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Covidien Ltd. (NYSE:COV)

F2Q10 (Qtr End 03/26/10) Earnings Call

April 21, 2010 8:30 am ET

Executives

Rich Meelia - Chairman, President and CEO

Chuck Dockendorff - EVP and CFO

Cole Lannum - VP of IR

Analysts

Kim - JPMorgan

David Roman - Goldman Sachs

Matthew Dodds - Citigroup

David Lewis - Morgan Stanley

Joanne Wuensch - BMO Capital Markets

Tao Levy - Deutsche Bank

Adam Feinstein - Barclays Capital

Tom Gunderson - Piper Jaffray

Kristen Stewart - Credit Suisse

Michael Matson - Wells Fargo Securities

Bob Hopkins - Banc of America

Larry Keusch - Morgan Keegan

Jason Bedford - Raymond James

Anthony Petrone – Jefferies

Operator

Welcome to the second quarter 2010 Covidien PLC Earnings Call. (Operator Instructions). I would turn the call over to your host for today, Cole Lannum, Vice President, Investor Relations. Please proceed.

Cole Lannum

Thanks, Nikita 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 second quarter results was issued earlier this morning and is available on our website and on the news wires.

During today’s call, we’ll make some forward-looking statements and it's possible that actual results could differ materially from our current expectations. 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 relation section of our website, covidien.com.

For the second quarter, we reported GAAP diluted earnings per share of $0.85. After adjusting for certain one-time items, our non-GAAP earnings for the second quarter came in at $0.88 per share.

Now, I will turn it over to Rich who will go into more detail on the second quarter results. Rich?

Rich Meelia

Thank you Cole. Overall, we had a very good second quarter from a margin and profitability perspective, delivering a 15% increase in adjusted operating income and a 22% gain in adjusted EPS.

We introduced a number of key new products and continue to make the investments necessary to deliver sustained, profitable growth. These results reflect the success of the company’s strategy to focus on growth and innovation. We were however disappointed with our top line performance in the quarter particularly in the pharmaceuticals and medical supply segments.

As we noted on our last call, business was surprisingly strong in the first quarter. That said Influenza registered an abrupt decline at the beginning of 2010 and as a result we saw a sharp drop off in related sales. As you may recall, last quarter we estimated that one-time factors primarily related to flu added about 1 to 1.5 percentage points of growth to the first quarter. In retrospect we might have underestimated the total flu impact and we believe that some of the growth reversed in the second quarter.

In addition, while we do not real-time procedure or market data anecdotal evidence indicates that procedures were relatively flat in the first couple of months of the quarter. This was consistent with our sales results, which were much weaker during the first two months. We rebounded somewhat in March and are continuing to see an increase this month as well.

Finally, the restraints we’ve seen through the last 18 months or so on capital equipment spending continued in the second quarter, impacting energy hardware and imaging delivery systems.

Looking at a couple of parts of the business in more detail, in medical devices we again registered strong increases for vessel sealing, cryosurgery and a good performance by the recently acquired VNUS and Bacchus business.

In the Respiratory category, we’re having other solid quarter for ventilators and benefited from the Aspect acquisition, which is meeting all our expectations.

We reported slower growth in our Endomechanical and soft tissue repair product lines, where we face some additional competitive pressures in the quarter and lost some market share in both product lines.

In the Pharmaceutical segment we are very pleased with the significant progress we made in radio pharmaceuticals. As you know that business has struggled for quite sometime as a result of operational challenges including continue disruptions to the supply chain.

While, patients are still experiencing intermittent shortages, I’m pleased to say that we have made significant progress maximizing supply and addressing the businesses unacceptable level of profitability. So thus we launched a broad based educational effort to highlight opportunities for providing imaging solutions to patients using alternatives, such as thallium where appropriate.

By moving patients to thallium, we can help address the general shortage of imaging agents as well as free up technetium for those patients, who truly need it. Second, we have significantly increased our own Moly supply working with the various worldwide providers to maximize the limited availability of this critical raw material.

Consequently for fiscal 2010, we now believe we will show significant increases in both generator and thallium sales versus 2009. The current shutdown of both, the Petten and Chalk River reactors are still affecting overall capacity for the industry. Demand will continue to outpace supply until one or both of these plants return to operation.

There will still be times over the next few months, where we will not be able to supply everything our customers need. That said, the planning we have done has already made a significant difference in the amount of Moly available, the number of imaging procedure performed and the number of patients served.

Finally, we have significantly progressed in our goals to return this business to acceptable profitability. While we no longer report imaging as a separate segment, the profitability improvements we have made in radiopharmaceuticals will certainly be a benefit to overall Pharmaceuticals segment profitability in 2010.

Turning to the rest of the segment, you know we reported a very significant sales decline in specialty pharmaceuticals this quarter, as both branded and generic sales were well below last year. The decline in branded products was largely attributable to RESTORIL, while the generic shortfall was due to increased competitive activity, difficult comparisons with the prior year and to a lesser extent distributor order timing.

In Medical Supplies as I noted, sales were below our expectations, the decline was broad-base as each of the four product lines were below a year ago. The sale decrease was due to difficult year-over-year comparisons, lack of flu related sales and some distributor inventory contraction.

