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Medtronic, Inc. (NYSE:MDT)

F3Q10 (Qtr End 1/29/10) Earnings Call

February 23, 2010 8:00 am ET

Executives

Jeff Warren - Vice President of Investor Relations

William A. Hawkins III - Chairman of the Board, Chief Executive Officer

Gary L. Ellis - Chief Financial Officer, Senior Vice President

Analysts

Bob Hopkins - Bank of America/Merrill Lynch

Michael Weinstein - J.P. Morgan

Matthew Dodds - Citigroup

David Lewis - Morgan Stanley

Kristen Stewart – Credit Suisse

Ben Andrew – William Blair

Bruce Nudell - UBS

Tao Levy - Deutsche Bank

Danielle Dubin - Leerink Swann

David Roman - Goldman Sachs

Presentation

Operator

Good morning. My name is Regina and I will be your conference operator today. At this time I would like to welcome everyone to the Medtronic third quarter earnings release conference call. (Operator's Instructions) Thank you. I would now like to turn the call over to Mr. Jeff Warren, Vice President of Investor Relations. Mr. Warren, you may begin the conference.

Jeff Warren

Thanks, Regina. Good morning and welcome to Medtronic's third quarter conference call and webcast. During the next hour, Bill Hawkins, Medtronic Chairman and Chief Executive Officer, and Gary Ellis, Chief Financial Officer, will provide comments on the results of our fiscal year 2010 third quarter which ended January 29, 2010. After our prepared remarks we'll be happy to take your questions.

A few logistical comments. Earlier this morning we issued a press release containing our financial statements and a revenue by business summary. You should also note that some of the statements made during this call may be considered forward-looking statements and that actual results might differ materially from those projected in the forward-looking statement. Additional information concerning factors that could cause actual results to differ is contained in our periodic reports filed with the SEC and we do not undertake to update any forward looking statement.

In addition, the reconciliations of any non-GAAP financial measures are available on the investor relations portion of the Medtronic website. Finally, unless we say otherwise, references to quarterly results increasing or decreasing are in comparison to the third quarter of fiscal year 2009 and all growth rates are given on a constant currency basis. And with that I'm not pleased to turn the call over to Medtronic Chairman and Chief Executive Officer Bill Hawkins.

William A. Hawkins III

Well, good morning, and thank you, Jeff. Q3 was another solid quarter. This morning we reported third quarter revenue of $3.851 billion which represents a 10% increase over the prior year as reported or a 6% increase on a constant currency basis. Q3 non-GAAP earnings of $867 million and diluted earnings per share of $0.77 both increased 8%. Our performance this quarter underscores the strength of our globally diversified portfolio; cardiovascular, neuromodulation, diabetes, and surgical technologies, all posted strong global results.

International continued to perform well across the board. In CRDM, high-power results were particularly strong with our share remaining stable. I was pleased by our solid operating results which included strong gross margins, SG&A leverage, and free cash flow that once again exceeded $1 billion. Our operating income and earnings growth today are the results of tough decisions we made a couple of years ago to align the organization to the changing market environment.

As I look at the highlights in the quarter, strong results from our international operations clearly stand out. International revenue grew 11% in Q3. China, Japan, Western Europe, and Middle East and Africa all grew double digits. Looking at it by business segment, five out of seven segments grew at or near double digits. International cardiovascular revenue grew 30% with all three businesses within that segment growing greater than 25%. International diabetes had solid double-digit revenue growth in continuous glucose monitoring and consumables. Neuromodulation continued to deliver strong mid-to-high teens growth in Europe and Central Asia in pain stim, deep brain stimulation, and InterStim. Finally, we saw strong growth outside the US of our recent acquisitions of Corval, Ablation Frontiers, and CryoCath. The integration of all these businesses are going very well.

Looking ahead we expect the opportunities in international markets to set the pace for our growth. We expect to receive CE market approval soon for Restore sensor, the world's first pain stim device that automatically adjusts stimulation based on a person's body position. We have recently launched Veo, the worlds' first sensor augmented pump offering low-glucose suspend technology, a first step towards closing the loop for people with diabetes. This summer we expect to launch the Advisa MRI pacemaker outside the US, balloon kyphoplasty in Japan, a new step platform in Europe called integrity, and many more new products. We are well positioned to continue driving market leading growth in international markets.

Turning from international to our group highlights, let me begin by noting that the new group structure we announced last fall is working extremely well. I am pleased with the progress that both Mike Coyle and Chris O'Connell are making in driving execution and developing sustainable growth plans, as well as unlocking valuable synergies across our segments in customer channels, product development, and operations.

In our cardiac group I was pleased by the results in both CRDM and cardiovascular. In CRDM we saw further strengthening in our US high-power business, particularly with CRT as our new attain leads and delivery system combined with our market-leading vision 3D devices show themselves to be superior in many ways. Even more encouraging is our product pipeline going forward. We continue to prepare for the expected launch of the Protecta smart shock family devices this summer. This new platform represents a significant new advance in providing a meaningful reduction in shock, the number one unmet physician and patient need.

In pacing we are excited about bringing our differentiated MRI compatible technology to the market. In the US our first generation MRI pacemaker which will be called REVO MRI is scheduled for FDA panel on March 19th. We anticipate launching REVO MRI this summer in the US. In addition, we plan to launch Advisa MRI SureScan, our next generation MRI pacemaker, in international markets this summer. Upon launch we will be the only company with MRI compatible technology on the market.

Our AF Solutions business continues to perform well in markets outside the US. We are very excited about the potential to bring our two novel AF ablation technology platforms to the US market in FY11. We look forward to the STOP-AF cryo data being presented at ACT in March. We also continue to make progress on our PMA for Ablation Frontiers catheters. When approved, these two technology platforms will position Medtronic to become the undisputed leader in one of the fastest growing markets in med cath. In addition, we expect to become the first company to have labeled indications for all stages of AF in the US.

Our cardiovascular segment delivered another exceptional quarter. As I mentioned previously, growth was broad based with coronary, structural heart and endovascular all contributing strong double-digit growth. In coronary, Endeavour continues to perform well in markets around the world. In endovascular we obtained the number one position in the US thoracic market this quarter and now estimate that we have market-leading positions in the triple A and thoracic markets in both the US and Western Europe.

