve outcomes and replacement becomes something that docs seem to really favor, and then you mentioned Endosense. Endosense gets us into the ablation catheter market in a way that they haven't been. I mean, I think, as strong as our market share and our leadership position has been in the atrial fibrillation space, the one part of our portfolio that probably hasn't been as strong, in terms of that market share, the ablation catheter market. So we had into this Endosense acquisition, it gives us force-sensing capability which is really what we think is going to be become the standard of care, and helps us address that piece of the market, and bringing us to a position of strength.

Brooks West - Piper Jaffray

So we ask you [every] question, hey Biosense just recorded this and you recorded this, and why aren't those numbers the same, and you always point us back to the product portfolio. Now that you have the ablation catheter, can you segment a little bit, is that the growth part of the market that you are getting into, versus the products that you have right now? How should we think about that, from an opportunity standpoint?

Donald Zurbay

Well I think, if you think about the $900 million market, that piece of it, the ablation catheter piece, that's really growing at double digits, where our market share has been fairly modest. And so, you are really stacking good market growth in the ablation catheter market, on top of our ability to take share, and we think there is no reason we can't take significant share with our product.

So, those few things are important and yeah, when you talked about Biosense, and this is probably one of the areas, where the growth rates have differed and there has been a little of an apples and oranges comparison.

Brooks West - Piper Jaffray

So if you think about share within the market, I think, (inaudible) we think a value having, roughly a third of the AF market, maybe a little bit higher than that. But in terms of the ablation catheter, somewhere in the mid-teens, is that fair? I mean, so there is an opportunity to that?

Donald Zurbay

Without getting all specific, that's not probably that far off.

Brooks West - Piper Jaffray

Okay. Let's talk a little bit about CardioMEMS as much as we can. I know, J.C. keeps making a point that, let us buy it before we put it into our numbers. But as analysts, we are prone to get ahead of you there. How do we think about again, the kind of broader opportunity for CardioMEMS and just remind us again, what the kind of timelines are there?

Donald Zurbay

Well, we haven't been real specific on the timelines. We don't own CardioMEMS currently, so we have an option to put just CardioMEMS at -- and at a point that there is FDA approval, we will execute a purchase on CardioMEMS. But we have not given specific timing on that. I mean, the opportunity is significant. We think this is the right product at the right time. It really addresses a lot of things that are going on in the broader market.

It's an opportunity to improve patient outcomes, to substantially reduce the cost of healthcare. The cost of hospitalizations for heart failure patients is $37 billion price tag. It's really just right at that. It's just right at that number at a time, where hospitals are concerned about rehospitalization and the penalties associated with that. So, we think there is just a lot of potential here.

Brooks West - Piper Jaffray

And J.C. remind me, there is an existing DRG for this technology as it stands right now, so we think about as, within the [right calf] procedure, which is kind of what, $15,000, $16,000 DRG, if that's the way to think about kind of the potential. And they are (inaudible) in AAA right now, where are they, what kind of ASP, do you know?

J.C. Weigelt

No. I don't know.

Brooks West - Piper Jaffray

Okay. Anything else, any other questions, no one here. Talk a little bit about the balance sheet. You know, we talked about kind of operating leverage for next year. One of the offsets there is of course the share count. You guys haven't been buying back shares. Talk about balance sheet opportunities with the cash that you are generating, and again, how do you think through kind of commitments you've already per acquisitions, is there an opportunity to start buying back shares again?

Donald Zurbay

Yeah. We have the capacity to execute on something that [fit shoes]. I think right now, we don't have authorization to do any kind of share repurchase today. We do -- I think if you look back at our history, we definitely strive to and made it somewhat of a goal, to at least mitigate the impact of shares outstanding, and the increase in shares outstanding from stock plans and other factors. And its true. I think we -- as the stock price has gone up this year, there is really two things working on that number, and the first is that there isn't a lot of option exercise activity, as you can imagine, and the second is just (inaudible) stock price going up, that does increase the shares outstanding.

So again, that's a factor that we are managing. But again, we don't currently have an authorization to repurchase any shares.

Brooks West - Piper Jaffray

Okay. I mean, just again theoretically, you guys have been kind of 50-50 camp in terms of returning cash to shareholders. No reason to believe anything would change in terms of post (inaudible).

Donald Zurbay

No I don't think so. Our first priority obviously is always to look at opportunities with investments -- or with acquisition type activity, and finding the right balance there. But we have a long history of doing share repurchase activity.

Brooks West - Piper Jaffray

Okay. We talked about the one warning letter in neuro. We didn't talk about the warning letter in CRM. You guys have kind of talked about hoping for first half of next year revolution there. Anything else we could say on the situation there?

Donald Zurbay

Not really. I mean, other than -- it's a top priority, there is a lot of resource being devoted to the activity, and we think we are right on track.

Brooks West - Piper Jaffray

Let me finish, we have got just a minute here left, with where we started again. Having run through all of the various top line opportunities, I mean again, I come back to -- we are sitting here a year later, we appear to have returned to volume growth in CRM. I always make the case that when CRM is working in [tangent], people are willing to believe the pipeline and everything else. But again, as you look at that dynamic here in [strapline], how do you think about the options that that opens up, in terms of thinking about the broader business intentions?

Donald Zurbay

I mean, the way I look at it is, we start 2013 with negative 3% growth, but with a commitment that we are an accelerator of growth, and that was the first quarter. Second quarter, we ended up flat, currency neutral. Third quarter, we are up 3%, and we have guided now to a fourth quarter where, at the top end, that's additional acceleration incentive. So if you say, that's our trendline and we have laid out some of the dynamics here that we think are going to be important as we move into 2014, we are not giving guidance for 2014 obviously, but we think that we are in a good position to continue to accelerate our growth.

Brooks West - Piper Jaffray

Good. I think that's a good place to visit. We are down to (inaudible). Thanks guys.

Donald Zurbay

All right. Thanks.

Question-and-Answer Session

[No formal Q&A for this Conference].

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