We continue to be very excited about our new product line-up for 2010. Last week, we showcased a number of new surgical and energy product at SAGES, which were very well received by the surgeons and attendants. Product such as ENDO GIA, with Tri-Staple Technology, the new SILS Hand Instruments and LigaSure 5 mm are examples of the innovation we are delivering from the increased R&D spending over the last couple of years. We also continue to make strategic investments in growth initiatives, which is enabled us to deliver sustainable, long-term top-line growth.

In Pharmaceuticals, we introduced a generic version of Actiq late in the second quarter and are scheduled to launch PENNSAID and EXALGO in the next couple of weeks. 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. These new products as well as the continued growth of our higher margin offerings increased my confidence that our growth is sustainable.

We look to make continued progress in margins as we improve our product mix, deliver manufacturing cost reductions and leverage the investment spending over the last few years.

We will continue our portfolio management activities providing incremental investment to large fast-growing product lines, while pruning those businesses that do not fit our growth and margin profile.

In addition, we look to broaden our product offerings through acquisition or licensing agreements and to expand into adjacent categories as we have been doing in the past. We will use our strong cash flow to make the investments that should allow us to drive sales and profitable growth.

Overall, our first half results are on plan from a sales perspective, somewhat ahead from a margin and profit perspective and we will remain optimistic about our prospects for 2010 and beyond.

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

Chuck Dockendorff

Thanks, Rich. I will focus the majority of my comments on the items below the sales line and then discuss our revised 2010 sales guidance. Our strong improvement in adjusted gross margin this quarter 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. Also, the shut down of Petten will require us to pay more for Moly and foreign exchange becomes less positive. We are confident that we will continue to drive favorable mix and launch innovative new products across our business, which should help offset these margin drains.

Second quarter SG&A was up significantly versus a year ago, primarily due to additional expenses from recent acquisitions combined with unfavorable exchange rates on our costs. As we noted previously, continued spending for the growth initiatives, expenses related to the launch of PENNSAID and EXALGO, the impact of acquisitions and a less favorable currency impact, all put up with pressure on SG&A this year. R&D was on plan and we remain committed to our goal to increase research and development to 5% to 6% of sales over the next few years.

Looking below operating income, net interest expense was about even with a year ago, as planned we continue to make progress lowering our tax rate, as our year to date adjusted rate, was about 450 basis points below the year ago level.

Next, let me take you through some tax flow highlights, we again generated a strong cash flow on the quarter and continue to expect that free cash flow will exceed $1.5 billion this year.

We also bought back about 0.5 million shares in the quarter. Since the inception, of the original buy back program; we bought back about seven million shares at an average price of $39.

Finally, I would 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. We are revising our sales guidance reflecting the strengthening of the dollar, the launch of EXALGO, the sale of the new US nuclear pharmacies, as well as the softness we are seeing in several product lines, particularly in medical supplies and portions of the pharmaceutical segments.

At current exchange rates, we now expect total company sales for 2010 to be up 5% to 8% versus 2009. By segment, at current rates, we now expect sales of medical devices to be in the range of up 9% to 12%. For pharmaceuticals and for medical supplies we anticipate sales will be about flat with 2009.

As we noted in the release we are not changing our guidance for operating margin, tax rate or free cash flow, all three remain at the levels announced last quarter. As you may recall, last November, we estimated that foreign exchange rates at that time would provide a benefit to earnings of about $0.14 to $0.16 per share in fiscal 2010. As you know that dollar has trended significantly higher since than and I know a lot of you are have expressed concern and how this might affect our profitability.

The recent move in the dollar however, is far less significant to-date than what we saw owing to financial crisis in late calendar 2008. Therefore, while the movement in currency will certainly put pressure to our earlier expectations we believe that significant profitability gains we have been able to achieve will allow us to offset a majority of the currency impact on the EPS line.

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

Cole Lannum

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

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Mike Weinstein with JPMorgan. Please proceed.

Kim - JPMorgan

This is Kim here for Mike. So the first question is, may be we could talk a little bit more about some of the segments within medical devices that were may be a little bit weaker than what we had in our model. I think you commented that in Endomechanical and Soft Tissue that you may have lost little bit of share. I think that you thought procedures were roughly flattish in the January, February timeframe.

Can you flush that out a little bit, you know, what's going on in the procedure market, who you think you are losing share to and then I guess how that trends going forward here in light of a good meeting at SAGES?

Rich Meelia

Sure. In medical devices, we saw some sockets in the Endomechanical space and this is a area where we have been growing faster in the market now for a number of quarters, and I think our competitor, J&J was very aggressive in the quarter, especially in light of the launches that we had at SAGES, try stay growing it and kind of reemphasizing the dual.

We believe that based upon initial orders that we're beginning to receive and the very and the heightened excitement regarding these products at SAGES that we'll be able to increase the growth rate that we've seen in Endomechanical line over the last several quarters, so you can't consistently take share against the larger competitors.

This kind of activity is not a big surprise if it weren't for the very exciting new launches that we've got in the pipeline and in addition SILS, which is a totally different application as you know in the minimum invasive surgery, we'd be a little bit more concerned. So we think we're in good position, we feel very strongly about our growth capability in this area and believe that once we start seeing the sales associated with the launch of these new products, we'll be in good shape.

Kim - JPMorgan

Then maybe just any comment on what's going on in the soft tissue business?