In structural heart, our integration of Corval is going very well. Corval is the leading transcatheter value on the market with approximately 75% share in transfemoral, the most preferred method for transcatheter aortic valve replacement. We were also pleased by the recent appeals court decision in Germany holding that our technology does not infringe on competitors' patents. We remain on track to start the US IDE clinical study this summer.

In late January we announced the pending acquisition of Invatec. This is another example of a strategic tuck in that leverages our global footprint, regulatory expertise, and customer relationships to create long-term value. This acquisition will increase our competitive position in the $2 billion peripheral vascular market. In addition, Invatec has exciting new drug-alluding balloon technology that is used in both the peripheral and coronary vasculature.

Turning to physio control I was pleased by the news last week that we have received notice from the FDA to resume unrestricted global shipments. Although it took longer than we expected, our investments have significantly raised the bar on quality. We appreciate the loyalty that our customers have shown us during the challenging time and we look forward to fully serving them as well as gaining new customers going forward.

Turning to our non-cardiac group, neuromodulation and diabetes delivered high-single digit growth and surgical technologies posted solid double-digit growth. These segments offset a slight year-over-year decline in spine. In neuromodulation, EBS and InterStim continued to deliver solid double-digit growth. Diabetes results continue to be driven by the worldwide acceptance of CGM or continuous glucose monitoring, and by the fact that we remain the only company with an integrated sensor and pump. I was particularly pleased by our growth in our surgical technology segment which returned to double-digit growth this quarter, driven in part by strengthening in our US capital equipment product line.

Moving to spine, we continue to focus on turning this segment around. As we have said before, we are in a rebuilding mode. While the market has slowed a bit, the good news is that overall it remains a healthy market. We continue to focus on strengthening our product portfolio. We also continue to invest in clinical evidence to expand the market and improve our strong competitive positions. We remain committed to returning this segment to market growth by the end of the next physical year.

Core spine constructs saw modest growth in Q3 and this business continues to track to our expectations at this point in our turnaround plan. Our launch of the TSRH 3Dx spinal system is off to a good start. I am also excited about the positive customer response to the limited launch and the select account of the first day of our Solera (ph) platform, a next generation posterior fixation system that will replace our industry-leading legacy system.

While we are pleased with this initial phase, it's important to note that the full impact of the Solera launch will build over the next six quarters. In biologics, modest growth in INFUSE was bolstered by our strategy to expand the business beyond BMP into ceramics and demineralized bone matrices. We continue to work on eight clinical trials designed to generate appropriate clinical evidence for expanded indications. Our next near-term opportunity is with Amplify, which we expect to be approved in FY11.

Finally on Kyphon, work continues. In regard to our recent announcement of a potential new US competitor, we are very confident in our current family of BKP intellectual property and the protection it gives to our innovative products. We will vigorously defend it against any competitor product that infringers on our technology.

Before turning the call over to Gary, let me make a few general comments regarding our overall position in the market and the outlook going forward. As our industry moves beyond the economic turmoil and uncertainty of the past year, Medtronic has never been better positioned to deliver market leading performance. We have weathered the storm better than most and are a stronger company today in large part due to the proactive changes we began to implement nearly two years ago. We have changed the way we pursue innovation both internally and externally. We have been disciplined about optimizing our portfolio through more efficient and effective resource allocation. We had the courage to make restructuring calls over the past two years, including de-layering the organization and increasing span of control.

We have made prudent investments in our internal markets and we boldly altered our business model for returning value to shareholders by increasing the dividend and continuing to repurchase shares while other companies went the opposite direction. And through all of this we remain steadfast to the Medtronic mission. We are seeing today how one Medtronic is unlocking the full potential of our diversified portfolio of businesses to create value through common technologies, cost savings, and better alignment with our customers.

I truly believe we are a stronger company today than we were in the past and we will endeavor to push ourselves to be even better going forward.

I'll now turn the call over to Gary who will take you through the financial results and after his comments I will conclude with some closing remarks.

Gary L. Ellis

Thanks, Bill. Third quarter revenue of $3.851 billion grew 6% after adjusting for a $144 million of favorable impact of foreign currency. Breaking this out geographically, revenue in the US was $2.236 billion, up 3% while sales outside the US were $1.615 billion increasing 11%.

After adjusting for the non-cash charge to interest expense due to the change in economy rules governing convertible debt, third quarter earnings and diluted earnings per share on a non-GAAP basis were $857 million and $0.77 respectively. GAAP earnings and diluted earnings per share were $831 million and $0.75 respectively.

Moving onto a more detailed analysis of our results, CRDM revenue of $1.243 billion increased 2%. Worldwide ICD revenue of $756 million grew 5%. After adjusting for our competitors' extra week in the comparable period, the US ICD market continues to grow in the low-to-mid single digits and the global ICD market grew in the mid-single digits.

Our market share continues to be stable both year over year and sequentially. We continue to see a shift in mix towards CRTD which has become an advantage for us due to our Protecta family of (inaudible) in our proprietary OptiVol Fluid Status monitoring technology.

We saw a solid increase in high-power volume in the quarter, offsetting modest price declines. ASP pressure remained in the low-single digits, although perhaps more in the 2%-4% range versus the historical 1%-2%. It's not unusual to see increased pricing pressure ahead of new product launches and we anticipate this trend reversing when we launch our new Protecta family this summer.

Pacing revenue, up $459 million declined 5%. We continue to feel pressure in Japan from the previously announced Kappa/Sigma field action. Our global decline was due to a combination of share declines and price erosion which should be addressed through the launching of our MRI compatibles technology this summer.

Cardiovascular revenue of $722 million grew 21% driven by balanced growth across all businesses. Coronary revenue of $386 million increased 23% and the international coronary grew 27%, reflecting the continued momentum of our Endeavour launch in Japan which contributed to over $40 million in revenue this quarter. We now estimate that our worldwide unit share for all coronary stints is 20%, up over 300 basis points year over year.

In the quarter we also announced the acquisition of Invatec. We expect to close this transaction in Q4. While we don't expect any material financial impact in Q4, we do expect it to be $0.03 diluted in FY11 and accretive thereafter.

Structural heart revenue, up $215 million, grew 20%, driven by 39% growth in international markets on the strength of our Corval transcatheter valves and above market growth in tissue values. Transcatheter valve therapy continues to gain acceptance in major markets and Germany and France have approved reimbursement. We continue to achieve our key objectives relating to the integration of Corval. We have completed our distributor integrations and the expansion of US and international manufacturing operations remain on track.

The vascular revenue of $120 million grew 15% driven by the ongoing success of our next-generation Endurance abdominal stint graft and our Talent abdominal and thoracic stint grafts in the US. Spinal revenue of $842 million declined 1%. Core spinal revenue of $630 million declined 2%. Core metal constructs grew in the low-single digits while Kyphon results had a year-over-year decline as the perception of referring physicians continues to be negatively impacted by the New England Journal article on retiboplasty (ph).

Looking at the worldwide spine market in Q3, although it had slowed ab it, growth remains in the upper single digits. Our preliminary analysis suggests that the market deceleration is primarily attributable to a slowdown in contribution from the mix as procedure growth and pricing trends remain stable.

Biologics revenue of $212 million grew 2%, reflecting growth from MASTERGRAFT Strips and PROGENIX PLUS as this business expands beyond BMP. INFUSE unit growth in the quarter was offset by negative mix due to a growth in smaller kits.

Neuromodulation revenue of $394 million increased 8%, driven by continued strength in deep brain stimulation in gastro-uro. Our DBS business saw a strong growth in Q3 driven by the continued US adoption of Activa RC and PC. Feedback for these neurostimulators has been very positive based on their size reduction over the previous generation and the new programming system.

Gastro-uro revenue continue to grow above the 20% level driven by another strong quarter from InterStim therapy. Our pain stim business grew in the mid-single digits and our infusion pump business experienced a year-over-year decline due to the difficult comparisons versus Q3 last year.

Diabetes revenue of $311 million grew 8% driven by very strong growth in our CGM franchise which his now annualizing at over $125 million. Insulin pumps have mid-single digit growth in the quarter driven by the growth in the US and Western Europe. Surgical technologies revenue of $239 million grew 12%, driven by growth in monitoring, BMP image guidance systems, and power and related service. Our nerve monitoring business continues to be very strong as customers upgrade to our Nerve Integrity Monitor 3.0.

Navigation in the US came back strong after a weak Q2 and we continue to see O-arm adoption in international markets. While capital equipment has been a tough market over the past year, we have performed well due to our quick reaction to modify our customer payment options.

Finally, Physio-Control revenue of $100 million increased 8%, driven by the LIFEPAK 15 monitor defibrillator. We were pleased to receive notice last week from the FDA to resume unrestricted global shipments.

Now, turning to the rest of the income statement, the growth profit margin 76.3%. Gross margin in the third quarter of last year was 75.7%. In addition to a modest FX benefit in the quarter, we continue to see the benefits of the broad portfolio initiatives we have under way to reduce our cost of goods sold by $1 billion by fiscal year 2012. We have maintained industry-leading gross margins in a challenging environment. In Q4 we would expect our gross margin to be between75.5%-76% of revenue due to less benefit from FX and a changing product mix, in part due to the reentrance of Physio-Control.

Third quarter R&D spending of $344 million represents 8.9% of revenue, but includes a negative 30 basis point impact on foreign currency translation. In addition to FX, R&D was impacted by tiny differences related to clinical spending as well as a focus shifting of resources to address regulatory issues. We remain committed to investing in new technologies to drive future growth and continue to expect R&D spending to remain in the 9.5%-10% range over the long term. In Q4 we would expect R&D spending to be about 9.5% of revenue.

Third quarter SG&A expenditures of $1.328 billion represented 34.5% of sales, compared to 36% of sales in the third quarter last year. SG&A expense benefited from our ongoing initiatives to leverage our facilities and IT expenses. Additionally, our realignment and restructuring efforts from both fiscal year 2008 and 2009 provide some tailwind in reducing expenditures.

This was partially offset by an increase in legal expenses in this quarter compared to last year, driven by an increasing amount of government scrutiny on the industry. We expect legal expenses to continue to run high for the remainder of the year. Overall, I am very pleased with the leverage we're driving in SG&A and we expect to deliver on our FY10 commitment of an 80-100 basis point improvement in SG&A.

Net other expense for the quarter was $148 million compared to $50 million in the prior year. The year-over-year increase primarily is a result of losses from our hedging programs which were $29 million during the third quarter compared to $31 million in gains in the comparable period last year.

Because we hedge our operating results during periods when the dollar is weakening, higher translated revenues will, for the most part, be offset by currency hedging losses. Looking ahead, based on current FX rates, we anticipate net other expense will be in the range of $120-$140 million in Q4.

The net interest expense for the quarter was $56 million. Excluding the $41 million non-cash charged interest expense due to the change in accounting rules governing convertible debt, net interest expense on a non-GAAP basis was $15 million.

At the end of Q3 we had approximately $6 billion in cash and cash investments. Looking ahead we expect our cash to continue to increase, however, low interest rates will negatively impact our return on this cash.

Turning to our tax rate, our effective tax rate, as reported in the third quarter, was 21.8%. Based on our current geographical earnings mix, we increased our year-to-date fiscal 2010 effective tax rate from 21% to 21.5%, which resulted in a cumulative catchup expense of $16 million in the quarter. Also included in the effective tax is an offsetting $7 million tax benefit associated with the finalization of certain tax returns, resolution of certain income-tax audits, and changes to uncertain tax position reserves.

As I just said, our year-to-date effective tax rate, exclusive of one-time adjustments, is 21.5%, which we believe is a reasonable estimate for the remainder of the fiscal year. However, this estimate does not assume that the US R&D tax credit, which expired on December 31st, will be reinstated this fiscal year.

Third quarter weighted average shares outstanding on a diluted basis were 1.109 billion shares. Fiscal year to date we have repurchased $733 million of our common stock and have remaining capacity to repurchase approximately 57 million shares under our board authorized stock repurchase plan. Through the end of Q3 we have also paid out $681 million in dividends.

As before, we have attached an income statement, balance sheet, and cash flow statement to this quarter's press release, and I direct your attention to these statements for additional financial details.