Rich Meelia

That's been another source about market growth and over the last several quarters in some cases two to three times market growth rate. It was a function of launching our absorbable tacking system of [lining and] meshes and our competitor Bard has done a nice job of getting back into the marketplace, and I think now as we project forward, we will see growth more in line with the marketplace and any of our [competitors] likely. Affecting that definitely will be our new products that are introduced by either ourselves or our competitors. So, I think what our models would have that soft tissue repair growing more with the marketplace.

Chuck Dockendorff

Kim, I do want to just clear the mesh side of things, while we didn’t grow multiple times in the market like we have in the last couple of years. We still even this quarter should grow that in line with market growth in mesh per se.

Operator

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

David Roman - Goldman Sachs

I want to just follow-up quickly on Pharma and Medical Supplies, at least in the Medical Supplies segment it appears though the weakness in the quarter was more due to one-time factors, but looking at the guidance it sort of flows through for the rest of the year. Can you just maybe talk a little bit about what’s going on there in more detail? Then n Pharma same thing, it doesn’t look as though the guidance implies any type of recovery in that business in the back half of the year?

Rich Meelia

This is Rich. We are not overly concerned with Medical Supplies. You got two things that are working there. In Medical Supplies the big distributor is account for close to 80% of those sales and we track a very important metric, especially as it relates to compensating our sales force and that’s their tracings to their customers to the hospitals and while our sales to these major distributors did soften considerably in January, February and as I said in our previous remarks, it began to pick up a little bit in March and April. Tracings to their customers, which is the ultimate test of the health of the business. We are actually up, year-over-year, so there clearly was some distributor inventory adjustments for whatever reasons.

Those are companies that make their own decisions about that. So we feel pretty good about that and secondly, we really have had supplies focused on profitability, more so than sales growth and one of the key contributors too have improved overall margins for one of the first time has been. [Surprise] when you will see when the queue comes out that its several hundred basis point improvement in margins in the supplies business and that’s exactly what we have asked them to do there. They are a big growth engine for the company but if we can get that type of profitability improvement out of almost $2 billion segment of fairly commodity supplies like products that management has done a good job with what they are asked to do.

So we really do not have major concerns with supplies based upon what we see.

Chuck Dockendorff

David on pharma, something to keep in mind and you should incorporate this when you are doing your modeling, remember we still plan on closing the sale of the nuclear pharmacies sometime in this quarter and as we noted before, that business runs somewhere between $40 million and $50 million on a quarterly basis of revenues. Those revenues will go away. We have no plans on taking that as discontinued operations or for restating or pro-forma in the last businesses. So that’s one thing to keep in mind on the pharma side of things.

Rich Meelia

Yeah and then just another comment no the pharma business. We did see some softness in generic narcotics. Part of that was, we had a big order from several customers, wholesalers in the first quarter. We saw some softening in the second quarter but we are also seeing some price pressure there as well. So as we speak we have got the launch meeting for Pennsaid and EXALGO and we launched that few weeks back.

So, the game plan there is to utilize this branded pain strategy to provide the growth, to offset really what is inevitable price deterioration in the generic business. So, we are very confident that the commercial launch of these two very important products will begin to provide the growth and then the other piece of good news in there, in that whole segment has been the ability of that team to really improve the performance of the radio pharmaceutical business. It's taken a couple of years but both the growth and the profitability specially in nuclear has been good.

David Roman - Goldman Sachs

Then just a follow up on Chucks comments on currency, is it fair to say that essentially if we don’t see a rapid trend here in the dollar that there are mixed opportunities to offset modest changes in currency and the concerns over a very high drop-through rate wouldn’t be founded in the current sort of FX environment?

Chuck Dockendorff

I think that is fair David I mean I think as you look at it, the dollar has strengthened over this last or six months of the year from where, when we went into the year it began the process and you have seen our operating margin actually come up and be better than what we expected, so we actually raised guidance in the first quarter.

So I think with the mix driving that we have another components that we have drawn from the business, any minor changes in that space will not really impact us significantly going forward. We seem to be able to handle that situation as it changes.

So again, I feel pretty good about the FX component of it and the one issue that is happening this year as you look at the next two quarters the year-over-year comparisons are relatively flat with the prior year, so it's going to be a lesser impact.

Operator

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

Matthew Dodds - Citigroup

Rich, to follow-up on your comments about Endomechanical and they are getting more aggressive there with J&J, can you say what’s going on there? Are they using price as a bundling and then also was that a US or non-US phenomenon?

Rich Meelia

First of all, Matt, it hasn’t been huge. Sometimes it's hard to strip out specific comparisons because Endo-surgery business incorporates several businesses, in which we do not compete, but to the best of our ability to strip it out, we did see some, its maybe 100 basis points kind of thing percent here.

Then we did see slowness on our side in the US so I think it's been mostly the US issue and I can’t say specifically what their overall strategies have been but we do believe that they did launch a new product Echelon product about six months ago and I think what we were planning to do with our Tri-Staple Technology.

So I think they are very aggressive in solidifying some of that business, and what happens as you know, is when you do have proprietary technology, you tend to find your way into accounts that contract in total with one or the other, and so I think they use that Echelon to solidify some of that business that we might have had in their accounts.

Those of you that were at the SAGES meeting, I think saw the real genuine enthusiasm for our customers, for both Duet and Tri-Staple, so we're pretty confident and we can execute the marketplace pretty well, but we think we have the capability to reestablish really good momentum in that Endomechanical space.

Matthew Dodds - Citigroup

One quick follow-up on surgical, can you just say how energy, how hardware did this quarter? Did you see any rebound?

Rich Meelia

Hardware did not have any significant rebound. We're not a great barometer on capital purchases, but with the ForceTriad and the delivery devices we haven't seen anything that would lead us to believe recognizing again that we are not the leading indicators for this, but we have this and I would suggest that the capital budgets have been loosened at the hospital level.

Operator

Our next question comes from the line of David Lewis with Morgan Stanley.

David Lewis - Morgan Stanley

Rich, could you just comment on Medical Supplies, you talked obviously again this morning about restructuring that segment. It sounds as if obviously the entity has done exactly what you expected, which was maybe some pressure and maybe there was some increasing in profitability.

I just wanted to understand through the remainder of the year what should we be expecting sort of limited rebound and that revenue trend line, but improving profitability or another way of asking it is, has the profitability increase be as good as the revenue decrease?

Rich Meelia

I would say that, we did not anticipate our obvious guidance versus what was reported this type of reduction from major wholesalers. So, that clearly was unexpected, but I will tell you that we have been very pleasantly surprised with the degree of profit improving in supplies through two quarters of this year. You will see when we release the Q in a week or so.

Chuck Dockendorff

David you saw that in the last quarter as well, I mean we had big gains of profitability in the last quarter as well.

Cole Lannum

Yes, I think profitability is up, but the actual dollar profits with its supplies is up significantly as well over 15% I believe and so that’s really what's driving the sales up and down.

David Roman - Goldman Sachs

Very helpful and then Rich when we think about the business strategically is what you are seeing in pharmaceuticals or more specifically actually, what you are seeing in supplies, make you more or less inclined to be aggressive on divesting assets or acquiring new assets.

Rich Meelia

I think the strategic basis for what we are doing going forward would be not in supplies, but its in pharma, its in devices, but we have often said that while the overall supply business doesn’t help us from a [optic] standpoint because of the low growth and absolute low margins. We will continue to maximize the value and do strongly believe that the best return to shareholders for us to do that as opposed to engage in some deluded divestitures.

So the portfolio management continue to emphasize growth in those other two segments, med devices and pharma, and maximizing profitability and supply. So supply, it could be little up and down based upon how effectively we are taking out low profitability. They really could have delivered higher sales if we wanted to forego that profitability improvement but their mission is pretty clearly understood by them and us. So that’s where we are headed.

David Roman - Goldman Sachs

Rich, if could I follow up…

Cole Lannum

Sorry, Dave, we are going to the next question.

Operator

Our next question comes from the line of Joanne Wuensch with BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

Thank you very much for taking the question. Can you go back to gross margins, please? The level that you delivered in the quarter is probably about two years ahead of my expectation. How much of that is foreign exchange for the quarter?

Cole Lannum

We don’t want to quantify it specifically. It was a small minor positive.

Joanne Wuensch - BMO Capital Markets

Okay. Minor positive, and how much of that was associated from the supplies? Is there any way to keep this out and then is there any way to think about, since you are two years ahead of my game plan, where you may be going over the next twelve to eighteen months with this?

Chuck Dockendorff

Yes, if you look at the gross margin improvement we have had, it's been 470 basis points up from the prior year quarter but a little higher than what we had in Q1. Then if you look at the drivers of that that we talked about, we have a lot of cost reductions going on as part of the restructuring programs and manufacturing variances that we set out to achieve each year. Then those things will tend to stay there. So once they are in there that will continue forward.

We also have a big component in there around mix and some of the portfolio moves we have made. Those will also stay in there going forward and that was really a majority of the increase you saw year-over-year. There is the smaller component related to FX and as Cole mentioned and this will you know tend to fluctuate as the exchange rates change over the course of the period, but the majority of that improvement are items that should stay in the gross margin level going forward.

Rich Meelia

One thing we feel pretty good about Joanne in the gross margin is the component, although we don't give the actual numbers there, but I would associate with cost reductions as Chuck said has grown dramatically from a year or two ago and we believe its directly correlated to these cost reduction programs as a part of our restructuring effort if you recall on the Tyco, we just did no restructuring, we are not allowed to do it. We have had two very effective restructuring program, and I think our ability to engage in operational excellence program has been well understood and now as Covidien we have been able to now and we've almost completed our third year.

Due to those types of activities and it is just good from our prospective to see the component of gross margin improvement that is coming from our controllable cost reduction efforts has in fact improved in the component that comes from those things you can control as much as like FX, has become a lesser piece.

Operator

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

Tao Levy - Deutsche Bank

Good morning, so at first on the volume trends side, you said you're seeing start up a little bit soft in the quarter and then started to improve in, and it sounds very different to what we heard yesterday from J&J where they talked about a lot of strength on their surgical volume side. So I was just trying to reconcile those two differences?

Rich Meelia

Tao, if you look at all the surveys that come out from some of the hospitals surveys that you approached to and then listen to different competitors, it is not consistent. This is not our data. This is data that we take from an outside suppliers and it's not through the whole quarter, it's through the first part of the quarter and that data showed these are our procedures.