Let me conclude by commenting on our outlook for the remaining quarter of fiscal year 2010. As you know, we continue to see significant fluctuations in currency exchange rates and they remain difficult to predict. Therefore, we continue to provide our revenue growth outlook on a constant currency basis. Consistent with last quarter's comments, we believe a constant currency revenue growth of 5%-8% remains reasonable for the fourth quarter. If exchange rates remain similar to yesterday for the remainder of the fiscal year, then our Q4 revenue would have an estimated favorable impact from currency of $120 million to $140 million.

Turning to our guidance, we continue to be pleased by our execution. In our first three quarter we delivered 11% earnings per share growth on a non-GAAP basis, even when including the diluted impact from acquisitions. Based upon this solid performance, we are comfortable raising the lower end of our earnings per share guidance for fiscal 2010 to a range of $3.20 to $3.22 per share. While we do not provide quarterly guidance, this implies Q4 earnings per share of $0.87-$0.89 and the current Wall Street consensus estimate of $0.87 appears reasonable at this time.

As communicated before, our earnings per share guidance excludes any unusual charges or gains that might occur during the fiscal year and the impact of non-cash charged interest expense due to the change in accounting rules governing convertible debt. This updated guidance represents FY10 earnings per share growth of 12%-13% after adjusting for our AF and transcatheter acquisition solutions.

One housekeeping item before I turn things back over to Bill and we'll conclude our prepared remarks. We will be hosting our annual institutional investors and analyst meeting this year on Monday, June 7th. This year the meeting will be held in New York City.

With that, I'll turn it over to Bill.

William A. Hawkins III

Thank you, Gary. Before we begin our Q&A session, let me close by nothing that Q3 was another step in building our track record of delivering consistent performance. We remain committed to our focus on innovation to drive growth, executing to generate efficiency and leverage to fund future opportunities, and in generating returns for our shareholders. We intend to end FY10 strong and looking ahead across all of our businesses, we are poised to deliver on one of the most robust pipelines in our history.

Innovation is the lifeblood of our company and the foundation on which it was built, and innovation will continue to fuel our success going forward. I would now like to open things up for Q&A. In the interest of getting to as many questions as possible we would respectively request that each caller limit themselves to one question and one followup. Operator, first question?

Question-and-Answer Session

Operator

(Operator's Instructions) Your first question comes from the line of Bob Hopkins with Bank of America/Merrill Lynch.

Bob Hopkins - Bank of America/Merrill Lynch

Hi, good morning. First question I wanted to ask was on the growth you saw outside the United States, specifically in Europe, because many of your competitors have reported difficult results, again, especially in Europe. So I was wondering if you could comment on what you're seeing in Europe currently? Was it your product mix, are you taking share? What do you see going on in Europe and confidence in that market being a healthy market going forward? Just kind of want a State of the Union on Europe if you can.

Gary L. Ellis

Yeah. Q3 was a good quarter for us in Europe across the board. I mean, and it is a combination of taking share and it is a combination of continuing to develop markets with new technologies like in the neuromodulation space, the diabetes business did well, the neuromodulation did well. Our cardiovascular business with Endeavor with Corval, with CRDM, with the atrial fibulation products — I mean, our constant currency for Europe and Q3 was around 12%. So it was a good solid quarter for us, balanced across the enterprise, and again, I think it speaks to kind of the strength of our diversified portfolio.

Bob Hopkins - Bank of America/Merrill Lynch

On the CRDM side, can you just go into a little bit more detail in terms of what you're seeing on the pricing front both in terms of ICDs and pace m ix and maybe within those comments talk just in a little bit more detail on why pacers were weak in the quarter and what you expect going forward?

William A. Hawkins III

Okay. First of all, let me start with pacers. ASPs were a little soft this quarter and I think you see this often in front of kind of a new cycle of innovation and as we've been saying, we're very excited about our MRI safe pacemakers which will be coming in the US and FY11 we'll be introducing Advisa outside the US in early FY11. But this quarter, I mean we did see a little bit more price impact than we have seen in recent quarters, but again, you got to look at the pacing industry over the last 50 years and there are sort of little cycles that we go through, but this is a business that we continue to think it will be a very solid kind of low-single digit kind of a growth business over time.

On the ICD side, again, we didn't see anything really unusual this quarter. We've seen, if you look at this year versus last year, I'd say that it's sort of in general, maybe a year ago we saw a 50-100 basis points, maybe this year it's close to 100-200 basis points. But we've been successful in managing through that because of the mix with new technologies. I mean, we're still seeing a benefit from the launch a year ago of the attained family of left-sided heart lesions. And then as we get ready to launch Protecta, we think that that's going to give us the opportunity to kind of offset perhaps some overall price pressure.

Bob Hopkins - Bank of America/Merrill Lynch

So is your opinion of the CRDM and especially ICD market growth outlook changed at all by what you're seeing this quarter?

William A. Hawkins III

No. We continue to see the ICD market in the mid-single digit. Outside the US this quarter was a little bit lighter than what we've seen, but high-single digits, low-double digits for outside the US, and the low-to-mid single digits in the US so we continue to see the ICD market in that sort of mid-single digits if you will.

Bob Hopkins - Bank of America/Merrill Lynch

Great, thanks so much.

Operator

Our next question comes from the line of Michael Weinstein of J.P. Morgan.

Michael Weinstein - J.P. Morgan

Thanks. Good morning, guys. Can we dive into the spine market a little bit? It would probably be helpful to get a better read on your core spinal business. First, can you tease out Kyphon's performance from that so that the down 2% core spine, how tough was it in Kyphon, and then talk about the market because the market did seem to stepdown this quarter? You suggested that you thought the stepdown was related to mix, but we are seeing more pushback in spine from the payers so we'd appreciate your insight into the health of the markets. Thanks.

William A. Hawkins III

Yeah, okay. Well, I mean first as you can imagine, I mean, I'm not happy about sort of our spine performance, but it's not a big surprise. We knew were going to be in this kind of rebuilding mode and probably the biggest disappointment for me has been Kyphon. And Kyphon, just for your information, what we saw for Kyphon is kind of close to what we saw last quarter in Q2. I mean, we have seen a decline year on year with Kyphon and it's multifactorial, the New England Journal of Medicine article didn't help us. We do have competition, not necessarily people who have on-label indications for kyphoplasty, but there are people that are positioning products that are sort of kyphoplasty like and that's had an impact.

We are investing in our pipeline and we'll be bringing out next year, we think, a whole range of new products in Kyphon that will further strengthen our overall position in that marketplace. But Kyphon continues to be an issue for us. And it's not just the BKP, it's also the X-STOP. So we have a number of things internally that we're doing, but we'll give you more visibility to that at the analyst meeting in June which we think will enable us to maybe organizationally put some more focus on the right areas to be able to reaccelerate growth there. But Kyphon was the biggest impact on the performance this quarter.

The overall spine business, as you heard me say, yes it is. We saw a little softening and you saw that in other companies as they reported. I don't argue with that this is still a very healthy market. The fundamentals are still strong. The volumes, the procedure volumes are strong, and we saw this quarter perhaps a little bit of an impact because of the fact that we haven't brought out as much new products and that's where we get the opportunity to, if you will, influence the value through mix. But as we bring out next year things like Solera and as we continue to drive the TSRH-3Dx and VERTEX SELECT, I think that is going to help us to drive the market. And we still are close to 40% of the market. So as kind of Medtronic goes, sort of the market goes.

Michael Weinstein - J.P. Morgan

Okay. I need to make sure I'm following you. So on the spine market you think it's stepdown to high-single digit growth this quarter, but you think that that rebounds with new product launches? Is that the picture?

William A. Hawkins III

I mean, Mike, I don't have a crystal ball, but you're not hearing anything that is fundamentally sort of different. I mean, if you think about the need and the unmet clinical need for people with sort of degenerate disk disease or people with deformity or people with trauma, I mean this is — we're still scratching the surface.

Reimbursement's still solid, our pipeline is solid, so I think you put it all together and there is nothing that would tell us that this market is kind of taking a step down. But this quarter there's no question we saw a bit of softening. And I think that has been, at least the checks that I'm getting from being out in the field and talking to hospital CEOs is that I think we've seen, because of what's happened in the economy overall, a kind of an impact on just general procedures because people's insurance is — they're without insurance and there's other factors which I think are kind of putting a little bit of an interim sort of damper on the overall health care market.

Michael Weinstein - J.P. Morgan

Okay. Let me just ask Gary one quick financial question and I'll let others jump in. It looks like, Gary, that your FX hedges are playing out favorably to what you thought they would a quarter ago. If you look at your other expense line it came in lower this quarter than what you saw, and it's obviously your guiding to a lower level for the fourth quarter than what you were thinking a quarter ago. Is that just because of the strengthening of the dollar?

Gary L. Ellis

It is, Mike. And the answer is the strengthening of the dollar versus various currencies. Obviously it's probably more important that the euro is the weaker part and the reality is even on, for example, revenue, we were a little softer on the FX benefit from revenue in the quarter than we expected, but interestingly enough, we're much softer than from what we predicted at the beginning of the quarter on the euro, but actually saw benefit, for example, in some of the other currencies that we don't hedge. And so the reality is my hedging losses ended up being less than we expected at the beginning of the quarter because the euro did weaken so much, but the fact of the matter is it didn't have as large of an impact on the revenue line so that's what we saw a little bit.

As you said, we saw a little benefit on the other income expense line from that and obviously we saw benefit just from the fact that we didn't get as much revenue benefit as we had originally expected at the beginning of the quarter, but part of it is just the mix on what currencies we hedge.

Michael Weinstein - J.P. Morgan

Gotcha, thank you.

Operator

The next question comes from the line of Matthew Dodds with Citigroup.

Matthew Dodds - Citigroup

Good morning. Just a couple questions, first, Bill, your comments on CRDM with the pricing, can you comment at all about whether that's a US trend or you're seeing pricing pressure O-US as well for pacers and ICDs?

William A. Hawkins III

I would say, Matt, it's really a global phenomenon. It's not just the US or O-US. I mean, we see it really in markets around the world.

Matthew Dodds - Citigroup

Okay. And then the second question is now that (inaudible) a lot of the FDA issues are behind you, is a spinoff now a possibility going forward? Have you revisited that?

William A. Hawkins III

Our focus right now is in gearing manufacturing back up and working to sort of the customers that have waited so patiently and we have, we think, the opportunity to drive this opportunity in the near term, but once we get through that we'll take a step back and reevaluate our strategic alternatives and go from there.

Matthew Dodds - Citigroup

Thanks, Bill.

Operator

Our next question comes from David Lewis of Morgan Stanley.

David Lewis - Morgan Stanley

Good morning. Gary, just a quick followup on Mike's question here. Just given the other income, even with the FX hedges it looks like the other income is coming in better than we would have expected. Are you still committed to year over year, at least an 80 basis point improvement in operating income?

Gary L. Ellis

For FY10 the answer is for operating income obviously we've seen that 80-100 basis point year to date both in higher gross margin and improved SG&A, so on the operating margin line the answer is yes, but as we've said before it's both. It's related to what we're seeing in gross margins where we're a little pleased on the gross margin line because the reality is with some of the pricing pressures Bill just has mentioned, we've been able to basically offset that and actually see our margins increase slightly where a lot of companies are struggling on the gross margin line, and at the same time on the SG&A line we have seen already year to date, about 100 basis points of improvement on the SG&A line itself. So we're focusing on numerous areas, but as a result we remain committed that that operating margin improvement that we've been talking about will be there for the full year. So we've executed on that so far and we don't see any reason to say that we're going to fall back on that in Q4.

David Lewis - Morgan Stanley

Great, very helpful. And then, Bill, just a strategic question on CRM here. You've got competitors talking more about the potential to integrate sales forces, perhaps soon increasing bundle in the industry. You've also seen your (inaudible) become a little more stable and perhaps you're anniversary-ing some of the more serious perception issues around Fidelis. So I wonder, thinking out at the next 4-6 quarters and given that you have new management, do you see any kind of fundamental change or any change at all in terms of how you manage this business? Do you get more conservative? Do you get more aggressive? Do you increase your level of spending? Maybe help us understand how the next 4-6 quarters could go.