So J&J in some procedures like orthopedics and cardiovascular in which we do not compete and so we are getting data on our procedures and it clearly show that they were down but they went from a 2 to 4% growth that we have been seeing to flat. The data is as good as what we get from our outside suppliers, not internally generated data and I think you do see some inconsistencies, but then again I think the base comparison does different from one company to the next.

Tao Levy - Deutsche Bank

The second question is acquisitions and sort of licensing in new products, what’s the market looking like there for you guys in terms of the opportunities obviously been you know pretty good at identifying targets in the past. Are they asking for higher prices this year versus last year? Is there an appetite to get acquired?

Rich Meelia

It just ebbs and flows of both the supply and the valuation. The valuation tends to be tie to the attractiveness of the segment to particular situation of the company itself. So, I can’t say from a trend standpoint, I mean nothing is ever inexpensive it seems and there are times that we have a pretty full plate and we're not looking at many opportunities. Right now there are some good opportunities that we've identified and we are working on it now.

Operator

Our next question comes from the line of Adam Feinstein with Barclays Capital.

Adam Feinstein - Barclays Capital

Can you just talk a little bit about what you guys are seeing within Pulse Ox and at the same time just you guys brought Aspect back into fall, just curious if you can talk about how that has gone relative to what you thought and the opportunity there.

Rich Meelia

In Pulse Ox, there hasn't been a whole lot of change. I think few years ago, we reorganized that group and kind of focused sales and marketing efforts on just Pulse Ox as opposed to people who were responsible for ventilation and airway products, and so that took us from either losing a lot of share and we would grow quite a bit slower than the market.

Over the last two or three years, where we're now growing slower than the market, but at a much less of a difference in Masimo, and so I don't see any changes relative to that and the Aspect deal, we continue to integrate that business both from the clinical and sales and marketing standpoint, but if you were to look at the key parameters, which we measure sales growth profitability, it's hitting basically on all our [cylinders].

Adam Feinstein - Barclays Capital

Just a quick follow-up, you had mentioned in your comments earlier about cost, in terms of your input cost going up, I just want to see if you can get some more detail there obviously Moly you've talked about, but are there commodity costs going up that we need to think about here.

Rich Meelia

It just typical, I mean as the economy begins to rebound, you begin to see upward pressure on some of the commodity cost that we buy related to oil and resins that have an impact in the oil prices, other things that go into our products.

So it just an upward pressure that we are beginning to see out there in marketplace and it does take a while for this to get into our products as we negotiate new contracts and we try to offset these going forward as well with other cost reduction programs and new purchasing initiative that we have out there, but it’s nothing here that we look at as a significant impact or large increase that we see imminent in the next couple of months.

Cole Lannum

It also important to highlight that some of that comes from copying as well because last couple of quarter we copy against relatively high input costs and added a bit further so that those comps are just a little bit tough as we grow along.

Operator

Our next question comes from the line of Tom Gunderson with Piper Jaffray.

Tom Gunderson - Piper Jaffray

Could you help to lineate a little bit on the sequence of pre-launch expense you've had on Pharma and Pharma being flat for the year, but the launch is coming up of PENNSAID and EXALGO in the next couple of weeks as you’ve said. All drug seem to be a little different, but is there a lot of detailing that’s going to happen in May and June and we start to see significant revenues towards the final quarter or is it faster or slower than that?

Chuck Dockendorff

Let me take you through a couple of things, Tom. First of all, we have, for intents and purposes completed the significant sales force expansion that we had planned there. So all the folks are on the ground and as Rich mentioned earlier, we are actually going through the launch meetings as we speak. A lot of the other spending that’s variable in nature has to do with upfront cost around advertising promotion but also things like sampling that have to go in the channel in the short term. So you have seen a little bit of that in the second quarter. You'll see a lot more in the third and fourth quarters.

Then from a ramping standpoint, some of that depends on how quickly we can get the message out there. It's important to realize we are not a Pfizer or Merck or GlaxoSmithKline from a sales force standpoint. Ours is relatively small but these are two very important branded launches for us. We have a lot of thought and work in the planning around this and speaking quarterly, where we will see those revenues, it is going to be a pretty tough thing to do. We have some ideas around it.

So I think what I would take away from this new model things, there is going to be a question mark around that. So we will get more of it in the third quarter versus the fourth quarter. Don’t know yet. Certainly, I think some of the underlying weakness in the base generics means that if we don’t do, if we are not out of the box very, very quickly, you might see another quarter or so of weakness in that pharmaceutical line and we try to take that into account where we adjusted the overall guidance for that business.

Tom Gunderson - Piper Jaffray

Thanks, and then, just a quick question on procedures on the outside market research you did. I am trying to look at how the economy may be coming back a little bit. Was there anything in the surveys you did that told you better or worse on bariatric surgery?

Rich Meelia

We believe that definitely there was softness in bariatric and we definitely and as does the survey we believe that is tied to the economy. So, as that comes back you should see some improvement there but as we have stated I think in the past Tom, the number of bariatric patients who come forward to the surgery versus those that are eligible still like 1%. So it's a highly under-penetrated market and the key there is the economy and the economy is just a few identify and convince these people to value of the actual procedure.

Operator

The next question comes from the line of Kristen Stewart with Credit Suisse. Please proceed.

Kristen Stewart - Credit Suisse

Thanks for taking the question. Just on price I know that obviously you talked about procedure, variability this quarter relative to what you have been seeing in the past. I was just wondering are you seeing any changes in the pricing environment within either medical or supplies and are you still able to pass through some of the increases in prices within the radio pharmaceutical business?

Rich Meelia

In terms of rather than give anecdotal comments about what you hear about that just relative to our own overall price volume results here for the quarter, price is virtually neutral. Slightly down but hardly at all so I think we would have to describe it as neutral and I think it's a reflection of many of the new products whether be in energy or surgical devices where it might cost our customer more money but they are actually finding the value is worth it and so I think that’s why you are seeing that.

In terms of Moly we had to had a lot of price increased, I do not believe that we are at the end of the road there at al. I don’t believe that the environment is going to change for the foreseeable future, I believe both us and our other only competitor in the generator side of things will continue to seek more price in that, not because, just because we can but the fact is, we are very pleased with the ability to bring our operating margins up but they are still below that of the, our overall Covidien and we believe there is room to expect more profitability for such a difficult supply chain. So there will be additional pricing opportunity in radio pharmaceuticals.

Kristen Stewart - Credit Suisse

Then just on operating margins, I know that you don’t disclose that now or come next year, but is that safe to say that all three businesses operating margin expansion in the quarter or do we see a little bit of weakness within pharma just given the dynamic there?

Chuck Dockendorff

Kristen, I think you have to wait in the queue, we don’t want to go in a more detail than that.

Operator

Our next question comes from the line of Michael Matson with Wells Fargo Securities.

Michael Matson - Wells Fargo Securities

I understand that Purdue Pharma is going to be launching a new version of OxyContin and I was wondering what impact this can potentially have on your generic business and EXALGO launch. Then additionally, is Covidien going to be required to run further [bio co-launch] trials to keep its generic oxycodone on the market?

Chuck Dockendorff

Sure. Couple of things about that, so, we currently do not compete that against Purdue's OxyContin. We do sell obviously an oxycodone IR product and to the extent that any manufacturer comes out with another pain product out there that they market, we look at it as another piece of the competitive profile, we take that into account and something like EXALGO, but we think that EXALGO particularly because it's differentiated in a number of different ways, obviously, the most obvious one is the fact that it's not an oxycodone-base product.

I don't think it's going to have a big impact there. On the generic side of things, the generic pain market and the branded pain market really operate in very different ways. I'm not speculating on what maybe going on with Purdue as other new branded products have come out over the last several years, it hasn't had a major effect on what's going on the generic side of things.

As you may know, chronic pain is an unbelievably difficult thing to manage and manage effectively, and so what you often have is physicians trying a number of different products and even having situations where an individual patient has a conditions while taken care of on a given product for a period of time and then starts to fail on it and then they have to move over to another product.

This product switching phenomenon is very, very common, which is one of the reasons why having more products in the market that attack pain in a different way is certainly a good thing for patients, but it's probably good thing for manufacturers as well, because you are going to see this are going backward and forward. I'm sorry what was the second part of your question Mike?

Michael Matson - Wells Fargo Securities

Just given the new OxyContin version, wondering if there would be any requirement for additional bioequivalence trials to keep their generic oxycodone on the market?

Rich Meelia

To my knowledge, there is nothing that Purdue has right now. The FDA has given us an indication on that would affect our generic Oxy-IR.

Michael Matson - Wells Fargo Securities

Then just second question would be on the Sleep Apnea business. Can you give us an update on where things stand there with your attempted selling that and just what the plans are?

Rich Meelia

Sure, just to review here one, we already closed sale of our Sleep Diagnostics business. We did that last calendar year. We're still in the process of closing our Sleep Therapy business. That has taken a little longer than we originally anticipated, but it is absolutely progressing. At this point, we think that we will close it some time this current quarter.

Operator

The next question comes from the line of Bob Hopkins of Banc of America.

Bob Hopkins - Banc of America

Two questions, one just on overall guidance and then the second one on Pharma. First on the overall guidance, obviously the major change here is just the tweak downward in terms of the top-line expectation, but despite that the range you gave does translate into a bottom-line that’s at the midpoint very close to where consensus is 340.

I know you don’t give EPS guidance specifically, but my question is at this point in the year, given the strong gross margin that you saw this quarter, I would think you would be confident with at least the midpoint of that operating margin guidance range that you gave if not a little bit stronger. Now just curious if you think that’s a fair statement?

Rich Meelia

I think unfortunately Bob, we are going to have to differ on that. We don’t want to comment on specific EPS numbers. What I would say though is doing the same while we think we are going to be able to offset most of the FX impact I think it is important to understand FX is not zero from that standpoint. So there are some pressures there, we just think we will be able to offset that but I don’t want to comment on any midpoints.

As we have noted before, we try to keep those ranges to help you understand with much more clarity about what's going on in each individual piece of the business and the P&L. I think it's unwise for anyone to ever assume that our intention is that any of those numbers should be mid-pointed in between the top and the bottom, just as no one should assume that all of the numbers should end up at the very low end of expectations or that every single one of the numbers would be at the upper end of the expectations.

Most likely, and I think this is borne out by past history, you will see a variety through the line as we actually report the actual numbers and some of them will be higher, some of them will be lower. Our goal is to get all of them within those numbers, but we've never intended anyone to assume to just take the midpoint of all those numbers and assumer we [blessed] that number, good or bad.