William A. Hawkins III

Well, I like my position right now with my overall cardiac franchise with CRDM and CV and with the recent restructuring and bringing in Mike Coyle, and as I referenced in my remarks, I've been very pleased so far with what Mike and Pat and Scott are doing to really position us as a company that truly covers the gambit and the whole area of cardiac through this management. So it's interesting, I mean seeing what some of the people have done, really some degree following some of the announcements that we've made, but we're looking at what we can do to better serve customers and by the way, customers — the definition of customers is changing.

I mean, it's not just the clinical customer. I mean, there are economic buyers that are becoming more and more important so I think w e are very well positioned to be able to serve customers in that broad term, with a broad range of technologies that really there's very little, if any, kind of shortfall.

David Lewis - Morgan Stanley

Okay, Bill. And maybe just one last quick pipeline question and I'll jump back in cue. The timing for (inaudible) has shifted here a little bit over the last 3-4 quarters, now we're sort of saying late summer. Would you say that given your conversations with the FDA, even though that's maybe pushed incrementally to late summer, your visibility on that timing has gone up or is it relatively similar to where it was six months ago? Thank you.

William A. Hawkins III

Well, David, I'm not sure where you're coming from in terms of that, our timing shifting. It really hasn't shifted. We've said the summer and we're still comfortable with that. So there's nothing — I mean, there's nothing that has happened that would in any way change our view when we think we can begin the IDE.

Gary L. Ellis

And we've obviously been in discussion with the FDA over that six-month period of time so do we have better visibility on where that is now versus even six months ago? The answer is yes, but as Bill said, we're still comfortable with the summer on starting the IDE.

David Lewis - Morgan Stanley

Okay. Thank you very much.

Operator

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

Kristen Stewart – Credit Suisse

Thanks for taking my question. I was just wondering if we could look out to March? Obviously you have a lot of dates coming up with the AF data coming out of ACC and then the panel meeting. With respect to the AF business, could you just maybe talk about what your plans are to further support that franchise in terms of building out a sales force? And then on the panel for the MRI safe pacemaker, could you just comment on what level of data should we be expecting to be released to support that panel review?

William A. Hawkins III

Well first on the cryo, again, we continue to be very excited about the opportunity here. This is sort of a new market for us and it's all upside. We'll be presenting at the panel and STOP-AF data will be presented at the ACC and we again remain cautiously optimistic that things will go well and we'll be in the market in the first half of FY11 with our CryoCath technologies and a little bit later in the year with the Ablation Frontiers technology. And we are building out a focused field effort to take all of our atrial fibrillation technologies, the Reveal technology, the CryoCath, the Ablation Frontiers, and the other EP diagnostic that we have and really coming out of the box with a pretty formidable critical mass in the AF space.

So we are excited about that. In terms of on the MRI, yeah, there's no specifics here other than we're well prepared and we will present at the panel and we are again, I would say cautiously optimistic that this would go very well for us.

Kristen Stewart – Credit Suisse

And then I guess just real quickly on Dawson (ph). They obviously have their panel (inaudible) the prior (inaudible) for me it is CRT. Did you guys ever submit some of your data from your studies to further expand the label in your devices?

William A. Hawkins III

No, not yet.

Kristen Stewart – Credit Suisse

Okay, thank you.

Operator

Our next question comes from the line of Ben Andrew with William Blair.

Ben Andrew – William Blair

Good morning. Can you talk a little bit more about the spine space? With the recent announcement from some competitors of targeting the kyphoplasty space particularly, what is your strategy there from a competitive standpoint? It sounds like you had some new products coming next year, but from a litigation standpoint, do you see the need to go down that path with multiple competitors seemingly targeting that space in the next several quarters?

William A. Hawkins III

Well, as I said, we first of all are very confident in the strength of our IP and as I said, we'll vigorously defend and assert our IP against any of those that we have reason to believe are infringing our intellectual property and we have a number of patents which protect that space that we really have, if you will, sort of brought to the market and developed.

From again, as you look at where we are today in regards to some of the competitors that are in the space. I look at the technology that we have and still feel extremely confident that we have market leading technology and many different dimensions, and at the end of the day we know that technology makes a difference, innovation sells. And so we will compete vigorously with the technology, we'll compete with the strength of our distribution, and the strength of our evidence.

Ben Andrew – William Blair

Bill, what's the situation now in Japan? Has the timing there changed for approval in reimbursement?

William A. Hawkins III

No. The timing is we're on track. We believe that we'll have early FY11 we'll be beginning to develop the market in Japan.

Ben Andrew – William Blair

Okay. And then last question on the construct side within spine, you talked about maybe the market slowing due to a reduced opportunity with mix. Do you see the new generation products you're bringing out over the next 5-6 quarters and rolling out offsetting that or are we looking at kind of a new normal with a little bit slower rate of growth sustainably for spine?

William A. Hawkins III

No. I think we believe that we'll be able to offset that with the Solera and with the TSRH-3Dx that we're bringing out and the XVBR that we've recently launched and some of the things that we're doing in the space. So the whole formula here is it's price volume, it's mix, and we look at kind of what's happened in the last quarter or so. We haven't had much benefit from mix. In fact, it's gone the other way and so we think that once we bring out new products and we can demonstrate the value that that will help lift the markets.

Ben Andrew – William Blair

Thank you.

Operator

Our next question comes from the line of Bruce Nudell with UBS.

Bruce Nudell - UBS

Good morning, thanks. I have a spine question and then a reform question. Bill, it looks to us like the US fusion market has about 5% procedure growth, maybe 5.5%, and the market's clearly been low-double digits for a long time, but reimbursement's great. So is there anything structurally that is going on now where that ASP inflation contribution could go down to the low-single digits or do you expect that you'd be able to maintain mid-single digit ASP with innovation?

William A. Hawkins III

Yeah, Bruce. I tried to answer this. I do think that we're — I don't see anything structurally changed. I don't see anything that would suggest the fundamentals are any different. In fact, if anything it's the other way. It means the prevalence of the general cyst disease and deformity and trauma is only increasing. And so we remain very bullish on the overall spine market. I do think, and again it's hard to quantify, but I do think what we have seen in the last maybe six months to a year with the impact of the economy and with the increasing unemployment rate, it has had, I think, a bit of an impact across the board and perhaps that's part of what we're seeing, but I think that will ultimately resolve itself.