Chuck Dockendorff

This is Chuck. If you look at look at year-to-date, we are at 21.8% and 22.1% in the quarter, so we are at the high range of those guidance numbers.

Bob Hopkins - Banc of America

That’s helpful. Then just to follow-up on Pharma, Obviously you have got a couple of launches upcoming here in the next couple of weeks and I am just curious, embedded in this guidance, the contribution that you assume from those products, I think we have dialed in roughly the $40 million to $50 million range contribution from those.

My question is, can you give us any sense as to what you are assuming? Do you assume a more moderate launch than what I am assuming, or just any help there in terms of what you are assuming in the back half of those launches would be great?

Chuck Dockendorff

The Actiq is out and I think we have said that’s a $30 million to $40 million peak sale coming on but it's going to take a little time to get to that but less so then the branded. Then the Pennsaid and EXALGO have peak sales I think.

Chuck Dockendorff

We said Pennsaid were in the $50 million and $100 million range, EXALGO the $200 million to $300 million range, of course there would be several years out. I wouldn’t expect either of the products to be very, very significant in the second half of the year. EXALGO probably be a little bit bigger than Pennsaid but I think at this point we don’t want to quantify how much that will be.

Rob Hopkins - Bank of America

Okay, but would you say I am way off at 40 to 50?

Chuck Dockendorff

40 to 50 for all three products or..?

Rob Hopkins - Bank of America

Exactly, for all three.

Chuck Dockendorff

I would say that’s as a good of a guess as any.

Operator

Our next question comes from the line of Larry Keusch with Morgan Keegan.

Larry Keusch - Morgan Keegan

Good morning. First question just sort of FX related for Chuck. The other income was substantially higher I guess versus the $8 million in the first quarter. So, I am wondering how much of that is FX related and along with the FX question the $0.14 to $0.16 that you alluded to earlier in your comments. So where do you think that kind of shakes out now given where FX is?

Chuck Dockendorff

First of all in the other income there isn’t any FX in there really to speak of. That mostly has to do with relations with tax sharing agreement we have and some of the adjustments we make in tax and what flows through there and that’s the major change within that component of it.

Related to the $0.14 to $0.16 we talked about that at the beginning of the year and that was when exchange rates were much different and then and in my comments clearly it is less than that. Now, we don’t really want to give guidance to the specific components within there but it has come down since that point in time and like we said I think the important factor to know within FX when you look at it year-over-year is that as we get in to the next two quarters based on today’s rates, the year-over-year comps are much less than what they were in the first two quarters.

Cole Lannum

I just want a clarify on the other income line, I want to make sure that everyone saw this, $13 million of that was a one-time gain that we pulled out for non-GAAP purposes. So, the ordinary operating adjusted that you just look at, was about $8 million.

Larry Keusch - Morgan Keegan

Then, again may be this is for Cole, I’m just wondering if you guys have any updated thoughts on where we stand with Petten and Chalk River. I guess we have been thing Petten could be perhaps in August, September, turn on, if they hold true to their time lines and I guess they have indicate may be it’s a month longer than they initially thought, but just your latest thoughts on where those two reactors sit right now?

Cole Lannum

Sure. Petten will lie to closer too and Petten, they have always fairly close on their timelines. Again we still think it is late August early September kind of timeframe. Although our latest information shows a bit that time is going to change. Although do understand this is a fairly complicated engineering feat but they are trying to go through.

Then there is always the possibility if they do it that they could get something done more quickly or could take a little more time than they expect but really no change there. Chalk River is been a situation where you know obviously that, that is going much more slowly than now people expected. I believe they pushed that out now until the July timeframe but what's important to note that, that has been pushed out at least half a dozen times over the last year.

I think the important thing to keep in mind with Chalk River is that, this alludes to some of things that Rich alluded to earlier. We definitely do want to give you impression to everyone out there that we've done a lot of really wonderful things in the logistical standpoint of manufacturing and the supply chain on Moly.

One of the things that for example bring the [polish] plant into production has done, is that it has lessened our overall reliance on Chalk River, and that doesn't help the overall patient situation, because there's still not enough product out there for overall patients, but we are able to manufacture much closer to our capacity if we have pent up without relying so much on Chalk River. So that helps us at least give us much product as we can possibly give to the customers.

Operator

Our next question comes from the line of Jason Bedford with Raymond James.

Jason Bedford - Raymond James

Good morning and thanks for taking the question. Just on the revenue guidance, how much of the revenues was FX-related versus core business?

Chuck Dockendorff

If you look at when we last gave guidance, the change in FX, in that component and it is a balance of all the currencies around the world. It was down about 1%.

Cole Lannum

The vast majority of it is currency, but I think it's important to understand, supply is and to a lesser extent pharma, it certainly came in a little bit weaker than expected. So there's some operational in that as well.

Jason Bedford - Raymond James

Then just on the cost side of things. SG&A is still growing much faster than sales here, and I realize you've got some launch cost over the next couple of quarters, but when do we start to see that trend reverse and start seeing some leverage of the SG&A line?

Chuck Dockendorff

I think if you look at the SG&A, it is up substantially over the prior year quarter and we talked about some of the components of that. The big piece of that is FX. It really is the biggest driver within that component when you look at the increase.