Gary L. Ellis

Bruce, just to add to Bill's comments the only thing I would say is the reason we think that the fundamentals are so strong is we know that we're still just touching — we haven't got full penetration in these markets, not only in the US, but even internationally as far as people with back pain. And as we continue to develop products that are minimally invasive and helping people really deal with that back pain and moving up that continuum of care, that's where we continue to see this market growth potential. So it's not just the Evo (ph) non-discussion side, it's clearly even just broader than that, but we still see tremendous opportunities for this as these procedures continue to increase.

Bruce Nudell - UBS

And then, Bill, I noticed in the President's language yesterday that the change in the definition of the med-tech tax, it's delayed until 2013 in his proposal, but it's also an excise tax. And when you buy a car you have these federal local taxes and nobody gripes about them and you don't try to negotiate the federal tax down. Is the change of the presentation of that fee going to be helpful in terms of the industry being able to pass that along to hospitals?

William A. Hawkins III

I don't know, Bruce. I think you know our position. I mean, all along we have been really questioning why you would tax an industry that has so much to offer in terms of just economic growth if nothing else, and just the contributions that we are making to overall health care. But the language was better. I mean, the fact that it's pushed out to 2013, the fact that it's an excise tax, and it's tax deductible — I mean, it's better. But the idea that we could pass it on, again, we sell through hospitals, it's not obvious that we could pass this on.

Bruce Nudell - UBS

Thanks so much.

Operator

The next question comes from the line of Tao Levy with Deutsche Bank.

Tao Levy - Deutsche Bank

Hi, good morning. I was wondering if maybe you could comment a little bit more on the slowdown that we're seeing in the US pacemaker market. I know you mentioned you had some field action stuff, but also the whole market seems to have really slowed down this past quarter. Is there anything specific going on there?

William A. Hawkins III

No, I don't think so. I mean, I did mention that we're seeing a little bit more ASP pressure, but we're with the introduction of MRI pacemakers in the not too distant future. I think that will help to kind of reaccelerate the growth a bit in the overall market, but there's nothing that would suggest that there's a declining demand for pacemakers. I mean, the fact is that with the changing of the demographics and the aging of the population, the fundamentals here are still very solid and so we've seen a little bit of the impact of price, I think, which has weighed in on the market, but that, we believe will change as we continue to innovate.

Tao Levy - Deutsche Bank

And if you look at Physio-Control, with the FDA news last week and let's say this quarter's performance, how much was Q3 limited by what was going on at the FDA? And as we go forward should we expect significant increases from these levels or you don't think it really had too much of a headwind on sales? Thanks.

William A. Hawkins III

No, it's had a headwind. It's had a headwind, so it's hard to quantify exactly what that has been, but we've been restricted from shipping certain products and now that restriction is limited so we will clearly see an increase in Q4 and going into next year because of the restrictions being limited.

Gary L. Ellis

Tao, basically the revenue for the last several quarters that when we've been restricted have been kind of at that $90-$100 million range and so Q3 was right in that kind of line. As Bill said, we don't know exactly what we're going to expect as we hit full launch on all the products. We've been very happy with obviously how customers have stuck with us, but we'll have to see how they respond now with our ability to really launch everything. And if you go back prior to that whole activity really happening, we're probably kind of in that more around the $120-$125 million range. So will we be able to get back up to that? We'll have to wait and see as we get back at full market itself.

Tao Levy - Deutsche Bank

Great, thanks. Very helpful.

Operator

Your next question comes from Larry Biegelsen with Wells Fargo.

Larry Biegelsen – Wells Fargo

Good morning. Thanks for taking my call. Excuse me, two questions. First, Bill, maybe on — I know it's early days, but the potential impact of 510(k) reform? Do you still think that 10% of sales as a percent of sales for R&D is a realistic target or could it go higher? And the other implications for a large company like Medtronic which obviously has a lot of resources, is this potentially an advantage for Medtronic? That's my first question.

William A. Hawkins III

Yeah. I mean, there was the meeting this week or last week with the FDA on the whole (inaudible) process, so this is still — there's a lot of discussion going on with the FDA On what's the right way to address some of the concerns that have been expressed and so it's not clear what will be the ultimate outcome. But as it relates to Medtronic, as we've commented before, most of the products that we sell are PMA products. So if there was a change in positing K, it's not really going to impact us necessarily as much as it may others. And yes, your point, it could have an impact on smaller companies and just the appetite for venture financing if the timelines are going to be drawn out? So I do worry about this as it relates to just our country's ability to continue to have leadership and innovation and medical devices.

Larry Biegelsen – Wells Fargo

And back on pacemakers, the MRI safe pacemakers, it sounds like you expect those pacemakers to help you take share in the US and internationally, and on that same subject, the Kappa/Sigma warning letter status, could that potentially impact the approval in the US of the MRI safe pacemaker? And lastly, on the same topic, are you trying to remove the limitation for chest scans for the Advisa outside the US? Thanks.

William A. Hawkins III

Well, when we talk to physicians in regards to what they see in terms of the importance of MRI, I mean to a person they say this is critical. 70% of people who get pacemakers need at some point to have an MRI. So we're obviously very sort of excited and bullish that this will enable us to gain share as we bring forth the Advisa outside the US and when we bring REBO here in the US. So yes, we think this is going to be a very important introduction around the world.

In terms of — there are no restrictions with Advisa outside the US so that's not an issue for us as it relates to chest scans.

Larry Biegelsen – Wells Fargo

And the Kappa/Sigma warning letter, Bill?

William A. Hawkins III

Oh, I'm sorry. Kappa/Sigma, we're waiting of the FDA to come in. We have corrected the things that they identified. We're hopeful that the FDA will be in sooner rather than later and this won't be an issue.

Larry Biegelsen – Wells Fargo

Thank you.

William A. Hawkins III

Okay, we'll take two more questions.

Operator

Your next question comes from Rick Wise with Leerink Swan.

Danielle Dubin - Leerink Swann

Good morning, everyone. This is Danielle in for Rick. First question, broadly speaking, can you talk about now you've made quite a few acquisitions over the last 12-18 months, can you talk about your use of cash and priorities as it relates to future acquisitions, share buybacks, et cetera?

Gary L. Ellis

This is Gary. As we've indicated, we continue to buyback obviously stock and dividends. So 40%-50% of our free cash flow we still are and continue to remain committed to returning that to shareholders in the form of share buyback and dividends. But we also feel that that gives us adequate ability to make acquisitions. And as you said, we have made several over the last 18 months, but they have been smaller sized obviously, more the tuck-in types of acquisitions that we feel have performed very, very well and so we're pleased by that.

And we still have the financial flexibility with the cash we are generating to allow us to make those types of acquisitions of technology and product line. So overall, the strong cash flow this company continues to generate gives us the flexibility, we believe to actually add to our product portfolio through acquisitions and to make sure we're returning the appropriate amount to our shareholders.

Danielle Dubin - Leerink Swann

Okay. And then just following up on the acquisition front, I mean, do you see any maybe white spaces in your business that you'd like to fill on that front?

Gary L. Ellis

Well, obviously we can't comment on that question specifically, but no, as we said, we like our portfolio. We have a very broad diversified portfolio and again, I think that is in part how we've been able to manage through a lot of the turbulence in the economy by having a diversified group of businesses. And we're in most of the spaces that we think are important with the aging of the population and as it relates to chronic disease. So our focus, and you've seen this the last 18 months, has been more on the tuck ins and how do we leverage this global footprint that we have with close to 9,000 people in the field. So our first sort of priority is if we can feed that distribution with more technologies and so that's really where we're focused.

Danielle Dubin - Leerink Swann

Okay, great. And then one more question, Japan, I believe we're coming up on a reimbursement review there for medical devices. How could this impact Medtronic's sales? What's your exposure in Japan across your business and does this change your strategy in Japan? Thanks so much.

Gary L. Ellis

Yeah. I mean just quickly on that, this is an industry. This is not just a Medtronic — and every other year Japan goes through a foreign average pricing review and an R-zone review and we've just completed negotiations there and so we are — it will impact us going into FY11. We'll see an impact in April. It's in that 5%-6% of revenue in Japan.

William A. Hawkins III

Okay, last question.

Operator

Our last question comes from the line of David Roman with Goldman Sachs.

David Roman - Goldman Sachs

Good morning and thank you for taking my question. Just two quick followups, Bill, when you first setup the goal to return the spine business to market growth by FY12, the market was growing in the 10%-12% range and now at least for calendar Q4 it looks like it probably grew more like 7%-8%. Should we think about the 7%-8% number as now the long-term bogey implied and also for your growth rate and then that gets us to the 5% growth for you or should we think about the market accelerating as some of the pressure you talked about abate over the next couple of quarters?

William A. Hawkins III

Well, that is a good question, David. Now, you should think about it in terms of what the market's growing at. And if the market's growing at 7%-8%, what we had said is that we're going to return to market growth and so it's in that 7%-8% growth range versus back up to 11%-12% growth range.

Gary L. Ellis

If we're successful with the new products and the market accelerates then yes, we could see some more, but right now based on, as Bill said, based on where the market is, I wouldn't do anymore than what the current market is indicating at this point.

David Roman - Goldman Sachs

And then if we look at this as sort of 20-ish percent of sales and that' a four point delta in market growth, first of all you expected what — why wouldn't that have an impact on your long-term growth rate or other businesses making up the difference?

William A. Hawkins III

Well, I'm not sure I understand the question. I mean, we haven't really given long-term guidance, but again, this comes back to the overall portfolio. We generated 6% constant currency, 10% as reported growth this quarter with fine sales that were flat to negative. So I mean, this is again, the whole value of having a broad based portfolio. We think CRDM is ticking back up. We believe spine will tick back up.

We continue to feel good about the neuromodulation business, the diabetes business, cardiovascular we had this year which we know was sort of an extraordinary year because of being in Japan with Endeavour and next year that will come down a little bit. But again, when I look at our portfolio with all the puts and takes, we feel very good that we can continue to deliver market-leading performance and maybe that's a good way to kind of summarize the call here because if you look at just again, this quarter again, 6% constant currency is arguably at the very high end of what we'd call the med-tech industry this last quarter and I think it speaks to the strength of our overall portfolio. So that's how we're playing it going forward. We know we've got some challenges with spine.

I'm confident we're doing the right thing to reaccelerate this going forward and so maybe in summary I think it was good quarter for us. We continue to demonstrate our ability to kind of make the tough decisions and to deliver and I think we're well positioned from a portfolio as well as geographically we continue to see opportunities to grow faster outside the US. We are investing disproportionately out there and so I remain optimistic about kind of the outlook going forward.

David Roman - Goldman Sachs

Could I just ask one quick question on gross margin? I think you had the highest gross margins of all the large cat med-tech this quarter, so far those that have reported. Could you just maybe talk about how, I think you told us in the past, you use your scale to offset some of the pricing pressures that are happening in the end-user markets?

Gary L. Ellis

Well, David, this is Gary. I mean, as we talked about, we started a process over two years ago. Now we're in our third year of this process where we saw a couple of years ago that we were going to see increasing pricing pressures and we had a program underway to pick $1 billion in costs of out of our product. And that was when we were still at that point in time, and even two or three years ago, had market leading gross margin. So we're never happy with where we're at and continue to challenge the organization to continue to do better. As a result of that we have taken already out — in the third year we'll have taken out over $600 million, almost $700 million of cost out of our products. That is how we're able to offset pricing pressure. The industry, I would say, is just starting to realize that maybe they need to be addressing that and as a result I think you're seeing gross margin pressures from some of the competition and some people in the industry where Medtronic has already taken the steps to make sure that that's not affecting us at this point.

David Roman - Goldman Sachs

Okay. That's very helpful. Thank you.

William A. Hawkins III

Yeah, thank you. Okay well again, on behalf of the entire management team I want to thank you for your interest in Medtronic, your continued support, and we look forward to seeing you in June in New York. Thank you.

Operator

Ladies and gentlemen, this does conclude today's conference. Thank you for participating. You may now disconnect.

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Source: Medtronic F3Q10 (Qtr End 1/29/10) Earnings Call Transcript
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