In addition to that we have got acquisition that we made in the year on VNUS and Aspect, so that driving the SG&A up as well and then inflation and other investments we're making out of smaller component within there. We talked about the SG&A line and leveraging that going forward and that’s a critical component of it.

I think it’s important that you go back to our overall guidance, which is really to drive the mid single-digits sales growth and double-digit earnings growth. When you look at the SG&A component and the SG&A related to our existing business, we are actually beginning to leverage that, which driving up lot of those costs and we will be going forward is somewhat around the acquisitions and some of the growth investments that we have made, but when you look at the components and the sales and marketing levels that we have around our base business and G&A, which is about third of that. Our G&A cost are actually beginning to come down as we consolidate some of the back-office systems and increase our shared-service component reductions within the cost component.

Cole Lannum

Operator, it's coming up on the bottom of the hour. We would like to go with two more questions and then we are going to have to wrap it up please.

Operator

Our next question comes from the line of Anthony [Petrone] with Jefferies.

Anthony Petrone - Jefferies

Anthony Petrone for Peter Bye. I have two questions, one is one gross margin. You covered it extensively here, just wondering what impact if that any was from portfolio reconstruction. I know you divested some lower margin products. How much of an impact was that in the quarter specifically if you can break that out?

Chuck Dockendorff

Again we don’t really want to breakout the specific components around it, but it did have a positive impact to the gross margin percentage within the quarter and portfolio moves that we are making and that’s exiting the low margin businesses, both in supplies and also some of the Sleep business that we have been in.

Anthony Petrone - Jefferies

Secondly on Moly, I know over in Poland you had a letter out recently where your capacity there should be increasing overall putting you in, I would imagine, a somewhat better position in terms of Moly supply. Do you envision any customer attrition away from the competitor in the marketplace from this? Are you seeing any of that as a result of a dislocation that we have seen here?

Rich Meelia

Yes, I would say that and if you go back and forth over the last five years or so, there has been so much volatility. Customers are going back and forth all the time. It's almost ludicrous to say that that’s a Covidien customer, that’s a [Olympus] customer because people are just fine whenever they can safely get the supply from. So as we solidify our position from a supply standpoint, we will take more business. There is no question.

Cole Lannum

Yes, I want to make it clear you understand this Anthony. Right now, there is case where the demand is far outstripping the supply period. Every single product that we can manufacture, we can sell. From the patient standpoint, there is still a lot of efficiency that we are trying to work through the pharmacies to try to maximize the absolute everything that’s out there.

Operator

Our final question will come from the line of Rick Wise with Leerink Swann.

Unidentified analyst

Yes, hi guys, its (inaudible) actually for Rick, today. Maybe if I could follow-up on Pharma. There is a lot of puts and takes it seems in the quarter and I am just wondering at this point, how big is RESTORIL at this point and what are the expectations for your base business for the next few quarters, given that we are coming off of a quite low point here, perhaps excluding the new products?

Cole Lannum

Sure. RESTORIL has been a $40 million to $50 million a year product. So think of it $10 million plus per quarter and in this current second quarter, it was quickly going towards year-end from a competitive standpoint. On the second question, on the base business, maybe to clarify a little, I just want to make sure I understand what you are asking there, could you clarify…?

Unidentified Analyst

Yes, your base business excluding, it did about a $100 million in specialty pharma this quarter, just wondering are your expectations this is going to be stable at these levels going forward or is it supposed to improve for reasons that perhaps we don't fully appreciate?

Cole Lannum

Yeah,, I don't want a particular or specific dollar number. As you can see, look in the past that does move around from time to time due to some seasonality around flu season for example, some benefits or issues we have around getting quota from the government for manufacturing narcotics. I think the thing that I will take away from it is, it was particularly weak in the quarter, we did get some competitive issues there and sure we did not get some big benefits from savings although that's we're expecting. Then I think you are going to see another couple of quarters of very tough comps in that base pharma business.

Unidentified Analyst

Maybe a big picture question, you just reported about 1% sales growth and your target is something in the mid single-digits. As we look over the next couple of quarters here, can you maybe help us understand some of the items that are perhaps more stable, the items that we saw in the quarter is perhaps more stable as some of things that you expect will improve?

Rich Meelia

Yeah, I think the device business was at 5%. That was not a major problem. We get some things that we think will improve that especially in the surgical devices side as well as energy with the LigaSure 5 line, so we think that will continue get better. I think we saw inventory reduction at our major distributor level, I think that will come back as well.

Then the key to Pharma is that these new products begin to create the momentum necessary to offset, I think what is some of the avoidable deterioration overtime in the generic side of things. So how well we're executing some of these things will determine our ability to get that kind of sales growth and we are very confident that these things are quite doable.

Cole Lannum

Ladies and gentlemen, starting at noon Eastern Time today a replay of the call will be available. Additionally, the replay will be available on our corporate website covidien.com a few hours from now.

For members of the media who have listened to the call and have additional questions, please contact Eric Kraus, our Head of Corporate Communications, and then for analysts having more detailed questions involving non-material information, Brian and I will be available to take your calls throughout the day. Thanks and have a great day.

Operator

This concludes the presentation. You may now disconnect. Good day.

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Source: Covidien Ltd. F2Q10 (Qtr End 03/26/10) Earnings Call Transcript
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